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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Introductory Remarks at April 13, 2004 Open Meeting


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Washington, D.C.
April 13, 2004

Foreign Bank Exemption From Insider Lending Prohibition

Good morning. The first item on today's agenda is a final rule, recommended for adoption by the Division of Corporation Finance that would establish an exemption for qualified foreign banks from the insider lending prohibition enacted as part of the Sarbanes-Oxley Act. The Act itself provides banks an exemption from the insider lending prohibition for certain lending by banks that are insured under the Federal Deposit Insurance Act. However, generally only domestic banks satisfy these criteria. Today's recommended rule would exempt those foreign banks that satisfy specified criteria similar to those that qualify domestic banks for the statutory exemption.

The recommended rule helps establish a more level playing field for foreign and domestic banks. Importantly, while the rule removes unnecessary burdens for foreign registrants seeking access to our markets, it is also consistent with the goals of the Sarbanes-Oxley Act. The rule applies only upon the satisfaction of carefully crafted conditions that are designed to track the policies underlying the existing exemptions in the Act. By removing burdens that might discourage foreign participation in our markets while at the same time respecting the goals of the Act, rules like this facilitate a greater variety of investment opportunities for investors in our markets while preserving important investor protections.

Since we proposed this rule in September, we have received many thoughtful comments. The comments have, for example, helped us to refine the rule to more precisely reflect the effects of foreign regulatory structures governing banks and how those structures affect insider lending. Also, the staff's recommendation reflects the concern raised about the application of the lending restriction to foreign government registrants. The final rule includes an exemption for these issuers.

I thank the staff for its careful consideration of the comments and for presenting us with this well-developed recommendation. You have once again demonstrated your ability to take on an important and complex issue and present us a high-quality product. I would also like to acknowledge the contribution of the staff of the Federal Reserve Board, who helped us think through the complexities of these issues.

Use of Form S-8 and 8-K by Shell Companies

The next item on our agenda is a proposal from the Division of Corporation Finance on public shell companies. The Division recommends that the Commission propose to:

  • adopt a definition of the term "shell company";
  • prohibit public shell companies from using Form S-8 to register securities for public sale; and
  • revise Form 8-K to require a public shell company, when it ceases being a shell company because of a "reverse merger" or "back-door registration," to file with the SEC the same information that would be required if it were an operating company becoming a public company by registering a class of securities under the Exchange Act.

The actions we are considering today are intended to further our efforts to deter fraud and abuse in the market for highly speculative securities. The Commission's efforts in this area go back to its earliest days. Encouraged by Congressional passage of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, the Commission in recent years has undertaken a number of initiatives in this area, including those aimed at penny stock fraud, blank check offerings and Internet and microcap company fraud.

While shell companies can have valid purposes, we know that shell companies also have been used over the years to defraud investors in this marketplace. Today's proposals are aimed at shell company transactions that have been used in attempts to exploit unsuspecting investors. One transaction involves using Form S-8, a form that is designed to be used to register securities for sale in connection with employee benefit plans. However, we have seen shell companies use S-8 to sell stock to outside parties without the full benefits of registration and delivery of a prospectus under a form designed for such sales. Other types of transactions involve so-called "reverse mergers" and "back-door registrations." Promoters can use these transactions for abusive schemes by gaining control over a public shell company and combining it with a private company. The promoters engage in fraudulent and misleading promotional efforts related to the combined company's prospects, leading to artificially high prices for the company's stock. The promoters then sell their stock at high prices before accurate information about the company becomes available. When they cease their promotional activities, the price of the stock drops in the hands of unsuspecting investors.

The proposals we are considering today seek to address each of these transactions. First, they would prohibit the use of Form S-8 by shell companies. Second, the proposals would provide the market more appropriate and timely information in "reverse mergers" and "back door registrations."

It goes without saying that the Commission must do everything in its power to prevent fraud and abuse in our markets, while at the same time we must not unduly affect the legitimate practices of small businesses. I thank the staff for crafting a proposal that considers this important balance. If approved by the Commission, I will look forward to the comments to help make these rules as effective as possible in protecting investors against the types of shell company schemes that we have seen in recent years.

Disclosure About Market Timing and Selective Disclosure

The final item on our agenda is a recommendation that we adopt amendments to our investment company registration forms. These amendments would require enhanced disclosure about fund policies and procedures concerning market timing and selective disclosure of the fund's portfolio holdings, including disclosure that highlights the existence of arrangements by which the fund facilitates these practices. The staff also recommends that we require mutual funds and managed insurance company separate accounts to explain both the circumstances in which they will use fair value pricing and the effects of using fair value pricing. These amendments, which were proposed last December, respond directly to the abusive market timing in mutual funds that was uncovered late last summer.

Abusive practices flourished in funds whose prospectuses created the impression that the fund limited market timing, when in fact those policies were being applied inconsistently or sporadically. Murky language and vague phrasing was used to cloak special deals and special treatment for large and influential investors.

In 1914, Louis Brandeis penned one of the most enduring lines in the canon of the federal securities laws. He wrote that "[s]unlight is . . . the best of disinfectants; electric light the most efficient policeman." I am pleased to support today's recommendation, which will shine some light on what has proved to be a dark and dingy corner of the mutual fund industry.

As always, my thanks to Paul Roye for his leadership and counsel and to the members of the Investment Management staff for their hard work and dedication on this and all of the recommendations that have been brought to the Commission in the past months. I particularly want to acknowledge the people who were instrumental in bringing today's recommendation to the Commission: Susan Nash, Paul Cellupica, Kieran Brown and David Schwartz.



Modified: 04/13/2004