Speech by SEC Staff:
Remarks to the Securities Industry Association

by

William H. Donaldson

Chairman,
U.S. Securities and Exchange Commission

Boca Raton, FL
November 7, 2003

Ladies and gentlemen: Good morning and thank you for having me here today. I must begin by reminding you that the views I express here today are my own and do not necessarily represent the views of the Commission or its staff. And let me warn you that my message today is an unpleasant, but important one. It's a message that I hope each of you will seriously consider. The SIA, as the primary trade group for the nation's broker dealers, is in a unique position to be an active participant in the solution to the ills facing the securities industry today. I use the word "ills" deliberately, too. Since joining the SEC, I have been distressed by the conduct we have seen from key participants in our nation's securities markets. The most recent examples of this conduct are, of course, the late trading and market timing abuses that have been dominating the headlines. These offenses now must be added to a laundry list of industry wrongdoing, which includes the analysts' conflicts, IPO abuses, the failures to give investors the breakpoint discounts to which they were entitled, sales practice abuses, and the hidden incentives some brokers have when favoring one mutual fund over another. I am left with the conclusion that these occurrences represent a fundamental betrayal of our nation's investors, and are symptomatic of a disease that has afflicted far too many in the industry. And, while I don't want to indict the whole industry for these recent problems, we all must work together to combat them and to work toward finding the proper remedies for the industry's woes.

Our nation's investors are a loyal and resilient group. The Dow is up, money continues to flow into our nation's mutual funds. We at the SEC are doing everything in our power to protect those investors and ensure that their trust is not misplaced. In a moment I will outline for you our plan. But we obviously can't do it alone. Indeed, you need to consider what you as an industry can do to regain the trust and loyalty of America's investors. I have a few ideas on that, as well.

Just as a surgeon operates to excise a patient's disease, we, too, must operate to excise the wrongdoers in our securities market. Toward that end, our Enforcement staff is vigorously ferreting out and punishing wrongdoers wherever they appear in our markets, including in the brokerage industry. Prior to recent damning revelations, the SEC staff had been focused on a number of areas.

One of our focus areas has been mutual fund sales practices and fee disclosures. In particular, our staff has been looking at precisely just what prospective mutual fund investors are being told about revenue sharing arrangements and other incentives doled out by mutual fund management companies and mutual funds themselves to brokerage firms who agree to feature their funds. We are concerned that there may be inadequate disclosure of the source and nature of such payments - and the fact that they may increase costs to investors as well as create conflicts of interest between investors and the financial professionals with whom they deal.

A second area of focus is the sale of different classes of shares in the same mutual fund. Very frequently, a fund will have issued two or more classes of shares, commonly referred to as A shares, B shares, and so on. Each class will have a different fee structure associated with it. In the last six months the Commission has authorized enforcement actions against two brokerage firms in connection with the alleged recommendations that customers purchase one class of shares when the firm should have been recommending another.

Yet another area of focus is the abuse of so-called "breakpoints." Regrettably, our staff and the staff of the NASD have found numerous instances in which it appears brokerage firms failed to give investors the discounts to which they were entitled. This week, we have issued, together with the NASD, Wells notices to a significant number of brokerage firms for their failure in this regard.

Since scandals erupted in early September, here's what we've done on the enforcement front to attack late trading and market timing abuses. We sued a registered representative for having allegedly facilitated late trading by some of his clients. We charged a senior executive of a prominent hedge fund with late trading, and barred him from association with an investment adviser. We also barred and imposed a $400,000 civil penalty on a mutual fund executive in connection with his alleged role in allowing certain investors to market time his company's funds. We instituted an action against a major investment management firm and two of its portfolio managers who allegedly market timed their own mutual funds. And just this week, we charged five brokers and a branch manager with having misrepresented or concealed their own and their clients' identities in order to facilitate thousands of market timing transactions. In each of these matters, we have coordinated closely with state regulators, who have also filed their own charges.

If there is more wrongdoing, we will find it and will punish the perpetrators. On September 4, the Commission staff sent detailed, compulsory information requests to the largest mutual fund complexes and brokerage firms in the country, including all of the country's registered prime brokers. Based on the responses to these requests, Commission staff have been dispatched to conduct onsite inspections and interviews and further investigation at dozens of firms. The findings to date are damning.

More than 25% of responding brokerage firms reported that customers have received 4 p.m. prices for orders placed or confirmed after 4 p.m., thereby enabling late trading. On the matter of market timing, almost 70% of responding brokerage firms reported being aware of timing activities by their customers. Further, documents provided by almost 30% of responding brokerage firms indicate that they may have assisted market timers in some way, such as by breaking up large orders or setting up special accounts to conceal their own or their clients' identities - a practice sometimes called "cloning" - to avoid detection by mutual funds that sought to prevent abusive market timing.

This last statistic raises the issue of omnibus accounts. The purchase and redemption of mutual fund shares through an omnibus account held at a brokerage firm often makes it difficult for funds to fully protect their shareholders. In the breakpoint context, funds can't track information about the underlying shareholder that might entitle the shareholder to breakpoint discounts. In the market timing context, funds are inhibited in their ability to assess redemption fees, limit exchanges or even kick out a shareholder who is market timing through an omnibus account because they don't know the identity of that shareholder. I believe now is the time for the brokerage industry to consider this problem and how it might be addressed. I believe now is the time for the Commission to do the same.

Of course, it is not just the brokerage industry that is to blame. Mutual funds themselves also were complicit. Through the same requests for information, we learned that emails submitted by approximately 10% of the responding mutual funds contained references to situations that possibly involved late trading. Three fund groups reported, or the information provided indicated, that their staffs had approved a late-trading arrangement with an investor. With respect to market timing, 50% of responding fund groups appear to have had at least one arrangement allowing for market timing by an investor.

Reform Steps

In order to prevent these types of abuses from occurring in the future, and in order to prevent other, innovative types of fraud, we - all of us - must be bold, decisive and aggressive in our plan of attack. Let me outline for you the minimum steps we need to take and have begun.

• Ensure that effective mechanisms are in place for compliance with applicable laws and regulations, including the appointment of a chief compliance officer;
   
• Promulgate clear rules to prohibit abusive and wrongful activity, including rules to address late trading;
   
• Ensure aggressive enforcement of violations of the securities laws, including the disgorgement of ill-gotten gains;
   
• Implement and further develop effective Commission surveillance tools to monitor industry compliance;
   
• Call for industry adoption of ethical standards focusing on placing the interests of investors first;
   
• Mandate effective governance structure for mutual funds boards;
   
• Address conflicts of broker-dealers in marketing mutual funds;
   
• Take prompt and meaningful action to address investment adviser conflicts in the management of mutual funds;
   
• Improve disclosure to investors, including costs and other fees charged to investors when investing in mutual funds; and
   
• Ensure greater oversight over unregulated entities that can adversely affect mutual fund investors.

We are well on our way to implementing many of these items. For example, we will be moving forward to make mutual fund fees and expenses more transparent and enhance disclosure of incentives and conflicts that brokers have in offering mutual fund shares to investors. In a few weeks, the Commission will consider a package of proposals for the Commission to combat late trading, market timing and other abuses. The staff is preparing rule proposals that would require a fund, or certain designated agents, rather than an intermediary such as a broker-dealer, to receive orders in fund transactions by 4:00 p.m. for an investor to receive that day's price. This "hard" cutoff would effectively eliminate the potential for late trading through broker-dealers who sell fund shares.

The staff also will recommend that the Commission adopt the mutual fund compliance policies rule, which the Commission proposed in February. This proposal calls for a chief compliance officer, accountable to fund directors, whose responsibility it would be to ensure that funds have effective policies and procedures in place to prevent activity such as late trading, market timing abuses and the selective disclosure of fund portfolio holdings that could facilitate trading on inside information.

The staff will recommend explicit disclosure in fund offering documents of market timing policies and procedures, as well as their policies on disclosing information regarding portfolio holdings. These disclosures would enable investors to assess a fund's practices in these areas and determine if they are in line with their expectations.

This regulatory-reform package is just the beginning and represents our immediate response to the abuses we've seen so far. I have also asked the staff to consider whether funds should have additional tools available to thwart market-timing activity. If the profit potential can be taken away from market timers, we can eliminate abuses in this area. For example, the staff is considering a recommendation that the Commission propose rules to require mutual funds susceptible to market timing activity to impose a two percent fee on redemptions by short-term traders.

I will not hesitate to call for other measures if we discover additional information in the course of our investigation that merits regulatory action. That being said, however, I must emphasize that the nature of the problems that we have uncovered in our investigation dictate that we not only address the specific problems identified, but that we also ask whether there are structural, governance, and oversight issues that must be addressed in the mutual fund area. I think that the Commission must be open to considering additional measures that would improve oversight of the mutual fund industry and assist in preventing the types of lapses that we are currently investigating. No reform - whether structural, fund governance or board composition - is off the table.

Also on the table is a review of how we at the SEC go about our business. We are reevaluating how we use our resources, how we conduct our exams, how we can better harness the technological resources now at our disposal with the additional funding we have received from Congress. Additionally, I am assembling a risk management group within the Commission that is tasked with looking forward at what could be tomorrow's abuses - not just abuses in the mutual fund industry, but all aspects of the securities industry to anticipate and hopefully head off major problems before they occur.

Moreover, I have ordered a reassessment of our policies and procedures on how tips are handled. Tips from whistleblowers are critical to our mission of pursuing violations of the federal securities laws. I want to be sure that there is appropriate follow through on this type of information and that they are given expedited treatment.

The SEC Enforcement Division's track record is impressive. Over the past year we have placed new cops "on the beat," and stepped up enforcement of the securities laws in all areas. In the 2003 fiscal year, which ended September 30, we filed a record 679 actions, up from 484 two years ago, a 40% increase, with almost no increase in resources.

We have also worked to return funds to investors who have suffered losses, rather than merely collect those funds for the government. As part of these efforts, we have obtained the single largest civil monetary penalty ever imposed for violations of America's securities laws - and the proceeds from this penalty will be made available to harmed investors.

We are also pursuing a broad agenda to make America's securities markets more secure. For example, we have been examining the hedge fund industry, and the Commission staff recently released a comprehensive report on hedge funds, suggesting that hedge fund advisers be required to register with the SEC. Some have argued that hedge funds are in no need of regulation. But in the course of the late trading and market timing investigation we are seeing how the activities of hedge funds can adversely impact ordinary investors.

We are also continuing to encourage and monitor the improvements in corporate governance at the nation's self-regulatory organizations, especially the New York Stock Exchange. Under the interim leadership of John Reed, the Exchange has made important progress in designing a reformed Board and governance structure. Both the Exchange and the Commission are far from done, but, to repeat, there has been important progress.

The Job of the Securities Industry

Now let me turn to how you can help in bolstering investor confidence and making our markets more secure. The matters that we are investigating highlight conduct that violates the very principles of trust and fairness that represent the foundation - the building blocks - of our equity markets. These episodes provide valuable ammunition to critics who charge - wrongly in my opinion - that the little guy can't win by investing in our markets.

That is what makes this continuing stream of fiduciary failures so damaging. The headlines sap investor trust and confidence - and potentially drive people to pursue alternative investments. So far, fund investors are staying loyal to this investment vehicle, and have not been redeeming their shares. But the industry now bears a higher burden to earn the trust of investors.

Restoring public confidence has been, and is, no small challenge. Indeed, it will be a major, long-term undertaking that will require companies throughout the securities industry to move beyond basic compliance and to establish new standards of integrity. Investors, whether in the United States or abroad, must be able to see for themselves that your industry, and other industries, have moved beyond simple compliance with the new laws, and are living up to the spirit underpinning all of our securities laws. Indeed, the future success of the securities industry - and our capital markets - hinges on the industry's ability to police itself with standards that go beyond perfunctory legal compliance.

This is not a new idea. In Joseph Kennedy's first major speech as SEC Chairman, on July 25, 1934, he pointed out that "wealth in the form of corporate securities can be maintained and developed only by a continuous free and open market, where the investors may buy and sell their securities assured of the going price and protected from sharp practices."

For the securities industry, and for all of American business, it should be clear that we are in a new era, with higher standards and enhanced scrutiny - by regulators, business partners, and the public at-large. There are and will be new bright line rules to be observed. But these rules alone will not prevent the onset of corporate corruption. Indeed, I hope that the securities industry, and the entire business community, will see these lines as the bare minimum when it comes to compliance. Because if there is going to be a true restoration of long-term confidence in the U.S. economy, and the global economy, what's really needed is the full engagement of the securities industry in an effort to advance an underlying spirit of reform. Every firm needs to conduct a fundamental assessment of its obligations to its customers. These assessments must be done at the highest levels, and senior management and the board should be ready to issue directives - or codes of ethics - about precisely what it means to put the customer first. They must identify, eliminate, manage and/or disclose the conflicts of interest between their firms and their customers.

Moreover, there must be a commitment to giving these ideas teeth - meaning that those who stand in violation should face swift and severe punishment. In short, it is critical that there be an industry-wide mindset to do the right thing, and that this becomes part of the industry's DNA, from top to bottom.

While the industry has a long road of reform ahead of it, there are signs of progress. Significant resources are being committed to implement the Global Settlement, as well as recently approved SRO rules that seek to promote the independence of analysts and the integrity of sell-side research. And some firms appear committed to exceed, rather than merely meet, these new standards. I have also been pleased to see that the Bond Market Association is developing "best practices" guidelines to manage research analyst conflicts in the fixed-income markets - even though these markets have not been the focus of recent reform efforts.

The securities industry should play a critical role in helping to improve the corporate governance of American companies. First, you can lead by example. As symbols of America's economic dynamism and vitality, you can be role models for good corporate behavior. Second, as you conduct the transactions that are your everyday business, you can be a force for reform - insisting on high standards among your business partners, and acting to root out unethical behavior where you find it. By helping to raise the ethical bar, and not lower it, you can help to create an environment where the interests of shareholders and customers are second to none.

I have spent many years in and around the securities industry, during which time I have seen that we have the world's most creative, and most industrious workforce. I have also seen that this industry is populated by fundamentally decent and honest people. Indeed, these traits provide the foundation of our economic vibrancy. The securities industry has found itself stuck in a legal and ethical quagmire, but I am confident that the industry will work together to pull the industry out of the muck and live up to a higher ethical standard. You can be sure that if you don't, those of us in government will.

In closing, I want to thank the SIA again for giving me this opportunity to speak at your annual meeting. It has been an honor to be with you, and I thank you.