Speech by SEC Commissioner:
Remarks before the Bond Market Association 2005 Legal & Compliance Conference
Paul S. Atkins
U.S. Securities and Exchange Commission
New York, NY
February 1, 2005
Thank you very much, Micah.
It is a privilege to be here today. Let me start by saying that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
Today, I would like to address the need in the new post-Sarbanes-Oxley world for the SEC to cooperate with regulated entities in developing a stronger oversight regime. I would also like to discuss the future trends in the bond market, some potential regulatory pitfalls that ought to be addressed, and suggestions to head off regulatory intervention.
The frenetic pace and the significance of the SEC's regulatory initiatives since the passage of the Sarbanes-Oxley Act in July 2002 are staggering. It is difficult to think of an area in financial services in which the SEC has not been active. Whether or not your firm has been touched by scandal or worse, you certainly have felt the increase in regulatory costs and burdens. Simply put, because some businesses lost their ethical compass, the shadow of those few has fallen across the rest.
Regulatory soul-searching is typical in periods of financial turmoil and usually leads politicians and regulators to conclude that future problems can be averted with increased regulation. In fact, the SEC was born out of just such a rush to regulation following the 1929 market crash, which came after an economic boom period, complete with a stock market bubble. In the 1930s, the government attempted to pull the country out of the depression by continued intervention, which included everything from price controls to an anti-free market domestic regulatory policy. These policies, most economists today would agree, were failures.
Now, with the implementation of Sarbanes-Oxley, the U.S. government has completed the largest securities law initiative since that time. History teaches us time and again that rarely do regulators seriously question, much less analyze, whether the prior regulatory framework was partly to blame for any or all of the problems. The regulatory response to the corporate scandals of the last several years has not been any different in this regard. We regulators do not ask whether we have done anything wrong, but instead what more we need to do. Market forces are painted as villains against which only regulators stand a chance.
While regulated entities must themselves do some soul-searching, private firms lay the groundwork for regulatory actions when they fail to uphold their own end of simple business ethics through voluntarily-implemented, effective compliance programs. A corporation that focuses on ensuring the long-term success of its business and reducing regulatory risk is more likely to implement strict internal controls than one that is primarily concerned with achieving short-term targets. The culture of a firm is determined by the tone set by its executives, the firm's organizational structure, compensation incentives, and the degree of oversight activity by gatekeepers such as directors, auditors, and attorneys. A CEO's tolerance or lack of tolerance of ethical misdeeds and a CEO's philosophy of business conveys a great deal throughout the organization. An informed, inquisitive, and well-rounded board of directors serves an important role in monitoring the corporation and management on behalf of stockholders for whose benefit the corporation ultimately exists. Sarbanes-Oxley has given these gatekeepers improved tools with which to fill their functions.
Now that Sarbanes-Oxley has also strengthened the hand of federal regulators in overseeing corporate gatekeepers such as directors, attorneys, accountants, and audit personnel, I worry about the form that oversight will take. The SEC understandably is interested in ensuring that these gatekeepers play an active role in shaping business decisions. My concern is that, frustrated by a few instances of incompetence or venality, we might devise our own overly-technical prescriptions for gatekeeper conduct. These technical prescriptions could dissuade talented professionals from serving in a gatekeeper capacity for public corporations.
This fear is particularly critical for broker-dealers. Public broker-dealers must not only comply with the federal gatekeeper and internal control provisions of Sarbanes-Oxley, but they must also comply with applicable SRO rules. Most recently, the SEC approved NASD rules requiring CEO compliance certifications and the designation of a Chief Compliance Officer.
Underlying all my other concerns is a basic philosophical one, namely we must not allow the American economy to be unduly encumbered by a web of regulations. Recently, the Wall Street Journal and the Heritage Institute released their annual "Index of Economic Freedom." For the first time in the decade-long history of the index, the U.S. is no longer among the top ten "most free" countries. Although it is wonderful to see other countries becoming freer, I do not like to see the U.S. losing its reputation for being one of the best places in which to do business. For the sake of a strong economy that delivers jobs and a rising standard of living, we cannot allow the United States to lose its appeal as an investment destination. President Bush said it very well in January when he stated in an interview that "it's very important not to get [the system] out of balance when it comes to [ ] government reach."
One way the SEC can provide this balance is to review its regulatory approach. Last week in Brussels, I spoke to officials of the European Union concerned with the financial services industry about the current regulatory environment in the U.S. They are very much focused on advancing their "Lisbon Agenda" for economic revitalization. We spent time discussing the differences in the regulatory approach taken on the two sides of the Atlantic. For example, the Financial Services Authority in England is a consolidated supervisor that oversees the banking, securities and insurance industries. Belgium and Germany have similar consolidated supervisors.
Unlike our enforcement approach, the FSA and other European regulators engage in prudential regulation. Prudential regulation fosters an atmosphere of cooperation between the regulator and the regulated entities, because it is based on the premise that both regulator and regulated have much to lose from fraudulent conduct. Both have reputational risk at stake - the regulator for questions of competence, and the regulated for basic threat to shareholder value, not to mention jail time, fines, disgorgement, restitution, customer retribution, etc. Critics of this approach believe oversight is compromised because regulators may become captured by the industry they regulate and have an incentive to keep discoveries of fraud out of the public eye.
But, supporters of a cooperative approach, both here and abroad, argue that regulators gain better and more current information about industry trends and corresponding concerns, as our banking regulators find on this side of the Atlantic. Regulators can work with the industry to develop market-based solutions to potential problems before a scandal occurs. As regulators, we must rely on industry participants to inform us of business projections, trends, and practices. Without adequate industry knowledge, regulators react to events retrospectively, rather than being prepared beforehand and raising concerns before a crisis develops. The chance of surprises is diminished for both regulator and regulated.
I think that, traditionally, the SEC has had good intentions of balancing regulatory cooperation with an appropriate enforcement mechanism. As I said earlier, regulators react to scandals by bringing enforcement actions and adopting new rules instead of addressing the reason why its oversight of the regulated industry failed. The SEC should now take a deep breath, survey the landscape, and focus its energies in a coordinated and effective manner. Rash, scattershot action will in the end create more confusion rather than sound regulatory policy.
Through our consolidated supervised entity and supervised investment bank holding company rules that we put into effect last year, the SEC has taken the first steps toward a prudential regulatory approach. I am very interested to see what our experience will be in this realm. I hope that those of you who are with firms participating in that program will give me your observations as time goes on. We are still working out this approach internally, so your comments will be greatly appreciated.
More generally, the SEC can achieve effective regulation and oversight by establishing clear standards and rules, by examining for compliance with them, and by bringing enforcement actions for violations of these rules. It is very counterproductive in the long term to use enforcement actions to supplement rules, because it may become apparent in retrospect that the rules were not clearly articulated in the first place. Basic questions of fairness arise for those subject to arguably new standards of conduct imposed after the fact through an enforcement proceeding. Unfortunately, we have to acknowledge that organizational inertia and the pain of tackling complex, controversial issues tend to keep regulators from being more proactive up front - before problems have manifested themselves.
Even worse from a long-term, good-governance perspective, the regulator's failure to provide clear standards compromises private-sector compliance efforts, because compliance officers cannot speak to their business colleagues with authority as to what is improper conduct.
In order to have a successful, cooperative regulatory approach, the regulator's knowledge base and expertise must be maintained for effective oversight. Industry participants should feel comfortable asking regulators about issues involving future market trends without fear of retribution or of prompting an examination. An effective regulator needs information about changing business practices to keep up with evolving markets. Leaving aside the possibility of some sort of Delphic ability, a regulator can only truly obtain this sort of information by interacting with regulated entities and answering their questions. Ideally, regulators should use this information to maintain and modernize regulations in an effort to prevent future problems.
I have been at and around the SEC for more than 20 years, and it seems that the same issues emerge and re-emerge like clockwork. These issues include 12b-1 fees, soft dollars, mark-ups, conflicts of interest, sales practices, and disclosure practices, among others. These are red flag topics that the SEC and the industry need to work together to resolve. Business practices change, but the principles underlying the securities laws remain the same.
Hand-in-hand with establishing and maintaining clear standards, the SEC also must ensure that it can carry out effective examinations for compliance. The failure to provide proactive regulatory guidance undermines our own oversight program and encourages informal, scattershot regulation by an examination staff struggling to cope with vague rules. Rulemaking and examination staff must work together prior to implementing regulations to ensure an agreed-upon plan of oversight.
Regulatory holes discovered during the examination process should be addressed through further guidance to regulated entities, either through formal interpretations by the Commission (if the issues are relatively minor), or better yet, using the statutory due-process, notice-and-comment procedures of formal rulemaking. The examination arm should create incentives for firms to evolve their compliance programs along with market changes.
A vital role for our examination process is discovering fraud - these are our front-line troops in that battle. But, we should never ask them to become - inadvertently - our main policy- making arm. That is for our rulemaking function. The examination division should also be used as a liaison process to answer questions, gather information on business trends, and work with the industry to improve compliance with the securities laws.
Regulatory oversight by multiple jurisdictions also poses challenges for the securities industry. As a result of the increasingly high-profile nature of securities regulation and the fact that securities regulatory issues are not neatly confined to one particular jurisdiction, regulators in multiple jurisdictions increasingly regulate or prosecute in response to the same set of facts. For example, a firm that negotiates a settlement with the SEC might also face actions by an SRO and one or more state attorneys general, who may elect not to work with us.
For the sake of the taxpayer and in the name of good government, the SEC should lead by example to ensure that regulatory cooperation enhances the effectiveness of the securities laws, while reducing the burdens of duplicative investigations by multiple regulators. That is not just for the benefit of companies that turn out to be innocent, but also for the taxpayer's benefit, who must pay for the efforts of these different regulators. We have to be efficient in coordinating efforts to make the most out of limited resources for which the taxpayer is paying so dearly.
Regardless of the future regulatory environment, firms should monitor their own regulatory risk and use market-based solutions and strong ethical guidelines to resolve questionable behavior. It is easy to say that the lessons learned today should be applied to tomorrow. But, the key, of course, is to think out of the box and anticipate future problems.
Speaking of which, we should spend a few minutes focusing on the future landscape of you in the bond business. A key date may be 2008. And, no, I do not mean the 2008 Olympic Games in Beijing or the next presidential election. In 2008, this country will begin to experience a major demographic shift when the first of the 76 million baby boomers will begin to retire. As they retire, these people may begin to shift out of their equity portfolios and invest more in bonds to meet their income needs as pensioners. Inevitably, this increased popularity of the bond market will mean that the bond business will be in for more scrutiny from the public and regulators.
What should the industry to do start preparing for this change? A review of sales practices, trading practices and transparency concerns is a start. Each firm should take this opportunity to evaluate its regulatory risk, work with industry groups to develop solutions to known risks, and avert a regulatory over-reaction.
Transaction pricing is one area that may pose regulatory risk to the bond market. When Commissioner Glassman spoke at this conference last year, she said that she hoped that no other SEC Commissioner would need to discuss transparency from this podium. Unfortunately, I will have to break that wish just a little bit. By now, you can probably recite all of the facts and figures about transparency in the bond market. On the other hand, I truly hope that you, as gatekeepers to the bond market, can continue to help to push for market-based solutions to avoid unwanted regulation in the future.
We do not have to look very far back in history to see several examples of regulators intervening in markets that either harmed customers or were deemed opaque. For example, the Nasdaq price-fixing scandal prompted the SEC to intervene and demand automation for the protection of investors. Soon after, the development of online trading gave investors a self-help mentality and changed their expectations for brokerage services. Investors and strong competition led Nasdaq to evolve from an antiquated telephone-based system to a highly-automated market. Spreads narrowed and execution quality improved. As in other sectors of the markets, a growing retail component of a securities product increased the regulatory scrutiny associated with those firms selling or trading the product.
The recent adoption of the hedge fund registration rule by a 3-2 SEC vote is an example of regulatory intervention into an industry where those seeking to expand the SEC's reach can play off of opaqueness and mystery. Even though an SEC staff study found no evidence of retailization in the hedge fund industry, three of my colleagues relied on perceived or anecdotal retailization for their vote.
I don't mean to be unduly alarmist, but this illustration shows that even an esoteric corner of the securities industry, characterized by sophisticated investors who are not investing their last retirement dime, can find itself on the wrong side of a misguided regulatory initiative.
I don't want to go any further without recognizing the bond market's progress in addressing sales practice and transparency concerns over the course of this year. In fact, it is appropriate that this conference comes on the first day that real-time transaction reports in muni bonds will be available. I am also happy to see that the expansion of available transaction reports in corporate bonds will begin distribution next week. Increased transparency allows investors to look after their own interests and reduces the risk of manipulative or unfair trading practices.
I would also like to compliment you for taking a proactive approach in establishing the Corporate Debt Market Panel. The Panel published a report in September 2004 outlining recommendations for specific guidance on general disclosures and information for individual investors. The recommendations touch both sales practices and post-trade disclosure issues. The report cites an NASD survey that found that 34% of individual investors participating in the survey either thought: (a) there was no fee for buying or selling a bond or (b) they did not know whether they were paying a fee.
That statistic is certainly troubling: Leaving aside whether investors know how much they are paying in fees, a substantial portion is not even aware that they are paying a fee. They clearly do not understand how the market works. The U.S. regulatory regime encourages market transparency to promote integrity and confidence in the markets.
The Panel took an approach that recommends investor education on post-trade transaction reports, disclosure of transaction fees to investors, and additional fee disclosures on the confirmation statement. These seem to be straightforward principles grounded in numerous SEC and SRO rules for other security products. There is no reason why the industry cannot begin to discuss this approach now, including fundamental tenets of existing regulation and potential unintended consequences of change, so that whatever standards we have are grounded on a solid philosophical base.
Bond trading has historically taken place in the over-the-counter market on a principal basis. For these transactions, existing NASD rules allow brokers to charge their customers a fair and reasonable mark-up on the prevailing market price. Determining the prevailing market price and what constitutes a fair and reasonable mark-up are difficult issues, similar to those I discussed earlier. These issues reappear through time and need to be monitored closely.
In September 2003, the NASD filed with the SEC an amended interpretation for the Additional Mark-Up Policy for Transactions in Debt Securities and filed an amendment to the rule proposal in June 2004. I hope that we will address this matter, including soliciting comments, expeditiously to remove any regulatory uncertainty surrounding this outstanding rule proposal.
You, as participants in the bond market, must also do your part. Proponents of disclosure of fees and the prevailing market price for securities say that investors armed with this information can shop around for a better price, police the broker's activity, and feel that they are getting a fair deal. Many of those opposed to this increased disclosure argue that it will reduce liquidity and the broker's willingness to commit capital. The NASD and the industry should closely monitor any negative effect of the recently implemented transparency rules on the bond market to test any effect on liquidity.
As a bond buyer myself, I realize that people buy bonds based not on the profit that a broker earns on a trade, but based mostly on yield and credit quality, comparing the investment's merits to others'. But, because it appears that retail investors' participation in the bond market will continue to grow, the calculus of dealing with the current bond investor profile may not work any more. Claims of excessive mark-ups, manipulation, and unfair pricing are just the type of occurrence that could lead to a regulatory reaction in the industry, particularly when a fiduciary duty is involved.
I would encourage you to engage in this debate regarding fee disclosures on trade confirmations. The practical difficulties associated with unbundling mark-ups from the prevailing market price might just be worthwhile when you contemplate the regulatory scrutiny that brokers will inevitably face to determine whether they are fulfilling their obligations of charging a fair and reasonable price on principal transactions. Last year, several economists published studies that suggested that retail customers were charged higher transaction fees than institutional clients due to the lack of transparency in the bond market. I do not have an opinion about the studies' conclusions, but I cite them as evidence of criticism that may grow over the years. Marketplace solutions certainly are preferable to possible alternatives, including an extension of national market system regulations to the bond market.
I am sure that all of you might be following the current debate about whether and how to restructure the national market system, the "Regulation NMS" proposal. The call for market structure reform, which began before I joined the SEC over two years ago, has taken an unpleasant turn towards technical tinkering with the pricing mechanism employed by our markets. I supported the initial concept of providing for regulatory certainty, removing barriers to competition, and leveling the playing field between market participants and market centers, but I cannot support government intrusion into the marketplace, and specifically, into the pricing of securities. I fully support market transparency, but the proposed trade-through rule outlined in regulation NMS is not a disclosure rule or a transparent form of regulation. Vibrant capital markets in the U.S. benefit investors and issuers throughout the world, so your voices are important on this issue as well as the ones that more directly affect your day-to-day regulatory obligations.
You all have been a very patient and indulgent audience. Thank you for your work to maintain a fair marketplace. The issues in the bond markets are fascinating and very important to our economic well-being. Please do not hesitate to contact me to discuss these issues. My door is always open, and I encourage you to tackle these issues head-on, before something else down the road tackles you. As I remind my Cub Scout sons, the motto to live by is "Be prepared."