Speech by SEC Commissioner:
Remarks at the Second Annual Wall Street Summit of the New American Alliance An American Latino Business Initiative
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
New York, N.Y.
October 24, 2002
Thank you, Tom (Tom Castro), for that kind introduction. It is a great pleasure to be here to speak to you today, not only as a member of the Commission but also as a member of the Latino Community. As such, it is wonderful to see so many friendly and familiar faces. Before diving into my remarks, however, it is necessary for me to make the disclaimer required of all Commission speakers, that the comments I make here today are my own and do not represent the views of the Commission, the other Commissioners or the staff.
I also would like to mention that Attorney General Eliot Spitzer had hoped to be here today. In fact, believing in the importance of the NAA's mission, he initiated contact with the NAA in an effort to be a part of today's program. Unfortunately, at the last moment, he was unable to attend because he had to participate in a meeting related to the global settlement on research analysts. He asked me to express his disappointment in missing the opportunity to speak with you and hopes to have the honor of doing so at some point in the future. Now, I would like to begin my remarks.
In the brief time we have today, first, I would like to broach the topic of being the first Latino Commissioner of the SEC, and then I would like to comment on some issues that are germane to the Wall Street community as a whole, particularly the Sarbanes-Oxley Act, conflicts of interest existing for investment bankers and analysts, IPO allocations, and an issue involving ECN fees.
I. Significance of the Latino community
As a member of the Latino Community in America and as a former member of the New America Alliance (NAA), it is appropriate to reflect briefly upon what it means to be the first Latino to be have been nominated by the President and confirmed by the Senate to be a Commissioner of the United States Securities and Exchange Commission. For starters it is important to say that a lot of people, many from this organization, actively supported my nomination. The danger in giving thanks is that I will leave an important person out through inadvertence. Nonetheless, I will try anyway and hope I don't miss too many: I owe thanks to people like Jose Villarreal, Raul Yzaguirre, Henry Cisneros, Moctezuma Esparza, Tom Castro, Jorge Castro, Frank Sanchez, Pilar Avila people outside this organization such as Bill Richardson and many of the best known Latino advocacy groups such as the National Congressional Hispanic Caucus, LULAC, NALEO, and MALDEF. Of course, I owe thanks to Senator Tom Daschle who on behalf of the Democratic leadership recommended me as one of the Democratic Party choices for nomination to the SEC. Senator Paul Sarbanes, Chairman of the Senate Banking, Housing and Urban Affairs Committee provided me strong support and ultimately, President Bush formally sent my nomination to the Senate for confirmation.
One lesson that is plain when our community unites and makes it clear that we need a particular result the odds become great that the objective will be achieved. I am the fortunate beneficiary of your support. I note that our community and many in this organization recently worked tirelessly behind the scenes to support the selection of the first Latino CEO of CalPers Fred Buenrostro. Although it is Fred's personal qualifications and excellence that resulted in his selection, united action by members of this organization and other Latinos certainly helped.
Upon reflection, my appointment demonstrates that our community has come of age. We should never again accept the tired line that "we would like to appoint Latinos to this position or that, but there are no qualified candidates." We should use Winston Churchill's response to Hitler's claim that Britain could not withstand the Nazi military might by saying "Poppycock." It is important that the NAA continue to identify qualified Latinos for important positions in business and government. It is important that this organization join with the other Latino organizations when such candidates and positions are identified. It is also important that NAA join with other organizations in identifying qualified Latinos to be directors on the boards of the major companies in America.
II. Significance of Sarbanes-Oxley
The Sarbanes-Oxley Act is a monumental piece of legislation that touches on virtually all areas of financial regulation. We at the SEC are very busy implementing the Act and still have much to do. The legislation, while an impressive piece of work, will only be as good as we all make it. All participants in the financial markets, including issuers, investment bankers, lawyers, accountants and regulators, have a common interest in restoring the strength and integrity of our markets and we all play a role in achieving those ends. I strongly urge all market participants to get behind the Commission's efforts to implement Sarbanes-Oxley and to embrace changes that will restore investor confidence in our markets. Our success will depend on the integrity and accountability of all market participants.
Our success also will be affected by our ability to improve the resources available to us at the Commission. As you have read, the Senate voted to appropriate approximately $750 million to the Commission to enable the Commission to carry out its mission and, in particular, to implement the mandates of the Sarbanes-Oxley legislation. The Administration stated that it supported an appropriation of approximately $550 million. Yet, most recently, the White House has backed away from both this number and the support of any significant increase to the Commission's budget. I find this extremely troubling. In the aftermath of Enron, Anderson, WorldCom and others, it is crucial that the Commission have the staff, technology, and other resources necessary to restore investors' confidence in the market. Although we at the Commission are working to the best of our abilities to achieve that goal, there is only so much that can be accomplished under the restraints placed on the Commission's resources as dictated by our budget. Thus, it is with the investors and the marketplace in mind that I encourage the powers that be to appropriate the monies necessary to permit the Commission to protect the public.
I also would encourage market participants to go beyond the requirements of the Sarbanes-Oxley Act in certain areas. For example, one of the major breakthroughs of the Act is the requirement that the members of the audit committee of the board of directors be independent. However, the SROs have gone beyond the requirements of Sarbanes-Oxley and proposed rules that would require all listed companies to also have compensation committees composed solely of independent directors and, just as significantly, that a majority of all of the directors of the board of a listed company be independent. I support this initiative and commend the SROs for their forward-thinking approach on this issue.
III. Investment Banking and Analyst Conflicts
Investment bankers wear many hats these days, including the roles of underwriters, capital providers, research analysts, investment bankers, investment advisors, and mutual fund managers. All of these functions currently operate under one roof at many banks. These various roles can, quite simply, create opportunities for the investment banks that are at odds with the interests of their clients and customers. These conflicts can have very significant financial consequences and raise serious questions about the banks' role as fiduciaries.
Two areas that reflect this apparent conflict of interest that have received quite a bit of media attention involve research analysts' conflicts of interest and conflicts that can arise in conjunction with IPO allocations.
Analysts' conflicts of interest, in a nutshell, raise the concern that analysts' research is improperly influenced by the pressure that analysts receive to issue positive research on specified companies in order to support the investment banking and underwriting business of the banks. Coupled with this pressure, analysts have often been compensated on the basis of the success of the investment bank's investment banking and underwriting businesses. The concern, of course, is that this sort of influence on the analysts impairs the quality and integrity of the analysts' reports, and can create a disincentive to provide independent research reports.
This issue has commanded significant attention in the last year and a number of initiatives have been undertaken to address the problem:
- On May 10, 2002, the SEC approved rules that had been proposed by the NASD and similar rules by the New York Stock Exchange to address analysts' conflicts of interest. The rules include restrictions on the relationships that are permitted between the investment banking and research departments of an investment bank. For example, the rules prohibit analysts from being subject to the supervision or control of the investment-banking department. Further, the investment banking department is prohibited from reviewing research before it is published except as necessary to verify factual information, and only then when the communications are made through a member of the firm's legal or compliance department.
- On August 2, 2002, the Commission issued a proposing release entitled "Regulation Analysts Certification," which, if adopted, would require that any research report circulated by a research analyst include certifications that the views expressed in the research report accurately reflect the analyst's views. The rule also would require the analyst to disclose whether he or she received any compensation or other payments in connection with the specific recommendations or views.
- On October 3, 2002, the Commission, together with the NY Attorney General, New York Stock Exchange, the NASD and NASAA (the state securities administrators) announced a joint effort to coordinate the investigations that these organizations had initiated with regard to analysts' research and IPO allocation concerns. Our cooperation with the states is very important. The states have a right and a duty to protect investors in their states and enforce their laws. At the same time, cooperation in our efforts will be critically important to achieving a swift and effective outcome. I exhort all of the parties involved to work together closely and collegially.
- Title 5 of the Sarbanes-Oxley Act addressed analysts' conflicts of interest and will form the template for some of the SEC and SRO rulemaking that we do in the future.
I can't discuss pending rulemaking proceedings or enforcement actions in detail. However, I can briefly outline some of the areas that will command our attention. The SEC and the SROs will need to harmonize the Sarbanes-Oxley Act with the other initiatives that have been undertaken to determine how we can best arrive at rules that fully satisfy the mandates of the Sarbanes-Oxley Act and build on some of the initiatives that were started earlier this year. Sarbanes-Oxley provides many protections from analysts' conflicts. For example, Sarbanes-Oxley:
- Restricts the prepublication clearance or approval of draft research reports by the investment banking side of the firm;
- Limits the supervision and compensatory evaluation of securities analysts by the investment bankers; and
- Prohibits the retaliation or threatened retaliation against analysts for unfavorable research.
The current rule proposals and those mandated by the Sarbanes-Oxley Act certainly will occupy much of our time and energy and require very careful consideration. We also must take on what arguably is a more delicate task. This is to step back from the specific rule proposals and look at the problem of investment banking conflicts of interest through the broader lens of restructuring. Clearly, the issue of the day is whether the research analysts' function should be broken off entirely from the investment banking and underwriting functions or whether they can stay under the same corporate umbrella.
I am not participating in the ongoing day-to-day discussions with the industry directed at reaching a broad comprehensive settlement. The SEC is ably represented by its enforcement staff and the states are represented by their appropriate officials and their staffs. My comments today are offered as encouragement and are not meant to divert any ongoing efforts. I would encourage the industry to think broadly and use this opportunity to impose "tough love" on itself. If the industry can fix the analyst-research conflict through its own accord or a process in which they participate, the industry will receive enormous benefits from helping to restore investor confidence in the securities markets, which will lead ultimately to more investors returning to the market and providing more business for the securities firms.
In considering a restructuring of the research analyst's function, it seems to me that there are a number of different ways to go. One way, which has received much attention is to require that research be broken off from investment banking and underwriting. If this approach is followed, it seems to me that it might not be enough to keep the research activity under the corporate umbrella of the investment bank even if it is a separate subsidiary and even if firewalls are imposed. Keeping research within the same corporate structure will continue to present the problem of the appearance that the research analyst is more lenient toward the companies that are clients of the investment banking side of the house.
Instead, if the separation approach is followed, research that currently is within the investment banks' corporate structures will be spun out and be independent if they exist at all. One possibility in this approach of separating the research function would be the creation of an independent cooperative formed by Wall Street firms that would hire analysts to produce specific reports that are funded by annual payments made by the cooperative's member firms. Unfortunately, the cooperative would still have the disadvantage of conveying the appearance of being operated by investment banks and presenting, albeit more subtly, the same conflicts.
The logical extension of the separation of research idea would be, alternatively, a truly independent research body sort of a "utility" that is not beholden to any issuer or any bank. Such a research utility could be operated by mandatory contributions from issuers and investment bankers and possibly operated by one of the SROs. A major criticism of spinning the research function from the investment banks and creating an independent research body is that we would run the risk that two separate classes of research would be created one being inferior and which would be provided to the small investor and the superior research that would continue to be conducted by the investment banks and be available only to their larger clients. It is likely that funding and appropriate incentives for research could be fashioned to deal with that concern.
An entirely separate solution would not require the "spinning" of research from investment banking at all. This alternative would have the advantage of leaving the industry structure mostly alone and letting the market place work things out.
Under this alternative, the SEC through the SROs could impose the requirement of an independent analyst's rating of issuers' securities. The basic idea is that an issuer, ideally through its audit committee, would hire an independent research analyst to evaluate and rate its stock and maintain periodic coverage of the stock. "Independent" would be defined much as in Sarbanes-Oxley and the SRO rules, and essentially would require that the independent research analyst not be beholden to investment banking or the issuer, apart from the fee paid. While this research would not be perfectly independent because it would be purchased by the issuer, the independent research firms would serve a role and be in a similar situation as are the independent rating agencies, independent property appraisers, and, of course, the independent auditors all of whose fees are also paid by issuers.
We would need to ensure that structural changes, including those proposed by the SROs, are implemented. These include prohibiting the investment banking side of the firm from controlling analysts' compensation, prohibiting investment banking from having veto or review authority over research, prohibiting retaliation against analysts for issuing negative research, and prohibiting analysts from being used as a marketing arm for the investment banking and underwriting sides of the firm. These should not be merely advisory rules but real rules with real consequences for their violation.
In support of the independent analyst rating idea, the SROs could provide a mechanism for determining which analysts would qualify as independent. Under this approach, other existing research performed by investment banking and by other sources could continue. However, a necessary part of this approach would be the requirement that research from the sell side be prominently labeled as "Marketing Materials" and with a "Buyer Beware" label. This so-called toxic label or the "Skull and Cross bones" label would help ensure that customers understand the conflicts inherent in research from full-service investment banks, and that they have the opportunity to weigh the credibility of the research in light of the conflicts. The market would determine the ultimate pricing and qualifications for the independent analyst rating. Presumably, the audit committees of the various issuers would insist upon quality work from capable independent research analysts to properly present their companies.
Obviously, important details would need to be fleshed out with these ideas. These thoughts that I have shared with you today are meant to be a thoughtful discussion of the subject and meant to identify the boundaries of the various possible solutions. It may well be that the parties in the ongoing settlement discussions determine to adopt an interim approach in which the parties themselves agree contractually with the authorities to create and fund a new structure for a period of time. Again, I encourage the industry and interested parties to seize the moment and eradicate this area of conflict. Restoring confidence of investors is ultimately good business.
IV. IPO Allocations
As with the area of analysts' conflicts of interest, IPO allocations have received significant attention in the last year and will continue to do so in the future. The idea that underwriters have used the IPO allocation process to garner undisclosed and often very significant benefits for themselves is unconscionable.
In January of this year, the NASD and the Commission charged Credit Suisse First Boston with siphoning tens of millions of dollars of their customers' profits in exchange for allocations of "hot" IPOs. In that action, CSFB agreed to pay $100 million in disgorgement and civil penalties.
In the end of July of this year, the NASD's board of governors issued proposed rules of conduct for IPO activities. The proposed rules would prohibit:
- Quid pro quo agreements whereby IPO shares are allocated in exchange for excessive compensation relative to the services provided by the underwriter.
- Laddering agreements whereby the underwriter solicits aftermarket orders in consideration of granting shares in hot IPOs.
- Spinning arrangements whereby the underwriter allocates IPO shares to an executive officer or director of a company on the condition that the officer or director give the company's investment banking business to the investment bank that underwrote the offering.
After the proposal of the new rules by the NASD, Chairman Pitt in August of this year announced an initiative designed to take a broad look at the IPO allocation process to determine where changes are called for. Under this initiative, the NASD and the NYSE named a leading group of industry professionals from the public and private sectors including those from private industry, investment funds, investment banks, law firms and academia, to act as an advisory committee to the SROs. After receiving the recommendations of the IPO Advisory Committee, the NASD and NYSE will make recommendations to the SEC. This will take a close look at the IPO process, including allocations of IPO shares and the price-setting process.
As with the analyst independence initiatives that are underway, I cannot comment on any specific proposals relating to IPO allocations. I will say, however, that I take extremely seriously the fiduciary duties that underwriters have to their customers and believe any rules that are adopted must at a minimum address the fundamental unfairness that appears to have existed in the IPO market in recent years.
- If underwriters are intentionally under pricing securities in their initial offerings, they take value away from their client the issuer and that is unacceptable. Underwriters need to be held responsible for the pricing matrix that they use. I think we need to closely evaluate the pricing mechanisms used in firm-commitment offerings to determine if there are structural problems that disadvantage the issuer and the aftermarket participants and disproportionately benefit the underwriters.
- If underwriters manipulate the price of an issuer's stock in the aftermarket so they and their favored clients can reap secret profits, that is unacceptable.
- If underwriters use the allocation of "hot" IPOs to their favored clients to gain advantage for themselves for example, in the form of investment banking services, "wash" trades, or other economic gains, that is unacceptable. One of the first items of business and this goes to the pricing issue I mentioned above will be the need to carefully examine why the IPOs of the late 1990s were so hot.
I believe that, at a minimum, senior executives of issuers have a fiduciary duty to disclose to the Board of Directors if they have or will receive any allocations of IPOs of other companies. Too often, these allocations appear to have been made in exchange for corporate favors such as granting future investment banking work to the underwriter's firm. To the extent individual officers or directors benefit personally as a result of their ability to direct corporate business, that is a benefit that the executives have a fiduciary duty to disclose to their boards. If the boards approve the allocations, then there still is a very real issue as to whether the money made by the executives must be disclosed to shareholders. I believe these profits on sale should be disclosed as indirect compensation under Item 402 of Regulation S-K and/or as a related-party transaction under Item 404 of Regulation S-K. Frankly, even if, under the particular circumstances, disclosure does not appear to be required by the letter of Items 402 and 404, it is information that shareholders should have and it should be disclosed if the profits are material. This is a matter that I think deserves close attention as part of our larger review of the IPO allocation problem. In the same vein, mutual fund executives and directors should disclose to their boards and shareholders if they will receive any IPO allocations from the underwriter. Allowing the light of day to shine on IPO allocations with pubic disclosure to shareholders should keep everyone honest.
V. ECN Access Fees
Another issue that I would like to mention, at least briefly in our limited time today, is the topic of ECN access fees. ECNs are subject to today's invigorated competition but some might argue that the fees they charge to access their quotes are not. Brokers must try to get the best price for their customers even when the best price is offered only by an ECN. Because brokers often have little choice but to pay whatever fee is charged by the ECN, competitive pressures on these fees have been all but paralyzed. Nasdaq market makers, by contrast, may not charge fees to access their quotes. In this regard, ECN access fees have stood alone in an otherwise fee-less arena. It is not surprising then that ECNs have decried Nasdaq's proposed imposition of access fees, despite defending their own. Wrapped into this issue of ECN fees is the question of failure to pay and denial of access.
To more accurately reflect the net price in the quote, I believe the Commission should consider whether ECN fees that are small in relation to the quoting increment should continue to be charged separately, instead of being reflected in the quote. In particular, ECN fees of over half the quoting increment- ½ cent or even more could be included in the quote, with the ECN quote rounded to the next penny increment, while ECN fees of ½ cent or less could be charged separately in addition to the quote. This approach would avoid reducing the ECN quote a full cent due to a relatively small ECN fee. At the same time, it would reflect in the ECN quote larger ECN fees, which could make the net ECN price only marginally better, or even worse, than the next best displayed price.
Under this approach, the ECN quote would more accurately reflect the net price available to non-subscribers from the ECN. 1 Although allowing small ECN fees to be charged separately from ECN quotes would reduce to some degree the full comparability of ECN quotes to other quotes, the dissimilarities would be limited by the small size of the separate fees relative to the penny quote increment. This approach also would reduce the impact on the quotation spreads of including all ECN fees in the ECNs' quotes, and would make the ECNs' displayed quotes more closely approximate their prices net of fees. As a result, the ECN displayed quotes would more accurately reflect opportunities for best execution. The alternatives to this proposal include eliminating the fees entirely or rounding all ECN fees into the quote. I have not reached a conclusion on either of these alternatives and merely offer the middle ground proposed above as a starting point. Again, I hope the market structure hearings to be held October 29 (next Tuesday) in Washington, DC, and November 12 in New York will provide a forum for discussion of this issue and encourage comment on this issue.
All the issues I discussed today, and many I did not, merit close attention. In addressing the issues, we must take appropriate steps to ensure integrity and fairness in the marketplace.
My job as a Commissioner is to represent all investors in America and to ensure the integrity of the financial markets. I have been blessed or cursed to serve at a time when the rules of how America does business are being rewritten and redefined. The product of the SEC will likely govern the conduct of business in America for the next fifty years or more. I will work constantly to make sure that both individual investors and the securities industry are fairly treated in the rules that we adopt and the new laws that we implement. I want to help create an environment where individual investors are treated fairly and the securities industry provides a level playing field in which to prosper when honest and fair services are provided. In discharging my new duties, I will never forget where I came from or the simple values of working people like my father honesty, hard work and service.
I will return your phone calls. Please know that I value your ideas and want to know your concerns.
1 Moreover, the ECN fee could be offset against any better undisplayed price in the ECN at a smaller increment than a penny in calculating whether to round the ECN's quote to the next penny because of the fee to be charged.