Regulatory Entity-Centrism in Financial Services

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Current focus on the entity may hamper effective regulation of the financial sector.

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For many of us, thinking about financial services regulation means thinking about the financial crisis and, more specifically, how best to prevent its recurrence.  Seemingly in tune with those concerns, policymakers, as we know, set about several years ago to reform “financial regulation” in its myriad permutations, encompassing regulation of investment advisers, hedge funds, brokerage firms, banks, and more.

In their reform efforts, policymakers have tended to conclude that more regulation is needed—more extensive requirements, a broader regulatory scope, a reconsideration of regulatory goals.  But the path pursued for each regulatory “category” tends to be rather different from the one chosen for any other.  After all, what does regulatory oversight of hedge funds have in common with regulation of securities brokers or insurance companies?  Such are the assumptions that underlie the Dodd-Frank Act.

And yet, despite what policymakers know or assume about regulatory reform, they consistently overlook a common thread—the “entity-centrism” of financial services regulation.  Because entity-centrism impedes the furtherance of regulatory objectives, eliminating it would be a productive and important step in many regulatory arenas.

What, then, is entity-centrism?  In simplest terms, it is regulation’s unwarranted emphasis on the entity.  Laws and rules are entity-centric when they assume that any particular entity—whether it be a corporation, a partnership, an LLC, or another entity form—is a stand-alone, solitary firm that operates independently of, and isolated from, any other entity.  In other words, regulation is entity-centric when it fails to acknowledge that financial services firms typically comprise multiple entities—parent companies, subsidiaries, and other affiliates—that,  together, function as a cohesive enterprise.

The most basic manifestation of entity-centrism appears in the very definition of the regulatory subject, the “thing” that is required to comply with regulatory obligations.  Almost universally, the subject of regulation is an entity.  For example, the “registrant” in broker-dealer, investment adviser, and mutual fund regulation is the entity providing brokerage services or advisory services or serving as the repository of shareholders’ investment assets.  So far, so good: that approach seems both simple and sensible.

The approach is deficient, however, in that it characteristically fails to accommodate registrants’ affiliates and control persons, whether that “control” exists by virtue of ownership or contract. Recent financial regulatory failures highlight the problems spawned by such regulatory tunnel vision.

Allen Stanford’s Ponzi scheme provides an excellent example of the problems that entity-centrism causes. Mr. Stanford used two entities to carry out his scheme.  The first entity was registered with the Securities and Exchange Commission (SEC) as a broker-dealer and was also a member of the Securities Investor Protection Corporation (SIPC), the organization that, under the authority of the Securities Investor Protection Act (SIPA), provides insurance to brokerage customers in the event of the broker’s insolvency.  The second entity was neither registered as a broker-dealer nor a SIPC member, thanks to its location offshore, out of the reach of U.S. regulators.

Despite victims’ pleas for SIPC to compensate them and the SEC’s efforts to compel that result, entity-centrism prevents it.  The Stanford entity that was a SIPC member was not the entity responsible for customers’ losses.  The responsible entity was  the offshore entity, which, again, was not a member of SIPC.  Under SIPA, it simply does not matter that both entities were merely gearwheels in Stanford’s larger machine.

MF Global Holdings’ 2011 bankruptcy provides another example of the challenges posed by entity-centric regulation.  Most casual observers will likely have heard that the primary regulatory concern arising from that episode was the circumstance that, at the time of the firm’s bankruptcy, approximately $1.6 billion was missing from the securities and commodity futures accounts held by its customers.  Or, more precisely, that amount was missing from the accounts held by its subsidiaries’customers.

In the case of Holdings, the usual entity-centrism of regulatory obligations, in which each subsidiary is effectively regulated as a separate and discrete unit in the relevant jurisdiction, meant that, once the ownership ties among the entities had been effectively severed—a common consequence of bankruptcy—Holdings was free to pursue interests adverse to the subsidiaries’ interests.

Accordingly, Holdings challenged some of the subsidiaries’ efforts to recover customer assets, even though Holdings (or, more precisely, its proprietary trading strategies) was responsible for the shortfall.  Entity-centrism also prevented the subsidiaries from accessing Holdings’ assets to fill the gap in customer funds, despite protective commodity futures regulations specifying that a broker’s own assets can be tapped in the event customer assets are missing at the time of insolvency.

To be sure, entities are the actors in our economy and the forces behind capital formation.  Moreover, perhaps the core function of the U.S. securities laws is to regulate an entity’s issuance of securities and investors’ subsequent transactions in those securities.  In other words, securities regulation supplements the (otherwise private) relationship between an entity’s core constituencies: owners and management.  In that sense, we might even say that securities regulation revolves around the entity.

Financial services regulation need not be so limited, however.  The regulation of those who effect transactions in securities and other financial instruments for the benefit of investors and the capital markets offers an example of regulation that does not demand an entity-focus.  Of course, recognizing entity-centrism and the problems it creates is only one small component of moving past it.  Other components are understanding the bases of its prevalence, formulating efficient alternatives, and implementing new approaches in disparate contexts.

Many challenges await – but clearly policymakers need to focus as much on identifying and properly characterizing the targets of regulation as they currently do on deciding what obligations will further regulatory objectives.

Anita K. Krug

Anita K. Krug is an Assistant Professor of Law at the University of Washington School of LawThis post draws from the author’s upcoming article in the Columbia Law Review, “Escaping Entity-Centrism in Financial Services Regulation.”