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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks before Financial Services Leadership Forum


William H. Donaldson

U.S. Securities and Exchange Commission

New York City, NY
September 27, 2004

Thanks Terry. I am honored to be part of the Financial Services Leadership Forum - an appearance made all the more challenging by your two previous speakers, President Clinton and my old friend Warren Buffet. I especially want to thank the McGraw-Hill companies, your leader Terry McGraw, and your flagship publication, Business Week, led by Steve Shepard, for sponsoring this gathering. As a long-term New York resident, transplanted to Washington for the duration, I want to acknowledge the stewardship of the New York Public Library Chairman, Sam Butler and President Paul LeClerc, and your predecessors who have helped to enhance this great institution as a pillar of the New York intellectual world. Let me also welcome members of the fourth estate by issuing the standard disclaimer that the views I express are my own and do not necessarily represent the views of the Commission or its staff.

When President Bush announced his intention to nominate me to be SEC Chairman, almost two years ago, the corporate landscape was littered with a number of high-profile failures. Corporate scandals had come to dominate the daily business news. Equity markets had plunged. Wall Street was tarnished, and the subsequent $1.4 billion penalty challenged the very core of the symbiotic relationship between investment banking and investment research. A new law, the Sarbanes-Oxley Act, had also been approved, and it represented the most far-reaching securities regulation since the passage of the Securities Acts of 1933 and '34, which had followed the economic boom of the 1920s -- a boom that ended with the stock-market crash of 1929.

Beyond the startling corporate failures, there were increasing and disturbing signs that even the largest, most respected U.S. corporations, guided by leaders of fundamental integrity and high reputation, had been infected during the boom years of the late 1990s with a perilous disease which I will call "short-term-itis." The symptoms of this disease were manifested by a focus on "making the numbers" and managing earnings in a way that satisfied the Wall Street beast. This was a beast that fed on the circular interdependence of a demand for increased earnings - even if achieved only by pennies per share - to satisfy management projections verified by investment research, which really was not true research at all. Another symptom was the demon of managements rewarded by stock options with no recognized accounting costs. There were signs that this sort of unacceptable behavior was on the verge of becoming accepted practice even in good corporations. The cumulative effect of this breakdown was a crisis of investor confidence, which in turn led to a demand for corrective action. The need for such action was accelerated by the twin events of the dot-com bubble bursting and the startling revelations of corporate fraud.

Of course, all of us here today are well aware of this period - although the ensuing economic recovery since then and vigor in our equity markets threatens to dull the memory of many. The sudden horror of 9/11 and the momentous global threat on our collective psyche had trumped lesser concerns about market integrity. Such was the situation when I assumed the Chairmanship of the Securities and Exchange Commission. It is an agency that has traditionally been one of the most respected in Washington, validating for the most part the wisdom of those who founded it in the 1930s. They sought a new regulatory agency anchored in the concept of disclosure via self-regulation of those under its purview, and the development of rules and the means for enforcement of those rules. Yet in the early 2000's it was an agency that was suffering through a period of demoralization in the aftermath of the malfeasance that surfaced when the boom gave way to bust.

I wish we had more time to fully explore the subsequent actions of the Commission, and I hope we can get at the heart of your specific questions and observations during the Q&A period - for surely the course we have taken has not been without criticism and concern in some quarters. But let me in the next few minutes try and touch on some of what I believe are the most important actions we have taken and are taking.

The backdrop to our current ongoing actions has been five simple goals that I, and a partnership of old and new colleagues at the Commission, have collectively put forth: 1) restore investor confidence, 2) hold accountable those who have violated the public trust, 3) make the securities markets more efficient and transparent by updating practices and requirements and taking advantage of modern technology, 4) implement structural change to the Commission organization that would help it become more anticipatory, and 5) promote responsible and independent corporate governance. These simple objectives will help restore confidence in our markets and strengthen the capital-raising mechanisms that have been the envy of the world.

While our work at the Commission will never be complete, we have made real and lasting progress toward the restoration of investor confidence. Keenly aware that no one enjoys hearing an extended speech, let me summarize our achievements and progress in the following areas.

First, we have put in place new people, ideas, and systems at the SEC to help lead us to a new level of effectiveness. A totally new Commission-wide "risk assessment program" is well underway.

Second, we have ensured rapid completion of rulemaking related to Sarbanes-Oxley and improved disclosure standards in other areas.

Third, we have spearheaded initiatives to reform the securities markets - with changes to SRO governance and market structure.

Fourth, we have pursued broad-based reform to address sudden, unexpected failings in the mutual fund industry.

And fifth, we have strengthened the SEC enforcement program, bringing to justice and holding accountable an unprecedented number of individuals and corporations who have violated the public trust.

The scope and pursuit of these goals has been substantial. Since my arrival, the Commission and its committed staff has helped the agency stay on track during a very active period - we have considered a record number of proposed rules and have adopted 52 final rules, prosecuted more than 1,000 enforcement actions, conducted 10 major studies (including hedge funds and proxy access). With the help of Congress and the President, the number of SEC employees has increased by 25%, as we have hired more than 900 new employees. We have cut our employee turnover in half, secured congressional approval for a compensation structure more in line with some private-sector salaries. We have instituted cross-divisional Task Forces to target concerns and problems, with the important aim of facilitating better communication and coordination between divisions. Let me explain some of our most important achievements.

A top priority for me upon arriving at the SEC was working to restore collegiality at the agency and to assess the way things were run. From the outset, it was apparent that our ability to affect change in the corporate culture we regulate would be enhanced by improving the performance of the SEC itself.

After a complete top-to-bottom review of the SEC, we set about to inject new thinking and to inspire a new vision - one that would help us to broaden the SEC's mandate beyond the enforcement of the securities laws to focus more on anticipating problems, rather than arriving at the scene only after a financial crisis or corporate scandal had occurred. I have referred to this as "looking over the hill and around the corner" for the next emerging problem.

For too long, the Commission found itself in a position of reacting to market problems, rather than anticipating them. There are countless reasons for this - not the least of which include historically lagging resources and structural and organizational road blocks. To address this, we have focused on "breaking down the silos" between the divisions and offices within the SEC, and helping to infuse the staff with a greater appreciation for and understanding of the SEC's core mission. The results of our work formed a new risk management initiative, and an Office of Risk Assessment. This critical initiative is the first of its kind at the Commission and it is already helping the SEC analyze risks across divisional boundaries and identify new or resurgent forms of fraudulent, illegal, or questionable behavior.

While relatively new, these internal reform initiatives will have, I believe, a profound and long-lasting impact on the way business is done at the SEC, and will help make our securities markets more dynamic and more secure.

Completed SOX Act Implementation

More than two years have passed since President Bush signed the Sarbanes-Oxley bill into law, following the wave of corporate and accounting scandals, and the Commission has completed the extensive rulemaking related to implementation of the Act, and done so under an extremely tight timeline. The rules adhere to the letter and the spirit of that landmark Act, and with sensitivity to the myriad issues raised by the rulemaking.

A critically important element of SOX was the creation of the Public Company Accounting Oversight Board. It is helping to restore integrity to the accounting profession, and will instill new confidence in the numbers reported by public companies. We oversaw the appointment of a widely-respected Chairman, William McDonough, and under his leadership, the PCAOB has progressed from start-up to effective operating entity.

SRO Governance and Market Structure

Another element of our effort to maintain fair, orderly, and efficient markets has been to examine how we can improve the system of self-regulation that governs entities such as the New York Stock Exchange and the NASDAQ market. I asked each of the self-regulatory organizations, in March 2003, to review the adequacy of their own governance practices. This review led to a proposal by the NYSE, which was approved by the Commission this past December, to implement important governance changes. The new NYSE structure and rules are important reforms, and the Commission will soon unveil new proposals to further improve the governance and financial transparency of the other self-regulatory organizations, ensuring they meet all of their regulatory obligations.

Last November, the Commission also approved new NYSE and NASDAQ rules establishing heightened corporate governance listing standards for issuers. I am a firm believer that all of the self-regulatory organizations, which play a critical role as standard setters for issuing companies, operators of trading markets, and front-line regulators of securities firms, must demand of themselves the same improved governance standards they require of listed companies.

Mutual Fund Reform

Just as important as the structure of America's markets is the integrity and fairness of the investment vehicles available in our markets. That is why the Commission has focused on the revelations of wrongdoing in the mutual fund industry. The complicity of certain elements of the industry in not only condoning certain unethical practices, but colluding to engage in outright illegal behavior has been an unwelcome shock to the system precisely at the moment when we thought the worst corporate corruption was behind us.

I don't need to rehash the litany of misdeeds for all of you, other than to say that elements within the industry clearly lost sight of certain fundamental principles - including their responsibilities to the millions of people who entrusted the fruits of their labor, and their hopes and dreams for the future, to this industry for safekeeping and enhancement. All investors are entitled to honest and industrious fiduciaries who will put their money to work for them in a way that is fully consistent with the letter and the spirit of America's securities laws.

To that end, the Commission has moved swiftly and forcefully to clean up the mess in the mutual fund industry, approving 9 of 12 new mutual fund rulemaking initiatives - all of which, taken together, 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. One particularly notable rule, approved by the Commission in June, includes a requirement for an independent board chairman and a board on which at least 75 percent of the directors are independent, thus solidifying the role of the fund board as the primary advocate for fund shareholders.

I've talked this morning about the preventative measures the Commission is taking to improve the functioning of our markets, and to create new investor protections. While I am confident these measures will achieve their desired result, I also know that there will always be certain individuals, or institutions, who violate our securities laws. This is a never-ending challenge for the Commission, because the laws are only as good as our ability to enforce them. And if the impression ever takes hold among everyday investors, or the wrongdoers, that the laws aren't being enforced, our markets will take a severe beating.

We have and are continuing to aggressively prosecute those who violate the law. Over the past 18 months, the Division of Enforcement has filed more than 1000 enforcement actions and obtained orders for more than $3 billion in penalties and disgorgements.

As much as has been accomplished at the Commission, there are still a number of action items on our agenda, many of which have received considerable attention. I'd like to highlight three of these proposals. Let me start with the work we have been doing at the Commission on hedge funds.

The Commission has proposed a rule that would require hedge fund advisers to register with the Commission under the Investment Advisers Act. The goal is simple: to enable the Commission to collect more accurate information and to enhance the Commission's ability to oversee this important industry, which will soon have assets totaling $1 trillion and which is no longer an investment only for wealthy and/or sophisticated investors. The industry has witnessed an explosive increase in the use of hedge funds targeted increasingly to smaller investors, and by trustees and managers of pension and other similar funds on behalf of smaller investors who may not know their savings are invested in hedge funds. Hedge funds can have a disproportionate impact on the market relative to their size - through leverage and active trading. We recognize that hedge funds can play an important liquidity role in our equity markets. But it would be irresponsible to do nothing, particularly in light of the evidence we've seen in relation to recent mutual fund scandals and increasing enforcement actions against hedge funds. The Commission does not know as much as it needs to about this growing sector of the investment management industry to protect all investors.

That said, we have no desire to regulate hedge funds as investment companies under the Investment Company Act, which could restrict their investment concentrations and leverage strategies. Nor do we want to require disclosure of their proprietary investment strategies or choke off their expansion. Our decision to utilize the Investment Advisers Act, which is primarily a disclosure and antifraud law, speaks to our modest objectives. We estimate that 40%-50% of hedge fund advisers are already voluntarily registered with us, suggesting that they do not feel constrained by the SEC's registration and inspection process.

The comment period for the proposed rule on hedge funds closed on September 15th and I firmly believe this proposal will, if approved, enhance investor protections, and help the Commission get ahead of an issue that clearly poses new challenges to our markets.

The next issue goes to the core of the SEC's mission to maintain fair, orderly and efficient markets. Since the creation of the national market system in 1975, new technologies and trading patterns have strained the existing facilities and rules that link our securities markets. The Commission has started the process of putting forward ideas on how to modernize our markets in the form of proposed Regulation NMS. It encompasses a broad set of proposals designed to improve the regulatory structure of the U.S. equity markets. These proposals target four substantive areas - trade-throughs, market access, sub-penny quoting, and market data. While this is an issue that certainly merits action sooner rather than later, any reforms we initiate will have far-reaching consequences. We are still reviewing a number of proposed enhancements to NMS and hope to bring forth our new rules shortly.

The third issue - a review of the proxy process related to nominating and electing directors - grows out of our belief that over the past decade, overly compliant boards of directors have often allowed management almost unfettered control over many critical governance issues. The Commission took the first step to address this issue head-on a year ago, when we adopted new disclosure standards to address the breakdown in shareholder communications by improving corporate disclosure in two areas. First, we improved the disclosure requirements regarding the process by which nominating committees consider director candidates, including those recommended by shareholders. Second, we improved the disclosure requirements about the processes by which security holders could communicate directly with members of the board.

The Commission took a third step to address the issue when we proposed a new rule that would require the inclusion of shareholder nominees in a company's proxy materials, under limited circumstances and upon the occurrence of certain triggering events. While we continue to work on structuring appropriate improvements to the rule, the goal is simple: to provide long-term shareholders with an effective means, under certain circumstances, of adding shareholder nominees to a management-proposed slate.

The Commission is still working on each of these proposals, and we are actively seeking input on them to ensure we are fully informed of all the different reform options. We encourage anyone with thoughts on these issues to submit a comment letter to our Commission staff.

I'd like to close with a few words about the SEC as an institution, as we continue to strive to help it adapt to escalating challenges in this new millennium. Our vision is to be the standard against which federal agencies are measured. We are working to strengthen the integrity and soundness of U.S. securities markets, while also conducting our work in a manner that is as sophisticated, flexible, and dynamic as the securities markets we regulate. Our mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. And in managing the evolving needs of a complex marketplace, we will do so in a way that promotes integrity, fairness, accountability, resourcefulness, teamwork, and a commitment to excellence.

Thank you again for the opportunity to speak this morning. I would be glad to take your questions or hear your observations.


Modified: 09/27/2004