Speech by SEC Chairman:
Statement at March 3, 2005 Open Meeting
Chairman William H. Donaldson
U.S. Securities and Exchange Commission
March 3, 2005
Fund Redemption Fees
The first item on our agenda is a recommendation from the Division of Investment Management that the Commission adopt a new rule that would permit, but not require, mutual funds to impose redemption fees. This rule -- one in a series of regulatory initiatives addressing the problems of late trading and market timing -- is designed to allow funds to impose fees to deter short-term trading and reimburse the fund for direct and indirect costs incurred as a result of short-term trading strategies. Under the final rule, fund boards of directors would have to either approve imposition of a redemption fee or affirmatively determine that a redemption fee is not necessary or appropriate.
The rule is a departure from the original proposal, which would have required most funds to impose a 2 percent redemption fee on short-term trades. The final rule – while requiring that the issue be considered by fund boards of directors – leaves to the boards the ultimate decision about whether to impose the fee, and, if so, at what level, provided that the fee does not exceed two percent of the amount redeemed.
I am pleased to see that the final rule has evolved in this way. While a redemption fee, when properly structured and consistently applied, can be an effective deterrent to abusive market timing, redemption fees are not really susceptible to a ‘one-size fits all’ approach. They are not costless to implement, and it is not easy to structure them in a way that captures all of the activity that we are trying to deter, and none of the activity that we aren’t. Moreover, funds are not equally vulnerable to abusive market timing. Thus, it makes a great deal of sense to turn to fund boards to analyze these issues on a fund-by-fund basis, and to rely on them to implement redemption fees if it is in the best interest of fund shareholders to do so.
The final rule also includes provisions addressing the persistent problem of applying redemption fees to trading that occurs through financial intermediaries’ omnibus accounts. The rule would require funds to enter into written agreements with their intermediaries under which the intermediaries agree to provide the fund, upon request, information about investors in omnibus accounts. These agreements would also have to provide that the intermediaries must execute instructions from the fund to restrict or prohibit further transactions by shareholders identified by the fund as having engaged in transactions that violate fund policies on frequent trading or market timing.
Financial intermediary omnibus accounts play a critical role in the efficient settlement of purchases and redemptions of mutual fund shares, but we have seen too many enforcement cases in which omnibus account trading was used to conceal abusive market timing trades and to bypass funds’ efforts to control this activity. These provisions of the rule will force funds and their distributors to cooperate with one another to enforce fund policies regarding frequent trading.
Finally, the staff is recommending that we request additional comment on whether there are ways in which it would be appropriate for us to standardize some of the terms – the ‘design elements’ if you will – of redemption fees, in order to reduce the cost of their implementation. Financial intermediaries handling securities transactions for multiple funds in multiple fund families have made it clear that they struggle to assess redemption fees when faced with a potentially unlimited combination of variables. It makes sense to explore whether there are steps that we can take to reduce this burden, while still giving fund boards sufficient flexibility to address the specific circumstances faced by their funds and their shareholders. To put it another way, we may not all need or want the same color, size or style of kitchen sink, but at the end of the day, it makes sense to standardize the connection between the sink and the plumbing. I look forward to hearing what commenters have to say on these issues.
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In a moment I will turn the discussion over to Paul Roye, Director of the Commission’s Division of Investment Management.
Before I do . . . as I expect most of you know, Paul has announced that he will be leaving the Commission to return to the private sector; this is Paul’s last Open Meeting. Paul has served as Division Director since 1998. He has served under two Presidents and three Chairmen. He has led the Division through times of relative calm and through times of turmoil and change and he has been the principal architect of a series of the most sweeping mutual fund reforms since enactment of the Investment Company Act itself. He is a man of extraordinary integrity and consummate professionalism, and his dedication to the needs and interests of the nation’s investors is unmatched. Paul, we hate to see you go, but you can leave secure in the knowledge that you leave a strong and lasting legacy.
Credit Rating Agencies (NRSROs)
The next item on our agenda is a recommendation from the Division of Market Regulation to propose a new rule that would define the term “nationally recognized statistical rating organization” or “NRSRO.”
An NRSRO is a credit rating agency whose ratings have earned sufficiently broad recognition in the marketplace that they can serve as an indication of a security’s quality, for defined purposes under the Commission’s rules.
The term “NRSRO” was originally adopted by the Commission in 1975 for determining haircuts applicable to different grades of debt securities under the net-capital rule. The term has since been used in a variety of other regulatory and statutory contexts. Today, ratings by NRSROs are used as benchmarks in federal and state legislation, rules issued by financial and other regulators, foreign regulatory schemes and private contracts. Despite its widespread use, the Commission has never defined the term “NRSRO.”
The Commission has undertaken a number of recent efforts addressing the subject of credit rating agencies in general and NRSROs in particular. These included public hearings in 2002, a report required by the Sarbanes-Oxley Act of 2002, and a concept release issued in 2003.
Most participants in the public hearings favored the regulatory use of credit ratings issued by NRSROs, considering them to be simple and well-understood benchmarks of credit quality. Participants also recognized that standards for NRSROs were necessary for the concept to be useful.
The Commission’s study pursuant to the Sarbanes-Oxley Act considered the role of credit rating agencies and their importance to the securities markets. We considered the impediments faced by credit rating agencies in performing their role, measures to improve information flow to the market from credit rating agencies, barriers to entry into the credit rating business, and conflicts of interest faced by credit rating agencies.
Our concept release examined whether credit ratings should continue to be used for regulatory purposes under the federal securities laws, and, if so, the process of determining whose credit ratings should be used, and the level of oversight to apply to such credit rating agencies.
One conclusion that the Commission has drawn from its examination of the topic is that market participants would be well served by a clearer set of standards for determining whether or not a credit rating agency is an NRSRO. Today’s proposal would, for the first time, define these standards in a Commission rule.
Importantly, the staff’s recommendations today, which have been crafted based on the Commission’s existing statutory authority, are only one component of a broader policy dialogue concerning credit rating agencies and their role in the financial markets.
Internationally, regulatory concerns have been raised regarding the appropriate oversight of credit rating agencies. A number of European regulators have undertaken initiatives designed to study how credit rating agencies operate and to discuss proposals to address any problematic issues that are identified. IOSCO created a task force to study issues concerning credit rating agencies in 2003 and published its “Code of Conduct Fundamentals for Credit Rating Agencies” in 2004.
Domestically, Congress is examining a variety of concerns regarding credit rating agencies, including whether additional legislation may be needed to assure sufficient regulation of the industry.
Some, including some members of the Commission, may already have views on whether a legislative solution is needed or desirable. With the staff’s recommended proposals today, we are creating a framework in which to develop a full record for decision making. The Commission looks forward to continuing this critical dialogue with Congress, with the industry and with the public.
Before I turn to Annette Nazareth to outline the proposal, I would like to thank the staff members who helped put it together. In particular, I would like to acknowledge Mike Macchiaroli, Thomas McGowan, Mark Attar and Rachael Grad.
2005 PCAOB Budget and Accounting Support Fee
The last item on our agenda is consideration of the 2005 budget of the Public Company Accounting Oversight Board and the 2005 accounting support fees for the PCAOB and the Financial Accounting Standard Board.
The PCAOB was created under the Sarbanes-Oxley Act to oversee the audit profession and help restore public confidence in financial reporting. To help the new Board accomplish that mission, Congress gave it the power to establish auditing standards, register accounting firms that audit public companies, regularly inspect those firms, and investigate – and, if necessary, discipline – audit firms that violate PCAOB or SEC rules. Congress also provided for SEC oversight of the PCAOB in several areas. One of those is Commission consideration and approval of the PCAOB annual budget.
The PCAOB’s budget forms the basis for determining the annual accounting support fee, which is allocated among public companies and is the primary source of the PCAOB’s funds. By establishing this mechanism for public funding, Congress sought to ensure that the PCAOB would be independent of the profession it is charged with regulating.
Many of the Board’s initial operations during 2003 and 2004 were basic organizational and start-up tasks, such as registering accounting firms, hiring staff, establishing operational rules and designing an inspections system. More than 1,400 accounting firms from around the world have now registered with the PCAOB. It is to the PCAOB’s credit that it was able to accomplish these important tasks in such a relatively short period.
The budget before us today covers the PCAOB’s projection of income and expenses for 2005. This will be the first full year of the PCAOB’s regular inspection program and will be the year when its investigations program is fully operational.
Because the PCAOB should have a solid year of operations behind it when it prepares its 2006 budget, Chairman McDonough has indicated that the Board’s next budget submission also will include its long-term strategic plans for its operations and budget, as well as a self-assessment of the PCAOB’s internal controls for its operations.
In addition to the PCAOB, the Act provides that the accounting standard-setter designated by the Commission also will be funded by an annual support fee. The Commission has designated FASB and its parent organization, the Financial Accounting Foundation, as this accounting standard-setter. We also will consider today a recommendation from the staff regarding the FASB support fee.
To their credit, both the PCAOB and the FASB are addressing many important and challenging issues facing our capital markets. While we have and will continue to be closely engaged with them in their substantive efforts to address these challenges, Congress sought to ensure that they would be strong, well-funded and independent bodies, who would utilize their expertise and resources to make many difficult policy judgments. The Commission has a critical oversight role in assuring that they act consistently with their legislative mandate, but it is not our job merely to substitute our judgment for theirs or to second-guess their actions. Rather, our job today is to determine if, consistent with the Act, they have a reasonable and well-founded basis for the assumptions and numbers they came up with in determining the PCAOB’s budget and the PCAOB and FASB support fee.
With that, I would like to thank Don Nicolaisen, the Commission’s Chief Accountant, and James McConnell, our Executive Director, for their work in analyzing the PCAOB’s and the FASB’s submissions and preparing their recommendations to the Commission. I know that your staffs have put a lot of time and effort into reviewing these submissions, and I would particularly like to thank Melanie Jacobsen, Ken Johnson, Bill Wiggins and Brian Croteau for their hard work. I would also like to thank the PCAOB and the FASB as well for their diligent efforts and cooperation throughout this process.