Speech by SEC Staff:
Remarks before American Bankers Association, Trust Management Association Meeting
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
May 2, 2003
Good morning. What a pleasure it is to be here today at such a magnificent location. The trip from Washington was pleasant, but I must say, that all changed when we entered the Goshen Pass it is breathtaking. I am told that Robert E. Lee thought it the most beautiful spot in America he certainly had an eye for beauty. Before coming here I asked some friends what the Greenbrier was like one associate told me that it really wasn't all that much. He said that, in fact, the place was used by the government to house the interned German, Japanese, and Italian diplomats at the beginning of the Second World War. Frankly, I am surprised that we were able to get any of the diplomats to return home after their stay.
While preparing my remarks for this conference I had an opportunity to reflect on the events of the past few years. Accounting scandals, a recession, concerns about terrorists, and a war have depressed market values, significantly reduced volume, and most critically, eroded investor confidence a rather gloomy picture, but a picture not unique in the history of the Commission. The industry was certainly in sad shape when the SEC was formed in 1934, and the markets were very unsettled during the "paperwork" crisis of the 1960s and let's not forget about the "market correction" of 1987. And while each period had its own unique qualities: depression, war, recession, accounting scandals, analyst conflicts, and loss of control of the back office, they all have a common attribute the loss of investor confidence caused by the erosion of market integrity. This morning I would like to talk to you a bit about the Commission's progress in implementing legislation that goes to the heart of the issue of market integrity: the Sarbanes/Oxley legislation. In the same vein, I would like to discuss the Commission's market integrity concerns in implementing the provisions of the Gramm/Leach/Bliley Act. But before I begin my comments, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff. 1
Congress took an important step toward restoring market integrity and investor confidence following the recent corporate and accounting scandals when it passed the Sarbanes-Oxley Act of 2002 in July of last year. Among other things, that legislation includes provisions designed to promote auditor independence and improved corporate governance for public companies subject to the Federal securities laws, including requirements related to audit committee composition and responsibilities, financial statement certification, and loans to insiders. The Sarbanes-Oxley Act also establishes a new oversight board for the accounting profession.
The Sarbanes-Oxley Act significantly affected the work of the Commission, particularly given the scope and extent of the rulemaking mandated by that legislation. To date, the Commission has adopted more than a dozen rulemakings in furtherance of the Sarbanes-Oxley Act, and proposed several others. The Commission also prepared four studies contemplated by the Act. I'd like to begin today by giving you a brief overview of some of the significant actions taken by the Commission to implement this important legislation.
One significant aspect of the Sarbanes-Oxley Act was its establishment of the Public Company Accounting Oversight Board to oversee accountants that perform independent audits of public companies. The Board is charged with establishing auditing, quality control, ethics, independence, and other standards and rules relating to the preparation of audit reports, periodically inspecting the operations of public accounting firms, and investigating and enforcing compliance by those firms and their associated persons with relevant laws and professional standards. As you may know, on April 15 the Commission nominated Bill McDonough the President of the Federal Reserve Bank of New York as Chairman of the Board. We expect the Board will be able to move forward with its vital work of ensuring that auditors of public companies meet the highest standards of quality, independence, and ethics.
In August 2002, the Commission engaged in rulemaking to implement two important provisions of the Sarbanes-Oxley Act. First, the Commission required a company's chief executive officer and chief financial officer to personally certify that the reports their company files with the Commission are both accurate and complete. Second, the Act accelerated the public reporting of insider transactions from 10 days after month end to two business days after execution of the transaction.
In January of this year, the Commission engaged in substantial additional rulemaking pursuant to the Sarbanes-Oxley Act. As a result, there now are requirements that non-GAAP financial information be presented in a manner that is not misleading, and be reconciled to the most comparable GAAP financial measures. We also prohibit insiders from trading during pension fund blackout periods. We require that accounting firms retain work papers and related documents relevant to audits or reviews; that an issuer annually disclose whether there is a "financial expert" on its audit committee (and if not, why not); that an issuer annually disclose whether it has adopted a code of ethics applicable to its principal financial officer, comptroller, or principal accounting officer; and that registrants provide an explanation of off-balance sheet transactions and correcting adjustments. We also implemented rules that established standards of conduct for corporate attorneys appearing and practicing before the Commission, and strengthened the Commission's auditor independence requirements. The Commission also adopted rules directing the national securities exchanges and the NASD to adopt rules to prohibit the listing of any security of an issuer that is not in compliance with specified audit committee requirements.
The Commission's rulemaking agenda with respect to the Sarbanes-Oxley Act is not yet complete, and important rule proposals currently are pending. For example, the Commission will consider rule proposals by the NASD and NYSE that would amend their existing analyst conflict rules. These rules would (1) prohibit investment banking personnel from retaliating against analysts for unfavorable research reports; (2) prohibit investment banking personnel from contributing to the supervision and compensation evaluation of analysts; and (3) restrict the prepublication clearance or approval of research reports by investment banking personnel. The Commission also will further consider proposed "noisy withdrawal" rules that would require an attorney to withdraw from representation of a company that engaged in material violations, and report such withdrawal to the Commission. In addition, the Commission will consider rules requiring annual internal control reports by management and auditor attestations regarding those reports.
Finally, with respect to Sarbanes-Oxley, the Commission prepared four studies for Congress that were required by the Act. These studies related to: (1) the role and function of credit rating agencies; (2) securities professionals who have "aided and abetted" federal securities law violations; (3) Commission enforcement actions involving reporting violations or restatements; (4) penalties and disgorgements in Commission enforcement cases; and (5) there also is a principles-based accounting study, which is due on July 30, 2003.
I also should say a few words about the global settlement relating to research analyst conflicts of interest that the Commission and other regulators announced earlier this week. As you no doubt have heard, on Monday, the Commission, the New York Attorney General, the NASD, the New York Stock Exchange, and state securities regulators announced that enforcement actions against ten of the nation's top investment firms had been completed, thereby finalizing the global settlement in principle reached and announced by the regulators last December. Under the terms of the agreement, each of the ten firms will physically separate their research and investment banking departments to prevent the flow of information between the two groups. Also, the firms' senior management will determine the research department's budget without input from investment banking and without regard to specific revenues derived from investment banking; and research analysts' compensation will no longer be based, directly or indirectly, on investment banking revenues or input from investment banking personnel, and investment bankers will have no role in evaluating analysts' job performance. Research analysts will be prohibited from participating in pitches and roadshows; and firms will be obligated to furnish independent research to its customers for a five-year period. I am also sure you have read that the ten firms will pay a total of $875 million in penalties and disgorgement. As a next step, the Commission and the self-regulatory organizations will be considering the extent to which elements of this global settlement should be incorporated into rules applicable to the securities industry as a whole. In any event, I believe the global settlement represents a significant step toward improving the objectivity and independence of research analysis, and addressing one of the more troublesome abuses that have led to the recent erosion of investor confidence.
Clearly, no meeting with members of the ABA would be complete without an update on Gramm-Leach-Bliley. The Gramm-Leach-Bliley Act represents the opposite impulse from the Sarbanes-Oxley Act. While Sarbanes-Oxley sought to constrain the conduct of corporations, the Gramm-Leach-Bliley Act sought to liberalize the choices of banks by eliminating many of the restrictions in the Glass-Steagall Act. But new choices create new potential conflicts.
As the Supreme Court observed, "the Glass-Steagall Act reflected a determination that policies of competition, convenience, or expertise which might otherwise support the entry of commercial banks into the investment banking business were outweighed by the `hazards' and `financial dangers' that arise when commercial banks engage in the activities proscribed by the Act."
These subtle hazards conflicts of interest extend beyond investment banking to the sale of products to individual investors, such as mutual funds, that are held by over half of U.S. households. When the Supreme Court made its observation about subtle hazards, it was actually analyzing the permissibility for banks to offer customers certain proprietary mutual funds. According to the Court,
It is not a matter of indifference to the bank whether the customer buys an interest in the fund or makes some other investment. If its customers cannot be persuaded to invest in the bank's investment fund, the bank will lose their investment business and the fee which that business would have brought in....The bank would have a salesman's stake in the performance of the fund, for if the fund were less successful than the competition the bank would lose business and resulting fees.
In the Gramm-Leach-Bliley Act, Congress adopted functional regulation as the principal safeguard to address these conflicts while providing banks with full organizational freedom to recombine as commercial and investment banking conglomerates. In implementing functional regulation, the Commission is seeking to enhance market integrity by ensuring that investors receive the same protections on the same investments regardless of whether they walk through the door of a commercial bank or an investment bank.
By adopting functional regulation, the Gramm-Leach-Bliley Act did not adopt an approach based on entity regulation with multiple competing securities regulators. The fundamental flaw in entity regulation is that multiple agencies interpreting the same laws inevitably would lead to unequal levels of regulation and investor protection. Rather than having multiple and potentially inconsistent interpretations and levels of enforcement, Gramm-Leach-Bliley mandated that the expert securities regulator the SEC should interpret and enforce the federal securities laws.
Registration of market professionals is a key element in the federal statutory scheme and plays a significant role in protecting investors. Companies that receive incentive compensation related to securities transactions generally must register as broker-dealers under the Exchange Act. This is, in part, because registration helps ensure that companies with a "salesman's stake" in securities transactions of the type described by the Supreme Court operate consistently with the customer protection standards governing broker-dealers and their affiliates. This includes sales practice rules.
In other words, registration promotes baseline levels of integrity among broker-dealers and their personnel. It also gives market professionals something to lose if they don't adhere to the competence requirements and rules of fair practice. Addressing that salesman's stake not only mandates registration of the individual who directly takes a customer's securities order, but also requires accountability of any other individual with a "salesman's stake" in that order. This includes the manager and supervisor of the registered representative or any other person in a position to direct, influence, or profit from the registered representative's securities activities. Under the securities laws, the entire chain of command is responsible for failures to adhere to the requirements of the securities laws. That responsibility prevents plausible deniability when something goes wrong, and puts everyone on the same team with respect to compliance as well as sales.
I am particularly concerned that companies that are not subject to SEC oversight should not be able to act as unregistered distributors of mutual funds or arms of broker-dealers, thereby circumventing the marketing, customer communications, and other sales practice rules that apply to broker-dealers.
The Commission's financial supervision of all levels participating in the interdependent network of securities professionals also contributes to the financial soundness and reliability of the U.S. securities markets financial soundness and reliability that is still the envy of the world.
A cornerstone of an effective system of functional regulation that is designed to ensure investor confidence is the elimination of all regulatory incentives to allocate trust, custodial, and securities activities among different entities to avoid a market professional's responsibility to investors or evade oversight by an expert securities regulator.
Equally important to imposing uniform regulation to ensure investor confidence is that no regulatory gaps remain. To prevent gaps, we may have to accept some regulatory overlap around the edges where banking and securities meet. At the same time, we will strive to minimize the regulatory burden by strengthening our system of coordination and cooperation with bank regulators whenever possible.
It is well known to members of this Association that Gramm-Leach-Bliley repealed the blanket bank exception from broker-dealer registration and replaced it with 15 narrower transactional exceptions. The Commission attempted to implement the functional regulation exceptions in May 2001. After receiving significant banking industry criticism, however, the Commission tolled the implementation. In an effort to be more responsive to industry concerns, the Commission also split the implementation into two parts, taking the bank dealer exceptions first. The Commission expects to adopt bank broker exceptions within the next 12 to 18 months, and plans to give banks additional time to implement compliance procedures probably a year once the Commission adopts a rule.
This Association's comment letters articulately described the banking industry's primary concerns. They centered on the regulatory burdens associated with implementing the trust and fiduciary activity's exception's "chiefly compensated" standard and the industry's inability to provide "meaningful" order-taking services for custodial accounts under the safekeeping and custody exception. In addition, the comment letters criticized the Commission's implementation of the networking and sweep exceptions as overly restrictive. The comment letters also sought clarification that the NASD's selling away rule, Rule 3040, would not apply to dual employees of banks and broker-dealers when operating under a bank exception.
Thus, taken together, we understand that banks are concerned with limits on their ability to take orders in accounts in which they hold securities in custody, limits on their ability to receive 12b-1 fees in connection with securities transactions in trust and advised accounts, and limits on their ability to pay sales incentives other than nominal per order referral fees to persons who are associated with a registered broker-dealer and regulated as securities salesmen.
I understand that banks want to provide a broad range of services to their customers but want to be unencumbered in determining how they are compensated by those customers or how these banks compensate their unregistered employees. Although the statutory framework does not contemplate banks having this level of flexibility to internalize their securities business, we are trying to preserve as much flexibility for banks as possible without negating the purposes of the statutory change.
Let me turn to some of the specifics of your business under the exceptions and any exemptions that the Commission may adopt.
First, I believe that the trust and fiduciary activities exception reflects a judgment in the Exchange Act that banks may engage in securities transactions as part of trust and fiduciary relationships without the investor protection standards found in the federal securities laws when banks are acting as and paid as fiduciaries. In other words, investors are protected by strong fiduciary principles under fiduciary law.
The most important condition in this statute addresses how banks may be "chiefly compensated" for such securities activities without shifting those activities to a registered broker-dealer. This means that over half, or 51% of the fees on an account-by-account basis must be from asset management or other type of relationship fees paid directly by the account.
I understand that Rule 12b-1 fees, that is, distribution fees, are the most difficult to allocate on an account-by-account basis.2 Yet the conflicts arise on an account-by-account basis and investor protections under the federal securities laws apply on an account-by-account basis. The Commission adopted a procedure based on a safe harbor that was designed to meet the "chiefly compensated" test but avoid the account-by-account calculation. Banks viewed the procedure as too burdensome.
So, as we rethink this test, I have some questions for you. What less burdensome procedures would assure that accounts within a safe harbor are the sort of accounts that do not generate 50% of revenue from sales compensation? If a line of business approach to the chiefly calculation does not provide enough certainty for the SEC, is there another formulation to address the concern that the "chiefly compensated" account-by-account requirement not impose a burden on banks that only receive a small percentage of sales compensation? 3 How can your interests be reconciled with the Exchange Act's requirement to protect every securities investor without opening up significant opportunities for regulatory arbitrage or gamesmanship? How can we preserve functional regulation and accommodate this business?
I would now like to turn to the safekeeping and custody exception. Under that exception, a bank is excepted from broker-dealer registration if as part of its "customary" banking activities, it engages in, for example, pledges and stock loans as custodian. The Commission reads this exception very narrowly. To accommodate additional securities business of bank custodians, and still implement the Exchange Act, the Commission provided additional exemptions for banks effecting transactions in securities as "custodians."
Your Association criticized the Commission's implementation of the custody exception, arguing that order taking comes within the ambit of custody services and therefore do not need to be pushed out. The Association also expressed the view that other law adequately protects investors in tax-deferred accounts, that order-taking as custodian is a "customary" bank activity, and that banks do not initiate securities transactions for these accounts. To reply simply to these complex arguments, taking orders from investors is the sine qua non of broker-dealer activity, and the Exchange Act requires the Commission to regulate all broker-dealers. Nevertheless, the Commission also created two exemptions to allow banks to effect securities transactions for investors investing for retirement. The Association, however, criticized these exemptions for limiting banks' compensation for these transactions.4
I understand that these exemptions do not meet all of your needs. I ask you to consider how the competing interests may be addressed. In my view, bank custody customers generally deserve the same investor protections as any other securities investor. Are there particular situations where the protections are unnecessary? Can key protections be maintained with conditional exemptions that do the same job at a lower cost?
Let us for a moment turn to the issue of networking. The Exchange Act generally prohibits unregistered bank employees from receiving incentive compensation for any transaction. A bank employee, however, may receive a nominal one-time fixed dollar cash fee that is not success-based.
As you know, the Commission stated that bonuses paid to unregistered bank employees could not be based on securities referrals. The Commission recognized "incentive compensation," regardless of whether it is paid after each securities transaction or on a delayed basis, creates the very securities salesman's stake that the federal securities laws are designed to address. The Association commented that the Exchange Act just prohibits bank employees from receiving brokerage commissions for securities transactions, but allows year-end bank bonus programs at a branch, department, or line of business level to continue.5 In our view, bonuses may create the same salesmen's stake that the Exchange Act exceptions are designed to preclude. Indeed, it is common practice among many securities firms to motivate their employees to sell by paying a small base salary and a much larger bonus. So my key question to you is is there a formulation that will assure banks a degree of flexibility in compensation without permitting unregistered employees a prohibited incentive to promote the securities business?
Finally, I would like to discuss the use of dual employees. As a practical matter, some banks will try to achieve the "seamlessness" in their sales efforts by using dual employees to effect transactions both for securities activities that fall outside of broker-dealer registration and for securities activities that are required to be conducted in a broker-dealer. If a bank also employs securities employees, the NASD "selling away" rule requires the broker-dealer to exercise the same level of supervision of those securities employees that the broker-dealer does with any other securities firm employees. That means that securities regulators must have access to the books and records that pertain to that employee's securities business, wherever it may have occurred, so that broker-dealers may effectively supervise that employee's securities activities.
The purpose of the NASD rule is not to assert jurisdiction over banks. The NASD's jurisdiction is over registered representatives and broker-dealers. The obligations at issue are personal to the registered representative, and do not flow to the bank that also employs the registered representative. If the registered representative cannot provide his or her employing broker-dealer with targeted information about his or her selling away activity, then it is the registered representative and the broker-dealer that will run afoul of the rule, not the third party bank.
Dual employees of broker-dealers and investment advisers are regulated under this rule. Thus, it seems appropriate to continue to apply the NASD "selling away" rule to licensed securities salesmen who sell securities on bank premises.
In my view, the NASD rule is a necessary safeguard against insider trading, manipulation, and other violations of the federal securities laws. I understand that some aspects of the rule may be burdensome. I note that in other contexts involving dual employees, the NASD has emphasized that broker-dealers have "tremendous flexibility" to develop and implement recordkeeping and supervision, so long as the systems are adequate and "reasonably designed to detect and/or prevent misconduct that could violate the federal securities laws."
I hope that you can understand our position. As bankers, you wouldn't let borrowers show you only a portion of their balance sheet or income statement. Further, your auditors and bank examiners want to see all of your records to get a full picture of your financial results. The same principles apply to registered representatives who are dual hatted a securities regulator has to have access to a 360 degree view of the representative's trading activity. It is all right with us to overlap a bit with bank regulators but it is not all right to risk a gap.
Having said this, we have asked the NASD to revisit aspects of the rule that may be too burdensome, such as the requirement to obtain trade-by-trade approval for transactions that are "away from the broker-dealer."
There may be even further room for the NASD to apply this rule to dual employee registered representatives in a way that is tailored to enhance regulatory efficiency. Some practices are so harmful to the proper functioning of the markets that they must fully remain subject to broker-dealer scrutiny. Insider trading is one obvious example. Market manipulation and front running are two others. If a broker-dealer failed to review all of its registered representatives' trades to identify possible insider trading, then a representative may find an opportunity to game the system by obtaining inside information through the broker-dealer while trading on the information through a bank, with neither the bank nor the broker-dealer in a position to properly monitor and act against the abuse. It is critical that gaps like this not be permitted to open up.
I recognize, however, that banks and bank regulators also may be in a position to identify and act against certain bank-side trading abuses by registered representatives. I also recognize that bank customers have a choice to forego the customer protections of the securities laws. Thus, it may be appropriate to permit broker-dealers not to review registered representatives' bank-side activities in certain instances to monitor sales practice violations such as unsuitable recommendations, while assuring that securities regulators have full access to all securities transaction information. That type of distinction between violations of sales practice rules and violations of standards that more fundamentally impact markets and trading can be one way to permit regulatory streamlining while protecting the oversight tools necessary to guard the principles of market fairness. We welcome your suggestions on others.
There is no question that much work remains to be done in order to bolster market integrity and thus investor confidence. And likewise we are eager to work together to achieve our goal of meeting our responsibilities under the Gramm-Leach-Bliley Act in the most cost effective and efficient manner possible.
Thank you for your kind attention.
1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.
2 "The Commission characterizes 12b-1 and shareholder servicing fees as 'sales compensation.' The ABA and ABASA disagree with that characterization. As previously discussed, the only fees received on a fiduciary account frequently will be fees paid by mutual fund companies." ABA July 17, 2001 letter at 5.
"Nor is it feasible for bank trustees to renegotiate plan fees in order to come within the `chiefly compensated' test. The employee benefit market has moved to compensation arrangements whereby bank trustee fees are paid by mutual funds rather than the plan sponsor." ABA July 17, 2001 letter at 6.
3 "Our members very strongly believe that line-of-business reporting should be permitted to make the necessary `chiefly' calculation. Such reporting would not allow full-service securities firms to evade Commission regulation by transferring their business in toto to a bank's trust department. No evasion of fiduciary regulation of these activities could occur; as such regulation is a condition of this exception. ABA July 17, 2001 comment letter at 7.
4 "We are unalterably opposed to the notion that in order to keep a legitimate customary banking activity in the bank, a bank must forego compensation. Nothing in the GLBA suggests that restricting compensation received by banks for providing safekeeping and custody services is warranted." ABA July 17, 2001 comment letter at 14.
5 "In using the term `incentive compensation,' the Congress meant to prohibit the bank employees from receiving brokerage commissions for securities transactions. Despite the clear meaning of this language, the SEC, nevertheless, suggests that this language covers and, therefore, prohibits year-end bank bonus programs when securities transactions of a branch, department, or line of business are considered in connection with awarding bonuses and employees." ABA June 4, 2001 comment letter at 2.