[Senate Hearing 108-783]
[From the U.S. Government Publishing Office]
S. Hrg. 108-783
THE STATE OF THE SECURITIES INDUSTRY
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
ON
THE RECENT INITIATIVES TO ENHANCE INVESTOR PROTECTIONS IN OUR
SECURITIES MARKETS, FOCUSING ON FUND ADVERTISING, PROXY VOTING,
SARBANES-OXLEY ACT REQUIREMENTS, FUTURE MUTUAL FUND ACTIVITY, THE HEDGE
FUND REPORT, AND THE CANARY INVESTIGATION
__________
SEPTEMBER 30, 2003
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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98-781 WASHINGTON : 2004
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Douglas R. Nappi, Chief Counsel
Bryan N. Corbett, Counsel
Dean V. Shahinian, Counsel
Alexander M. Sternhell, Staff Director, Securities Subcommittee
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
C O N T E N T S
----------
TUESDAY, SEPTEMBER 30, 2003
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Hagel................................................ 4
Senator Enzi................................................. 4
Senator Corzine.............................................. 13
Senator Bunning.............................................. 15
Prepared statement....................................... 30
Senator Miller............................................... 18
Senator Allard............................................... 18
Prepared statement....................................... 30
Senator Carper............................................... 25
WITNESS
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission..................................................... 4
Prepared statement........................................... 30
Response to written questions of:
Senator Sarbanes......................................... 36
Senator Bayh and Senator Miller.......................... 38
Senator Allard........................................... 41
Senator Chafee........................................... 43
Senator Bayh............................................. 47
Senator Reed............................................. 48
Senator Schumer.......................................... 48
(iii)
THE STATE OF THE SECURITIES INDUSTRY
----------
TUESDAY, SEPTEMBER 30, 2003
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met, at 10:05 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Richard C. Shelby
(Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing will come to order. I would
like to welcome back to the Committee, Chairman Bill Donaldson
of the SEC.
As investors slowly recover from the financial fraud and
manipulation that characterized the pre-Sarbanes-Oxley era,
they now confront business practices and conflicts of interest
through which
securities firms seem all too willing to sacrifice investors'
interests for the sake of profits.
We have seen a number of instances in which the Wall Street
investment game appears rigged against the retail investor. In
April, this Committee examined the global settlement concerning
the conflicts of interest between investment banks and their
research analysts. We learned that in order to attract and
retain investment banking clients, bankers pressured analysts
to issue exaggerated reports that they knew were false or that
omitted crucial negative information.
It appeared that everyone on Wall Street knew that analysts
were issuing favorable reports in order to inflate stock prices
and generate more banking business. The average retail
investor, however, was unschooled in Wall Street's ways and
lost out.
Recently, we have learned about a number of trading
practices involving hedge funds and mutual funds that, once
again, profit Wall Street at the expense of average investors.
New York Attorney General Spitzer uncovered agreements by which
certain large mutual funds permitted a hedge fund to execute
illegal trades in exchange for a large investment in the mutual
funds. Simply, the mutual funds gave the hedge fund better
prices and more information than was available to the average
fund investor. This illegal arrangement is just one of the many
troubling issues that has come to light in the mutual fund
industry.
Mutual funds have always been perceived as the safe
investment option for average investors. Yet with the recent
revelations regarding illicit trading techniques and additional
criticisms concerning cost disclosure and fund sales practices,
many have come to question the perceived fairness of the mutual
fund industry.
With respect to the hedge fund industry, this Committee has
once already considered the lack of transparency and disclosure
surrounding the operation of an industry where billions of
dollars flow daily. I understand that the SEC has issued a
report on the industry and made several recommendations
concerning new regulations intended to protect investors. I
look forward to hearing the SEC's conclusions and proposals on
this subject.
We have also heard a lot regarding the ability of self-
regulatory organizations to adequately protect investors'
interests. As a result of the controversy surrounding Dick
Grasso's compensation, investors have questioned the New York
Stock Exchange's corporate governance standards and its
effectiveness as a regulator for its member firms. Many contend
that the NYSE's self-regulatory structure, in which the
chairman is essentially paid by the industry that he oversees,
has turned NYSE into an ineffective regulator. Given the
current regulatory structure of our markets, I believe it is
critical that investors have confidence that regulators are
constantly monitoring the industry and are protecting them
against misconduct. I understand that the SEC is reviewing the
New York Stock Exchange's governance structure and considering
the viability of self-regulatory organizations for the
securities markets. I look forward to hearing an update from
Chairman Donaldson here this morning.
During my tenure as Chairman of the Banking Committee, I
have expressed a great concern for investor protection and the
need to reform the culture on Wall Street. Our markets depend
on a transparent financial system in which investors receive
full and timely disclosure concerning their investments and
securities firms look out for investors' best interests. Too
often it appears that securities firms circumvent transparency
and neglect investors' interests in the pursuit of profit. Too
often it seems that Wall Street treats sanctions and settlement
costs as a cost of doing business.
I believe that we are at a critical juncture in regulating
the securities industry. Congress and the SEC need to reassure
investors that our markets are a place where they can safely
invest their money. Although we cannot legislate morality or
legislate away greed, we can ensure that the SEC relentlessly
pursues wrongdoing to promote trust in our markets. The purpose
of today's hearing is to consider issues concerning investor
protection in our securities markets and to understand how the
SEC is addressing them. Mr. Chairman, we look forward to your
testimony and to the round of questions that will come.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Chairman Shelby. I
am pleased to join with you in welcoming Chairman Donaldson of
the SEC back before the Committee.
Chairman Donaldson, there is a Chinese saying that one
should live in interesting times, and I thought of that saying
and of you when I looked at this morning's The New York Times.
I am going to hold it up. Now, this is on C4. It really is
rather daunting.
``Corporate Conduct in the Courthouse. `We are ready for
it,' Ex-Chief of Tyco Says as His Trial Begins.'' This is
Kozlowski. That is this story.
Then here, ``SEC Demands Documents From Former Enron
Chief,'' and here is a picture of Ken Lay, who refuses to
produce records that his lawyer says are covered by the Fifth
Amendment right against self-incrimination.
``Charges That Ex-Employee Lied to Hide Medco Fraud.'' That
is a continuation from page 1.
``Investment Banker's Trial Begins With Scrutiny of Jurors.
The criminal trial of Frank P. Quattrone,'' and then it goes on
from there.
``Rite Aid Lawyer Falsified Earnings, Prosecutor Says.''
And if that is not enough, over here, ``Amex Is Accused Of
Breaking Pact,'' and I thought to myself, I wonder how that
impacted Chairman Donaldson at breakfast when he turned inside
and saw that.
In addition--and I am going to ask you about this later--
there is a full-page ad in Thursday's The Wall Street Journal:
``In the wake of scandals like Enron and WorldCom, investors
deserve a true voice in director elections.'' And then it goes
on and discusses the question of open access for shareholders
as the next step.
So, Mr. Chairman, I am pleased you are holding this
hearing. It gives us an excellent opportunity to assess the
status of efforts on a broad front that promote integrity in
our markets and the confidence of our investors. And in many
respects, this comes at a very opportune time.
Just in the last several weeks, serious questions have
arisen in the equities markets over the corporate governance
practices of the New York Stock Exchange--questions involving
possible conflicts of interest, apparent lack of transparency,
levels of executive compensation, and, of course, they also
involve the very important question of self-regulation, the
traditional dual role of the NYSE as both a securities market
and as a regulator of its members.
We know that Chairman Donaldson met yesterday with John
Reed, who temporarily has taken over the leadership of the
NYSE. I would be interested in his read on where that is going.
In the mutual funds market, the Attorney General of New
York has brought charges against major investment companies
that allegedly were given preferential pricing to a hedge fund,
contrary to their policies and the law. I understand both the
SEC and the Attorney General of New York are continuing an
investigation of mutual fund practices.
Many other issues remain with us, the appropriate
regulation of hedge funds among them. Increasingly, they are
marketed to a widening circle of investors, although they
remain in many ways unregulated.
We held a hearing on this earlier in the year, under your
leadership.
Chairman Shelby. Yes, we did.
Senator Sarbanes. And, yesterday, the Commission released a
staff study on hedge funds addressing questions of
registration, valuation, sales to retail investors, and other
concerns. They made a number of important recommendations. We
look forward to hearing about them this morning.
There is a whole range of other issues--the credit rating
agencies, the suitability requirements, sale of proprietary
mutual funds. We need to address I think, again, the adequacy
of the Commission's funding and what we may need to do in the
Congress about that. So we have a very full agenda here, and I
look forward to this hearing.
I want at the outset to commend the Commission, the
Commission staff, and Chairman Donaldson for their dedicated
efforts. They are facing major challenges, obviously, and
stories of the sort that I cited here, which completely
dominate. Every story on that page sends a negative message
with respect to market integrity and investor confidence. We
need to keep driving hard to clean this situation up so we do
not get those kinds of stories dominating the press day in and
day out.
I think we are making important steps, and I am pleased
that Chairman Donaldson is in place, as I have indicated in the
past. But, obviously, he and his fellow Commissioners have
major challenges ahead of them, and we need to work closely
with the SEC in all respects in order to help clean up this
situation.
Thank you very much.
Chairman Shelby. Senator Hagel.
COMMENTS OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, I have no statement, and I
appreciate your holding the hearing and look forward to the
Chairman's testimony.
Thank you.
Chairman Shelby. Senator Enzi.
STATEMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. Mr. Chairman, I appreciate your holding the
hearing, I appreciate Chairman Donaldson being here, and I
would submit my statement for the record.
Chairman Shelby. Chairman Donaldson, your statement will be
made part of the record in its entirety. You proceed as you
wish.
STATEMENT OF WILLIAM H. DONALDSON
CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Chairman Donaldson. Chairman Shelby, Ranking Member
Sarbanes, and Members of the Committee, thanks for inviting me
to testify today on the Securities and Exchange Commission's
recent initiatives to enhance investor protections in our
securities markets. I appreciate having this opportunity to be
here. I want to thank you and your Committee for your continued
interest in the issues before the SEC. You are helping us to
move our agenda forward, and that is helping to ensure that
America's securities markets remain the strongest in the world.
Since its creation in 1934, the SEC's mandate has been to
protect investors and ensure the integrity of America's
securities markets. That mandate has taken on even greater
importance in recent years, as you indicate. With more than 95
million Americans invested in mutual funds, representing
approximately 54 million U.S. households, and a combined $6.5
trillion in assets, mutual funds are a vital part of this
Nation's economy. While much of the public focus over the last
few years has been on the events surrounding public companies,
the Commission has undertaken an aggressive agenda to identify
and address challenges in the mutual fund industry, an agenda
that helps us to protect this vital segment.
It is critical that mutual fund investors have access to
reliable information on which to base their investment
decisions. In this regard, we continue to emphasize the
importance of full and fair disclosure of fund fees and
expenses. I would like to summarize for you several rulemaking
initiatives that are designed to give fund shareholders a
better understanding of their fees and expenses.
Just last week, we adopted rule amendments to modernize the
mutual fund advertising requirements to encourage more
responsible advertising. The new amendments require that fund
advertisements state that investors should consider a fund's
fees before investing in it and must include information about
the fund's investment objectives and risks, as well as an
explanation that the prospectus contains this and other
important information.
The Commission also, last week, proposed new rules under
the Investment Company Act that would broaden the ability of
one fund to acquire shares of another fund, so-called ``funds
of funds.'' The proposal included improvements to the
transparency of the expenses of these funds to further assist
investors.
We have also proposed that mutual funds be required to
disclose, in dollars and cents, the amount they effectively pay
by being invested in a fund over the reporting period.
We also anticipate taking actions to improve the disclosure
of breakpoint discounts on sales loads linked to the dollar
amount of purchases. We want to ensure that investors
understand those discounts and are receiving them.
Another area we are looking at is the need to increase
investor understanding of the incentives and conflicts that
broker-dealers have in offering mutual fund shares to
investors. Initiatives we are considering in this area include
a comprehensive revision to mutual fund confirmation form
requirements to highlight these conflicts.
While a critical component of investor protection is
ensuring that investors have the information they need to make
an informed investment decision, it is also important that the
funds and their adviser have strong internal controls and
governance structures. So, in addition to its disclosure
initiatives, the Commission has also focused its rulemaking
efforts on fund governance and internal compliance issues.
In February, the Commission proposed rules aimed at
ensuring better compliance with regulations governing mutual
funds. These rules would mandate that funds and investment
advisers maintain comprehensive compliance policies and
procedures reasonably designed to prevent violation of the
Federal securities laws. Additionally, I would note that we
diligently have applied the provisions of the Sarbanes-Oxley
Act to mutual funds in every way we could. While many
characteristics of mutual funds are different from those of
publicly held issuers, we are able to tailor our rulemaking to
account for these differences in every case as dictated by the
legislation.
We have also included mutual funds in initiatives to
increase shareholder participation in the director nomination
process. Last month, we proposed rule changes that would
strengthen disclosure requirements in operating companies and
mutual funds related to the nomination of directors and
shareholder communications with directors. The enhanced
disclosure provided by the proposal should benefit fund
shareholders by improving the transparency of the nominating
process and board operations, as well as increasing
shareholders' understanding of the funds in which they invest.
I understand that the Committee is interested in getting an
update on a few other issues for today's hearing, so let me
just briefly bring you up to speed on those areas.
Since June of last year, the SEC staff has conducted a
comprehensive study focusing on the investor protection
implications of the significant growth of hedge funds. Just
yesterday, as you mentioned, the SEC staff released a report
that outlines factual findings, identifies concerns, and
recommends certain regulatory and other actions to improve the
current system of hedge fund regulation and oversight. The full
text is available through the SEC website.
While I am looking forward to studying the staff's report
and receiving comments from the general public in line with the
recommendations that have been made, I will say, as I have said
before, that I believe that the Commission needs to have a
means of examining hedge funds and how they operate. Speaking
only for myself, I believe that the registration of hedge fund
advisers would accomplish this.
While I am on the topic of hedge funds, let me update you
about our involvement in recent allegations regarding a hedge
fund's practices in late trading and market timing of mutual
funds. We have put in motion an action plan to vigorously
investigate this matter, assess the scope of the problem, and
hold any wrongdoers accountable. And we will do so in close
coordination with State regulators. I have also asked our staff
to study whether we need to take additional regulatory steps to
address these concerns.
Now I would like to turn to an issue that is important both
from a regulatory standpoint and from the standpoint of the
investing public: The critical need for sound governance
practices by self-regulatory organizations. I believe that
self-regulatory organizations should be exemplars of good
governance. At a minimum, SRO's should demand of themselves the
same high standards of governance that the New York Stock
Exchange and Nasdaq propose for their listed issuers in the
wake of several widely publicized corporate scandals. To
further that goal, this past March, I directed each self-
regulatory organization to undertake a review of its own
governance practices.
Since then, disclosure of the compensation awarded to the
former Chairman of the New York Stock Exchange has heightened
the scrutiny that the Commission, the securities industry, the
investing public, and the media are paying to exchange
governance standards that reflect the highest commitment to
independent and transparent decisionmaking. Prior to the
current controversy, the NYSE and a few other self-regulatory
organizations instituted special governance committees to
further study how their structures and processes might be
improved. I applaud those efforts, but I believe that more
remains to be done. I understand that the New York Stock
Exchange's new interim Chairman, John Reed, intends to
reexamine these governance issues in more depth. I look forward
to working with Chairman Reed on this important initiative.
Finally, the Committee requested an update, since my
testimony on May 7, on the status of the research analyst
global settlement, the SEC's portion of which was filed with a
Federal court on April 28, 2003.
Since the filing of the proposed settlement agreement with
the Federal court, U.S. District Court Judge William H. Pauley,
III has issued a series of orders requesting that the parties--
both the Commission and the participating firms--submit
additional information to the court relating to the terms of
the settlement. We have done that and are awaiting the court's
action.
That concludes my formal testimony. I would be pleased to
answer any questions that you may have or hear any
observations. Thank you.
Chairman Shelby. Thank you, Mr. Chairman.
Mr. Chairman, many press accounts have stated that it is
untenable for a regulator to be simultaneously running a
business. Some argue that if the business of price discovery
and trading is the New York Stock Exchange's dominant concern,
then it may be time for the SEC to consider whether there
should be a separation of regulatory functions of the New York
Stock Exchange from the business functions.
In recent comments, Mr. Grasso reflected the predominance
of business concerns at the New York Stock Exchange by
characterizing himself as ``two-thirds businessman and one-
third regulator.''
Mr. Chairman, should the New York Stock Exchange separate
its regulatory function from its business operations?
Chairman Donaldson. That is a complex question. As you
know, going back to the original securities acts in the 1930's,
I think the then-Commission implementing those acts did what
was then a very wise thing, which was to include in the self-
regulatory organization a regulatory mechanism, build it down
to the operating level so that the regulation would not be part
of a large government bureaucracy. They left that to the SEC to
oversee, basically regulation that was embedded with
practitioners. And, through the years, that has worked pretty
well, with some noticeable exceptions.
However, we are at a stage now, in my view, where we really
have to reexamine the locus of the regulatory mechanism, and
there are many different ways of achieving that, which is now
embedded in the Stock Exchange mechanism.
I think the key issue here is how the regulatory mechanism
is financed, where the funds come from, and also, where it
reports to the governance structure. And that leads into the
governance structure. You must have, in my view--and this is
what the New York Stock Exchange is working on right now in the
form of John Reed as new temporary Chairman--a broad structure
which avoids the obvious potential conflicts of interest
inherent in those that are being regulated riding herd on
themselves.
Chairman Shelby. That is hard to do, though, is it not?
Mr. Donaldson. Pardon?
Chairman Shelby. It is going to be hard to do. You want to
do business, and then you are regulating, too.
Chairman Donaldson. Yes. I think that there are a number of
different approaches to this. I had the opportunity yesterday
to discuss this with John Reed. We have done some thinking of
our own. But I believe that the first step here is for the New
York Stock Exchange to get at its own governance structure.
Chairman Shelby. It goes to corporate governance, does it
not?
Chairman Donaldson. It goes to the corporate governance. It
goes to the representation on the board by practitioners,
security industry practitioners, the member firms. It goes to
the independence of the directors. As you suggest, it goes to
just how do you maintain a regulatory mechanism and yet not
have it subjected to not only the potential conflicts of
interest inherent in board membership, but also have it
basically influenced, if it is, by that aspect of the Exchange
which is a business.
In the final analysis, the New York Stock Exchange is a
competing market. One of the issues that we have is to make
sure that that competition is fair competition and to make sure
that investors are protected. But in the final analysis, within
the rules we set down, it is a business. It is a competitive
business, and it cannot be subjected to or sublimated, if you
will, to the regulatory role that is resident there.
Chairman Shelby. Mr. Chairman, many are questioning why it
was the Attorney General of New York Eliot Spitzer and not the
SEC that discovered and initiated the current investigation
involving trading practices in the mutual fund industry. Does
it concern you, as the Chairman of the SEC, that a
whistleblower first reported a violation to a State Attorney
General rather than to the SEC? And what are you doing to
coordinate investigations and enforcement action with the
States?
Chairman Donaldson. Well, I wish the whistleblower had
reported it to us. On the other hand, I believe that legitimate
whistleblowers, no matter where they report, are welcome.
I think that if your question goes to, you know, should we
have picked up the collusive arrangements between a hedge fund
and----
Chairman Shelby. Or even reached out to people that would
apprise you of such things.
Chairman Donaldson. Well, the allegations against the
Canary hedge fund with the mutual fund it is alleged to have
colluded with, that was very hard to find--a design that is
designed to cloud an illegal act between two parties. And I
suspect that, in a normal look at mutual funds, it would have
been tough to find that. If we--and this gets back to the hedge
fund report by our staff--had the right to go into that fund,
hopefully we would have combined that with the ability to
inspect on the other side, and we would have discovered it. But
we did not, and I suspect as we go on down here in all aspects
of what we are doing, there will be people who have special
knowledge of collusive and illegal acts who serve as
whistleblowers. And I do not think we will be the recipient of
all those pieces--I want to assure you that we do look into
every accusation like that, but I suspect we are not going to
get all of them.
Chairman Shelby. Will you be looking at all the mutual
funds to see if what has come out lately is widespread in the
industry?
Chairman Donaldson. Yes.
Chairman Shelby. And do you have the people to look at it?
And if not, why not?
Chairman Donaldson. Basically--I was looking into the
entire program that we underwent once that accusation was made.
We have been in touch via letters to some--I think 75 percent
of the mutual fund industry--requesting their comments on how
they handle so-called trading, late trading aspects and the
pricing aspects. We have been in touch with the various trade
organizations asking them to go out with letters and warnings
to the members of those trade organizations----
Chairman Shelby. Wait a minute. Not just warnings. Will you
be, at the SEC, doing the probing yourself to see if this is a
widespread practice?
Chairman Donaldson. Absolutely. That is exactly what we are
doing. And we are putting considerable resources into that. We
view this as a very important aspect of what we are doing. We
want to either find out--hopefully, we do not--that this is a
broad-based practice, or we want to find out that it is not.
Chairman Shelby. Senator Sarbanes, thank you for your
indulgence. I am way over my time.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Donaldson, before I get to some specific matters,
I want to ask a question about a time frame. You are now
looking at mutual funds--you have got an ongoing investigation.
And you have just published a hedge fund report. Only
yesterday, you met with the interim head of the New York Stock
Exchange concerning the corporate governance practices and many
other aspects of its activities.
In March, you directed each self-regulatory organization,
not just the New York Stock Exchange, to undertake a review of
its own governance practices. The SEC is considering rules with
respect to investors' ability to nominate and elect corporate
board candidates. And there are other matters as well that I
have not mentioned.
When we were discussing the Sarbanes-Oxley Act and we had
Chairman McDonough of the Public Company Accounting Oversight
Board here just a short while ago, the general view was that by
the beginning of next year, next calendar year, that framework
would be fully in place, and so that all the actors would know
the framework within which they were working.
My question to you is: When do you realistically anticipate
that, with all these other areas in which you are working--and
I know as days go by new things come to light--reach the point
where a framework has been fully into place and you can then
say to people, well, these are the arrangements under which you
must operate, you need to adjust your practices to conform to
them, and then get on about your business?
I think it is very important to try to get that settled as
quickly as we can without giving up doing the quality work that
is necessary. But do you have any sense in your own mind as you
look out over the landscape when you may be able to get all of
this into place?
Chairman Donaldson. Are you referring----
Senator Sarbanes. I know your staff has been working
overtime now for more than a year, and I respect that. But we
have to get this thing up and settled, so to speak.
Chairman Donaldson. Are you referring specifically to the
mutual funds, Senator, or are you referring to some----
Senator Sarbanes. And the hedge funds, the corporate
governance at the Stock Exchange, the shareholder--the whole
agenda.
Chairman Donaldson. It is a pretty broad question, and I
think there are different timetables in different areas. Let me
say in the mutual fund area, you know, as far as fees and
expenses and that thing, this month we will be--we have put
forth some specifications on mutual fund advertising rules,
which, in effect, will get at the whole fee structure, if you
will, in terms of public disclosure. We are looking at now a
comprehensive revision of mutual fund confirmations. And I have
to remind you that this--you know, we are affecting a huge
business, and we are incurring all sorts of attitudes toward
what must be disclosed, and we are looking at the expenses of
doing that. You know, we are trying to act deliberately but not
precipitously in all these areas.
I think that in terms of the governance aspects of the
Sarbanes-Oxley Act, in terms of the corporate world, if you
will, all of the regulations are in place now. I mean, we have
the independent audit committees. We have the new
responsibility for the audit committees. We have a whole series
of things that are there. The rules are there. PCAOB is going
to be exercising its responsibilities in terms of the function
of auditors and accountants and so forth. So that is in place.
On the hedge fund report that we have just received, the
staff has made specific recommendations, and the process now is
for us to receive comments from all interested parties as
against not only the report itself, but also the
recommendations in it. And I would hope that within a
relatively short period of time we will have gathered all of
those comments, and then the Commission itself can make its
decision.
There are some uncertainties here on the hedge fund thing.
There are uncertainties as to costs, resources, et cetera, et
cetera. But we will be well into it in the early part of next
year.
Senator Sarbanes. Well, do you think the end of this year
or the early part of next year is a reasonable timetable to get
all these things into place?
Chairman Donaldson. For some of these things, yes. For
some, not. For some, we need to do more research. I cannot
emphasize enough that we cannot be precipitous. We have to be
careful. We have to be sure that some of the things we are
doing do not have unintended consequences. After all, we are
setting rules for the long haul here, so that I think we need
to pursue this with all deliberate speed.
I also would say that we are in the process of building our
staff, and we are well along in that, and that is going to give
us more resources. I would say something else in terms of some
of the impact of some of the rules and regulations we are
putting in, and that is that we have a management effort
underway now to organize ourselves in two ways that I think
will attack both our deployment of resources and the rapidity
with which we can take action.
In terms of the deployment of resources, we have to get a
lot smarter than we have been in terms of looking around the
corner and over the hill and anticipating problems. And we have
to get a lot smarter in terms of how we deploy our resources
and using sampling techniques and efficiency techniques--we
have to get more efficient in the way we uncover things. We
cannot just go out after everything. We have to get more
efficient in the signals that we get and how we act on signals
to concentrate our efforts in areas of high concern.
Senator Sarbanes. May I ask one more question?
Chairman Shelby. Go ahead.
Senator Sarbanes. I want to ask just one more question. I
think it is important as you are doing this to make systemic
changes that may diminish the likelihood of abuses happening,
in addition to punishing the bad apples. But, for instance, it
seems to me on these late trading mutual funds, you have got to
figure out some changes in the system that inhibit that kind of
practice as well as go after the ones who have been engaged in
it. And I think the industry itself needs to be thinking about
how they can do that.
In that regard, one systemic change that might be made with
respect to corporate reform addresses this The Wall Street
Journal full-page ad that was California Public Employees, the
Connecticut Retirement Plan, New York State Common Retirement
Fund, AFSCME, about open access for shareholders as the next
critical step of corporate reform. And they have a number of
proposals with respect to giving investors timely access to the
ballot. They seem to be sensitive to guarding against corporate
raiders or hostile takeovers, which is one concern that has
been raised.
I appreciate it is a complex situation, but if that can be
structured, then the shareholders, particularly these big
institutional
investors, may become part of the system of assuring
responsible behavior on the particular of management as it is
translated through the shareholders to the board of directors
and then to the management.
Where is the SEC on these questions of open access for
shareholders?
Chairman Donaldson. Well, as you know, this is an area of
considerable concern for us. The issue of shareholder
participation in the election of directors has been around for
a long time, and not a lot has been done about it. And we
intend to propose measures to do something about it.
Now, there is a trade-off here. There is a trade-off
between the efficiency and effectiveness of a corporate board
of directors constituted by people who are working in the best
interests of the corporation, as opposed to a model that would
have representation that has separate agendas, constituency
interests, and so forth, which could result in a malfunctioning
board.
So we are trying to go down a narrow path here which says
that there should be some measure of shareholder participation
in the selection process of directors if there is evidence that
large numbers of shareholders' wishes are not being reflected
at the board level. If, in fact, in proxy materials a proposal
is put forth year after year that receives a large number of
shareholder votes and a corporation does not do anything about
it, then we say that is when there should be a way that
shareholders could propose somebody for the board. But that
somebody for the board cannot be--has to go through the same
thing that any board member would in terms of conflicts of
interest. We cannot put competitors on the board, or we cannot
put people that have some a vested interest on the board. It
has to be a truly independent shareholder, not paid for by
somebody else, et cetera.
So that is a long way around saying that we are working
very hard on a proposal. We have it out there now in terms of
our general direction, and you will hear from us very shortly
on some specific rule proposals that get at some of the things
I am discussing.
Senator Sarbanes. Mr. Chairman, I may revisit that, but
thank you, Mr. Chairman. My time is up.
Chairman Shelby. Thank you, Senator Sarbanes.
Senator Hagel.
Senator Hagel. Mr. Chairman, thank you.
Chairman Donaldson, welcome. As you know, the SEC, OFHEO,
and the U.S. Attorney's Office in Alexandria are looking at
management and financial accounting issues regarding Freddie
Mac. Can you give this Committee some sense of timing as to the
SEC investigation, when you are anticipating to have a report,
and maybe a status on where you are in that investigation?
Chairman Donaldson. As you know, Senator, Freddie Mac has
agreed to voluntary registration of its shares, and we were
working with them to get them prepared for the voluntary
registration of their shares.
Up until now, we have not been their regulator, so that
there are two things going on here. There is the internal
investigation going on in Freddie Mac by its regulator, which
we do not have anything to do with. There are our efforts to
get them to a point of conformance with our registration rules
and regulations. We do not control the timing of what is going
on with the other regulators.
What we do have an interest in, even though they are not
registered with us now, is evidences of fraud. And if there is
evidence of fraud, even though they are not registered, the
impact on the marketplace, we would have a role there.
Senator Hagel. Are you reviewing that now?
Chairman Donaldson. We are looking at that right now, yes.
Senator Hagel. Can you tell us anything more about that?
Chairman Donaldson. No, I really cannot at this point.
Senator Hagel. But you have it under active review--
management and accounting?
Chairman Donaldson. Yes, we are in touch with them, and we
are interested in any evidence of fraud that there might be or
might not be.
Senator Hagel. Thank you.
As you know, the Nasdaq market has been in the process of
trying to complete its separation from the NASD for 3 years. I
know they have an application in with the SEC. Can you give us
a sense of where that is?
Chairman Donaldson. Basically, the NASD and the Nasdaq
market itself has applied to be classified as a stock exchange,
and there are certain qualifications under the Securities Act
as to what constitutes a stock exchange, and part of that--
without getting too detailed--it has to do with opportunities
for order interaction and pricing improvements such as exist on
the New York Stock Exchange. And right now they do not qualify.
And we have been in discussions with them to see if we can get
some modification in their approach. We also are concerned, as
we are with the issue of public ownership. The Nasdaq market
has, in effect, backed into public ownership. I mean, there is
public ownership of the Nasdaq market, and that brings into
focus what oversight or board governance measures one would
have if it should happen in the future that there would be a
large external owner of that--what protections could be built
into the board of directors and in the event of more extensive
ownership, and with some other securities markets, perhaps even
total ownership by somebody other than the members of the
Exchange. And that is an area that we are working on very hard
right now.
But I assure you that we are not just sitting on the Nasdaq
application. We are trying to integrate that and our concerns
with it, with our concern for the overall market structure
issue. We are in a period now where, with the advent of
nanosecond-trading, with the advent of the ECN's and so forth,
we are in a period where the whole market structure issue needs
to be reviewed, and we are in the process of doing that. And
that is going to take some time because it is a very complex
issue, and I think this gets back to Senator Sarbanes'
question.
When we step back from all of this, when we step back from
the press reports and look at the American market system,
including the New York Stock Exchange, the Nasdaq, the regional
exchanges, the ECN's, and so forth, we still have the best
system in the world. And we have to be very careful, as we try
to change it and modernize it and accommodate the technology
that has come into being, that we do not make some false steps
here that would destroy our market and have it go somewhere
else. And that is why we want to pursue all of this with
deliberate speed but not haste with the unintended consequences
we would regret.
Senator Hagel. Thank you.
Mr. Chairman, thank you.
Chairman Shelby. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman. Thank you for
holding this hearing, and I welcome Chairman Donaldson. Like
many others, I think you are doing at outstanding job, but the
array of issues is pretty remarkable, as we have discussed as
we have gone through.
I am going to focus on the mutual fund industry primarily
today, but it is not because I do not have interest in the
kinds of things that Senator Hagel and others are talking
about, because they are really key. But it strikes me that when
we look at the issues that are on the table with regard to
mutual funds, they have a lot of overlap in the kinds of issues
that preceded Sarbanes-Oxley and corporate America and other
places with regard to corporate governance and now we see
echoed in the New York Stock Exchange.
Isn't it time when the requirement is only that 40 percent
of the directors of mutual funds be independent and that there
is no independence question with regard to the chairman and
that many of the mutual funds are embedded in organizations
that benefit both from sales practices and as the discussion on
fee disclosure shows, is not it time for independence to be
brought to the corporate governance structure? And are you
pursuing that? Do you believe that is the direction that needs
to be taken along with--and I will follow this up--another
element that I think is a model or circumstance that flowed
from Sarbanes-Oxley? Do we have enough staff to actually
provide the checks and balances from the regulatory side to be
able to look at the mutual fund industry in a consistent way
that we do not run into a situation where we think we are
regulated, but we are really not because we do not have the
ability to actually go through and bring the kind of discipline
to the process that is necessary?
So it is really on two fronts: First, the governance
concepts, which I think really gets at a whole series of
things, whether it is fees, whether it is the intermixing of
hedge funds and mutual funds management. I would like to hear
your views on that. And then, second, with regard to do you
have enough staff to be able to apply the same kinds of
standards that you might in other areas? We certainly had to
grow staff when we are talking about looking at implementing
Sarbanes-Oxley. We looked at the number of accountants, the
number of people that were involved in the enforcement area,
whether it was adequate. Is it adequate today with respect to
the mutual fund industry?
Chairman Donaldson. Well, let me address the staff issue
first, Senator. As you know, we are in a major build-up of
staff. We are trying to do that again, deliberately. We are not
just out hiring willy-nilly. We have a system going now in
which we are going to be very quality conscious. And I am
pleased to report that, you know, we really could only get
going on some of the nonlawyer hiring as recently as July. And
we now are going full blast, and we are hiring. So we will have
additional resources.
Are those resources adequate to do all the tasks before us?
I would reemphasize what I said before, and that is that we
have to be more effective in the way we use our staff because
we have to have--to put it in industrial terms--a productivity
improvement, if you will, so that we are concentrating our
people on areas of high risk, high need, and high potential for
investor problems. And I think that we have only just begun to
concentrate on that.
So, I cannot answer you yet in terms of do we have enough
people. I think we do--I think we will have by the end of this
year, and I think we will have implemented some of the things
that I am talking about in terms of early warning systems and
so forth that will help us be more efficient.
Senator Corzine. When you are looking at your priorities,
though, is the mutual fund industry one of those areas where
you believe that there is need for additional staff and----
Chairman Donaldson. On which part?
Senator Corzine. In the mutual fund industry itself. It is
a specialization that is somewhat different than----
Chairman Donaldson. I think that right now we are pleased
with the build-up that we are having in that staff right now.
We think it is going to be adequate to what we have on our
agenda.
The Investment Company Act rules require a majority of
independent directors. I am now getting into your second
question here. And I would like to make a general statement,
which is that in addition to the rules and regulations that are
in the Investment Company Act, in addition to the changes that
we either have made or are not making, I believe we are
heightening the awareness of the directors of mutual fund
companies. I think we are heightening awareness of the
responsibility similiarly for just regular industrial
corporations. And the real impetus that will reduce the need
for our staff to expand and expand and expand is if the mutual
fund industry and corporate America will take it upon
themselves not to just wait for the rules to come along, but to
change their processes, to realize where there are conflicts,
to realize where there is too little sunshine in terms of
disclosing, what, you know, the costs of mutual funds are, et
cetera. I mean, that is the old saw of corporate
responsibility, in this case mutual fund management
responsibility. And I am hopeful that we are going to see some
changes in that area that are self-imposed rather than thrust
upon them by rules.
Senator Corzine. Do you have a view on the independence of
the chairman in mutual funds?
Chairman Donaldson. On the?
Senator Corzine. The independence of the chairman of a
mutual fund board?
Chairman Donaldson. My own personal view on that is to try
to make myself available and listen to the arguments on both
sides. The industry believes that there is a certain efficiency
involved with a chairman that is intimately involved with a
number of funds and knows--as opposed to somebody totally
independent with no knowledge of the industry, somebody that is
familiar with a fund group and how it operates. There is some
merit to that.
I feel ultimately that there needs to be more independence
in that chairman role, but we are balancing that and looking at
it.
Senator Corzine. Thank you, Mr. Chairman.
Chairman Shelby. Mr. Chairman, before I call on Senator
Bunning, I think that you are absolutely right that we have
raised--everybody, the public, the media, and the people--the
level of debate on all of the issues involving integrity,
conflicts of interest, and self-dealing in the capital markets,
including mutual funds, perhaps. The question is: Where do we
go from here? And how long is it going to take? I was thinking
of some questions Senator Sarbanes was asking.
Senator Bunning.
COMMENTS OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman, for holding the
hearing. And thank you, Chairman Donaldson, for being here.
In your staff report on hedge funds released yesterday, the
staff looks at requiring hedge fund managers to register with
the SEC as investment advisers. Does the SEC have the resources
to take on this new responsibility, especially in light of the
fact that there could be up to about 3,000 new registrations?
Chairman Donaldson. Right. Well, I think that the first-
level response to that is that we would--if the Commission does
decide to require registration, it would be the regular--the
forms and what information we are requiring would be tailored
to particular interests that we would have in the hedge fund
industry. So that is the first level.
Senator Bunning. Well, wouldn't transparency be the number
one issue that all of us are looking for, according to The Wall
Street Journal, according to the general consensus of the
American people, a little more sunlight into what really hedge
fund--what function they perform?
Chairman Donaldson. Well, that is a very important part of
what we are interested in. However, I would say that what we
have not concluded is that certain of the proprietary
techniques used in hedge fund management, some of the ways the
funds are managed--you know, we do not feel that it would be
fair to require disclosure of that in a competitive
environment, unless we saw evidence of the fact that the
techniques were somehow impacting the marketplace in a way that
needs to be regulated. There are other things that we are
interested in.
Senator Bunning. But we have evidence, obviously, or at
least there is very strong evidence that hedge funds have been
bending the rules, in fact, stepping over the line as far as
mutual funds purchases. Anybody that is at all familiar with
investments knows that if you buy after the close at the close
price and then you can sell in the morning at the morning
opening, you have a chance to build in a profit.
Senator Sarbanes. You are telling me.
[Laughter.]
Senator Bunning. Big time.
Now, if that is what a hedge fund is doing, you should be
able to stop that. You are not the regulator, but you should be
the regulator of hedge funds.
Chairman Donaldson. Well, there are two parts to that. It
takes two to tango. It takes the hedge fund, and it takes the
mutual fund that it is dealing with.
Senator Bunning. That is correct.
Chairman Donaldson. You are absolutely right in terms of
both sides need--the mutual funds have made their own efforts
to close down the kind of trading that you talk about by higher
fees, redemption fees, et cetera. The issue here is whether
they have tried hard enough, and an even bigger issue is
whether they have aided or abetted those kinds of transactions.
And there is some evidence, at least in one fund--and we are
looking at it. Whether it is more widespread or not remains to
be seen.
On the hedge fund side, I think that what we are looking at
is the registration of the hedge funds so that we can go in and
see what they are doing. And, again, on the Canary situation,
had we been able to be on both sides of that, we would have had
a much higher probability perhaps of catching it. And I do not
wish to imply that we are going to catch every----
Senator Bunning. I only get 5 minutes, so let me----
Chairman Donaldson. Go ahead.
Senator Bunning. Let me get into derivatives, because I
worry daily about derivatives and their use in our markets
today. Now, I know there are certain investors who have big
concerns about derivatives, and I know that the Chairman of the
Federal Reserve thinks they are wonderful things. But I worry
about the regulation of derivatives, the same as I worry about
the regulation of hedge funds.
What is the SEC doing to make sure that derivatives are
used properly?
Chairman Donaldson. I share your concern about the use of
derivatives and the risks that are out there and the lack of
knowledge that exists. Clearly, the Federal Reserve is involved
in this, was intimately involved in the Long-Term Capital
instance where derivatives almost caused--or did cause--a big
flap.
Senator Bunning. Yes.
Chairman Donaldson. And almost a major failure.
I think that we are doing everything we can to understand
the impact of derivatives and the potential impact that they
can have. But it is not just we that can do it, I mean, because
they are so pervasive into areas that we do not regulate--
foreign banks and other entities which use these instruments.
And I think it is a matter of concern. We have the President's
Task Force where the Chairman of the Federal Reserve, the
Chairman of the SEC, and the Chairman of CFTC get together and
their staffs get together, and this is one of the issues that
is discussed at those meetings.
Senator Bunning. All I can tell you, Mr. Chairman, is that
the American investor who had implicit confidence in the
markets at one time, they do not now. And unless the Securities
and Exchange Commission in their regulatory function can
instill back that confidence by doing something and overseeing
the markets better, we are never going to have the same
confidence that we had 30 years ago, 20 years ago in our
markets, and that is absolutely essential if this country is
going to move forward. We cannot have the productivity of the
American worker and our GDP advancing with a no-growth-job
economy unless people trust our regulators. And I am just
saying that as a matter of fact. And not only you as a
regulator, but also all those who are regulating everything
else government-wise.
So, please, please, with haste and with due diligence, get
your job done.
Chairman Donaldson. Senator, if I can, I believe that goal
is the top goal for me and for the Commission, and that is
trust in us as a regulator.
I just have to say, as an aside on derivatives themselves,
that there are aspects of derivatives that are helpful. Insofar
as derivatives shift and share risk, the case could be made
that we have avoided a lot of disasters because of the
judicious use of derivatives to lay off risk and spread it
around.
So we have to be very careful that we do not throw out the
good with the bad.
Senator Bunning. One of the smartest investors in this
country said, ``It is a ticking time bomb.'' And I do not have
to tell you who that is.
Chairman Donaldson. And he had another very smart investor
on the other side, who currently is Chairman of the Federal
Reserve, who disagrees with him.
Senator Bunning. Well, it is easy to invest in Government
bonds.
Chairman Shelby. Senator Miller.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. Thank you, Mr. Chairman, for holding this
hearing, and Mr. Chairman, thank you for being with us and for
the job you are doing and the way that you have responded to
the questions.
The questions that I came prepared to ask have already been
asked, but I think I would ask: Would you care to comment on
the current working relationship between the SEC, the State
securities administrators, and the State attorneys general on
resolving the various enforcement issues that have arisen, and
do you think there are any changes that may be needed to be
made in the SEC's relationship with the States?
Chairman Donaldson. It is an excellent question. It is one
that we are very concerned about. Let me just say this, that we
need and encourage all the help we can get from local
regulators in the securities industry at the local level where
they can uncover and investigate things that go beneath our
screen, so that if there is malfeasance or fraud or whatever at
a local level, we welcome the local administrators and
securities administrators.
At another level, and that is the level of the structure of
the markets themselves, we believe and I believe very strongly
that we cannot have 50 different structural solutions, we
cannot have 50 different ways, perspectives as they are put
out, and trading rules and so forth. So that, if the solution
or the fine is followed by some structural change. I believe
that that has to be done by the Federal administrators.
Having said that, we need to and we have cooperated with
local securities regulators. Just 2 weeks ago in connection
with the chairwoman of the State regulators trade association,
we agreed to enter into a joint arrangement with them to see if
we could not improve communication and cooperation. That will
go a long way.
I will say it again and in frank answer to what you said,
there are areas where a local authority can step in too late to
an investigation that is already under way and in so doing
interrupt a carefully put-together investigation by a Federal
functionary, and this is where I think we get into trouble,
where there is considerable work that has been done, cases
being built, and someone comes in from left field and does not
really add anything and in fact might create an environment
where the accused will get off because of a technicality.
Senator Miller. Thank you.
Chairman Shelby. Senator Allard.
COMMENTS OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you very much. I have a
statement here that I would like unanimous consent to be
included in the record.
Chairman Shelby. Your statement will be made part of the
record, Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
I would like to explore a little bit the Investment Company
Act of 1940 and whether or not any amendments may be needed to
bring it up-to-date or whether it is okay the way it is.
I understand that in order to manage a mutual fund
effectively, generally, what is required is that the SEC has to
grant about 8 to 10 exemptions from the Investment Company Act
and that many times, the SEC may or does impose conditions of
its own as a condition of granting those exemptions.
Am I correct in that?
Chairman Donaldson. I did not get the last part, Senator.
Senator Allard. That in addition to the 8 or 10 exemptions
from the Act, you have your own conditions that you also place
on the applicant and in the management of the mutual fund.
Am I correct in that?
Chairman Donaldson. Yes.
Senator Allard. Okay. If so many exemptions from the
present Act are required to do business, do you think the Act
should be brought up-to-date to reflect present-day realities?
Chairman Donaldson. At the present moment, we think we have
the authority, rulemaking authority, under the Investment
Company Act to do what we think needs to be done. That could
change, but at this juncture, we do not think we need----
Senator Allard. The exemptions that you grant on a fairly
regular basis, is the nature of these exemptions time and time
again, or are they variable depending on----
Chairman Donaldson. Yes. A perfect example of that would be
the rules that will allow the so-called ``fund of funds'' to
not require an individual exemptive under, would allow a mutual
fund to buy another fund that might have a different
objective--a mutual fund that might own stocks and want to buy
a money market fund. Right now, we give exemptions for that
being done, and we are changing that now so that that can be
done without the----
Senator Allard. Where they use the money market funds more
or less as a holding fund, and then you have your investment
fund over here.
Chairman Donaldson. Right.
Senator Allard. The Investment Company Act gives the SEC
explicit authority to sue investment company management for
charging excessive fees and imposing a fiduciary obligation on
the adviser with relation to receiving these fees. How many
times has the SEC used this statutory authority?
Chairman Donaldson. I cannot tell you that off the top of
my head, but I will get the answer to you, Senator.
Senator Allard. I think it is--
Chairman Shelby. You may furnish that for the record.
Senator Allard. We would like to have that as a part of the
Committee record, if you would, please.
Chairman Donaldson. Sure.
Senator Allard. Now, the same power is given to any
shareholder of the fund and to the SEC to intervene in any such
action, and you may not know how often this has occurred, but
if you do, I would like to have you share that with the
Committee now; if not, we would like to have that as a part of
the record also.
Chairman Donaldson. We will be glad to give you that.
Senator Allard. Thank you.
Given the extensive enforcement powers provided to the SEC
under the Investment Company Act, do you find the need for
amendment of the Act to empower the SEC further? I think you
answered that question earlier, and the answer is ``No''--you
are comfortable with what you have. Is that correct?
Chairman Donaldson. Right.
Senator Allard. Okay. I have one other area that I might
explore with you a little bit. Middle-class and individual
investors have seen a rapid expansion of the investment
opportunities available to them and particularly many more
individuals are investing in mutual funds which can help them
save for their children's college education or for their
retirement.
Has the Commission considered in its new initiatives
regarding mutual funds how important is the balance between
individual investors and large institutional investors, such as
what was brought up here by the Senator from Maryland?
Chairman Donaldson. What do you mean by ``balance,''
Senator?
Senator Allard. We have individual investors out here, and
then you have the whole, large mutual, bloc investors, retail.
How do you balance their interests?
Chairman Donaldson. Well, there are two parts to that
question. One is the interests in terms of access to a
different source of investment vehicles, if that is what you
are talking about.
Senator Allard. Yes.
Chairman Donaldson. And I think that is a balance that is
brought up in the hedge fund report by the staff in terms of
the various safeguards there for minimum assets and earning
power and so forth for individual investors getting into the,
``hedge fund'' kind of vehicle. I think you are talking about
the issue, as you move from retail into larger and larger
purchases, there are discounts allowed, and trying to make sure
that people are protected as they get to be larger investors by
the discounts they get for buying more.
That is one whole side of your question. The other side is
the protection of individual investors in the marketplace
itself trying to buy and sell stocks versus large institutions
trying to buy and sell stocks. I think the hallmark of our
system has been the protection of the individual investor, the
protection that allows the individual investor to compete but
to compete fairly with people who have more muscle. And that
gets to market structure, it gets to issues such as price
improvement, and it gets to the way the central marketplaces
are organized, and that is what we are working very hard on, to
make sure that the individual investor is protected.
Senator Allard. Thank you.
I see my time has expired, Mr. Chairman.
Chairman Shelby. Thank you, Senator.
Senator Allard. It is amazing how fast it runs when I have
questions, but I am sure it is balanced.
I want to thank you for holding this hearing and
reemphasize what so many Members of this Committee have said
previously, that we have to maintain the confidence of the
investor--that is what it is all about--and if we do not do
that, we all suffer.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you.
Chairman Donaldson, back to mutual funds, if we can. The
mutual fund industry has come under scrutiny, as we all know,
as investors learn more about the business practices of mutual
funds and their brokers. For example, many investors do not
realize that their brokers may receive bonuses for selling them
certain funds. Are these payments breaches of the fiduciary
duties owed by brokers to shareholders, or are investors simply
unaware of these common practices?
Do you think that investors believe that brokers have a
greater fiduciary duty to them than is currently required by
law? Do we need some changes there?
Chairman Donaldson. This has been an area of inquiry for
us, the so-called ``incentives,'' if you will, or rather, the
hidden incentives, for a broker to sell one fund versus
another, and we are on a trail of bringing some sunlight to
these practices.
Chairman Shelby. Good.
Chairman Donaldson. The individual investor has the right
to know that if a broker is recommending a particular fund,
what outside of the performance and suitability of that fund is
inducing the broker to recommend it, and we believe that there
needs to be more disclosure there than there is right now.
Senator Sarbanes. Would you yield on that, Mr. Chairman?
Chairman Shelby. Go ahead, Senator Sarbanes.
Senator Sarbanes. I think that is a very limited answer. I
understood--and the NASD has just disciplined one of its
investment banking firms--that there are certain practices that
they have a rule about that you are just not supposed to do it,
not that you should just disclose it. I mean, they had brokers
of theirs promoting the sale of their own mutual funds,
proprietary mutual funds, and they were giving them tickets to
Britney Spears and Rolling Stones concerts, tickets to the NBA
Finals--listen to this one--tuition for a high-performance
automobile racing school, and trips to resorts.
The NASD said this was prohibited under their rules, and
they levied a heavy fine on them. So, I do not think disclosing
it is enough; I think those are practices that just ought not
to take place. It is a tremendous inducement to these brokers
not to pay attention to the interests of their investors, is it
not?
Chairman Donaldson. There are many different aspects of the
way that mutual funds are sold, and I think the first level of
understanding here on our part is to understand what those
inducements are that the customer does not understand. Now,
whether it is illegal to give baseball tickets to a customer of
yours, I would really wonder about that. I mean, that is
commerce, that is business; you entertain customers, you do
whatever you can to get them to do business with you.
Where it reaches some level of illegality, I think is
something that we would certainly look at. But I think what I
tried to respond to Senator Shelby's question was that it is
not the baseball tickets so much as it is the fact that somehow
either the mutual fund company or the brokerage firm is
rewarding, paying, the broker to push a particular fund. I
think that is kind of a different issue than the broker having
baseball tickets.
Senator Sarbanes. For whom?
Chairman Donaldson. Well, again, I think customer
entertainment is part of American business life.
Senator Sarbanes. You mean a baseball ticket for the
investor?
Chairman Donaldson. Yes. I mean, if----
Senator Sarbanes. What about a baseball ticket for the
broker from his brokerage firm, which creates a competition and
says to them, ``We want to push these proprietary mutual funds;
these are our mutual funds''? Was the NASD wrong in what they
did here? They fined an investment house $2 million and
censured them, and they fined a supervisor $250,000 and
censured him because they did not have proper monitoring
practices. And then it says--this is their release, the NASD--
``In enacting the noncash compensation rules, the SEC and NASD
recognize that the types of sales contests seen in this case
increase the potential for investors to be steered into
investments that are less suitable than some alternatives.
These rules were designed to prevent the conflicts of interest
that might arise for the broker when faced with such a
choice.''
Chairman Donaldson. Senator, I misunderstood your question.
I thought you were talking about the broker himself giving
baseball tickets to his client. You are talking about----
Senator Sarbanes. No, no. I am talking about the investment
house running a competition----
Chairman Donaldson. Yes, you are talking about non-
monetary----
Senator Sarbanes. --and saying to the brokers, ``If you can
push a certain number of our own proprietary funds, you will
get these Britney Spears tickets'' or tuition for a high-
performance automobile racing school, so the broker ceases then
to meet the suitability test for his clients.
Chairman Donaldson. Sure. You are talking about nonmonetary
compensation. You are talking about even monetary compensation
that is not disclosed. And I agree obviously that is a
violation of the NASD rule and a violation of our rules, and it
is quite correct that action be taken against them. But I
misunderstood what you were talking about in terms of whom it
was being given to and from whence it was coming.
Chairman Shelby. Chairman Donaldson, in prior hearings on
hedge funds here in the Banking Committee, you addressed
problems concerning--which you have alluded to already--the
retailization of hedge funds and the conflicts of interest
inherent when advisors manage both a hedge fund and a mutual
fund.
Chairman Donaldson. Right.
Chairman Shelby. Describe how the report's recommendations
address these concerns or will address these concerns.
Chairman Donaldson. Again, the conflict of interest would
be a fund group, let us say, or a manager that on the one hand
is running a mutual fund and being compensated for doing that
with fees, and on the other hand is running a hedge fund where
the compensation normally is not only fees but also a
participation in the profits, and the potential conflict of
interest as to where securities that you buy or sell are put.
Does an attractive IPO that is bound to go up in price get put
in a hedge fund as opposed to put in a mutual fund.
Chairman Shelby. Yes; obvious conflict.
Chairman Donaldson. And that is an obvious conflict.
Chairman Shelby. Mr. Chairman, some people contend that
further SEC regulation of hedge funds will drive capital
offshore. What is your perspective on this?
Chairman Donaldson. I do not think that is a worry, because
if you have more than 14 U.S. investors, no matter where you
are located, you still come under our purview. You cannot
escape it.
Chairman Shelby. They have to do what is right, do they
not?
Chairman Donaldson. Yes. If you have U.S. investors there,
it would fall under our jurisdiction.
Chairman Shelby. I have a couple of things left. The New
York Stock Exchange--we hope to hear from you and Mr. Reed when
the governance review is complete on the New York Stock
Exchange--when do you expect the New York Stock Exchange to
deliver its report on corporate governance practices, and when
do you expect the New York Stock Exchange to designate a
permanent CEO?
Chairman Donaldson. Mr. Reed, very wislely, has wanted to
take a look at the work that the Stock Exchange has done on
corporate governance before releasing it or giving it to us in
answer to our request, and I think that is done with my total
concurrence, because I think that there are issues involved in
the corporate governance paper, if you will, that will be
changed as a result of a totally new, independent person coming
in and having a fresh look at it.
So this is a complex subject that Mr. Reed has undertaken
in terms of how to organize the governance of the Stock
Exchange to avoid some of the things that have happened here in
the last period of time.
I want to emphasize that we should not confuse the
governance issues with other aspects of the Stock Exchange
management and particularly its regulation. Again, I do not
think we should be too hasty to throw the baby out with the
bath water. I think the Stock Exchange is going to have to come
up with a structure----
Chairman Shelby. Sometimes you need to give the baby a
bath, though, do you not, daily, so to speak?
[Laughter.]
Chairman Donaldson. I think the Stock Exchange is going to
have to come up with a governance structure that guarantees the
independence of the regulatory aspect of what they are doing
but somehow keeps its proximity so that it is not just a
bureaucracy out here somewhere that does not really understand
how difficult it is to conform to, let us say, trading
regulations.
Chairman Shelby. Sure. Mr. Chairman, you have already
described a lot of the priorities on your agenda at the SEC
that you are doing to help bring confidence back to the
investor, and to the people. Are there other types of conflicts
of interest that you are looking at, that your enforcement
division is investigating? For example, in prior testimony
before this Committee, you mentioned a concern with tying
activities. Where are we there?
Chairman Donaldson. On what, Senator?
Chairman Shelby. Tying; tying activities.
Chairman Donaldson. Tying, yes. Well, we have a set of
priorities, if you will, and clearly you are seeing some of
them emerge here in terms of the hedge fund study, in terms of
the market structure study, in terms of the work we are doing
in mutual funds, in terms of all the other things that we are
doing in terms of enforcing the Sarbanes-Oxley mandates.
In terms of tying, I think that this is an issue that
concerns me in terms of the relationship between providing
certain services in order to get other business, and it is a
very sophisticated subject. It is one that I think we have to
have a constant look at. I think the bank regulators have to
have a constant look at it. I do not want to say it is not a
priority, but I want to say that it is something that we
continue to gather information on.
Chairman Shelby. I know that it has not reached the
priority status such as accounting fraud, corporate fraud,
corporate mismanagement, now mutual funds, and so forth. When
will you have some type of perspective on how wide and deep the
mutual funds problem is?
Chairman Donaldson. You are not talking tying now; you are
back on----
Chairman Shelby. No. We are talking about mutual funds and
the problems that have arisen lately. How deep is that and how
wide is it, and if you do not know now, when will you know?
Chairman Donaldson. I have four or five pages here of
different aspects of mutual fund regulation where we are either
putting rules in now, contemplating rules, or investigating, so
it is hard for me, without getting very specific as to what the
timetable on each one of these items is. But I would say that
it is a top priority for us to resolve some of the issues we
have been talking about this morning. I would think that we are
going to work--we have already put into effect a number of
things, and we will roll these out over the immediate future.
Will we be finished by the end of 2004? I do not know.
Chairman Shelby. I believe you are up to the challenge. I
just know that a lot of things are in your basket, and they
have not been resolved yet, and when one thing seems to be
coming along, then we have another scandal or something close
to a scandal, conflicts of interest in dealing with mutual
funds or capital markets or corporate fraud or something else,
and it just undermines investor confidence, as you well know.
Chairman Donaldson. I am well aware of that. I think a lot
about it in terms of investor confidence. It is regrettable
that some of the enforcement actions we bring are from the
past--in other words, we have finally caught up with it--and it
is not new malfeasance, but it is something that happened
months or years ago, and yet it hits the newspapers and is
greeted as something new.
The thing that upsets me more than that is malfeasance that
appears on I would say my watch right now, the continuing to
look under a leaf and see things that we do not think should be
there. That bothers me.
Chairman Shelby. You plan to look under the tree and the
leaves, don't you?
Chairman Donaldson. Yes.
Chairman Shelby. Okay.
Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman.
Welcome, Chairman Donaldson. In the SEC staff report that
was issued yesterday, the report notes that there are several
benefits that inure from hedge funds, and the report says,
``Hedge funds play an important role in a financial system
where various risks are distributed across a variety of
innovative financial instruments. By reallocating financial
risk, this market activity provides the added benefit of
lowering financial costs shouldered by other sectors of the
economy.''
It goes on to say: ``The absence of hedge funds from these
markets could lead to fewer risk management choices and a
higher cost of capital.''
That is just part of what the report says, and this is my
question: Given the importance of hedge funds in capital
markets today and thus the broad market implications of hedge
fund regulation, including registration, do you plan to consult
with the President's Working Group on Financial Markets prior
to any regulatory action that the SEC may take with respect to
hedge funds?
Chairman Donaldson. Well, as I mentioned earlier, the state
we are in now is the investigative work has been done over a
year; we put out the staff's conclusions with recommendations.
The next step is that we would hope to get reactions back from
various interested parties, and one of the reactions we would
hope to get back is the reactions from the President's Working
Group. We would hope to hear their reactions to what our staff
has suggested before we make any final decision. So the answer
is yes, I would plan to present that to the President's Working
Group.
Senator Carper. Good. Thanks.
The second question is one dealing with SEC's regulatory
structure. At other times when you have been before our
Committee, I have asked you about the moneys, the additional
appropriations that we have provided to the SEC to hire new
staff to enable you to meet your statutory responsibilities. In
your speech this summer before the National Press Club, I
believe you mentioned that you have created a new management
structure operating out of the office of the Chairman to help
you manage your expanded agenda and expanding resources while
promoting cooperation amongst the SEC's various divisions and
offices.
You noted that this structure would help the Agency to
anticipate issues, not just to react to them. Could you explain
a bit more about this new structure and maybe share with us--
even though it has not been in place for very long--examples of
issues that the Agency has anticipated due to this new
structure?
Chairman Donaldson. Yes. I would begin with a focus from
the Chairman's Office on Management itself, and the first step
in that has been to change the structure of my office and to
bring in three people to perform the role that a chief of staff
used to perform----
Senator Carper. Say that again--bring in what kind of
people?
Chairman Donaldson. People to perform chief of staff
junctions. One of the managing executives in my office has most
of the functions that the chief of staff used to have in terms
of the relationship of the Chairman's office with the other
Commissioners and the Commissioners' staffs. That is a chief of
staff kind of role.
One of the other managing executives is responsible for our
external affairs, to include our relationships with the public
and the press and so forth and our relationships with you on
the Hill.
The third managing executive is the executive for internal
management. This gentleman, Peter Derby by name, brings a long
history of operating a very successful new bank in Russia, of
all places, where he started a de novo bank and built it to
great prominence, known for its integrity, and so forth. And
Peter Derby is in charge of effecting some of the things that I
have been talking about in terms of management of the Agency
itself--to wit, we are attempting to get more synergism and
cross-fertilization going between the five divisions of the
Agency, and I do not have time, and I would be glad to
elaborate on that, but we are trying to get much more
information-sharing and collaborative work and so forth than
perhaps has existed in the past.
Second, we are organizing a series of management controls,
if you will, which for lack of a better word, we are calling
``dashboards.'' These are mutually agreed-upon standards of
performance in the various divisions. The word ``dashboard'' is
where we are able, at the senior levels in the Agency, to see
what progress is being made in a number of different areas in
terms of the amount of time it takes to get projects out, how
much progress we are making in the hiring that we have to do,
et cetera. It is a way of looking at progress against--I will
not say deadlines, but against mutually agreed-upon objectives.
Third and perhaps most important is an attempt to organize
a risk assessment or policy planning group outside of the
various divisions whose role is to--and I used the words
before, and I will use them again--look over the hill and
around the corner and try to anticipate problems coming down
the pike and to see if we cannot somehow get involved in those
problems before hand instead of just playing a mop-up game.
And this is not to imply that we do not have that kind of
risk assessment in each one of the divisions, but this will
stimulate that work within each division, and we will have a
little bit of a longer view. And again, I do not want to
promise too much in terms of this effort, but it basically will
heighten our anticipatory capabilities so, rather than just
reacting to something that has happened or a tip that has come
in or whatever, we are out there trying to anticipate what is
the next problem area and what can we do about it now.
Senator Carper. All right. Thanks for sharing that with us.
Thanks, Mr. Chairman.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
Chairman Donaldson, I have not done it recently, but last
year at one point, I reviewed the authorities and powers of the
SEC under the Securities Acts of the early 1930's, and my
recollection is they are quite broad, and you really have very
plenary authority.
Now, a considerable delegation of that authority has been
exercised by the SEC with respect to the self-regulatory
organizations, but my recollection of the statute is that the
ultimate decision in a sense rests with you, and it leads me to
this question--whether there is any power or authority that you
think you need that you do not have to enable you to enforce
the policies and programs that you believe a self-regulatory
organization should be pursuing--for example, the New York
Stock Exchange or the Nasdaq.
Chairman Donaldson. At this juncture, Senator, I would say
that I do not see the need for new powers now. However, we are
facing, as the subject matter this morning illustrates, a lot
of challenges in a lot of areas. I am sure there is going to
be--I should not say I am sure--I would anticipate that there
probably will be pushback in certain areas that we are trying
to change, and my hope is that we can convince any who might
push back that we do have the authority to effect change.
Now, the New York Stock Exchange is a pretty good example
of how I believe we should exercise that authority. I believe
it is up to the New York Stock Exchange to straighten out its
own internal governance situation, and that is probably going
to require actions inside the Stock Exchange amongst the seat-
holders and so forth who are willing to give their vote to have
that happen. And I am not making any prejudgment on what that
is, and I believe it should rest with the Stock Exchange board
and right now with the new leader of that board to figure out
exactly what governance structure will fit that institution. It
is up to us to have oversight on that.
Senator Sarbanes. I think it is important for you to send a
message that this perhaps semi-slumbering lion, the SEC, having
been fed a very good meal with the Congressional appropriation
and having been disturbed by these things that are happening,
is now up and about and prowling around, and that these various
delegations and so forth need to be exercised in a way to
protect the investor, and they need to get moving.
I agree with you that we have to be prudent in what we do,
and this Committee last year was certainly prudent; we did not
fly off the handle when we tried to deal with the legislation.
We took it step-by-step. So, I am not for throwing the baby out
with the bath water, but I thought Chairman Shelby was right on
the mark when he said sometimes you have to give the baby a
bath; I thought that was a very appropriate observation. They
have really got to shape up their ship, don't you think?
Chairman Donaldson. That is what we are trying to do, and I
would like to assure you that we will use every power that we
have to try to clean up whatever it is out there.
Senator Sarbanes. But at the moment, you do not see a
problem in terms of your power in getting the Exchange to
enforce and carry out the policies and programs you think they
should carry out; is that right?
Chairman Donaldson. I do not think right now that we have
any need for additional powers, but----
Senator Sarbanes. Let me urge you again to take a look at
this ad in The Wall Street Journal by the largest public
employee retirement systems in the country with respect to
timely access for shareholders to the board of directors. I
think that is an important source of additional support the SEC
could gather--it is a way of structuring the system so that
built into the system is the oversight that is desirable, so it
gives the shareholders a chance to exercise that kind of
overview, and I think that is very important. I know you are
looking at those rules right now, as I understand it.
The final point I would like to leave with you, that I made
reference to earlier, is how hard I thought the SEC staff have
been working. I know they have been under enormous pressure now
for more than a year; ever since the legislation was passed,
they have had to go on fast-forward to move those things. Now
these other issues keep arising, and they are doing studies,
making recommendations, then you have to promulgate rules, then
you have to review the comments, then you have to put the rules
into place--all of that. So, I would urge you again to try to
finally resolve this pay and benefit parity issue for your
employees.
We provided in the statute that ``the Commission shall seek
to maintain comparability with such agencies regarding
compensation and benefits.'' It seems to me that clearly, you
should be comparable with the other various financial
regulatory agencies. I mean, you are demanding an awful lot of
your people. You have a staff of dedicated people. They are
facing major challenges, and I think it is important to try to
resolve it. I know you have made some advances on that front,
but my understanding is it is not yet completed, and I would
urge you to carry on through and get that settled so that it is
not a distraction--so it is not an impediment within developing
a real, forward-moving esprit de corps at the SEC as it faces
its challenges.
Chairman Donaldson. Right. Let me thank you for your
compliment to the staff of the SEC. They are doing an
outstanding job, and they are working very hard at it, and they
deserve every kind of support that we can give them.
We have moved ahead on pay parity, as you know, and now we
are working to resolve the other issues of benefits and so
forth, and we are not there yet, but we are working on it, and
it is a very high priority for us.
Senator Sarbanes. Thank you.
Chairman Shelby. Mr. Chairman, I am not one to propose too
much regulation on anybody, but sometimes it seems that some
people cannot regulate themselves. We have seen it in the
accounting profession and others. A lot of us have gone through
colleges and universities where you had an honor system, and
you knew to heed the honor system because there were
consequences--huge consequences--among other things. Maybe the
universities and colleges did not look at you every day, but
you were in a sense self-regulatory to a point but not
ultimately, because if you cheated in colleges and
universities, you paid an awful price.
It seems that people are cheating, big time, people out of
millions if not billions of dollars, and I am not sure they are
paying a price for it. Part of your job, as you well know, as
the top regulator over the securities market is to seek out
these people who abuse the system, and I think you are off to a
good start. But it is troubling again to me that we have not
brought the investor confidence back to the level that we need
to, and I think, what you do at the SEC will depend a lot on
how fast investor confidence comes back.
People have to believe in the system, and as Senator
Bunning lamented earlier, so many do not today, and for good
reason. And we do not need that. It undermines everything. It
undermines our economy, it undermines our country, does it not?
Chairman Donaldson. I think that from my point of view, we
will exercise our authority and responsibility as firmly and as
swiftly as we possibly can.
I believe that a major step in investor confidence will
come from the conviction that the SEC itself is on the job.
Senator Sarbanes. Prowling around, as they say.
Chairman Donaldson. Yes, exactly--and that we are on the
job. And I agree with you that investor confidence is at a low
point. Confidence in American business is at a low point--not
just investor, but the American public--that has rubbed off on
them. And I think we are going to do everything in our power to
restore that.
Chairman Shelby. I believe you are doing that. I think you
are on the right road. I believe Senator Sarbanes and I agree
that you are on the right road. It is just a tortuous road to
travel.
Thank you, Mr. Chairman.
Chairman Donaldson. Thank you.
Chairman Shelby. The hearing is adjourned.
[Whereupon, at 11:57 a.m., the hearing was adjourned.]
[Prepared statements and response to written questions
supplied for the record follows:]
PREPARED STATEMENT OF SENATOR JIM BUNNING
Thank you, Mr. Chairman, for holding this important hearing and I
would like to thank Chairman Donaldson for testifying today.
The markets are doing much better since you came before this
Committee for your nomination hearing. Consumer confidence is up, and
the economy seems to be turning around. Job growth is still not where
it should be but the strong growth in the markets is usually a
precursor to economic growth. So, overall things look pretty good in
our equities markets. We seem to have weathered the recession that
started in 2000, the attack of September 11, the corporate scandals and
2 wars.
You started at a very difficult time for the SEC, when there was a
real lack of confidence. There were a lot or problems at the SEC when
you took over. Your predecessor was a very good attorney, but he lacked
some political skills. I think he was also blamed for a lot of things
that started before he became Chairman. But things seem to be turning
around now and I believe the American people have much more confidence
in the SEC.
I think seeing a few perp walks by the heads of some of our
corporations who broke the law really helped in that regard.
During the question period, I will get into this a little more and
ask your assessment on how the SEC is doing and where you think it can
be improved. I would also like to talk a little about the hedge funds
report the SEC staff put out yesterday.
Hopefully, we are coming out of this recession and the markets are
leading the way. There are a lot of things that can pull us back and I
trust you will remain vigilant at the SEC to make sure nothing in your
area of responsibility does pull us back.
Once again, thank you Mr. Chairman for holding this hearing and
thank you Chairman Donaldson for testifying today.
----------
PREPARED STATEMENT OF SENATOR WAYNE ALLARD
I would like to thank Chairman Shelby for holding this hearing to
learn about recent initiatives to enhance investor protections in our
securities markets. I am particularly pleased with the Commission's
diligence in the past months in identifying and addressing challenges
in the mutual fund and hedge fund industries. I look forward to hearing
Chairman Donaldson's comments about the state of our securities
industry, particularly as it relates to ways in which we can further
protect the investor and encourage participation in our securities
markets. I also anticipate hearing your thoughts on the recent
recommendations of the Commission staff.
The role of the Securities and Exchange Commission has taken on
even greater importance in recent years with the increasing number of
Americans investing in equities. Middle class Americans invest in
mutual funds to plan for retirement, to fund their children's
education, or to purchase a home. More sophisticated investors like
foundations, endowments, and pension plans utilize hedge funds to
pursue positive returns, regardless of whether the securities markets
are declining or rising. The opportunity for different levels of
investors in the securities markets is integral to allowing Americans
participation in the growth and development of our economy. Likewise,
we must maintain the protection of investors and ensure the integrity
of America's securities markets so that investment continues, and our
economy remains healthy.
Thank you, Chairman Donaldson for appearing before the Committee
today to discuss an issue that is essential to the health of the
American economy. I look forward to your testimony and the discussion
today.
----------
PREPARED STATEMENT OF WILLIAM H. DONALDSON
Chairman, U.S. Securities and Exchange Commission
September 30, 2003
Introduction
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, thank you for inviting me to testify today on the Securities
and Exchange Commission's recent initiatives to enhance investor
protections in our securities markets. Since its creation in 1934, the
SEC's mandate has been to protect investors and ensure the integrity of
America's securities markets. That mandate has taken on even greater
importance in recent years, as increasing numbers of people have become
equity investors. With more than 95 million Americans invested in
mutual funds, representing approximately 54 million U.S. households,
and a combined $6.5 trillion in assets, mutual funds are a vital part
of this Nation's economy. While much of the public focus over the last
few years has been on events surrounding public companies, the
Commission has undertaken an aggressive agenda to identify and address
challenges in the mutual fund industry, an agenda that helps us to
protect this vital segment of our investing public.
I would like to highlight some important actions we have recently
taken to help ensure that mutual fund investors have the information
they need to make their investment decisions.
Fund Advertising
Just last week, we adopted rule amendments to modernize mutual fund
advertising requirements to encourage more responsible advertising. The
new amendments require that fund advertisements state that investors
should consider a fund's fees before investing. The amendments also
require advertisements to include information about the fund's
investment objectives and risks, as well as an explanation that the
prospectus contains this and other important information about the
fund. The amendments also strengthen the antifraud protections that
apply to fund advertising and encourage fund advertisements to provide
information to investors that is more balanced and informative,
particularly in the area of investment performance, so that investors
have access to up-to-date performance information.
In addition to rulemaking initiatives, the Commission has engaged
in educational efforts to caution investors against the dangers of
overemphasizing fund performance in investment decisions. These efforts
included publishing an investor alert on the Commission's website that
explains the importance of looking beyond past performance in making
investment decisions. We also placed a ``cost calculator'' on our
website that allows investors to compute the impact of fees and
expenses of various funds on their performance and facilitates
comparison of funds.
Fund of Funds
The Commission also last week proposed for public comment new rules
under the Investment Company Act that would broaden the ability of one
fund to acquire shares of another fund, so called ``funds of funds.''
These funds often are used as asset allocation vehicles for a fund to
gain exposure to a sector of the market by investing in another fund.
This proposal also included recommended amendments that would improve
the transparency of the expenses of funds that invest in other funds by
requiring that the expenses of the acquired funds be aggregated and
shown as an additional expense in the fee table of the acquiring funds,
thereby giving investors in these funds more complete information about
expenses.
Proxy Voting
In January, the Commission adopted rules that require mutual funds
to disclose their proxy voting records. These rules enable fund
shareholders to monitor their funds' involvement in the governance
activities of portfolio companies. Under the rule, funds are required
to file their proxy voting record with the Commission, which will make
it publicly available through the EDGAR system. The rules also require
mutual funds to disclose in their registration statements the policies
and procedures they use to determine how to vote proxies related to
portfolio securities. Funds have already begun complying with this
requirement, and they are required to start filing their proxy voting
reports next year.
Sarbanes-Oxley Requirements
In addition to Commission initiatives, mutual funds also are
subject to the corporate governance requirements of the Sarbanes-Oxley
Act. In each rule we have proposed and/or adopted under the Act, we
have applied the corporate governance requirements to both operating
companies and mutual funds, with some tailoring for the unique aspects
of mutual funds. These rules include the rules on CEO and CFO
certification requirements, code of ethics requirements, disclosure of
audit committee financial experts, auditor independence and, most
recently, audit committee listing standards. This last rule, adopted as
part of a broader rulemaking regarding audit committee standards,
applies only to listed companies and therefore includes only exchange-
traded funds, or listed closed-end funds. The rule directs the
exchanges and Nasdaq to prohibit the listing of any security of an
issuer in violation of new standards of audit committee responsibility
and independence.
Future Mutual Fund Activity
In addition to these rulemaking activities, we have a number of
other initiatives in the pipeline.
Breakpoint Disclosure
We anticipate taking action to improve the disclosure of breakpoint
discounts, which are discounts on front-end sales loads based on the
aggregate amount of purchases of a fund's shares. Funds that offer
breakpoint discounts must disclose the breakpoints and related
procedures in their offering documents. Brokers that sell shares of
funds that offer discounts have an obligation to help ensure that
shareholders are receiving those discounts. Late last year, however,
the staffs of the NASD and the SEC identified concerns regarding
breakpoints. The staffs discovered that many fund investors were not
receiving the appropriate discounts. The SEC and NASD took swift
action--reminding funds and brokers of their obligations, requiring
brokers to assess the extent of the problem, and directing the industry
to convene a task force to address the problem. In July, a Joint NASD/
Industry Report on Breakpoints was released containing recommendations
to assure that investors receive available discounts on mutual fund
shares subject to front-end sales loads.
The Breakpoint Report contains a number of recommendations to limit
the problems associated with the provision of breakpoint discounts, as
well as to improve the disclosure of breakpoint opportunities. I have
directed the staff to draft a rule for Commission consideration
consistent with these recommendations to help ensure that investors
receive the appropriate discounts in the future. In addition, the NASD
and SEC staffs continue to monitor and quantify the problem and have
directed firms that have failed to provide the appropriate breakpoints
in the past to compensate and make whole any affected investor. We and
the NASD will continue to investigate, and where warranted, will bring
enforcement actions in this area.
Shareholder Report Disclosure of Operating Expenses
We have also proposed additional disclosure to increase investors'
understanding of the expenses they incur when investing in a mutual
fund. Under this proposal, mutual funds would be required to disclose
in their shareholder reports the ``dollar amount'' of fund expenses
paid by shareholders on a prescribed investment amount--based on both
the fund's actual expenses and return for the period, as well as the
fund's actual expenses for the period based on an assumed return of 5
percent per year. By using both these measures, the dollar disclosure
would enable investors to determine the amount of fees they paid on an
ongoing basis, as well to compare the amount of fees charged by other
funds. The goal of the proposal is to educate investors and to
encourage cost competition among funds. This proposal also would
require more frequent disclosure of portfolio holdings (for example,
quarterly rather than semi-annually) to enhance investor understanding
of the securities in the fund's portfolio so investors can make better
asset allocation decisions. I expect the Commission to consider
adopting these new requirements in the near future.
Highlighting Broker Incentives and Conflicts of Interest
Another area we are looking at is how to increase investor
understanding of the incentives and conflicts that broker-dealers have
in offering mutual fund shares to investors. Initiatives we are
considering in this area include a comprehensive revision of mutual
fund confirmation form requirements. I envision a revised confirmation
would include information about revenue sharing arrangements,
incentives for selling in-house funds and other inducements for brokers
to sell fund shares that may not be immediately transparent to fund
investors.
In addition to its disclosure initiatives, the Commission has
focused its rulemaking efforts on fund governance and internal
compliance issues. Although we have focused on these issues for some
time, recent events in the mutual fund industry underscore the
importance of funds' maintaining appropriate measures to ensure their
adherence to both the letter and spirit of the Federal securities laws.
Mutual Fund Compliance Rule
In February, the Commission published for comment proposed rules
aimed at ensuring better compliance with regulations governing mutual
funds. These rules would mandate that funds and investment advisers
maintain comprehensive compliance policies, and procedures reasonably
designed to prevent violations of the Federal securities laws. The
rules also require that funds designate a chief compliance officer.
While the proposal does not enumerate specific elements funds must
include in their compliance programs--as funds are too varied in their
operations for us to impose a single list of required elements--it is
designed to ensure that policies and procedures are in place to lessen
the likelihood of securities law violations and detect any violations
that do occur.
Consequently, we would expect funds to have policies and procedures
to address pricing of portfolio securities and fund shares; processing
of fund shares on a timely basis; portfolio management processes,
including allocation of investment opportunities among clients; the
accuracy of disclosures made to investors in fund prospec-
tuses (disclosures that would include representations regarding market
timing policies and procedures); and processes to value client holdings
and assess fees based on those valuations.
While we expect that these rules would help protect investors by
improving day-to-day compliance with the Federal securities laws, the
rules should also increase the efficiency and effectiveness of the
Commission's mutual fund examination program. Our oversight is
predicated on the assumption that those who manage mutual funds have
procedures to comply with the law. While the proposal would codify the
prudent compliance practices already followed by most fund complexes,
in some cases mutual funds have few compliance controls in place or
have gaps in their controls. These proposals are intended to raise the
standard of compliance among all mutual funds, and I expect the
Commission will consider adoption of these requirements later this
fall.
Director Nomination Rules
We have also included mutual funds in initiatives to increase
shareholder participation in the director nomination process. Last
month, we proposed rule changes to strengthen disclosure requirements
relating to the nomination of directors and shareholder communications
with directors. The proposals apply to both operating companies and
mutual funds.
The proposals would require a fund to disclose additional
information regarding its process of nominating directors, including
whether members of the nominating committee are ``interested persons''
of the fund; a fund's process for identifying and evaluating
candidates; whether a fund considers candidates for director nominees
put forward by shareholders; and whether a fund has rejected candidates
put forward by large long-term shareholders or groups of shareholders.
The proposals would also require a fund to disclose information
regarding shareholder communications with directors, including whether
the fund has a process for such communications and the procedures
shareholders should follow; whether the communications are screened;
and whether material actions have been taken as a result of shareholder
communications in the last fiscal year.
The proposed rules implement the first part of the recommendations
of a Commission Staff Report issued on July 15, 2003, regarding
improvements to the proxy process. The enhanced disclosure provided by
the proposal should benefit fund shareholders by improving the
transparency of the nominating process and board operations, as well as
increasing shareholders' understanding of the funds in which they
invest. The Staff Report also recommends under certain circumstances
that major long-term shareholders, or groups of shareholders, be
provided access to proxy materials to nominate directors where there
are objective criteria indicating that shareholders may not have had
adequate input in the proxy process. I expect that we will propose
rules to implement this recommendation shortly, and that they will
apply with equal force to mutual funds.
Updates On Other Issues
I understand the Committee is interested in getting an update on a
few other issues for today's hearing, so let me briefly bring you up to
speed in those areas.
Hedge Fund Report
Since June of last year, the SEC staff has conducted a
comprehensive study focusing on the investor protection implications of
the significant growth of hedge funds in recent years. As part of that
study, the staff reviewed documents from 65 hedge fund advisers
managing more than 650 different hedge funds with more than $160
billion of assets. The staff also visited hedge fund advisers and prime
brokers and conducted a series of examinations of registered funds of
hedge funds. Finally, the staff benefited from views expressed at a
highly successful two-day Roundtable we held at the Commission, during
which a variety of experts discussed key aspects of hedge fund
operations, as well as the views contained in approximately 80 public
letters we received commenting on the roundtable discussion and hedge
fund issues.
When I testified before you in April, the study was still at the
fact-gathering stage and the staff had not reached any conclusions.
Just yesterday, however, the Commission released a staff report (the
Report) that outlines the staff's factual findings, identifies concerns
and recommends certain regulatory and other actions to improve the
current system of hedge fund regulation and oversight.
Let me emphasize at this time that this is a staff report. The next
step is for the Commission to consider these recommendations to
determine how we may wish to proceed. Any recommendation that the
Commission determines to act upon will require us to go through the
appropriate administrative process, so rest assured that investors,
market participants, and other interested persons will have ample
opportunity to comment upon any of the recommendations that the
Commission chooses to pursue. However, I would like to highlight for
you today some of the staff's findings and its primary recommendation.
In its Report, the staff identifies a number of areas of concern
regarding hedge funds: (i) lack of Commission information about hedge
funds and their advisers' activities; (ii) lack of prescribed and
uniform disclosure by hedge fund advisers; (iii) valuation and other
conflict of interest issues; (iv) the potential for increased
investment by less sophisticated investors, directly or indirectly, in
hedge funds; and (v) despite the relatively low absolute number, an
increase in the number of enforcement actions regarding hedge fund
advisers. Many of these concerns arise from the unregulated status of
hedge funds, which generally allows them to operate without Commission
oversight. Consequently, the primary recommendation of the staff is
that the Commission should consider revising its rules to require that
hedge fund advisers register under the Advisers Act. While I am looking
forward to studying the staff's Report and the recommendations
contained in it before drawing any conclusions, I will say, as I have
before, that I believe that the Commission needs to have a means of
examining hedge funds and how they operate. Speaking only for myself, I
believe that registration of hedge fund advisers would accomplish this.
Canary Investigation
While I am on the topic of hedge funds, let me update you about our
involvement in recent allegations regarding a hedge fund's practices in
late trading mutual funds, as well as questions concerning funds'
permitting market timers to arbitrage the funds, which underscore the
importance of the SEC's ongoing review of the hedge fund and mutual
fund industries. Both of these activities have the potential to harm
long-term investors in mutual funds.
The conduct alleged in the case involving Canary Capital, an
unregistered hedge fund, is reprehensible and in violation of fiduciary
principles. We have put in motion an action plan to vigorously
investigate this matter, assess the scope of the problem and hold any
wrongdoers accountable, and we will do so in close coordination with
State regulators.
Already, we have filed a civil action against Theodore Sihpol, a
salesperson at Bank of America Securities, who was Canary Capital's
primary contact at Bank of America. Our examiners and enforcement staff
are actively investigating this matter, not only the extent to which
the allegations in this particular case are true, but also whether this
conduct occurs at other firms in the securities industry. I want to
emphasize that we will aggressively pursue those who have injured
investors as a result of illegal late-trading and/or market-timing
activity and, where possible, to seek recompense for these investors in
connection with mutual fund transactions.
Additionally, the Commission's staff has sent detailed information
requests to registered prime brokerage firms, other large broker-
dealers, transfer agents, and the 80 largest mutual fund complexes in
the country seeking information on their policies and practices
relating to market timing and late trading. Specifically, we are using
our examination authority to obtain information from mutual funds and
broker-dealers regarding their pricing of mutual fund orders and
adherence to their stated policies regarding market timing. We also
have sought information from mutual funds susceptible to market timing
regarding their use of fair value pricing procedures to combat this
type of activity.
More broadly, I believe that the industry must take steps to review
its own conduct. To that end, I sent letters to major trade
associations for the mutual fund and broker-dealer industries asking
them to notify their members to review and reassess their procedures
relating to the handling of mutual fund investments in accordance with
applicable law.
While our enforcement efforts are a key tool in protecting the
Nation's investors, another critical tool is regulation to minimize the
potential for abuses to occur in the first place. We will consider what
we learn from the investigation to determine whether we should pursue
additional regulatory measures to thwart this type of activity.
Specifically, our staff is studying whether we need to take additional
steps to (1) pursue measures to prevent the circumvention of forward-
pricing requirements for fund shares and market timing restrictions,
(2) require funds to have written policies and procedures to address
short-term trading in their shares, (3) require improved disclosure
regarding market timing procedures, (4) provide funds with additional
tools to deter market timing activity, and (5) address concerns related
to the selective disclosure of fund portfolio information.
NYSE / Corporate Governance
I would now like to turn to an issue that is important both from a
regulatory standpoint and from the standpoint of the investing public:
the critical need for sound governance practices by self-regulatory
organizations. I believe that self-regulatory organizations should be
exemplars of good governance. At a minimum, SRO's should demand of
themselves the same high standards of governance that the New York
Stock Exchange and Nasdaq proposed for their listed issuers in the wake
of several widely publicized corporate scandals. To further that goal,
this past March I directed each self-regulatory organization to
undertake a review of its own governance practices.
Since then, disclosure of the pay package awarded to the former
Chairman of the New York Stock Exchange has heightened the scrutiny
that the Commission, the securities industry, the investing public, and
the media are paying to exchange governance standards that reflect the
highest commitment to independent and transparent decisionmaking. Prior
to the current controversy, the NYSE and a few other self-regulatory
organizations instituted special governance committees to further study
how their structures and processes might be improved. I applaud these
efforts but I believe that more remains to be done. I have assurances
that the NYSE's new interim Chairman, John Reed, will reexamine these
governance issues in more depth. I look forward to working with Mr.
Reed on this important initiative.
Our securities markets are the strongest in the world. They have
earned this position not only because they have the largest issuers,
the greatest depth and liquidity, the most capital, and efficient
execution systems--but they also have a high degree of investor
confidence. I intend to assure that investors can have a strong sense
of trust and confidence in our exchanges. To this end, the Commission
and its staff will be working diligently with the SRO's to craft a
regulatory environment that sets a high bar for sound and rigorous
governance practices.
Global Settlement
Finally, the Committee requested an update, since my testimony on
May 7, on the status of the research analyst global settlement, the
SEC's portion of which was filed with a Federal court on April 28,
2003. As described in the Commission's May 7 testimony, the global
settlement would impose significant monetary relief, require the firms
to make structural reforms to their research and investment banking
operations, require the firms to provide customers with independent
third-party research, and establish an investor education fund.
Since the filing of the proposed settlement agreement with the
Federal court, U.S. District Court Judge William H. Pauley, III has
issued a series of orders requesting that the parties--both the
Commission and the participating firms--submit additional information
to the Court relating to the terms of the settlement. Those orders,
dated June 2 and July 3, address a range of issues. Among the issues
addressed were:
the implications for the proposed Federal settlement should
any State determine not to settle with a firm, and whether there is
a timeframe in which each state must act on the proposed State
settlements;
the allocation of the settlement payments between disgorgement
and penalties, and whether any firms intend to seek Federal tax
deductions or third-party indemnification for settlement payments;
the operations of the Distribution and Investor Education
Funds, such as the identity of potentially relevant securities and
time periods, the number of shares of each potentially relevant
security purchased by each firms' customers, the total dollar
volume of such purchases, and whether the Investor Education Fund
should have audit procedures.
The Commission and the firms filed responses to the Court's orders,
and the proposed global settlement remains pending before the Court.
Nevertheless, the Commission staff believes that, in anticipation of
the Court's approval of the settlement, firms are moving forward with
preparations to implement the settlement requirements. Moreover, the
staff of the Commission will respond to any future inquiries from the
Court, and will work to have the global settlement implemented as soon
as possible.
Conclusion
Thank you again for inviting me to speak on behalf of the
Commission and the investing public. We, at the Commission, take our
responsibility of protecting our Nation's investors very seriously. I
welcome the opportunity to share our current initiatives with you, and
I would be pleased to answer any questions that you may have.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM WILLIAM H. DONALDSON
Q.1. Some witnesses in testimony to the Banking Committee have
recommended that public companies boards of directors have a
majority of independent directors and that their nomination and
compensation committees be composed totally of independent
directors. The New York Stock Exchange and the National
Association of Securities Dealers have proposed corporate
governance reforms that would require listed companies to have
a majority of independent directors on their boards of
directors and to have all independent directors on their
nomination and compensation committees, subject to an exception
for controlled companies in which a group has voting control.
The exception would apply both where a group owns a majority of
the equity, and where a group owns a minority of the equity
position. The Federal securities laws require the Commission to
approve only rules of an SRO that it finds are not designed to
permit unfair discrimination between issuers. What is the
rationale for requiring some issuers to establish minimum
independence qualifications for directors, but not others?
A.1. In the NYSE and Nasdaq proposals, a ``controlled
company''--defined as a company of which more than 50 percent
of the voting power is held by an individual, a group, or
another company--was excepted from the requirement of having a
majority of independent directors on its board and having
nominations and compensation determined exclusively by
independent directors.
The rationale for this exception is that majority
shareholders, including parent companies, have a right to
select directors and control certain key decisions by virtue of
their ownership rights. Any company in which such a majority
prevailed would be entitled to this exception.
In addition, the NYSE stated in its summary of comments on
the recommendations of its committee that developed its
corporate governance proposals that more than half of
commenting companies noted that the majority independent board
requirement would create insuperable difficulties for companies
controlled by a shareholder or parent company.
It is also important to note that through the associated
disclosure requirements of these proposals, the company would
be required to put investors on notice that it is using the
controlled company exception. In addition, a controlled company
would not be exempt from--and would still need to comply with--
all the audit committee requirements mandated by the Sarbanes-
Oxley Act, including the requirement to have an audit committee
comprised solely of independent directors.
Q.2. An article in the September 23, 2003, The New York Times
entitled ``Worry Over a New Conflict for Accounting Firms,''
indicates that auditors are citing language in the Commission's
releases implementing Section 404 of the Sarbanes-Oxley Act to
justify providing services in connection with the internal
controls of public company clients, despite the fact that such
advice may place auditors in the position of auditing their own
work, in light of the auditor attestation called for by Section
404. The same point was made in the testimony before the
Committee on September 23 by Edward Nusbaum, the CEO of Grant
Thornton.
The Commission's release on internal controls indicates
that:
Because the auditor is required to attest to management's
assessment of internal control over financial reporting,
management and the company's independent auditors will need to
coordinate their processes of documenting and testing the
internal controls over financial reporting. Nos. 33-8238; 34-
47986; IC-26068, Part II.B.3.b (Auditor Independence).
The Commission's auditor independence release states that
``[an] accountant would not be precluded [by the
prohibition on `[d]esigning, implementing, or operating systems
affecting the financial statements]'' from making
recommendations on internal control matters to management or
other service providers in conjunction with the design and
installation of a system by another service provider. Release
No. 33-8183; 34-47265; 35-27642; IC-25915; IA-2103, FR-68, Part
II.B.2 (Financial Systems Design)[Emphasis supplied.]
How do you respond to the criticism that the Commission's
rules can allow an auditor to attest to its own work insofar as
internal control systems are concerned? What is the line
between an auditors' ``assisting in documenting internal
controls'' and its ``designing and installing'' such a system?
Is the Commission considering clarifying the distinction
between the two activities, or engaging in fact finding about
the services accounting firms are offering to their audit
clients in connection with the new internal controls rules?
A.2. The Commission's rules prohibit an auditor from auditing
his/her own work, acting as a member of management and, more
specifically, performing the internal audit function, through
an outsourcing arrangement, for an audit client that files
financial statements with the Commission. The auditor of a
public company's financial statements, therefore, shouldn't
design or implement that company's internal controls over the
financial reporting process.
During an audit of a company's financial statements,
however, an auditor must obtain an understanding of the
company's internal control system. Investors benefit if the
auditor informs management of any deficiencies in the controls
that are noted during the audit and is able to recommend
improvements in those controls. In fact, auditing standards
require that such communications occur. Management, however,
must decide whether or how to implement those recommendations.
As noted in the question above, Section 404 of the
Sarbanes-Oxley Act requires that managements now assess and
report on the effectiveness of the company's internal controls
and that the auditor report on management's assessment. In
preparing for the initial operation of Section 404, managements
of many companies have asked the auditors of their financial
statements to assist company employees by, among other things,
providing templates to be used in documenting controls and
finding areas where management might want to improve the
controls. Auditors generally may provide these types of
assistance provided management makes all decisions regarding
the design, implementation, and operation of the company's
internal controls. For example, an auditor's independence would
be impaired if the auditor decided what tests management should
perform on the internal controls, chose the samples or even the
size of the samples of transactions to be tested, or provided
management with software that directed a conclusion about the
effectiveness of the company's internal controls.
The SEC staff has discussed this issue with several
accounting firms and has cautioned those firms against assuming
a management role or taking any action that would lead to the
auditor having a vested interest in the design, selection, or
operation of the
internal control system.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BAYH AND
SENATOR MILLER FROM WILLIAM H. DONALDSON
Q.1. As you may know, I have been following the Nasdaq exchange
registration application with interest for several years. At
our September 30 hearing you stated that Nasdaq does not
qualify for exchange registration because it does not provide
opportunities for order interaction and price improvement. This
statement surprised me. As I understand it, in 1998, the
Commission stated that ``Nasdaq performs what today is
generally understood to be the functions commonly performed by
a stock exchange,'' and that ``Nasdaq's use of established,
nondiscretionary methods bring it within the revised
interpretation of `exchange' in Rule 3b-1.'' \1\ Please provide
me with the analysis that now leads you to conclude that Nasdaq
does not qualify as an exchange and why diversion from your
predecessors' conclusion is warranted.
---------------------------------------------------------------------------
\1\ Securities Exchange Act Release No. 40760 (December 8, 1998),
63 FR 70844, 70852 (December 12, 1998). See also, Securities Exchange
Act Release No. 44201 (April 18, 2001) at note 22 (The Commission has
found that Nasdaq falls within the definition of ``exchange'' under
Section 3(a)(1) of the Act.).
A.1. Prior to the adoption of Regulation ATS in December 1998,
the Commission had defined the term ``exchange'' somewhat
narrowly as a system that utilized the capital of specialists
in a marketplace ``generally understood'' to be an exchange.
Through Regulation ATS, the Commission established a framework
that would allow an alternative trading system (ATS) to choose
whether to be a market participant and register as a broker-
dealer, or to be a separate market and register as a ``national
securities exchange.'' The primary goal of the new regulation
was to integrate ATS's into the National Market System (NMS).
The Commission's objective of incorporating ATS's into the NMS
was accomplished through an expansion of the definition of
exchange found in Securities Exchange Act Rule 3b-16. The
expanded definition covered most ATS's, but exempted ATS's from
national securities exchange registration if they chose to
register pursuant to Regulation ATS.
As you accurately note, the expanded definition of exchange
required the Commission to address the definition's
applicability to Nasdaq, a subsidiary of the only registered
``national securities association.'' Specifically, the
Commission stated in the Regulation ATS adopting release that
Nasdaq did, in fact, fit within the new expanded definition of
exchange and that it could apply for registration as a national
securities exchange. Moreover, the release stated that the
requirements for registration as a national securities
association were ``virtually identical'' to those of a national
securities exchange. Notwithstanding the adopting release
language, the Commission has always been wary of the critical
distinction between the operation of national securities
exchanges and the Nasdaq interdealer market. Specifically,
Nasdaq does not offer intramarket price priority, while
national securities exchanges require a degree of order
interaction and potential price improvement beyond what is
available at the national best bid and offer (NBBO).
Thus, the Commission is currently reflecting upon
intramarket price priority in the context of Nasdaq's pending
application to
become a national securities exchange. The Commission is
particularly concerned that, if Nasdaq is permitted to operate
as a national securities exchange without intramarket price
priority, other national securities exchanges will surely
follow. This raises the question of how important is
intramarket price priority and is it in investors' interests
for it to no longer be offered by national securities
exchanges. Clearly, these are key market structure issues that
have implications well beyond whether Nasdaq's registration
application is granted.
Q.2. You also stated concern about public ownership of an
exchange and what kinds of protections can be built into such a
structure. I understand that at the request of the Commission,
Nasdaq prohibits any one shareholder from voting more than 5
percent of the shares outstanding, regardless of the percentage
of shares owned by a shareholder. In addition, the SEC reviews
and approves all changes to Nasdaq's articles of incorporation
and by-laws, which would give the SEC the ability to review any
changes to Nasdaq's corporate structure. Aren't a number of
exchanges around the world (including the Chicago Mercantile
Exchange) publicly owned public companies? I am not aware of
any problems from this structure, is the SEC? As I understand
it, the key value of public ownership is transparency and
accountability since public companies are subject to all the
disclosure rules and things are not secret and clubby. They
must file quarterly disclosure reports, detailed information on
executive compensation and their business, and audited
financials so all the world, including SEC can monitor what
they are doing.
A.2. You are correct that there has been a recent global trend
toward the demutualization of financial exchanges. The Chicago
Mercantile Exchange completed its demutualization and became
the first publicly traded U.S. financial exchange in December
2002, when its shares began trading on the New York Stock
Exchange, Inc. (NYSE). In addition, the National Association of
Securities Dealers, Inc. (NASD) is in the process of
demutualizing the Nasdaq Stock Market, Inc. (Nasdaq) and has
applied to register it as a national securities exchange. The
NYSE announced its desire to demutualize in 1999, but has not
made significant progress in that regard to date. A number of
overseas exchanges have also moved toward demutualization,
including the Stockholm Stock Exchange, the Amsterdam Stock
Exchange, the London Stock Exchange, and the Deutsche Bourse.
You are also correct that the periodic reporting
requirements, imposed upon public companies, benefit investors
in a number of ways, including by making public companies'
financial conditions and corporate governance practices
transparent. Moreover, Nasdaq has argued that it should be
permitted to offer its shares to the public in order to compete
effectively. Specifically, Nasdaq has asserted that going
public would unlock its inherent value and provide it with
capital for use in competing with the nimble electronic
communications networks (ECN's). Nasdaq believes that
demutualization and registration as a national securities
exchange will help it compete by streamlining its corporate
decisionmaking.
While benefits may be gained from the demutualization of
financial exchanges and from the public trading of exchange
shares, these issues raise potential problems. For instance, a
commercial self-regulatory organization (SRO), engaged in
developing its business and competing with other SRO's, may not
be able to police its members effectively. Some argue that
inherent conflicts of interest exist in the demutualized
exchange environment between the SRO's goal of serving profit-
driven shareholders and the SRO's obligation to act as a front
line enforcer of the Federal securities laws. These conflicts
could present themselves in a variety of ways, including
discrimination through the imposition of disciplinary sanctions
on members, unfairness in what services are offered to
different types of members, and discriminatory fee setting.
Moreover, profit-driven SRO's may be tempted to maximize
shareholder profit, by making overly aggressive reductions in
self-regulatory spending. In addition, a market, like Nasdaq,
could be confronted with the difficult decision of either
submitting to the listing standards of another market, like the
NYSE, or listing shares on its own market. If Nasdaq selected
the latter option, it would find itself in the tenuous position
of being regulated by its own listing standards regulatory
staff. Thus, the Commission is in the process of considering
whether the traditional nonprofit SRO model is still effective,
but is wary of the potential problems that can result from
permitting exchanges to go forward as for-profit entities.
Q.3. You also stated that Nasdaq had ``backed into'' its status
as a for-profit company. Is it not true that the Commission was
involved and engaged in every step of that process and the
plans were approved by the Commission? What did you mean by
``backed into?''
A.3. During my testimony before the Subcommittee, I indicated
that Nasdaq had ``backed into'' its current status as a for-
profit entity. Your inquiry as to how I could characterize
Nasdaq's actions as such when the Commission has overseen the
actions taken by Nasdaq is well taken. By way of background,
the NASD was completely reorganized in 1996 in the aftermath of
a Department of Justice and Commission investigation into
anticompetitive practices by OTC market makers. This
reorganization resulted in the creation of a parent holding
company and two operating subsidiaries--Nasdaq and NASD
Regulation, Inc. Encouraged, in part, by the lofty market
valuations of public companies in the late 1990's and the
global trend of demutualization, NASD explored the possibility
of demutualizing Nasdaq, registering it as a national
securities exchange, and raising capital for Nasdaq through a
public
offering.
In that regard, on April 14, 2000 the membership of the
NASD voted overwhelmingly to turn Nasdaq into a for-profit
company and alter its ownership structure. This ongoing
transformation is being accomplished in two stages. In the
first stage, up to 49 percent of Nasdaq's common stock was
offered in a private placement to NASD members, Nasdaq issuers,
institutional investors, and strategic partners. After a
further sale of Nasdaq stock in the second phase and the
triggering of certain warrants, NASD will own a minority stake
of Nasdaq, but will retain significant voting rights held in a
voting trust until such time as Nasdaq is registered as a
national securities exchange. NASD has stated that the purpose
of the demutualization of Nasdaq is to permit the NASD to focus
more intently on its primary task of member regulation, to
streamline Nasdaq's corporate decisionmaking process, and to
unlock Nasdaq's inherent value through a public offering.
As recent events have indicated, potential conflicts of
interest may arise when there are insufficient barriers between
regulatory staff and commercial pressures. While the Commission
generally has supported the NASD's efforts to insulate its
operations from commercial pressures by demutualizing Nasdaq,
there are, as outlined above, very serious issues raised by
Nasdaq being a publicly traded national securities exchange.
Q.4. Mr. Chairman, the Commission held public hearings on
market structure issues earlier this year and part of last
year, I think. What is going to be the outcome of those public
hearings and what is the time frame for it?
A.4. As you correctly note, the Commission held public hearings
in late 2002 to address a wide variety of complex market
structure issues, including the quoting and trading in subpenny
increments, the fair and efficient access among different types
of market centers, the appropriateness and level of access
charges between market participants, the protection of prices
across different types of markets and its relationship with
best execution, the sale and distribution of revenue generated
by market data, and the criteria for registration as a national
securities exchange. The overriding theme derived from the
hearings was that the principle of a centralized National
Market System, as set forth in Section 11A of the Securities
Exchange Act of 1934, remains valid today and is worth
preserving with some modernization. Having considered industry
views, the Commission is now in a position to take action. In
that regard, we are crafting Commission proposals for
rulemaking that will be published for public comment in the
Federal Register. We anticipate that proposals on access to
markets (including access fees and the trade through rule) and
market data will be published in early 2004. Thereafter, we
would expect to issue proposals addressing other market
structure issues, including those relating to the self-
regulatory system and the criteria for registration as a
national securities exchange.
RESPONSE TO A WRITTEN QUESTION OF SENATOR ALLARD
FROM WILLIAM H. DONALDSON
Q.1. The Investment Company Act gives the SEC explicit
authority to sue investment company management for charging
excessive fees and imposing a fiduciary obligation on the
adviser with relation to receiving these fees. How many times
has the SEC used this statutory authority?
A.1. Section 36(b) of the Investment Company Act of 1940
(Investment Company Act) authorizes the Commission to institute
enforcement actions against investment advisers for charging
investment companies excessive fees. Section 36(b) imposes on
an investment adviser to an investment company a fiduciary duty
with respect to the receipt of compensation for services, or of
payments of a material nature, paid by the investment company
or its shareholders to the adviser or its affiliated persons.
The Commission and investment company shareholders may
institute an action in Federal district court against the
investment company's investment
adviser and its affiliated persons ``for breach of fiduciary
duty in respect of such compensation or payments'' paid by the
investment company or its shareholders.\1\ Congress adopted
Section 36(b) in 1970 in response to concerns that investment
company advisory fees were not subject to the normal
competitive pressures prevalent in other areas of commerce
because investment companies typically are organized and
operated by their investment advisers.\2\
---------------------------------------------------------------------------
\1\ Section 36(b) of the Investment Company Act. An investment
adviser's duty under Section 36(b) relates to all of the compensation
that the adviser and its affiliated persons receive from the investment
company, including any distribution payments such as Rule 12b-1 fees.
\2\ See SEC, Report on the Public Policy Implications of Investment
Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. 10-12, 126-27,
130-32 (1966). Section 36(b) was adopted in response to Congress's
recognition that the Investment Company Act, as originally enacted,
``did not provide any mechanism by which the fairness of management
contracts could be tested in court.'' Investment Company Amendments Act
of 1970, S. Rep. No. 91-184, 91th Cong., 1st Sess. 5 (1969).
---------------------------------------------------------------------------
The Commission has instituted two enforcement actions under
Section 36(b) against investment advisers, among others, for
breach of their fiduciary duties with respect to the receipt of
compensation. In SEC v. American Birthright Trust Management
Co., the Commission alleged that the compensation paid by an
investment company to its investment adviser for advisory and
related services was excessive in light of the services
actually performed by the investment adviser, and that most of
the advisory services provided to the investment company were
actually provided by a subadviser retained by the adviser.\3\
In addition, in SEC v. The Fundpack, Inc., the Commission
alleged that an investment adviser and its affiliates breached
their fiduciary duty under Section 36(b) by operating
investment companies in a manner designed to generate
benefits for themselves at the direct expense of the investment
companies and their shareholders.\4\
---------------------------------------------------------------------------
\3\ See SEC v. American Birthright Trust Management Co., Lit. Rel.
No. 9266 (December 30, 1980).
\4\ See SEC v. The Fundpack, Inc., et al., Lit. Rel. No. 8698
(March 22, 1979).
---------------------------------------------------------------------------
Investment company shareholders have instituted numerous
actions under Section 36(b). The seminal case under Section
36(b) is Gartenberg v. Merrill Lynch Asset Management, Inc.,\5\
in which the court interpreted Section 36(b) as involving an
evaluation of whether the compensation that is paid to an
investment adviser is ``so disproportionately large that it
bears no reasonable relationship to the services rendered and
could not have been the product of arm's length bargaining.''
\6\ The court identified several factors (commonly referred to
as the ``Gartenberg factors'') that should be evaluated when
determining whether a breach of fiduciary duty has occurred.\7\
Courts generally have evaluated subsequent Section 36(b)
actions using the Gartenberg factors.
---------------------------------------------------------------------------
\5\ 694 F.2d 923 (2d Cir. 1982).
\6\ Id. at 928.
\7\ These factors generally include: (1) the nature and quality of
all of the services provided by the investment adviser (either directly
or through affiliates), including the performance of the investment
company; (2) the investment adviser's cost in providing the services
and the profitability of the investment company to the adviser; (3) the
extent to which the investment adviser realizes economies of scale as
the fund grows larger; (4) the ``fall-out'' benefits that accrue to the
investment adviser and its affiliates as a result of the adviser's
relationship with the investment company (for example, soft dollar
benefits); (5) the performance and expenses of comparable investment
companies; (6) the expertise of the independent directors, whether they
are fully informed about all facts bearing on the investment adviser's
service and fee, and the extent of care and conscientiousness with
which they perform their duties; and (7) where relevant, the volume of
transaction orders that must be processed by the investment adviser.
---------------------------------------------------------------------------
To date, investment company shareholders have had mixed
success in litigating Section 36(b) actions. In certain Section
36(b) cases, the investment advisers to investment companies
have chosen to settle the litigation, and some of these
settlements have
resulted in lower investment company advisory fees. In the
remainder of the cases, however, the investment advisers have
prevailed. The Commission staff monitors these actions.
The Commission's staff continues to evaluate potential
actions under Section 36(b) according to the standards set
forth in Gartenberg. The staff typically examines the minutes
of investment company board of directors' meetings to determine
what factors the board considered in evaluating the company's
advisory fees. In addition to examining board minutes, the
staff also considers any other information relied upon by
directors in assessing the investment company's advisory
fees.\8\
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\8\ Under Section 15(c) of the Investment Company Act, it is the
duty of directors of a registered investment company to request and
evaluate, and the duty of an investment adviser to such company to
furnish, any information that may reasonably be necessary for the
directors to evaluate the terms of any investment advisory contract
with the investment company.
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RESPONSE TO A WRITTEN QUESTION OF SENATOR CHAFEE
FROM WILLIAM H. DONALDSON
Q.1. While the Sarbanes-Oxley Act and other Federal laws make
it clear that electronic data and other information must be
preserved at the initiation of a formal investigation, it is
not clear what steps a company should take to preserve and
protect electronic data when it becomes aware of an informal
SEC investigation or inquiry.
Electronic data, including e-mail, is often routinely
deleted in order to manage the large volume of information
generated in the normal course of business. As a result, there
is the potential that critical evidence is being routinely
deleted between the time a company becomes aware of an informal
investigation and the notification of a formal investigation.
Are you concerned that such data loss is having a negative
impact on the SEC's ability to enforce the Sarbanes-Oxley Act?
If so, should the Commission study the issue to determine
whether its enforcement function would be improved by
developing specific guidelines regarding what electronic data
must be preserved when a company becomes aware that it is the
subject of an informal investigation?
A.1. E-mail and other electronic records are important to SEC
investigations of potential wrongdoing by securities firms,
public companies, accounting firms, individuals, and others.
The Sarbanes-Oxley Act and other laws and rules impose record
retention and preservation requirements on certain entities or
persons in various circumstances. Indeed, some of these
requirements are applicable even prior to the initiation of a
formal Commission investigation.
In the case of broker-dealers, for instance, Rule 17a-
4(b)(4) under the Securities Exchange Act of 1934 requires that
broker-dealers retain, among other records, ``originals of all
communications received and copies of all communications sent
(and any
approvals thereof) by the member, broker, or dealer (including
interoffice memoranda and communications) relating to [their]
business as such . . . .'' The Commission interprets this rule
as covering electronic records, including e-mail. The required
retention period is ``not less than 3 years,'' and the
obligation to preserve records applies whether or not the
Commission is conducting an investigation of the broker-dealer
or its employees. Violations of this rule have resulted in
enforcement action. For example, in December 2002, the SEC, New
York Stock Exchange, and NASD filed joint actions against five
broker-dealers for violations of recordkeeping requirements
concerning e-mail communications. The firms consented to the
imposition of fines totaling $8.25 million, along with a
requirement to review their procedures to ensure compliance
with recordkeeping statutes and rules. The firms--Deutsche Bank
Securities Inc., Goldman, Sachs & Co., Morgan Stanley & Co.
Incorporated, Salomon Smith Barney Inc., and U.S. Bancorp Piper
Jaffray Inc.--agreed to be censured and to pay fines of $1.65
million per firm to the U.S. Treasury, NYSE, and NASD. Section
802 of the Sarbanes-Oxley Act imposes a similar requirement on
public company auditors to routinely retain audit or review
workpapers. The Commission's rules promulgated pursuant to
Section 802 specify that accounting firms must retain for 7
years certain records relevant to their audits and reviews of
issuers' financial statements. The records to be retained
include an accounting firm's workpapers and certain other
documents that contain conclusions, opinions, analyses, or
financial data related to the audit or review. Compliance is
required for audits and reviews completed on or after October
31, 2003. This preservation requirement applies whether or not
the Commission is conducting an investigation.
Section 802 of the Sarbanes-Oxley Act also includes a
provision addressing the handling of records in Federal
investigations and bankruptcy. Specifically, the provision
makes it a felony for a person to destroy or create evidence
with the intent to obstruct an investigation or matter that is
within the jurisdiction of any Federal agency.\1\ In one of the
first uses of Section 802, on September 25, 2003, the U.S.
Attorney's Office for the Northern District of California, the
Federal Bureau of Investigation, and the SEC jointly announced
that a former Ernst & Young partner who allegedly altered and
destroyed audit working papers, was arrested on criminal
charges for obstructing investigations by both the Office of
the Comptroller of the Currency and the SEC. Also in connection
with the document destruction, a former Ernst & Young senior
manager pled guilty to one count of obstructing the examination
of a financial institution. The SEC instituted administrative
proceedings in which the Division of Enforcement alleged that
the partner and a former audit manager engaged in unethical and
improper professional conduct in violation of SEC Rule of
Practice 102(e) as a result of their alteration and destruction
of documents. The SEC also instituted a settled administrative
proceeding against the former senior manager for his role in
the document destruction.\2\
---------------------------------------------------------------------------
\1\ The Sarbanes-Oxley Act also includes a provision making it a
felony punishable by a fine and up to 20 years in prison to corruptly
alter, destroy, mutilate, or conceal a record or document, or attempt
to do so, with the intent to impair the object's availability for use
in an official proceeding. Sarbanes-Oxley Act, Section 1102, codified
at 18 U.S.C. 1512(c).
\2\ A recent Commission action against the accounting firm
PricewaterhouseCoopers provides another example involving document
alteration and destruction prior to the commencement of a formal SEC
investigation. In that proceeding, the Commission concluded that it was
appropriate to sanction the firm for an audit failure caused by the
firm's audit partner because prior to the commencement of the SEC's
investigation the firm made undocumented changes to its audit working
papers and discarded other documents relevant to its audit.
Accordingly, the Commission charged the firm with engaging in improper
professional conduct in violation of Commission Rule of Practice
102(e).
---------------------------------------------------------------------------
The language of Section 802 also covers acts of destruction
either in contemplation of or in relation to matters within the
jurisdiction of a Federal agency. The author of this provision,
Senator Patrick Leahy, stated:
This statute is specifically meant not to include any
technical requirement, which some courts have read into other
obstruction of justice statutes, to tie the obstructive conduct
to a pending or imminent proceeding or matter by intent or
otherwise. It is also sufficient that the act is done ``in
contemplation'' of or in relation to a matter or investigation.
It is also meant to do away with the distinction, which some
courts have read into obstruction statutes, between court
proceedings, investigations, regulatory or administrative
proceedings (whether formal or not), and less formal government
inquiries, regardless of their title. Destroying or falsifying
documents to obstruct any of these types of matters or
investigations, which in fact are proved to be within the
jurisdiction of any Federal agency are covered by the statute.
[emphasis added]
A recent ruling in a criminal case, U.S. v. Kim, is
illustrative of the concerns expressed by Senator Leahy about
other obstruction statutes. Kim was charged with making a false
statement to the SEC staff that were investigating possible
insider trading by Kim. The false statement was made on
September 12, 1999 while the staff had open a preliminary
inquiry. On September 23, 11 days after Kim made his statement
to the staff, the staff closed the preliminary inquiry and
opened a formal investigation. A jury subsequently convicted
Kim of making a false statement to the staff in violation of 18
U.S.C. Sec. 1001.\3\
---------------------------------------------------------------------------
\3\ This section makes it a felony to knowingly and willfully make
a false statement in matters within the jurisdiction of the executive,
legislative, or judicial branch of the Government of the United States.
---------------------------------------------------------------------------
At sentencing in January 2003, the district court applied
the sentencing guideline applicable to fraud and violations of
18 U.S.C. Sec. 1001. The U.S. Attorney had requested a harsher
sentencing guideline applicable to violations involving
obstruction of justice under 18 U.S.C. Sec. 1505. Section 1505
prohibits anyone from corruptly ``endeavor[ing] to influence,
obstruct, or impede the due and proper administration of the
law under which any pending proceeding is being had before any
department or agency of the United States.'' In order to apply
the requested guideline, the district court determined that it
would have to find that the conduct set forth in Kim's
conviction satisfied the requirements of Sec. 1505.
In declining to apply the requested harsher guideline, the
district court held that ``no `proceeding' [within the meaning
of the term in Sec. 1505] was pending at the time of the
interview.'' Reasoning that Congress ``understood there to be a
point at which Section 1505 took effect--and by extension, a
prior period during which Section 1505 did not apply,'' the
court was unable to conclude that the Section . . . plainly and
unmistakably proscribe[s]' false statements made to Federal
agents prior to the commencement of formal agency
proceedings.'' [emphasis in original] [citation omitted]. The
court relied on the fact that Kim's false statement was made
prior to the Commission's authorization of a formal
investigation and that no request for formal investigative
authority was pending. The court concluded that prior to the
authorization of a formal investigation, ``the activities of
SEC investigators are more in the nature of an `informal
inquiry.' '' With the Commission's strong support, the
Department of Justice has appealed this ruling to the Court of
Appeals for the Ninth Circuit, arguing that several appellate
courts have held that Federal regulatory agency investigations
are ``proceedings'' for purposes of the Federal obstruction
statutes without regard to whether such investigations are
preliminary, formally authorized, or conducted only by agency
staff. The appeal is pending.
In light of the language of Section 802 of Sarbanes-Oxley,
as well as its legislative history, it would appear that under
that provision, when an entity or person is aware of even an
informal Commission inquiry, the destruction or alteration of
documents prior to the initiation of a formal Commission
investigation, would be a violation of law. Notwithstanding the
Kim ruling, even prior to enactment of the Sarbanes-Oxley Act,
there were circumstances in which the destruction or alteration
of documents before the commencement of a formal Commission
investigation was found to be improper and/or to constitute
obstruction of justice.\4\ Under pre-existing law, if entities
or persons were aware of a likelihood that the Commission staff
would investigate their conduct, it would have been improper
for them to destroy relevant records. Such a circumstance could
arise, for example, if an entity was aware of an SEC informal
inquiry relating to its conduct, if during an informal inquiry
the Commission staff instructed the entity or person to
preserve relevant records, if an entity voluntarily self-
reported violative conduct to the Commission staff, or if
professional standards imposed an independent requirement that
documents be retained.
---------------------------------------------------------------------------
\4\ Cf., U.S. v. Cisneros, 26 F.Supp.2d 24, 39 (D.D.C. 1998)
(stating with respect to 18 U.S.C. 1505, which prohibits obstruction of
proceedings before departments, agencies, and committees, that ``it is
established that the statute protects preliminary and informal
inquiries against obstruction as well as formal proceedings.'')
[citation omitted]; ``It is established . . . that the statute protects
preliminary and informal inquiries against obstruction as well as
formal proceedings.'' United States v. Poindexter, 725 F.Supp. 13, 22
(D.D.C. 1989) [citations omitted]; ``Congress clearly intended to
punish obstruction of the administrative process . . . in any
proceeding before a governmental agency--at any stage of the
proceeding.'' Rice v. United States, 356 F.2d 709, 712 (8th Cir. 1966).
---------------------------------------------------------------------------
Indeed, the Department of Justice's obstruction of justice
case against accounting firm Arthur Andersen, LLP was based on
Andersen's destruction of documents relating to its audits of
Enron after the firm learned that the SEC had begun an inquiry
into Enron. The document destruction described in the Andersen
indictment occurred after the SEC had begun an informal inquiry
of Enron, but prior to the commencement of its formal
investigation. Nevertheless, Andersen was convicted of
obstruction in violation of 18 U.S.C. 1512(b)(2).\5\
---------------------------------------------------------------------------
\5\ This statute, which predates Sarbanes-Oxley, provides in
relevant part that: Whoever knowingly uses intimidation, threatens, or
corruptly persuades another person, or attempts to do so, or engages in
misleading conduct toward another person, with intent to cause or
induce any person to (A) withhold testimony, or withhold a record,
document, or other object, from an official proceeding; (B) alter,
destroy, mutilate, or conceal an object with intent to impair the
object's integrity or availability for use in an official proceeding;
(C) evade legal process summoning that person to appear as a witness,
or to produce a record, document, or other object, in an official
proceeding; or (D) be absent from an official proceeding to which such
person has been summoned by legal process shall befined under this
title or imprisoned not more than 10 years, or both.
---------------------------------------------------------------------------
The Division of Enforcement does not believe that the
unavailability of records disposed of prior to the initiation
of formal investigations has substantially undermined the
Commission's overall enforcement efforts. Nevertheless, the
loss of any potentially relevant documents is a serious matter.
The best way to address such conduct is through serious
sanctions that serve a deterrent function. Accordingly, the
Division of Enforcement intends to continue to vigorously
enforce existing document preservation and retention rules, and
work closely with the criminal authorities when it appears that
parties take steps to obstruct SEC investigations by destroying
or altering records.
RESPONSE TO A WRITTEN QUESTION OF SENATOR BAYH
FROM WILLIAM H. DONALDSON
Q.1. With all of the recent conflict of interest scandals on
Wall Street, little has been said about the practice of
internalization which involves brokerage firms trading against
their own customers' orders because they view them as
profitable trading opportunities. We understand that this
growing controversial practice in the listed options markets
may soon be systematized and taken to a new level if the SEC
approves a pending proposal from the Boston Stock Exchange
called ``BOX.'' If the SEC is concerned about conflicts and has
publicly called for greater study of the adverse effects of
internalization, why would the SEC approve any aspects of the
proposal that furthers internalization?
A.1. Internalization in the options market is not new. Each of
the five options exchanges permits firms to internalize a
portion of their customers' orders. The Boston Stock Exchange's
proposed new options facility--BOX--would also permit members
to internalize customer order flow.
BOX's trading rules were published for comment in January
and the comments we received raise a number of concerns. BOX
proposed to address many of these concerns in amendments
published recently. Commission staff is now analyzing the
comment letters received on these amended trading rules. The
Commission staff is closely analyzing BOX's trading rules,
together with the thoughtful comments received, to determine
whether BOX would reduce price competition in the options
market by permitting internalization to take place to a greater
extent than it does today.
It is very important that the Commission's review of
significant new market innovations, such as the BOX, not impede
the entrance of new competitors to our marketplace. At the same
time, we are obligated to ensure that any proposal will be
consistent with the Federal securities laws, including the
protection of investors and the public interest.
RESPONSE TO A WRITTEN QUESTION OF SENATOR REED
FROM WILLIAM H. DONALDSON
Q.1. As you know, e-mail and other electronic records have
become critical evidence in SEC investigations of fraudulent or
inappropriate behavior by securities firms. Sarbanes-Oxley and
other regulations require the preservation of these records
when a formal
investigation is initiated, but some critical records seem to
be lost between the onset of an informal investigation and that
of a formal one. What can you attribute this loss to? Are
standard practices in the administration of corporate data
processing systems to blame? If so, is the SEC considering any
steps to mitigate this loss, such as developing guidelines
identifying what data must be preserved when an informal
investigation is initiated?
A.1. Please see the answer to the preceding question submitted
by Senator Evan Bayh.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM WILLIAM H. DONALDSON
Q.1. Mr. Donaldson, the SEC has recently come out with some
proposals on hedge funds--that they be better regulated, that
they register with the Investment Advisors Act of 1940, and
that the eligibility requirements for smaller investors be
increased.
I do not know whether you would agree with this summary,
but it has been pointed out to me that the thinking behind the
1940 Act was, in short, that if you were marketing to smaller,
less ``sophisticated'' investors you needed to register. And if
you were marketing to wealthy, ``sophisticated'' investors it
was expected that the investor had the wherewithal and
experience to judge the risk himself, so no registration and
looser standards.
By that logic, the SEC's proposal could be seen to
contradict the thinking behind the 1940 Act.
Finally, I would like to get your views on whether, if
hedge funds are performing well and attracting some of the best
investment talent, how can we increase the average person's
ability to invest with them. Currently we are raising the
threshold, but if the performance is there, perhaps we can also
consider ways to enable average investors to benefit from hedge
fund performance.
A.1. Two questions are posed. First, you inquire as to whether
the recommendations that the staff made in its September 29,
2003 report to the Commission, Implications of the Growth of
Hedge Funds,\1\ contradict the rationale behind the regulatory
framework of the Investment Company Act of 1940 (Investment
Company Act). Second, you seek my views on whether the
Commission should consider making hedge fund investments
available to a wider universe of investors.
---------------------------------------------------------------------------
\1\ Implications of the Growth of Hedge Funds (September 2003),
available at http://www.sec.gov/news/studies/hedgefunds0903.pdf (Hedge
Fund Report).
---------------------------------------------------------------------------
Hedge funds generally avoid regulation under the Investment
Company Act by relying on one of two exclusions from the
definition of an investment company set forth in that statute.
Section 3(c)(1) of the Investment Company Act excludes from the
definition of an investment company any issuer whose
outstanding securities are beneficially owned by not more than
100 persons and which does not presently propose to make a
public offering of its securities (Section 3(c)(1) hedge fund).
Section 3(c)(1) reflects Congress's view that investors in
small, privately placed investment companies are able to access
the type of information necessary to protect their own
interests.\2\
---------------------------------------------------------------------------
\2\ Although Section 3(c)(1) does not specifically require any
level of financial sophistication for an investor to be eligible to
invest in a Section 3(c)(1) hedge fund, many such hedge funds rely on a
safe harbor provided under the Securities Act of 1933 (Securities Act)
to offer and sell their securities. See Regulation D under the
Securities Act. Under Regulation D, hedge funds may offer and sell
their securities to accredited investors and no more than 35
nonaccredited investors. In general, accredited investors are
individuals who have a net worth above $1,000,000, or who have income
above $200,000 in the last 2 years (or $300,000 with spouse) and have a
reasonable expectation of reaching the same income level in the year of
investment.
---------------------------------------------------------------------------
Section 3(c)(7) of the Investment Company Act excludes from
the definition of an investment company any issuer that does
not propose to make a public offering and whose securities are
owned
exclusively by ``qualified purchasers.'' Qualified purchasers
are generally individuals with $5 million in investments and
others who own or invest at least $25 million in investments.
Section 3(c)(7) reflects Congress's view that certain highly
sophisticated investors do not need the protections of the
Investment Company Act because those investors are in a
position to appreciate the risks associated with pooled
investment vehicles.\3\
---------------------------------------------------------------------------
\3\ Section 3(c)(7) was added to the Investment Company Act in
1997. See S. Rep. No. 293, 104th Cong., 2d Sess. 10 (1996).
---------------------------------------------------------------------------
The staff 's Hedge Fund Report makes no recommendations
with respect to Section 3(c)(1) or 3(c)(7), nor does it
recommend any regulatory action under the Investment Company
Act that would
affect who may invest in hedge funds. In fact, the staff 's
report essentially recommends maintaining the current
regulatory approach that investors in hedge funds that are
generally smaller or are owned by highly sophisticated
investors do not require the protections of the Investment
Company Act.
Under the staff 's primary recommendation, hedge fund
advisers would be required to register with the Commission
under the
Investment Advisers Act of 1940 (Advisers Act). Unlike the
Investment Company Act, which imposes a comprehensive
regulatory
regime on investment companies, the Advisers Act is a
disclosure-oriented regulatory scheme that requires investment
advisers to disclose certain information, including, for
example, information about their organizational structure,
assets under management, nature of the services they provide,
and how they address certain conflicts of interest. The
Advisers Act does not regulate the sophistication of an
investment adviser's clients.\4\
---------------------------------------------------------------------------
\4\ The Advisers Act differentiates among advisory clients based on
the types of fees that they are charged by prohibiting registered
investment advisers from charging performance-based fees (for example,
fees based on a percentage of the fund's capital gains and capital
appreciation) to their less wealthy clients. Most hedge funds charge
these types of fees. Under rules adopted by the Commission under
Section 205 of the Advisers Act, an investor must have $750,000
invested with the investment adviser or generally have a net worth of
$1.5 million to be eligible to invest in a Section 3(c)(1) hedge fund
that pays a performance fee. If the Commission were to require the
registration of hedge fund advisers under the Advisers Act, this rule
would have the effect of raising the minimum net-worth or investment
required for investment in Section 3(c)(1) hedge funds that pay
performance-based fees to their advisers.
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You also seek my views on whether the Commission should
increase the availability of hedge funds for less sophisticated
investors. In the Hedge Fund Report, the staff identified some
of the differences between hedge funds and registered
investment companies and expressed its view that such hedge
funds have characteristics that may provide certain benefits,
including increased diversification, to less sophisticated
investors. The staff concluded that while it did not believe
that these investors should invest directly in hedge funds, it
was worth inquiring into whether there may be benefits of
having registered investment companies engage in the types of
strategies that are currently being utilized by hedge funds.
The staff recommended that the Commission consider issuing a
concept release with a view toward determining whether hedge
fund strategies may be effectively deployed in registered
investment companies and what types of relief might be
necessary under the Federal securities laws to effectuate this
goal.
As you know, the Commission has the staff 's
recommendations under consideration, but has not yet made any
decisions as to which recommendations it may direct the staff
to proceed upon. We look forward to taking up these
recommendations for consideration in the near future.
Q.2. Mr. Donaldson, information drives the health of our
securities markets, and I want to ask you about one of the most
critical pieces of information--how much money a company
actually earns.
A recent article (Sunday, September 21, 2003) in The New
York Times on the many different ways to measure a company's
earnings is titled, ``Counting the Ways to Count Earnings.''
Perhaps the title says it all.
Last time you testified I asked you about yet another
differential--the differences between book and tax income--and
I appreciated your willingness to consider that issue.
What can or should the SEC do to clear through this
confusion on earnings?
In your view, do we have a risk to the long-term health of
the securities markets if the most critical number driving
those markets--earnings--is such a source of debate and varying
standards?
A.2. The newspaper article cited in your question refers to
three measures of corporate earnings based on a particular
company's financial results. These are operating earnings,
reported earnings, and core earnings. The article defines
reported earnings to be earnings calculated using generally
accepted accounting principles (GAAP). Operating and core
earnings, as referred to in the article, add or remove items
from reported earnings.
Because companies may manipulate such ``pro forma''
earnings to create a desired result, Congress, in Section
401(b) of the Sarbanes-Oxley Act of 2002 (Act), directed the
Commission to write rules that would require disclosures of
``pro forma'' earnings to be presented in a manner that (1)
does not contain an untrue statement of a material fact, or
omit to state a material fact necessary to make the ``pro
forma'' financial information, in light of the circumstances
under which it is present, not misleading, and (2) reconciles
the disclosure with the financial condition and results of
operations of the issuer prepared in accordance with GAAP. On
January 22, 2003, the Commission announced, in Securities Act
Release No. 8176, adoption of the rules required by section
401(b).
These new rules take a three-part approach to the
disclosure of ``pro forma,'' or ``non-GAAP'' information.
Consistent with Section 401(b) of the Act, these rules impose
requirements on the disclosure of non-GAAP information, rather
than prohibiting that disclosure.
The first part of this approach--new Regulation G--
imposes the requirements of Section 401(b) of the Act on
any public disclosure or release of material information
(regardless of whether that disclosure or release is filed
with the Commission) that contains non-GAAP financial
measures. The measures discussed in the cited article--
``operating earnings'' and ``core earnings'' are examples
of non-GAAP financial measures.
The second part of the approach imposes additional
requirements regarding the inclusion of non-GAAP financial
measures in filings with the Commission. Among other
things, these additional requirements obligate companies to
disclose clearly how management uses each disclosed non-
GAAP financial measure and why that measure is useful to
investors.
The third part of the approach requires companies to
furnish their earnings releases to the Commission on Form
8-K and, in addition to complying with Regulation G,
disclose clearly how management uses each non-GAAP
financial measure included in the earnings release and why
that measure is useful to investors.
Q.3. In the development of the Sarbanes-Oxley Act, there was
considerable debate regarding the appropriateness of funding
accounting standard-setters through voluntary private sector
contributions. The Act creates a system of levies on publicly
traded companies for the Financial Accounting Standards Board
(FASB). Currently, the FASB's international counterpart and
partner, the International Accounting Standards Board (IASB),
is funded largely through voluntary contributions. Do you have
any thoughts regarding whether the FASB approach is appropriate
for the IASB?
A.3. The Trustees for the International Accounting Standards
Committee (IASC) Foundation, which currently raises funds for
the IASB, are reviewing alternatives for the future funding of
the IASB, including alternatives that could reduce reliance on
voluntary contributions. While approaches such as the Sarbanes-
Oxley Act provisions for funding for the Financial Accounting
Standards Board through ``support fees'' assessed on issuers of
securities might be considered, significant differences exist
between the IASB and FASB and the IASB situation is more
complex. One important difference is that the goal of the IASB
is to set global accounting standards. The standards it sets
are or will be the mandated accounting standards for the
European Union countries beginning in 2005 and for a number of
other countries that have decided to adopt international
accounting standards. It is possible that some of these
countries might have competitive interests in the outcome of a
specific IASB project. Care would have to be taken, therefore,
to assure that those countries with companies or other sources
(for example, nonvoluntary sources, if such approaches are
adopted) providing the most funding for the IASB would not seek
added influence with the IASB.
In any event, we believe that the IASC Foundation Trustees
should be allowed to complete their review and, after
appropriate consideration of all the issues, present their
conclusions and recommendations for public consideration.
Q.4. Your testimony states that the global settlement is still
being reviewed by the U.S. District Court. Does the SEC intend
to further revise its rules affecting stock analysts to impose
additional safeguards to all securities firms?
A.4. The court gave final approval of the global settlement on
October 31, 2003.
The Commission is currently determining whether regulatory
gaps still remain in the area of analyst research, and is
considering what, if any, additional analyst rules are
appropriate for the entire industry, including whether there
are additional elements of the settlement that should be
incorporated into industry-wide rules.