Speech by SEC Commissioner:
Remarks Before the SIA Operations Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
May 12, 2006
Good morning. I'd like to thank Mark Lacritz for inviting me to join you here today. I'd also like to thank Rich (Richard) Bommer, at the SIA, for his efforts in bringing this conference to fruition. Sometimes I feel that the operations people don't get the credit they deserve because they're not the people shaking the investor's hand, signing the underwriting agreement, or ringing the bell at the stock exchange. I know we're in Phoenix and not Oz, but I imagine that operations staff sometimes feel like they're the little man behind the green curtain... just ignore the man behind the curtain! In this case, however, it's the operations personnel who make things happen and get things done.
That reminds me of a mediocre operations-related joke, and, seeing as it is bright and early in the morning, I'm going to toss it out there. Here goes.
At a recent computer software engineering course, the participants were given an awkward question to answer: "If you had just boarded an airliner and discovered that your team of programmers had been responsible for the flight control software, how many of you would disembark immediately?" Among the ensuing forest of raised hands only one man sat motionless. When asked what he would do, he replied that he would be quite content to stay aboard. With his team's software, he said, the plane was unlikely to even taxi as far as the runway, let alone take off.
My point? You matter. I'm interested in your concerns with respect to the market, the industry and our regulations. Let me know what's going on and when you see problems. Now, turning to my remarks, let me remind you that the comments I make today are my own. They do not represent the Commission, my fellow Commissioners or the staff.
I'd like to spend my time discussing a few topics which fall directly within your purview but which have implications for a much larger group of people investors. Technological developments paired with creative applications are driving us to a global marketplace at a heart-stopping pace. Competition in this context magnifies all of the relevant concerns associated with these developments. Thus, it is incumbent upon us, the SEC, to recognize this phenomenon and be responsive to the need to modify existing regulatory frameworks when necessary to accommodate these advancements. Such action must be taken both in relation to our domestic marketplace but also in relation to the way in which our US securities industry fits into the larger, developing, global marketplace. Guiding our hand in all of these decisions must be an underlying concern for the investor and fair markets.
With that in mind, I'd like to start out by talking about a few issues that we are examining on the home front, such as electronic-proxies and Regulation NMS, and then conclude with some discussion touching on issues that cross our borders, including self-regulation and international market consolidation. I would note than even though I am characterizing some of these topics as domestic, per se, we can no longer limit our analysis of these issues to the U.S. Our decision making process as regulators is informed by the experiences we observe our counterparts undertaking in their home jurisdictions. That's just part of what it means to operate in a global marketplace.
As I'm sure you know, late last year the Commission proposed amendments to the proxy rules that would allow issuers and other persons to furnish proxy materials to shareholders by posting them on an Internet web site and providing shareholders with notice of the availability of the proxy materials. The proposed amendments are intended to lower the cost of proxy solicitations, which are ultimately borne by shareholders, by taking advantage of technological developments and the growth of the Internet and electronic communications. Further, the proposed amendments also would apply to a soliciting person other than the issuer, which has the potential to reduce the costs of engaging in a proxy contest. Notably, under the proposed amendments, shareholders would be able to choose to affirmatively "opt out" of the Internet delivery regime and receive paper copies of the materials at no cost, but the default rule would be one of "notice and access."
When the Commission voted to propose these amendments, I commented at our open meeting that I supported the proposals because I liked the idea of reducing the cost of soliciting proxies. However, I also cautioned that we should take great care in ensuring that the proposed rules, if finalized, would not have unintended consequences. In addition, by now, we've received numerous comment letters on the proposed rules, which raise a number of concerns about the proposed rules, as they are currently drafted. Let me briefly highlight a few of these.
A. Costs of Contested Proxy Solicitations
When we proposed the Internet proxy rules, I felt that one of the benefits of the proposals was that they would also apply to soliciting persons other than issuers, which we anticipated might reduce the costs of engaging in a proxy contest. To me, this was a very important potential benefit of the proposed rules because, as you know, I have long been concerned with the difficulty that shareholders have in nominating candidates for director. Based on the comment letters we've received, however, I've begun to have some questions as to whether these cost savings will actually materialize.
In particular, at least one commenter has presented data showing that only 5% of the costs associated with proxy contests are related to the printing and mailing of the proxy materials, meaning that 95% of the costs of proxy contests are associated with items such as professional fees paid to law firms, proxy solicitors, investment banks and public relations advisors. This same commenter asserted that, based on their analysis, not printing and mailing the proxy statement would have saved only an average of 1.7% of the total costs of a contested solicitation. Thus, if the results of this data are to be believed, it appears that the proposed rules would not be able to significantly reduce the costs of proxy contests because they would affect a line item representing only an insignificant minority of the costs.
Further, some have raised questions about whether issuers and other soliciting persons would even want to make use, in a contested solicitation, of the "notice and access" model found in our proposed rules because in such a situation, companies would choose not to deliver proxy materials electronically and would instead opt to use mail, ostensibly due to the greater impact that paper proxy materials would have.
B. Decreased Voting Levels
Another comment that we received is that based upon survey data investors would be less likely to vote via their proxy cards if the proposed rules were adopted. If true, I think this result would be contrary to the goals of the proposed rules. Furthermore, it's been suggested that decreased levels of voting could make it more difficult for some companies to achieve a quorum at their shareholder meetings. This in turn might lead to higher costs for companies, as they might be required to hire proxy solicitors to generate enough votes to establish a quorum. Further, if enough companies were unable to reach a quorum, there could be gridlock during proxy season due to large numbers of companies having to routinely hire proxy solicitors.
C. Separating the Proxy Card from the Proxy Materials
In addition, I was and I remain concerned about an aspect of the proposal that would allow companies to separate the proxy card from the rest of the proxy materials. As currently proposed, the rules would allow a company to include a proxy card with the mailed notice of availability of proxy materials, but would permit the company to post the proxy statement and annual report on its website. My concern about this arrangement that is, the separation of the proxy card from the rest of the proxy materials is that it might encourage shareholders to vote their proxies without reading the information in the proxy materials. If this occurs, I think we run the risk of undermining the spirit of the proxy rules.
At our open meeting, I specifically noted that our proposal solicits comment on this point, and that we would have to carefully consider the comments that we receive. Not surprisingly, we have received many comments on the proposal, and more than a few commenters have shared my concern about separating the proxy ballot from the rest of the proxy materials. Moreover, at least two comment letters have pointed to separate shareholder surveys indicating that investors would, in fact, be less likely to look at annual reports and proxy materials under our proposals. Given these comments, I remain very concerned about this aspect of our proposals, and I'm committed to finding a solution to this.
One option may be to prohibit companies from sending the proxy card with the notice, and instead to require the proxy card to be available only electronically with the rest of the proxy materials. In such a case, the shareholder could either print out the card and mail it in, or alternatively, simply vote electronically. I know that some have criticized each of these options: first, having shareholders print out the proxy adds a second step to the voting process; and second, there may be technological obstacles to overcome in administering electronic voting. But I'm also confident that each of these issues can be addressed.
D. Opting Out of Electronic Delivery
Let me highlight one more potential area of concern, which stems from the fact that our proposal essentially changes the "default" rule to one of electronic delivery, with shareholders being required to affirmatively opt for paper delivery for each company and during each proxy season. By contrast, the current "default" rule is one of paper delivery, although shareholder may affirmatively opt for electronic delivery. We have received a number of comment letters expressing apprehension about changing the default rule, including a number of surveys indicating that requiring shareholders to "opt out" of electronic delivery may disproportionably impact certain groups of investors, such as seniors.
This is something that I think should be addressed. Some of the commenters have requested that we modify the rule by requiring shareholders to affirmatively "opt in" if they want to receive the proxy materials via the Internet. Others have suggested retaining the "opt out" feature of the proposed rule, but have recommended that once a shareholder chooses to "opt out" of Internet delivery, the "opt out" should be permanent; that is, it should stay in effect until the shareholder changes its mind, rather than automatically defaulting back to Internet delivery each year. I think both of these suggestions are interesting, and again, require further thought by the Commission and our staff.
In summary, while I do have some concerns and questions about our proposed rules regarding Internet delivery of proxies, I also concur with the goals of the proposal to reduce costs and improve efficiency. If we can manage to address the issues raised by commenters, then I think this rule will be a valuable means to achieve these ends, without sacrificing investor protection.
Regulation NMS is another issue which has been driven by the impact of technological advancements on investor interests. Each day, the US equity markets handle trading volume in NMS stocks of more than 3.9 billion shares and $120 billion. Accordingly, it is no surprise that there has been great concern regarding the upcoming July compliance date. There is a lot at stake when one proposes significant structural modifications to the nation's market structure. Just last week I was saying to the Security Traders Association that I anticipated the Commission shortly would be considering a recommendation from the staff to extend the compliance deadline and perhaps take a phased approach to implementation. That is indeed the case, and I believe this discussion bears mention again.
Regulation NMS was approved in June of 2005 and there should have been no surprises regarding the July 2006 compliance date. But theories and reality do not always coincide. With the looming date, broker-dealers, led by the SIA, have expressed frustration with the inability to complete programming of their systems while they wait for final rules from the SROs. Vendors, trading centers, and broker-dealers also must wait for the SIP and NMS Plans to finalize market data functionalities before they can program. Surveillance systems must be implemented and tested based on the ultimate rule sets and systems modifications. And industry participants must have time to gain experience trading on the new systems. As the SIA recognized in its own timeline and its March 2006 letter to the Division of Market Regulation, there are a number of functional stages of compliance that must be completed before the proverbial "switch" can be flipped "on," if we are to avoid any disruption to the functioning of our equity markets. Like building a house, these events must be completed in sequence. Thus, an extension should come as no surprise. The only "unknowns" are the dates along the timeline for the phase-in and the consequences of failure to meet those dates.
The Division of Market Regulation has spoken with the industry to determine meaningful and realistic dates, and I hope you will see them in the next week or so. I will tell you that I do not look lightly upon the extension because I fear that people will move NMS to the back of their to-do lists, counting on future extensions if, again, they are not ready by the compliance date. Practical realities, however, dictate an extension. The changes required by Regulation NMS are revolutionary and, therefore, time consuming. Nine out of our ten registered exchanges are retooling their systems. Be aware, however, that an extension is not an opportunity to focus your efforts elsewhere. When the time comes, those who are not ready will have unprotected quotes; in other words, they will be left behind.
As far as the timeline itself, the first step will be to complete the notice, comment, and approval process of the SRO rules regarding Automated Quotations, ISO orders and IOC orders. This will be followed by the SROs' publication of their final specifications. This will allow for the beginning of the NMS Access Linkage, wherein the firms will have programmed their systems in response to the SROs' systems. The operation of the SRO systems, other than those providing order protection rule protection, will commence next. The final step will be compliance with the order protection rule for the stocks a process that will involve two rounds. The goal will be to provide sufficient time between these last two steps of implementation in order to allow for experience with the new conditions and necessary systems tweaks.
As we move through the hurdles in this timeline, I encourage industry participants to continue to come to the staff early and often with any problems that arise. Only then can we provide guidance to ensure that everyone is able to adhere to the schedule. I commend the industry and the SIA on the working group and the conferences that have been held thus far, as well as the upcoming SIA conference on market structure. Such discussions have been immensely useful in continuing to move the ball.
As I see it, each delay is a strike at the investor.
Self-Regulation and International Market Consolidation
Automated trading is not the only large scale change facing our markets and, consequently, our investors. Over the past several years, many U.S. exchanges have demutualized and become for-profit entities. Some have even become publicly-traded companies. For example, the NYSE and Nasdaq are both for-profit companies owned by publicly-traded companies. The Philadelphia Stock Exchange, Chicago Stock Exchange, and NYSE Arca, Inc. (formerly know as the Pacific Exchange) are demutualized, as well as the International Securities Exchange, which is publicly-traded.
This trend by SROs to demutualize and become for-profit entities raises the need for the SEC to reexamine the role and structure of self-regulation. The conflicts which arise in the context of SRO regulation generally are magnified in the world of for-profit exchanges. Consequently, we at the SEC must exercise heightened sensitivity to the rule changes proposed by the exchanges. We must assure that market quality and investor protection trump competition between market centers. Shareholder interests may guide the for-profit SROs, but investor interests guide us.
In January, the SIA released its statement of goals and principles that should underlie SRO restructuring. In summary, the principles addressed: investor protection, fair competition, efficient regulation, expert regulation, reasonable and fair costs of regulation, industry participation in self-regulation, and regulatory accountability. I cannot, and would not want to, quibble with these lofty aspirations. They are generally the same principles as embodied in the SEC mandate. Although I would caution that some of the tenets underlying the SIA principles may take a different approach to satisfy the principles than I or the Commission would advocate. Likewise, I am generally supportive of the SIA goals of efficiency, elimination of duplicative regulation, fair representation, and transparency. Again, it is the execution of these goals in which I have yet to reach a conclusion as to the preferred course of action.
Without question, the current model of self-regulation is outmoded. As I have said in several recent speeches, the Commission must analyze, and act upon, the alternatives for a system of regulation that accounts for the developments in the marketplace and the changes in SRO ownership structures. Time's a wastin'. There are three starting points for this process. First, the Commission needs to follow up on the concept release it issued on this subject over a year ago by reviewing the comment letters and exploring which alternatives have merit in today's marketplace. We should narrow down to two or three alternatives and explore them in detail.
I myself have been analyzing several of these models, seeking the thoughts of industry members, academics, and foreign regulators. In particular, I have been focusing on the independent regulatory and market corporate subsidiary model, the two hybrid models and the universal industry regulator. At this stage in my thinking, I tend to favor the hybrid model for its ability to eliminate regulatory duplication as well as some of the conflicts of interest engrained in our present SRO system. I am curious, however, as to whether separating out the member regulation is enough. Would such an approach ease regulatory questions when it comes to cross-border mergers, acquisitions, and common ownership structures?
The second starting point would be to act on the Commission's proposal regarding fair administration, transparency, governance, and ownership of SROs. You will recall that many of these standards have been imposed on SROs informally already. For example, the proposals would require independent boards and key board committees, as well as impose ownership and voting restrictions. They also would require that exchanges establish policies and procedures to maintain a separation between their regulatory functions and their market operations and other commercial interests, and would require that funds received from regulatory fines, fees, and penalties be used for regulatory purposes. While not a final solution to all of the questions facing us, the proposal surely provides us with the steps toward that end. Moreover, even if the Commission chooses to modify the specifics of the proposals, at least the Commission will be forced to focus on these issues in the near term.
The third starting point is to have the Commission actively assist in the harmonization project undertaken by the NYSE and NASD, as aided by the industry, to produce one rule book for member regulation. As a part of the Commission's approval of the NYSE/ARCA merger, the NYSE committed to work with the NASD and securities firm representatives to eliminate duplication and inconsistent regulation of broker-dealers within their existing regulatory framework within one year. Breaking the rules into four categories, thus far, the NYSE has established committees composed of NYSE, industry and NASD members, although the NASD has yet to designate its participants.
It is my understanding that the committees have had initial meetings and are developing their timeline for action. The staff of the Division of Market Regulation also has been consulted. I would encourage their regular and active participation in the meetings to both keep this project on the fast track and provide a counterbalance during the review process so as not to lose any of the protections afforded by the existing rules. The idea is to consolidate and conform the rules, not to eliminate them. Corporate governance, market access, and many of our investor protection rules are written into the SRO rules.
Consolidation cannot be far behind harmonization. Accordingly, I see harmonization as a step along the road to modernizing the self-regulatory framework. The question will be how to consolidate, not if to consolidate. Will it be a hybrid model or a universal regulator? Who will own what and who will control what? But those are questions for another day.
In looking for the answers to those questions, we should be informed by the experiences of our counterparts in foreign jurisdictions. Most large foreign exchanges demutualized before the trend started in the US, and their regulators have taken different approaches to the issues we are now facing. For now, let me make it clear that we at the Commission are acutely aware of the problems presented by for-profit SROs operating under an outdated regulatory regime. We are closely monitoring the SRO rule filings to ensure that investor interests are not eclipsed in favor of business interests.
In addition, our search for answers to the self-regulatory dilemma cannot be focused solely on the latest model for US exchange structures the demutualized exchange. We must consider the future. The new self-regulatory regime, whatever it may be, must take into account the possibility of foreign-U.S. market combinations.
B. International Market Consolidation
By increasing the ability of exchanges to value their businesses and providing additional sources of capital, these new structures can provide SROs with increased flexibility. This flexibility allows an exchange to more easily explore and enter into strategic alliances and other business transactions to expand the scope of their services. It is not surprising, therefore, that recently there has been interest by U.S. markets in foreign markets.
For instance, in the past few months Nasdaq has expressed an interest in acquiring the London Stock Exchange. Nasdaq made an indicative offer for the LSE on March 9, 2006; withdrew its offer on March 30; and then purchased a 14.99% stake in LSE on April 11. Just this week, that stake became 22.7% after additional purchases. The NYSE also has stated that it intends to pursue domestic and international acquisitions and strategic alliances to further strengthen and diversify its business, enter new markets, and advance its technology. Both the NYSE and Nasdaq have used their new flexible structures to pursue follow-on public offerings to quickly raise additional capital for their ventures.
As you may imagine, a transaction between a U.S. market and a foreign market could raise securities law regulatory issues in the U.S., or be subject to Commission review depending on the structure of the transaction. The transaction itself may be subject to issuer registration requirements for the offer and sale of securities in the U.S. In addition, U.S. proxy rules, cross-border tender offer rules, and other applicable rules may apply. If a transaction resulted in changes to the U.S. exchange's existing rules, Commission approval would be needed. However, it is possible even likely that any business combination would not result in any such changes.
If, however, the transaction resulted in the U.S. market and foreign market combining trading platforms, or otherwise providing access between markets, exchange and broker-dealer registration requirements in the U.S. would apply. If any transaction resulted in the cross-listing and trading of securities between the U.S. and foreign exchange, issuers on the foreign market would be required to register its securities in the U.S. and comply with U.S. exchange listing requirements including Sarbanes-Oxley requirements. Finally, if a foreign market were to acquire a U.S. exchange, prior Commission approval of changes to the NYSE or Nasdaq's rules, including those that limit ownership and voting of shares of stock of the parent company of the NYSE or Nasdaq, would be required.
In our global forecast, some combination is inevitable. The question is when will this take place? Chairman Cox and members of the FSA and Commission Staff have discussed this very issue of foreign ownership. It's not as easy as it may sound. There are issues of regulatory equivalence, nationalism, and politics with which to contend. Different ideals are incorporated into the exchange structures in various ways even if the underlying goals are similarly rooted in investor protection and fairness.
I challenge you to think of the operational concerns that such cross border mergers, acquisitions or join ventures would present. In its discussions regarding the LSE, Nasdaq, for example, has focused on the synergies its electronic platform has with the LSE platform and the cost savings and other efficiencies that a union could produce efficiencies that would accrues to the benefit of the investor. The unified trading platform of Euronext boasts similar cost synergies. Will Regulation NMS provide a similar opportunity for synergies in the U.S. markets? If so, will this ease the transition for some form of cross border transaction among exchanges? Where is the investor left in these scenarios? With the pace of technological innovation and the entrepreneurial spirit of the industry, I imagine the answers we seek will not be that long in coming.
There are a number of other front-burner issues facing the SEC that are demonstrative of the combined forces of technology and globalization, which I'll mention briefly. In both bilateral and multilateral contexts, such as through IOSCO and various dialogues and MOUs, we have been working with the industry and fellow regulators to develop the necessary regulatory guidelines to address the collective problems facing the securities industry. In some instances, we encourage industry led efforts to resolve the various issues. In others, regulation is required. And in some instances, a joint approach is best.
For example, the issue of OTC derivatives, particularly credit derivatives, raises a number of operations concerns related to processing, risk management, and control issues. As the credit derivatives market has grown, major industry participants and their domestic and international regulators have been meeting regularly to discuss the market practices tied to such instruments. The industry, in response to problems raised in the discussions, has outlined a number of concrete steps to improve the market infrastructure surrounding these instruments. These steps could only be solved with the collective input and support of the regulators.
On the other hand, industry input was instructive in the development of the consolidated supervised entity, or CSE, regime but regulation was necessary to establish the framework for supervision and coordination between various jurisdictions. As you likely know, the EU's Financial Conglomerates Directive (FCD) requires the application of consolidated supervision to the holding companies of all financial institutions in the EU. With respect to EU financial institutions with holding companies outside the EU, the FCD calls for an assessment of the "equivalence" of the consolidated supervision that applies to such holding company. The FSA was tasked with this responsibility with respect to each investment banking group with a major presence in the UK, and it recently made an equivalency finding regarding SEC supervision of these CSE firms.
In connection with that finding, the SEC and FSA have agreed to the roles that each will play in the supervision of CSEs and their affiliates, and the information to be shared in the context of such supervision. The information sharing component of this agreement was memorialized in an MOU signed by Chairman Cox and FSA Chief Executive Officer John Tiner just this past March. Specifically, the arrangement will facilitate the exchange of confidential supervisory information currently collected by both regulators.
These examples demonstrate that much has been accomplished in addressing the trends of technological advancement and globalization, but the pace of development is fast. Considerably more work remains to update and modify our regulatory scheme to ensure that we are complimenting the developing, global marketplace while safeguarding investors.