Speech by SEC Chairman:
Remarks before the the Council on Foreign Relations
William H. Donaldson
U.S. Securities and Exchange Commission
New York, NY
May 19, 2005
Thanks, Bob, for that introduction, and thanks to the Council on Foreign Relations for inviting me to speak. I've been a member of the CFR for many years and have great respect for the work of this organization. And I appreciate having this opportunity to be with you this evening to discuss some of the issues facing our financial markets.
Before I proceed, our ethics rules require that I tell you that the views I express here are my own and do not necessarily represent those of the Commission or its staff.
The last three years have been an extraordinarily active time for the Commission, a period that may well be remembered as the most productive and consequential in the Commission's history since its founding in 1934. Beginning with the corporate scandals that astonished the public in 2002 and continuing with the mutual fund crisis that followed the next year, investor confidence was sorely shaken, with dangerous potential long-term consequences for the well-being of the nation's capital markets.
In passing the Sarbanes-Oxley Act of 2002, Congress expanded our tools to combat the root causes of corporate breakdown, and the increased funding we began to receive shortly thereafter has been invaluable in helping us to address wide-ranging malfeasance. Working with the additional authority and resources provided by Congress, the Commission has responded forcefully to these scandals with targeted rulemaking and precedent-setting enforcement actions.
Over the same period of time, the Commission has pursued long-needed structural reforms in the operation of our securities markets, and, through its enforcement program, has addressed serious shortcomings in the behavior of a range of market participants.
One might think of our rulemaking and enforcement efforts in terms of securities, on the one hand, and exchanges and markets, on the other. (We are, after all, the Securities and Exchange Commission.)
First, as to securities, we have worked to improve the disclosure and governance associated with securities investment, in order to help investors make more informed decisions and better monitor the activities of their agents and intermediaries. In the context of a specific securities investment, these include corporate managers, boards of directors and investment advisers. Second, as to exchanges and markets, we have worked to improve the overall operation of the markets where securities are traded, again through measures designed to ensure that investor interests are given primacy over the interests of their agents and intermediaries, in this case market centers, exchange specialists, market makers and broker-dealers.
Let me give a few examples in each category as background for later discussion. I'll focus first on securities and second on exchanges and markets.
We have worked to make sure that the investment represented by a security is managed in a way that puts the interests of the investor first. We have sought to achieve this through enhanced disclosure requirements that bring a greater degree of clarity and accuracy to the information available about the security, and through our work to strengthen the governance associated with the issuer, which not only reinforces sound disclosure practices but also addresses conflicts between the interests of investors and those of their intermediaries. Our focus on strengthening corporate governance is, as Alan Greenspan put it in a commencement address at the Wharton School last Sunday, a way to reinforce "the principle that . . . corporate managers should be working on behalf of shareholders to allocate business resources to their optimum use."
Our efforts to improve corporate governance include implementing the audit committee independence and responsibility requirements of the Sarbanes-Oxley Act. Strengthening the role of the audit committee has been at the center of our efforts to improve corporate governance, and since the audit committee takes responsibility for overseeing the auditor, it is also a linchpin in our effort to ensure auditor independence at public companies. In addition, we successfully encouraged the listing markets to upgrade their corporate governance standards in ways that recognize the importance of independent checks on management, including requirements relating to majority independent boards, independent nominating, compensation and audit committees, board approval of related party transactions, and shareholder approval of equity compensation plans.
We implemented the CEO and CFO certification provisions of the Sarbanes-Oxley Act, building on an initiative we proposed before the enactment of Sarbanes-Oxley. We believe these certifications have been instrumental in emphasizing, in a direct and personal way, the responsibility of management for their company's disclosures, and thereby improving, hopefully, the "tone at the top" at our public corporations.
A key piece of our corporate governance reform effort has been the adoption of rules by the Commission, and approval of the Public Company Accounting Oversight Board rules requiring that management report on the effectiveness of their system of internal controls, and that the auditor attest to management's report. These rules, required by section 404 of Sarbanes-Oxley, have perhaps the greatest long-term potential to improve the quality and usefulness of corporate reporting of any of this era's corporate reforms. At the same time, implementation of these requirements for the first time in connection with the 2004 reporting cycle resulted in significant costs, some portion of which may have been driven by a lack of a clear risk-based focus by participants in the process. We believe the implementation of the section 404 rules needs to be improved going forward. Last Monday our staff and the PCAOB issued significant new guidance addressing ways for making the process more efficient.
The reforms I've just outlined are targeted primarily at operating companies. We have also pursued a record number of enforcement actions against advisers to mutual funds who were found to have violated their customers' trust. To address the governance weaknesses in this industry that may have contributed to the breakdown, we have worked to reshape the internal fund governance framework.
The most significant change - and for some critics the most controversial - is the Commission's requirement that a fund relying on certain core exemptive rules have a chairman, and three-quarters of the board, independent of the management company. This rule helps to address the inherent conflict that exists between the interests of a fund's shareholders, who want to limit fees and expenses, and the interests of the fund's manager, whose goal is to maximize revenues.
A final example of our aim to help ensure that the interests of the investor precede the interests of those managing the investment, is our decision to require hedge fund investment advisers to register with the Commission beginning in early 2006. Among other things, registration of advisers in this market, which is rapidly approaching $1 trillion in assets, will require hedge fund managers to adopt basic compliance controls and should ultimately improve the overall quality of disclosures made to investors.
Exchanges and Markets
It is not enough for a securities investment to be managed in the investor's interest, if it is then traded in a marketplace where the interests of intermediaries are given precedence. For that reason we have also worked to make sure that in the exchanges and markets themselves, investor interests come before the interests of their agents and intermediaries. As with our efforts to enhance investor protection with respect to particular securities, our rulemakings and enforcement actions reaffirm this basic principle.
Our most significant rulemaking effort aimed at exchanges and markets has been the adoption of Regulation NMS, an integrated set of reforms that update the regulatory apparatus governing U.S. equity markets. A central component of Regulation NMS is the so-called trade-through rule, a rule designed to ensure that when an investor sends an order to a trading center, the order will be filled at the best price then immediately available anywhere in the national market system. Among its benefits, this rule should protect individual investors who may not be able to monitor the order-routing decisions of their intermediaries, whose decisions could be affected by factors such as payment for order flow.
We have also proposed reforms to the system of SRO governance designed to ensure that the critical regulatory functions of our nation's securities markets are not compromised as the markets become subject to heightened competitive pressures, and as the markets increasingly become subject to public ownership.
Our enforcement actions directed at curbing abuses that harm the markets have included cases involving improper trading by specialists on the nation's exchanges, unhealthy practices in IPO allocations, and conflicts of interest in the research analyst profession. The common thread in each of these cases has been market intermediaries who put their own financial or business interests ahead of the interests of investors.
I'd be happy to discuss any of these topics in more detail with you in a few minutes, but let me turn to the future and the overarching question of why we've been so active in the last two to three years. Some observers have complained that the pace of regulatory activity is "damaging the long-term competitiveness of U.S. companies and the U.S. capital markets." Notably, these complaints do not seem to come from those with the greatest economic interest in the long-term health of our public companies and markets. Indeed, investors have overwhelmingly supported our agenda.
Investor protection is our statutory mandate, and it's a goal worth pursuing for its own sake. But it's important to realize that the benefits of strong investor protection reach far beyond the important principle of ensuring that investors, whether individual or institutional, are dealt with fairly. Maintaining investor confidence through strong investor protection is the surest, and perhaps only, way to ensure that the U.S. capital markets remain the best place in the world for corporations to raise capital. As my old friend and long-time member of the Council Walter Wriston once sagely observed, "Capital will always go where it is welcomed, and stay where it is well treated."
Walt's remarks could not be more relevant in light of two distinct developments that are unfolding around us. In keeping with my theme, one of these developments will affect securities, and the other will affect exchanges and markets. Both developments vividly illustrate that true mobility of capital is becoming a reality in ways that were difficult to see even a few years, if not months, ago. Both underline our national interest in providing the premier venue where capital is welcomed and well-treated.
Focusing first on securities, we are witnessing real progress towards international convergence of accounting and disclosure standards. True convergence will ultimately make it easier for investors to compare competing securities investment opportunities - with little concern about geographical boundaries - and decide which offers the best potential return. Investors will drive the push towards convergence around a transparent system of accounting because the market will penalize investments whose features are not well understood. And if a biotech company in Bangalore offers a better product than a biotech company in Boston, and is transparent in telling its story, common accounting and disclosure standards should make it easier for investors to understand where their capital is likely to be better treated.
Focusing then on exchanges and markets, an investor's ability to deploy capital without significant geographic constraints will be enhanced by developments clearly on the horizon. The transactions recently announced by the New York Stock Exchange, Archipelago, Nasdaq and Instinet, and even the unsuccessful Deutsch Börse/London Stock Exchange transaction, foreshadow a world where competition among market centers breaks through geographic borders and becomes truly global in nature.
It's a simple proposition, but one that perhaps explains why we've been so focused on improving the governance and disclosure associated with securities, and improving the way investors are treated in the securities market. If you have resources to invest, are you going to invest in a well-understood, fairly managed asset that trades in a transparent and efficient market, or are you going to invest in an asset that lacks reliable information or is perhaps not clearly managed in your interest, or that trades in a market where you can't discern the role of the intermediaries?
I'll pause on that note. I'd be happy to continue the conversation with Bob, who I know has thought long and hard about the issues I've been outlining.