The SEC Makes Some News

Yesterday morning, I was privileged to attend a speech by SEC Commissioner Paul Atkins at the NYSE.  After ringing the opening bell, he offered an address entitled “Revitalizing America’s Markets at 250” before a room full of a few hundred invited guests.  Subsequently, the SEC denied a series of requests from issuers to list 3X and 5X leveraged ETFs.  Both were newsworthy, though for very different reasons.  Here are my views on them (which are not necessarily those of my employer).

After sharing a bit of economic history about the role that lower Manhattan has played in our nation’s development and then offering context about the Securities Act of 1933 that created the SEC, Commissioner Atkins laid out an agenda for easing regulatory burdens upon public companies.  He stated:

One of my priorities as Chairman is to reform the SEC’s disclosure rules with two goals in mind. First, the SEC must root its disclosure requirements in the concept of financial materiality. Second, these requirements must scale with a company’s size and maturity.

Underlying those goals is a desire to make it easier for companies to go public by shrinking the amount of boilerplate disclosure that all public companies must file as part of proxy statements and the like.  The venue was particularly appropriate, since the NYSE (and Nasdaq) benefits from more companies coming to market and would rather have more IPOs to facilitate public participation in the capital raising process.  I certainly share that view. 

The difficult part about any change to regulation, however, is that there can be unintended consequences.  Much of the current disclosure that the Commissioner views as onerous began with good intentions before moving away from a high standard of materiality.  Yet it can be tricky to determine what might be material for all investors.  Sometimes there are key elements about a company’s health buried in a footnote.  Efficiency should not come at the expense of transparency.

As his talk progressed, I jotted a few hypothetical questions that I would have asked if there was a Q&A session.  (For those who saw me typing on my phone during the speech, this is why – I wasn’t texting or sending emails.)  They included:

• The U.S. Government has been taking stakes in companies this year.  How does that fit in with the desire for free markets that are lightly but intelligently regulated?
• Referencing the ’33 Act’s genesis from a need to curb the abuses of the late 1920’s that contributed to 1929 Crash, do you anticipate cryptocurrency regulation that echoes that spirit?  [My primary thought is in regard to excessive margin, but there are other aspects too]
• While it is understandable why smaller companies would find copious disclosure requirements to be particularly onerous, smaller companies also tend to be more susceptible to the type of trading practices that led to the ’33 Act.  How is the best way to balance that?

Along the lines of excessive leverage, the SEC issued a series of nearly identical, sharply worded letters to nine issuers who were attempting to list a variety of 3X and 5X single-stock and narrow-based ETFs.  In doing so, the SEC noted that, “Rule 18f-4 limits fund leverage risk by requiring that an open-end fund’s Value-at-Risk (VaR) does not exceed 200% of the VaR of a designated reference portfolio.”  The ETF filings were an overt attempt to skirt that rule via a loophole that arose via the government shutdown.  If the SEC doesn’t respond to a filing for a new issue within a certain period of time, that silence can be taken as assent.  Had the shutdown lasted long enough, these ETFs could have sneaked onto the market.  I appreciate the issuers’ chutzpah, but not their motives.

I have never been a fan of leveraged ETFs because I have seen too many investors fail to recognize the underperformance that is inherent in these products.  It is typically well-disclosed (there’s that word again!) in their prospectuses that these products attempt to replicate the daily movements of the underlying product but will likely fail to do so over time.  A recent IBKR Podcast explained this in detail. 

But ETFs that are leveraged greater than 2X would make a mockery of current margin requirements.  Federal Reserve Regulation T, which governs margin requirements, broadly states that brokers can lend a customer up to 50% of the total purchase price of a security.  That roughly corresponds with a 2X ETF.  A 3X ETF would imply an initial investment at the minimum 33% maintenance margin level, while a 5X ETF would imply 20% initial margin. 

I’m all for financial innovation, and I believe that the SEC is as well, but there is a difference between innovation and exploitation.  The Commission wisely recognized that distinction.