Speech by SEC Commissioner:
Annual Conference Institute of International Bankers
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
March 1, 2004
Thank you. My history with the Institute began almost 20 years ago, and I must admit that it was not an auspicious beginning. I was a brand new consultant, fresh from the Fed, working on a project that had nothing to do with the Institute. However, in the process, I inadvertently opened up a can of worms that gave Larry Uhlick serious heartburn. I was not very popular with your membership, to say the least. But the world has changed. That particular can of worms has closed, and Larry assures me that all is forgiven, so I am particularly delighted to be here today.
Before I begin, let me state that the views I express here today are my own and do not necessarily reflect those of the Commission or the Commission's staff.
In just a minute, I'm going to talk about some of the issues that I know are high priority items for you, including the Commission's implementation of Gramm-Leach-Bliley, our proposal for consolidated supervision of investment bank holding companies, and our views on progress towards international accounting standards. But before turning to these specific issues, I'd like to take a look at the broader picture and talk about some of the "lessons learned" from the corporate scandals of the recent past as well as the abuses that have come to light in the mutual fund investigations.
Not surprisingly, the chief ingredient in the recipe for fraud - whether in the corporate world or in the mutual fund industry -- is greed. However, conflicts of interest, complacency, complicity and a lack of transparency have all - unfortunately -- made major contributions to the problems confronting the financial services industry.
Greed is just part of human nature, and there is very little any regulator can do to eradicate it. But by changing incentives and disincentives, we've tried to channel greed in a better direction. We've adopted rules requiring the certification of financial information in companies' periodic reports by CEOs and CFOs, better disclosure of off-balance sheet arrangements, restrictions on the use of non-GAAP information and a management report on internal controls over financial reporting. And certainly there is a clear trend towards the ratcheting up of civil and criminal sanctions. Prison time for securities violators may be the ultimate deterrent to fraud, but we believe that more aggressive pursuit of disgorgement, higher civil penalties, and the wider imposition of officer and director bars in SEC enforcement actions will have a deterrent effect as well.
Conflicts are ubiquitous in the financial services field. The conflicts that got some of the companies that have been in the headlines and their gatekeepers into trouble are familiar to us now. We've seen analysts write favorable research reports to preserve investment banking relationships with issuers - even when they privately held far less positive views. We've seen auditors look the other way when a client engages in financial fraud because of their fear of losing a lucrative client. And situations in which attorneys appeared to have forgotten that when they represent a corporation, they are representing the shareholders - not the officers -- were the genesis of our "up the ladder" reporting requirements for attorneys practicing before the Commission.
Additional conflicts have surfaced in our mutual fund investigations. We've seen investment advisers that, notwithstanding prospectus disclosure to the contrary, permitted market timing in mutual funds in exchange for the timers' deposit of "sticky" assets in their funds or related hedge funds, which increased management fees. We've seen portfolio managers market-timing their own funds. We've seen broker-dealers being paid by mutual funds to get their funds placed on a firm's "preferred list" and the firms paying their brokers more to push those funds. Needless to say, the special compensation wasn't adequately disclosed to customers, who never got a real opportunity to gauge its effect on the validity of their brokers' recommendations.
Complacent boards of directors also contributed to the problems. In too many situations, it appears that boards were of the "potted plant" variety that did little more than rubber-stamp management's decisions. Judging from their actions, many directors failed to appreciate the scope of their responsibility to demand that management act ethically and put investors' interests first.
Complicity can be another part of the problem. We have attempted to get at this by focusing on a company's internal controls. We've also taken enforcement action against external entities that were involved in frauds, including action against some big banks that assisted Enron in misleading its shareholders by disguising what essentially were loan proceeds as cash from operations. We recently charged an individual for his alleged involvement in providing financing to the market-timers and late traders.
And finally, transparency. Many of the rules we adopted under Sarbanes-Oxley were designed to encourage the integrity and transparency of corporate financial reporting.
The Commission is working to improve transparency in the mutual fund area as well. We have proposed to require mutual funds to include a Management's Discussion and Analysis in their annual reports; we have a new proposal for disclosure to investors - both at the point of sale and on the confirmation -- in connection with the purchase of mutual fund shares through brokers; and we've also adopted a new rule requiring funds to disclose in shareholder reports expenses per $1,000 invested.
So this is a snapshot of the issues the Commission is working hard to address. With the bulk of the rule proposals dealing with the mutual fund problems now out for comment, the Commission is making progress on several of the issues affecting the international banking community.
The first is Gramm Leach Bliley, legislation enacted in 1999 that, among other things, provided for the functional regulation of securities activities. The legislation eliminated banks' historical exemption from the definitions of "broker" and "dealer" under the federal securities laws and replaced it with various specific transaction-based exceptions. The Commission adopted some interim final rules implementing the "push-out" provisions of Gramm Leach Bliley in May 2001 that were roundly criticized. After that, the Commission postponed the rules' effectiveness and committed the staff to work with the banks and the banking regulators to find workable solutions to banks' practical concerns.
When I began to work with the staff on this soon after I joined the Commission two years ago, the first thing I wanted to do was to improve the process and - hopefully - the outcome. To improve the process, we decided to split the broker and the dealer issues, tackle the bank dealer rules first, and increase the transparency of our process. We reached out to the banks and met not only with bank lawyers, but also with the banks' operational personnel to understand the practical business problems banks would face in complying with the new definition of "dealer."
It took us quite a while to figure out what different banks do and how they do it, evaluate their business under the statutory framework, and develop proposals to accommodate bank securities transactions. Then, after drafting rule proposals, the staff briefed bank industry groups and bank regulatory agencies. The feedback they got permitted the staff to make adjustments before making recommendations to the Commission.
The Commission adopted the bank dealer rules in February of last year, and we are now working on the much more difficult task of defining terms under the "broker" exceptions, but again with a more transparent, interactive process. The staff has again asked bank trade groups to give us a better understanding of the banks' practical concerns. For whatever reason, we have not had as much input from the banks as we had on the dealer side, but we will keep on trying. Our staff is in the process of drafting new proposals, and will be discussing them with bank regulators and other interested parties. We are committed to a deadline for adopting the "push-out" rules by year-end of 2004, with a compliance date 12 months later. To meet this deadline, the Commission must publish the proposals for comment in the next few months. I am not in a position today to go into very much detail, but my impression, based on conversations with the Market Reg staff, is that the proposals have taken the banks' concerns into account in many respects.
Another item of interest to you is the Commission's proposal for consolidated supervision. As you know, the Commission proposed last fall an alternative net capital calculation that would more closely align regulatory capital with firms' internal risk models. The proposal would also implement consolidated supervision in anticipation of the European Union's Financial Conglomerates Directive, which will require the application of consolidated supervision to EU financial firms, including the EU affiliates of U.S. firms.
Some banks -- including banks represented by this group - and their regulators have expressed concern that our alternative capital proposal, known as the CSE proposal, will duplicate the regulatory oversight provided by home country consolidated supervisors. I am sympathetic to these concerns. Let me assure you that that is not our intent. We are particularly mindful of the potential burden to firms that are already subject to consolidated supervision, and we are not looking to usurp the role of that supervisor.
Having said that, our ability to offer reduced capital is based on our ability to assess risks from holding companies or other affiliates on the broker-dealers we regulate. As a regulator, we have to be in a position to address excessive risks before they escalate to a dangerous point.
Before adopting final rules for CSEs, we will carefully consider all comments. Our goal is to find the right balance between having the information we need to assess the major risks posed to broker-dealers by their affiliates' operations, and not burdening business with duplicative or inconsistent requirements. I intend to stay very involved in the rulemaking process going forward, and I will be sure to focus on the issues reflected in your comments.
On the subject of international accounting standards, our goal is clearly convergence. The IASB has grown in stature and credibility, and its International Financial Reporting Standards ("IFRS") will become mandatory in the EU in 2005. Our Chief Accountant, Don Nicolaisen, tells me that his staff is spending a lot of time gearing up on IFRS and that all the large accounting firms are developing IFRS training programs in anticipation of the 2005 goal.
With 2005 fast approaching, the IASB is busy finalizing several key accounting standards, one of which is IAS 39. This standard deals with financial instruments, including the measurement and recognition of derivatives at their fair value, similar to FAS 133 as part of U.S. GAAP. This standard has stirred up considerable debate and has been opposed by some European banks and insurance companies. At present, the European Commission has not yet indicated whether it will adopt IAS 39 and the related standard for disclosures, IAS 32. While FAS 133 may not be perfect, it is the best derivatives standard we have at the moment. Our Chief Accountant has stressed the importance of transparent reporting of financial instruments and has indicated that the IAS standards represent a positive step towards such reporting on a global basis.
Since October 2002, the IASB and the FASB have been working towards converging international standards and U.S. GAAP. As part of these short-term convergence efforts, the FASB issued several exposure drafts last December to modify accounting of inventory costs, earnings per share calculations and non-monetary assets, areas that were identified for the 2005 convergence target. However, progress towards convergence will not stop here. Other long-term efforts by the boards are currently underway, including accounting for business combinations and revenue recognition, and reporting of comprehensive income. The cumulative effect of all these efforts will put all of us closer to the goal of international convergence.
Turning to foreign screens, I know that is an important issue for you. Although it is on our screen, as the Chairman has stated, we will consider this once we have completed an examination of our domestic market structure issues. As you may know, that examination is underway with the publication for comment last week of a number of market structure proposals.
I want to end on a high note, so I have saved two pieces of good news for you until the last. First, for those of you associated with U.S. public companies, you'll be pleased that we have delayed the compliance date for the internal controls provisions of Section 404 of Sarbanes-Oxley. This is the requirement for companies to include in their annual reports a report by management on the company's internal control over financial reporting and the auditor's report. For public companies with assets of over $75 million that have filed at least one annual report, the compliance date has been postponed until the end of its first fiscal year on or after November 15, 2004. For all other registered companies, the compliance date is the end of the first fiscal year beginning on or after July 15, 2005.
Second, I know the international banking community is anxious for the Commission to level the playing field between U.S. and foreign banks when it comes to the prohibition against loans to directors and executive officers under Section 402 of Sarbanes-Oxley. The comment period has ended on the Commission's proposal to exempt foreign banks from this prohibition, and while there is no specific date for action on this, I'm happy to report that the staff plans to make a recommendation to the Commission on a final rule very soon. Where we can, we certainly want to level the playing field between domestic and foreign banks, and this is a good example.
Thank you for the opportunity to speak to you today. I'd be happy to take some questions.