Speech by SEC Chairman:
Remarks before the Bond Market Association
William H. Donaldson
U.S. Securities and Exchange Commission
New York, NY
April 20, 2005
Thanks, Ed, and thanks to the Bond Market Association for inviting me to speak. I'm delighted to have the opportunity to discuss some of the Commission's ongoing work on a range of issues of importance to the fixed-income markets. Before going any further let me issue the standard disclaimer that my remarks here are my own and do not necessarily represent those of the Commission or its staff.
I'd first like to take a moment to recognize the BMA's work in investor education and in helping the industry shine the light on conflicts of interest. Your public website is an excellent resource for investors who are considering whether to invest in bonds, and I wholeheartedly commend you for it. And the Guiding Principles report you issued last May is also an example of an industry-led initiative to identify and address those conflicts of interest that, if left unmanaged, only yield more work for regulators. I'll return to this later, but wanted to applaud your efforts and underscore the SEC's interest in working on the issues laid out in the report.
I am also pleased to have the opportunity to speak to the people who are on the frontlines of our debt capital markets. You are catalysts for capital formation, and the work you do helps to spark economic opportunity and economic growth. I could go on at great length about the importance of the bond market to American corporate finance, but if I did I suspect I would be telling you things you already know. Instead, I'd like to talk today about some regulatory initiatives that relate to the bond market, and then turn to some issues that the industry itself ought to, in my judgment, be thinking about.
Current Regulatory Topics
Let me comment briefly on three current regulatory topics: trade-reporting transparency, the NASD's mark-up proposal and the structured products initiative we have been working on with the bank regulators.
I'll start with what I see as a developing success story: transparency in trade reporting.
In early 2004, I convened an internal working group, comprised of staff from various offices within the Commission, to assess the state of the fixed-income markets and to make recommendations for improvements in these markets. The working group delivered its recommendations to me in September, and it had a number of useful thoughts, including continued advocacy for more comprehensive - and more timely - reporting of fixed-income trade executions to the NASD and the Municipal Securities Rulemaking Board.
We are seeing progress here on multiple fronts. On the municipal side, the MSRB completed the last phase of its transparency initiative on January 31, when it introduced a requirement for near-real time transaction reporting. As you know, muni dealers must now report transactions to the MSRB's Real-Time Transaction Reporting System within 15 minutes of trade execution.
On the corporate side, the NASD implemented a new phase of its TRACE system on February 7, which reduced the reporting period for most issues to 30 minutes after trade execution. The proposal also substantially expanded the availability of price information. As a result, data on roughly 99 percent of all transactions in TRACE-eligible securities - representing 95 percent of par value - is publicly available in near-real time. Moreover, on July 1 of this year, the 30 minute window for submitting trade reports will narrow to 15 minutes.
That said, the new NASD rules continue to provide for significant delays in price transparency - up to 10 business days - for trades in some lower-rated debt. This was a response to industry concerns that transparency might adversely affect market liquidity and the willingness of dealers to commit capital.
We often hear this concern when we push for more transaction-reporting transparency in the bond market, and I think we all need to reflect on whether this concern is well-founded. The NASD, for instance, commissioned two studies to address the relationship between transparency and liquidity for TRACE securities and found no conclusive evidence that enhanced transparency has adversely affected liquidity. In addition, economists in the SEC's Office of Economic Analysis have studied the relationship between transparency and transaction costs in the corporate bond market and found that trading costs are lower for issues with publicly disseminated prices than for similar issues for which prices are not disseminated, and that these costs fall when a bond's prices are made transparent. The clear implication here is that transparency has not adversely affected liquidity in the corporate bond market.
These studies underscore why the Commission continues to call for the removal of barriers to transaction-reporting transparency, particularly minimizing TRACE dissemination delays. Accordingly, in approving the most recently proposed TRACE enhancements, the Commission expressed its expectation that the remaining lags in TRACE dissemination should be eliminated as soon as possible. Simply put, investors are telling us that it's time to let the sun shine into the dark corners of the debt market.
Calculation of mark-ups
The calculation of mark-ups continues to be a front-burner topic. As you are probably aware, last month the Commission published for comment a proposal from the NASD that would establish guidance for bond dealers on how to calculate mark-ups consistently with NASD fair pricing rules and with Commission decisions interpreting the Exchange Act. The proposal also speaks to when and how a debt security's prevailing market price could be determined. The proposal would require bond dealers to base mark-ups on the security's prevailing market price, which in most cases would be a dealer's contemporaneous cost. While this standard already applies to non-market making dealers, the NASD's proposal would apply it to market makers as well, who are currently able to base the mark-up on their inter-dealer sale prices.
The Commission received a number of thoughtful comments on the proposal, including a letter from the Bond Market Association in opposition. The BMA argued that by diminishing dealer compensation, the proposal could ultimately harm liquidity in the market. I will want to explore this issue of liquidity before the Commission takes final action on the NASD's proposal.
The final regulatory initiative I'd like to touch on concerns the complex structured finance activities that financial institutions engage in with their corporate clients. Last May, the Commission joined with federal banking regulators in requesting public comment on a proposed interagency statement concerning these activities. This guidance emphasized the need for financial intermediaries to be diligent in avoiding involvement with products that are designed to evade an accounting or legal requirement.
Let's be clear where the common ground is. I think we all agree that we cannot go back to the days of Nigerian barge transactions, Raptors and Jedi's, with bankers, lawyers and accountants working feverishly to design exquisitely complicated transactions that serve no legitimate business purpose, but that achieve a favorable financial statement result. There is now a widespread understanding that financial services professionals are accountable, reputationally and sometimes legally, for the transactions they help their corporate clients design and execute.
Structured finance transactions pose no problem for the markets or market participants when they are properly disclosed and serve legitimate business ends - such as effecting a real transfer of risk, a real hedge of a liability, or a real influx of third-party capital. Corporations often need complicated structures to achieve these goals in the most efficient manner possible, and there is nothing wrong with bringing together the brightest financial, legal and accounting minds to create the optimal strategy for a corporate client. These same professionals simply must realize that they cannot ignore the corporation's real reason for wanting to do the transaction. We need to be clear that engineering a particular accounting result is not by itself a legitimate business objective.
The SEC and the banking regulators received a number of insightful comments, including one from the BMA, and many of these issues may be able to be addressed through guidance that does not change existing law, create new legal obligations for market participants or try to impose a one-size-fits-all mandate. Our staff, together with staff from the banking agencies, is taking these comments into account while crafting final guidance.
What the Industry Can Do
Let me now turn from the things that are on our plate, to some thoughts on what those of you in the industry might consider.
The fixed-income market is a very different animal from the equity market, and these differences are reflected in a regulatory regime that is tailored to the characteristics of the fixed-income market. But there are major similarities as well, and while the critical differences can be ticked off in a heartbeat by every one in this room, it is the similarities that are most obvious to investors and to the public.
Last month's WorldCom settlement brought an unwelcome reminder that a bond underwriter can run as much risk for liability in a fraud-tainted corporate collapse as your colleagues on the equity side of the house. As more and more retirement money shifts from equity into fixed income - a safe prediction given the long-term demographic trends now underway - there is reason to suspect that the public, and therefore the policymakers, will focus more on the similarities and will be less persuaded by the differences.
And what are these similarities? Both markets run on the willingness of investors to commit capital, and investors will be unwilling to play in a game if they suspect the deck may be stacked - particularly in the fixed-income market, where products are more structured. Another similarity is that investors in both markets will demand that your product work as advertised, and that if it doesn't, they'll insist that you stand behind it.
The challenge for your industry will be to ensure that the public and regulators do not see issues in your market that remind them of problems in the equity market. If they do, the natural reaction will be to think that a solution deemed appropriate for the equity market should also work for the bond market.
Learn from your colleagues in the equity market - look at some of the mistakes made in that market, and rather than conclude that they could never happen here, ask yourselves what sorts of practices in the bond market might implicate the same fundamental concerns. And then set about correcting them.
An obvious place to start is with fixed-income research. You're all familiar with the Internet bubble-era scandals that produced the Global Research Analyst Settlement, and you probably also know that fixed-income research is not covered by the terms of the Global Settlement. Fixed-income research wasn't directly implicated in those scandals - indeed, I recall a celebrated example where a bond analyst, using a traditional balance-sheet approach, voiced a view quite contrary to the bullish research call coming from the equity side of the house.
Here are some questions that might frame the issue for you: Is it the case that fixed-income analysts are any less susceptible to pressure from their colleagues in investment banking, from the debt syndicate desk, or from corporate clients themselves? In addition, are there other kinds of conflicts applicable to all research? Industry participants, including issuers and customers, should continue to be proactive in self-examining and addressing conflicts as they arise: How are you managing the pressure created when an issuer threatens to retaliate against the analyst or the firm? What about the pressure created when an institutional investor threatens to withdraw business from the firm if the analyst downgrades a portfolio security?
To the extent that bond analysts have been able to resist the pressure to hype favored banking clients, has it been because of the counterweight provided by the institutional nature of the buy-side customer base? If so, what will happen as the character of that customer base begins to shade more into baby-boomer retiree retail?
As the BMA has recognized in its report, "Guiding Principles to Promote the Integrity of Fixed Income Research," conflicts may indeed exist for fixed-income research. The report's guidelines are a good step to address such conflicts, and are an excellent example of the BMA's efforts to help your industry get in front of problems before they become scandals, and before they provoke a regulatory response. As the report points out, there should be internal firewalls at each firm to ensure the integrity of fixed-income research. Compensation for research analysts should be structured to promote independence. And conflicts of interest must be fully and immediately disclosed. Moreover, Commission Regulation AC recognizes the importance of analyst independence in the bond arena and equally applies the certification requirements to equity as well as fixed-income research.
Let me turn to another question for you to consider. Do your customers truly understand what they're paying or receiving when they trade with you as principal? Look at the high degree of transparency that investors are demanding in other areas of the securities markets: investors are demanding to know how their intermediaries are compensated. And investors may not distinguish between dealers and brokers as intermediaries. Do your customers understand how you calculate your mark-ups and mark-downs? The NASD issued an important report last September which had a number of useful recommendations on ensuring the integrity of the bond market. The report recommended improvements to trade confirmations, better distribution of bond information through media channels, increased availability of trade information through TRACE, and the development of industry benchmarks against which investors can compare the price and yield they receive. The report also suggested it may be appropriate for the MSRB to make similar improvements for the muni market.
I think the industry would be well advised to study the NASD's recommendations carefully, as well as its recent proposals to implement the recommendations, and to understand that what the NASD is saying is merely a distillation for the bond market of what investors are demanding across the board in the securities markets. There are clear benefits to heeding the investors' calls. As transparency increases and investors become more familiar with the fixed-income market, trading volume and the size of the market will increase along with it. Just as surely, there are clear downsides if investors start to get the sense that the industry is foot-dragging in the face of their demands. Once again, investors are calling for sunlight.
I mentioned a few minutes ago the natural expectation of investors that sellers will stand behind the product they sell. In the new issue market, the lawyers have a special term for it: underwriter liability. There is nothing new about this - since 1933 investors have had a federal right to sue underwriters for material misstatements and omissions in offering documents, and since that time an underwriter's best protection against this major source of liability has been the due diligence defense.
I applaud the recent efforts by the Bond Market Association to bring industry members together to discuss how to improve the due-diligence process. I do, however, think that there are a few points you ought to keep in mind.
The underwriters have largely relied on due diligence for two important reasons - first, to ensure that their understanding of a deal, and the disclosures, are in fact correct. And second, to provide a legal defense if the disclosure is materially defective.
I well understand the competitive pressures you are under to get deals done quickly, and I know that often "quickly" means "now." But you may also recall the wise old saying, "marry in haste, repent at leisure."
A transaction twenty years ago might have taken six months, and five years ago it might have taken two weeks. Today it can be done overnight, and next year it might take even less time, as the character of the buy-side evolves. At the same time, the Commission has taken pains not to insert unnecessary speed bumps into the offering process, in order to let issuers and underwriters move as quickly as they desire. Indeed, the Securities Act rule reforms that the Commission is now considering, if adopted, would further flatten the speed bumps and thus probably accelerate the time pressure for offerings, especially those by well-known seasoned issuers. But the standard for legal liability remains that which is enshrined in the Securities Act. You can move as fast as you like, but your customers will be protected by that standard.
The principles of underwriter liability and the due-diligence defense were, of course, created in a much slower-paced era. The advent of shelf registration over twenty years ago, with time pressure issues akin to those facing market participants today, raised similar concerns regarding due diligence. The discussion today is a variant of the one we have heard for those twenty years. But the basic principles continue to apply. How they apply may be a more nuanced question, especially for a well-known issuer and particularly so for one the underwriter regularly follows. In the end you must decide whether, in a compressed timeframe, you have the ability to bring to bear your business, legal and financial knowledge of the issues and general acumen in order to conduct the inquiry into the issuer's business and prospects that the due-diligence defense demands - and that your accounts expect.
I applaud the BMA's work in helping to educate the industry on what the due-diligence obligation entails, though I would caution against any approach that relies overly much on checklists. You are the gatekeepers to the capital markets and your responsibility - and hence your liability - reflects that central role. The essence of due diligence is to understand the issuer's business model and the risks it faces, then to root out the relevant facts and apply your judgment to them. The act of checking off the boxes is not a substitute for judgment.
Ethics and integrity in the industry
I'll try to wrap up on a broader theme. The long-term health of the fixed-income market does not depend on regulators at the Commission and elsewhere advancing the right mix of policy reforms. Important though that may be, even more important is for those of you in the industry to conduct yourselves in a manner that respects not just the letter of the law, but also the spirit behind the law.
I am pleased that the securities industry has taken steps to heighten the awareness of securities professionals to these broader ethical issues. The Securities Industry/Regulatory Council on Continuing Education has endorsed new standards adopted by the SROs that mandate ethics training every three years for registered persons, as part of their regular continuing education requirements. These enhancements to the continuing education regime should help securities professionals better recognize ethical dilemmas, become more familiar with the process for making ethical decisions, and address organizational pressures that could influence ethical decision-making. I commend the securities industry for taking this important step. Adding ethics to your continuing education program sends a powerful message to the public about the industry's commitment to ethical behavior.
But creating, preserving and strengthening an ethical culture takes more than training, a corporate code, and having the right governance structure in place. Ironically, some of the worst corporate offenders in recent years had taken these steps. Creating an ethical culture means instilling and maintaining a commitment to doing the right thing, this time and every time - so much so that it becomes entwined in the essential DNA of the firm.
The firm's leadership must, of course, set the right tone at the top, but this culture can't be limited to senior management, the compliance department, and the aspirational wording of a corporate mission statement. The culture must be learned, reinforced and shared by each and every employee. The firm must develop in its employees the courage and commitment to question whether a particular course of conduct is truly ethical, or is truly in the best interests of clients and customers - even in the absence of specific rules, and even when the competitor chooses a different course.
The time and effort to usher in the reforms I've touched on will not be without cost. But I firmly believe the investment will yield long-term returns in the form of enhanced investor confidence and continued willingness to participate in the bond market. We've already seen real progress, and with the work of the Bond Market Association and others, I am confident that this progress will continue.
I want to thank you again for giving me this opportunity to speak, and thank you all for listening.