SEC: always playing catch-up
1998
Long Term Capital Management, a hedge fund that had managed more than $100 billion in assets, teeters on the brink of collapse after suffering catastrophic losses in the bond market. Fearing that the failure of the enormous fund will set off a system crisis, the Federal Reserve orchestrates a $3.5 billion bailout by private investors.
After studying the near-collapse of LTCM, a White House task force recommends stronger disclosure requirements for hedge funds, but stops short of recommending more federal oversight for the largely unregulated firms. The Washington Post reports that Treasury officials on the task force “favored regulating hedge funds, but [SEC Chairman] Arthur Levitt and [Federal Reserve Chairman] Alan Greenspan were staunchly opposed.”[35]
In October of 1999, a GAO report on LTCM identifies the lack of regulation of hedge funds as a significant factor in the LTCM crisis. The report finds that the SEC lacked the statutory authority necessary to evaluate the financial stability of LTCM or the systemic risks posed by the fund’s market positions.[36]
U.S. General Accounting Office. Long-Term Capital Management — Regulators Need to Focus Greater Attention on Systemic Risk, GGD-00-3. Washington, DC: General Accounting Office, 1999.
Kathleen Day, “White House to Urge New Rules for Hedge Funds,” Washington Post, 29 April 1999.
2001
Enron collapses (see discussion in the box below).
2002
In response to the accounting scandals at Enron and WorldCom, Congress passes the Sarbanes-Oxley Act, a major piece of financial-reform legislation. The law includes sweeping changes to the regulation of corporate accounting, including a ban on auditors performing a dual role.[37] Industry groups and executives criticize Sarbanes-Oxley as onerous and unnecessarily costly to business.
Mike Allen, “Bush Signs Corporate Reforms Into Law,” Washington Post, July 31, 2002.
2003
The SEC staff issues a report on the rapid growth of hedge funds. The report warns that, “The Commission is impeded in its ability to formulate public policy that appropriately protects the interests of the U.S. investing public unless it also has access to accurate and current information about hedge funds and their advisers.” In 2004, responding to the staff report, the SEC adopts rule 203 (b) to the Investment Advisers Act of 1940. The new rule would require most hedge funds to register with the SEC. The hedge fund industry sues the agency and, in June 2006, the rule is struck down in federal court.
Testifying before the Senate Banking Committee later that summer, SEC Chairman Christopher Cox asks for the power to regulate hedge funds (which now manage more than $1 trillion in assets).[38] As reported by Bloomberg, Cox says, “The commission stated, when we adopted the hedge fund rule [Rule 203 (b)], that its then-current program…was inadequate … that is once again the case.”
Kevin G. Hall and Robert A. Rankin, “Do hedge funds need rules to avert trouble?” The News and Observer, 9 August 2007.
2005
After the Senate repeatedly defeats bills to control corporate bankruptcy abuses, Stephen Labaton writes in the New York Times about the increasing congressional hostility to financial regulation. Labaton describes a radically different climate from that which prevailed after Enron and WorldCom, in which “corporate lobbyists…ask for and receive more from lawmakers, who no longer seem to be concerned about recrimination at the polls.”
Regulation stymied…and Enron blows up
In September of 2001, Enron, the Houston-based energy-trading giant, files for bankruptcy. The company’s collapse is followed by revelations that it had engaged in a massive, wide-ranging fraud, deceiving investors about its performance for years. The once-mighty firm leaves behind $67 billion in debts and legions of wiped-out investors. Many of Enron’s employees lose their pensions and their life savings, which they had invested in the company’s now worthless stock.
The size and extent of the fraud raises questions about the state of financial regulation. In particular, the rules governing corporate accounting come under fire, when it is discovered that Arthur Anderson, Enron’s auditor, participated in the fraud. The Big Five firm had maintained extensive consulting contracts with Enron while acting as Enron’s auditor, a common (and legal) practice thought by industry critics to represent a potential conflict of interest.
In 2000, the SEC had proposed a series of rule changes to control conflicts of interest in the accounting industry, including a rule that would have prevented firms from consulting for the same companies at which they were auditors. As reported in the New York Times, Chairman Arthur Levitt said the change was essential because, ”Without confidence in an auditor’s objectivity and fairness, how can an investor know whether to trust the numbers?” The proposal was met with fierce opposition from the industry, notably three of the Big Five firms (Ernst & Young and PricewaterhouseCoopers supported the plan) and the American Institute of Certified Public Accountants.
Robert R. Garland, a managing partner at Deloitte, was quoted in the New York Times at the time: “Given what is at stake, and the fact that there is no demonstrated problem, it would be irresponsible to take on the considerable risks surrounding the proposed rule. There is no evidence that broad scope of services has an adverse effect on audit quality. My own personal experience has caused me to conclude just the opposite.”
After an extensive lobbying campaign by the plan’s opponents — described by the chairman of the SEC as “the fiercest, most vitriolic, political opposition campaign I have ever experienced,” the SEC dropped the outright ban on auditors serving a dual role from its proposal.
What emerges instead, Floyd Norris writes in the New York Times, are new rules that simply restrict the “amount and nature of the work that the auditing firms will be doing for their clients, and will require that the auditing committees of corporate boards consider whether the non-audit services are consistent with maintaining auditor independence.” Firms are still allowed to perform internal audits and consulting work for audit clients — a practice Arthur Anderson continues at Enron.
In the wake of Enron’s collapse, SEC Chairman Harvey Pitt, who has strong ties to the accounting industry, continues to defend the SEC’s rules for auditors. Quoted in the New York Times, Pitt says: “Auditor independence is not the cause of the problems that we are witnessing…This system has enough flaws and enough difficulties in it that cry out for repair.”