Impact of Lengthening SEC Shutdown

Market Risk Seen Rising, Capital Formation Declining 

Financial markets and Wall Street firms face a rising risk as the partial shutdown of the U.S. government leaves key financial agencies running with up to 95 percent of staff on furlough and many operations down, market regulation experts said. The curtailment of activities at the Securities and Exchange Commission was seen adding uncertainty to markets and curbing hopes for a wave of initial public offerings. 

“There are hidden market risks that loom larger the longer federal agencies remain shuttered,” warned Michael Arone, chief investment strategist of State Street Global Advisers in a client note. The SEC plays a large role in certifying the reliability of financial data and material information on companies and in examining the practices of thousands of covered firms. 

Even before the shutdown the agency had been contending with staff shortages and tight budgets that have hampered its ability to perform its oversight role and update its technology. The past two years have been marked by a cyber breach that went undetected for months, serious court reversals that have voided scores of enforcement actions that resulted in nearly $1 billion in lost settlements and high staff turnover that has undermined morale.

The central role the agency plays in overseeing the markets could be the biggest of the buried risks of the agency being sidelined for a prolonged period. The shutdown has hit during the first major market disruption since the financial crisis in 2008. 

Market Volatility Adds to Shutdown Risk

Investor pessimism has grown in recent months and many institutional investors anticipate a bear market to take hold in the year ahead, according to a poll of 500 money managers by consultant Natixis last month that found two-thirds of the money managers expected the end of the bull market this year. The shutdown also has derailed a wave of initial public share issues that had been a source of optimism in what was being heralded as a record year for IPOs.

The SEC's absence at the onset of a bear market was just one of the shutdown risks cited. Analysts said such market downturns can sometimes be orderly affairs in which prices simply erode. Recent history, however, suggests otherwise as volatile trading has returned. 

For the SEC, downturns are times of rising investor complaints and enforcement actions as fraud tends to increase, adding to the SEC’s enforcement case load. Examiners can be called on more often for emergency inspections at firms struggling with losses, and regulators' services are needed more often.

"There could be a bigger impact now than there might have been because of the current volatility in the marketplace," said Ken Joseph, managing director for disputes and regulation at consulting firm Duff & Phelps and a former senior official at the SEC's New York examinations office. "Especially in times of market volatility and generally lower share prices, a vigilant SEC needs to be on duty to fulfill its investor protection and capital formation mission."

Delayed Start for "Year of Unicorns"

The agency's operation plan for the shutdown has included provisions to recall staff for emergencies or special situations needing quick attention. In markets that are extremely volatile, Joseph said, the need grows for "the agency’s resources to monitor for, and respond to, the risks of insider trading, market manipulation, and the unintended consequences of model-driven and high-speed trading are likely severely tested." 

The initial impact thus far has been moderate. A much-noted delay in what many expected to be a "Year of the Unicorns" initial offerings of Tesla, Pinterest and other high-growth Wall Street favorites — has disappointed both investors and the Wall Street firms expecting a windfall of fees for the new issues.

The SEC's routine, non-emergency operations have been put on hold. Among the more significant are the package of investor protection rules highlighted by regulation Best Interest have been delayed. Scheduled examinations have been cancelled, and only emergency inspections will be undertaken.

Loss of Data Hampers Risk Assessment

The ceasing of the SEC's analysis of markets and covered firms' was seen having little impact over the short term but could, over a longer period, could leave firms less able to assess risks in the marketplace. Gaps in data could expose them to counter-party risk and other vulnerabilities. 

The SEC plays a central role in assuring the integrity of the marketplace by monitoring for fraud or inaccuracies. Over time, this could undermine investor confidence. In a wider view, the information-driven market depends on the reliability of data across a wide range of industries such as housing data, corporate earnings and firms' financial positions. 

“Investors may notice a sudden decrease in market information as the shutdown wears on, as several key agencies will cease reporting, said Arone in his comment on the impact of the shutdown. He added that “It’s not just investors who have been left in the dark. Some of the unreleased data normally factors into the Fed’s interest rate plans”.

Crisis Role Limited, but Can Be Important

The data impacted by the shutdown at the SEC and other agencies ranges from crop reports to construction spending, said Arone. The Federal Reserve will be deprived of some data sets that are used to determine interest rates and financial stability.

The SEC plays only a minor role in market stability, but its resources are required when individual firms appear to be facing trouble. Its role is important in identifying problems and preventing them from becoming systemic problems.

When investors began mass liquidation of Third Avenue Focused Fund in December 2015, the markets went through a period of extreme volatility amid fears of a widening credit crisis. The SEC stepped in to manage an orderly liquidation of the fund and the market in time recovered from the credit scare.

SEC Looks Through "Rear View Mirror"

The SEC is often described as the watchdog for investors, or the top cop for Wall Street. Neither description fully describes its role -- the agency has never performed day-to-day oversight that might compare to the Fed role.

“The SEC looks at things through a rear view mirror,” said Evan Stewart, a partner in Cohen & Gresser LLP’s financial services practice. It's primary role, he said, is to examine firms’ behavior and adherence to securities laws and draft new regulations as needed. Nonetheless as time goes on market participants will have a less data to assess overall risk and specific areas of concern.

“If a shutdown lasts more than two months there could be larger structural issues, and collateral damage,” Stewart said. ”If you don’t find a (billion-dollar investment fraudster Bernard) Madoff because nobody can get into the SEC office handling cases, that is problem of pretty mammoth proportions.”

The SEC already has significant legal problems that have posed operational challenges. Legal experts say that a growing backlog in cases for an agency already dealing with recent court reversals that overturned long-time agency practices. A U.S. court ruled that the SEC must adhere to five-year statute of limitations on disgorgement in civil enforcement cases that already cost the agency $800 million in settlements that went past the limit. The agency was scrambling to complete an unknown number of cases before the deadline neared in other pending cases. 

Legal Bottlenecks Seen Growing

Scores of actions were also scheduled to be reheard due to another ruling last year in which the Supreme Court voided SEC administrative law court settlements on constitutional grounds over the appointment of in-house judges and could run up against similar statutory limits in such cases. The agency lost 10 percent of its enforcement staff in budget cutbacks last year that made progress difficult.

The agency has made it a priority to streamline enforcement and examinations to reduce backlogs. Instead the unfinished business faces more delays or potentially decide not to drop some of its pending actions. The shutting down of activity in both areas could be seen undermining the agency's strategic use of such actions to deter fraud and rule violations. The agency continues to monitor for emergency situations and its plan calls for action in cases where investors' assets are at risk.

The SEC has kept its automated filing system in operation throughout the shutdown. The SEC's contingency plan for the shutdown listed three dozen contracts with outside providers that will be unaffected by the shutdown, with critical data security and technical operations outsourced, which will lend continuity. But items that need approval or that require the attention of specialized SEC staff could pose immediate problems and add more delays when the agency returns to full strength. 

Capital Formation in Jeopardy

The SEC also plays a role in reviewing mergers and acquisitions, in concert with the Federal Trade Commission, and similar entanglements could dampen the capital formation that the Trump administration made the centerpiece of its economic programs. 

The assistance the SEC staff provides to firms on filings could be diminished for a prolonged period by staff too hard-pressed to provide the assistance it usually does. Agency staff in audits, financial reports and accounting provide assistance to companies filing earnings reports, share offerings and material disclosures. 

The IARD system for registering investment advisers has accepted filings automatically but staff approvals are required for the registrations to become effective. The work done by a specialized data analysis unit, which has been used increasingly for examinations and enforcements, has also been put on furlough.

Bright Spot: Agency's Preparedness

A bright spot for the agency has been its preparedness for the shutdown. The contingency plan has given clear messages to covered firms and corporate filers on how to handle required filings. The system appears to have worked as normal, ingesting the usual heavy load of data it normally handles. The agency's public affairs office responded to inquiries on the status of its operations pointed to the SEC internet site as the source of information. It has issued no new statements in the New Year.

The contingency plan, in place for more than a year, has communicated clearly what it will not do, making clear the status of its operations. The starting of the key financial results reporting period began on the fourth week of the shutdown as normal, requiring the agency to ingest a massive amount of data critical to investors but the process is largely handled by the firms, who announce results publicly and send the data to the SEC at the same time. 

Impact Could Play Out in Long Term

The impact of the partial shutdown has been muted thus far, in part because of the contingency plans honed by the SEC in a series of series of budget stalemates and threatened shutdowns over the past decade. But new threats from cyber attacks or the reputation of sound U.S. market regulation built over many years.

"The shutdown is definitely a problem for the financial markets and capital formation because our financial markets depend on investor confidence and integrity," said Joseph. " Uncertainty, coupled with volatility and generally declining market prices, does not foster the kind of market environment that instill confidence in many investors.

(By Richard Satran of Thomson Reuters Regulatory Intelligence)

Richard Satran is a financial journalist covering daily and emerging issues for Thomson Reuters Regulatory Intelligence.