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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks to the Council of Institutional Investors


SEC Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Washington, D.C.
March 25, 2004

Thanks for that introduction, Sarah, and thanks too for inviting me to join you today. I want to begin by acknowledging the valuable contributions of the Council of Institutional Investors. For nearly two decades, the Council has been an influential advocate for institutional shareholders, helping to highlight good — and bad — corporate governance practices, and working in many ways to maximize the returns shareholders derive from their investments.

Since this is my first opportunity to speak before the Council, I would like to use the occasion to review some of the SEC's recent activities, while also touching on some of the major issues facing us 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.

When President Bush first talked with me, in late 2002, about assuming the Chairmanship of the SEC, the agency, traditionally one of the most respected in Washington, had been taking a beating. Underfunded, understaffed, and faced with an expanded workload, it was reeling from criticism that it had been MIA as the seeds of the corporate scandals were being planted in the 1990s.

But I had three reasons for accepting the President's offer: First, I firmly believed, and continue to believe, that a strong SEC would be critical in helping to restore public and investor confidence at a time when many Americans associated big business with corruption. Second, I believed that the range of experience I had in the corporate and financial worlds, over many years, could be helpful in addressing the Commission's many challenges, in hopefully an informed and balanced way. And third, I had a very strong negative reaction to the erosion of corporate standards that went well beyond the high-profile scandals. Integrity and ethics were shunted aside during the bull market of the 1990s and the dot-com boom. Too much of corporate America was infected with a dangerous short-term mentality, as companies tried to comply with financial analysts' demands that earnings-per-share conform to artificially imposed projections. This short-term focus was fueled by stock option incentives to management, and acquiescence of gatekeepers, like accountants, some of whom turned their backs or actually condoned accounting manipulation.

During my first few days at the Commission it was evident that we needed to adopt a more proactive and anticipatory approach to our work — a mindset that would encourage our staff to look around corners and over hills in anticipation of the source of future problems. To do this effectively required a complete reevaluation of how the SEC historically functioned, so as to foster an unprecedented level of communication, coordination and cooperation between staff in the divisions and offices. Thanks to significant budgetary help from Congress and the President, we finally had the resources to hire more than 800 new professional staffers — primarily lawyers and accountants — and Congress enabled us to accelerate the pace of hiring efforts with the enactment of Excepted Service Hiring Authority, which took effect last June.

To assimilate the substantial number of new staff, we undertook comprehensive reviews of every SEC division and office — assessing current needs and resources, reviewing methodology, and installing performance measures.

The additional resources also enabled us to begin a new program of risk assessment, with multi-discipline teams drawn from inside the agency. They will be integrated with a new Office of Risk Assessment, which will serve as the focus of the Commission's new proactive approach, aimed at early identification of new or resurgent forms of fraudulent, illegal, or questionable behavior.

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 are overseeing policy, external affairs, 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 corporate governance issues first, because I am aware of your historical and ongoing interest, and then turn to the activities of four major divisions within the SEC: Enforcement, Investment Management, Market Regulation, and Corporation Finance.

Corporate Governance

Perhaps the most important issue facing American corporations in the years ahead will be improving their governance structures. We are emerging from a period in which we have seen countless examples of these structures failing, causing corporate distress and a severe weakening of investor trust and confidence. The Commission's response has been twofold. First, we have brought charges against the alleged wrongdoers. Over the past few years, the Commission has sued the country's ten largest broker-dealers, as well as 14 current Fortune 100 companies, or their officers. And over just the past year, as we have learned of mutual funds engaging in late trading, market timing, and selective disclosure, the Commission has brought charges of misconduct against 11 of the 25 largest mutual fund complexes.

Our second response to the governance failures has been to introduce corrective measures designed to help prevent these failures in the future. One such proposed measure, which I know is of interest to all of you, would require companies, under certain conditions, to add shareholder nominees to the management slate in the proxy materials. In over-simplified terms, our current proxy rules give dissatisfied shareholders just two options: start a proxy fight for control or sell their stock. We are seeking to find middle ground, particularly at a time when corporate governance, while improving, is still not where it should be.

We have received many thoughtful responses to the rule we proposed for comment in October. Two weeks ago, the Commission held an illuminating daylong roundtable discussion, aimed at giving people on all sides of the issue an opportunity to speak out, and to help us examine any alternative or improved ways of moving ahead. Many of the comments were insightful enough to warrant further discussion, to ensure that we are indeed striking the right balance. If there is a better approach out there, we want to know about it.

At the roundtable — and I'd like to thank Ann Yerger from the Council for participating — we heard a number of good suggestions. We discussed different ways of addressing this issue. The Commission has extended the comment period on the proposals until next Wednesday, March 31, and we welcome all input. From there we will analyze the different ideas that have been advanced, and determine how best to proceed.

The backdrop to this discussion is the recognition that an important element needed to strengthen corporate governance is a stronger, more active board of directors and, to an increasing degree, a board that is independent of management. The combination of the Sarbanes-Oxley Act, our rulemaking efforts, and changes in exchange-listing standards has helped assure the independence of directors and to encourage them to be more assertive about exercising their oversight authority. Thus the question of how directors are nominated and elected becomes even more critical.

Today, nominees and directors emerge from a system that really excludes meaningful input from shareholders. The pending SEC proposal seeks to provide a modest counterweight to this system.

  • It requires substantial and demonstrable shareholder dissatisfaction.
  • 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.

In seeking to allow shareholders a greater prospective voice at companies where shareholders' voices are not being heard, the proposal will make those other changes work better — even at companies where shareholder nominees are never put forward or elected. Let me say again that any determination of a final rule will be informed by the many excellent suggestions and reflections from a broadly diverse group of commentators.

So while work remains on significant issues, I'd also like to recognize the progress of the past two years. This is partly a tribute to Sarbanes-Oxley, which provided the bright red lines for compliance. I know that some have expressed concerns about the law's costs, but these concerns must be weighed against the many long-term benefits that are flowing, and will continue to flow, from greater transparency across the corporate landscape.

But Sarbanes-Oxley can only succeed if corporate America embraces not just the letter of the law, but also its spirit. And I am seeing this spirit, as growing numbers of business leaders recognize the mistakes of the past few years and are determined not to repeat them. I and other commissioners and staff have used the bully pulpit to encourage such thinking, and to encourage these leaders to grasp the importance of independent audit, compensation, and nominating committees, and be reminded of the importance of long-term performance.

For all the progress though, this has yet to engender much goodwill among the general public, and the investing public in particular. The Wall Street Journal noted recently that, "big corporations are stuck in the doghouse." A recent national poll 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." Some have said government should rein in the high pay of CEOs. I don't agree. I would, however, like to see company boards show greater discipline and judgment in awarding pay packages that are linked to long-term performance. Compensation committees, in particular, need to set a much broader definition of performance — performing an evaluation that goes well beyond EPS and other financial measures, to identify what management excellence, and hence reward, is all about.

Corporation Finance

Let's move for a moment to the efforts of a few of the SEC's divisions. The 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 Corporation Finance, 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 Management Discussion and Analysis, or 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 an introduction or executive overview to better summarize information for investors. 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 element to enhance public-company disclosure is a proposal the Commission adopted recently to expand the Form 8-K requirements by increasing the number of important events that public companies must report on a current basis. These changes shorten the time periods for filing current reports, and add a number of new items triggering current reports.

Investment Management

Late trading and abusive market timing in the mutual fund industry, uncovered over the past six months, represented a fundamental betrayal of American investors. Improving our regulatory structure in the face of these revelations of wrongdoing is a vital issue facing the Division of Investment Management. The Commission and staff are 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. And to prevent abusive market timing, we have proposed a 2% redemption fee on shares purchased and sold in five or fewer days, and reminded funds of their obligation to address stale pricing of their portfolios. Once again, the open comment period is proving to be invaluable in helping us consider these issues.

We have also adopted a rule requiring all funds and advisers to maintain comprehensive compliance policies and procedures, and to designate a chief compliance officer. And we have proposed two important initiatives on fund governance and oversight. The first 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 would raise the ethical standards of investment advisers by requiring them to adopt comprehensive codes of ethics embodying their fiduciary obligations.

To augment our oversight of mutual funds, we have also formed an SEC staff task force that will be assessing the possible need for a new approach to a longer-term 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. The task force will examine how new technologies can be used to enhance our oversight responsibilities.

On the fee front, the Commission has voted to seek comment on possible revisions to rule 12b-1. And to promote disclosure, 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%.

Another important issue facing the Division of Investment Management centers on the growth of hedge funds. Their pool of assets is approximately $700 billion, and growing rapidly toward $1 trillion and beyond. The Commission needs a reliable way of collecting information on them, which it lacks today.

The Commission's staff is preparing a proposed rule to register hedge fund managers as investment advisers, which would give the Commission such an oversight role. 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.

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 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 voted to publish the staff report. If the Commission approves a proposed rule, we will solicit comments from all interested parties on a proposed rule, to ensure that any 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.

Market Regulation

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. Several recent phenomena have created problems in resolving the protection of best price in our trading systems. 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 Commission recently voted to publish for comment Regulation NMS — National Market System — and two hearings on the regulation are scheduled, for April 1 and April 21. 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.


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 — and 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 connection with all of our enforcement work, we have also strengthened our traditional cooperation with state officials.


I am encouraged by the work the Commission staff has set in motion over the 12 months, as well as the work it has completed. And I know this has been a difficult period for everyone working in or around the capital markets. The past five years or so have had more peaks and valleys, and general tumult, than any other equivalent time period in recent memory. Extraordinary wealth has been created, and destroyed, during this period. Regaining the confidence of all investors will still take time, but I believe American business is moving in the right direction, and will win back this confidence. I am optimistic about the future and I am confident that the progress we have seen recently will endure.

I want to thank the Council of Institutional Investors again for giving me this opportunity to speak today. You are helping to foster the important discussion on what should be done to strengthen the mores of corporate America and how to help our markets resume their primary role as an engine of prosperity — for people in the United States, and throughout the world.



Modified: 03/25/2004