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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks to the National Association of Securities Dealers


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

May 12, 2004

Thanks Bob, and thanks for inviting me to join you this morning. You and the other leaders at NASD - including Mary Schapiro, Doug Shulman, as well as your regulatory team - are doing great work to help advance investor protections and enhance market integrity. I particularly commend Bob Glauber's announcement earlier this morning of the formation of a NASD task force to identify and recommend ways to bring greater transparency to mutual fund costs and disbursement arrangements. We support this initiative and look forward to input as we move ahead. The joint regulatory efforts of the SEC and the NASD reach back many years. I am committed to building on them to advance new and better protections to ensure the continued vitality of our markets.

I am particularly happy to have this opportunity to speak to such a large group of legal and compliance professionals. You are on the front lines of America's financial markets, and well positioned to help ensure that a high ethical standard is upheld throughout the securities industry. Before going any further, let me issue the standard disclaimer that the views I express here are my own and do not necessarily represent those of the Commission or its staff.

When I became SEC Chairman, I set four goals for myself and for the Commission: restore investor confidence, hold accountable those who have violated the public trust, promote responsible corporate governance, and make the securities markets more efficient and transparent. In setting these goals, I knew that working to advance them would be a job akin to painting the Golden Gate Bridge - it would never end. But as all of you know, these objectives are fundamental to the foundation of our securities markets.

They were all the more urgent when I became Chairman -- the corporate landscape was littered with high-profile failures, scandals had come to dominate the business news, and equity markets had plunged. All of this occurred following a high-octane era that had many distinguishing - one might even say, notorious -- features. Perhaps the most worrying was the serious erosion of ethical principles in business, coupled with a dangerous short-term performance mentality, as companies tried to comply with financial analysts' demands that earnings-per-share conform to artificially imposed projections. This short-term focus was fueled by stock option incentives to management, and by the acquiescence of gatekeepers, like accountants, some of whom condoned such accounting manipulation.

The cumulative effect of this produced a crisis of investor confidence, which in turn led to a demand for corrective action. The enactment of the Sarbanes-Oxley law in July 2002 marked the beginning of a new era for American business, given its measures to promote transparency and reform the accounting profession. The SEC staff has skillfully implemented the many different provisions of the landmark law, and the implementation process has been complemented by the Commission's focused rulemaking in a number of areas affecting America's financial markets. There are still many reforms under consideration, and we will remain vigilant in the meantime. But I do believe we have made real and lasting progress on cleaning up our markets and helping to restore investor confidence. I'd like to talk first about some structural reforms we are initiating at the SEC, which I believe will improve the work of the Commission. Then I'll run through some of the critically important issues facing our different divisions, and close with a few words about the role you can play to enhance an ethical code governing the securities industry.

Risk Assessment

Since being named SEC Chairman, I have become convinced that the Commission needs to devote more time and energy to anticipating potential problems across the securities industry. I call it "looking over the hill and around the corner" for the next emerging abuse of the securities laws. Last year, following a thorough internal review of how the agency identifies current problems and - equally important - future risks, we initiated a new risk management program and laid the groundwork for an Office of Risk Assessment and Strategic Planning, the first of its kind at the Commission. The goal is twofold: to become better equipped to anticipate potential problems, and then to hopefully prevent these problems from infecting our markets. Our first priority has been to infuse the agency's various divisions and offices with a commitment to risk assessment in their own spheres of responsibility. We have organized internal risk teams for each major program area. This framework allows for what I like to think of as a bottom-up approach to assessing risk in each of our divisions. A good example of this bottom-up approach can be found in our Office of Compliance Inspections and Examinations, OCIE. We asked our front-line examiners across the country - through OCIE's new internal risk management team - to look at potential problems in the mutual fund industry and broker dealer industry. With input from examiners in our regional offices, OCIE is producing a complete "risk map" of these areas. The new Office of Risk Assessment will work to coordinate these internal risk teams to push the entire agency to proactively anticipate potential problem areas across the securities industry, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities.

I believe the risk assessment initiative will influence all of our work in the agency - from enforcement, to examinations, to rulemakings, to our review of required filings. It will ensure a process whereby senior managers at the Commission have the information necessary to make better, more informed decisions and to proactively adjust operations, resources, and methods of oversight to address new challenges and prevent new problems. The initiative will also help foster better communication, coordination, and even cross-fertilization between the divisions and offices within the Commission.

Task Forces

Another illustration of this effort to enhance communication, collaboration, and cross-fertilization across divisions and offices is the creation of policy task forces. These task forces bring together staff from various divisions and offices to brainstorm, evaluate, and create policy options that will help us undertake issues of emerging concern in protecting our securities markets. Currently, there are six task forces tackling a number of important issues: soft dollar arrangements, bond market transparency, college savings plans, the so-called 529 plans, enhanced mutual fund surveillance, enhanced SRO surveillance, and, over the longer haul, our entire disclosure regime. The task forces are meeting with relevant, interested parties such as individual investors, industry representatives, and fellow regulators to gather critical intelligence and data. The goal is to produce policy options designed to address problems over the long haul.


Underpinning all of the work at the SEC is the enforcement of America's securities laws, and holding those individuals accountable who are alleged to have violated the laws. To that end, our enforcement division aggressively pursues wrongdoing, and does so in a manner that is, I believe, both forceful and fair. Over the past few years the Commission has sued the country's ten largest broker-dealers, as well as 14 current Fortune 100 companies, or their officers, and in just the past year, we have brought charges of misconduct against 12 of the 25 largest mutual fund complexes. The division also filed more enforcement actions in the previous fiscal year than in any other year on record.

I cite these numbers only as measures of just how pervasive malfeasance has been in the securities industry in recent years, and of the impact of the expanded enforcement powers vested with the SEC thanks to Sarbanes-Oxley. Those expanded powers are not only helping us to pursue wrongdoers, but also to return to investors a portion of the penalties we impose against firms, through the Fair Fund provisions.

Looking forward, the division continues to aggressively pursue enforcement actions, and over the past seven-and-a-half months has obtained orders for approximately $1.7 billion in penalties and disgorgements. As part of our enforcement agenda, we will continue to bring actions not only against corporate wrongdoers, but also financial institutions that have aided and abetted financial fraud.

Corporation Finance

The Division of Corporation Finance continues to focus on helping improve disclosure at public companies -- our interpretive release on Management's Discussion & Analysis or MD&A, and our proposed rule providing the first-ever framework for registration, reporting, and disclosure in the $800 billion asset-backed securities market, are just two very recent examples. But the division is also taking on other important issues in the area of corporate governance as well.

Today, nominees and directors emerge from a system that really excludes meaningful input from shareholders. In over-simplified terms, our current proxy rules give dissatisfied shareholders just two options: start a proxy fight for control, or sell their stock. We are seeking to find middle ground, particularly at a time when corporate governance, while improving, is still not where it should be.

In fact, in seeking to allow shareholders a greater prospective voice at companies where shareholders' voices are not being heard, should build upon and support other corporate governance changes brought about by the Sarbanes-Oxley Act, our own rulemaking efforts, and changes in exchange-listing standards that have helped assure the independence and performance of directors.

Market Regulation

The Division of Market Regulation is fully occupied with a number of vital issues - and none more important than addressing changes in the structure of America's equity markets. As our financial markets continue to evolve due to innovative technologies, new market entrants, and changing investment patterns, the Commission must monitor these changes and ensure that the regulation of the market structure remains up to date.

In February, the Commission proposed Regulation NMS - National Market System - which is a comprehensive package of rule proposals aimed at modernizing the national market system that Congress mandated in 1975. In brief, the proposed regulation would encourage honoring the best price between markets by establishing a uniform trade-through rule for both exchange and Nasdaq-listed securities, with exceptions for slow markets and informed investor opt-outs. It would address the issues of efficient access between markets and inconsistent quote prices by establishing a uniform market center access rule with a de minimis fee standard. It would ban the display of sub-penny quotes in most stocks. And it would alter the rules concerning how market data is disseminated and priced.

We published Regulation NMS as a proposal of very specific rules in order to advance the discussion on a very complex set of issues. Its publication is an important step forward not because we have reached decisions on any of the proposals' provisions -- far from it - but because we want comment on these detailed proposals. We are fully aware that these rules may have consequences not contemplated by the drafters of these proposals. We seek the help of knowledgeable market participants to answer a number of fundamental questions about the premises of some of these proposals, and their impact on today's markets. For example:

  • While recognizing the development of electronic trading and the difficulties of integrating electronic and manual markets, should we worry about the impact on investors of allowing trading to occur at inferior prices to better limit orders that are displayed on other markets? Does allowing some investors to opt-out of honoring better-displayed prices undermine price priority and investor willingness to display limit orders?

  • The fast market-slow market dichotomy in the proposal has encouraged the NYSE to declare that it will become a fast market. But how do you integrate a business model that values speed over price with one that has traditionally valued price over speed?

  • The opt-out exception allows investors to ignore prices even on fast markets. Should investors be able to trade-through the quotes of markets that can be reached instantly? Why would they want to?

  • Do the proposed access rules and restrictions on access fees actually succeed in improving the ability to trade across markets?

The SEC's market-structure hearing in New York last month focused on these and other questions inherent in the proposals. While far from producing a consensus view, the hearings provided a chance for market participants to voice their concerns, to press one another about their competing interests, and to confront the difficult policy choices facing the Commission as we consider whether to adopt or modify Regulation NMS.

The comment period on the Regulation runs until the end of the month, and we plan to read these comments closely, and weigh the analysis they provide. I urge those of you interested in this proposal to comment - and to help us advance our goal of reforming our markets in such a way that they benefit all investors - be they big or small, individual or institutional.

Investment Management/Hedge Funds

Since you've just heard from Paul Roye on our recent mutual fund rulemakings, as well as our future agenda, I won't repeat that discussion. I would only offer as a footnote my view that completion of these rulemakings - and our future agenda in the mutual fund area - will in fact amount to a fundamental reform of how the mutual fund industry does business.

But I do want to touch on one other important issue being worked on by our Division of Investment Management. You have likely seen some of the media coverage concerning the SEC's attention to hedge funds. I'd like to give you my perspective on the issue. Given the rapid rate of growth of hedge funds, the size of their assets - about $800 billion and rapidly approach $1 trillion - and the involvement of some hedge fund managers in illegal behavior, the Commission staff is evaluating a form of registration and an oversight regime for hedge fund managers. The goal is simple: to enable the Commission to collect more accurate information about this important industry, and better target our inquiries to those hedge fund managers where there is some reasonable concern that they may be violating the federal securities laws. There is no desire to regulate how hedge funds make their investments, or to choke off their expansion, as hedge funds have an important role to play in our equity markets.

But critics of our focus on hedge funds cannot, in my view, have it both ways - on one hand, to demand that the Commission be proactive and prevent and detect emerging but as of yet unforeseen harms and abuses, but on the other hand, to handicap our abilities to obtain simple, fundamental information that facilitates our identification of such abuses.

The critics also argue that hedge fund investors are wealthy and sophisticated individuals who do not need protecting. This is not the point. Hedge fund managers are directly and indirectly providing advisory services for many U.S. investors - with significant impact on those investors, and on the operation of the U.S. securities markets. Increasingly hedge funds are being purchased by intermediaries on behalf of millions of ultimate small investor beneficiaries, retirees, pensioners, and others who are not generally thought of as the traditional hedge fund investor. This makes it critical for investors that the Commission has more information about hedge funds and their managers - especially the impact their market activities have on the other participants in our equity markets - the other side of the trade so to speak.


Having reviewed both the changes we're seeking to bring about in the internal organization of the SEC and the major policy reform initiatives we are pursuing, I'd like to turn now to ethics and integrity in the securities industry and markets. Let me say at the outset that after many years in and around the securities industry, I believe the overwhelming majority of the people who work in this industry are honest, and dedicated to meeting the needs of their clients. But as all of you know, there are some individuals who have lost sight of their basic responsibilities - engaging in conduct that is well outside the lines of what is acceptable, and in so doing violated the ethical code that must govern this industry.

The Commission has pursued enforcement actions against these individuals, and we have also pursued new rules that affirm the importance of compliance and ethics in the workplace. But our rules alone won't be enough. Our rules never have been enough, are not today enough, and never will be enough. What's really needed is a change in mindset - one that fosters not only a "culture of compliance" but also a company-wide environment that fosters ethical behavior and decision-making. Creating that culture means doing more than developing good policies and procedures, doing more than installing competent compliance staff, and doing more than maintaining compliance resources and up-to-date technology. It means instilling an ethical culture - a company-wide commitment to do the right thing, this time and every time - so much so that it becomes the core of what I call the essential "DNA" of the company.

As we all know, the securities industry is defined by its dynamism and frequent change - new products, new systems, and vigorous competition. In this climate, business practices will frequently outpace any government regulator's ability to develop specific rules governing these practices, and they will further outpace any lawyer's ability to provide conclusive guidance by interpreting existing rules.

This is where having a culture of doing what is right - in the absence of specific rules and even in the face of your competitors' choosing a different path - is vital. This is where the courage and commitment of the firm's leaders is needed to question whether a particular firm practice - no matter what the lawyers say - is truly ethical or is truly in the best interests of client and customers. This culture can't be limited to the senior management level, it can't be limited to the compliance department, and can't be limited to the clever wording of a corporate mission statement - it must be embedded in the firm's "essential DNA" and shared by each and every employee.

What I'm talking about is creating a renewed culture of compliance in the securities industry. All of you can play a central role in that renewal within your own firm. At bottom, of course, you can run a state-of-the-art compliance department. You know how to do that much better than I, but it at least means having a vision for how compliance activities relate to a larger strategic goal. It means having a method for identifying potential areas of vulnerability. It means having a method for establishing control points for every identified risk. It means documenting each risk so that individuals inside and outside the company know what they are and where they are. And finally, it means specific people should be accountable for managing each element of this compliance system.

Although I know that establishing and maintaining a world-class compliance department is no mean feat, I also want to ask you to do even more - to do more to help instill a true culture of compliance throughout the firm. And I believe you can provide that help in several ways.

First, you can help by focusing attention not just on compliance regarding issues clearly addressed by existing rules, but also on the identification of potential but not-yet-developed conflicts of interest within the firm - where new business relationships or revenue streams could create conflicts with the best interests of the firm's customers. You can help educate not just the people who report to you, but also the heads of business units and even the firm's senior management on the nature of these potential conflicts, and why it is important to the firm to manage these potential conflicts.

Second, you can help by ensuring that employees of the firm understand their fiduciary responsibilities to certain customers, such as retail investors and fund shareholders, and that they understand what those responsibilities mean - that customers always come before the balance sheet and not the other way around.

Third, you can improve the firm's compliance culture by routinely informing senior management of compliance breaches and educating your senior managers about trends that may lead to future compliance breaches if not adequately addressed.

Fourth, you can try to involve yourself in the process of evaluating and approving new products or new business ventures. This will allow you to immediately implement new compliance processes to address the risks those new products or business lines may present.

Fifth, you can stress to your compliance staff colleagues that the firm's policies and procedures to track compliance should constantly be evaluated, modified, and updated - with the goal of adapting compliance to the rapid changes in the business environment in which the firm operates.

And finally, you can help by your personal example. Each time you make a decision - no matter how large or small the decision, and no matter who is in the room or who is not in the room to see you make the decision - ask yourself more than whether it is the legally required thing to do. Go further: ask yourself whether the proposed decision - to the best of your judgment - is the right thing to do.

The investment of your time and effort to establish this renewed culture of compliance is not without costs. But I believe it will pay long-term dividends, as it will enhance integrity within companies, and thus inspire confidence among customers and investors. In fact, if there's one message I hope you'll take away from my remarks it is that we are partners in this mission, and the power to affect change lies as much with you - and the other participants in the industry - as it does with us at the Securities and Exchange Commission.

Thank you.



Modified: 05/13/2004