Speech by SEC Commissioner:
Eighth Annual Conference on The Practical Implications of SEC Regulation Outside the United States
by
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
London, England
February 17, 2004
Thank you. It is a pleasure to be here although, as much as I love visiting England, I wouldn't normally choose to visit in February. In fact, during the three years that we lived in Cambridge, we always tried to leave for warmer, sunnier climates in February. But it's a break from the freezing winter we are having in Washington.
Before I begin, I must give the standard disclaimer that the views I express today are my own, and do not necessarily reflect the views of the Commission or its staff.
I have been a Commissioner for two years now, and it has certainly been an eventful time. We have learned a number of lessons, and have become all too familiar with the recipe for financial market disasters. The key ingredients include greed, conflicts, compliance failures, complacency, complicity, and lack of transparency. We have taken a number of steps to combat all of the problems and will be watching carefully to see if we have been effective in carrying out our mission to protect investors and promote efficient capital markets.
When it comes to greed, I know we can't change human nature. But I think it's important to change incentives and disincentives, so that greed can be channeled in a better direction. To encourage the integrity and transparency of corporate financial reporting, we have adopted rules requiring the certification of financial information in companies' periodic reports by CEOs and CFOs, better disclosure of off-balance sheet arrangements, restrictions on the use of non-GAAP information and a management report on internal controls over financial reporting. And certainly there is a clear trend towards the ratcheting up of civil and criminal sanctions. Prison time for securities violators may be the ultimate deterrent to fraud, but more aggressive pursuit of disgorgement, higher civil penalties, and the wider imposition of officer and director bars in SEC enforcement actions will surely have a deterrent effect as well.
Regarding conflicts, I would encourage firms to identify and understand the financial conflicts in their businesses, eliminate them to the extent possible and, for those that can't be eliminated, manage and disclose them to customers. The Commission's global analyst settlement, the auditor independence requirements, the audit committee independence requirements contained in NASD and NYSE listing criteria, and mutual fund disclosures are all meant to address conflict issues.
One of the best vehicles for instilling ethical procedures and preventing fraud is a strong compliance function. That requires more than lip service. It requires money, staff, training programs, and - most important the backing of senior management to instill the right culture. Our "up-the-ladder" reporting rules for attorneys practicing before the Commission, and the requirement that mutual funds have a compliance officer reporting directly to the board fall into this category.
Complacency, especially on the part of boards of directors of public companies and mutual funds, seems to have enabled a number of financial scandals. It appears that some boards were far too accepting of the information they received from management and did not ask the tough questions that real diligence requires. Our focus on board governance overall, and independence in particular, is meant to address this issue. And we have and will continue to take enforcement actions against boards when warranted.
Complicity, in my view, is one of the most disturbing aspects of the frauds we've seen. To my mind, complicity connotes an active willingness to be involved in a fraud. To get at this, we have focused on a company's internal controls. We've also taken enforcement action against certain external entities involved in frauds, including, for example, some of the big banks that assisted Enron in misleading shareholders about its financial condition. And we recently charged a person associated with a bank for his alleged involvement in providing financing to some of the late traders and market timers in the mutual fund investigations.
And last, but not least, is the importance of transparency. We have been working hard to expand and improve disclosures in a variety of ways, and I will have more to say on these initiatives a little later.
Your program for the rest of the day will focus on how we expect you and your clients to implement our new requirements, so I will leave the details to my colleagues who are speaking later.
What I would like to focus on is what remains to be done - so I will now turn to the challenges for the future. We need to reassess our rules in the context of a continually changing environment. Some rules may have simply outlived their purpose. For example, Rule 12b-1 fees, the fees used by mutual funds, in large measure, to pay broker-dealers to distribute their funds, may have outgrown their original purpose of promoting the growth of the nascent mutual fund industry some 25 years ago. As a result of the conflicts in some of these distribution arrangements, we put out for comment last week a proposal to amend Rule 12b-1 to ban the directed brokerage practices that have become commonplace and at the same time we requested comment on the advisability of eliminating the rule entirely.
Advances in technology also require us to re-examine the fairness and effectiveness of our rules. Very shortly, the Commission is going to be considering a number of market structure proposals, including the controversial trade-through rule currently in effect in the listed markets. A broker is not supposed to execute a customer's order in one market when a better price is available in another market. But the emergence of automatic execution by electronic communication networks ("ECNs") competing with traditional manual markets has complicated the situation, to say the least. While the purpose of the rule was to protect limit orders, the problem is that the rule requires the ECN to wait the 30 seconds it takes the floor-based specialist to respond. That might not have seemed like a very long time in 1978 when the rule was adopted, but it's an eternity today. And if the market moves during that 30 seconds, the specialist may decide not to execute the order. Best execution has come to mean different things to different customers. Many customers value the split-second speed and certainty of execution offered by the ECNs over - not a certain better price, but simply the possibility of a better price -- on an exchange.
Another reason for reassessment is that some statutory provisions may be being abused, for example, soft dollars. The Exchange Act contains a safe harbor for investment managers to pay up for research and other brokerage services. Over the years, some managers have stretched the definition of "research" to include products and services having little or no relation to the manager's investment decision-making process such as the adviser's overhead costs. Another serious problem in this area is the lack of transparency regarding the uses of soft dollars.
Other rule changes have affected existing rules. Decimalization has resulted in narrower spreads, but decimalization has exacerbated the practice of "stepping ahead" of or "pennying" customer orders, where market participants submit orders that better a displayed quote by an insignificant amount.
In these situations in which the status quo does not work, we need to recognize this and consider appropriate changes promptly.
Within our overall mandate to protect investors, we also need to recognize the impact of our rules in a global marketplace. And we need to come at this from two perspectives. One is whether existing or new rules do or will reduce U.S. companies' ability to compete in world markets. The other is whether our rules will make it unattractive for foreign companies to issue securities in our markets. The members of this audience have first-hand knowledge of these practical implications, and I welcome your constructive feedback on issues such as our attorney "up-the-ladder" rule and the Section 404 internal controls rule that have been particularly controversial.
We also need to recognize that we shouldn't write rules just because we can. Writing rules is easy. Writing good rules is hard. And writing no rules in this environment is even harder. We need to focus on whether the rule is a real solution to a real problem, not window dressing, not form over substance and, most importantly, not counter-productive.
Looking ahead, we need to revisit the SEC's oversight role in three specific areas. First, we need to take a fresh look at the SROs -- the securities industry self-regulatory organizations such as the NASD, the New York Stock Exchange and the other exchanges. There are advantages and disadvantages to each of the current self-regulatory models - the NYSE model, with market and regulatory functions combined in a single entity, and the NASD/Nasdaq model, in which regulatory and market functions are separated within a holding company structure. We need to look at ways in which conflicts of interest can be minimized, and we need to be open to new options and new solutions. I'm sympathetic to ideas about consolidating SRO regulatory functions. I'm also interested in exploring the creation of one or more independent entities - somewhat akin to the Public Company Accounting Oversight Board -- that would carry out the SROs' regulatory functions, but without the "self" -- it would be an SRO without the "S"! Whether organized as an affiliate of an SRO, but operating under separate management, or an entirely separate entity, such a body would operate subject to SEC oversight. Under the current SRO models, competition appears to have acted to minimize regulatory costs. Under the ideal model, a competitive regulatory apparatus would maximize regulatory effectiveness.
Second, we need to reconsider our oversight of the NRSROs, the nationally recognized statistical rating organizations better known as the credit rating agencies. The Commission put out a concept release several months ago, raising a number of issues - both procedural and substantive -- regarding the Commission's role in designating and overseeing credit rating agencies. Our staff is analyzing the comments we've received. I look forward to a discussion of the scope of the Commission's role with respect to rating agencies, including consideration of a more transparent designation process for rating agencies and a more effective plan for Commission oversight of their operations. We're not interested in second-guessing the agencies' ratings, but if we provide an NRSRO designation, we should ensure that their procedures are fair and reasonable, and that any conflicts in their operations are addressed appropriately.
And third, we are discussing extending our oversight of hedge funds. As part of a staff study, the staff of the Division of Investment Management recommended that the Commission consider rulemaking that would require hedge fund advisers to register with the Commission as investment advisers. I have been vocal about my concerns about such a proposal. I don't doubt that there are aspects of hedge fund activity that would benefit from scrutiny. But it is not clear that registration and the concomitant inspection process is the way to do it. Since hedge funds are vehicles for high net worth individuals and institutions, hedge fund investors presumably have the wherewithal to conduct appropriate due diligence. If fraud occurs, we have our normal enforcement powers. I wouldn't want to dilute and divert the limited resources we have to devote to the inspection of mutual funds that are the primary investment for Mom and Pop investors. And I wouldn't want to mislead investors into thinking that SEC exams of hedge funds give them a good housekeeping seal of approval. So stay tuned on this one.
Another important challenge is the continuing need for clarity of disclosure. Complexity and opacity hide problems. The result is not only that people don't understand what is happening, they don't ask appropriate questions. There are a number of possible reasons for this - they're not paying attention, don't know what questions to ask, or fear that they will look dumb. Ultimately, as with the Emperor's new clothes, though, someone finally points out the naked truth. Examples of this phenomenon include the use of special purpose entities to hide financial frauds, the impact of derivatives and their complex accounting treatment on financial reporting, and inappropriate compensation packages. By contrast, clarity and transparency promote better behavior. People think twice about what they are doing if the naked truth is staring them -- and the rest of the world -- in the face.
Specific examples of what we are doing in the disclosure area include our new interpretative guidance on Management's Discussion and Analysis in company filings, our new proposal for disclosure in connection with mutual fund purchases through brokers both at the point of sale and on confirmations, and our new rule requiring disclosure in shareholder reports of expenses per $1,000 invested in a mutual fund. We take these disclosures very seriously and, on behalf of your clients, so should you. These are not technical requirements to get around. They are meant to convey useful information to investors. As Alan Beller, the Commission's Director of Corporation Finance, and a lawyer himself, has said on several occasions, "Disclosure is too important to be left solely to lawyers."
Which brings me to the next challenge, one that is very near and dear to my heart - Investor Education. Survey after survey shows that investors at all stages of life are woefully lacking in the knowledge needed to make sound investment decisions. I assume that the same is true in Europe. As part of our continuing efforts to educate investors, I am particularly excited about the role of our new investor education fund set up under the analyst settlement. Another of our recent initiatives is to use the notice-and-comment portion of our rulemaking process as an opportunity to reach out to educate investors. For example, we recently voted to put out for comment a rule proposal that would require brokers to give specific new disclosures about costs and conflicts of interest to investors when they purchase mutual funds, 529 plans and variable annuities. We will use the proposed rule as a springboard to help educate investors about issues critical to making good investment decisions. Further, with other federal agencies, the Commission is also a participant in the Financial Literacy and Education Commission set up by Congress in 2003 to encourage government and private sector efforts to promote financial literacy and coordinate the financial education efforts of the federal government.
To conclude, the final challenge is perhaps the most difficult one. We need to figure out the right way to incent all of our constituencies to put investors first. What I am talking about is complying with the spirit as well as the letter of the law - focusing on accounting objectives, not just rules, having boards of directors take their fiduciary responsibilities to shareholders seriously, having attorneys counsel their clients to make financial disclosures clear, not bury important disclosures in boilerplate and legalese to avoid litigation. We've made the point with enforcement actions, taking action against issuers whose financial disclosures technically complied with GAAP, but overall painted an inaccurate picture of the company's financial condition, and we're trying to make the point with corporate governance requirements.
I'll close with a true story. In my former life as a consultant on risk management, I met with the CEO and senior management of a client to help develop a risk management group. At the first meeting, I asked each of them to articulate their vision of the mission of the new group. The CEO answered first. He said, it's very clear. The mission is to make sure we do the right thing. There were a few moments of silence, and then the rest of the group started asking: The right thing for whom? The company? The employee? The customer? The community? The shareholders? Clearly, the answer wasn't quite so obvious.
We at the SEC are expecting our constituencies - whomever they are and wherever they may be - to do the right thing. And what that means is perfectly clear - the right thing for investors within an ethical framework. As corporate attorneys, your client is the corporation and your job, as I see it, is to help your clients do the right thing for their investors. That is my challenge to you.
Thank you.
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