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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks Before the Council of Institutional Investors' Fall Conference


Chairman Harvey L. Pitt

U.S. Securities and Exchange Commission

The Plaza Hotel, New York
September 23, 2002

These remarks reflect solely the personal views of Chairman Pitt, and do not necessarily reflect the views of the Commission, the individual members of the Commission, or the Commission's Staff.

Good morning.

As we all know, our securities markets are roiling from revelations of corporate misconduct and accounting chicanery. This would be a serious problem any time, but it's all the more so because our markets now serve so many individual investors - over half the households in America. While the first "I" in your name might be thought to bespeak representation of large, monolithic investors, it's through your members, and the mutual fund industry, that most individuals find their way to our equity markets.

That's why I was pleased to accept Sarah's invitation to attend this year's annual meeting. I'm genuinely delighted to be here with you, to convey three messages: First, I want to share my deep concern for the challenges we all face at this time. Second, I want to explore with you the SEC's important role, and the solutions we envision, as we seize upon this historic opportunity to create fundamental, long needed, changes in our capital markets and securities regulation system. Third, I want to discuss the critical role you play in our efforts to restore investor confidence and improve how our capital markets function.

There's a tiny museum in downtown Seattle's Pioneer Square called the Klondike Gold Rush National Historical Park. The museum chronicles Seattle's role in the 1897 to 1898 gold rush in Alaska and Canada. Approximately 70,000 folks stampeded through Seattle during the Klondike Gold Rush. Those who made fortunes weren't the ones panning for gold; they were the ones selling pans! Seattle's merchants flourished, selling everything from arctic underwear to insect-proof masks. Some even sold stock. If prospectors didn't go to the Yukon, they could always buy stock in the Klondike Gopher Company, a business that claimed to train gophers to find gold. (Its motto must have been, "Gopher the Gold," to "burrow" a phrase)!

A hundred years later, Americans experienced a similar gold rush. As with Seattle's rush, the euphoria of the '90's has since given way to an ugly and unacceptable string of business scandals. All Americans have felt, and continue to feel, the consequences of these events. Innocent investors, employees and retirees, who made life-altering decisions based upon a stock's perceived value, have found themselves left with rapidly sinking investments that ate up the fruits of years of their hard work. It's these Americans, whose faith fuels our markets, whose interests are, and must be, paramount.

You represent these investors. After all, institutional investors are really just large agglomerations of regular folks. Maybe they're teachers, or firefighters, or simply people who choose to invest their money in the same mutual fund. But they all have at least one thing in common - they all make tremendous sacrifices to invest their hard-earned money. They're people busy doing their jobs, lacking time to research stocks and bonds in which to invest for their retirement or their children's education. So they give their money and their trust to you. As major shareholders, you play a vital role in monitoring the stewardship of the companies in which you invest. Your role is critical to improve corporate accountability.

Long before the recent string of corporate implosions, the need for change was great, but unrecognized in the euphoria of the recent '90's. When I took this job, I did so in the hope I could make a difference for individual investors, and for the efficiency and fairness of our capital markets. Although I didn't expect these long-simmering problems to boil over as they have, I have the chance to clean up this mess and set the stage for a new era of enhanced disclosure and transparency for the benefit of investors. It's a chance I won't pass by.

Even before the scandals erupted, we knew there were a number of things we had to do to make sure that investors - and I mean individual as well as institutional investors - were treated fairly by those upon whose good faith and integrity they relied. Lost in the shuffle of finger pointing and blame-assignment are the historic achievements the SEC has made over the past year. These are achievements of which we can, and should, all be proud. We've done far more to open up our processes so that individual investors reap the benefits of an honest and unrigged marketplace, with our "real time" enforcement program, our attack on corporate officers and directors who do not live up to their duties, our efforts to bring transparency and honesty to securities disclosure and analysis, and our efforts to make shareholders the true owners of their corporations.

In these efforts, we've not been alone. Last fall, after uncovering Enron's defalcations, we launched the most aggressive reform agenda in our history. At the time, there was a real debate over whether the SEC had, as we believed, legal authority to implement the changes we sought, including the end of accounting self-regulation. On July 30, President Bush eliminated any doubts about our authority to proceed with our proposed reforms when he signed the Sarbanes-Oxley Act into law. These reforms include a new oversight board for the accounting profession, new measures intended to promote auditor independence, new disclosure requirements for public companies, and stronger criminal penalties for securities fraud.

Sarbanes-Oxley codifies our numerous initiatives. This legislation offers all of us an incredible opportunity to effect dramatic changes in the way our capital markets, as well as those who serve our capital markets, are regulated. It's a privilege to have the opportunity to help solve these problems. At the SEC, we've a huge amount of work ahead of us, but my newly ensconced colleagues and I will do everything we can to implement the reforms on which we've been embarked and that the Act now clarifies our ability to effect.

Among our major tasks is creating a new private sector regulatory regime for the accounting profession. We must pick five "prominent individuals of integrity and reputation who have a demonstrated commitment to the interests of investors" to serve as our first Board, which will register all accountants that audit public companies, oversee standard setting for their conduct and independence, discipline them if they err, and perform regular quality control reviews to make sure firms are functioning at the highest professional levels.

We must appoint the Board by October 28th, but we hope to complete the effort by the end of this month, to give us more time to focus on start-up issues. We've received nearly 500 names thought qualified to serve from every constituency, and from the investing public. We'll pick the five board members unanimously. We're committed to choosing persons of the highest integrity and dedication to the public good.

Corporate governance has been a prime focus of ours, because it affects the quality of financial statements and the stability of companies - matters about which we have a longstanding interest, and a legitimate obligation to address. Last week, for example, we proposed requiring mutual funds and investment advisers to disclose information to shareholders and clients about how they vote their proxies for the securities they hold.

Today, over half of all Americans participate in our securities markets; most, through mutual funds. Currently, over 50 million Americans own mutual funds, representing more than 53% of American households. SEC-registered investment advisers manage and have discretion over $19 trillion of assets, including large equity securities holdings. Mutual funds they manage hold nearly one-fifth of all publicly traded U.S. equity securities.

These securities are held for the benefit of the investors who are the fund shareholders. They belong to fund investors, who are entitled to know how their property is being voted. The voting power these securities represent carries the ability to influence the governance of U.S. companies. Moreover, voting decisions by funds and advisers have an enormous impact on the financial well being of millions of ordinary citizen-investors. Despite the influence of this voting power, many mutual funds and investment advisers don't disclose their policies on how they vote portfolio securities; fewer enable shareholders to learn if voting policies were in fact followed. Some wield voting power in the face of conflicts; they may cast votes furthering their own interests rather than those for whom they vote.

At present, the Commission's rules do not require mutual funds or investment advisers to disclose either their proxy voting policies and procedures or their proxy voting records. The Council's advocated these disclosures and, since year 2000, we've received multiple rulemaking petitions on this subject, from the AFL-CIO and others. The idea for these disclosures first arose nearly thirty years ago, yet nothing was done. Over the past year, I met with proponents of the rulemaking petitions; I indicated my commitment to changing this record of Commission inaction, and I assured them our response would be forthcoming before another year was allowed to pass.

Particularly since recent events have caused an erosion of confidence in public companies and financial institutions, I'm pleased we're finally addressing the petitions, which are premised on bedrock principles of the federal securities laws: transparency and adherence to fiduciary duties that require advisers to vote in their clients' best interests. If adopted, these proposals would give investors fundamental information about the practices of those who vote proxies on their behalf. In addition, they would encourage mutual fund directors and investment advisers to exercise their fiduciary responsibilities with respect to proxy voting in an appropriate manner. They would discourage or expose proxy voting conflicts of interest.

The potential for conflict is a driving factor behind our rule proposal. People who vote shares belonging to others can vote those shares for their own benefit. This would be a breach of fiduciary duty and transparency. By forcing them to disclose their policies and their voting records, we can deter breaches. The federal securities laws are premised on the notion that, if people are forced to disclose potential conflicts, they are less likely to engage in them. While some conflicts may not be strictly prohibited under the federal securities laws, their disclosure, as well as letting people know their consequences, is absolutely required. And that has a way of helping people conform their behavior to the types of standards we'd like to see them apply.

We've one more piece of the existing petitions to deal with, and I've directed our Staff to present proposals to us quickly. I'm talking about a proposal to require greater and more frequent disclosure of fund portfolio holdings. This has been a topic of great debate, but I believe issues don't become easier if permitted to languish. I'm determined to have us vote on this issue before year-end.

Our corporate governance system requires that corporate leaders be faithful to the interests of shareholders and act with both ability and integrity. Most of the problems we've seen recently result from a failure of company executives to honor their fiduciary duties. To restore public confidence in the integrity of senior corporate managers, companies must demonstrate a strong commitment to the development and enforcement of rigorous corporate governance standards. Sarbanes-Oxley has touched on some of these areas, and corporate governance is getting much-needed attention in other quarters as well, including the New York Stock Exchange and Nasdaq, who we asked to work with the corporate and shareholder communities to review their corporate governance and listing standards, including important issues such as officer and director qualifications and codes of conduct of public companies. Their thoughtful efforts represent a significant step in addressing major concerns raised by recent events. We're working hard to pull together a comprehensive rulemaking to address these issues, and it will include reforms such as:

  • requiring stockholder approval of all stock option programs;
  • requiring a majority of directors of public companies be independent;
  • requiring audit, compensation and nominating committees be comprised entirely of independent directors; and
  • tightening "independence" requirements to reduce the ties between independent directors and the company or its executives.

The quick pace and the breadth of these reform proposals encourage me, and we look forward to their finalization.

Our primary concern is to ensure that management's and shareholders' interests are aligned. This is tougher than it sounds. For example, for years, conventional wisdom said granting corporate managers stock options would align their interests with those of their shareholders. We now know that isn't necessarily so. Options can align those interests, but if managers can reap profits from their options while shareholders are losing some or all of their equity stake, the options create conflicting, not aligned, interests.

The key, in my view, is to ensure that, if a company chooses to grant options to corporate managers to create incentives to build value in the company, the options actually work as intended, rather than create an unearned windfall for those managers. There are, in my view, several components to this.

First, I believe shareholder approval should be required before any officer and director stock option plans (and other equity compensation plans) can be implemented. Making equity incentive compensation available to management is in the interest of shareholders. Companies should be required to make full disclosure and submit such plans to a shareholder vote as a fundamental first step.

Second, the decision to grant options to senior management, and the terms of those grants, should be entrusted to a committee of independent directors. The core function, and key benefit, of the independent directors is to help prevent management practices that may deliberately, or inadvertently, misalign shareholder and management interests. Overall, the role of all independent directors is critical to good corporate governance, and should be strengthened. The definition of "independent" also needs to be tightened. These directors need to be truly independent from management. They need to be serving shareholders, not CEOs.

Third, options are potentially troublesome if they are structured to reward, or are capable of rewarding, short-term performance. Corporate boards should require officers to demonstrate sustained, long-term growth and success before actually exercising options. This would abolish perverse incentives to manage earnings, distort accounting or emphasize short-term stock performance. The award of options seems to be most compatible with shareholder interests if tied to long-term corporate performance. This is critical to strengthen honest managers' resolve and restore confidence in and credibility to our financial markets.

Recently issues have arisen regarding shareholder suffrage regarding options treatment. My approach to these issues is, above all else, pragmatic. The purpose of shareholder proposals is to give shareholders a chance to inform management about how they feel regarding major issues confronting corporations. Last year, when Disney was presented with a proposal to let shareholders express their views regarding whether their company's outside auditors should be allowed to do any consulting work, I strongly endorsed the right of shareholders to express their views on such a topical issue, breaking with past tradition. I believe the same is true with respect to options accounting. Whatever one's views are on the merits of the subject, it is clearly an issue of extraordinary importance; as a result, I don't think corporations should be able to exclude aggressive shareholder proposals like these under the rubric of the "ordinary business exception."

Indeed, I've asked our Director of Corporation Finance, Alan Beller, to consider a proposal to eliminate the "ordinary business exception" from the list of reasons that companies can exclude otherwise validly promulgated shareholder proposals. It is my hope that we can eliminate this exception, making shareholder suffrage a reality, and sparing our Staff from trying to resolve what is, or isn't, within the purview of ordinary business issues facing public companies.

Corporate disclosure practices are another important agenda item. A sports club in DC runs a print advertisement saying, "Hey CEOs, here's one place you can show off your losses." It's a clever ad. At the SEC, we're also encouraging CEOs to show off their losses. Last year we began the needed enhancement of our corporate disclosure system. Sarbanes-Oxley requires us to make many additional regulatory reforms to improve the quality and timeliness of financial disclosure.

On August 27th, we adopted rules requiring CEOs and CFOs to certify the contents of quarterly and annual reports. These rules implement important sections of the Sarbanes-Oxley Act of 2002. In re-establishing the true accountability of corporate leaders, CEOs and CFOs must certify to their shareholders that everything investors should know about the company has been disclosed.

We've also adopted amendments to accelerate the filing deadlines for quarterly and annual reports. These changes will be phased in over three years, ultimately requiring annual reports to be filed within 60 days and quarterly reports within 35. It was long overdue for the SEC to shorten report deadlines set more than 30 years ago, when companies still were dependent on paper and pencil, adding machines, carbon paper and the U.S. mail to prepare and file their reports with us. Significant technological advances in the intervening decades have enabled companies to capture, communicate and evaluate information and prepare their reports more rapidly. That savings should have been passed on to shareholders a long time ago.

Similarly, we've adopted rules that accelerate filing deadlines for corporate insiders to report transactions in their company's securities. These include transactions with the company. These deadlines shrunk to only two days - from periods of up to 410 days.

We have many more rules we must propose and adopt under Sarbanes-Oxley. Consistent with administrative law, Congress articulated broad standards in Sarbanes-Oxley and left to us the job of defining legal requirements under those standards. You play a critical role in this process. We need your insights and suggestions on the best ways to implement Sarbanes-Oxley concepts.

These are just some of the initiatives on which we're embarked. It's a dramatic and exciting time to be at the SEC. Over the next two years, we'll remake our regulatory system into a system that complies with our legislative mandate, and restores investor confidence that ours are indeed the best, the most liquid, the most resilient, and, above all, the fairest capital markets in the world. That's our aim, but we can't do it alone; we need your help. If we focus on solutions, together we can improve the regulatory framework, and reshape the essence of corporate disclosure, corporate governance and accounting regulation with thoughtfulness, care and creativity. That's why I took this job and, it's why I'm still here.

Thank you.



Modified: 09/23/2002