Speech by SEC Chairman:
Remarks to the Practising Law Institute
Chairman William H. Donaldson
U.S. Securities and Exchange Commission
March 5, 2004
Good morning, and thanks for inviting me to join you today. I want to begin by acknowledging the great work of the Practising Law Institute. This program was a wonderful innovation that is now a mainstay event for securities practitioners. It represents a unique opportunity for the Commission, including me, and our colleagues, to talk in some depth about what we're doing and what we're thinking. I want to thank in particular this year's co-chairs, Annette Nazareth and Paul Roye, as well as those who have worked with them. The schedule over the next two days promises an array of interesting discussions and presentations by many members of the SEC family.
We meet just a few weeks after my first anniversary on the job, and I would like to use this occasion to touch on the progress we have made, while also highlighting some of the major issues we will be grappling with in the period ahead. Before going any further, I hasten to issue the standard disclaimer that the views I express here are my own and do not necessarily represent those of the Commission or its staff.
Looking back on the past 12 months, as well as the past few years, much of the news has been downright depressing, given the revelations of gross fraud and malfeasance that permeated the bull market of the 1990s. Enron, WorldCom, Tyco, and HealthSouth are names that have become worldwide symbols of corporate wrongdoing. This wave of corporate fraud, of course, led to demands for sweeping reform, which in turn led to the enactment of the Sarbanes-Oxley Act, the most far-reaching securities legislation since the passage of the 1933 and '34 acts. More recent disclosures that a number of mutual funds engaged in late trading, market timing, and selective disclosure have also led individual investors to be outraged, and to demand a swift response. We have brought a number of enforcement actions and have proposed a number of corrective measures, the details of which I will touch on later.
When President Bush first talked to me about the SEC post, in late 2002, the landscape wasn't pretty. The country faced a deluge of corporate fraud and malfeasance coupled with the effects of the dot-com bubble burst and overall market decline. Shortly after my confirmation as SEC Chairman, the details of the alleged wrongdoing at HealthSouth began to emerge. The implosion of this company and others, coincident with an overall economic slowdown, threw thousands of people out of work. The economic impact was even more widespread and deep-seated, as the revelations of fraud and abuse severely weakened investor trust and confidence.
It was against this ominous backdrop that I arrived at the SEC. The agency has traditionally been one of the most respected in Washington, but it was going through a rough patch. It was underfunded, understaffed, faced with an expanded workload, and reeling from criticism that it had not done enough to stop the corporate scandals of the previous few years.
Some have questioned my sanity in accepting the job. I did because I felt a real opportunity was being presented to make a difference at a crucial time. I felt that the range of experience I had in the corporate and financial worlds, over a long career, could be helpful in addressing the many challenges.
But there were additional reasons for assuming the Chairman's role. I had a very strong and personal negative reaction to the shortcomings in our system that went well beyond the high-profile scandals: I was, and am concerned by, a general erosion of standards of integrity and ethics in the corporate and financial world that had evolved during the boom times and bull market of the 1990s. There was a dangerous short-term mentality reflected in complying with financial analysts' demands that earnings-per-share conform to artificially imposed projections that envisioned increases, even by pennies, each successive quarter. The acquiescence by the gatekeepers, like accountants, who turned their backs or actually condoned such accounting manipulation, combined with stock option incentives to management, fueled the short-term focus. In many cases, this focus sacrificed proper long-term investment decisions.
I firmly believed, and continue to believe, that a strong SEC is critical in helping to restore public and investor confidence at a time when the standing of business was and remains at a low point - not matched since the SEC was created.
Upon arriving at the SEC, I quickly concluded that 50% of the job should be focused on internal management, 50% on policy formation, and 50% on restoring investor confidence, through the use of the "bully pulpit." I know that adds up to 150%, but it provides a sense of the urgency - and enormity - of the task.
Starting on the internal reforms, and management, one of my goals has been to help restore the SEC's credibility as the investors' watchdog. And that meant reforming how the SEC operates. We have undertaken comprehensive reviews of every SEC division - assessing current needs and resources, reviewing methodology, and installing performance measures.
We have also been working to instill a new culture among all Commission staff. I want us to become better equipped to see over the hills and around the corners of problems that may be looming in the distance. To this end, we are recruiting people to join, and lead, our new Office of Risk Assessment, which will be focused on early identification of new or resurgent forms of fraudulent, illegal, or questionable behavior.
We are also trying to break down the "stovepipe" culture, in which the SEC's highly-capable staff sometimes fails to communicate across division lines. Congress helped us to solve this problem, which stemmed in part from a vastly expanded workload, by providing funds for the hiring of 800 new professional staffers - primarily lawyers and accountants - and we have been able to accelerate the pace of hiring efforts thanks to Excepted Service Hiring Authority. We are addressing the "stovepipe" issue in a number of ways - a recent example being an off-site retreat a few weeks ago for the most senior SEC officials, where we discussed our priorities and how we can work together more effectively.
As part of our broader internal reforms, we have also reorganized the Chairman's office within the SEC, with the traditional SEC chief of staff role now divided among three experienced executives who joined last year and now oversee policy, external relations, and management and operations.
Let me focus the rest of my remarks on a range of policy areas that are front and center at the SEC. I will touch on them in the context of four major divisions within the SEC: Enforcement, Investment Management, Market Regulation, and Corporation Finance.
Let's start with the Division of Enforcement, which has put forth a world-class effort over the past year, demonstrating that it can be both forceful and fair. It was intimately involved in negotiating the terms of the global settlement on equity analyst conflicts, which is currently driving important reforms in the investment-research industry. It is important to recognize the outstanding achievement of the division, which filed 679 enforcement actions - more than in any previous year - 199 of these actions involved financial fraud or reporting.
Beyond these statistics, there have been a number of significant cases involving not just Enron and WorldCom, but also KPMG, Xerox, AIG, Vivendi, and Gemstar. Equally important, we have used the full powers accorded to us by Sarbanes-Oxley to obtain more funds for return to harmed investors. We also are bringing enforcement actions against not only corporate wrongdoers but also against financial institutions that have aided and abetted financial fraud. In addition to freezing assets at firms charged with securities violations, we have also pursued a number of enforcement actions against the mutual fund industry. In pursuing all of these enforcement actions, we have also strengthened our traditional cooperation with state officials.
A major issue facing the Division of Investment Management today is how to improve our regulatory structure in the face of revelations of wrongdoing by mutual funds - reaching beyond the areas of late trading and abusive market timing. This wrongdoing represented a fundamental betrayal of American investors, and the SEC is working to both punish the malefactors and to put new measures in place to help prevent this behavior from being repeated.
We have proposed a hard 4 p.m. close for mutual fund share trading, to prevent funds, brokerage firms, and other intermediaries from placing or confirming orders after the markets have closed. We have adopted a rule requiring all funds and advisers to maintain comprehensive compliance policies and procedures, and to review them annually. And we have proposed two important new rules on fund governance and oversight. The first rule would require independent chairmen of mutual funds, and that 75% of fund directors be independent. Fund directors have a critical role to play in guarding investors' interests - and helping to protect fund assets from uses that primarily benefit management companies. The second rule would raise the ethical standards of investment advisers by requiring them to adopt comprehensive codes of ethics embodying their fiduciary obligations.
On the fee front, the Commission has voted to seek comment on possible revisions to rule 12b-1, and to require a 2% redemption fee on shares purchased and sold in five or fewer days - proposed rules which are designed to eliminate stale price arbitrage.
On the disclosure front, the Commission seeks to promote easily-understandable disclosures that facilitate informed decision making by fund investors. To this end, we have adopted revisions to mutual fund advertising rules that direct investors to data that is more detailed about fees and performance. More recently, we required mutual funds to disclose the cost in dollars associated with a $1,000 investment in a fund, based on the fund's actual expenses for the period and, for comparative purposes, based on an assumed rate of return of 5%.
To augment our oversight of mutual funds, we have also formed an SEC staff task force that will be drafting the outlines of a new surveillance program. I have asked the task force to examine the mutual fund reporting regime - looking at both the frequency of reporting to the Commission and the categories of information to be reported. I have also asked the task force to examine how new technologies can be used to enhance our oversight responsibilities.
Like other divisions at the SEC, Market Regulation is consumed with a number of vital issues - and none more important than addressing changes in the structure of America's equity markets. Just last week, the Commission voted to publish for comment Regulation NMS. This regulation incorporates a set of four substantive proposals on market structure. These proposals would create a uniform trade-through rule for both exchange-listed and Nasdaq-listed securities; establish a uniform market center access rule and access fee standard; prohibit market participants from accepting, ranking, or displaying orders, quotes, or indications of interest in sub-pennies; and reorganize the rules governing the National Market System. Today, I will touch on just the trade-through rule.
Several recent phenomena have created problems in resolving the protection of best price in our trading system. New technologies have made electronic trading platforms much faster and offered greater assurance of execution of a displayed order size compared to slower, floor-based markets. Intervening and uncertain access fees make protection of the best price even more difficult. The critical issue is how best to capture the benefits of speed and certainty of execution, while maintaining the bedrock principle of assuring that all investors are protected so that their better-priced orders are executed. By modernizing the National Market System, we will help our markets retain their position as the deepest and most efficient in the world, which will benefit investors regardless of their size or sophistication.
The SEC's Division of Corporation Finance, which works to ensure that investors have access to the material information that will allow them to make informed investment decisions, continues to focus on its mission of helping to improve disclosure at public companies. The bulk of the Sarbanes-Oxley rulemaking fell to Corp Fin, and last year it completed its Herculean task with a round of balanced rulemakings that implemented both the letter and the spirit of the new law.
More recently, the Commission adopted an interpretive release that sought to give guidance on improving MD&A. The general areas covered included presentation, with an emphasis on layered disclosure and increasing prominence of the most important information, as well as encouraging the use of introduction or executive overview. The SEC is urging corporate America's management to bring its unique perspective to the forefront of MD&A, to avoid boilerplate, and to embrace meaningful disclosure.
A second piece of enhancing public-company disclosure is a proposal the Commission will consider next week to expand our Form 8-K requirements to increase the number of important events that public companies must report on a current basis. These changes would shorten the time periods for filing current reports, and add a number of new items triggering current reports.
Other High-Profile Issues
Looking forward, there are a number of other important issues we will seek to address in the period ahead. One such issue is a proposed rule that would allow shareholder nominees to be added to the management slate under certain conditions. In over-simplified terms, our current proxy rules give dissatisfied shareholders just two options: start a proxy fight for control or sell their stock. The proposed rule offers a middle ground, particularly at a time when corporate governance, while improving, is still not where it should be.
An important element of strengthened corporate governance is a stronger, more active board of directors and, to an increasing degree, a board that is independent of management. Under Sarbanes-Oxley, we have taken modest steps to increase the independence of the board, requiring audit committees and other committees to be independent of management. But nominees and directors still result from a system that operates in a relationship with the CEO and maybe other top managers. The current SEC proposal seeks to provide a modest counterweight to this system.
- It requires substantial shareholder dissatisfaction and a demonstrable suggestion that the counterweight is necessary.
- It provides the possibility of a structurally more independent nominee and director, one coming from shareholders.
- It is designed to stand apart from any contest for control and to focus instead on director and board independence and effectiveness.
- It is designed to avoid special interest or single-issue directors.
This proposal is designed to complement the recent changes in board structure and requirements. By allowing shareholders a greater prospective voice, it will make those other changes work better - even at companies where shareholder nominees are never put forward or elected.
The current proposal is intended to be a measured one that seeks to create another pathway to independence for a very limited number of directors - and only with those companies where this independence is demonstrably needed. In addition to comments received when the proposal was first put forth for comments, the Commission will be seeking further input as it holds a roundtable on this issue next Wednesday, March 10. People on all sides of the issue will have an opportunity to be heard. If there is a better idea out there, we want to know about it.
The Commission staff is also preparing a proposed rule to the Commission to register hedge fund managers as investment advisers, giving the Commission an oversight role in the explosive growth of hedge funds. Even though these hedge fund advisers manage substantial amounts of money for a large number of clients, they escape registration as investment advisers by reaching their clients indirectly though pooled vehicles. Their pool of assets is big enough - approximately $700 billion and growing rapidly toward $1 trillion - and the thresholds for investment are low enough, that the Commission needs a reliable way of collecting information on them.
Last fall, the staff completed its report on the implications of the growth of hedge funds. The report highlighted several key areas of concern related to this hedge fund growth, including the Commission's limited ability to obtain comprehensive and reliable information about hedge funds, the emergence of registered mutual funds that invest their assets in hedge funds, and the recent increase in the number of hedge fund enforcement cases. Our review of the mutual fund scandal revealed that hedge funds all too often were active participants in these frauds.
Given these concerns, the staff report recommends that the Commission require hedge fund managers to register as investment advisers, which would give the Commission greater insight into the activities of hedge fund managers and improve our ability to detect and deter fraud. We have already seen that the Commission's focus on hedge funds has caused many hedge fund managers to pay more attention to their accounting and how they price securities.
The Commission has voted to publish the staff report. We will solicit comments from all interested parties to ensure that a final rule strikes the right balance between giving the Commission the tools we need and supporting the important role that hedge funds can play in our financial markets.
As important as all of these issues are, by far the most important is improving the governance of American corporations. The Commission has pursued, and will continue to pursue, efforts to enhance and improve corporate governance to help restore the moral DNA of entities throughout the U.S. economy.
Sarbanes-Oxley provided the bright red lines for compliance, and we have made real progress in implementing the law. It is not without costs, but it is misleading to look at the short-term costs without factoring in the long-term benefits.
As the Commission continues working to set new standards for corporate governance, I and other commissioners and staff have tried to speak out - to use the bully pulpit - to promote new thinking by and about business leaders. They need to grasp the importance of independent audit, compensation, and nominating committees, and be reminded of the importance of long-term performance. Stepping back and reviewing where we are today on corporate governance relative to the past few years, there has been real progress. And that is a tribute to both new laws, like Sarbanes-Oxley, but also a new spirit of compliance, as growing numbers of business leaders recognize the mistakes of the past few years and are determined not to repeat them.
But it is also true that, as The Wall Street Journal bluntly put it recently, "big corporations are stuck in the doghouse." A national poll released recently by Harris Interactive found that three-quarters of survey respondents graded the image of big corporations as either "not good" or "terrible." And by far the most contentious issue is executive compensation. As The Economist has pointed out, "In 1980, the average pay for the CEOs of America's biggest companies was about 40 times that of the average production worker. In 1990, it was about 85 times. Now this ratio is thought to be about 400." I don't believe that the government should intervene to set compensation levels, but I do believe that company boards must show greater discipline and judgment in awarding pay packages that are linked to long-term performance. I would like to see a much broader definition of performance; an evaluation that goes well beyond EPS, of what management excellence, and hence reward, is all about.
I will close by saying that the bad news notwithstanding, I am optimistic about the future. Much work still lies ahead, but I am confident that the progress we have seen recently will endure, and that we will continue to see greater responsibility and more realism from American business leaders.
I want to thank the Practising Law Institute again for giving me this opportunity to speak today. You are providing a valuable platform from which I and other SEC officials can convey our important messages about what we've done, and what we hope to do to clean up corporate America and restore confidence in our companies and our markets.