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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks to the Practising Law Institute


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

November 6, 2003

Good morning, and thanks for inviting me to join you today. I want to begin by acknowledging the great work of the Practising Law Institute, and in particular the efforts of Annual Institute Co-chairs Linda Quinn, Curtis Mo, and David Harms. They have brought together an outstanding faculty and have attracted the large and distinguished audience gathered here this morning. Your schedule over the next three days promises an array of interesting discussions and presentations on securities regulation.

The subjects to be covered at this year's institute are timely. In the past eight years, we may have seen the greatest creation - and elimination - of wealth in possibly any other equivalent period in human history. We have also seen a wave of corporate scandals, with revelations that even the fiercest critics of capitalism could scarcely have imagined. These ongoing scandals have severely undermined the standing of American business. They have also sapped the confidence of millions of investors, who have been left to wonder whether they have been participating in a scheme that's rigged against them.

It is imperative that American investors see that steps can and will be taken to respond to this situation, and to reduce the likelihood of it happening again. There are those, including some attorneys, I fear, who believe that the emphasis should be limited to modest reforms targeted at the most visible signs of corruption. I strongly believe this would be a mistake.

We must not overlook that the failures of corporate governance, auditing, and financial reporting that surfaced in connection with the stock market boom of the late 1990s reached beyond the gross failures alleged to have occurred at companies whose names we all know - Enron, WorldCom, Tyco, Adelphia and the like. There was a widespread erosion of business principles, and a dangerous short-term mentality that guided much business decisionmaking. The recent developments involving mutual funds, brokers, and advisers engaging in late trading and market timing transactions are a sad reminder that improper practices have continued in some quarters. One of the great challenges facing our corporate and financial communities in the months and years ahead will be to speak out against these practices - loudly and regularly - and to stand up for greater integrity and transparency in everyday business. Only then will there be true, long-term restoration of confidence in our markets.

At this point I hasten to issue the standard disclaimer that the views I express today are my own and do not necessarily represent the views of the Commission or its staff.

I want to talk, in a moment, about the SEC's aggressive agenda for helping to restore investor confidence, but first I want to highlight two aspects of the Sarbanes-Oxley Act.

First, while the sweeping reforms contained in Sarbanes-Oxley address a broad spectrum of subjects crucial to our nation's companies and capital markets, one of the law's most important objectives is to strengthen the performance of the traditional "gatekeepers" to the markets, especially public company accountants, research analysts and lawyers. Second, Sarbanes-Oxley provides the Commission with important new tools to enforce our nation's securities laws.

Starting with the gatekeepers point, I particularly want to address the impact on lawyers. The attorney conduct rules adopted by the Commission this past January implement the so-called "up the ladder" principle for attorneys appearing or practicing before the Commission in the representation of a public issuer. The basic principle that the rules build upon is unassailable and needed reinforcement - the client of a lawyer representing a corporation is the corporation - and not the CEO, or other members of management, or the company officer doing the deal on which the lawyer is working.

The Commission's January rulemaking did more, however, than reinforce this "know-your-client" principle as required by Sarbanes-Oxley. It also included a new provision authorizing a public company attorney to make "permissive disclosure" to the Commission in cases where the attorney reasonably believes disclosure is necessary to prevent a fraud or other serious violation likely to cause substantial injury to shareholders. This provision, which goes beyond the minimum requirements of Sarbanes-Oxley, codified into our regulations a concept that had already been recognized in the ethics rules of the vast majority of states.

The Commission also proposed for public comment additional attorney conduct rules that would have implemented so-called "noisy withdrawal" requirements. The noisy withdrawal rules remain under consideration today, as does an alternative that would require attorneys to notify the company of their resignation and the company to report the resignation to the Commission. These proposals go beyond the "corporation as client" principle and stand for the important idea that some violations of law provide such risk of financial injury that the public interest requires attorneys or their clients to make the Commission aware of the attorney's resignation for professional reasons.

Since the extension of the comment process on these proposals, the legal profession has continued to evaluate its responsibility to the public interest in these kinds of circumstances. I was very pleased that at this past August's American Bar Association convention in San Francisco, the ABA's House of Delegates adopted amendments to the organization's model code of ethics to include a "permissive disclosure" provision in some circumstances involving financial interests, thereby effectively allowing a noisy withdrawal in many cases similar to those identified in the Commission's rules. This is an important recognition of the public interest by the leaders of the bar and forms a clear basis for state codes of conduct to evolve in this direction, including in contexts outside the Commission's jurisdiction. As we continue to consider the issues in rulemaking pending before us in this area, we are also acting vigorously to enforce our existing regulations, and to advance the principles underlying them. Further, the Commission has made clear that in cases where our rules apply, a uniform federal provision must prevail over conflicting state law.

The second aspect of Sarbanes-Oxley I wanted to touch on is how it has helped us to enforce federal securities laws. To summarize, the legislation strengthened our ability to obtain meaningful remedies, and expanded our authority to return funds to harmed investors via the creation of the so-called fair fund. I know that Saturday morning of your conference is devoted to enforcement and litigation matters, with participation of Commission staff, and I am sure that these points will receive the full discussion they deserve.

As part of our enforcement efforts, we filed a record 679 actions in the 2003 fiscal year, which ended September 30, up from 484 two years ago. 199 of these involved financial fraud or reporting violations. The Commission also sought to bar 170 offending corporate executives and directors from holding such positions with publicly-traded companies in the past fiscal year, up from 51 two years ago. Further, we are holding accountable not just the companies who engage in fraud, but also those advisers who help to enable it.

We have also worked to return funds to investors who have suffered losses, rather than merely collect those funds for the government. As part of these efforts, we have obtained the single largest civil monetary penalty ever imposed for violations of America's securities laws - and the proceeds from this penalty will be made available to harmed investors.

Beyond Sarbanes-Oxley, our initiatives to serve and protect investors cover the spectrum of our principal areas of activity - including hedge funds, market structure and continuing efforts to improve issuer disclosure. Given their importance and public attention, three areas where we are concentrating our efforts are particularly deserving of attention.

First, the scandals involving late trading, market timing and insider trading at mutual funds have revealed wrongdoing in the part of the securities industry where individual investors are most exposed and must be protected. The wrongdoing must stop, past and present malefactors must be brought to account through both civil and criminal sanctions, and we must institute reforms that provide better protections in the future.

In addition to vigorous enforcement, taken in conjunction with our fellow regulators from the states, we are pursuing a broad regulatory agenda. The Commission's staff has been focused on mutual fund reforms, and so far this year the Commission has proposed or adopted 16 rulemakings related to mutual funds. Through these rulemakings, the Commission has sought to enhance fund governance and internal controls, improve fund disclosures, and minimize conflicts between funds and their managers. We have also sought public input on additional measures the Commission should take to improve the mutual fund regulatory framework, so that we can avoid a repeat of the problems that we are currently investigating. The 16 rulemakings initiatives, as well as those still to come in areas like further strengthening compliance procedures, improving fund board structure, and enhancing disclosure of incentives and conflicts of broker-dealers when selling fund shares, coupled with the staff's work on hedge funds, will represent what I believe to be the Commission's most productive year in investment management regulation since being charged in 1940 with overseeing this segment of the financial services industry. In addition, at my request the SEC's Division of Investment Management is preparing recommendations to prevent late trading through stricter rules and to address market timing.

Second, we are continuing to encourage and monitor the improvements in corporate governance at the nation's self-regulatory organizations, especially the New York Stock Exchange. Under the interim leadership of John Reed, the Exchange has made important progress in designing a reformed Board and governance structure. Both the Exchange and the Commission are far from done, but, to repeat, there has been important progress.

Let me highlight one issue associated with governance at the New York Stock Exchange, and that is the locus of the regulatory function. Clearly the responsibility of an SRO for running a marketplace, as well as the responsibility for the regulation of that marketplace, brings into the forefront a potential conflict of interest. As I noted in my recent congressional testimony, there are a number of different ways of addressing this potential conflict, ranging from a total separation of the regulatory function to a partial separation, to an internal structure that separates the reporting function and financing of the regulation inside an SRO. I have not changed that position put forth in my congressional testimony.

Third, the unresponsiveness of boards, sometimes tied to corporate governance weaknesses, demonstrates the need for shareholders to have a more meaningful voice in the proxy process. In August, the Commission proposed rules that would require more robust disclosure of the nominating processes of public companies, and specific disclosure of the processes by which shareholders may communicate with company directors. Last month, the Commission proposed rules that, for the first time, would establish a procedure for the inclusion of shareholder nominees for director to be included in the company's proxy materials, alongside the company's nominees. These latter rules regarding disclosure of shareholder nominees in the company proxy are currently in their comment period. The proposed rules have tried to strike a balance between providing appropriate benefits to shareholders and not unnecessarily interfering with the proper functioning of boards. The proposals have nonetheless been criticized by advocates on both sides of the issue, and we will factor all of these views into our deliberations.

Returning to Sarbanes-Oxley, as you move through your program over the next three days, I hope you will recognize that while the new mandates growing out of the law involve the bright line tests typical of regulation, simply complying with them for the sake of compliance does not represent more effective corporate governance. Indeed, I hope you will start by asking not, "How do our clients, and how do we, comply with the new rules?" but rather, "What is the right conduct for the client, and for me? And what are the best practices we should be striving to embrace?" You can help your clients to see, and to understand, the big picture. Because the real need is for an underlying spirit of reform, in which a company-wide mindset is inculcated to do the right thing.

Throughout the Commission's history, attorneys have played a vital role in advising their corporate clients not only to obey the letter of the law but also to do the right thing. Never has that role been more important than it is today. For all the progress American business is making on corporate governance, we are also witnessing unwarranted negativity about the burdens of Sarbanes-Oxley.

I am happy to say that a significant number of the businesses I am in contact with believe that the Act and related developments are improving financial reporting, the conduct of auditors, corporate governance and the overall tone of America' businesses. But I am concerned that some attorneys are advising, and some companies are concluding, that Sarbanes-Oxley serves only to establish an avalanche of new mandates that must be satisfied through elaborate check-the-box compliance programs that take time away from strategic thinking, that require changes in the risk-taking calculus of American companies, and that impose costs that outweigh any conceivable benefits.

What I would hope the legal profession and others will realize, and act on, is that Sarbanes-Oxley presents not only burdens, but also opportunities - opportunities to improve internal controls, improve the performance of the board, improve their public reporting and improve their value for their shareholders. I firmly believe that this larger view is in furtherance of your clients' legal and business interests.

In closing, I want to thank the Practising Law Institute again for giving me this opportunity to speak today. By providing education and training in a forum like this one, the PLI is setting an example that I hope other educational institutions and independent groups will build on. You are helping to set the stage for renewed confidence in our companies and our markets.


Modified: 11/06/2003