Speech by SEC Commissioner:
Remarks Before the Security Traders Association of New York
71st Annual Conference
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York, New York
April 19, 2007
Thank you for that kind introduction. It is an honor to be here today. Before I get started, I need to satisfy my own compliance people and tell you that the comments that I am about to make are my own and do not necessarily reflect official SEC policy or the opinions of my fellow Commissioners.
April 19 marks the anniversary of the Battle of Lexington and Concord that triggered the start of the American Revolution. More than two centuries later, we are still enjoying the fruits of the courageous efforts of the American colonists and the freedom that was won through the American Revolution. I am here today to talk to you about another revolution - the revolution in our securities markets.
With the Dow closing at an all-time high, there is no better time to be speaking to a room full of securities professionals. As you all know, the securities markets are in a period of unique and dynamic change. There are major market structure changes taking place here in the U.S. as well as in the international markets, some of which I will talk more about in a minute. Significant business and regulatory changes are also afoot. The NASD and NYSE Regulation are scheduled to complete their merger in June. The NYSE and Euronext have completed their merger and will presumably now seek to capitalize on the efficiencies that the combination provides. The NYSE is back in the bond trading business. NASDAQ is creating and/or buying an options market and is reinvigorating its PORTAL system for 144A securities; institutional trading firms like BATS, ITG, and GETCO represent a significant portion of the NYSE and NASDAQ trading volume. And, the way some other people have been talking -- all around us, in the back alleys and in the unlit corners, "dark pools" are multiplying! Perhaps dark pools ought to be the subject for the next blockbuster horror movie.
All of these changes are happening at a time of grave concern about the competitiveness of the U.S. capital markets. Indeed, the mayor of this fine city -- Michael Bloomberg, recently partnered with New York Senator Charles Schumer to publish a report on the state of the financial services industry in New York and the U.S. as a whole. Some of the very insightful findings in their report are directly relevant to those of you who are here today. Specifically, the report found that the financial services industry here in New York soon could suffer from a dwindling influx of talented workers due to immigration and regulatory policy. Also, the report noted that a large percentage of global securities and derivatives trading activity is moving from the United States to foreign countries, with the City of London being the biggest beneficiary. Not surprisingly, the report pointed out several areas in which the SEC plays a problematic part, and suggested several reforms for the agency to pursue. Oh well, at least we weren't blamed for the immigration issues!
Many of the concerns raised in the Bloomberg/Schumer report were echoed by two other distinguished policy groups. In March, the Commission on the Regulation of U.S. Capital Markets in the 21st Century, a group organized by the U.S. Chamber of Commerce, issued its report with recommendations, including a substantial number of recommendations that are aimed at improving SEC policies and internal processes. Last November, the Committee on Capital Markets Regulation, which is chaired by Glenn Hubbard and John Thornton and directed by Hal Scott, issued an interim report that similarly recommended that the SEC implement specific reforms.
As if this chorus of discontent was not enough, many of the SEC-related concerns found in the three reports were raised again in a recent summit meeting of business and governmental leaders sponsored by U.S. Treasury Secretary Hank Paulson.
All three written reports call upon the Commission to reconsider the ways in which we fulfill our statutory mandates of investor protection and the promotion of efficiency, competition, and capital formation. A constant theme in the reports drafted by the three groups is that excessive, overlapping, and unnecessary regulation in the U.S. is a major reason for our loss of market share in the global capital markets.
Although the perspectives and findings of each group were unique, there is a common thread of very important SEC-related issues among them. Among other things, each report recommended: (1) quick and substantial changes to the rules and guidance implementing section 404 of the Sarbanes-Oxley Act, (2) streamlined and coordinated regulatory processes that require meaningful cost benefit analyses, and (3) involvement jointly by the President's Working Group (which is made up of the Secretary of the Treasury and the chairmen of the Board of Governors of the Federal Reserve System, the SEC, and the Commodity Futures Trading Commission) to provide transparency and predictability in the enforcement process.
We at the SEC cannot and should not ignore these findings and recommendations. We must recognize and understand how the markets have evolved when we consider whether our weighty regulatory precedent still makes sense. We need to ask ourselves a question that Secretary Paulson has recently posed: "Have we struck the right balance between investor protection and market competitiveness - a balance that assures investors the system is sound and trustworthy, and also gives companies the flexibility to compete, innovate, and respond to changes in the global economy?"2 The reports can help us answer this question.
I believe that the Commission is duty-bound to analyze, understand, and -- if warranted -- respond to each recommendation that pertains to us. Unfortunately, a coalition of contrarians -- we can call it the "What-me-worry?" Crowd -- has recently begun a campaign to mute the calls for action in the three reports. As I understand it, they contend that the U.S. capital markets are perfectly fine and that there is little haste needed to examine the calibration of our regulations and how we implement them.
To support this position, they have been citing, among other things, a three-page research report that purportedly contradicts the findings of the three policy groups. The report states that "foreign issuers of IPOs are flocking to US exchanges at unprecedented levels."1 Strangely, that statement is inconsistent with the study's own statistics, which show the high-water mark was in the late 1990s. Moreover, this study is merely a tabulation of the number, size, and proportion of foreign IPOs in the US market during the past 20 years, apparently without adjustment for inflation. A fundamental flaw in this simplistic view is that it looks at the US market in isolation, something that the three policy groups have stressed that we no longer have the luxury to do. As the Bloomberg/Schumer report points out in, the US share of global IPOs has fallen from 57% in 2001 to 16% in 2006, while Europe's has increased from 33% to 63% during the same years.
Another statistic this crowd likes to point to is the decline in the number of securities class action lawsuits over the last couple of years. While it may be true that the number of lawsuits has decreased, the disturbing reality is that the dollar value of these cases has increased.2 I obviously do not know the merit of these cases, but it is important to remember that even if only a smaller number of them are frivolous, meritless lawsuits can drain the time and resources of companies.
I am happy to have useful statistics for the debate, rather than empty rhetoric. It is also good that this debate is taking place while market conditions are strong - the Dow has hit its all-time high, strong macro-economic fundamentals, healthy investor interest, and -- as I am sure you all appreciate - the securities industry coming off a record-breaking year of profits, lead in large part by trading profits.3 The strong US capital markets continue to offer foreign firms many benefits, including deep liquidity, visibility to US investors, transparency, and corporate finance and business strategy opportunities. But, at the same time, other markets have grown and liberalized during the past couple of decades, narrowing the advantages of our markets. This is ultimately for the good of all. As they say, "A rising tide lifts all boats."
But, as Benjamin Franklin is credited with saying, "A small leak will sink a great ship." In the end, companies are rational -- they expect benefits to exceed costs. If that is not the case, they will go elsewhere or raise capital in the deep and flexible US private markets. Our job as regulators is to examine the costs that we impose on market participants through our regulations to make sure that those costs do not exceed the benefits.
I am pleased to say that there have been recent glimmers of hope when it comes to the SEC taking an economic view of rulemaking. Perhaps the best example of this is the review undertaken by the SEC's Office of Economic Analysis regarding the effectiveness of the short sale rules. For many years, academics had been questioning whether the SEC's short sale price test, or "tick test," was needed. The tick test, which has been on the books for seventy years, restricts the prices at which short sales may be executed. Our economists conducted a pilot test on approximately 1,000 securities to investigate whether removing the price tests would make stocks more susceptible to patterns associated with downward manipulation. They did not find evidence to suggest that pilot stocks are more likely to be manipulated downward than other stocks. Based on the results of the pilot, the Commission proposed last December to eliminate the tick test across the board. I commend the ingenuity of the staff - both in OEA and Market Regulation - in formulating this approach, and I look forward to seeing similar empirical methods used in the future.
Unfortunately, proactive regulatory thinking does not characterize all that the SEC does. The SEC remains bogged down by the regulatory missteps it made prior to the arrival of Chairman Cox. During that time, a majority of the Commission - when I found myself in the minority - promulgated several rules that did not satisfy the cost benefit analysis and other procedural requirements for our rulemakings - including the not trivial requirement that the SEC act within by the authority granted by Congress. Two of these rules, the hedge fund registration and mutual fund independent director rules, were challenged and defeated in federal court. A third, and the most relevant to this crowd - Regulation NMS-has so far successfully escaped court review, and is in the process of a much-delayed implementation process.
In a nutshell, Reg. NMS rules fall into four categories: (1) the trade through rule (it is an understatement to say that the sweet-sounding appellation "Order Protection Rule" is a misnomer); (2) the access rule; (3) the sub-penny rule, and (4) the market data rules. Some of these rules are much more problematic than others.
In my view, Reg. NMS represents a massive regulatory intrusion into our secondary trading markets that was completely unwarranted, given the lack of evidence of market failure and the availability of substantially less intrusive means to advance the enumerated goals. Reg. NMS has the potential to do significant harm to our markets by unduly interfering with the operation of the competitive forces. Over the years, these forces have benefited investors immensely by reducing trading costs and increasing market efficiency. Whatever its justification, Reg NMS is a carte blanche for unsupervised meddling by the SEC staff in the marketplace for years to come.
The most problematic component of Reg NMS is the trade-through rule. I believe the members of STANY stated it perfectly in the group's 2004 NMS comment letter when you noted that "there will be no need for a uniform trade-through rule if issues of connectivity, access, and automatic execution are adequately addressed."4 Importantly, the comment letter then stated that "if the [NBBO] in every market is immediately available to 'away markets' then STANY believes broker-dealers' best execution obligations would be sufficient to protect the interests of all investors and ensure that superior prices are sought." I completely agree with this position. And so I am sorry to report that now - despite the fact that competition has driven the manual markets to automate - we will soon have a trade-through rule and at the same time no assurance of best execution compliance for orders sent to some of these automated markets.
My opposition to the adoption of Reg. NMS does not in any way make me less interested in the implementation process. Quite to the contrary, I have been fully engaged in the process to ensure that the rules are implemented in the least burdensome and most cost-effective manner possible and in a way that limits their potential harm to our markets' competitiveness. I am grateful that market participants have been providing crucial feedback to the Commission on Reg. NMS implementation. You certainly have given us a good deal to think about along the way.
As most of you know, the original compliance date for the trade-through rule and market access rules - which together are the heart of NMS - was June 29, 2006, almost one year ago. As with other, less significant components of Reg. NMS, this deadline has been repeatedly and significantly delayed. The first extension, which the Commission approved in May 2006, replaced the June 29 deadline with a complicated phase-in schedule. The revised schedule was as follows: (1) October 16, 2006 was the deadline for SROs to publish technical specifications; (2) February 5, 2007 was the deadline for full operation of Reg. NMS compliant trading systems; (3) May 21, 2007 is the start date for full industry compliance, but this is only on a pilot basis involving 250 stocks -- this will be the first deadline directly affecting the folks in this room; (4) July 9, 2007 is the deadline for full industry compliance for all stocks; and (5) October 8, 2007 is the completion date for the phased-in compliance process.
I said last year that I doubted that the industry could meet even these more generous timeframes. So, it was no surprise this January when the New York Stock Exchange requested a further extension of the February 5 trading system deadline. The Commission approved a one month extension of that deadline, even though the additional one month period was not enough time for the NYSE to remedy its inability to route orders to the ADF and ISE! The Commission also extended the May 21 deadline to July 9, and the July 9 deadline to August 20. The October 8 deadline remains in place -- at least for now! I guess the "NMS" in Reg. NMS will never stand for "No More Stalling."
Predicting that the implementation of Rules 610 and 611 would be significantly delayed was easy when the industry could not even meet the deadlines for the two least problematic requirements in NMS - the prohibition on subpenny quotations and the reduction in the Regulation ATS fair access threshold. The rules were scheduled to be implemented by August 29, 2005, and they required minimal systems changes. Yet when market participants looked closely at the implications of the rules on their business processes, interpretive questions arose, which delayed the implementation of both rules.
Why all of the delays and extensions? The difficulty in the creation of new, electronic trading systems by the exchanges was undoubtedly one reason for the extensions. However, the truth of the matter is that the unduly complex and burdensome nature of the rules themselves made the extensions necessary. The implementation process already has been a rude awakening for many, and we have not even gotten to the broker-dealers yet!
Technology is only one aspect of the implementation burden. The SEC staff, by delegated authority, has provided several exemptions to facilitate the implementation of NMS, including a significant exemption from Rule 611 for "Qualified Contingent Trades." Exemptions are necessary to tailor an inappropriate, "one size fits all" rule to the needs of a dynamic marketplace. At bottom, however, these exemptions, along with the implementation delays, are the clearest sign that NMS was unworkable as proposed - and remains so today. Should you have any lingering doubt about the workability of Reg. NMS, keep in mind that the staff has issued over 50 "Responses to Frequently Asked Questions" for Rules 610, 611, and 612. Our staff is getting calls for more guidance in the areas covered by the FAQs. Believe it or not -- the Responses have generated questions of their own!
I will continue to watch carefully the implementation of Reg NMS and hope that its consequences turn out to be a non-event - other than the thousands of hours and multiple millions of dollars spent in an effort by market participants to implement it. The trouble is that the real consequences for our markets will not be known for years, after the damage has been done and after trading patterns have shifted in unpredictable ways and perhaps to other venues. There will be more exemptions, more questions, and maybe even more delays before this is over. I implore you and your firms to provide us with feedback as we continue to slog through the NMS quagmire!
In another, less formal matter, Chairman Cox recently discussed what I deem to be an important improvement in the process by which the Commission considers whether to impose penalties on corporate issuers. The new process for evaluating the propriety of corporate penalties requires Commission authorization prior to the commencement of settlement negotiations. The staff will come to the Commission to seek authorization to enter into settlement negotiations. The Commission will determine at that point if a settlement is appropriate and, if so, what the general parameters of such a settlement should be, including whether a settlement should include a monetary penalty paid by the company and, if so, a range for the possible amount. If the staff secures a settlement within the Commission's pre-approved parameters, the final Commission approval will occur in a streamlined manner. This should eliminate the problems that arise for the staff when, after they spend tremendous amounts of time and effort negotiating a settlement - often with multiple parties and multiple regulators involved - a majority of the Commission decides it cannot support all aspects of the proposed settlement, for example, when a corporate penalty is too low or too high.
This new procedure will be necessary in only the small subset of investigations in which corporate penalties are a possibility. It is in no way meant to hamstring our staff in their extraordinarily difficult efforts to police the securities markets and is intended to be a neutral application of the Commission's statement on corporate penalties. The new procedure offers the staff -as the attorney, and the Commission - as the client, a mechanism by which to jointly formulate a strategy for settlement. It is not intended to be a curb on the staff's proper use of discretion, and it is not intended to lengthen or complicate the internal settlement process. It is my hope and expectation that the new procedure not only will improve the staff's negotiating position in these cases, but will also alleviate frustrations suffered by all parties in the SEC settlement process. The goal is that committed use of the procedures will make the settlement process more streamlined and efficient for the affected party, the staff, and the Commissioners.
I commend Chairman Cox and Linda Thomsen, the Director of the Division of Enforcement, for instituting this new process. I have the utmost respect for the Enforcement staff and the terrific work they do. I hope that the new process will become a useful tool for them.
As Chairman Cox recently noted, the new settlement process is consistent with Commission precedent. Indeed, the earliest Commissioners were known to "roll up their sleeves" and slog through investigative files. More recently, and perhaps even more relevant, former Chairman Hamer Budge instituted a policy that required the staff to receive Commission authorization before engaging in settlement discussions. In a 1970 memo, Chairman Budge and the Commission spelled out for the staff new procedures for Commission authorization of settlement negotiations. Unlike the new procedure, the 1970 memo did not limit the types of cases to which the Commission pre-approval would apply. Although the Chairman Budge process is no longer followed, there remains in our rules an expectation that settlement negotiations be authorized by the Commission.
The Commission's 1970 memorandum is important for another reason too - it is viewed as the foundation for what we now call the "Wells process." As you may know, the Wells process involves the submission by a potential defendant of a brief - a so-called "Wells submission"- to the staff that addresses the legal, factual, and sometime equitable issues raised by the staff's proposed action. The Wells process was one of the many recommendations presented to the Commission by the Wells Committee in 1972. The Committee was a formal advisory committee created by Chairman William Casey and led by John A. Wells and former SEC Chairmen Manuel F. Cohen and Ralph Demmler. The SEC charged these lions of the SEC bar with undertaking a broad consideration of the SEC's enforcement policies and practices. Their specific mandate was:
- To advise how the SEC's enforcement objectives and strategies may be made still more effective.
- To examine the Commission's enforcement practices and procedures from the point of view of due process, the relationship of enforcement action to notice of legal requirements, the attribution of responsibility for violations and the protection of reputation and rights of privacy.
- To review and evaluate the Commission's enforcement policies and practices in light of its statutory responsibilities to protect investors and insure the maintenance of fair and honest markets for transactions in securities.
- To make recommendations on the appropriate blend of regulation, publicity and formal enforcement action and on methods of furthering voluntary compliance.
- To make recommendations on criteria for the selection and disposition of enforcement actions, on the adequacy of sanctions authorized by law and the suitability and effectiveness of sanctions imposed in SEC proceedings.5
Although not all of the recommendations proposed by the Wells Committee in its report were adopted by the Commission, the Wells process remains the SEC's central due process mechanism in enforcement matters. I believe that advisory committees like the Wells Committee can play a key role in the review and improvement of SEC rules and processes, and in fact they have performed such a function many times over the years. I would welcome new committees to review the functions of our divisions and offices. Indeed, the contributions of advisory committees could be particularly valuable in helping us to analyze and make changes in response to the recommendations made by the various capital markets committees.
You have been a very patient audience, and I appreciate your attention. I welcome your active involvement in the issues I discussed today, and all of our issues. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thank you again for your time and attention.