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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the SIA Research Conference


Annette L. Nazarethi

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

New York City
October 16, 2003

Good afternoon. I am delighted to be here today to discuss sell-side research issues and other current matters affecting the securities markets. Before I begin, I must note that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.1

It almost goes without saying that our marketplace has recently endured a series of severe jolts to investor confidence. Over the past year or two, there has been the steady stream of revelations concerning alleged conflicts of interest that have compromised the integrity of the financial services industry. And the detrimental activity rooted in these conflicts has occurred not just in one isolated corner of our markets, but rather across a broad array of areas, including accounting and auditing, corporate governance, sell-side research, investment banking, and more recently, the mutual fund arena and SRO governance. Congress and regulators continue to respond aggressively with regulatory reforms and enforcement actions designed to restore investor confidence. Our primary focus has been to eliminate or reduce conflicts of interest and, to the extent they remain, to assure they are better disclosed. The industry has also shown a willingness to do its part. The reputational black eye endured by the financial services industry has served as a stark reminder of one indisputable truth - that the securities markets thrive when investors have confidence in the fairness and integrity of the system, and that they suffer immeasurably if investors refuse to participate due to a lack of confidence in the markets and market professionals. While challenges certainly remain ahead, significant steps have been taken, and I do believe we are on the right path.

This afternoon, I'd like to highlight some of the steps the Commission has taken to address conflicts in sell-side research and corporate governance. I'll also share some concerns with respect to an emerging area where conflicts of interest are once again being scrutinized - the area of SRO governance.

I. Analyst Conflicts

The potential for conflicts of interest has always been present in the research analyst-investor relationship. There have been longstanding concerns that analysts could issue recommendations for the sake of benefiting their own personal holdings or the trading positions of their firms. To address these potential conflicts, securities firms developed compliance procedures designed to mitigate them. More recently, however, additional conflicts of interest arose as a result of the commingling of investment banking and research services. As investment banking became a more prominent part of the business model for multi-service securities firms, research analysts became key players in landing investment-banking business - playing increasingly important roles as part of the sales teams for investment banks. They became media stars generating millions of dollars for their firms and themselves.

The increased prominence of research analysts exacerbated certain potential conflicts of interest, and in many cases impaired the independence and objectivity of their research. Analysts were able to parlay their media stardom into an ability to move markets at the drop of a "strong buy" recommendation. Too many analysts became focused on the large revenue possibilities associated with bringing in new investment banking clients, rather than issuing objective research based upon a company's fundamentals.

As you all know, the Commission participated in a joint formal inquiry into market practices concerning research analysts, and the conflicts of interest that can arise from the relationship between research and investment banking. This inquiry found a number of serious problems afflicting a significant portion of sell-side research. First, we found that firms' use of research analysts in bringing in investment banking business intruded heavily upon analyst independence. Analysts were pressured to initiate and maintain favorable coverage on investment banking clients. These pressures were exacerbated by the fact that analysts were evaluated, in part, by investment banking professionals, and that their compensation was influenced by their contribution to investment banking revenues.

Serious problems developed as a result of these pressures. In certain instances, the firms' marketing or "pitch" materials implicitly promised that a company would receive favorable research if it agreed to use the firm for its investment banking business. Also, some firms accepted payments for research without disclosing those payments. Even worse, the inquiry exposed instances where research analysts published fraudulent research reports that were contrary to their true views, which were expressed only to favored customers, if at all.

The joint inquiry resulted in a settlement of enforcement actions by the Commission, the NASD, the NYSE, and the States against ten of the nation's largest securities firms, alleging undue influence by investment banking interests on the firms' research. This Global Settlement included substantial monetary relief, imposed structural reforms - such as firewalls and compensation restrictions - that seek to promote analyst independence, mandated additional disclosures regarding potential conflicts, and required that firms provide independent research, at no charge, to accompany their own.

In addition to the structural reforms and disclosure provisions included in the Global Settlement, the Commission recently approved a comprehensive set of SRO rules that seeks to promote independence of analysts and the integrity of sell-side research in a number of significant ways. These rules impose structural reforms designed to eliminate pressure on research analysts from investment banking. They also impose trading restrictions on analysts and firms. Finally, they require specific disclosures of material conflicts - including compensation from the issuers that are the subject of research reports. The Commission also added its own rule - Regulation AC - to promote the integrity of research by requiring that analysts certify to the truthfulness of their research reports.

Underpinning all of these regulatory efforts is the principle that investors must have confidence that an analyst's recommendation is based on an honest evaluation of the performance of the company, and not impaired by conflicts of interest such as the firm's efforts to gain investment banking business or an analyst's attempt at self-enrichment.

We have achieved much in our effort to address the conflicts of interest associated with sell-side research. Our work, however, may not be completed. Among other things, the Commission is considering whether any of the provisions of the Global Settlement should be applied to the industry more broadly. Specifically, Commission staff is evaluating the possibility of recommending a comprehensive Commission rulemaking that would incorporate into one single federal standard all of the rules applicable to research analysts, including the SRO rules and certain provisions of the Global Settlement. In addition, recognizing that our markets are becoming increasingly global in nature, the staff has been working with foreign regulators in an attempt to harmonize our respective rules dealing with research analyst conflicts of interest.

While our efforts at identifying and addressing conflicts of interest will continue, I believe it is the firms themselves that are in the best position to identify and manage these conflicts. When assessing your business practices, I strongly encourage you to think broadly and critically about the types of conflicts of interest that may arise, and to devise creative and effective solutions to mitigate them. I know that this is a daunting challenge. Potential conflicts of interest are inherent in many aspects of the financial services business. But managing those conflicts is central to the success of our financial system.

If there is one lesson we should all take from the recent spate of scandals, it is this - there is no safety in numbers. You cannot hide under the shade of "standard industry practice." The research analyst debacle has clearly demonstrated that the excuse of "everyone else is doing it" is an ineffective defense. Firms that ignore conflicts of interest do so at their peril, and I strongly encourage you to be proactive in identifying and addressing potential conflicts. Furthermore, I believe a constructive environment where the Commission and the industry work effectively and in concert on these issues could help enormously in restoring investor confidence, to the benefit of us all.

I am pleased to observe that the industry appears to be taking significant steps in this direction. Substantial resources are being committed to implement the recently approved SRO rules and the Global Settlement, and some firms appear committed to exceed, rather than merely meet, these standards, both in terms of timing and substance. Industry groups also are taking important steps to build upon existing law and guidance to more effectively address analyst conflicts. The Bond Market Association, for example, is developing "best practices" guidelines to manage research analyst conflicts in the fixed income markets which, as you know, were not the focus of the recent reform efforts. An exercise such as this evidences a commitment to reform through pro-active efforts to identify and manage potential conflicts of interest in the securities business. I applaud those involved in these worthy endeavors.

II. Corporate Governance

Another significant rulemaking effort undertaken recently by the Commission to address potential conflicts of interest has focused on corporate governance reform. After all, we must ensure that investors participate in a marketplace where a company's activities are transparent, and its governance reflects the interests of shareholders - not the self interest of management.

The Commission's actions, which are by now well-known, have included new rules to: require CEOs and CFOs to certify as to the accuracy of their quarterly and annual reports; accelerate the disclosure of personal securities trading by corporate insiders and prevent executives from trading during pension blackouts; and require disclosure of whether a company has a code of ethics for executive officers, and whether it has a designated "audit committee financial expert." In addition, the Commission adopted rules requiring heightened standards of auditor independence and better disclosure of off-balance sheet arrangements, and prohibited markets from listing the security of any issuer that does not comply with the requirements governing audit committees. Finally, as you may know, the Commission expects to consider shortly a series of important NYSE and Nasdaq rules that impose a wide range of corporate governance standards on listed companies. All of these provisions - and that's not the complete list - are aimed at rooting out and reducing potential conflicts of interest relating to corporate governance, and disclosing those that still exist.

III. SRO Governance

The last topic I'd like to touch upon is SRO governance. Recent revelations concerning allegations of governance failures at the NYSE highlight the importance of ensuring that our SROs focus on the effectiveness of their internal governance standards. As you know, earlier this year Chairman Donaldson called upon each of the SROs to review their governance practices in light of the Sarbanes-Oxley Act, and urged them to meet the same high governance standards as those imposed on public companies. As a result, the NYSE formed a Special Committee on Governance whose mandate, among other things, was to conduct a full-scale assessment of the NYSE's governance practices.

I believe it is telling that few, if any, of the SROs, including the NYSE, had focused their reviews on their own transparency, such as that relating to their decision-making processes or the compensation of senior executives. In light of recent events, it is incumbent on us to ask why these quasi-public institutions are not subject to transparency and reporting requirements substantially similar to those applicable to public companies. I would expect the benefits of increased transparency to be realized almost immediately. "Transparency is the best disinfectant" is an oft-quoted statement of William O. Douglas, but one that rings particularly true in this context.

Another area relating to SRO governance that the Commission is likely to revisit is the composition of SRO Boards of Directors. About five years ago, there was a significant effort to move SRO Boards towards having a majority of "public" directors. However, some SROs, including the NYSE, instead have Boards comprised of a majority of "non-industry" directors which, as defined, includes representatives of companies that are listed on, or have other material relationships with, the exchange. As our notions of best practices in governance evolve - and the bar clearly has been raised in light of the Sarbanes-Oxley Act - it is incumbent on us to revisit what it means to be a "public" director of an SRO. In light of our strong interest in ensuring that the self-regulatory function is as fair and rigorous as possible, would it not make sense to refine our concept of a "public" director to include only those persons with no material relationship with the exchange, whether as a representative of a regulated firm, a listed company, or otherwise? The independence standards soon to be applicable to the Boards of listed companies could serve as an appropriate model in this regard. We also should be looking for guidance to the various current "best practices" on governance - such as the ABA's Cheek Report and the Business Roundtable's recommendations, as well as those established pursuant to the Sarbanes-Oxley Act - and analyzing where the SROs' governance is at variance. There may be legitimate reasons for some of the distinctions, but we should critically analyze those differences to ensure that the best and most appropriate governance practices are in place at our SROs.

Finally, it has often been said that the success of self-regulation depends upon the independence of the regulatory function from the business interests of the market with which it is associated and the participants in that market. As we review corporate governance at the exchanges, we must again consider whether improvements can be made in the structure of self-regulation. At a minimum, I believe it makes sense to separate the regulatory function and the market function within an SRO, through distinct budgeting and oversight lines within the same legal entity, or through a separate corporate structure. An alternative model, which some have advocated, is to have a single SRO responsible for member regulation, and each exchange retain responsibility for market regulation. This "hybrid SRO" model could help reduce the number of regulators of broker-dealers, but it also could raise questions as to which regulatory functions relate to member regulation and which relate to market regulation. I am not, at this stage, advocating one model over the other. There are any number of ways to structure an SRO to achieve a more independent regulatory function, and I do not believe it is necessary for the Commission to mandate one single model at this time. Rather, we should work diligently with the SROs and market participants to identify and study the options in more depth, and then build consensus on the structure or structures that most effectively mitigate the potential conflicts of interest inherent in the notion of self-regulation.

In closing, I would like to reiterate how critically important it is for each of you, as well as all members of the securities industry, to embrace all of the recent reforms I have discussed today. Having just experienced one of the most challenging times in our markets' history, we have a unique opportunity to address these issues, and ensure that the U.S. securities markets continue to be the fairest, deepest, and most liquid in the world.

Thank you.



Modified: 10/16/2003