Speech by SEC Commissioner:
Remarks Before the Securities Industry Institute
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
The Wharton School
Philadelphia, Pennsylvania
March 6, 2006
Thank you, Ted, for that kind introduction. It is a privilege to be here with all of you today. We at the Commission like to emphasize the important role that education plays in the proper functioning of the securities markets, and we generally focus on issues involving investor education. With the Securities Industry Institute program, the SIA underscores the importance of education for securities industry professionals. While the investing public relies on the SEC to be the ultimate watchdog of the securities markets, the public places their trust in professionals like you — and your firms — on a day-to-day basis. I applaud you for being here to deepen your knowledge of the securities markets — and I applaud your firms for sponsoring your education here.
I plan to talk about three topics today — some recent initiatives undertaken by the Commission, the SEC's agenda as we look ahead in 2006, and what we are learning from actions taken by the agency in the recent past. Before I begin my remarks, and to keep my own compliance people happy, I must tell you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
I am optimistic about the direction in which the Commission is heading. As you know, Chairman Chris Cox came to the Commission from the U.S. House of Representatives in August of last year. He has brought to the agency a new spirit of leadership, collegiality, and a sense of cooperation and mutual goal-setting that he honed through years of working in the House. He is an insightful, engaged, and enthusiastic leader. Under Chairman Cox's leadership, the Commission has been busy on a variety of projects.
Just last week the Commission approved the proposed merger between the New York Stock Exchange and Archipelago. That transaction will be consummated tomorrow, and soon the Commission will be considering the NYSE's planned "Hybrid" automated trading system. Between the merger and the Hybrid system, the NYSE is proposing drastically to transform itself from the member-owned, floor-based model that it has utilized for over two hundred years. On a related, but no less important note, five years after it filed its application, Nasdaq finally achieved registration as a national securities exchange in January.
Also in January, the Commission unanimously issued a statement setting forth certain principles regarding the imposition of penalties against corporations. As you no doubt have seen over the last few years, SEC penalties in financial fraud and other cases have often been one hundred million dollars and more. In the penalty statement, we stated that a determination on the appropriateness of a corporate penalty would turn principally on two considerations: (1) the presence or absence of a direct benefit to the corporation as a result of the violation, and (2) the degree to which the penalty will recompense or further harm the injured shareholders.1
We recognized that, "If the victims are shareholders of the corporation being penalized, they will still bear the cost of issuer penalty payments (which is the case with any penalty against a corporate entity)."2 That is a critical acknowledgement that has been all too often lost in recent years. In financial fraud cases, shareholders, who are the ultimate owners of the corporations on which we impose these penalties, may already have been punished through reputational and stock-price damage to the company. I am pleased that the Commission, true to congressional intent behind the Remedies Act of 1990, has now publicly committed itself to a more rational and systematic approach to deciding whether to impose penalties on shareholders.
Another January initiative was the SEC's rule proposal regarding the disclosure of executive compensation. The proposals would refine the currently required tabular disclosure and combine it with improved narrative disclosure, including a new Compensation Discussion and Analysis section. Companies would provide a total compensation figure for each of the named executives. Executive compensation disclosure would be organized into three broad categories: compensation over the last three years, holdings of outstanding equity-related interests received as compensation that are the source of future gains, and retirement plans and other post-employment payments and benefits. There would also be enhanced disclosure about related person transactions, director independence, and other corporate governance matters.
I was working for Chairman Breeden in 1992 when the last major overhaul of executive compensation disclosure took place. In the ensuing years, some critical holes in compensation disclosure have developed and become apparent. I hope the proposed rules will address those problems in a manner that will give shareholders better information for their investment decisions without imposing unnecessary burdens on issuers.
A hot topic on the Commission's radar screen this year is the structure of our self-regulatory system. Actually, this has been a hotly debated topic for the SEC since the agency was created in 1934. But recent initiatives undertaken by the Commission, as well as fundamental market structure changes such as the NYSE/ARCA merger and Nasdaq exchange approval I mentioned earlier, have really brought the issue to the fore.
One year ago, the Commission issued a concept release concerning self-regulation and requested public comment on the various issues raised in that release. The genesis of the concept release was the rise of for-profit, shareholder-owned self-regulatory organizations — or SROs — as well as recent failures by SROs to satisfy their statutory obligations. The latter point was accentuated by the NYSE's April 2005 settlement of SEC allegations that the exchange failed for years to police fraudulent and pervasive proprietary trading by its member specialist firms. And, lest we think that one premier SRO is better than the other, the Commission found early last year in a report of investigation (that means we thought it was important to make the point publicly but we did not bring charges) that the NASD, and certain non-SRO affiliates who were delegated some of the NASD's SRO responsibility, failed to properly oversee fraudulent trading activity by a member firm.
Besides the two major SROS, the NYSE and the NASD, there are several other, smaller SROs — generally the AMEX and the regional stock exchanges. SROs are overseen by the SEC, and each SRO has a broad mandate under the Exchange Act to oversee its members' activities, and the activity on its market. Congress created the SRO structure in the Securities and Exchange Act of 1934 Act, and has supported the structure in subsequent legislation such as the 1975 securities law amendments. One key rationale of this system, and one with which I particularly agree, is that the markets can generally regulate more efficiently and effectively than the federal government. In light of the recent SEC enforcement actions and the rise of for-profit markets, however, many have called for a complete restructuring of the SRO system.
The SEC's SRO concept release sought comment on several alternative regulatory approaches. I will not bore you with a description of each, but the changes range from "tweaks" of the current system, to an abolition of SROs that would result in direct SEC regulation. I am not here to promote one of these options over the other, but I do agree with the sentiment expressed recently by John Thain, the CEO of the NYSE, in a WSJ article when he recognized that steps must be taken to address "redundant rules and examinations that brokerage firms currently face." I look forward to the debate regarding Mr. Thain's proposed joint venture between the NYSE and the NASD, as well as other approaches to the duplication problems experienced by member firms.
To be sure, regulatory duplication is not the only reason that the Commission should be addressing SRO structure issues. While very important, that issue has actually been on the table for decades. No, the major impetus for Commission action should be the recent shift to for-profit marketplaces. In the new paradigm, public companies own exchanges, and often the exchange itself is a public company. What hasn't changed is the SRO status, and the attendant obligations, for each registered exchange. To fulfill their SRO obligations, these public-company, or public-company-affiliated, exchanges can utilize distinct, non-profit regulatory entities. In the case of the NYSE and Nasdaq, those entities are NYSE Regulation and the NASD, respectively. Pursuant to contract, these regulatory entities have been delegated much or all of the exchanges' SRO duties.
This paradigmatic shift in SRO structure has created a very real potential for conflicts between and among the various SRO affiliates. For example, within the NYSE structure (at least the structure that will be implemented starting tomorrow), a public company, the NYSE Group, will be the holding company for the stock exchange, NYSE Market, Inc., and NYSE Regulation. NYSE Regulation will be delegated the SRO duties, and will be funded — properly funded according to the NYSE — by the exchange, the public company, and by the "member and regulatory fees" it collects.
Despite certain safeguards that were put in place to ensure the independence of NYSE Regulation, such as an independent board of directors, there remains the potential for conflicts of interest in the NYSE structure. Similar conflicts are inherent in the Nasdaq structure.
One major conflict for both the NYSE and Nasdaq groups is the use of penalties. NYSE Regulation and the NASD (on behalf of Nasdaq) may levy penalties against member firms. Both the NYSE and Nasdaq have stated that they will use the penalties only for "regulatory purposes." We all know, however, that money is fungible, and that the penalty money flowing into "regulation" could theoretically be financing expenditures that would otherwise have to be paid with other public company funds. You can see where I am going here — images of a police officer driving a forfeited Porsche start to come to mind.
Regardless of whether the penalties replace funds that would otherwise come from the public company or are used for legitimate regulatory purposes, the Commission should take a hard look at how the NYSE and Nasdaq groups use penalty monies. To that end, as part of the NYSE/Archipelago merger approval, the NYSE has committed to filing a proposed rule with the Commission detailing its intended use of penalties. The NASD and Nasdaq have statements regarding their use of penalties, and we certainly will look at those also.
But that is only half of the conflict. Given the organizational structure of the NYSE conglomerate, revenues derived by the subsidiaries — including NYSE Regulation — will roll up on a consolidated basis to the public company, NYSE Group. That means that penalties collected by NYSE Regulation will roll up into the aggregate revenue calculations for NYSE Group. To extrapolate for a minute, that means industry measures of performance for the NYSE Group that take revenue into consideration, such as S&P indices, could inadvertently credit the NYSE Group for revenues — the penalty revenues — that have nothing to do with NYSE Group's business. This penalty-inflated revenue number could also be determinative of whether the NYSE Group satisfies the listing standards of the NYSE Market, where its shares will be traded — what an irony!
The Nasdaq group structure presents a similar issue with respect to penalties collected by the Nasdaq exchange. You can rest assured, however, that the Commission will be looking into this aspect of how the NYSE and Nasdaq groups use penalties. The Commission should ensure that these SROs have the appropriate rules and policies in place for the use of member penalties, and that the financial statements of their affiliated public companies appropriately reflect the status of such penalties.
The SROs are not alone as they try to manage the consequences of change. Sometimes it feels like we at the SEC have been playing the role of old man Scrooge in Dickens's famous tale, but unlike the progression in that story we are stuck with visions of "Regulations Past" instead of being able to move on to "Regulations Present" and "Regulations Future." Indeed, given the problems with prior regulations we promulgated (over my dissent), "Regulations Past" have become "Lawsuits Present" and, I presume, "Lawsuits Future." I hope that, as Scrooge did, we have seen the light and will make better decisions going forward.
One of the Commission's most problematic actions in the last few years was the promulgation of Regulation National Market System — or Reg NMS — last April. As you can guess, I vociferously dissented against Reg NMS. In my view, Reg NMS represents a massive regulatory intrusion into our secondary trading markets that was completely unwarranted, given the lack of evidence of market failure and the availability of substantially less intrusive means to advance those goals. Reg NMS has the potential to do significant harm to our markets by unduly interfering with the operation of the competitive forces that over the years have benefited investors immensely by reducing trading costs and increasing market efficiency.
However, dissenting from the adoption of Reg NMS does not in any way make me less interested in the implementation process. Quite to the contrary, I intend to be fully engaged in the process to ensure that the rules are implemented in the least burdensome and most cost-effective manner possible and to limit their potential harm to our markets' competitiveness. I am grateful that the SIA and other market participants have been providing crucial feedback to the Commission on Reg NMS implementation, and I must say they have given us a good deal to think about.
In a nutshell, the Reg NMS rules fall into four categories: (1) the trade through rule (it is an understatement to say that the appellation "Order Protection Rule" is a misnomer); (2) the access rule; (3) the sub-penny rule, and (4) the market data rules. Some of these rules are certainly more problematic than others.
The first compliance date for the heart of Reg NMS — the trade-through rule and market access rules — is June 29, 2006. When you think of the many interdependent elements involved, the Commission majority at the time set a naively ambitious timetable for the implementation of Regulation NMS. A lot needs to get done before the rules can take effect. Specifically, the Commission needs to issue a great deal of interpretive guidance and take action on a host of SRO and NMS Plan rule proposals. SROs and the SIPs need to develop specifications and code changes to their systems. Broker-dealers need to revise their own systems and develop compliance policies and procedures. Industry-wide testing needs to occur to ensure that all the pieces work individually and together. Industry participants also need some live working experience with new SRO rules, SIP processes, and concepts introduced by Regulation NMS, in particular the intermarket sweep order.
If our experience with the implementation of the first two pieces of Reg NMS — the prohibition on subpenny quotations and the reduction in the Regulation ATS fair access threshold — are any guide, the implementation process will be a challenging one for the industry and Commission alike. These first two pieces of Reg NMS were supposed to be the easy parts to implement, hence their original compliance dates of August 29, 2005. Mind you, these rules required minimal systems changes. Yet when market participants looked closely at the implications of the rules on their business processes, interpretive questions arose, which delayed both the implementation of the Regulation ATS threshold and the subpenny prohibition.
When the deadline for subpennies rolled around on January 31, it was hardly a surprise when we learned that several exchanges were not prepared for the subpenny implementation — they could not support subpenny trading in stocks priced under $1. With the locked/crossed market rule not yet implemented, the exchanges' inability to trade the stocks in subpennies has resulted in many locked and crossed situations. Will this be a harbinger of things to come?
This problem is compounded by the current regulatory environment, in which the industry is extremely concerned about being second-guessed with 20-20 hindsight by regulators. As a result, the industry is looking for as much particularized guidance as possible on the various elements of Regulation NMS.
The trade-through rule presents the most interpretive issues for the industry. For the trade-through rule, the two general areas where the clamor for interpretive guidance has been the loudest so far are: (1) how the various exceptions to the rule will operate; and (2) what are the compliance requirements generated by the rule.
With respect to exceptions, questions have primarily been raised regarding the use of the self-help exception, the operation of the intermarket sweep exception, and the content of the benchmark order exception. SEC staff recently issued some guidance, but this tends to raise more questions than it answers.
The self-help exception is intended to allow trading centers to bypass otherwise protected quotations of automated market centers that are inaccessible for whatever reason, usually systems failure. Left unanswered in the adopting release is exactly when trading centers can avail themselves of the exception — for example, how many attempts do they have to make within what time frame before bypassing a particular quote? Did the staff's interpretive guidance provide sufficient comfort to market participants that they can use the exception as circumstances warrant to get around non-responsive quotes in their order-routing and execution strategies?
The intermarket sweep exception is another area where firms are asking for additional guidance. The exception is critical to the operation of the rule as it allows trading centers to have assurance that their execution of any particular order does not result in a violation of the rule. As a result, intermarket sweep orders, or ISOs, will likely become the primary order type in the market place after the implementation of the rule. That is certainly a curious turn of events, because the intermarket sweep exception was originally conceived as a work-around when the SEC staff and then Commission majority acknowledged that a pure order-by-order trade-through rule would not work on a modern, market-wide basis. It is crucial then that we tread extremely carefully in our interpretation of this exception and the parameters of this order type so as to not unduly interfere with the flexibility of trading centers to structure their operations in response to customer needs and competitive realities.
The benchmark order exception is intended to allow for the continued execution of orders that are executed without reference to the current market price. While the release focused on VWAP executions as an example of a benchmark order, little was said about other executions that could qualify for the exception.
The second major set of interpretive issues around the trade-through rule relates to the expected content of a trading center's policies and procedures to prevent trade-throughs of protected quotations. I hope that the staff guidance answered many of the questions on policies and procedures, but I understand that there are lingering issues. For example, is it clear that firms would be considered to have appropriate compliance procedures if they reasonably sampled trading activity for compliance with the rule and maintained such records?
With respect to locked and crossed market restrictions, I have heard some in the industry voice concerns that they will be subject to materially different rules and compliance demands from the various SROs through which they conduct business. It is my current understanding that the staff is encouraging the SROs to take a largely uniform approach to this rule and to submit similar proposed rules restricting locked and crossed markets.
While such an approach may reduce the likelihood that firms will be subject to widely differing regulations and compliance requirements, the Commission also will have to be careful that in dispensing final interpretive guidance it is not forcing markets' operations into a one-size fits all approach. This type of approach could very well have adverse effects on innovation.
Another observation worth making here is that it would benefit the SROs to make their Reg NMS implementation plans known to their membership as early as possible to eliminate potential confusion and to allow members to get on with their own implementation efforts.
As for access fees, Reg NMS limits the fee charged with respect to the execution of an order against a protected quotation or the best bid or offer of an exchange, Nasdaq, or NASD to $0.003 for NMS stocks priced above $1.00. I have not heard much at all from the securities industry so far about implementation issues related to the access fee restriction, but I assume the silence on this issue simply reflects the fact that other matters have taken precedence. I have no doubt that issues will arise regarding this restriction.
Nasdaq's pending proposal to prohibit ECNs from directly charging an access fee on its market raises the question whether prohibiting access fees would implicate the Exchange Act prohibition on SROs fixing their members' commissions. The Commission's majority avoided the question in approving Nasdaq's existing $0.003 access fee cap by stating that since access fees could be charged at any rate below three mils, the proposal did not fix a particular commission rate. The result reached in the Nasdaq rule proposal could have implications for how access fees are charged and collected in a Reg NMS environment.
On the market access requirements, it appears that the current ITS Plan participants are working on a stop-gap measure to utilize the ITS infrastructure (without the ITS governance provisions) as a voluntary means for routing orders among the listed markets once Reg NMS goes into effect. It will be interesting to see how the volume transacted through this proposed interexchange linkage will compare to the volume through ITS today. And, I will be interested to see whether private linkage systems will be as prevalent in the listed space as in the Nasdaq space once automated access is available across the markets trading listed stocks.
You have been a very patient audience, and I appreciate your attention. I welcome your active involvement in the issues I discussed today, and all of our issues. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thanks again for your time and attention.
Endnotes
http://www.sec.gov/news/speech/spch030606psa.htm
