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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the Teachers' Retirement System of the State of Illinois Opportunity Forum


Commissioner Roel C. Campos

U.S. Securities and Exchange Commission

Chicago, Illinois
July 31, 2006

Good evening. I'd like to thank Scot Bevill and his colleagues at TRS for inviting me to address you today at the third annual TRS of Illinois Opportunity Forum. Thanks also to my friend Martin Cabrera, who may have given the idea to Scot to invite me. I see other friends in the audience as well.

As the SEC's first Hispanic Commissioner, you might guess that I am a vigorous and at times loud advocate of minority representation in all facets of the financial industry. I will speak much about this topic in the second half of my remarks. Initially, I will address issues relating to small businesses and in particular, small broker dealers. I will also deal with the issue of soft dollars and so called "give ups." Much is also happening that involves the SEC. We just passed a comprehensive set of rules for executive compensation that, for the first time, will present all aspects of compensation for the use of investors. The issue of back dating options seems to also dominate the news and I am prepared to address this. Further, as you know, the DC Court of Appeals has recently vacated the SEC's rule on the registration of advisers to hedge funds. Perhaps there will be some time to take questions on these topics.

Speaking of the financial industry and seeing as there are a few brokers in the audience, I have a story for you.

A young hot shot broker (who was not a selection of the TRS Illinois) decided to take the day off and go back to visit some of his professors in his old school. When he made his way into the entrance he noticed a dog was attacking a small child. He quickly jumped the dog and strangled it. "Bad Dog!" The next day the local paper reported the story with the headline 'Valiant Student Saves boy from ferocious dog.'

Our broker friend angrily called the editor and loudly and strongly suggested that a correction be issued and that the paper state clearly that he was a successful Wall Street Broker and not a student. The next day the paper issued a correction and the headline read: 'Pompous Stock Broker kills School Mascot.'

The morale of the story may be "leave well enough alone," or "Wall Street Brokers have very little goodwill."

Okay, now that I've got your attention, before I go any further, I must provide you with the Commission's standard disclaimer that the remarks I give today are my own and do not represent the thoughts of the Commission, my fellow Commissioners or the Staff. Let me begin with addressing the subject of small business. As we all know, most minority-owned businesses are small businesses, including minority broker dealers.

At the Commission, we must make a determination as to the impact of our regulations on small business. We must consider the burden and promotion of efficiency, competition, and capital formation of each proposed action, generally and with respect to large and small entities. For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996, we must determine whether the rule is a major or minor rule based on its impact on the economy. The required Regulatory Flexibility Analysis specifically directs us to evaluate the degree small entities are subject to the rule. The point I'm trying to make is that the regulation of the Commission has a direct effect on small businesses, and that means small minority businesses as well. That includes small broker-dealers, small investment advisers, small issuers, small clearing firms, small capital providers, and the like.

Small Broker-Dealers

I understand that some smaller broker-dealers may have experienced difficulties remaining in the brokerage business. In particular, some small introducing broker-dealers may be finding it more difficult to find a clearing firm to handle their accounts. To the extent that this difficulty may arise from new Commission rules, as I mentioned before, we do take into account the effect those new rules may have on smaller broker-dealers during the rule-making process. Further, to the extent that rules can be amended to accommodate the concerns of smaller broker-dealers without sacrificing investor protection objectives, the Commission generally tries to do so.

These difficulties also may be arising due to changes occurring in the clearing business. The staff believes that the clearing firm business is an active and competitive market that is heavily influenced by two forces: economies of scale and an increased recognition of the risks involved in the clearing business. Clearing firms generally compete for the transaction volume small introducing broker-dealers can provide in order to achieve economies of scale. Currently there are approximately 360 clearing and carrying firms. While we at the Commission don't doubt the assertions by some smaller broker-dealers that they may be finding it more difficult to find a clearing firm to handle their accounts, this pool of 360 clearing firms should be large enough to allow effective competition for introduced accounts.

Clearing firms seem to worry that one of their greatest risk exposures may be the business introduced to them by smaller broker-dealers. Clearing firms seem to also be concerned about small broker-dealers that are introduced to them through "piggyback clearing arrangements." As a result, clearing firms may now be requiring that small introducing broker-dealers maintain larger good faith deposits than in the past. In addition, some clearing firms may no longer be allowing their correspondent firms to introduce other broker-dealers to them through piggyback arrangements.

In the event that any of you believe that either an existing or proposed new rule imposes excessive or unwarranted costs on small introducing broker-dealers, I strongly encourage you to send us a comment letter regarding the rule in question. Well-drafted comment letters have a strong influence on Commission rulemaking. I know that I will personally be concerned and engaged in considering and seeking to eliminate the effects of our rules on small broker-dealers.

Soft Dollars and Give Ups

I will move on to soft dollars. As I noted at the Commission open meeting approving the guidance, the magnitude of soft dollar use in the US is significant. According to a recently published report by Greenwich Associates, soft dollar use in the United States has remained steady at just under $1.0 billion in 2006 — approximately 9% of total equity institutional commissions for the period. As originally conceived in 1975, the soft dollar safe harbor was designed to permit funds to use commissions to purchase primarily research that was bundled with execution, without being held to have violated their fiduciary obligations solely for not having paid the lowest possible commission costs. The use of soft dollars has spread to services far beyond research to those that closely resemble the type of overhead items for which use of soft dollars was specifically prohibited.

The Commission's recent guidance was issued in an attempt to reign in the abusive practices, and to address the growth and development of the technology, products and services currently available to money managers. In short, the guidance outlines a three-part test for evaluating whether a service falls within the safe harbor of Section 28(e). First, the money manager must determine whether the service falls within the statutory limitations and consequently that it is eligible "research" or "brokerage." Second, the manager must determine whether the eligible service provides lawful and appropriate assistance in the performance of his investment decision-making responsibilities. This step in the analysis is particularly important in relation to mixed-use products. Finally, the manager must make a good faith determination that the amount of client commissions paid is reasonable in light of the value of products or services provided by the broker-dealer. This test does not modify a manager's obligation to seek best execution.

To provide greater clarity within the broad categories of eligible research and brokerage products and services, the guidance details certain items that are in and certain items that are out of the safe harbor. Importantly, the lists are illustrative and should not be considered exclusive. When in doubt, managers should revert to the text of the interpretation in which the Commission explains, for example, that eligible research must reflect an expression of reasoning or knowledge. If uncertainty continues to linger, I recommend managers err on the side of caution and pay for the service out of their own pocket. Remember, the context in which we are analyzing services is a safe harbor from a fiduciary duty — not an entitlement.

Some managers, such as Fidelity, have taken matters into their own hands, encouraging brokers to unbundle the commissions they charge, exposing the cost of the actual execution and the cost of the ancillary research services. Others, including the 2004 Mutual Fund Task Force and the SIA, support a more moderate approach of instilling transparency and disclosure to the soft dollar regime, thereby preserving the safe harbor but arming shareholders and fund directors with information on how their money is spent, without demanding unbundling. I too have urged this position for the near term but continue to believe we must look at all alternatives.

That is why, at this time, the Commission has not only attempted to provide current and meaningful guidance for interpreting the safe harbor, but it has also reaffirmed its position on third-party research. Such research falls within the safe harbor so long as, among other things, the broker is obligated to the third party to pay for the services. Despite our earlier decree, we had heard that a number of third-party research providers have faced difficulty stemming from supposed uncertainty on behalf of brokers and money managers as to whether the third-party research remained within the safe harbor. These reports were disturbing not only for the third-party research provider, who might be a small, up and coming company trying to compete against the conflicted, in-house research provider, but also for small firms. The small firm, which accounts for over 80% of the NASD's members, often does not have an in-house research staff. It relies on third-party research providers. Moreover, as I just mentioned, the small firm often relies on soft dollars to pay for that research.

Lastly, the Commission's interpretation modified the proposed guidance with respect to commission-sharing arrangements. In the interest of recognizing the realities of the marketplace, the new guidance expands the scope of the "provided by" language when certain conditions are met and states that broker-dealers may reasonably allocate functions among themselves, including the minimum requirements for complying with the guidance. Thus, small introducing broker-dealers or independent research providers are not cut out of the soft dollar equation because they do not themselves perform all of the functions of "providing" a service and "effecting" a transaction.

It is important to note that the guidance does not alter the Commission's position with respect to "give ups." A manager still cannot use soft dollars to make payments to a broker-dealer that did not provide any services to benefit the advised accounts. Instead, the Commission guidance provides that arrangements that allow for a portion of the commissions to go to one broker-dealer for execution and another for research are not "give ups" in contravention of the "provided by" and "effecting" language of the statute. I believe this approach is the appropriate approach that retains Congressional intent but moves us into the year 2006. I would be interested to hear your comments on the matter.

Diversity in the Financial Sector

I know we are running short on time but I'd like to end my remarks where I began by focusing on the importance of conferences such as this one that emphasize the importance of diversity in the financial industry. The need to change the culture of the financial industry to understand the value of minority participation is immense. While some firms have seen the advantages to tapping the minority pool for the many benefits it has to offer, and have aggressively incorporated diversity into their firm's business, most have not.

The US Census Bureau has noted that the number of firms owned by minorities and women continues to grow faster than the number of other firms. And we have all heard the statistics detailing the rapid transformation in the US population as the minority population grows.

Last month (June 2006) the GAO released a study of the financial services industry in which it reviewed overall trends in management-level diversity and diversity initiatives from 1993 through 2004. With respect to the degree of diversity in the industry at the management level, the study disappointingly revealed insubstantial changes over the 11 year period. The 2005 SIA Report on Diversity Strategy, Development and Demographics adds a little more to the picture by suggesting that the increases in minority demographics have primarily taken place over the last few years. The study found an increase in minority representation from 18% in 2003 to 21% in 2005 (noting that much of the rise was attributable to an increase in the number of Asian/Pacific Islanders and not widespread to other minorities such as African-Americans and Hispanics).

The GAO study found that more firms have recently been initiating programs to increase their minority workforce, including developing scholarships and internships, establishing programs to foster employee retention and development, and linking managers' compensation with their performance in promoting a diverse workforce. Even so, overall success is limited and some firms noted problems in recruiting and retaining minorities and in gaining employee support for diversity programs. Having identified some of the obstacles to diversity, we should target them for solutions.

Interestingly, the SIA report noted that firms reported the top five reasons for diversity initiatives as follows:

  • Increased competitiveness in attracting key talent
  • Changing workforce demographics
  • Need to assess specific client markets, clients, or consumer segments
  • Need to improve financial performance
  • Need to ensure compliance with legal requirements

These factors provide instruction for both sides of the story. Increasingly in America, the labor force will consist of minority individuals. To obtain its share of talent, the financial sector must tap into that pool. Secondly, demographics cannot be altered. Statistics show clearly that the minority population, in particular Hispanics, will comprise almost forty percent of all individuals under thirty in America by mid century or earlier. Consequently, it is a business necessity that strategies be devised to bring and incorporate this population as users and clients of financial products. Business failure awaits those who ignore indisputable facts. Minority professionals can aid greatly the financial sector in marketing and bringing the billions of dollars that are in the minority communities into the industry.

Just two weeks ago, on July 17, 2006, the NAACP released the 2006 edition of the NAACP Consumer Choice Guide, commonly known as the 'business report card.' The financial services industry received a C, maintaining its ranking from 2005. The industry had a D+ overall when first rated in 2000. The report notes that overall the industry tends to have strengths in community reinvestment and charitable giving, but has only modest performance in employment, advertising/marketing, and vendor relationships. This is unacceptable in the year 2006. Companies must look at diversity as a strategy with tactical implications that have a direct impact on a company's profitability.

In reviewing minority owned businesses, and here's where we get back to the notion of small businesses, the GAO study suggested that such companies face an uphill battle in obtaining access to capital for a number of reasons. For example, these businesses may be concentrated in service industries and lack assets to pledge as collateral. As start-ups that are small and lack technical expertise, these businesses are less attractive to lending institutions. Or, lenders may discriminate in providing credit (although the study notes that it is difficult to measure this factor because of limited data availability).

So let's bring this home somewhat. Because few minorities have had the opportunity to be in Wall Street firms, few minorities can qualify to receive capital from institutional investors such as TRS Illinois. This presents the classic dilemma of "I would like to have you manage money, but you don't have the track record and experience. But how can I get the track record and experience if you won't let me manage the money." Here are a few ideas that TRS and others are using with great success. In evaluating managers and firms for receiving investment allocations from the pension plan or investor, a qualifying factor could be whether there are minority professionals in the investment team. Perhaps a joint partnership with a minority firm in developing investment expertise by the minority owners. What about the use by the applicant of minority professionals such as lawyers, brokers, accountants, consultants? It seems to me that these are ways that a dedicated effort by institutional investors could make a large difference.

To that end, I commend the TRS of Illinois. As I understand it, TRS has two programs designed to develop minority representation in the financial community. The first is the Minority Business Enterprise Brokerage program which is targeted specifically to increasing the use of minority broker-dealers. Within the program, TRS has minority trading goals of 15% of all equity commissions and 10% of total par traded for fixed income for fiscal year 2007. I understand these goals have been raised in each of the three years of the program's existence and are continuing to increase. I also understand that the minority trading goals have been met with respect to the targets of assets under management by minority-owned investment managers of 12%.

The second program is the Emerging Manager Program, which seeks developing investment managers who show promise to invest successfully on behalf of TRS. The program is designed specifically for smaller firms which, as we have discussed, frequently are minority firms. TRS's program is not limited to minority firms but to all small firms. I don't know how partnering between minority firms and other more experienced managers is treated, but it seems as though this technique could be hugely beneficial. These two programs are the examples we need, and I commend TRS of Illinois for a great start down the road to diversity. Without sounding too cliché, remember, nothing ventured nothing gained.

In fact, I would encourage everyone, including TRS to go even further. We should all be thinking outside the box on how to incorporate minority participation into the various facets of our business. In the case of TRS and other pension funds, for example, could one expand from minority broker-dealer and investment adviser goals to lawyers, research analysts, clearing firms and others?

I cannot underscore enough the importance of encouraging the industry to embrace diversity on multiple fronts. As I have argued, I believe in strong and full minority participation, not because of charitable instincts — although fairness demands it, but instead because it is an absolute business imperative. First, the industry, with the insistence of pension plans like TR Illinois, must address the actual number of minority individuals in the financial sector workforce and their distribution throughout the ranks of staff and management. Second, the industry and pension plans and other institutional investors must cause and support the expansion of minority businesses within and outside of the financial community and ensure their ability to access capital. In other words, it is simply unacceptable that minorities in America are not fully members and users of the financial industry. The American economy and the financial sector can afford nothing less. I hope those of you here today, in particular TRS of the State of Illinois, will continue to lead others as you have in this imperative. Without apology, you must continue to push the financial industry, your managers, and other pension plans in this direction.

And I'll just conclude with a theme I've often heard from the New American Alliance. The financial industry must move from mere inclusion to full participation of minorities.

Thank you for your attention. I look forward to any questions you may have.


Modified: 08/08/2006