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Functional regulation against entity regulation

(Article published in the Aug 2, 2006 issue of Manila Standard Today)

When the young Francis E. Lim was at the University of Pennsylvania Law School for his Masters of Law degree, “functional regulation” was already a securities industry mantra in the United States.  Consequently, it is not surprising that, many years later, as the current Philippine Stock Exchange President and chairman of the Technical Working Group (TWG) of the Senate working on Senator Osmeña’s bill for a Revised Investment Company Act (RICA), he was open to the idea of including the Investment Trust Funds (UITFs) in the bill’s coverage.

After all, there is a lot that may be said, as proponents of functional regulation insist, in favor of subjecting the same activity under the regulation of the same government authority, regardless of who, or what the entity is that, conducts such an activity.  With the emotional winds packed by the slogan, “leveling the playing field”, at its back and the undeniable loss sustained in May by UITF “investors” who in unison put up the usual cry-baby claim that they were “not properly protected” by the system, it really seems reasonable to conclude argue that both mutual funds and UITFs, apparently being of the same activity, ought be subjected to the same rules.

        Historically, “functional regulation” was disputed territory in the turf war between the banking and the securities industry regulators in the US.  It was first articulated by then US SEC Chairman John Shad in his testimony in 1982 before the Senate that was then conducting hearings on a proposal by the Reagan Administration to enable banks to engage in a wide range of securities activities through subsidiaries regulated by the SEC.  Mr. Shad cites four advantages of functional regulation, namely, that it (a) allocates jurisdiction to the government agency that knows the activity best; (b) consistency with regulatory philosophy; (c) minimizes regulatory duplication, overlap and conflict; and, of course, (d) establishes conditions for equal treatment of competitors.  This last one, obviously, is the “level the playing field” battle cry heard at the TWG discussions.

 










Since contextually “functional regulation” would have the effect of diluting the bank regulators’ imperium over their subjects, its opponents were those who stood to lose.  They maintain that, for banks, entity and not functional regulation is the best approach.  The then US Comprotroller of the Currency Eugene Ludwig in 1994 for his part stated the position en contra.

“A single regulator,” says Mr. Ludwig,” is in a better position to evaluate risks across product lines, to assess the adequacy of bank capital and operational systems to support all of the activities of the bank, to take integrated supervisory and enforcement actions that address problems affecting several different product lines, and to identify and deal with emerging supervisory issues.  This strength of the institutional approach is particularly appealing in an era when supervisors more and more are finding that many risk factors, market risk, interest rate risk, legal risk, and so on, exist across product lines and are interconnected.”  The fall of Barings is an example of the real world of the folly of not looking at an institution as a whole. 

“Function regulation” was early on frowned upon by the US courts (American Bankers Ass’n v. SEC, 804 F.2d 739).  But when the views pro and con clashed once again during the deliberations on how to modernize the US financial services environment, the US Congress, where academic disputations are constantly tested in the crucible of political pragmatics,  opted for functional regulation of sorts.  Passing the Gramm-Leach-Bliley Act which became law on 12 November 1999, the US Congress repealed the famous Glass-Steagall Act and gave the SEC greater powers in dealing with the securities activities of US banks.  However, of interest to our local trust officers, Section 211specifically carved out common trust funds. 

It would be sheer colonial mentality to cite the Gramm-Leach-Bliley Act as basis for not including UITFs (which are the direct progeny of the US common trust funds).  But the reason why common trust funds successfully withstood the onslaught of the functional regulation attack is worth examining.

It was not political horse-trading, I submit, that resulted in preserving the banks’ regulatory authority of over the US common trust funds.  It was,  the recognition that while it is good policy, as functional regulation preaches, to subject all players playing the same game to the same rules, US Congress acknowledged that common trust funds (a.k.a. locally as UITFs) are not playing the same game as mutual funds are.  The identical appearance of the hood of the two vehicles, i.e. pooling of funds, obscures the radically different engines that drive each of them.  But UITFs and mutual funds perform  two distinct functions.

Beneath the hood of a mutual fund is a commodity; under the hood of a UITF is caring, a term which, I submit, has the same root as the ancient virtue of caritas.

The commodity that a mutual fund peddles is a “security”.  Although broadly defined, a security nevertheless is characterized by the deliberate bundling of rights and obligations. Thus, it represents a set of rights which the owner is entitled to enforce against the issuer. Beyond that set, the owner has no other.  The owner has a set of obligations, too, that he owes the issuer. But other than those obligations, he has no other.  Deliberate and conscious limits and borders are thus the hallmarks of a security.

Thus, a bond entitles the owner to a return of principal at maturity and interest thereon.  The owner of a plain vanilla bond thus has no say in the way the money is spent and, for as long as repayment is assured, could not care less about how the company performs.  An owner of a share of stock has interest in how a company does, but, really, management of the corporation is not in his hands as such.  He does not even, unlike the bond holder, have the right to get his money back.  Indeed, there is some truth to a cynic’s definition of a security issuer as one who is able to take money from your pocket to put in his without being called a thief.

For this reason, the center strategy of securities regulation in protecting investors is full and fair disclosure.  The consumers must be given the wherewithal to make an informed choice to acquire or not to acquire a specific security, and if the former, which specific security to get.  The SEC oversees a market where everything material must be bared to anyone with legitimate interest and no one who is able must be barred from honest buying or selling.  The securities market is not a place for the weak of heart, the feeble of mind, the shallow of pocket, nor the inattentive and distracted.

But the market for trusts, and UITFs, is.  A trust is for one who would rather go to church than read the charts; one who prefers to watch HBO rather than Bloomberg; one who would count how many angels could stand on the head of pin than compute for the present value of stream of cash flow promised but not committed.  These people have neither affection nor appetite even for the fullest and strictest disclosure by the most compliant of securities issuer.

        For this reason, trustees by all societies have been subjected (long before the idea of the modern corporation reared its head) to standards of loyalty so strict as to demand that they act even against their own self-interest when demanded by the interest of their beneficiaries.  They answer to courts not of law but to courts of the King’s conscience.  They are fiduciaries par excellence.

Entity regulation that examines each and every nook and cranny of a trustee’s being is, I submit, the approach to the UITF, not functional regulation that limits itself to only what he does like the others . For when a man of means purchases units in a mutual fund, he merely in-vests in the issuer’s purse.  But when that same man hands his money to a UITF, he en-trusts part of himself in his trustee’s heart.  
 

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