5 March 2005 – LAWFUEL – The Law News Network – Let me begin by thank…

5 March 2005 – LAWFUEL – The Law News Network – Let me begin by thanking Annette Nazareth and Paul Roye, and their staffs, as well as the Practising Law Institute, for all the work they have done to prepare for this year’s SEC Speaks conference. I would like to single out Paul, who as many of you know will be leaving the Commission later this month. He is a consummate professional and has helped to shepherd the Division of Investment Management through a particularly volatile period. I am very sorry to see him go.

This is also an appropriate time to recognize the work of the SEC staff. They are a select corps of professionals, dedicated to preserving the integrity of America’s securities markets and restoring investor confidence. I am fortunate to have them as colleagues, and I would like to continue a proud tradition and ask them all to stand so we can give them the recognition they deserve.

Two years ago, I came to this conference and made my first public address as SEC Chairman. I told you what I had seen develop over the previous decade, and reviewed the consequences that emerged, and said this had made me “alternately very sad and very angry.” I also said it was time for all of us to “pull up our socks,” and that “the stage is now set for the serious pursuit of [market and] corporate reform.”

Since then the Commission has implemented an array of valuable reforms. Our reforms will provide investors with more reliable information, and will help to address the conflicts of interest that erode investor confidence and can create inefficient markets. There will always be more to do of course. But I am pleased with what we have achieved up to now, proud of the SEC’s professional staff, and committed to move forward to take additional steps to ensure that America’s securities markets will continue to be a model for markets throughout the world.

Before going any further, let me issue the standard disclaimer, which will be familiar to all of you, that the views I express here are my own and do not necessarily represent those of the Commission or its staff.

Over the next two days you are going to hear in detail from this dedicated staff and from the other Commissioners about some of our recent initiatives and current plans. I would like to take my time this morning to put a few of these matters in a larger context and also to discuss how important your role is in ensuring vibrant and honest markets.

The overarching theme for our efforts is one of ethics and integrity. Our rules have, at their core, a purpose of promoting honest and ethical behavior in the marketplace. They demand that market participants provide complete and accurate information about their activities and practices, so that others can make informed decisions about whether to invest or whether to deal with particular market participants.

Our rules also demand that market participants take steps to manage the influence of conflicting interests. We recognize that at some level, conflicts are inevitable, and that trying to eliminate all of them is not a practical objective. But we also recognize that managing these conflicts is a critical ingredient of a healthy financial and corporate industry.

In today’s markets, with an enormous diversity of participants and more complex strategies and products, there is increased potential for conflicts. Honest and successful markets must address them in ways that effectively protect investors. Much of our activity in the last two years has had that objective.

In some cases the conflicts are so stark and susceptible to abuse that the only solution is to work to eliminate them or, at the very least, to provide clear disclosure about them. Over the past 18 months the Commission has brought 61 cases related to mutual funds, and we’ve levied approximately $1.4 billion in disgorgement and $1 billion in penalties. Many of these cases have involved harm to investors where market participants succumbed to conflicts and violated SEC rules.

As another example, the Division of Investment Management has taken the lead in helping to reshape the internal fund governance and oversight framework, in ways that will both address the areas where there are potential conflicts of interest and, how to address them and how to better disclose them to investors. The most significant example is, of course, the Division’s proposal, which was adopted by the Commission, to provide that funds relying on certain core exemptive rules have a chairman, and 75% of the board, independent of a fund’s management company.

Yet another example involves our auditor independence rules administered by the Office of the Chief Accountant. Because of the importance of independence of external auditors, these rules involve flat prohibitions on activities that could compromise independence. OCA has been very busy providing guidance in this area and will continue to do so where appropriate. We will also continue to see enforcement action in this area where it is appropriate to preserve these important independence principles and protect investors.

More generally, as part of our overall risk-based approach to regulation, the Commission’s Office of Compliance Inspections and Examinations has focused special attention on conflicts of interest, because that is often where the greatest risks arise. OCIE has also initiated risk-focused examinations, which target areas where firms may be most likely to favor their own interests over those of investors.

One area of concern, as an example, has been hidden payments between market participants. These payments include revenue sharing payments in which advisers pay broker-dealers to enhance sales of fund shares. Our examiners found that many funds made these payments with fund assets, such as its brokerage dollars. Many of these arrangements were poorly disclosed – or not disclosed at all – leading to a number of enforcement actions. After reviewing our examination findings, the Commission adopted rule amendments banning mutual funds from directing brokerage in exchange for distributing a fund’s shares.

Another area Commission examiners have been reviewing is whether firms are fulfilling their duty to seek best execution for their customers’ orders, particularly when conflicts of interest exist that may incentivize the choice of execution venue. These conflicts of interest include payments for order flow, the use of soft dollars, revenue-sharing arrangements, internalized execution opportunities, imposition of excessive mark-ups and mark-downs and improper use of confidential or proprietary trading information.

As part of the Commission-wide effort to identify emerging problems before they spread, examiners have been looking at the breadth, scope, and resources allocated to compliance. SEC staff are also working on developing mechanisms to better identify indications of problems at an early stage by creating surveillance programs for SROs and for funds and advisers. And we are committed to establishing a compliance outreach program for Chief Compliance Officers (“CCOs”). OCIE will work with other offices and divisions within the Commission to provide CCOs with information and guidance they can use to enhance their firm’s compliance.

Some conflicts are best managed by focusing on how they are disclosed to investors. For example, the executive compensation process presents clear potential conflicts and clear potential for abuse. Yet, as I have said on many occasions, the solution is not to have the SEC or any regulator set compensation. Good disclosure can do a lot to address this conflict. One problem is that there has not been good enough disclosure under current rules.

The Division of Corporation Finance has been looking at this, and the Commission has brought cases in this area. This is an area where I have been disappointed by the contribution of some lawyers, who appear in at least some cases to devise their own narrow interpretations of the rules while disclosing as little as possible, rather than to seek helpful disclosure for investors. A second issue in this area is that our rules may need to be refocused, and the Division of Corporation Finance is exploring how they can be enhanced and clarified.

Another area where we have used disclosure to address potential conflicts is in the area of nomination of directors, where rules adopted in late 2003 have shed greater transparency on how nominating committees and boards go about the process of identifying and selecting independent directors. This has been augmented by tighter independence standards and enhanced disclosure requirements regarding independence.

The Division of Market Regulation’s efforts to address conflicts also extend to its efforts to strengthen independence and accountability among self-regulatory organizations. I am concerned that the pressures raised by the inherent conflicts between an SRO’s self-regulatory functions and its market operations, and the pressures that can arise in an increasingly competitive marketplace, may hamper an SRO’s ability to fulfill its regulatory duties. To that end, the Commission recently published a concept release on the structure of the SRO system, which explored this issue, among others, in depth. At the same time, the Commission approved for public comment a rulemaking that would overhaul SRO requirements related to governance and transparency.

Under these proposals each SRO would be required to take steps to separate its regulatory function from its business operations and to also appoint an independent Chief Regulatory Officer, who would be responsible for all regulatory issues and would report to an independent committee of the board. The comment period for this important rulemaking expires this coming Monday.

One of the most unusual, and I think potentially one of the most valuable ways we have developed to identify and address conflicts in a sensible way, involves the initiative of the Division of Enforcement, working with other Divisions within the Commission, to undertake a broad-ranging Conflicts Review Project. Securities industry firms have voluntarily conducted comprehensive reviews of the conflicts of interest they encounter in their businesses. To date, 15 firms have either already met with or have scheduled meetings with representatives of Enforcement, Market Regulation, OCIE, Investment Management, and other Commission staff to discuss the specific results of each firm’s review. The Commission’s staff has worked to make these sessions a dialogue, and the meetings have also provided a forum for the firms to identify industry-wide conflicts issues and potential solutions.

As my descriptions of OCIE’s activities in particular make clear, we are trying to be anticipatory as well as reactive. Some of our rulemaking and other efforts have clearly been responses to wrongdoing and even scandal. Our package of mutual fund reform actions is an example. In other respects we have sought, as I have said before, to look around corners and over hills. For example, the Division of Corporation Finance has implemented extensive revisions to the current report on Form 8-K. These revisions anticipate the disclosure needs of investors and markets in an age of growing demand for real-time information, by requiring more timely disclosure regarding a large number of material corporate events.

Corp Fin also recognized the rapid growth of the asset-backed securities market and anticipated the need for comprehensive registration, disclosure and reporting standards for that market. The Commission adopted for the first time rules that provide more transparent and enforceable standards for this very important market.

Market Reg’s watershed efforts to overhaul our National Market System rules are also part of our anticipatory efforts. While an important part of this huge project is to update our rules to catch up to the current state of our markets, an equally important part seeks to ensure that we are devising rules that will operate effectively as technology and markets change in the coming years.

Attorney Conduct

Until now I’ve been talking about the Commission and what we have been doing. I’d like to talk now about what the 1200 of you, assembled here and listening in today, and your colleagues, can do to make our securities markets stronger and more secure. You are on the frontlines of the securities industry, and the work all of you do helps to shape the character of our markets.

Let me note at the outset that after many years in and around American business, I believe the overwhelming majority of business leaders, and professional legal and accounting advisers, are honest – dedicated to meeting the needs of their customers, investors, and clients and adhering to high standards of ethical conduct. But in recent years, there have been some individuals who have lost sight of their basic responsibilities – and have engaged in conduct that is well outside the lines of what is acceptable.

I’ve just described the overarching goal of our laws and rules as the promotion of honest and ethical behavior in the marketplace. But our rules and our enforcement actions alone won’t be enough. Honest markets depend on the integrity of participants and their advisers. Some aggressive participants – and compliant advisers – will continue to test the boundaries of new laws. Some will pursue questionable activity right up to technical conformity with the letter of the law or accounting standards, and some will step over the red line, perhaps with the help of a lawyer or accountant. The success of our mission depends on those of you who do not succumb to those practices.

We also know that much of American business is defined by its dynamism and frequent change – new products, new systems, and vigorous competition. Business practices will frequently outpace any government regulator’s ability to develop specific rules governing these practices. But the quick pace of change should not rob you of the ability to provide thoughtful guidance to your clients – guidance that applies well-established principles to new situations as they develop. And, if you find yourself in uncharted territory, you always have the option of consulting us for guidance on how best to proceed.

This is where you can counsel your clients to pursue a path that is rigorous in conforming to the letter and the spirit of laws and rules. This path should also have a strong ethical cast that will promote the short- and long-term interests of investors, clients, customers, and other stakeholders. As advisers, your guidance can distinguish between simple compliance with the securities laws and behavior that reflects the spirit underpinning these laws.

An important part of your role, then, is to apply your judgment to new situations as they evolve. You will see them before we do. And you have the ability to address questions and issues before they erupt into quagmires. Indeed, it is in your clients’ interests to prevent their issues from becoming our problems. Your job, as the counselors of the actors in our financial markets, is to identify today’s issues and prevent them from blossoming into tomorrow’s scandals.

As just a single example, last year we took a modest step in requiring the registration of hedge fund advisers. Those of you who advise hedge funds have a particularly good opportunity to help your clients by promoting their ethical business behavior.

Similarly, think how much anguish we could have avoided if a few more lawyers had pointed out to their hedge-fund clients that late trading of mutual fund shares is illegal, as are duplicitous market timing and quid pro quo “sticky asset” arrangements. That sort of common-sense advice would have been more effective in keeping the client out of trouble than engaging in rhetorical somersaults to justify the activities the client wanted to pursue.

In thinking about these issues, I’d like to offer a few thoughts that I hope can help to guide you as you guide your clients.

I hope you will do your best to explain to your clients the principles behind our rules. Similarly, I hope you will not expend significant time, money, and energy devising structures aimed at evading requirements and trying to achieve an accounting or disclosure result that is “better” only because it achieves technical compliance with a rule while artfully dodging the rule’s purpose.

I hope you will focus attention on identifying what we sometimes call “appearance” problems, which refer to those potential but as-yet-undeveloped issues, such as conflicts of interest that can trip up a client, or new business relationships or revenue streams that could create conflicts with the best interests of the firm’s customers. You can help your clients to integrate compliance and ethics into discussions about new products or new business ventures, and address in real time the risks those new products or business lines may present.

You can help corporations to encourage their employees to learn from their mistakes. If there is a breach in ethics or compliance it is imperative to figure out what went wrong and how it can be prevented from happening again.

And most important, you can help corporate leaders to set a personal example, and insist that when a decision is made, no matter how large or small, everyone is obligated to check his or her internal compass and ask whether the course of action is the right thing to do.

The Commission is, of course, firmly committed to both the rules governing attorney conduct, and to the principles that underlie them, and we will enforce them when violated. But the rules are also flexible enough to allow for professional judgments, and we will honor this flexibility as long as we have reason to believe that attorneys are seeking to effect compliance with the letter and the spirit of the law. We are all human – even the Commissioners and staff of the SEC!


So while there is still much that can be done to strengthen corporate integrity, and there is still much each of you can do, I want to reiterate what I said at the opening: we have seen real progress over the past few years, and our challenge now is to continue building on that progress. Forums like this one are an invaluable opportunity for discussion and debate about the pressing issues facing the securities markets. I want to thank the Practising Law Institute for sponsoring your many events, and most particularly this annual get-together, which brings together the SEC professionals and your members for valuable discussions.

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