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U.S. Securities and Exchange Commission

Speech by SEC Staff:
"Come With Me to the SEC"

Remarks before the Brown University Commencement Forum


Annette L. Nazareth

Director, Division of Market Regulation
U.S. Securities and Exchange Commission

Providence, Rhode Island
May 24, 2003

Good morning. I'm delighted to have been asked to speak to you today about the work of the Securities and Exchange Commission. It's a pleasure to be here this weekend to celebrate the accomplishments of the Brown Class of 2003 and also to celebrate my own 25th college reunion. Events such as this are an opportunity to reflect upon all of the connections that bring us together as a Brown community.

My own Brown indoctrination began at a very young age. My mother brought me to Pembroke alumni events when I was no older than my daughter Caroline is now - about 8 years old. So it is a real treat to be back at Brown with my mom in the audience. I am also delighted to see some long standing (I won't say "old") friends here today, including Steve Ehrlich - a former member of the Brown board and one of my valued Wall Street mentors. And finally - this is an exciting "first" - my children have agreed to endure this presentation.

We all celebrate not only the friendships and community, but also the world of possibilities that Brown brings to each of us. Brown knows no limits, and by extension it expands our own boundaries beyond our imaginations. It nurtures our collective intellectual curiosity and provides us with the skills to meet whatever challenges we choose to undertake. I am extremely grateful for the world of possibilities that Brown opened up to me - and I share in the pride and excitement of this year's graduates.

Before I begin my presentation today, I must note that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.1

Most would agree that there could not be a more fascinating or challenging time to work at the Securities and Exchange Commission. It goes without saying that, in recent years, confidence in the U.S. corporate and financial sector has been seriously eroded. The incredible growth of the 1990s made the stock market an attractive option for millions of Americans who had never invested before. Many people came to believe that the stock market was just a game that if played right, guaranteed tremendous returns. And many on the inside became obsessed with share price rather than sound operations and good corporate governance, which seemed irrelevant for the short-term success of their stock.

As the bull market of the nineties began to subside, we were hit by two unexpected events. The attacks of September 11 made the entire country, including the markets, take notice of our own vulnerability. Then, beginning with the revelations of wrongdoing at Enron, the weaknesses in corporate America that had been overlooked or ignored came to light. We witnessed startling revelations of corporate fraud and corruption as well as failures in our systems of disclosure and corporate governance. As the markets reacted, many investors, and sadly, particularly small investors, saw their savings disappear, along with their dreams for the future.

I'd like to share with you the musings of a Supreme Court Justice that seem particularly apropos. He said, and I quote:

I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that `a man cannot serve two masters.' .... The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function. Yet ... corporate officers and directors who award to themselves huge bonuses from corporate funds without the assent or even the knowledge of their stockholders, reorganization committees created to serve interests of others than those whose securities they control, financial institutions which, in the infinite variety of their operations, consider only last, if at all, the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle. The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity are incalculable.2

As relevant as these observations are today, it may surprise you to learn that they were offered by Justice Harlan Stone in 1934. That same year the SEC began operations, created to address the abuses that became apparent in the wake of the 1929 stock market crash. I believe that this highlights not only the cyclical nature of the economy, but also of financial regulation. In good economic times, there is a tendency for abuses to arise undetected and, after the fall, a call for reform and more zealous regulatory oversight.

In many ways, the runaway bull market of the 1990s and the scandals that have come to light both on Wall Street and throughout corporate America since the burst of the market bubble, resemble the market boom of the 1920s and the period after the crash of 1929. In both cases, as the band played faster and faster, standards continued to deteriorate, and in both periods, those deteriorations came to light in a dramatic fashion that prompted a major reexamination of securities market practices and their regulation.

In a few minutes, I will describe in depth some of the significant regulatory initiatives underway at the SEC to address the most recent tide of market abuses. But first, to place those initiatives in context, I'd like to briefly describe the origins of the SEC, its mission, and how it functions.

History of SEC

The SEC's foundation was laid in an era that was ripe for reform. Before the Great Crash of 1929, there was little support for federal regulation of the securities markets. This was particularly true during the post-World War I surge of securities activity. Proposals that the federal government require financial disclosure and prevent the fraudulent sale of stock were never seriously pursued.

Tempted by promises of "rags to riches" transformations and easy credit, most investors gave little thought to the dangers inherent in uncontrolled market operation. During the 1920s, approximately 20 million large and small shareholders took advantage of post-war prosperity and set out to make their fortunes in the stock market. It is estimated that of the $50 billion in new securities offered during this period, half became worthless.

When the stock market crashed in October 1929, the fortunes of countless investors were lost. Banks also lost great sums of money in the Crash because they had invested heavily in the markets. When people feared their banks might not be able to pay back the money that depositors had in their accounts, a "run" on the banking system caused many bank failures.

With the Crash and ensuing depression, public confidence in the markets plummeted. There was a consensus that for the economy to recover, the public's faith in the capital markets needed to be restored. Congress held hearings to identify the problems and search for solutions.

Based on the findings in these hearings, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were designed to restore investor confidence in our capital markets by providing more structure and government oversight. The main purposes of these laws can be reduced to two common-sense notions:

  • First, companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.

  • And second, people who sell and trade securities - brokers, dealers, and exchanges - must treat investors fairly and honestly, putting investors' interests first.

Monitoring the securities industry requires a highly coordinated effort. Congress established the SEC in 1934 to enforce the newly-passed securities laws, to promote stability in the markets and, most importantly, to protect investors. President Franklin Delano Roosevelt appointed Joseph P. Kennedy, President John F. Kennedy's father, to serve as the first Chairman of the SEC.

Creation of the SEC

The primary mission of the SEC is to protect investors and maintain the integrity of the securities markets. As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, these goals are more compelling than ever.

The world of investing is fascinating, complex, and can be very fruitful. But unlike the banking world, where deposits are guaranteed by the federal government, stocks, bonds and other securities can lose value. There are no guarantees. That's why investing should not be a spectator sport; indeed, the principal way for investors to protect the money they put into the securities markets is to do research and ask questions.

The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company's securities are a good investment. The SEC is a "full disclosure" agency, and one of its primary missions is to strive to close information asymmetries that may exist among market participants. In the words of Justice Brandeis, "Sunshine is the best disinfectant." Only through the steady flow of timely, comprehensive and accurate information can people make sound investment decisions.

The SEC also oversees other key participants in the securities world, including stock exchanges, broker-dealers, investment advisors, and mutual funds. Here again, the SEC is concerned primarily with promoting disclosure of important information, enforcing the securities laws, and protecting investors who interact with these various organizations and individuals. Crucial to the SEC's effectiveness is its enforcement authority. Each year the SEC brings between 400-500 civil enforcement actions against individuals and companies that break the securities laws. Typical infractions include insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them.

Fighting securities fraud, however, requires teamwork. At the heart of effective investor protection is an educated and careful investor. The SEC offers the public a wealth of educational information on its Internet website, including a database of disclosure documents, known as EDGAR, that public companies are required to file with the Commission.

Though it is the primary overseer and regulator of the U.S. securities markets, the SEC works closely with many other institutions, including Congress, other federal departments and agencies, the self-regulatory organizations (such as the stock exchanges), state securities regulators, and various private sector organizations.

Organization of the SEC

As to organization, the SEC is comprised of five Commissioners, four Divisions and 18 Offices. With approximately 3,100 staff, the SEC is small by federal agency standards. Headquartered in Washington, DC, the SEC has 11 regional and district Offices throughout the country.

The SEC's five Commissioners are appointed by the President with the advice and consent of the Senate. Their terms last five years and are staggered so that one Commissioner's term ends on June 5 of each year. No more than three Commissioners may belong to the same political party. The President also designates one of the Commissioners as Chairman, the SEC's top executive.

The Commissioners meet regularly to discuss and resolve a variety of issues. These meetings are open to the public and the news media unless the discussion pertains to confidential subjects, such as whether to begin an enforcement investigation.

The SEC has four operating Divisions. The Division of Corporation Finance oversees corporate disclosure of important information to the investing public. The Division of Investment Management oversees and regulates the $15 trillion investment management industry and administers the securities laws affecting investment companies (including mutual funds) and investment advisers. The Division of Enforcement investigates possible violations of securities laws, recommends Commission action when appropriate, either in a federal court or before an administrative law judge, and negotiates settlements on behalf of the Commission. While the SEC has civil enforcement authority only, it works closely with various criminal law enforcement agencies throughout the country to develop and bring criminal cases when the misconduct warrants more severe action.

And last but not least, the Division I head - the Division of Market Regulation - establishes and maintains standards for fair, orderly, and efficient markets. In essence, we do this through our regulatory oversight of the major securities market participants: primarily broker-dealer firms and the self-regulatory organizations - the stock exchanges, NASD, MSRB, and the clearing agencies. As you may know, each of the stock exchanges and Nasdaq has self-regulatory powers to create and enforce rules for their members. These entities, which are overseen by the SEC, play a critical role in our marketplace not only because they are the front line in regulating broker-dealers, but also because their rules can establish ethical standards and codes of conduct that extend well beyond the anti-fraud authority of the SEC.

Events of the Past Decade

The SEC strives to fulfill its mission of investor protection and market integrity through the full range of economic and political cycles. As the boom of the 1990s intensified, large numbers of investors began to believe they truly were investment geniuses. Raising capital, even for companies that were not much beyond the embryonic idea stage, became relatively easy. "Hot IPOs," where a company's stock price tripled or quadrupled within hours after the initial offering, were a recurring phenomenon. Research analysts became media stars, as their consistently bullish recommendations rarely proved inaccurate. For many, investing became a game, with little distinction being drawn between online trading and online gambling - except that the former appeared to have much better odds. The U.S. markets seemed to evidence a "Lake Wobegon Effect," where every investor and every company was well above average. In retrospect, of course, it's clear the markets were in a bubble but, of course, bubbles are difficult to see from the inside.

As the size and complexity of the securities markets mushroomed throughout the 1990s, the SEC became increasingly hampered both by a deregulatory political environment and resource concerns. In a bull market, the value of regulatory oversight can be difficult to discern - when everyone is making money, regulations often seem to just get in the way. In 1994, Congress targeted burdensome securities laws in one of its ten planks, and for several years, the Commission found itself under significant political pressure to deregulate the securities markets, as well as starved for resources, both human and financial.

In 1995, for example, legislation was introduced in Congress to redefine the SEC's mission, freeze the SEC's budget for five years, and reduce the number of SEC commissioners from five to three. A "top to bottom review" of SEC operations was undertaken by Congress, with the aim of "cutting all regulatory deadwood." During much of the late 1990s, the SEC was directed by the administration to seek a "no growth" budget with respect to staffing and other resources. At the same time, the Commission became subject to extremely high attrition, principally because its employees were earning substantially less than their counterparts in the private sector and even those who worked for the other financial service regulatory agencies.

The pendulum, of course, has now swung the other direction. The bursting of the stock market bubble, the multibillion dollar financial scandals involving prominent companies such as Enron and WorldCom, the indictment of the venerable accounting firm of Arthur Andersen, and revelations of the pervasive conflicts of interest facing research analysts and abuses in the allocation of "hot IPOs," have sparked widespread and vocal calls for renewed regulatory vigor with respect to the securities industry.

Who is to blame for the spate of recent scandals? The stories of many of the principal bad actors are well known. But I think it's fair to say there were widespread failures by the financial gatekeepers as well, including the accountants, lawyers, analysts, CEOs, the self-regulatory organizations, and even the SEC itself. When our system is operating properly, each of these persons or entities plays a key role in ensuring the integrity of our markets. And even investors, although they clearly bear the lowest level of responsibility for these events, could have helped themselves by exercising sufficient diligence and skepticism in making their investment decisions. In any event, we all have learned important lessons from these events, and I am optimistic the systemic changes that are underway will strengthen the integrity of the markets, in many important ways, going forward.

Congress took a significant step toward restoring market integrity and investor confidence when it passed the Sarbanes-Oxley Act 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.

Furthermore, Congress significantly increased the size of the SEC's budget, and provided Commission staff with "pay parity" with other financial regulators, such as the Federal Reserve Board and the Office of the Comptroller of the Currency. These initiatives, together with the general economic downturn, have stemmed much of the attrition by talented staff that the SEC experienced in recent years. With its new resources, the SEC also will be hiring hundreds of additional enforcement and regulatory staff to more effectively oversee the U.S. securities markets and market participants.

Current Regulatory Initiatives

I'd like to spend the remainder of my time this morning giving you a sense of some of the important regulatory initiatives currently underway at the SEC. The major piece of legislation that resulted from the recent financial scandals - the Sarbanes-Oxley Act - significantly affected the work of the SEC, particularly given the scope and extent of the rulemaking it mandated. To date, the SEC has adopted more than a dozen rulemakings in furtherance of the Sarbanes-Oxley Act, and proposed several others. The SEC also prepared four studies contemplated by that legislation.

Public Company Accounting Oversight Board

One significant aspect of the Sarbanes-Oxley Act is 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, this past Wednesday the SEC unanimously approved Bill McDonough - currently the President of the Federal Reserve Bank of New York- as Chairman of the Board. We now expect the Board to 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.

Commission Rulemaking

In August 2002, the SEC engaged in rulemaking to implement two important provisions of the Sarbanes-Oxley Act. First, the SEC required a company's chief executive officer and chief financial officer to personally certify that the reports their company files with the SEC are both accurate and complete. Second, the SEC 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 SEC 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. In addition, accounting firms must retain work papers and related documents relevant to audits, registrants must provide an explanation of off-balance sheet transactions and correcting adjustments, and issuers must annually disclose whether there is a "financial expert" on its audit committee (and if not, why not). Further, the SEC has significantly strengthened its auditor independence requirements, and established standards of conduct for corporate attorneys appearing and practicing before the SEC. An issuer also must annually disclose whether it has adopted a code of ethics applicable to its principal financial officer, comptroller, or principal accounting officer, and insiders now are prohibited from trading during pension fund blackout periods. Finally, the SEC has 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 SEC's rulemaking agenda with respect to the Sarbanes-Oxley Act is not yet complete, and important rule proposals currently are pending. Among other things, the SEC 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 SEC. In addition, the SEC will consider rules requiring annual internal control reports by management and auditor attestations regarding those reports.

One important area of Commission rulemaking required by the Sarbanes-Oxley Act involves the issue of research analyst conflicts of interest, and the Division of Market Regulation has been devoting substantial resources to this project. In recent years, investor confidence in the integrity of Wall Street research has been shattered. As investment banking became more prominent in the business models of multi-service securities firms, research analysts developed into key players in landing investment-banking business. Sell-side analysts came to play an important role on the investment banking sales team, and there were reports of issuers choosing a particular investment bank based on the promised research coverage by the bank's analyst. Analyst compensation also came to be criticized as being too closely linked to attracting and retaining investment-banking business to allow for objectivity. In fact, those compensation links led to charges of analysts being pressured by the investment banking division to issue and maintain favorable ratings. And I'm sure you've heard some of the more outrageous e-mail communications from research analysts - privately referring to the stock of investment banking clients as a "piece of junk," "a powder keg," or "going to zero," but yet at the same time publicly giving those companies the firm's highest stock rating.

In order to improve the objectivity, reliability and usefulness of information that analysts provide to investors, the Sarbanes-Oxley Act requires the Commission or the self-regulatory organizations to adopt rules to address conflicts of interest that can arise when analysts recommend securities in research reports and public appearances. These rulemaking requirements complemented a great deal of work already underway by the Commission and self-regulatory organizations to address potential analyst conflicts of interest.

In May 2002, for example, the Commission approved rules designed to lessen analysts' conflicts and improve disclosure. Among other things, these rules prohibit analysts from offering or threatening to withhold a favorable research rating or specific price target to induce investment banking business. They also prohibit analysts from being supervised by the investment banking department, and bar securities firms from tying an analyst's compensation to specific investment banking transactions. In addition, these rules bar analysts from trading securities of companies they follow during certain "blackout periods" surrounding the issuance of a research report, and require securities firms to disclose in a research report if it received any investment banking compensation from the subject company in the past 12 months. Furthermore, they require analysts, and in some cases securities firms, to disclose if they own shares of recommended companies, and require securities firms to disclose in research reports the percentage of all the ratings they have assigned to the "buy," "hold," and "sell" categories, as well as historical performance information. And finally, the rules require analysts to disclose during public appearances if they or their firm have a position in the stock and whether the subject company is an investment banking client of the firm.

Global Settlement

I also should say a few words about the global settlement relating to research analyst conflicts of interest that the SEC and other regulators announced last month. As you probably have heard, on April 28, the SEC, 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 pitch meetings 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 SEC and the self-regulatory organizations will be considering whether and to what extent 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.


Let me conclude by saying that, despite the recent scandals and market turmoil, I believe the American financial system and securities markets are the strongest in the world. Although we are in a period of some economic stress and uncertainty, the fact that we are undergoing the type of open and positive approach to rectifying the mistakes of the past is the hallmark and strength of our economic and political system. Taking further steps to strengthen business by reaffirming our commitment to transparency, accountability and shareholder interests is essential to restoring investor confidence and can only make us stronger. It's true, there may be costs associated with doing so, but the costs of turning a blind eye will be far greater in the long run.

As we move forward, restoring the confidence of investors and the integrity of the markets is weighty responsibility for the SEC and others. As you know, this is no simple task, and it cannot be achieved overnight. Investor confidence is intangible. There is no statistic that can accurately tabulate it, no measuring stick to keep track of its growth. There is no single piece of legislation or rule that can send the signal to America that all the problems have been fixed, and it's safe to get back in the market.

But, a good combination of thoughtful legislation and responsible rulemaking has helped us move in the right direction. Corporate America and Wall Street have been given a wake up call and told that things must change. The Sarbanes-Oxley Act laid the groundwork for sweeping reform, and the SEC is committed to vigorously implementing that legislation. And for those of us on the SEC staff, we find that our work has renewed significance, as we are given a real opportunity to "make a difference," by taking tangible steps to strengthen the securities markets in ways that will benefit investors and the financial system for years to come.

Thank you all again for the opportunity to share my thoughts on this wonderful Commencement weekend.


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 Justice Harlan Stone, Dedication of Michigan Law School Quadrangle, 1934.



Modified: 06/12/2003