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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the NYSE Regulation First Annual Securities Conference


Annette L. Nazareth

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

New York City, NY
June 21, 2005

Good afternoon. I am honored to be here today at the NYSE Regulation's First Annual Securities Conference. "First Annual" implies that there is an expectation of many more conferences to come, and I hope that this will be the case. It is reasonable to conclude that we will have regulatory and compliance issues well into the future, so I welcome this first of many opportunities to discuss these important matters in such a thoughtful setting. Before I begin, however, 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

For over 200 years, the cornerstone of the securities markets has been integrity and trust. There are few other areas in our economy where billions of dollars of transactions are effected so seamlessly with the nod of the head or the utterance of one word - "done." It is axiomatic in this industry that without integrity and trust, the efficient capital raising mechanism of the securities markets would not exist. And one does not have to think too long or too hard to come up with examples of the damage caused in the marketplace on those occasions where trust and integrity were called into question.

Many of you, as compliance or legal officers, serve several clients. You serve the firm, which looks to you to protect its most valuable, albeit off-balance sheet, asset, its reputation; but you also serve the investor, who makes investments based on trust in the firm.

Before discussing some of the current conflict issues facing us, let me note that I appreciate the difficult nature of the task you face. Having worked in the industry for a number of years, I can assure you that I understand the significance of the "bottom line" and how frequently compliance and legal officers are regarded as a drag on profits, the "L" in the "P & L," so to speak. However, after some of the recent settlements, I suspect that the expense of compliance is seen in a more positive light.

Conflicts of Interest: A Recent History

Over the last few years, the securities industry has witnessed a series of scandals that threatened to erode integrity and trust and thus undermine the vitality of the markets. Underlying many, if not all, of these scandals was a failure by industry participants to adequately address conflicts of interest.

Conflicts of interest are inherent in the financial services business. Broker-dealers and investment advisers, when acting as intermediaries or fiduciaries, are obligated to act in the best interests of their customers. Such duties mean placing their customers' interests before their own. However, securities firms and their affiliates sell many products and engage in different, often interrelated, business activities with the same customer. As with any business, some products and activities are significantly more profitable than others. Where there are significant profits to be gained in certain areas of a firm or with certain customers, there is also a powerful incentive to skew one's practices in order to increase profits, to the detriment of others. In addition, in the ordinary course of business, securities and advisory firms acquire confidential and sensitive information in their various roles as agents, advisors, and lenders. This information is not available to other market participants. Thus, there is a significant potential for conflicts of interest and the misuse of confidential information or customer relationships.

The Commission has worked diligently to address problematic practices rooted in conflicts of interest that have arisen in the marketplace. The best-known of these was the Global Settlement with research analysts. The Commission has also developed rules to address the conflicts and compliance problems made apparent in mutual fund, advisory, and brokerage firms. These initiatives have focused on: (1) addressing late trading, market timing, and related abuses; (2) improving the oversight of mutual funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) managing or eliminating certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) in a further effort to promote accountability, improving disclosure to fund investors, particularly fee-related disclosure.

The Commission staff is building on these initiatives to address conflicts in all of its forms in the securities industry. In September 2003, then Director of Enforcement, Steven Cutler, called upon financial services firms to undertake a top-to-bottom review of business operations with the goal of addressing conflicts of interest of every kind. In response, a great many firms undertook a conflicts review and more than a dozen made presentations to the Commission staff describing their findings.

These firms used both in-house legal and compliance personnel and outside counsel and consultants to review their businesses. The reviewers examined business lines and current compliance policies, and conducted extensive interviews with personnel at all levels of the organization. Through this internal review process, the firms sought to identify significant risks and develop a better understanding of their businesses, thus heightening awareness of potential business conflicts. These forward-looking reviews should prove helpful to each firm's compliance personnel in identifying and preventing abuses. I cannot over-emphasize the need for firms to continually review their operations for conflicts. While clearly such reviews are conducted at some cost to the firms, these costs pale in comparison to the reputational loss and potential fines and settlements associated with a failure to address conflicts of interest.

I'd like to share with you now just a few of the broad areas of conflicts that broker-dealers and their affiliated asset managers described in their presentations to the staff. How each firm specifically addressed these conflicts varied depending upon its specific internal business structure.

Some securities firms identified potential conflicts related to the presence of research analysts on the trading desks, particularly in their fixed income areas, where gaining knowledge of otherwise confidential or restricted information is possible. Several firms noted that current information barriers, that restrict access to information about firm positions and that require analysts to separate when preparing reports, do not address information shared orally on a trading desk. These firms also noted that research analysts are evaluated for purposes of performance and bonuses by sales and trading personnel, which may influence the analysts' objectivity.

Securities firms also spoke of potential conflicts related to the firm's facilitation of customer orders, with the related receipt of confidential order information, while the firm engages in proprietary trading. Absent strong information barriers, information could flow to the detriment of the customer, but to the benefit of the firm. Another concern centered on employee investments in certain types of securities that are less transparent for the firm to surveil (e.g., hedge funds or private equity funds), which could conflict with their sales and trading activities for customers. The firms also highlighted the persistent issue of firm personnel having the ability to make allocation decisions that could prefer the employee's interests over customers, such as when portfolio managers allocate superior trades to personal accounts rather than the publicly held funds they manage, or that could prefer one customer over another, such as when a prime broker decides to buy-in short positions of some customers and not others.

Securities firms also face conflicts when they introduce their customers to hedge funds if they received a fee for such service from the hedge fund and the capital introduction employees also make investment recommendations to the customers without disclosure of the firm's relationship with, or financial gain from, the hedge fund.

Securities firms also described conflicts that result when they pay their registered representatives higher compensation for selling certain products (e.g., proprietary products vs. non-proprietary products). Firms also face conflicts when recommending mutual fund shares involving various sales loads and in determining the class of fund shares best suited for a particular customer. Finally, with the increase in the alternatives in account fee structures, firms face conflicts in recommending an asset-based fee or transaction-based fee securities account, which may detract from careful consideration of what is suitable for the customer's needs.

Securities firms also spoke of potential conflicts when broker dealers render fairness opinions, with fees that are contingent on the success of the transaction, as well as advise on the investment banking aspects of the same deal. They also have conflicts as a result of maintaining multiple relationships with companies, such as acting as an underwriter, advising on M&A transactions, making markets, and holding principal debt or equity positions. Firms also may be asked to provide advice to the company at the same time they possess knowledge about that company gained through confidential business relationships, e.g., being a creditor of the company. In addition to the internal conflict a firm may have with an issuer-customer, by acting in several capacities on the issuer's behalf, the firm may create conflicts with customers that may invest in the issuer-customer. These potential investors are often unaware of the various conflicts and the many opportunities for the securities firm to profit from acting in several capacities or utilizing several affiliates on behalf of a client.

Of the conflicts recently identified by brokers, the staff is currently working on proposals for Commission consideration to address two areas of concern, namely conflicts in soft dollar practices of investment advisers and broker-dealers and broker-dealer sales practices. Let me tell you more about these initiatives.

Conflicts in Soft Dollars

As you know, fiduciary principles require a money manager to seek the best execution for client trades, and prohibit a money manager from using client assets for its own benefit. The use of client commissions, or "soft dollars," to pay for research and brokerage presents money managers with significant conflicts of interest. This is because the money manager obtains benefits for itself from directing client orders (and the associated commissions) to certain broker-dealers with which the manager has a soft dollar arrangement. Section 28(e) of the Securities Exchange Act of 1934 protects money managers from liability for breaching its fiduciary duty solely on the basis that they paid more than the lowest commission rate in order to receive "brokerage and research services." To qualify for the safe harbor, the money manager must determine, in good faith, that the amount of the commission paid to an executing broker was reasonable in relation to the value of the brokerage and research services the manager received.

Because the interests of the investment manager and the client are not well-aligned, soft dollar arrangements may create incentives for investment managers not to optimize client execution strategies, resulting in higher client trading costs and poorer performance. Soft dollars may also contribute to artificially high commission rates. Investment managers may lack incentives to negotiate with broker-dealers for the lowest possible commissions consistent with their best execution obligation, because they benefit from the amount of commissions paid to the broker-dealers. Soft dollars may even impact market structure and trade flows by, for example, producing incentives for money managers not to use ECNs and other alternative trading systems that do not offer soft dollar arrangements but which may in fact offer the most efficient execution service under the circumstances.

Soft dollar practices may equally distort the market for advisory services by diminishing the transparency of actual asset management costs and reducing the ability of clients to evaluate those costs (and assess the money managers' performance and conflicts of interest). As a result, soft dollars may foster artificial demand for asset management services, because the clients perceive such services to be less expensive than they actually are, thus protecting smaller, less efficient investment managers.

In 2004, the SEC's internal Task Force on Soft Dollars, which includes Commission staff from six divisions and offices, reviewed industry soft dollar practices and considered the views of market participants such as members of the investment management, brokerage, and third-party research communities, and of other regulators such as the NASD and the Financial Services Authority of the United Kingdom.

Based upon the recommendations of the Task Force, I anticipate that the Commission may clarify the scope of the brokerage and research services that are eligible for the safe harbor. The Commission may also seek to improve accountability as to products and services received and documentation of these arrangements through enhanced recordkeeping.

We do not believe it is sensible, in considering soft dollars, to differentiate between proprietary and third-party soft dollar arrangements. Third-party research offers independence and clarity of pricing. We believe that third-party and proprietary research are equally appropriate and eligible for safe harbor treatment if the requirements of Section 28(e) are satisfied.

Sales Practices: Conflict Disclosure

Before concluding, let me speak to one final conflict that deserves additional consideration.

Today, mutual fund complexes have a variety of ways to compensate broker-dealers for their distribution services and most of the compensation arrangements involve costs to the investor, either directly or indirectly. In addition to sales fees (which broker-dealers earn at the time of the transaction, and are often different from the loads paid by customers to the fund), broker-dealers may receive a continuing stream of asset-based 12b-1 fees from their customers' mutual fund investments. Broker-dealers may also be compensated for their distribution efforts through revenue sharing arrangements with the adviser or other affiliate of a fund. They also may receive payments that are characterized as service fees, recordkeeping or transfer fees, or continuing education sponsorships. Moreover, funds may reward broker-dealers for mutual fund sales with "portfolio brokerage commissions" - that is, commissions for effecting trades for the fund's own portfolio.

Broker-dealers may also pay differential compensation to their in-house sales personnel. For example, registered representatives may be paid more for selling their customers B shares than A shares of the same fund, or selling proprietary funds versus other funds, because the firm earns more from the former products. Investors too often are not aware of these compensation arrangements at the time they decide to invest.

Disclosure problems, however, are not limited to transactions in mutual funds. The growth of state-sponsored 529 plans raises similar concerns. Because investors in those programs may be particularly inexperienced - and because these plans are exempt from disclosure under the Investment Company Act of 1940 - heightened cost and conflict disclosure in this context may be even more critical. The distribution of unit investment trust interests, particularly insurance securities, raises similar cost and conflict issues.

All of these payment streams, of course, create conflicts for broker-dealers and their registered representatives because they are designed to promote the sale of some fund shares over others, when the funds may not be equally beneficial for customers.

The Commission has published point of sale disclosure proposals that are intended to provide investors with information concerning the conflicts of interest raised by these payment practices. That is, the Commission has proposed to require broker-dealers to give their customers some fundamental and useful information about their costs and the broker's conflicts of interest at the time of sale - when the customers can factor the disclosure into their investment decisions - as well as additional information in their transaction confirmations - when the customers can factor it into their decisions of whether to make additional investments of the same type in the future. The better the disclosure of these conflicts at an early point in time, the higher the likelihood of a better investment decision.


Whether conflicts relate to research analyst and investment banking issues, mutual fund sales and trading practices, or broker-dealer recommendations and disclosures, left unattended, they can evolve into scandals that significantly impact a firm's reputation and financial well being, and have the potential to harm the integrity of the markets and the trust of the investing public. It is incumbent on legal and compliance officers at broker-dealers, investment advisers, and other industry participants to look carefully at their firms' business practices, critically examine their internal controls and policies, and promptly resolve actual and potential conflicts that arise in the ordinary course of their business.

The conflicts I have highlighted today are merely the conflicts du jour. But there are conflicts inherent in countless aspects of the securities business. The key is to identify them and to manage them appropriately, whether through structural changes, or disclosure. We can all be confident that we will never arrive at a place where we have eliminated all conflicts. But we must be vigilant in managing them.

As legal and compliance officers, you can protect your firm by looking closely at your firm's activities, understanding the transactions, identifying the many capacities in which your firms act on behalf of a client, and monitoring the various compensation arrangements. If a payment or compensation arrangement appears to raise conflicts, you have probably identified an issue that could become tomorrow's problem.

We at the Commission remain committed to helping you address these conflicts in order to ensure a better marketplace for all.

Thank you.



Modified: 06/21/2005