Speech by SEC Chairman:
Remarks Before the Investment Counsel Association of America
Chairman William H. Donaldson
U.S. Securities & Exchange Commission
Palm Beach, Florida
April 22, 2004
Thanks for that introduction, David, and thanks to the ICAA for inviting me to join you today. I want to begin by acknowledging the Investment Counsel Association of America's 65 years of standing tall as an influential advocate for high standards of integrity and competence at investment advisory firms. 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.
You are on the frontlines of our financial markets, and you and your firms occupy positions of great trust and responsibility, as millions of Americans rely on you to put their money to work in our capital markets. There are a number of critical issues under consideration at the SEC that directly impact you, but first I want to briefly describe the important work of the various divisions of the Commission not directly concerned with your industry. There are many important elements of our overall agenda to protect investors and promote investor confidence, and we are pursuing this agenda following our complete reevaluation of how the SEC has historically functioned, as we try to create a new environment at the agency - one that rewards teamwork and effective coordination and communication among the staff, the divisions, and the offices at the SEC.
Our enforcement division is working aggressively to pursue wrongdoing in a manner that is both forceful and fair. In fiscal 2003, the division filed 679 enforcement actions, more than in any other previous year. The SEC has also increased the frequency of examinations of those funds, advisers, and other market participants posing the greatest compliance risk, and we're conducting more examinations targeted to areas of emerging compliance risk.
There have also 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. And we are bringing enforcement actions against not only corporate wrongdoers, but also against financial institutions that have aided and abetted financial fraud.
The Division of Market Regulation is fully occupied with a number of vital issues - and none more important than addressing changes in the structure of America's equity markets. As our financial markets continue to evolve due to innovative technologies, new market entrants, and changing investment patterns, the Commission must monitor these changes and ensure that the regulation of the market structure remains up to date.
In February, the Commission proposed Regulation NMS - the National Market System - which is designed to enhance and modernize the national market system that was created in the 1970s. Regulation NMS 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 distribution of market data.
Yesterday in New York City, we had a very useful hearing on Reg NMS, where we fully explored the complexity of the market structure issues raised by the proposals, potential alternatives to the proposals, and additional suggestions from some of the key market participants. In whatever final form Reg NMS may be adopted, the proposals collectively would constitute the most significant upgrade of the national market regulatory framework in over a quarter century.
The Division of Corporation Finance continues to focus on helping to improve disclosure at public companies. It recommended rules, which the Commission recently adopted, that expanded the categories of events that trigger prompt disclosure; and it is preparing recommendations for the Commission's consideration that would require comprehensive disclosure in the asset-backed securities market, which some estimate to be as large as $800 billion. Finally, the Commission recently issued guidance with regard to preparing MD&A disclosure that avoids boilerplate and provides investors with more meaningful disclosure.
The staff is also working on a proposed rule that will require companies under certain conditions to add shareholder nominees to the management slate and the proxy materials. Today, nominees and directors emerge from a system that really excludes meaningful input from shareholders. 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.
In fact, in seeking to allow shareholders a greater prospective voice at companies where shareholders' voices are not being heard, the proposal should build upon and support other corporate governance changes brought about by the Sarbanes-Oxley Act, our own rulemaking efforts, and changes in exchange-listing standards that have helped assure the independence of directors.
As you are well aware, a particularly urgent priority for the Division of Investment Management, and the entire Commission, has been instituting reforms to the mutual fund industry. During my years in and around American business and America's financial markets, I've seen isolated cases of wrongdoing here and there. But I think we were all shocked to discover the complicity of certain elements of the industry in condoning widespread unethical and illegal practices.
Most in the fund industry are honest, dedicated custodians of their clients' capital. But it has become painfully obvious that some lost sight of certain basic principles - most importantly their responsibility to millions of investors. Investors are entitled to honest and industrious fiduciaries who abide by fair and ethical legal principles. Yet too many of these fiduciaries engaged in conduct that is well outside the lines of what is acceptable, and in so doing violated the ethical code that must govern the fund industry.
Our regulatory efforts to address these violations seek to strengthen the governance structure of mutual funds, address conflicts of interests, enhance disclosure to mutual fund shareholders, and foster an atmosphere of high ethical standards and compliance within the industry.
The Commission has made significant progress, and will continue to move aggressively to track down and pursue wrongdoers, while expeditiously considering and adopting all of the currently outstanding mutual fund rule-making proposals, including: break point disclosure, mutual fund governance, the investment advisers' code of ethics rule, disclosure regarding the factors considered by the funds' board in approving an advisory contract, the proposed amendments to rule 12b-1, the so-called "hard 4 o'clock close," portfolio managers' disclosure, the mandatory 2 percent redemption fee, and new confirmation form and point of sale disclosure.
Let me spend just a few minutes describing a few of these initiatives in detail.
Starting with our efforts to put an absolute halt to abusive late trading, we originally proposed a hard 4 p.m. close for mutual fund share trading. This proposed rule amendment would provide a secure pricing system that would be largely immune to manipulation by late traders, by requiring that orders be placed with the fund or its primary transfer agent or clearing firm by the time set by the funds.
During the comment period, the Commission has received many thoughtful observations, some raising concerns about how the proposal might adversely affect certain investors, such as 401(k) participants and investors in earlier time zones, and many offering helpful alternative suggestions. As one alternative to the proposal, some have advocated a system of audited controls that would better prevent and detect late trading. And others have recommended the use of more sophisticated technology to create tamper-proof time stamping of trade tickets that would help eliminate, or at least better detect, late trading. The staff is analyzing this information to determine whether there is an effective alternative to the hard 4:00 rule proposal that would not disadvantage certain investors and does not distort competition in the marketplace. It may very well turn out that we adopt a combination of some of the alternatives that have been presented to us during the notice and comment process.
We have also seen that when fund shares are mispriced, market timers have an arbitrage opportunity that can be used to exploit a fund and disadvantage its long-term investors. That is why the Commission acted in December to reemphasize the obligation of mutual funds to fair value their securities in such circumstances.
And just last week, the Commission adopted amendments that would require enhanced disclosure regarding fund policies and procedures covering market timing and selective disclosure of a fund's portfolio holdings. These new disclosure requirements address abusive practices of funds whose prospectuses were misleading about efforts to limit market timing and used murky language to cloak special deals for large and influential investors.
The aggressive regulatory effort I have just outlined will help to combat the ills plaguing the mutual fund industry and to minimize the possibility of future illegal, fraudulent, or harmful activity. As I testified before the Senate Banking Committee two weeks ago, I think we have all the authority we need to move our rulemaking agenda, and the leadership of the committee seemed to agree that additional legislation is not necessary at this time.
Turning to what's ahead on the Commission's agenda, we have created special, multi-divisional task forces that are designed to bring together staff from various divisions and offices to brainstorm, evaluate, and create strategies to proactively undertake issues of potential concern in protecting our securities markets. These six task forces, which are underway now, will tackle a number of important issues: soft dollar arrangements, bond market transparency, college savings plans, or the so-called 529 plans, enhanced mutual fund surveillance, enhanced SRO surveillance, and, over the longer haul, our entire disclosure regime. The task forces will meet with relevant, interested parties such as individual investors, industry representatives, and fellow regulators to gather critical intelligence and data and ultimately work toward addressing problems over the long haul.
I know that soft dollars are of particular interest to you, and I want to thank the ICAA for your public support of our task force on soft dollars. The task force is comprised of SEC staff from five divisions and offices, and it has already met with a number of industry representatives, including the ICAA and some of your members. Its goal is to more fully understand all aspects of how soft dollars are used, and the pros and cons of various alternative reform approaches, including possible unintended consequences of some suggested reforms.
Like so many of the challenges we're facing, the area of soft dollars is complex, and we must be cautious as we move forward with reforms in this area. I believe that at the very least, the Commission, through the rulemaking process, should consider narrowing the definition of qualifying "research" under the safe harbor so that only "real" research - with valid, intellectual content - qualifies as research. I would also expect the Task Force to consider whether the costs of research and execution should be quantified, as well as other ways in which the costs of research could be made more transparent. Some have advocated a distinction between third-party research and proprietary research. My own view is that we should not draw such distinctions, but the Task Force will also consider this issue.
Since becoming Chairman, I have become convinced by events - the discovery of market timing and late trading abuses by mutual funds being just one such event - that the Commission needs to devote more time and energy to anticipating potential problems across the investment industry. Last year, following a thorough internal review of how the agency identifies current problems and - equally important - future risks, we initiated a new risk management program and laid the groundwork for an Office of Risk Assessment and Strategic Planning, the first of its kind at the Commission. The first phase has been to organize internal risk teams for each major program area. This framework has already been put into place and allows for what I like to think of as a bottom-up approach to assessing risk in each of our divisions.
A good example of this can be found in our Office of Compliance, Inspections, and Examinations, OCIE. We asked our front-line examiners - through OCIE's internal risk management team - to look at potential problems in the mutual fund industry and broker dealer industry. Indeed, with input from examiners in our regional offices, OCIE is producing a complete "risk map" of these areas.
When fully operational, the new Office of Risk Assessment will work in coordination with these internal risk teams to push the entire agency to proactively anticipate potential problem areas across the securities industry, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities.
I believe the risk assessment initiative will influence all of our work in the agency - from enforcement, to examinations, to rule-makings, to our review of required filings. It will also help foster better communication, coordination, and even cross-fertilization between the divisions and offices within the Commission. The result will be to ensure a process whereby senior managers at the Commission have the information necessary to look "over the hill, and around the corner" - to make better, more informed decisions and to proactively adjust operations, resources, and methods of oversight to address these new challenges.
One illustration of the importance of the risk assessment effort is the Commission's woefully inadequate knowledge about hedge funds. Critics of our focus on hedge funds cannot, in my view, have it both ways - on one hand, to demand that the Commission be proactive and prevent and detect emerging but as of yet unforeseen harms and abuses, but on the other hand, to handicap our abilities to obtain simple, fundamental information that facilitates our identification of such abuses.
The critics argue that hedge fund investors are wealthy and sophisticated individuals who do not need protecting. This is not the point. Hedge fund managers are directly and indirectly providing advisory services for many U.S. investors - with significant impact on those investors, and on the operation of the U.S. securities markets.
In fact, hedge funds are being purchased by intermediaries on behalf of millions of ultimate small investor beneficiaries, retirees, pensioners, and others who are not generally thought of as the traditional hedge fund investor. This makes it critical for investors that the Commission has more information about hedge funds and their managers - especially the impact their market activities have on the other participants in our equity markets. Hedge funds have become one of the fastest growing segments of the investment management business - with assets fast approaching $1 trillion - and we have seen hedge fund managers engaged in illegal behavior that results in taking advantage of the long-term retail investors.
So building on the risk assessment capability we're developing in the agency, we are evaluating a form of registration and an oversight regime for hedge fund managers different from what we use for other investment advisers. This registration and oversight could be specifically tailored to the unique dynamics of these funds and managers. We could thus better target our inquiries to those hedge fund managers where there is some reasonable concern that they may be violating the federal securities laws.
Reforms in the Investment Advisory Industry
Finally, let me turn to issues of specific concern to the investment advisory community in general. One of the lessons the Commission learned from the late trading and market timing abuses is that we needed to give all the regulated entities over which we have jurisdiction the necessary tools to fulfill their fiduciary obligations to investors. To that end, the Commission last December adopted a requirement that all investment advisory firms designate a chief compliance officer and adopt and implement written compliance policies and procedures. And in January the Commission voted to propose rule amendments that would require investment advisers to adopt and enforce codes of ethics that would apply to their personnel.
As you know, under the new compliance rules, the chief compliance officer, who must be in place by October, should have a comprehensive understanding of the Advisers Act. This person should also have the full responsibility and authority to develop and enforce appropriate policies and procedures, to reduce the likelihood of securities laws violations. The adequacy and effectiveness of these policies and procedures must be reviewed at least once a year. The review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures.
The Commission's proposed rule requiring all registered investment advisers to adopt codes of ethics recognizes the bedrock principle that investment advisers are fiduciaries and owe their clients a series of duties enforceable under the Investment Advisers Act.
The proposed code of ethics would set forth standards of conduct for advisory personnel that reflect the adviser's fiduciary duties, its need to comply with the federal securities laws, and to address conflicts of interest. The code requires certain personnel to report their personal securities holdings and transactions, including transactions in any mutual fund managed by the adviser or an affiliate. The code would also require that supervised persons receive and acknowledge receipt of a copy of the code of ethics. Finally, the code of ethics must include provisions that address the safeguarding of material nonpublic information about client transactions, reporting promptly any violations of the code of ethics, and mandating pre-clearance of personal investments in IPOs and private offerings.
The compliance rule and our code of ethics rule proposal can form the regulatory foundation from which leaders in the investment advisory industry can elevate ethical standards throughout the industry. And you, the members of ICAA, have taken an important step to do just that - with your work to develop best practices for codes of ethics for the industry. Your best practices can incorporate the requirements of any final SEC rule and go beyond the scope of our rule to encourage best practices throughout the industry. But neither our rules nor your model code of ethics will be enough. Senior executives in the investment business - which is to say, people like you - have a critical role to play in setting the right tone, and embracing a culture of compliance that will inculcate a firm-wide mindset to do the right thing. Only senior executives like you can make this culture part of every entity's moral DNA - from top to bottom. It must start at the top, because much, if not all, of the corruption that's come to light started not at the bottom of companies, but rather at the top. And when there is malfeasance at the top, it easily filters down, and infects every corner of an organization.
So what does it mean to ask senior executives in the investment adviser industry to elevate their firm's moral DNA? It means that senior executives must recognize that while maintaining their focus on the bottom line, they must also remain focused on the ethical lines. It means that management needs to incorporate sound ethics and compliance measures into company business practices, and it means remaking business systems to reduce the incentives, or pressures, for cutting corners. It means that leaders not only live up to the letter of the law, but also internalize and advocate the spirit of these reforms to everyone in their organization. It means that senior managers need to communicate at every level of the business - with consistent actions and words - that ethical conduct is absolutely critical to the success of the business. Finally, leaders must remember that establishing integrity as an organizational culture is a lengthy process - one that requires prioritization, communication, training, and reinforcement.
The investment of time and effort to establish this culture is not without costs. But it will pay long-term dividends, as it will enhance integrity within companies, and thus inspire confidence among customers and investors. In fact, if there's one message I hope you'll take away from my remarks it is that we are partners in this mission, and the power to affect change lies as much with you - and the other participants in the industry - as it does with us at the Securities and Exchange Commission.