Remarks at the 13th Annual Public Fund Boards Forum
Commissioner Cynthia A. Glassman, U.S. Securities and Exchange Commission
December 6, 2004 – LAWFUEL – First for law news – As representatives of the public pension fund industry, you are the stewards of the financial investments of millions of individuals. I welcome the opportunity to speak with you today about the challenges of striking a balance in crafting regulations that carry out our mission to protect investors and maintain the integrity of the securities markets while not unduly interfering with investor choice or impeding market innovation. Given the considerable changes that have taken place in the securities industry in the past two and a half years, I can truly attest that maintaining a regulatory balance is indeed a challenge. My tenure at the Commission has been a variation of the often-cited curse – may you live in challenging times. Before I continue, 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 will begin today with an overview of my approach towards regulation and then describe how I have applied this approach to some recent Commission actions. As I have often said, I am particularly concerned that we perform a meaningful cost/benefit analysis prior to the adoption of any rule. Further, it is worth noting that, as an economist, my philosophical preference is for market, rather than regulatory solutions. From my perspective, there is a fine line between free markets and efficient and effective regulated markets, and it is this line that the Commission must strive to walk.
The starting point for me in determining whether a particular regulation is warranted is to identify the problem clearly. This step, while seemingly obvious, is in my view not always done. For example, the Commission recently adopted a rule requiring hedge fund advisers to register with the Commission. One of the reasons I dissented from both the proposed rule and its adoption was that the Commission failed to define the problem that the rule sought to rectify. I will talk more about this rule later.
Once the problem is identified, the next step is to evaluate its scope in order to gauge an appropriate response. In making this determination, it is important to remember that just because we can regulate by adopting new rules, does not necessarily mean that we should. Rather, we should ask whether a rule is needed at all or whether market forces, if allowed to work, will bring about the desired result.
After a problem has been identified and its scope has been evaluated, and if it appears that a new rule proposal is warranted, I look to several factors: What are we really trying to accomplish with the rule? Will the rule be effective in achieving the intended result, or is it merely cosmetic? Is the rule practical? Does the rule go too far or not far enough? Do the benefits outweigh and justify the costs of implementation? Will the rule raise unrealistic expectations? In performing this analysis, I am guided by the Goldilocks principle: does the rule go too far, not far enough, or is it just right? Inherent in this principle is a desire to avoid unintended consequences. I believe rules should be written as narrowly as possible in order to achieve the desired result – and no more.
I will illustrate my regulatory approach with some recent agency rulemakings, including ones that I think were warranted and those that, in my view, lacked justification. A clear example of a worthwhile rulemaking is the Commission’s recent rule under the Securities Act and the Investment Company Act that requires mutual funds to disclose breakpoint discounts in their funds’ prospectuses. The Commission began by identifying the problem and its scope. Brokers have an obligation to disclose these discounts to customers, but a joint review by the Commission, the NASD and the NYSE revealed that customers did not receive discounts to which they were entitled in 32% of the transactions reviewed. The Commission remedied this problem by enacting a rule to require mutual funds to enhance their prospectus disclosures about breakpoints.
In voting to adopt this rule, I was satisfied that the Commission’s goal of giving mutual fund investors enough information to make informed decisions about whether to invest and how much to invest in a particular fund was sound. I concluded that the rule was warranted and would be effective because it mandated that information that should already have been provided to investors would in fact be made available. I likewise found that the benefits clearly outweighed the costs. This was because funds, for the most part, already had breakpoint discount policies and already disclosed much of the required information in their registration statements. The rule merely required including these policies in the funds’ prospectuses, which mutual funds could accomplish at nominal expense. Had this information been included in the prospectus, it is more likely that investors would have known to utilize the breakpoints. More to the point: If investors in the Commission’s joint review had utilized the breakpoint discounts, they would have saved on average $364 per transaction. Thus, the costs to implement the rule were justified in light of the benefits. Further, given the careful tailoring of the rule, it was unlikely to produce unintended consequences.
Unlike my enthusiasm for the breakpoint disclosure rule, I only reluctantly supported a rule requiring investment companies to disclose their proxy voting policies and make their actual votes available to their clients. Here is why.
What the Commission was trying to accomplish was clear: it wanted mutual fund investors to have access to information about how their funds voted and why they voted the way they did. Much less clear were the benefits to be derived by investors from knowing how their funds voted. I was not convinced by the proffered evidence that most mutual fund investors really desire such information. The Commission received close to 8,000 comment letters on this proposal, more than 90% of which were form letters. In the context of over 90 million mutual fund investors, this response was not statistically compelling.
My understanding is that for most fund investors, a primary, if not the most important factor in choosing a mutual fund is its performance. This rule thus raised red flags at the ‘do we need the rule’ analytical stage. I was particularly concerned that we were imposing costs without concomitant benefits, and that the rule may have substantial unintended consequences, including potential misuse by special interest groups. Ultimately, however, I supported the proposal on the basis that disclosure is the bedrock of the securities laws and that this fundamental principle justified the rule. Because the first deadline for mutual funds to report their actual votes was only this past August, it is too soon to tell whether investors have found this rule beneficial or what effects disclosure of proxy votes has had. And, as I stated when we adopted this rule, I requested that an impact study be conducted by the staff at an appropriate point to evaluate the operation of this rule and whether there are any unintended consequences.
Another rulemaking that I found to be worthwhile in concept, and that Congress mandated the Commission to adopt, is the implementation of Section 404 of Sarbanes Oxley. There is, however, a significant possibility of unintended consequences that may result from this rule. As all of you are aware, Section 404 requires management to assess and auditors to attest to a company’s internal control structure and procedures for financial reporting.
It is important to note that internal controls are a means to an end, not an end in itself. There is a spectrum of outcomes following a company’s review of its internal controls, encompassing at one extreme a lack of clear controls, to controls that exist but are not well documented, to the opposite extreme of good controls that are well documented. Obviously, the better a company’s controls and documentation, the less likely that inaccuracies will surface in financial reports, either by accident or on purpose.
As you are probably aware, under Section 404 all accelerated filers were required to include their management’s assessment and auditor’s attestation of internal controls for years ended after November 15, 2004, with all remaining filers to do so for years ended after July 15, 2005. However, after near continuous discussion with the audit community during the summer and fall, the Commission just last week gave accelerated filers with a public equity float of less than $700 million – more than half of accelerated filers – an extra 45 days from the due date of their 2004 10K to file their internal control report and related auditor attestation. The Commission concluded that this extension was necessary in order to address the resource concerns, both at this group of companies as well as their auditors, that were making it difficult to meet the prior deadlines.
We have been hearing that even with our recent extension, some companies may still have difficulty meeting the new deadline and a number of companies may report material weaknesses, thus preventing their auditors from issuing a clean internal controls opinion in their annual reports. I hope that the markets keep this new information in perspective, especially if the auditor has been unable to issue an unqualified opinion on the company’s financial statements. The companies and their auditors are still feeling their way on these requirements and the process undoubtedly will need fine tuning. Moreover, because this is the first year for Section 404 reporting, there is a risk that the market will misinterpret internal control opinions. To reiterate, material weaknesses in internal controls do not necessarily mean the financials are inaccurate. They do mean that the company has some process improvements to make. I believe the key here is for management to be upfront with investors in their disclosure – “here is what we are doing, here are our concerns or issues so far (if any), and here is what we are doing about it.” Boilerplate disclosure is not sufficient.
We have also heard concerns that the documentation and controls have gone beyond what is reasonable and what was intended – for example, five officers of a company signing off on a purchase that was formerly approved by one – and we may be losing the forest for the trees. I have been concerned from the outset that this could turn into a check the box exercise rather than being incorporated into a robust risk management framework. On the other hand, we have heard that the adoption of our 404 rules and Auditing Standard Number 2 has had a positive effect in improving companies’ processes. Further, prior to adoption, investors really had no basis to judge whether a company had good internal controls. Having said all that, I will encourage the Commission and the Public Company Accounting Oversight Board to monitor the implementation of 404 and refine the rule if appropriate to achieve its true intended purpose.
Although most of the rules that the Commission has adopted during my tenure were substantially justified, I consider the adoption of a few rules to be unjustified. For example, the Commission’s recent mutual fund governance rulemaking did not pass muster under my analysis and I dissented from its adoption.  Although the dissent, which I wrote jointly with Commissioner Atkins, contains considerably more detail that we have time for today, a few points are worth highlighting.
The aspect of the new rule that concerned me is the requirement that the boards of directors of mutual funds have an independent chair and that seventy-five percent of directors are independent of the fund’s management. In the adopting release, the majority postulated that the new requirements will “strengthen the hand of the independent directors when dealing with fund management, and may assure that independent directors maintain control of the board and its agenda.” Unfortunately, the Commission conducted no analysis of existing data to support the majority’s position. A particular standard of independence is not, itself, a legitimate regulatory objective. Rather, I believe such a standard must be objectively linked to real benefits to investors before we mandate it for all funds. In my opinion, the majority failed to demonstrate any real benefits, let alone link them objectively to the independence standard adopted. Moreover, existing rules already provide for a board with a majority of independent directors and afford these directors significant influence over a fund’s operations.
In my view, the benefits of this rule are illusory and not supported by any empirical data. In fact, the only study included in the record suggested that funds with an inside chair actually had superior performance compared to funds with an independent chair, with no negative effect on fees. While one study cannot conclusively resolve the debate over an independent chair, it does demonstrate that more analysis should have been conducted prior to the adoption of this rule.
In contrast to the illusory benefits, the costs of this rule are real. Approximately eighty percent of all fund firms have interested chairs that will have to be replaced, yet the majority did not identify “any out-of-pocket costs” associated with the independent chair requirement. The majority also ignored the costs associated with an independent chair’s hiring of staff, which is likely to result from the rule’s implementation. All of these costs ultimately will be borne by the fund’s investors.
I note that this debate is not over; the U.S. Chamber of Commerce has filed suit to enjoin enforcement of the rule on the grounds that it exceeds the Commission’s authority. Additionally, included in Congress’ pending omnibus spending bill for fiscal year 2005 is a requirement that the Commission submit a report to the Senate Appropriations Committee “providing justification” for the independent chair requirement.
Another rule from which I dissented is the Commission’s recent requirement that hedge fund advisers register under the Investment Advisers Act. Let me be absolutely clear: I agree with the majority that we need more information on hedge funds. My disagreement is with the majority’s solution to how that information should be gathered and put to use. As with the independent chair rule, I also filed a written dissent jointly with Commissioner Atkins to the hedge fund adviser proposed and final rule. In the interests of time, I will highlight just a few salient points.
A fundamental failing of this rule is that the problem that the rule seeks to solve is not supported by the facts. The professed problems were increased fraud in, and retailization of, hedge funds. However, neither of these premises holds up under scrutiny. First, the majority adopted this rule relying on 51 enforcement cases, but the rule would be inapplicable in virtually all of the cited enforcement cases, either because the adviser had less than $30 million in assets under management and was therefore too small to register or because the case did not actually involve an adviser to a hedge fund, but rather, a garden-variety fraudster using the buzz words “hedge fund” to target victims. Second, contrary to the majority’s stated concerns, the Commission staff in 2003 prepared a report suggesting that retailization was not a problem because the staff had not uncovered evidence of significant numbers of retail investors investing directly in hedge funds.
In addition, by requiring all hedge funds to register with the Commission, ironically the rule may stimulate more retailization of hedge funds – the very consequence that the rule purports to protect against. Specifically, because pension funds tend to limit hedge fund investments to those with registered advisers, the mandatory registration of all advisers will expand the potential universe and thereby afford even more opportunities for investment in hedge funds. An additional unintended consequence is that the rule may encourage less liquidity in the market. This is because the rule defines a hedge fund as an investment that allows redemption in less than two years. Therefore, to avoid adviser registration, a hedge fund may simply require a longer lock-up period for its investors.
Another reason for my dissent was that there were many viable alternatives that could have been, but were not, adopted. For example, information about hedge funds that the Commission needs can be obtained from other sources, including other regulators and market participants, as well as through a notice and filing requirement. The Commission should have, but did not, collect and analyze the existing information and determine what new information would be useful, before imposing mandatory registration. Although a Commission task force has been constituted to identify hedge fund risks, it should have completed its work prior to the promulgation of this rule, so that the rule could be specifically tailored to address actual, as opposed to hypothetical, concerns. Further, the Commission failed to demonstrate that this rule was the most cost-effective way to accomplish its objective. The Commission’s limited resources will be diverted under this rule, and the Commission will now have to allocate staff to the inspection of these additional advisers. Lastly, the rule did not contain a meaningful cost-benefit analysis, although it appears to impose significant costs on hedge funds and their investors without demonstrating real benefits.
The analysis I undertake in determining whether a proposed rule is justified remains equally important – if not more important – after the rule has been implemented. I think that the Commission has an ongoing duty to monitor the implementation of our rules and analyze their impact to see if they are accomplishing their objectives. We should make a serious effort to revisit, review, and revise our rules so that they achieve their intended effect in the most effective and least intrusive way. This is, in fact, what I came to the Commission intending to do, but a few little things – the collapse of Enron, Worldcom and others, the implementation of Sarbanes Oxley, and the mutual fund scandals, for example – intervened.
In other words, just because a rule represents the way it has always been done, doesn’t necessarily make it right now. Over time, rules can become obsolete or outlive their original purpose. A good example is the Commission’s recent release soliciting comments on proposed changes to the implementation of the Securities Act of 1933 that, among other things, would make it easier for issuers, especially the largest issuers, to disseminate information to investors during the securities offering process. This proposal arose, at least in part, from the recognition that the internet and other means of communications have revolutionized the flow of information, rendering some of the Commission’s information restrictions outdated, if not outright impediments to the offering process. The goal of the proposed rule is to promote the delivery of information to investors in a more transparent and efficient manner by streamlining the offering process and removing restrictions that at one time were appropriate but may no longer be necessary.
For example, under the current ‘gun-jumping’ provision, an issuer may not make written offers after the filing of the registration statement other than through the lengthy statutory-prescribed prospectus. Yet, the issuer can make oral offers and communicate information outside of the prospectus. Subject to certain filing and legend requirements, the proposed reforms would allow the issuer to ‘free write’ during the so-called quiet period. Suffice to say that I anxiously await comments on this proposal and encourage their submission.
There are a number of other proposed rules that the Commission has under consideration, including Regulation NMS, confirmation and point of sale disclosure requirements for broker-dealer sales of mutual funds, and mandatory redemption fees and the hard 4 close for mutual funds. Because these proposals are pending and I am still doing my balancing act, I simply note that I will apply the analysis that I’ve outlined to any final rule proposal in order to continue maintaining a balanced regulatory approach.
Let me now briefly address enforcement policy. It is equally important to strike a balance in the enforcement policy arena, but here the balance sought is in the form of just and proportionate resolutions – to punish and deter bad conduct without chilling appropriate business activities. As in the policymaking arena, I take an analytical approach and strive to avoid unintended consequences.
For example, as you may have read in recent news reports, I am concerned about the ever-increasing severity of monetary penalties the Commission has imposed on corporate defendants in enforcement actions over the past several years. I fully support punishing wrongdoers, and believe that a goal of punishment is future deterrence. But, we must achieve this goal without hurting the very investors we aim to protect.
Where a corporation’s shareholders have benefited from the fraud, I believe that a monetary penalty against the company may be an appropriate punishment. However, in many recent financial fraud cases the victims of the corporate misconduct were the shareholders – typically in the form of a drastically reduced or even worthless stock value. Corporate penalties, in my opinion, add insult to injury by further hurting the shareholders already victimized by the fraud. This is because corporate penalties allow a company’s management to settle an enforcement action with corporate funds rather than with money belonging to the individuals who ultimately were responsible for devising and executing the actions that gave rise to the fraud. After all, I think most would agree that corporate entities do not engage in wrongdoing; corporate personnel do. Therefore, fines should come out of the pocket of the responsible individual, not the shareholders. The use of corporate funds to pay penalties deprives the company of funds that could otherwise have been reinvested in the company or put to other productive use to actually benefit the shareholders. Moreover, as corporate penalties increase, their severity threatens the corporation’s ability to do business and may negatively impact stock and bondholders, employees, and other innocent corporate stakeholders. Who is truly being deterred? If anyone, I suggest it is new management that may be deterred from coming into these situations, cleaning up the mess left by the fraudsters and putting the company back on the path to growth.
In contrast, I believe that imposing fines commensurate with the wrongdoing on individuals will result in greater deterrence of other wrongdoing and less cost to innocent shareholders. Again, I want to be very clear – I do support monetary penalties and, in fact, large monetary penalties if the facts so warrant. However, I believe that unless we hit the fraudsters themselves where it hurts, we are to a certain extent “barking up the wrong tree” and penalizing shareholders who were already penalized by the fraud itself and/or became shareholders after the revelation of the fraud and thus were not even owners of the company at the time.
In concluding today I will reiterate what I stated at the outset: The Commission, in fulfilling its mission of protecting investors and maintaining the integrity of the securities markets, should not regulate for the sake of regulation. Rather, where markets are functioning, we should let them work without unnecessary interference. If regulation is necessary, we must be careful to craft rules that are narrowly tailored to the particular needs of the situation and do not result in unintended consequences.
You can help us achieve this goal. As pension plan advisers and fiduciaries, you have a unique perspective. You have significant involvement in the securities markets and can raise red flags for us if you see conflicts of interest or questionable practices in your market interactions. I also encourage your comments on our rulemaking and concept releases. I am particularly interested in your insights and your data on the costs and benefits of our proposed rules.
Lastly, my fellow Commissioners and I frequently meet with outside stakeholders in order to better understand their perspectives. These meetings, like comment letters, inform our views on regulation. I especially want to hear from you if you think we are impeding your business, missing industry problems, or are being too aggressive or not aggressive enough in enforcing the securities laws. Simply put, I welcome your input to help me achieve the right regulatory balance. Thank you.
 See, e.g., Investment Company Institute, Understanding Shareholders Use of Information and Advisers, available at http://www.ici.org/shareholders/dec/rpt_undstnd_share.pdf.
 See Dissents of Commissioners Cynthia A. Glassman and Paul S. Atkins, Investment Company Governance, Rel. No. IC-26520, available at http://www.sec.gov.
 See Assessing the Significance of Mutual Fund Board Independent Chairs, a Study for Fidelity Investments by Geoffrey H. Bobroff and Thomas H. Mack (Mar. 10, 2004), attached to Comment Letter of Eric D. Roiter, Senior Vice President and General Counsel, Fidelity Management and Research Company, available at http://www.sec.gov.
 See Dissents of Commissioners Cynthia A. Glassman and Paul S. Atkins to Rel. No. IA-2266, available at http://www.sec.gov.