Speech by SEC Commissioner:
Remarks to Hellenic Capital Market Commission and the American-Hellenic Chamber of Commerce
by Isaac C. Hunt Jr.
Commissioner, U.S. Securities & Exchange Commission
September 28, 1999
Good evening, it is an honor for me to participate in this evening's event sponsored by the Hellenic Republic Capital Market Commission in collaboration with the American-Hellenic Chamber of Commerce.
I appreciate this opportunity to speak to you about some of the new trends in the Regulation of Financial Markets throughout the world. But before I begin, I am obligated to give you the usual disclaimer that employees of the United States Securities and Exchange Commission, even Commissioners, must make when speaking publicly, which is that the views I express here today are my own and do not necessarily reflect the views of the Commission, other Commissioners, or the Commissionís staff.
Today, I would like to talk to you about some of the challenges facing securities regulators throughout the world and how we in the US are responding to these challenges.
Technological developments, in recent years, have had a fundamental impact on securities markets. New electronic trading systems and the explosive growth of the Internet have provided millions of Americans with unprecedented access to these markets, and introduced people unfamiliar with the capital markets to the benefits of investing. Technology and the Internet are valuable tools for investors, who can now monitor, manage, and trade their own portfolios. Investors now have direct access to a new wealth of market information, which enables them to make informed investment decisions without relying on market professionals. These developments have also had a great impact on the securities markets by increasing market liquidity and transparency.
Via the Internet, investors in Athens could, with the click of a mouse, purchase securities listed on the New York Stock Exchange and then, with a second click, sell those securities in Tokyo. What protections are available for those Athens investors? How do we as regulators ensure that there is full and fair disclosure regarding such purchases and sales of securities? Should we even attempt to regulate transactions of our citizens that occur on foreign exchanges?
As you know, in the United States, with limited exceptions, a company may offer or sell its securities to the investing public only if it first registers those securities with the Commission. This registration process requires the issuer of the securities to provide potential investors with audited financial statements and disclosure of certain material, non-financial information. The statutes and rules requiring this information are designed to ensure that investors receive the necessary information enabling them to make informed investment decisions.
Some have suggested that the Internet should be exempt from our disclosure-based system of regulation; they suggest that the Internet is some special jurisdiction where the laws of individual countries do not apply. We at the Commission do not believe that the Internet is a new jurisdiction. We believe it is merely a new medium being used to communicate traditional, securities-related information. Consequently, if securities are offered to investors in the U.S. via the Internet then our securities laws and regulations should apply.
Cyberspace contains no special safe harbors. If a rule or regulation requires that an investor receive certain disclosure before purchasing a security, then that investor is entitled to that disclosure even if he or she purchased the security electronically. The protection of investors is no less necessary when a security is purchased at "www.wallstreet" than when it is purchased on Main Street, USA or on Constitution Square in Athens.
So our premise in America is that our securities laws and regulations apply to transactions conducted through the Internet. However, that being said, we do not wish to regulate every securities transaction conducted on the Internet. We recognize that the US does not have a monopoly on the Internet and that companies throughout the world may offer and sell securities through the Internet without ever intentionally contacting or targeting US citizens.
Accordingly, in March of last year we issued an interpretive release which provided guidance on when a web site that is accessible world-wide would be considered not to have offered securities or services to persons resident in the U.S. We stated that we would not view issuers, broker dealers, exchanges and investment advisers to have targeted U.S. residents with their Internet offers if they have implemented measures "reasonably designed" to guard against offers or sales of securities, or the provision of services, to such US persons. These "reasonably designed" measures include the following: putting a disclaimer on the web site that the offer is not being made to US residents; obtaining the postal address of the purchaser to ensure that he is not in the US; and ensuring that payment was not made through a US bank.
An undeniable benefit of the Internet and current technology is that they allow smaller companies to better compete with more established and higher-capitalized firms. Should we have different rules for these smaller firms? The Internet also allows investors to reach information not covered by Commission regulations through "hyperlinks." This access raises the question of what liability should apply to hyperlinked materials. How should the Commission regulate chat rooms? We at the SEC have attempted to provide some guidance in these areas through new rules and interpretive letters, but many questions remain unanswered.
Perhaps our most serious challenge is the one that has always existed. How do we prevent fraud? The same characteristics of the Internet that provide better education for investors also provide fertile ground for those individuals set on committing fraud. Creating attractive web sites is now child's play. Many investors have been lured into investing in a company because its web site looked professional and polished, and persuasively described the company's business operations. In some cases, these investors belatedly discovered that the only thing the company has operated is its web site. How do we combat this problem when the culprit may be in another country? Investors everywhere must be reminded that the slick presentation of information does not guarantee its veracity.
Recently, our Division of Enforcement brought civil actions against 44 individuals and firms for publishing fraudulent on-line newsletters and research reports. Some of these individuals and firms had published on-line newsletters and research reports that purportedly offered unbiased, independent information on potential investments. In truth, these reports were bought and paid for by the very companies that the authors of the "research reports" professed to evaluate. Instead of getting unbiased professional opinions, investors were actually just being preyed upon by those looking for quick cash.
While the Internet has created challenges the electronic age has brought benefits to our regulatory system; the use of the internet in the 1980's allowed the Commission to move from paper filings to electronic filings by implementing the Electronic Data Gathering Analysis Retrieval System, commonly referred to as EDGAR.
This system allows filings to be made with greater speed, gives investors faster access to the filed information, and permits wider dissemination of the filings
Today, all US public companies are required to file electronically with the SEC. Within twenty-four hours after a filing is made it is posted on the SECís Internet web site. As a result, the small investor in Iowa or in Athens can now obtain access to these documents with the click of a button.
Our EDGAR system, combined with our Internet web site, has enabled the Commission to better educate and thereby protect investors. Investors download thousands of pages of information daily from our web site. Our web site also provides information on our rules and regulations, recent policy considerations, and enforcement activities. We also have used our site to provide investors with a "financial tool kit" to help them make more educated investment decisions.
Our Division of Enforcement uses our web site to alert the public to known investment scams and other illegal activities. We have received numerous enforcement referrals through our web site. Investors often will click to our web site to alert us to possible scams that they have noticed while "surfing the web." Our web site also has allowed us to more efficiently help small businesses. For example, we have provided information on how small businesses can issue securities.
We also have encouraged companies to use their own Internet web sites to provide information and disclosure to investors directly. Recently, we have found that more and more companies are delivering prospectuses and proxy statements through their web sites and by e-mail. Additionally, some companies now allow their shareholders to vote their proxies electronically through the issuerís web site. The Internet not only provides these companies with significant cost savings, but it provides investors with quicker access to material information.
The Internet offers us, as regulators, the unique opportunity to make our markets more equitable to all investors. Small investors can now obtain access to information that formerly was available only to the largest of institutional investors. For example, some companies now are broadcasting their quarterly conference calls with securities analysts on the Internet.
As a regulator there are many challenges ahead, but the Internet has made this world a little smaller. But if the Internet is to obtain its true promise, investors must have confidence in the information that they obtain from it. For if investors come to distrust it, the Internetís promise will be lost. Therefore, we as regulators must strive to work closer and coordinate our regulations better, so that the promise of a true global market place, where all can participate, is realized.
Another securities market revolution which the technological developments I earlier referred to has made possible is the emergence of the so called "day trader." Through the use of sophisticated computer software, day traders sit in front of computer screens and look for nothing more than real time price movements. What it is that they are buying or selling is of no concern to them. The coin of the realm for the day trader does not extend beyond volatility. If you sense a stock will rise, buy. If you sense it will fall, sell.
This is the strategy of day trading. It is neither illegal nor is it unethical. But it is highly risky. In recent months, many of us at the Commission have been asked more than once why the SEC cares whether a day trader loses his or her money; it's their life and it's their choice.
But that's not the issue. We are concerned that some day traders don't fully understand the level of risk they are assuming. We are concerned that some people may be lured into the false belief that day trading is a surefire strategy to make them rich. And, when individuals are swayed by misleading advertising, the Commission has a duty to act.
That's why we should be focusing on the advertising and marketing practices of many day trading firms. It is in this area that I believe the Commission's partnership with the states is most crucial. A number of states have been leaders in addressing this issue, not only as a matter of securities law, but as a matter of consumer protection.
The National Association of Securities Dealers also has proposed rules that are designed to address the sales practices of day trading firms. This proposal would require these firms to disclose to their potential customers up front the risks associated with this activity, and to screen potential day traders to determine the suitability of this investment methodology to their individual situations.
Eliminating deceptive marketing and advertising practices is a big part of the solution. Another is how day trading firms comply with the law. The Commission is in the process of completing an examination sweep of day trading firms. Our preliminary findings indicate that many of these firms have extremely lax compliance practices. The inability of some firms to monitor their adherence with capital, margin, and the short sale rule, or to maintain adequate books and records, raise serious concerns. These rules, in many ways, go right to the heart of the integrity of our markets and market participants. The Commission will vigorously pursue any violations of law, and has a number of enforcement investigations underway.
The use of margin, in particular, has raised a number of issues. We have found that many day traders do not fully appreciate that by borrowing to buy securities, they can actually lose substantially more than their initial investment. So when day trading firms aggressively promote the lending of equity between day traders to cover margin deficiencies, We find it troubling. We are reviewing this practice to ensure that firms are following the law and that they fully disclose to customers the risks of trading on margin.
Now, the SEC can regulate and the Congress can legislate all we want. But if an individual does not take the personal responsibility to be informed of the risks involved in day trading, no rule or law will fully protect him or her. I do not intend to minimize, in any way, the responsibility of the firms to fully disclose the risks involved, but day traders need to take the time to consider what they are getting themselves into.
The SEC will do everything it can to ensure that day trading firms are operating within the boundaries of the law. But we sincerely hope that individuals considering this type of strategy do their homework before risking their hard-earned money.
Finally as to the impact of the new technology on our financial markets, a few words on the impact of the new electronic communication networks, or ECNs, on the traditional securities trading venues.
As you can imagine, with the growth of these new ECNs and their ever increasing market share, as well as the serious thought our two principal markets- the NYSE and the NASDAQ - are now giving to demutualization and to shifting to for-profit status, we at the Commission have thought long and hard about what the markets of the future will look like. There may be more dramatic changes taking place in our markets now, and at a more rapid pace, than at any time in the more than 60 years that the SEC has been attempting to regulate the American securities markets, and these changes are, in large part, technology driven. In fact just a few evenings ago, Thursday September 23, 1999, Chairman Arthur Levitt gave a major speech on this topic, "Dynamic Markets, Timeless Principles," at Columbia University Law School in New York City, in which he addressed many of the issues we face in trying to determine what the markets of the next millennium will look like and how best to regulate them. I will try to cover some of the topics he discussed in that talk and which we have been wrestling with as they relate to today's topics.
In simplest terms, ECNs bring buyers and sellers together for electronic execution of trades. They have provided investors with greater trading alternatives, and have greatly reduced execution costs. As a result, these networks present serious competitive challenges to the established market centers. More fundamentally, they demonstrate the breath-taking pace of change that results when technology and competition merge. The Commission has no intention, whatsoever, of standing in the way of a movement towards for-profit status. But such developments do raise the question of how best to maintain our time-honored system of self-regulation. Some at the Commission believe that, at a minimum, there must a strict corporate separation of the self-regulatory role from the marketplace it regulates for the protection of investors in a for-profit structure.
Many initially thought that one SRO that regulates all markets, alleviates conflicts and reduces redundancy, paperwork, and operational costs is the solution to this problem. Others advocated a model where each market would maintain the regulatory and surveillance function solely for its own market -- but member regulation, sales practices, and all other aspects of intermarket trading would be overseen by a single SRO.
I believe none of us at the Commission are wedded to any particular model at this point -- a great deal more thinking needs to be done. Any restructuring, however, must provide that the self-regulatory obligation be vigorously fulfilled, adequately funded, and dedicated to serving the public interest.
The U.S. system of self regulation has created a degree of oversight that is unique. We simply cannot allow the mandate of self-regulation to take a back seat to the desire for short-term profits in a new for-profit environment. As I have indicated, these issues are breaking quickly, and the Chairmanís speech has already generated much needed dialogue on the future of our market structure and regulatory oversight.
I next would like to say a few words about how we in the U.S. regulate what we call mutual funds (and what are called "collective investment schemes" in many other parts of the world.)
First a note on the importance of mutual funds to Americans: Over the last several decades, mutual funds have taken on tremendous importance in the lives of everyday Americans. For many Americans, mutual funds are the primary investment vehicle for saving a down payment on a home, preparing to send children to college, and planning for retirement.
Let's look at the big picture:
- One out of every three American families invests in mutual funds -- that's more than 30 million households.
- Fund assets, at approximately $5.5 trillion, exceed insured commercial bank deposits, which stand at about $2.5 trillion.
- Americans today have more wealth invested in mutual funds than in real estate. A few years ago this would have been unthinkable.
- Millions of fund investors across the country read magazines and watch TV programs that are devoted to personal finance topics, such as mutual funds.
- And, billions of dollars in retirement savings is invested in mutual funds. As a matter of fact, approximately half the assets in the world's largest mutual fund -- Fidelity's Magellan Fund -- are comprised of investment through 401(k) - type retirement plans.
Because mutual funds, both foreign and domestic, are so important to so many Americans today, we at the Commission are always considering what, if anything, we can do, together with the mutual fund industry, to improve the operations of the participants in that industry.
To that end, in February 1999 the Commission sponsored a roundtable on the role of independent directors and how to improve investment company governance and the effectiveness of such directors in protecting the interests of mutual fund shareholders.
Chairman Levitt charged the round table, made up of independent fund directors as well as senior fund executives, legal counsel to funds, investor advocates, and leading academics, to address such topics as the following:
- What role do independent directors play in negotiating fund fees and expenses? How do they decide whether fund directors are getting their money's worth?
- What are the fundsí distribution arrangements? Independent directors have special responsibilities under the Investment Company Act of 1940 to determine that when fund assets are used to pay distribution expenses, there is a reasonable likelihood that the payments will benefit the fund and its shareholders.
- What are the fund's brokerage arrangements? Which broker is the fund using, and why? Is the fund truly receiving best execution?
What can independent directors do to ensure that shareholder communications are accurate and give full information about the fund?
The Commission and its staff continue to discuss what, if any, rulemaking proposals we should develop, given the Roundtable results, and whether follow-up discussions and conferences should be held.
Another recent SEC initiative relating to fund governance was our adoption, in August of this year, of new rules restricting personal trading by mutual fund portfolio managers to help ensure that the personal trading of mutual fund insiders does not compromise the interests of mutual fund shareholders. We adopted this rule because of the perceived conflicts of interests that exist when (1) a portfolio manager buys an initial public offering ("IPO") or private placement when, arguably, the fund should have had the first opportunity to buy into the deal, or (2) a future investment decision for the fund could be influenced by the portfolio manager's personal position in a stock.
Although 72% of mutual fund companies already had codes of ethics barring investment personnel from participating in IPOs, this new rule amendment underscores our continuing concern that fund companies take every measure to ensure that fund insiders always put the interest of the fund and its shareholders ahead of their own.
Finally a word about transparency. When we speak of one of the best qualities of the U.S. securities markets as being transparent, we mean that they operate without hidden aspects, on complete information. You can "see through" the information around you and find out exactly what is going on. In a transparent market, exchanges and dealers publish both the prices at which they are willing to trade, and the prices at which stocks have traded, hopefully in all relevant markets, so that customers may obtain the best prices for their order in any market, no matter where first routed.
A fundamental element of transparency, and of fairness, requires that those persons with a special relationship to issuers--officers, directors and other "insiders" -- be perceived as receiving no special benefit from their status to the detriment of the ordinary shareholders of the issuer.
From this concept springs the rules against "insider trading" in so many markets developed and emerging.
In fact, one of the original provision of the U.S. securities laws, Section 16(b) of the Securities Exchange Act of 1934, goes so far as to presume a lack of transparency and fairness if a defined insider - an officer, director or holder of 10% of more of an issuer's securities - buys and sells, or sells and buys, the issuer's securities within a six month period. Any profits the insider makes in such transactions are recoverable for the issuer, and therefore for the benefit of the issuer's ordinary shareholders.
We believe all such persons with special relationships to a corporation, including defined insiders, persons with the political power to affect the fate of the corporation regulators, or others, have an obligation to be transparent and fair in using their special relationship to an issuer in any market which is to maintain the confidence of its investors.
Again, my thanks to the Capital Market Commission and the American-Hellenic Chamber of Commerce for inviting me to Athens once again and having me share my thoughts on these important issues with you.