Palm Beach, Florida – April 3, 2005 – LAWFUEL – The Law News Network …

Palm Beach, Florida – April 3, 2005 – LAWFUEL – The Law News Network – Thanks, Bill, and thanks to the Financial Services Roundtable for inviting me to speak this morning. From a glance at the organizations represented in the Roundtable, and the leaders I see in the audience, it’s clear that you represent a wide cross-section of the U.S. financial services industry. This, then, is a great opportunity for me to discuss a number of ideas about how the Commission and the industry can work together to improve our financial markets and keep them a source of prosperity. At the outset let me issue the standard disclaimer that my remarks here are my own and do not necessarily represent those of the Commission or its staff.

The American financial services industry, with its success in sparking economic growth here and abroad and its long track record of innovation, has earned the respect and envy of the world. The industry is led by professionals of integrity, and many of you are here today. We can nevertheless acknowledge that the industry’s image has been tarnished by what’s come to light recently, as we’ve learned of unmanaged conflicts of interest within the industry that have become too common, as well as the industry’s involvement in some of the more notorious corporate scandals. Moreover, it’s become apparent that pressure from the industry may have contributed to an erosion of a long-term focus among corporate managers. This has been a turbulent period in the history of the American economy, but if we learn from the experience, we’ll see it as an opportunity to improve the way business is done. And in particular, it can be an opportunity to strengthen the financial services industry and make it more competitive globally for the long haul.

There has been real progress as regulatory reform has taken hold, and as many business leaders, including those in the financial industry, have abandoned the misguided and unethical practices that were so prevalent in the final years of the 1990s. At the same time, one need only read the front page of the paper to be reminded that more work remains – for regulators and the industry – to root out wrongdoing. If I could use an analogy, we aren’t in a sprint. We’re on a long-distance run, and for that we need to keep our staying power.

Before turning to some of the Commission’s recent activity, I’d like to touch briefly on what we strive for at the SEC, since our work is sometimes mischaracterized out in the “echo chamber.” At their core, our rules aim to protect investors by promoting honest and ethical behavior in the marketplace. To do this, our rules demand that market participants take steps to manage the influence of conflicting interests. We recognize that some conflicts are inevitable, and that trying to eliminate them entirely is not a practical objective. All market participants must nevertheless address conflicts in ways that protect investors or, at the very least, in ways that adequately inform investors so that they have the power to protect themselves. We firmly believe that managing conflicts is critical to the long-term health of the financial marketplace. Much of our activity over the last two years has been in the service of this belief.

The governance reforms that we and the listing markets have introduced in the last few years are likewise rooted in the management of conflicts. Examples of these include the conflict between an investment management company’s duty to the mutual fund it advises, and its duty to its own investors, and the conflict between the relationship of corporate directors with the CEO and their loyalty to the company’s shareholders. Our rules are designed to encourage the practice of enlightened self-governance by the companies we oversee – governance that identifies conflicts and appreciates the need to manage them.

There is much the financial services industry can do to complement our efforts. Not only can you work with us by improving your own governance, but because of the nature of your influence throughout the economy, you have the ability to encourage corporations across the country to manage for the long term. As but a single example, the industry could help corporations manage the conflict between the possible short-term interests of management and the long-term interests of shareholders by attaching much less significance to quarterly EPS numbers, and instead focusing on whether a company is, in the words of a popular business writer, “built to last.”

Let me turn to some of what the Commission has achieved over the past two years, and then move to some of what lies ahead. I’ll also try to offer some thoughts about what the industry might do to work with us and, in the process, lighten our load.

Strengthening Governance and Addressing Conflicts of Interest

I think you would agree that the most transformative corporate reform measures of our day have been the changes ushered in by the Sarbanes-Oxley Act of 2002. I don’t think I need to review its specifics, since most of you – and the corporate clients you serve – live with the law on a daily basis. There is, of course, a lively debate about the costs of compliance with the law’s requirements. In line with the long-term orientation I’ve just discussed, I hope you’ll agree that the Sarbanes-Oxley reforms should yield extraordinary long-term benefits in the form of improved financial reporting, better management control, and more ethical behavior by companies and gatekeepers. This, in turn, should lead to sounder corporate governance, better and more reliable reporting, improved corporate performance, enhanced investor confidence and, ultimately, a lower cost of capital.

Let me focus for a moment on Section 404 of the Act. The regulations that implement Section 404 require a company’s management and auditors to report on the effectiveness of internal controls over financial reporting. Section 404 may have the greatest long-term potential to improve financial reporting. At the same time, it may also be the most urgent financial reporting challenge facing corporate America and the audit profession in 2005. In the short haul, it certainly seems to be the most expensive of the Sarbanes-Oxley reforms, and it has attracted a fair amount of criticism on that score.

We’ve been listening to all sides in the 404 discussion. The Commission is monitoring the roll out of Section 404 to ensure that its benefits are achieved in the most sensible way. Indeed, we included several measured extensions over this past year to accommodate the first wave of reporting, and we will hold roundtable discussions later this month to hear feedback. We have also established an Advisory Committee on Smaller Public Companies, to consider whether the costs imposed on smaller public companies by this provision, and others within Sarbanes-Oxley, are proportionate to the benefits. The responsiveness we are demonstrating with Section 404 reflects a critical aspect of the Commission’s approach – that we can and must address unnecessary costs and unintended consequences while rigorously ensuring that we maintain the investor safeguards of good disclosure and transparency.

Section 404 is aimed broadly at the way public companies are managed. We have introduced other reforms targeted to the specific sectors we regulate. In the mutual fund industry, for example, we have worked to reshape the internal fund governance framework when funds engage in certain activities that raise conflicts of interest. The most significant change in the governance framework – and for some critics the most controversial – is the Commission’s adoption of a rule providing that a fund relying on certain core exemptive rules have a chairman, and three-quarters of the board, independent of the management company. This rule helps to address the inherent conflicts that exist between the interests of a fund’s shareholders, who want to limit fees and expenses, and the interests of the fund’s manager, whose goal is to maximize revenues. As Bob Dylan once observed, “you gotta serve somebody.” We think it ought to be the fund shareholders.

Good disclosure is also an effective way to manage conflicts. But you ought to consider the problem from our point of view: good disclosure practices may be a lot more effective in heading off investor harm in the first place than they are at remedying the harm once it has become ingrained. As an illustration, some recent examples of our work to address conflicts of interest are the ongoing risk-focused examinations being conducted by our Office of Compliance Inspections and Examination. These exams target areas where firms may be likely to favor their own interests over those of their customers, and a key question we look at is how the potential conflicts are disclosed. If we find that firms are generally doing a good job of disclosing the conflicts so that their customers can make informed decisions, then in some respects that’s the end of our task. Of course, we may need to address instances of poor disclosure by outlier firms, but if the industry as a whole seems to be effective in conveying critical information to the customer base, it’s unlikely that we would need to introduce structural regulatory changes. In this respect, there’s a lot the industry can do to make future regulation unnecessary. On the other hand, if there’s widespread indifference to adequate disclosure of a particular conflict or rampant abuse, then it’s often the case that we will need to address that conflict with regulation.

We are also working to strengthen the governance of self-regulatory organizations. As I’ve said before, I am concerned that the pressures raised by the conflict between an SRO’s self-regulatory functions and its market operations, and the pressures that do arise in an increasingly competitive marketplace, may hamper an SRO’s ability to fulfill its regulatory mandate. This concern is, if anything, heightened by the growing movement here and abroad toward public ownership of trading markets. The comment period recently closed on our concept release on the structure of the SRO system, which explored this issue in depth, and our proposed rulemaking that would overhaul SRO requirements related to governance and transparency. Under the rulemaking proposal, each SRO would be required to take steps to separate its regulatory function from its business operations and also to appoint an independent Chief Regulatory Officer. I’m looking forward to reviewing the comments and then moving forward on the proposals.

The measures we’ve adopted over the last few years only start the process, and we will need energetic assistance from the financial services industry to make them succeed. Those of you in the brokerage business are demonstrating your commitment to reform by the serious manner in which you are reducing the influence of investment banking on research. Those of you in the mutual fund industry are demonstrating your commitment in the way you are embracing the critical role of the chief compliance officer. Each of these reforms will help to make our markets work better, but they depend on the commitment of people like you to honor the spirit of the reforms, not simply the letter of the law.

Looking Ahead

I’d like to look ahead and talk about what you might expect from us in the future. First, let me mention a change in emphasis that informs a lot of what we are doing, and give you a few examples of this change in action. We are in the process of revamping our own approach to oversight in order to equip the Commission to better anticipate, find and mitigate areas of risk, fraud and malfeasance. The effort is exemplified by the establishment of our Office of Risk Assessment, which brings together professionals experienced in seeking out potential areas of concern. We want our efforts and oversight to be more anticipatory and preventative – we want to look over the hills and around the corners.

A current example of this approach has been the SEC’s hedge fund adviser registration initiative. This will enable the Commission to gain greater insight into the activities of hedge fund advisers, at a time when hedge funds are growing in size, in number and in influence throughout the securities markets, with assets totaling nearly $1 trillion.

In the same spirit, our Division of Corporation Finance recognized the rapid growth of the asset-backed securities market – a market with $2 trillion of outstanding securities – and anticipated the need for comprehensive registration, disclosure and reporting standards. Acting on the Division’s recommendation, a few months ago the Commission adopted rules that provide more transparent and enforceable standards for this very important market.

In an effort to get ahead of potential risk areas that could affect our largest broker-dealers, the Commission recently promulgated rules designed to allow them to elect supervision by the Commission at the holding company level. A qualifying broker-dealer is permitted to calculate regulatory capital charges in a manner consistent with its own internal risk management practices. This market-based approach to capital adequacy should help us develop a deeper understanding of the risks faced by financial services companies.

Finally, another recent example of our revamped approach to oversight comes from the Division of Enforcement. That Division has undertaken a broad-ranging Conflicts Review Project in which firms in the industry have, on a voluntary basis, conducted comprehensive reviews of the conflicts of interest they encounter in their businesses. If you’ll recall what I touched on a few minutes ago, efforts like the Conflicts Review Project could be a catalyst for the industry to address conflicts on its own, in advance of a scandal, and make future regulation unnecessary.

I’ll now try to give you a preview of what you might expect from us in the next few months.

I expect the Commission to take action on our proposal – known as the “hard 4 rule” – to address late trading in mutual funds. Our staff is analyzing information regarding technological alternatives to a hard 4 rule that may be effective in addressing the problem of late trading, without imposing unnecessary burdens on investors, funds or intermediaries. This follows the Commission’s vote last month to require that fund boards decide whether to charge a redemption fee in order to address abusive market timing. We also requested comment on whether we should standardize terms for these fees, in order to facilitate their imposition and collection.

We are examining the conflicts that can arise from the use of soft dollars by money managers. A Chairman’s Task Force is reviewing the impact of soft dollars on the securities markets, and how soft dollars impact the interests of investors. In addition, the Task Force is reviewing whether we can improve disclosure to better inform investors and fund directors about their fiduciaries’ use of soft dollars, and who benefits from them. I expect the Commission to take up the issue in the coming months.

We are looking at reform of mutual fund disclosure practices. We continue to search for the best method of informing investors about broker conflicts and compensation. We will use input from the actual consumers of disclosure to fashion a regime that better serves the needs of fund investors. As an initial matter, I expect that we will complete our initiative to require key disclosures to be made at the point of sale. I also expect that we will take up an initiative to better inform investors about mutual fund transaction costs, because often investors do not understand how the costs associated with the purchase and sale of a mutual fund’s portfolio securities affect their bottom-line investment.

Fundamental to all of our mutual fund reforms, is, of course, to ensure that mutual fund companies embrace them. We are committed to providing assistance to chief compliance officers, and last month I announced the development of a “CCO Outreach” program that will enable the Commission and its staff to better communicate and coordinate with CCOs. We will rely on your help to make this program a success.

We expect to make progress on our efforts to finalize the broker push-out rules. When Congress repealed the Glass-Steagall Act and gave banks increased leeway to conduct securities-related operations, Congress defined the nature of securities activities that banks may conduct without registration as a broker. These activities are not unlimited, of course, and some work remains to clarify how banks can conduct their operations without running into compliance difficulties. We will continue to work with the banking regulators and with the industry in order to promote our investor-protection mandate while mindful of the industry’s need for flexibility and the bank regulators’ objective of ensuring the safety and soundness of the national banking system. Indeed, last month we extended the Gramm-Leach-Bliley compliance date for bank brokerage activities until September 30, to give us all more time to craft a set of rules that will work for the industry, while maintaining the prime investor-protection principle that Congress intended to achieve with functional regulation of securities activities. On a related note, in response to comments received last year the Commission may consider making the exceptions and exemptions from broker-dealer regulation that are available to banks also available to thrifts.

The final item I’d like to mention is Regulation NMS, which I expect the Commission to take action on next week.

You are one of the few audiences who don’t require an extended tutorial on the topic. You understand why we need to update the regulatory framework for our equity markets, and I daresay many of you are quite familiar with the individual proposals in Regulation NMS and are well versed in the arguments for and against them. So I will keep my remarks brief, and focus only on the trade-through aspect of the proposal.

I’d ask that you put our work on the trade-through rule in perspective. As you know, the listed market has had a trade-through rule for decades. Much of the strident criticism that we hear about our proposal appears to focus on the existing ITS rule, not on the rule we have proposed. Let me be clear. The ITS rule is a 35-year-old anachronism that has plainly outlived its usefulness. The Commission is not proposing to validate or extend the ITS rule. Quite the contrary: the Commission has proposed a strengthened and modernized trade-through rule – one that recognizes the differences between an electronic market and a manual market.

I realize that the topic is complex, and that as a result it is easy for opponents of a trade-through rule to introduce all manner of breathless hyperbole and misleading claims into the debate. But the argument that our proposal is designed to preserve the hegemony of the floor-based exchanges, a claim rather shrilly advanced in some quarters, ignores even the experience of the last twelve or thirteen months. If that were the Commission’s objective, we could have accomplished it a lot more easily by doing nothing and letting the old ITS rule remain in place, and continuing to force “away” markets to route ITS commitments to floor specialists. Instead, I ask you to look at what we did. We proposed to replace the ITS rule in February 2004, and subsequently, in April 2004, the major floor-based exchanges both announced plans to substantially increase their automated trading activity. The impact of this development on the exchanges and on some of their key constituencies will be profound, but the benefits for investors should be enormous.

The trade-through rule that the Commission has proposed is pro-competition – in the best tradition of the market-reform initiatives that the Commission has spearheaded over the last several years. Much of the public debate over the trade-through rule has focused on one type of competition – competition between markets. But there are two kinds of competition that we intend to foster. One is competition between markets and the other is competition between orders.

Both kinds of competition are essential for vibrant and healthy markets, as Congress recognized in 1975 when it told us to perfect the national market system. Some of the loudest voices in this debate seem to downplay order competition. But the Commission hasn’t forgotten that one of the great strengths of the U.S. equity markets is that the trading interest of all types and sizes of investors is integrated, to the greatest extent possible, into a unified market system. This integration ultimately works to the benefit of both retail and institutional investors. A trade-through rule such as the one we have proposed would help maintain the confidence of all types of investors in the U.S. equity markets, and I believe this is why our proposal has, in the main, been supported by investors large and small.

What the Industry Can Do

Let me conclude with a few observations. I know there’s a feeling in some quarters that the reforms of the last few years have been too fast and furious, that there is redundancy in our efforts and those of the States and other regulators, and that some of our enforcement and inspection activities amount to stealth rulemaking. Let me assure you that we hear these concerns and we take them seriously. In particular, we have stepped up our partnership with the association of State securities regulators.

But the most effective solution to the problem of what some might perceive as over-regulation, as I tried to suggest earlier, lies with the industry. Our rules and enforcement actions cannot alone ensure that our markets and our corporations will be clean and ethical. What’s really needed – from people throughout the financial services industry – is the proper mindset. There should be an industry-wide culture that fosters ethical behavior in decision-making. Creating, preserving and strengthening that culture means doing more than developing good policies and procedures, doing more than installing competent legal and accounting staff, and doing more than giving them resources and up-to-date technology. It means instilling and maintaining an ethic – an industry-wide commitment to doing the right thing, this time and every time – so much so that it becomes entwined in the essential DNA of the industry.

The industry needs to look beyond simple compliance with the letter of the law in a check-the-box manner. The industry also needs to search for a new way to instill ethics, integrity, honesty and transparency into its way of doing business. Pie in the sky? Perhaps. But if the industry is really interested in making our work unnecessary, then the ball is in your court.


In closing, let me assure you that I have a keen appreciation for the work all of you do in financial services – I was a member of the industry myself, for many years. While the industry has experienced some turmoil in recent years, out of it has come positive results. The Commission’s reforms have addressed many problems that needed fixing. And of equal or greater importance, I believe there is a growing recognition, throughout the industry, that the abuses and questionable practices of the past cannot be repeated. This counts as real progress, and our challenge now is to continue building on it.

The importance of the task ahead is underscored by the extraordinary growth potential for financial services. With rising numbers of investors, expanding global markets and innovative new financial instruments, the future is filled with opportunities for your industry. We want this industry to be positioned to capitalize on these opportunities, and we look forward to working with you, not against you – not as an adversary, but as a partner.

Thanks again to the Financial Services Roundtable for this opportunity to speak, and thank you all for listening.

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