Speech by SEC Chairman:
Remarks Before the Foundation Financial Officers Group Spring Meeting
SEC Chairman William H. Donaldson
U.S. Securities and Exchange Commission
May 12, 2005
Thank you, Linda, for that introduction, and thank you to the Foundation Financial Officers Group for inviting me to speak. I am a firm believer in the unique role of private foundations in the life of our country, having served as a trustee and chairman of several. In that capacity I’ve witnessed firsthand the ability of a foundation to augment its work with a thoughtfully administered investment program. It’s a pleasure to be with you this morning.
Before I proceed, our ethics rules require that I tell you that the views I express here are my own and do not necessarily represent those of the Commission or its staff.
I. Addressing the corporate and mutual fund crises
I’d like to touch first on some of what the Commission has done to address the corporate and mutual fund scandals of the past few years, and the erosion of confidence in our capital markets that followed. I speak from the perspective of having worked in these markets for a substantial part of my professional life. This experience has shown me that a culture of well-regulated markets and well-governed corporations can reduce the cost of capital for corporations and provide a more stable platform for long-term investment and economic growth.
But these benefits are compromised if markets are dysfunctional or corporate governance breaks down. As we all know, the ebullient markets of the 1990s eventually came to an end, followed by revelations of widespread malfeasance at a number of leading companies and a recognition that ethical standards had eroded throughout the business sector. It was a period similar to that following the stock market crash in 1929, though in the more recent era a much higher number of investors and percentage of households were directly touched. This combination of corporate corruption and widespread public participation in the equity markets laid the groundwork for a crisis in investor confidence, the likes of which I have not seen in my career. It led to Congress’s decision to adopt the sweeping reforms contained in the Sarbanes-Oxley Act of 2002.
A. The Sarbanes-Oxley reforms
Following the guideposts laid down in the Sarbanes-Oxley Act, the Commission set itself on an active course to calm investor fears and to begin the delicate work of restoring investor confidence. In the summer of 2002, the Commission launched its most active period of rulemaking since it was founded in 1934.
By mid-2003 we completed – under extremely tight mandated deadlines – the extensive rulemaking required by the Sarbanes-Oxley Act. Critically important has been nurturing the growth of the Public Company Accounting Oversight Board, which was created by the new law to restore integrity to the auditing and accounting profession.
Another key piece of this reform effort was the adoption of rules by the Commission and the PCAOB requiring that management report on the effectiveness of their system of internal controls, and that the auditor attest to management’s report. These rules, required by section 404 of Sarbanes-Oxley, have, I believe, the greatest long-term potential to improve the quality and usefulness of corporate reporting of any of this era’s corporate reforms.
At the same time, implementation of these requirements for the first time in connection with the 2004 annual reporting cycle resulted in significant costs. Some of this may be attributable to one-time start-up expenses as many companies, for the first time, rigorously and systematically documented and tested their key internal controls. However, we are also aware that some costs may have been due to excessive or duplicative effort by management and auditors. This may have been driven by a lack of a clear risk-based focus by participants in the process. We believe the implementation of the section 404 rules needs to be improved going forward. After extensive consultation at our recent roundtable, we intend to issue guidance that will address ways for making the process more efficient and effective. As I have said on other occasions, section 404 is too important not to get right.
B. The mutual fund reforms
As the Sarbanes-Oxley rulemaking was being completed in the fall of 2003, we began to learn of widespread abuses in the mutual fund industry, the eight-trillion dollar home to the investments of millions of investors. The willingness of some within the industry to condone unethical practices and to engage in outright illegal behavior came as a shock to investors and regulators. It was apparent that the hard work of trying to restore investor confidence was not yet completed. Our ambitious program of regulatory reform and complex enforcement actions continued well into the next year and, indeed, continues today.
In addition to the unprecedented level of enforcement activity targeted at mutual fund advisers, as of today the Commission has approved 10 major new mutual fund reform initiatives. Taken together these initiatives seek to strengthen the governance structure of mutual funds, address conflicts of interest, enhance disclosure and transparency, and foster an atmosphere of high ethical standards and compliance.
The centerpiece of the Commission’s efforts is the rule that requires funds relying on certain exemptive provisions to have an independent chairman and 75 percent independent board members. By addressing the basic conflict of interest between the financial interests of mutual fund shareholders and the financial interests of their fund’s management company, our new rule amendments create a structure that I believe will facilitate implementation of both the letter and the spirit of our reforms.
To further reduce the incidence of ethical breakdowns at mutual funds, the Commission approved a rule that requires compliance policies and procedures, as well as a chief compliance officer. To help foster an ethical, compliance-oriented atmosphere, we have required that all registered investment advisers adopt a code of ethics. The code of ethics must set forth standards of conduct for advisory personnel and address conflicts such as those that arise from personal trading.
I do believe that our rulemaking and enforcement actions, coupled with the critically important Sarbanes-Oxley Act, have begun to correct many of the abuses that characterized our financial markets in the late 90’s and early years of this decade.
II. Staving off future crises
But before one gets the idea that our work at the Commission over the last few years has been completely reactive in nature, let me talk about a change in emphasis that we have tried to bring to the Commission, and give you a few examples of this approach in action.
I believe in the positive impact of identifying potential problem areas and dealing with them before they erupt into full-blown crises. The importance of this kind of forward-looking approach is underlined by the nation’s experience with both the scandals that preceded the Sarbanes-Oxley reforms and the scandals that led us to institute the mutual fund reforms. In both cases, an ounce of prevention might have been worth a pound of cure. Yet I can only imagine the indignation and outrage in some quarters that such an ounce of prevention might have precipitated.
There is a certain mindset that holds that significant regulatory action is appropriate only in retrospect, or only after things have gotten so bad that the risk of investor harm threatens to become a certainty. We have sought to launch the Commission on a different course, an approach that anticipates problems before they develop, and deals with areas of concern that have perhaps lingered untended for many years with their pernicious consequences long unnoticed by the public at large.
A pair of recent rulemakings exemplifies this forward-looking approach: our hedge fund adviser registration requirement, which we adopted last December, and our market structure reforms, which we adopted a few weeks ago in April. The controversy generated by these reforms both within and without the Commission also illustrates the practical difficulties faced by the Commission when it seeks to take action that is anticipatory in nature, as well as reactive.
A. Hedge fund adviser registration
The hedge fund adviser rule may be of particular interest to you given your own investment portfolios. As you are well aware, there has been explosive growth over the last few years in the hedge fund industry – in terms of the number of funds, investors, and investment managers participating in the industry, as well as the assets under management. From what we can tell, the number of hedge funds has increased at least five-fold over the last 10 years, and the dollar amount invested in hedge funds is approaching the $1 trillion mark – up fifteen-fold in the last 10 years.
Against the backdrop of this growth, we witnessed the broadening of the investor base from institutions such as pension funds, endowments, and, of course, charitable foundations, to include relatively small investors investing through funds of hedge funds. At the same time, there has been an increased number of enforcement actions involving hedge funds, and it was difficult to deter this fraud – or to discover it – without a compliance regime and a program of examinations and inspections by our staff.
To address this concern and others, the measure we adopted requires certain hedge-fund managers to register with the Commission under the Investment Advisers Act. This is far from the Draconian measure some have portrayed it to be. It will simply permit the Commission to collect important information about the operations of hedge fund advisers; allow us to conduct examinations; require hedge fund managers to adopt basic compliance controls; improve disclosures made to investors, particularly with respect to portfolio valuation; and prevent felons or individuals with serious disciplinary records from managing hedge funds.
Some critics have said that to bring hedge fund managers under the Advisers Act will create a false sense of security – a kind of good housekeeping seal of approval. But from our long history with mutual funds, it should be clear that our oversight of investment companies and investment advisers is not meant to endorse the merits of a particular fund management style. In fact, Congress anticipated this concern and explicitly prohibited registered advisers from making any representation that we have recommended or approved them.
Instead, registration will help the Commission to better understand the impact that hedge fund advisers have on the interests of individual, institutional and professional investors, while also enhancing our ability to address those instances of fraud that are probably inevitable in a market this large. Given the size of the market and its growth rates, I believe we would have been remiss had we failed to take action on this front. Every week seems to bring another article in the press about the crowding of hedge funds into similar investment strategies and the difficulty that this implies for hedge fund managers eager to post market-beating returns. If history is any guide, it is just this sort of pressure that can lead otherwise well-intentioned professionals to pursue practices that can ultimately result in disaster for the investors that they serve. While I do not believe that our registration initiative will prevent all scandals from occurring in the future, I am hopeful that it will provide a much-needed ounce of prevention by helping to foster a culture of compliance among these heretofore unregulated or lightly regulated investment professionals.
B. Market structure reforms
I’ll turn briefly to the market structure reforms that we adopted early last month. Regulation NMS is an integrated set of reforms that will modernize the regulatory structure of the U.S. equity markets. Many of the issues settled by Regulation NMS had lingered for years and had caused serious discord among market participants. Few opposed the notion that the existing structure of the national market system was outdated in many respects and needed to be modernized. Although these issues had been studied and debated and evaluated from nearly every conceivable angle, the Commission still faced considerable pressure not to act in the absence of a headline-grabbing crisis.
After a long and exceptionally open period of public comment on the rulemaking process, the Commission finally decided to move forward and make decisions on final rules so that the U.S. equity markets could continue to meet the needs of investors and public companies. Although the substance of the final rules was not welcomed with open arms by all market participants – nor could it have been – I believe there was a great deal of consensus that the Commission needed to act with a degree of certainty and finality so that market participants could make strategic plans with the firm knowledge of how their regulatory landscape would be structured.
While I don’t think that the groundbreaking transactions announced by the four major equity marketplaces two weeks after the adoption of Regulation NMS were caused by the specific action that we took, I do believe that their ability to come to terms was facilitated by a clear understanding of what the rules of the road were going to look like. I imagine that their negotiations would have been considerably tougher had they been dealing with a Commission that announced that after more than five years of studying equity market structure in all of its complexity, it still hadn’t been able to make up its mind.
C. Other proactive initiatives
Let me give you a few more illustrations of what the Commission is doing to be more proactive and to anticipate incipient problems before they become major crises. While these activities may not have generated the same level of coverage as the controversies surrounding our hedge fund adviser and market structure initiatives, each of them is an important and worthy effort by the Commission and its staff to get out in front of developing issues – to look over the hills and around the corners.
Increased professional staff
On the structural side, since December 2002 we have hired more than one thousand new professionals – accountants, lawyers and economists. As we bring in new people, we are trying to improve communication across the lines of our operating divisions and offices to protect against the natural organizational tendency towards a “silo” mentality.
Office of Risk Assessment
We established our Office of Risk Assessment. This office brings together professionals experienced in seeking out potential areas of concern, and will equip the Commission to better anticipate, find and mitigate areas of risk, fraud and malfeasance.
Conflicts Review Project
Our Enforcement Division has embraced the effort to help identify and solve problems proactively, instead of deferring action until after harm has occurred. Working with other parts of the agency, it has spearheaded a broad-ranging Conflicts Review Project. Securities industry firms have voluntarily conducted comprehensive reviews of the conflicts of interest they encounter in their business. A number of large firms have met with Commission staff to discuss the results of their reviews. The staff has worked to make these sessions a dialogue, and the meetings have also provided a forum for the firms to identify industry-wide conflict issues and potential solutions. Efforts like the Conflicts Review Project could be a catalyst for the industry to address conflicts on its own, in advance of a scandal, and make future regulation unnecessary.
III. Initiatives on the near horizon
Let me give you a preview of what you might expect from us in the coming months.
We are examining the conflicts that can arise from the use of soft dollars by money managers, a topic that you and your colleagues may have a direct interest in. Improved disclosure practices may be the best prescription here, and we are looking at ways to make sure that fiduciaries better inform their investor clients about their use of client brokerage, because we believe that clients should have a better understanding of who benefits from the deployment of this important portfolio asset. I am a firm believer in the value of independent research, and in taking any action on the subject of soft dollars we will endeavor to promote a level playing field between independent research and proprietary research.
Securities Act reform
I also expect that we will finalize a number of important reforms to the offering process under the Securities Act of 1933. These reforms have many components, but of particular interest to investors is that the reforms seek to modernize and liberalize our existing regulations on communications, with the goal of allowing more information to be disseminated to investors during the offering process.
Mutual fund disclosure review
Turning back to mutual funds, I have asked the staff to carry out a top-to-bottom review of the entire mutual fund disclosure regime and how we can maximize its effectiveness on behalf of fund investors. Few would disagree that many mutual fund disclosure documents are too long and complicated. Investors need disclosure that is clear, understandable, and in a usable format. Investors also need information that is timely. We need to examine ways to make better use of technology, including the Internet, in our disclosure regime.
The Commission is currently considering a proposal that would require certain critical disclosures to be made to investors at the point of sale – exactly when the investor is being asked to make an investment decision. I believe that this particular initiative, though modest in scale, could ultimately presage a profound evolution in our overall approach to disclosure.
Finally, I expect that the Commission will consider improvements to the disclosure regime that applies to executive compensation. While I do not believe that the Commission could or should act to limit executive compensation, I would like to see greater disclosure of pay packages – with not only the total amount of compensation provided, but a clearer explanation of each element of the package, including benefits that may not be easily quantified but which the CEO clearly cares about. The Commission is continuing to evaluate the disclosure required under our existing rules, while our staff is looking at ways to modernize these rules.
I’ve spoken of the Commission’s ongoing work to address the root causes of the corporate and mutual fund scandals of the last few years, and the erosion of investor confidence that followed. Non-profit organizations have also found themselves under scrutiny in recent years. The IRS is exploring compensation levels at some non-profits, and has increased funding for examinations devoted to tax-exempt entities. In Congress, Senator Grassley has been leading an effort to improve public disclosure by tax-exempt organizations.
While I don’t believe that non-profits should anticipate a regulatory response of the magnitude experienced by public companies, corporate governance is a topic that continues to be on the minds of policymakers. I do believe that there is an opportunity for non-profit organizations to learn from the governance failures at some of the country’s largest corporations, and it seems to me that your foundations have a leadership role to play in setting the standard for non-profit governance.
There’s another public dialogue in which you, as the financial officers of the country’s largest foundations, should be able to play a constructive role. As you are no doubt aware, there is a feeling voiced in some quarters that the reforms of the last few years have been too fast and furious, and that the “pendulum has swung too far.” These concerns don’t seem to have been voiced by investors, but they are an influential part of the policy debate.
I believe that it is important for investors to have a voice in this dialogue, and I think we’d be better for it if investors such as yourselves made your voices heard. As financial officers of America’s largest foundations, I hope you will use your influence and authority to demand that markets and intermediaries live up to the spirit of our reforms, and not just the letter of the law. For while we’ve seen real progress over the last couple of years, every generation seems to learn anew that the price of well-functioning markets and honest intermediaries is eternal vigilance.
Thank you, again, to the Foundation Financial Officers Group for this invitation to speak, and thank you all for listening. I’d be happy to take your questions.
Check against delivery.