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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the Security Traders Association, Washington Congressional Conference


Annette L. Nazareth

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

Security Traders Association
Washington Congressional Conference

May 9, 2002

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.

Good morning. It is a pleasure to participate once again in this conference and to be included with such distinguished speakers. As usual, before I start, I am required to point out that these comments represent my views — they may not represent the views of the Commission or my colleagues on the staff.

As you are aware, the Commission has been very busy these past several years addressing very complex market structure issues. I want to thank the STA for the helpful insights and comments you have shared with us. We value the prospective of those involved in the day-to-day functioning of the marketplace, and we fully expect that our long and productive relationship will continue under the able leadership of John Giesea, President of the STA.

As we address the many issues facing our markets, we are frequently confronted with diverse opinions and alternatives, some which are motivated by intellectually honest differences of opinion, and others that are driven by economic self-interest. Regardless of the genesis of an opinion, it is incumbent upon those of us at the Commission to assure that whatever course we take, our actions are consistent with the goal of preserving the integrity of the marketplace because without market integrity there is no investor confidence and without investor confidence there is no marketplace. Let's face it, the U.S. securities markets are the strongest, most transparent and vibrant in the world because investors are confident that they are being treated fairly — and while recent events such as 911, analyst conflicts, Enron, and audit inadequacies have sorely tested this confidence, we are committed to fashioning solutions that will ensure that our securities markets remain the "gold standard" that other markets try to emulate.

Analyst Conflicts

Yesterday, the Commission took an important step in enhancing investor confidence by approving rule changes proposed by the New York Stock Exchange and the National Association of Securities Dealers to deal with analyst conflicts of interest in connection with the preparation and publication of research reports for equity securities. The need for rule changes has been the focus of intensive and extensive examinations by the Congress, Commission staff, the SROs, and the industry for many months. The goal of the rule changes is to create more transparency concerning conflicts of interest in research analyst recommendations and to craft rules that, to the full extent possible, would minimize those conflicts.

In multi-service securities firms, analysts often play a number of roles. For example, they have become key players in assisting investment banking departments to attract business. Because issuers may choose a particular investment bank based on the firm's research coverage, some firms may seek investment-banking business by promising favorable research. In these respects, sell-side analysts are part of the sales team for investment banking. The second major role that analysts play is in issuing research reports and appearing on television and in other electronic media where they recommend securities. Investors may assume that analysts in this role are providing objective opinions and advice to investors. However, this may not be the case. For example, many people are questioning the objectivity of analyst opinions during the demise of Enron.

The different demands and objectives of these roles result in conflicts of interest for analysts and their firms. These conflicts are exacerbated by reporting relationships between the research department and investment banking that undermines analyst independence. In addition, analyst compensation has often been so closely linked to the success of investment banking that it jeopardizes, if not destroys, the objectivity of research they produce. Moreover, the disclosure of these conflicts of interest is often inadequate.

A major concern is that investors who rely on analyst recommendations may not know the extent of the conflicts of interest that could affect the analyst's rating. Many investors learn of analyst opinions and ratings from television, without the benefit of conflict disclosures found in research reports. However, even the disclosures in research reports often are hard to find: they appear as inconspicuous boilerplate in long footnotes.

The new rules seek to address these problems in order to restore investor confidence in the integrity and objectivity of research. That investor confidence is critical to the strength of our capital markets. The new rules comprise a significant package of proposals and will entail some serious effort on the part of the firms to be implemented.

Significant elements of the rules include:

  • A prohibition on offering favorable research to induce investment banking business;
  • Structural reforms to increase analyst independence; for example, analysts will not report to investment banking. Moreover, legal and compliance departments will have new responsibilities to monitor communications between research and investment banking with respect to draft research reports;
  • A prohibition on tying analyst compensation to specific investment banking transactions;
  • Increased disclosures of both analyst and firm conflicts of interest in research reports and public appearances by analysts;
  • Restrictions on personal trading by analysts; and
  • Disclosure of data and a price chart showing the firm's ratings "track record."

These rules address clearly identified deficiencies in brokerage firm structures and disclosures relating to analysts. I note that consideration of these proposals has been helped enormously by the comment letters we received, many of which were from members of the securities industry. That is not surprising, as restoring and maintaining investor confidence is a goal shared by regulators and the industry.

Short Sales

Another important market integrity issue that we are currently working on is short selling. As you are probably aware, short selling has been a frequent target of criticism during market downturns. Many individual investors express suspicion or hostility toward short selling, arguing that it depresses the price of securities and is generally bad for the market. This sentiment was especially evident when the markets reopened after September 11th, with many investors viewing short selling as "unpatriotic." Some advocated that the practice be restricted, or even banned altogether.

In contrast, there are other market participants, including many of you sitting in this room today, who believe that the Commission's short sale rule, Rule 10a-1, is an unnecessary impediment to a free market. Others who support the goals of short sale regulation nonetheless believe that the rule, which has remained virtually unchanged since its inception more than 60 years ago, no longer fits today's markets, and should be modernized.

Short selling, of course, has important uses in facilitating liquidity, hedging, and as an expression of legitimate investor sentiment that a security is overvalued. On the other hand, protections against abusive short selling are important for issuer and investor confidence. While a consensus on short sale regulation is probably unattainable, changes can be made to improve Rule 10a-1. Notably, adjustments to current short sale regulation may be required to keep pace with recent developments in the securities markets, including Nasdaq's plan to become a national securities exchange, the impending commencement of trading in single stock futures, and decimalization. An amended short sale rule could address these market changes, while also continuing to serve as an important safeguard against potential manipulation.

In particular, the staff believes that the Commission could consider a carefully targeted approach that would shift regulatory controls to the areas where they are most needed, while also easing restrictions where they appear unnecessary to protect the markets. As you may be aware, the Commission issued a Concept Release a couple of years ago seeking comment on ways to modernize short sale regulation. Several of the concepts presented in the release focused on this shift in regulatory control, suggesting that the short sale rule be extended to non-exchange listed securities, while also excepting from regulation the most highly liquid securities that are traded on organized markets with high levels of transparency and surveillance. Both of these approaches received support from commenters. A large number of individual investors, more than 2200 in all, urged further regulation to prevent short sale abuses in thinly capitalized OTCBB and PinkSheet securities.

I believe that increased investor confidence can be fostered by regulatory simplicity and decreased investor confusion. The current environment for short sale regulation has different tests applying to securities listed in different markets. Rule 10a-1 applies to exchange-listed securities, while the NASD short sale rule applies to transactions in Nasdaq National Market Securities, but not to Nasdaq SmallCap, OTCBB, and other securities traded over-the-counter.

This distinction in the application of the short sale rule between the Nasdaq market and the listed market will become less clear provided the Commission approves Nasdaq's registration as a national security exchange. As you know, Rule 10a-1 operates using a tick test and the current Nasdaq rule is a "bid test." Given the recent changes in the markets, particularly the quote flicker resulting from decimalization, I believe that a uniform short sale rule based upon the consolidated best bid might be the best way to promote the fundamental goals of short sale regulation across the markets. A "bid test" (e.g., a test restricting short selling in any security to a price above the best bid, or at the best bid in an upward market) would facilitate relatively unrestricted short selling in advancing markets, and would provide greater flexibility for modern trading systems, including increasingly popular automated trading systems that offer price improvement based on the NBBO. It would also protect investors by preventing short selling at successively lower prices in an attempt to accelerate a decline in the market.

If the Commission does determine to effect short sale relief, it will be incumbent on all of us to convey to investors that we are not abandoning the goals of short sale regulation, but rather updating the rule to reflect market developments, and shifting regulation to the areas where it is most needed. By doing so, we can ensure that investor confidence remains high, and that our markets, in turn, remain strong.


Another component in the investor confidence equation is the role of our securities clearance and settlement system. As we saw in the aftermath of the September 11th terrorist attacks, investors did not hesitate to return to our markets, in part because of their confidence that when our markets are open they work!

When investors go to their brokers to buy or sell securities, they have three expectations. First, the process must be transparent. Second, investors expect the process to be reliable, with minimal exposure to risks. Finally, investors want high quality, affordable services. At present, our industry is able to meet these expectations. However, as trading volumes continue to rise and as our markets become more global, our ability to offer investors exceptional services at competitive prices will be tested. One way to maintain our standards and retain investor confidence is to increase efficiency and reduce risk in the clearance and settlement system.

In recent years, the securities industry has responded to this challenge with a major initiative to shorten the settlement cycle from three days to one day, affectionately known as T+1, and to improve efficiency by implementing straight-through-processing. While the 1995 implementation of the T+3 settlement cycle has been successful, there is still a need to further reduce credit and market risk. Implementing a one-day settlement time frame reduces by two-thirds the market's settlement exposure; and investors can obtain and reinvest their proceeds sooner.

Achieving straight-through-processing will also streamline back-office procedures, increasing efficiency to the system while minimizing operational risk. Through automation, manual intervention will become the exception rather than the norm. As a result, fewer fails will occur by human error, and accurate trade data will reach the clearing corporation and the depository more quickly. Back office staff can then focus on processing today's trades rather than correcting yesterday's.

As I mentioned earlier, last year, the strength of our industry's infrastructure was tested far beyond anyone's imagination. No one could have anticipated the tragic events of September 11th. Yet, the preparedness of our industry helped minimize its impact on our clearance and settlement system. Dedication and cooperation across the industry allowed firms to move to alternative sites and utilize back-up facilities in order to reopen the markets in a relatively short period of time.

However, risks were exposed. As a result, many are of the view that we need to proceed all the more diligently on the T+1 initiative in order to reduce the exposure to credit and market risks and thereby reduce the chance that a future crisis will have a major systemic impact on our financial system. Many believe the impact of the events of September 11th was unusual in that the settlement fails that occurred resulted almost exclusively from operational problems. Most financial crises involve both operational and credit issues. In a sense, then, we were fortunate in the aftermath of September 11th because, had credit problems arisen, the systemic consequences would have been much more severe, particularly given the fact that the settlement cycle for government securities was lengthened to T+5.

Many are of the view that the September 11th experience demonstrates how physical certificates add cost and operational risk to the financial system. For certificates being processed for trades conducted days prior to the 11th, delays were inevitable. The Depository Trust Company's staff was unable to return to their facilities until the Saturday after the attacks in order to process the certificates. In addition to processing delays, the risk of loss associated with paper was unfortunately highlighted. Several broker-dealers stored physical stock certificates for their customers in vaults beneath the World Trade Center, and those vaults were destroyed in the terrorist attacks. While commendable efforts were made by the Securities Transfer Association, the Securities Industry Association, the Securities Information Center, and others to streamline the replacement process, some point out that this problem would not exist if the U.S., like many foreign jurisdictions, had converted to either a dematerialized or book-entry only system. As a result, they argue that the use of physical certificates should be further discouraged, in order to avoid the operational and other problems they caused in the wake of the September 11th events. This will be a challenge, particularly for broker-dealers with a retail investor base. But, we must persuade them that getting paper out of the system will enhance investor protection and the efficiency of our markets. This will translate into greater investor confidence.

The resilience of our markets before and after September 11th demonstrates the strength of our national clearance and settlement system. In shortening the settlement cycle to one day, investors' expectations for timely, reliable, affordable transaction processing will continue to be met. Additionally, the industry will reap long-term benefits associated with straight-through-processing.

Achieving straight-through-processing and T+1 will eventually realize costs savings to the industry and, ultimately, investors. While future cost savings are desirable, the staff is sensitive to the fact that implementing T+1 requires market participants to make sizeable investments of their time and resources in the near term. The Securities Industry Association estimates that the industry will wind up spending about $8 billion to accomplish all of the T+1 goals. Commission rulemaking will be a part of this process. In that connection, the staff will consider the costs and the scope of the benefits as part of any T+1 rule proposal. In fact, in a recent press release, Chairman Pitt announced that our new chief economist, Lawrence Harris's "first task will be to examine the costs and benefits of moving to next-day processing of stock trades."

ECN Fees

Before I end my remarks, I want to touch briefly on a point that I know is important to you, ECN access fees. In Regulation ATS, the Commission recognized that ECNs could charge reasonable access fees. The Commission further stated that SROs could regulate ECN fees to ensure that any fees are charged in a manner consistent with the SRO's market (such as requiring the fee to be incorporated in the displayed quote). No SRO has done so. It has become clear that changing market conditions, such as the narrowing of the spread and the participation of fee charging ECNs in automatic execution systems, may be adversely effecting the profitability of traders and harming the integrity of the public quotation. Indeed, this organization, along with other market participants, has taken the lead in providing thoughtful and helpful analysis on this issue. We have heard your concerns and they are helping us to frame our continuing examination of this issue in our dynamic and ever-changing capital markets.


There is no doubt that our standard of living is a direct result of industry's ability to raise capital and that market integrity is a vital component in the capital raising equation. Our goal at the Division is to assure that our securities market — which all other markets attempt to imitate — remains the "gold standard."

Thank you for your kind attention.



Modified: 05/22/2002