[Senate Hearing 109-413]
[From the U.S. Government Publishing Office]
S. Hrg. 109-413
THE STATE OF THE SECURITIES INDUSTRY
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
ON
THE EXAMINATION OF THE STATE OF THE SECURITIES INDUSTRY, FOCUSING ON
RECENT INITIATIVES REGARDING MARKET STRUCTURE, CREDIT RATING AGENCIES,
MUTUAL FUNDS, AND THE IMPLEMENTATION OF THE SARBANES-OXLEY REQUIREMENTS
__________
MARCH 9, 2005
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
______
U.S. GOVERNMENT PRINTING OFFICE
27-871 WASHINGTON : 2006
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
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 THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Mark F. Oestrele, Counsel
Bryan N. Corbett, Counsel
Dean V. Shahinian, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
----------
WEDNESDAY, MARCH 9, 2005
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Allard............................................... 3
Senator Stabenow............................................. 4
Senator Hagel................................................ 5
Senator Bennett.............................................. 5
Senator Schumer.............................................. 19
Senator Sununu............................................... 25
Senator Enzi................................................. 29
WITNESS
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission..................................................... 5
Prepared statement........................................... 29
Response to written questions of:
Senator Sarbanes......................................... 38
Senator Allard........................................... 40
Senator Stabenow......................................... 48
Senator Enzi............................................. 49
Senator Bunning.......................................... 51
Senator Carper........................................... 62
(iii)
THE STATE OF THE SECURITIES INDUSTRY
----------
WEDNESDAY, MARCH 9, 2005
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:10 a.m., in room SD-538, 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
Donaldson of the Securities and Exchange Commission. Mr.
Chairman, you spend a lot of time with us, but this is the
nature of the Banking Committee and also the SEC, as you well
know. I appreciate your willingness to spend time with us. This
morning's hearing is an opportunity for the Committee to learn
more about the SEC's current regulatory initiatives.
For the past 18 months, the SEC has pursued an aggressive
agenda of reform in the mutual fund industry. While continuing
to bring enforcement actions against wrongdoers, the SEC has
enacted a comprehensive set of new rules aimed at improving
fund governance, eliminating market timing and late trading,
and enhancing disclosures to investors. To date, the SEC has
adopted 10 rules, and additional rules are pending regarding
soft dollars,
12b-1 fees and point of sale disclosures. In addition to
completing its rulemaking, the SEC continues to examine other
fund industry products and practices, such as the role of
pension consultants, 529 education plans, and the sale of
periodic mutual fund products to military servicemen and women.
Clearly, there is more work to be done in this area, Mr.
Chairman, and I look forward to hearing about recent
developments and perhaps some future actions that you are
contemplating.
I commend the SEC for its response to the problems in the
mutual fund industry. Through your leadership and the hard work
of the SEC staff, I believe that investors have begun to regain
their confidence, Mr. Chairman, in the mutual fund industry.
A month ago, this Committee held a wide-ranging hearing on
credit rating agencies. We examined the competitive landscape
of the industry, the transparency of the ratings process, and
the conflicts of interest. We also considered the SEC's process
for granting the ``NRSRO'' designation and whether the SEC
should implement an oversight regime. Last week, the SEC
proposed a rule that would define the criteria and process for
obtaining the NRSRO designation. This proposal, I believe, is a
first step toward addressing some of the issues identified here
at this Committee, but I have additional concerns regarding
industry practices, the scope of the SEC's authority, Mr.
Chairman, and the appropriate level of SEC regulation.
Another prominent pending before the SEC is the adoption of
Regulation NMS. This proposed regulation would effect the most
significant changes in the last 30 years to the structure of
our stock markets. Since you last testified before the
Committee on Regulation NMS, the Commission has revised its
proposal concerning the application of the trade-through rule.
This debate has engendered considerable controversy, and it is
critical that the final outcome establish a framework, Mr.
Chairman, that enables our markets to remain fair, efficient,
and competitive. I look forward to your discussion of
Regulation NMS.
Mutual funds, credit rating agencies, and Regulation NMS
are just a few of the many important issues pending before the
Commission. This morning, I anticipate a wide-ranging
discussion and examination of the SEC's actions.
Mr. Chairman, you and your staff certainly have a busy
agenda. I appreciate your and the SEC staff 's efforts to
protect investors and to ensure the integrity of our capital
markets, and we look forward to your testimony here today.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you, Chairman Shelby. I join with
you in welcoming Chairman Donaldson back before the Committee
on today's hearings on the state of the securities industry.
Chairman Shelby, I want to commend you on your commitment
to having this Committee perform its oversight
responsibilities, which is, of course, a very important part of
our agenda, sometimes not fully appreciated by the public or
even by some Members of Congress in terms of the role that it
plays. This hearing provides an important opportunity to review
developments in the securities industry and the efforts of the
Commission to promote the integrity and efficiency of our
markets and to ensure the protection of our investors.
When we compare the condition of the securities industry of
today with that of a few years ago, we see a number of
improvements. Technological advances are increasing the speed
and efficiency of markets while reducing costs. Securities
underwritings are increasing. Municipal bond investors have
access to near real-time pricing data. Corporate boards and
managers increasingly focus on improving transparency,
disclosure, financial integrity, and governance. As a
consequence, investors have more confidence in our capital
markets. I have frequently stated that I regard our capital
markets as a major economic asset of the Nation.
The SEC has been active in its enforcement and in its
rulemaking as it seeks to implement recent legislation to
address problems that continue to exist in the industry and to
otherwise protect investors. Chairman Donaldson and his fellow
Commissioners have improved the effectiveness and morale of the
Commission. Chairman Shelby has instituted his Polishing the
Jewel program and other initiatives, and I want to commend him
on that. We understand it has had a marked uplifting impact on
the employees of the Commission.
Mr. Chairman, in closing, I want to commend once again the
process that the SEC uses in developing and promulgating its
regulations. Some people may take this for granted, but it is
an important part of wise policymaking is to have a fair and
open process available to all interested participants. As we
know, the staff of the Commission considers issues, often for
very substantial periods of time. Before recommending a
proposed rule on a particular complex issue, a concept release
soliciting public comment may be issued prior to formulating a
rule proposal.
When the SEC proposes a rule, it provides a period for
public comment. The SEC assesses the public reaction to the
proposal, and as it deems appropriate may extend the comment
period or solicit additional comments on particular points. It
did so, for example, with Reg NMS, which you made reference.
The SEC goes through a process of carefully assessing the
public comments. Simultaneously, it may hold public hearings or
roundtables on the issue to gain additional information. The
staff will meet with interested parties.
Sometimes, the comment process leads the Commission to make
additional proposals, and the SEC may again publish and solicit
comment, as it did just last December with Reg NMS. Once again,
there is careful review of the comments before a final rule is
published.
Actually, at a hearing last year, we had a panel before us,
quite a number of industry participants with different views on
Reg NMS, but all agreed, in response to question, that the
process had been very fair and very open. And I have to say I
think this sets a standard in terms of how to develop public
policy, and I want to commend Chairman Donaldson, his fellow
Commissioners, and the staff at the Commission for the
openness, the fairness, and the thoroughness of their process,
and as a consequences, I think the thoughtfulness that goes
into their decisionmaking.
These are very complex issues, and it is very rare that it
is all one way or all the other. I mean, there is always a very
nuanced response that has to be made, and I say to all
interested parties, I think the process the Commission has
developed over the years, and to which it holds, makes a very
important contribution to working out some reasoned answers to
very difficult problems.
Thank you very much, Mr. Chairman.
Chairman Shelby. Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Thank you, Mr. Chairman.
I would also like to join both you and Senator Sarbanes in
welcoming Chairman Donaldson to the Banking Committee, and I
would like to thank you, Mr. Chairman, for holding this hearing
to discuss several securities issues pending before the
Securities and Exchange Commission. All of these issues are of
great importance to the securities industry, investors, and
could very well change the Commission's daily operations and
interactions, and I am glad that the Committee is having this
discussion today.
The Commission has certainly taken on a lot in the past
couple of years on tough issues that impact the way the
industry operates and the manner in which the public views the
investment world. I was pleased to hear that the Commission
extended the compliance date for banks with respect to the
implementation of the pushout provisions in Title II of the
Gramm-Leach-Bliley Act. I am hopeful that this extra time for
comment will prove beneficial as the Commission further
considers the interests of many of the community banks and
thrifts throughout the country as well as the State of
Colorado.
I have concerns, however, that while I also look forward to
hearing from Chairman Donaldson about Regulation NMS, the
restructuring of the national market system has been a long
time coming, and I believe that the appropriate changes are
necessary for our markets to keep up with the changing demands
of technology and investors. I have concerns, however, that the
Commission may be moving too quickly toward a final rule when
there still seems to be so many concerns on all sides of the
issue.
Again, I would like to thank you, Chairman, in advance for
appearing before the Committee today to discuss significant
pending securities issues at the SEC, and I look forward to
your testimony and the discussion today.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you.
Senator Stabenow.
STATEMENT OF SENATOR DEBBIE STABENOW
Senator Stabenow. Thank you, Mr. Chairman, and welcome. We
are always glad to have you, Chairman Donaldson. I know that
these are very busy times for you and the SEC, and I would like
to commend you on a number of fronts for your efforts.
The job that you and the Commission perform is absolutely
vital to maintaining a robust and vibrant economy, as you know,
and providing working men and women the peace of mind that they
need to become investors in the American Dream. As you testify
today, I will listen especially closely to your comments on
Regulation B, the so-called ``pushout rule.'' The small and
medium-sized banks in my State of Michigan are very concerned
about the costs and consequences of having to implement a
regulation that they feel runs counter to the intentions of the
Gramm-Leach-Bliley Act.
I understand that just yesterday, the Commission postponed
implementation of the regulation until September 30, so between
now and the end of September, I look forward to working with
you and with the Commission in providing a common sense
approach to the issue of securities activities inside our small
and medium-sized commercial banks. I am also very interested in
hearing your comments about how we can better secure our
financial markets and make them fair for the common investor.
As we continue moving toward a future where more and more
households are invested in the market, I know that you share a
concern that we ensure that the average investor, the investor
who does not have access to levers of power on Wall Street, can
invest without fear that the mutual fund they are investing in
or the brokerage house that they hired are covertly working
against them by gaming the system. We have seen results of this
in 2003, and I am very glad to see that the SEC is making a
concerted effort to address many of these problems.
But I also believe that those efforts may be at risk
because of budgetary pressures, and I am very committed to
doing all that I can to fully fund the enforcement activities
of your agency. The Budget Committee, of which I am a Member,
is marking up the President's budget proposal today, and at the
markup, I am going to be supporting an amendment by Senator Jon
Corzine to protect your enforcement funds from the deep cuts
that are, unfortunately, being proposed in so many parts of our
Federal budget. If we are to help our constituents secure their
retirement future and encourage the American public to save,
then, we must give them the peace of mind of knowing there is a
level playing field and that they are not at a disadvantage
when putting their money into the market.
So again, I welcome you. I appreciate all of your efforts
and the efforts of the Commission, and I look forward to your
testimony.
Chairman Shelby. Senator Hagel.
COMMENTS OF SENATOR CHUCK HAGEL
Senator Hagel. I would just like to welcome Chairman
Donaldson and I look forward to his testimony, Mr. Chairman.
Chairman Shelby. Senator Bennett.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you, Mr. Chairman.
Chairman Donaldson, we are glad to have you here. We always
appreciate your willingness to subject yourself to these kinds
of inquisitions. I will be particularly interested in
discussing with you the questions of the implementation timing
and specifics of the implementation of the FASB rule with
respect to expensing of stock options. I continue to be
concerned about naked short selling and the impact of the rule
you have adopted. I have information, at least from my
constituents, that the rule has not been effective in stopping
naked short selling, and we might spend a little time on that.
And then, I would appreciate what you might have to tell us
with respect to deregistration on the part of European
companies who say that Sarbanes-Oxley is simply too burdensome,
and they would prefer to no longer be listed on American
markets in order to avoid those expenses.
So those are the three items that are on my mind, and I
look forward to an exchange with you on them. Thank you, Mr.
Chairman.
Chairman Shelby. Chairman Donaldson, welcome again to the
Committee. Your written 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. Good morning, Chairman Shelby, Ranking
Member Sarbanes, and Members of the Committee. Thank you for
inviting me to testify. I am glad to have the opportunity to
answer any questions you may have concerning the securities
industry generally, and getting, back to your specific
questions, I understand that you are particularly interested in
the Commission's recent initiatives regarding market structure,
credit rating agencies, mutual funds, and the implementation of
the Sarbanes-Oxley requirements. I plan to address these in
detail. As you know, the Commission has devoted considerable
resources to initiatives in each of these areas.
Let me begin with a status report on Regulation NMS, a
broad set of proposals designed to modernize and strengthen the
regulatory structure of the U.S. equities markets. The
Commission has expended considerable effort to strike the
appropriate balance in developing the proposals in each of the
four substantive areas addressed by Regulation NMS: Trade-
throughs, market access, subpenny quoting, and market data.
Of those, the proposed trade-through rule has by far
generated the most attention, and I would like to focus my
remarks on that aspect of Regulation NMS. I would note,
however, that the Commission has not yet taken final action on
any part of Regulation NMS, and my fellow Commissioners and I
are in a process of weighing and considering a number of
different policy issues which each of us must consider in
deciding how ultimately to vote on Regulation NMS proposals
when they are put before the Commission.
Let me begin by emphasizing three important policy goals I
believe would be furthered by the trade-through rule. First,
the rule would provide an effective backstop on an order-by-
order basis to a broker's duty of obtaining best execution for
market orders. Retail investors typically expect their market
orders to be executed at a price no worse than the relevant
quotation at the time of the order execution. Yet, it can be
difficult for investors to monitor where their orders, in fact,
are executed and whether they are executed at the best price.
The trade-through rule, in combination with a broker's duty
of best execution, is designed to benefit retail investors by
generally prohibiting the practice of executing orders at
inferior prices. Second, the trade-through rule is designed to
promote fair and orderly markets and investor confidence by
providing greater assurance that limit orders displaying the
best prices are not bypassed by trades at inferior prices.
Retail investors, in particular, may feel unfairly treated
when they are the most willing buyer or seller, and yet their
best-priced limit orders are traded through. By protecting the
best-priced orders, the rule is designed to promote a fair
playing field for both small and large investors.
Finally, the trade-through rule is designed to encourage
the use of limit orders and thereby contribute to greater
market depth and liquidity. Displayed limit orders are the
building blocks of public price discovery and efficient
markets. Although there are many types of liquidity, displayed
limit orders represent, by far, the most transparent and
readily accessible source of liquidity. They also provide an
essential benchmark that guides the use of other types of
liquidity, such as undisplayed trading systems, matching
systems, and dealer capital commitments. As a result, the
enhanced displayed liquidity and public price discovery
elicited by the trade-through rule should contribute to more
efficient trading throughout our equity markets.
Turning to the proposed rule itself, I should stress that
the trade-through rule, if adopted by the Commission, would
take a substantially different and more comprehensive approach
than the existing SRO and ITS trade-through rules. The trade-
through rule would, for the first time, establish a uniform
trade-through rule for all National Market System stocks. As a
uniform rule, it would cover both exchange-listed stocks, which
are governed by existing SRO trade-through rules and Nasdaq
stocks, which have never been subject to a trade-through rule.
Furthermore, the rule would only protect automated
quotations, in essence, those quotations against which an
incoming order can execute immediately and without human
intervention. It would not protect manual quotations. In so
doing, the trade-through rule would correct a significant
problem with the existing trade-through rules, which treat all
quotes alike and effectively force fast markets to route orders
to slow markets, where they can sometimes languish unfilled
while a market moves away.
The reproposed trade-through rule also would incorporate a
series of discrete exceptions--including those which
accommodate sweep orders, address rapidly changing or
``flickering'' quotes, and allow for self-help when a market
experiences a systems malfunction--that are designed to assure
that the rule works in a relatively frictionless manner.
Finally, the trade-through rule would eliminate significant
gaps in the coverage of the existing trade-through rules such
as the exemptions for off-exchange block trades and 100-share
quotes that have seriously undermined the extent to which the
SRO rules protect limit orders and promote fair and orderly
trading.
I should note that the reproposal asks for comment on two
alternatives to the scope of the automated quotations in each
market that would be protected. The first alternative, the
Market BBO so-called ``alternative,'' would protect the best-
displayed bids and offers on each exchange, Nasdaq, and
Nasdaq's Alternative Display Facility. The second alternative,
the Voluntary Depth Alternative, would protect not only the
best quotes but also orders below the best bid and above the
best offer that a market voluntarily chooses to display in the
consolidated quotation stream.
Commission staff is in the midst of evaluating the more
than 1,500 comment letters received on the two trade-through
rule alternatives as well as other aspects of the Regulation
NMS reproposal. As I noted earlier, I have asked the staff to
complete their analysis and prepare a recommendation for
consideration in short order. While the issues raised by the
trade-through rule and other components of Regulation NMS are
extremely complex, and in some cases controversial, they have
been further analyzed and debated over the course of many
years, and I believe the time for action has arrived.
I can assure you that the Commission will carefully
consider the comments received on Regulation NMS, including
many from you and your colleagues, and that we are committed to
achieving a result that furthers the important policy
objectives that I have described without burdening the
efficient operation of the markets.
On to credit agencies: I will now turn to the Commission's
recent work with respect to credit rating agencies. By way of
background, the Commission originally used the term
``nationally recognized statistical rating organization'' or
``NRSRO'' with respect to credit rating agencies in 1975,
solely to differentiate between the different grades of debts
held by broker-dealers as capital to meet Commission capital
requirements.
Since that time, ratings by NRSRO's have become benchmarks
in Federal and State legislation, domestic and foreign
financial regulation, and privately negotiated financial
contracts. The definition and interpretations of the definition
would provide credit rating agencies with a better
understanding of whether they qualify as an NRSRO.
The rule proposal builds on earlier Commission work with
respect to the role of credit rating agencies. This work
included public Commission hearings, a report required by the
Sarbanes-Oxley Act, and a 2003 concept release. Panel
participants at public hearings included NRSRO's, non-NRSRO
credit rating agencies, broker-dealers, buy-side firms,
issuers, the academic community, and the SEC Commissioners.
Most participants favored the regulatory use of credit ratings
by NRSRO's as a simple, efficient benchmark of credit quality
and stated that standards for NRSRO's were necessary for this
concept to have meaning.
In addition, the Commission conducted a study of credit
rating agencies and submitted a report to the President and
Congress under the Sarbanes-Oxley Act on January 24, 2003. The
report considers the role of credit rating agencies and their
importance to the securities markets, impediments faced by
credit rating agencies in performing that role, measures to
improve information flow to the market from credit rating
agencies, barriers to entry in the credit rating business, and
conflicts of interest faced by credit rating agencies. Finally,
the Commission issued a concept release in 2003 to further
study issues raised in the Sarbanes-Oxley report.
The concept release examined whether credit ratings should
continue to be used for regulatory purposes under Federal
securities laws and, if so, the process of determining whose
credit ratings should be used and the level of oversight to
apply to such credit rating agencies. One conclusion the
Commission has drawn from its examination of the topic is that
market participants would be well-served by a clearer set of
standards for determining whether or not a credit rating agency
is an NRSRO.
The Commission rule proposal of March 3, last week,
responds to a number of issues raised by commentators in the
concept release. The proposal retains the NRSRO concept and
proposes a definition of an NRSRO. Moreover, the Commission
would interpret the elements of the definition to provide
greater clarity as to the meaning of that term. In addition, in
light of the longstanding reliance by broker-dealers, issuers,
investors, and others on the existing no-action process, if the
Commission adopted a definition of an NRSRO, the Commission
plans to continue to make its staff available to provide no-
action letters as appropriate. No-action letters would be
granted for a specific period of time, after which the no-
action relief would need to be reconsidered.
The Commission notes that this proposal is intended only to
address the meaning of the term NRSRO as it is used by the
Commission. It does not attempt to address many of the broader
issues raised in response to the 2003 concept release, such as
whether the NRSRO designation unnecessarily raises barriers to
entry to the credit rating business, except to make it clear
that the credit rating agencies can confine their activities to
limited sectors of the debt market and geographic areas.
The Commission believes that to conduct a rigorous program
of NRSRO oversight more explicit regulatory authority from
Congress is necessary. We believe that a well thought-out
regulatory regime could provide significant benefits in such
areas as recordkeeping and addressing the conflicts of interest
in the industry. It would be important to ensure the public
does not misconstrue any regulatory authority over credit
rating agencies as a statement that the Government has vouched
for the accuracy or quality of a credit rating.
Finally, the current NRSRO's have sought to craft a
framework for voluntary oversight by the Commission.
Discussions have been ongoing concerning the possible precise
terms of such a framework. It is not clear at this time what
form that framework might take. It is hoped that the framework
will enhance oversight of NRSRO's from current levels by
providing a means by which the Commission's staff can access,
on an ongoing basis, whether an NRSRO continues to meet the
NRSRO definition.
It is important to recognize that even if the industry does
adopt such a framework, it would not give the Commission the
same authority that actual legislative authority could. For
example, if a credit rating agency failed to observe a
provision of the voluntary framework, the Commission would not
be able to bring an enforcement action. Moreover, the framework
does not envision direct inspections by Commission staff, and
the Commission would instead be in a position of relying on
inspections conducted by third parties hired by the credit
rating agencies.
Accordingly, if Congress believes more extensive Commission
oversight is appropriate and possible with a voluntary
framework, legislation may be needed if the industry does, in
fact, adopt a voluntary framework. Congressional attention
would be especially useful because the question of whether to
impose a regulatory regime on the credit rating industry raises
a number of important policy considerations that would need to
be examined, including substantial First Amendment issues.
The Commission welcomes Congressional attention and, of
course, would stand ready to work with Congress on crafting
appropriate legislation if Congress determines that such
legislation is necessary.
The mutual fund rulemaking: Let me turn now to this
significant area of Commission focus and reform activity. Last
year, in the wake of the mutual fund late trading and market
timing scandals, the Commission undertook an aggressive mutual
fund reform agenda. The reforms were designed first to improve
the oversight of
mutual funds by enhancing fund governance, ethical standards,
compliance, and internal controls; second, to address late
trading, market timing, and certain conflicts of interest;
third, to improve disclosures to fund investors, especially
fee-related disclosures.
It is my hope and expectation that, taken together, these
reforms will minimize the possibility of the types of abuses we
witnessed in the past 18 months from occurring again. When I
last testified before this Committee on mutual fund reform in
April 2004, we had taken final action on just two of our mutual
fund initiatives, although many were in the proposal stage.
Today, I am pleased to announce that we have adopted 10 of our
initiatives and expect to complete the remaining two matters on
our reform agenda in the coming months.
I would like to review for you the significant steps we
have taken to strengthen and improve the mutual fund regulatory
framework. With respect to enhancing mutual fund governance and
internal oversight, a centerpiece of the Commission's reform
agenda was the fund governance initiative. In July 2004, the
Commission adopted reforms providing that funds relying on
certain exemptive rules must have an independent chairman and
75 percent of the board members must be independent. In
addition, the independent directors of these funds must engage
in an annual self assessment and hold separate executive
sessions outside the presence of management. The Commission
also clarified that these independent directors must have the
authority to hire staff to support their oversight efforts. I
believe that these fund governance reforms will enhance the
critical independent oversight of the transactions permitted by
the exemptive rule.
As I said before, I believe that a management company
executive who sits as chair of a fund's board is asked to do
the impossible: To serve two masters. There are times when the
executive's duties to the management company and its
shareholders simply conflict with what is in the best interests
of the fund investors. This is the case, for instance, when
fund boards review many of the transactions permitted by our
exemptive rules. I believe that an independent chairman and 75
percent of independent directors level the playing field on
behalf of fund investors and blunt the control and dominance
that many management companies have historically exerted in the
fund board room.
Our fund governance reforms will also facilitate the
effective implementation of other mutual fund initiatives the
SEC has adopted and has put forward. These reforms, which are
detailed in my written statement, include requirements for
compliance policies and procedures, chief compliance officers,
a code of ethics, a voluntary 2 percent redemption fee, a
directed brokerage ban, and a late trading hard 4:00 proposal.
Let me focus for just a moment on the hard 4:00 proposal.
To address the problems associated with late trading, which, as
you know, involves purchasing or selling mutual funds after the
time a fund prices its shares, typically 4:00, but receiving a
price that is set before the fund prices its shares, the
Commission proposed the so-called ``hard 4:00 rule.'' This rule
would require that fund orders be received by the fund, its
delegated transfer agent, or a clearing agency by 4:00 in order
to be processed that day.
We have received numerous comments raising concerns about
this approach. In particular, we are concerned about the
difficulties that a hard 4:00 rule might create for investors
in certain retirement plans and particularly investors in
different time zones. Consequently, our staff is focusing on
alternatives to the proposal that could address the late
trading problem, including technological alternatives.
The technological alternatives envisioned would include a
tamper-proof time stamping system and an unalterable fund order
sequencing system. These technological systems would be coupled
with enhanced internal controls, third-party audit
requirements, and certifications. Our staff has been gathering
information from industry representatives to better understand
the potential inherent in different technological systems that
could be used to address this problem.
Given the technological implications of any final rule in
this area, it is important that we get it right. Thus, I have
instructed the staff to take the time necessary to fully
understand the technological issues and the alternatives
associated. Consequently, the Commission likely will not
consider a final rule in this area until mid-2005.
Improving mutual fund disclosure, particularly disclosure
about fund fees, conflicts, and sales incentives has been a
stated priority for the Commission's mutual fund program
throughout my tenure as Chairman, even before the mutual fund
scandals came to light. As such, disclosure enhancement has
been an integral part of our reform initiatives. I have
highlighted these and other mutual fund-related initiatives in
my written testimony.
But let me move on to another important area that you have
mentioned, and that is the Sarbanes-Oxley implementation. Two
years ago, when I came on board at the Commission, the country
was still reeling from its disappointment with cooked books,
indefensible lapses in audit and corporate governance
responsibilities, and intentional manipulation of accounting
rules. These lapses led to staggering financial losses and a
crisis in investor confidence.
The resulting Sarbanes-Oxley Act of 2002 called for the
most significant reforms affecting our capital markets, in my
view, since the Securities Exchange Act of 1934. The Act
established the foundation necessary to improve financial
reporting and the behavior of companies and gatekeepers, and we
have completed the rulemaking to implement these critically
important reforms.
Key requirements have taken hold, including CEO and CFO
certifications of the material completeness and accuracy of SEC
periodic filings, enhanced disclosure of off-balance-sheet
transactions, electronic reporting within two business days of
insider transactions, increased disclosure of material current
events affecting companies, strengthened rules regarding the
independence of auditors and audit committees, establishment of
the PCAOB, issuance of the first PCAOB inspection reports on
the large accounting firms, issuance of important auditing
standards by the PCAOB, and, for the first time, as required by
Section 404 of the Act, public reporting on internal controls
and their effectiveness by both management and its auditors.
I would like to focus for just a moment on Section 404
requirements for management and a company's auditor to report
on the effectiveness of internal controls over financial
reporting. This section of Sarbanes-Oxley may have the greatest
long-term potential to improve financial reporting. It may also
well be the most urgent financial reporting challenge facing a
large share of corporate America and the audit profession in
the year 2005.
I expect that we will begin to see a number of companies
announce that they or their auditors have been unable to
complete their assessments or audits of controls and additional
companies announce that they have material weaknesses in their
controls. For this initial pass, that result should not, by
itself, necessarily be motivation for immediate or severe
market reactions, in my view.
Section 404 is a disclosure provision, and investors will
benefit from receiving full disclosure regarding any material
weaknesses that are found: Full disclosure about the nature of
any material weaknesses, their impact on financial reporting,
and the control environment and management's plans to remediate
them. This disclosure will allow investors and markets to make
the appropriate judgments about what companies and auditors
find.
Section 404 will work as intended if it brings this
information into public view, and, in that event, the
disclosure of material weaknesses and internal controls should
be the beginning and not the end of the analysis for investors
and markets. The goal should be continual improvement and
controls over financial reporting and increased investor
information and from that investor confidence. This should lead
to better input for management decisions and higher quality
information being provided to investors.
While these benefits are clear, it is also important that
we evaluate the implementation of our rules and the auditing
standard issued by the Public Company Oversight Board to ensure
that these benefits are achieved in the most sensible way. We
have been very sensible in the implementation of all aspects of
the Sarbanes-Oxley Act and especially to this very significant
aspect. This has included several measured extensions over this
past year to accommodate the first wave of reporting.
In addition, in order to assess SEC and PCAOB rules for
Section 404, now that we will have the first year of actual
experience under the rules, the Commission will hold a
roundtable discussion this April, and we are currently
soliciting written feedback from the public regarding
registrants' and accounting firms' implementation of these new
reporting requirements. There will be open discussion via a
website and then, of course, a very important set of roundtable
discussions bringing together all of the players.
Through the roundtable and this feedback, we will be
closely listening to and assessing the experiences with the
management and auditor internal control requirements, including
seeking to identify best practices for the preparation of these
reports and evaluating whether there are ways to make the
process more efficient and effective while fully preserving the
benefits of the requirements. Throughout the process, the
Commission and its staff will closely coordinate with the PCAOB
and its staff, and we will seriously consider whether any
additional guidance is necessary or appropriate.
We are also actively engaged in other activities to
evaluate and assess the effects of the recent reforms,
including the internal control reporting rules. For example, we
have announced we are establishing a Securities and Exchange
Commission Advisory Committee on Small Public Companies. The
Advisory Committee will conduct its work with a view to
protecting investors, considering whether the costs imposed by
the current regulatory system for smaller public companies are
proportionate to the benefits, and identifying methods,
hopefully, of minimizing costs and maximizing benefits.
In addition, and at the request of the Commission staff,
the task force of the Committee of the Sponsoring Organization,
COSO, has been established and anticipates publishing
additional guidance this summer in applying COSO's framework
for smaller companies. Our actions have not been limited to
smaller companies. We also are cognizant of the regulatory
challenges our foreign registrants face. For all these reasons,
we recently extended the compliance date for internal control
reporting for an additional year for smaller companies and for
foreign public companies. A review of the first year
experiences of our larger registrants also should help smaller
and foreign issuers in preparing for their first reports.
Mr. Chairman, Members of the Committee, I thank you for
your indulgence. My testimony covers a broad spectrum of
serious and very complex issues. There are a number of other
substantive activities underway as well, but I have tried to
limit my update to those things. I thank you all for your
interest and attention. Together, we have made significant
progress over the last several years in rebuilding public
confidence.
This concludes my prepared testimony, and I would be glad
to try and answer any questions you may have. Thanks very much.
Chairman Shelby. Thank you, Mr. Chairman.
Mr. Chairman, about 2 years ago, this Committee held a
hearing on analyst conflicts of interest in the Global
Settlement. We examined how investment houses used research
reports to bolster investment banking business. Some press
reports suggested recently that these conflicts are still
prevalent on Wall Street, particularly with respect to Fannie
Mae, Freddie Mac, and their bankers.
Since the announcement of the Global Settlement, do you
think that Wall Street has adequately addressed these
conflicts, or have firms reverted to their old ways now that
the regulatory spotlight has moved on to other practices? These
are concerns that we have.
Chairman Donaldson. Well, I think the price of making new
rules is eternal oversight, if you will. It is like going on a
diet. You get the weight off, but once you get the weight off--
--
Chairman Shelby. You have to keep it off.
Chairman Donaldson. --you have to pay attention to make
sure it stays off.
Chairman Shelby. We want to help you to keep it off.
[Laughter.]
Not you but the metaphor you are using.
Chairman Donaldson. Well, we are very concerned with
keeping our oversight crisp and focused and----
Chairman Shelby. Keeping people honest and keep conflicts--
--
Chairman Donaldson. I beg your pardon?
Chairman Shelby. Keep people honest and keep people from
engaging in so many conflicts, perhaps?
Chairman Donaldson. Absolutely. I think that it is
inevitable that there are certain conflicts that are
intolerable in the investment business. There are certain
conflicts that are inherent to the business. When you are
standing in between a buyer and an issuer, both want the best
deal, and you have to resolve that conflict. So we try to do
the best we can in writing rules around those sorts of
inevitable conflicts.
Chairman Shelby. But you are going to continue to be
diligent in that area, I suppose.
Chairman Donaldson. We will, I can assure you.
Chairman Shelby. Go back to Regulation NMS, the trade-
through rule. It is my understanding that the proponents of the
trade-through rule contend that the rule ensures that investors
receive the best price when they trade their shares. Opponents
of the trade-through rule contend, as I understand it, that
although the rule may have served a useful function, it no
longer makes sense in today's markets. Technological
innovations have created new systems and programs that allow
market participants to make instantaneous trading decisions
with minimal human intervention in executing trades.
What is the real problem you are trying to address here, in
view of what I just said?
Chairman Donaldson. Basically, we are trying to reconcile
two different, and hopefully not mutually exclusive,
objectives. One objective is the protection of the so-called
``best bid or offer,'' and this is, in my view, a rock upon
which our markets have been so successful through the years.
That means if someone is willing, an individual investor in
particular, to put a bid or an offer out there, they must be
assured that somebody will not trade around them--that, in
effect, they are offering, as the trade said, they are offering
a free option to the marketplace. And they must be rewarded for
that by making sure that their order will be honored.
We are trying to reconcile that objective, and, by the way,
the best markets are those that have the most displayed limit
orders out there, so that incentive to put that order out there
as opposed to keeping it in your pocket is very important.
Chairman Shelby. Information.
However, as you know, there are new electronic ways of
trading faster than this on some of the floor exchanges, and
certain buyers believe that the speed of execution and the
integrity of their order is more important to them than
necessarily honoring that best bid or offer. So the purpose of
the trade-through rule--and again, I must emphasize that the
new trade-through rule that we are talking about addresses two
things: One, it will only be applied to an instantaneous
quotation, for example, to an electronic quotation where the
transaction can take place immediately, and two, it will
basically, in applying to that transaction, it will address the
general inefficiency of the trade-through rule as it has been
applied in the older system currently existing in the markets,
which was devised 20 or 30 years ago, which is like a horse and
buggy kind of thing to identify trade-throughs.
It is a modern, efficient way of assuring that we have both
speed and best bid and offer priority.
Chairman Shelby. Mr. Chairman, if the trade-through rule is
necessary to protect buy and sell orders and promote investor
confidence, why do such huge organizations like TIAA-CREF, a
well-known institutional investor, oppose the trade-through
rule? Is there a lack of consensus on this proposal among the
investing public?
Chairman Donaldson. As in any of these undertakings that we
do, there are always people on all sides of this. There are
many different interests, if you will, represented out there.
The whole national market system proposal that we are putting
forward will affect in one way or another a number of those
interests. There are an equal number of large investors like
the ones that you cited, more, as a matter of fact, that
believe in our trade-through rule and have so stated.
But I think that the real issue here, as I say, is that
this is a compromise. This is a compromise between those that
would say just speed and trade anywhere you want, and that is
of interest to certain funds, who would love to not have to
honor the best bid and offer and would love to trade somewhere
without people----
Chairman Shelby. You say it is a compromise. Is it a
compromise to protect people other than the public? Does it
protect some people in the status quo as opposed to new ways of
doing business?
Chairman Donaldson. No, what I was going to say, is that it
is a compromise trying to get the best of both worlds, and I
think that the most important aspect of this is that in
addition to enforcing the trade-through rule for an electronic
transaction, there will be no protection in the so-called
``slow markets.'' So, if you have a market as envisioned by the
New York Stock Exchange and some of the other markets who will
have an electronic market and side-by-side a floor-based or a
so-called slow market, those who choose to operate in the slow
market will not be protected by the trade-through rule.
Chairman Shelby. Do they have a similar situation in, say,
Frankfurt, or is it totally electronic?
Chairman Donaldson. In Frankfurt?
Chairman Shelby. Yes, in Frankfurt, for example, or in
London.
Chairman Donaldson. We have to deal with the markets as
they exist in this country, and I do not think the Frankfurt
Stock Exchange in any way is similar to the New York Stock
Exchange for a whole lot of reasons.
Chairman Shelby. Do they have a trade-through rule, I guess
I am asking you, on the Frankfurt exchange?
Chairman Donaldson. Yes; well, the German and the English
block trades go off the exchange.
Chairman Shelby. Okay.
Chairman Donaldson. They will not under our new rule here
in the United States. The blocks will be forced to conform to
the national market system rules.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
Chairman Donaldson, I read this report of your speech
earlier in the week before a securities lawyers' conference
here in Washington in which you made the point, according to
this article: `` `Lawyers and auditors are crucial gatekeepers
for the integrity of the markets. Lapses over the past few
years by outside advisors directly contributed to financial
frauds that devastated thousands of investors. I hope you will
not expend significant time, money, and energy devising
structures designed at evading requirements and trying to
achieve an accounting or disclosure result that artfully dodges
the rule's purpose,' Donaldson said,'' and you also, as I
understand it, talked about the conduct of auditors at
accounting firms of all size and that Agency officials will
continue to scrutinize auditors' relationships with their
clients for possible violation of independence rules.
As I understand it, the SEC has lodged enforcement actions
against lawyers and also against auditors, particularly where
they feel the relationship has gotten too close with their
clients for them to render impartial reviews of financial
reports. How serious do you regard this problem as being, and
what do you foresee the Commission doing as we move ahead?
Chairman Donaldson. In the ordinary course of our
enforcement actions, we are confronted with professional
malfeasance, and we have law requirements that allow us to
bring actions against lawyers and accountants and to deny them
the privilege to appear before the Commission and, in certain
cases, more restrictive actions. What I was talking about in
that speech was not the gross aiding and abetting actions that
become illegal. What I was talking about was a state of mind.
We can write all the rules we want, but what really counts
is the state of mind of not only management but also, I
believe, the advisors to management, and that would include
auditors; it would include accountants; it would include
lawyers; it would include anyone who might be considered to be
a gatekeeper. And what I was urging was that they pay attention
to their role, not only to show just exactly how you can walk
up to and conform with a law and not to just figure out ways of
legally getting around that law but also to be a counselor on
what the intent of the law was.
Now, that is a long answer. I believe that you know, during
the 1990's, when a lot of these problems arose, I think there
was a problem. I hope that, because of our actions and by
speaking as I have, people are beginning to think twice about
defining their role only as an executor of clever ways of doing
things.
Senator Sarbanes. Now, in the carrying out of Section 404
of the Sarbanes-Oxley Act, you have given some additional time
for the filing of the 404 reports to smaller companies and to
foreign companies; is that correct?
Chairman Donaldson. Yes.
Senator Sarbanes. And that would be until some time next
year; is that right?
Chairman Donaldson. Yes; we approved implementation of
Section 404 in June 2003. Last week, we extended the compliance
date for nonaccelerated filers, that is, companies with less
than $75 million market cap and for foreign private issuers,
and this extension benefits roughly 65 percent of our
registrants, and it is important to note it affects only about
5 percent of the total U.S. market cap.
The requirements were effective for the first time for
companies with more than a $75 million market cap for the
fiscal year ended December 2004. We have granted a 45-day
extension for companies with less than $700 million market cap.
So what we have tried to do is to adjust, if you will, for
smaller companies and for foreign issuers, this is a big
process, a process versus the number of people available to do
it in small companies.
Senator Sarbanes. So as I understand it, if you are above a
$700 million cap, these are U.S. companies now, you are
required to file, well, now, I mean, those reports will be
coming out, and we will be able to take a read on whether there
are material deficiencies.
Chairman Donaldson. That is right.
Senator Sarbanes. If you are between $75 million and $700
million market cap, they have another 45 days to come in with
their reports, and if you are under $75 million, you can go to
next year rather than this year.
Chairman Donaldson. That is right, 2006.
Senator Sarbanes. And the foreign companies, I gather, is
without relationship to the market cap.
Chairman Donaldson. That is right.
Senator Sarbanes. I gather part of that was pushed by the
fact that they were all currently being required to conform
with international accounting standards as a part of the
process in their own respective countries and that also is, for
some of them at least, a difficult process, and this was to
recognize that and give them additional time; is that correct?
Chairman Donaldson. That is correct.
Senator Sarbanes. The ultimate objective, though, would be
that any public company listed on a U.S. exchange would be
meeting the same requirements. They may be delayed in when they
get there, but eventually, they will have to get there just
like the companies that have already moved ahead in order to
make this analysis and make the appropriate certifications.
Chairman Donaldson. Absolutely; the issue here has been, as
you know, Europe and the European Union have moved to
international accounting standards as of January 1, so they
have to go all of a sudden from, let us say, Italian GAAP and
German GAAP, they have to go to international accounting
standards; and then they have to go another step to reconcile
international accounting standards with U.S. GAAP at the same
time that they are dealing with the stock option expensing
item.
So we decided that we would give the European issuers some
time to go through this difficult process, and it is very
difficult for them, but, ultimately, it is just a matter of a
year extension. It is not a matter of letting them out of our
requirements.
Senator Sarbanes. And unless we hold everyone to it, we are
going to be faced with the anomalous situation of having
companies listed who are meeting different standards and
requirements, and of course, that is not the purpose.
Eventually, given appropriate time to work through some of
these practical problems, and I recognize there are some
practical problems, but eventually, all companies listed on
American exchanges would be meeting the same standards; is that
correct?
Chairman Donaldson. Yes, that is correct.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
Chairman Donaldson, my question is in regard to the FASB
December 16 approval of the rule requiring the expensing of
stock options.
Chairman Donaldson. Yes.
Senator Allard. I understand the SEC's response at this
point is you are going through what you call interpretive
guidance to assist companies with implementation. And, you
know, for some of us, there is concern out there, because the
stock options have been a way of increasing productivity and,
if you are a new company, getting people into your company with
some talent based on what they may feel is the future of that
particular company.
And so, I am curious as to how you are viewing the
interpretive guidance procedure, and what are you thinking
about as far as the interpretive guidance procedure, and in
what way and how would that help a new company that is getting
started?
Chairman Donaldson. As you know, the FASB standard requires
that options expensing begin in the third quarter of 2005.
Senator Allard. Right.
Chairman Donaldson. As an accounting matter, this makes
sense, because clearly, I mean, the expensing of them makes
sense, because the options do have a cost, and the trick here
has been the formula to decide exactly how much should be
expensed. That is where there are various models that have been
approved by FASB, and our staff now is in the process of
formulating guidance on this subject in response to a number of
questions that have been raised. The staff plans to issue this
guidance this month in terms of questions that we have had
about the different models.
Of course, the models are all contingent and dependent upon
the numbers you put into them, the assumed rates and so forth.
This gets to be a very complex subject. There are lots of
entrepreneurs out there who are putting forth ways of doing
this, if you will; economists, mathematicians, and so forth who
are getting pretty sophisticated, and we intend to offer
guidance in terms of the interpretation of these different
models, and we will do that, as I say, this month.
Senator Allard. The guidance that you are offering, is this
guidance that is being reflected back to FASB or guidance that
is being reflected to companies or both?
Chairman Donaldson. I would say both. We are in constant
touch with FASB, and our Chief Accountant and the PCAOB talk
all the time, and certainly, the guidance that we are giving
would be coordinated with FASB.
Senator Allard. And those are to come out when, now? You
say within the next month?
Chairman Donaldson. Yes, this month.
Senator Allard. Okay; toward the end of this month, you are
thinking?
Chairman Donaldson. Sometime this month.
Senator Allard. Sometime this month.
Chairman Donaldson. Yes.
Senator Allard. Now, the guidance, then, it is going to be
in the form of various approaches that you may take if you are
a business in complying with that FASB requirement on stock
options where you expense them?
Chairman Donaldson. There are, as I say, different models
that are acceptable, and there are--once you understand the
models and understand their application to your business, you
will be able to select a model, but you also will have to
disclose the model that you have accepted and the inputs that
you put into it, so that somebody from the outside will
understand what went into your determination.
Senator Allard. You are talking about a formula that might,
for example, fit into a computer, and then, you just put in
those variables that would apply to your company once you
decide which model you would like to go with, and then, would
that try to facilitate--I am trying to understand how this
could be that quickly put out by the companies so they could
comply.
Chairman Donaldson. As I say, these models, you know, have
been a subject of great investigation and debate by FASB. There
are a number of Ph.D. scholars, mathematicians, and so forth,
and economists who have been advising on these very
sophisticated models. However, there are some very
sophisticated consulting groups around that will help companies
do that if they do not have the wherewithal or the talent in
their company to do it. And we hope to be in a position, as I
say, to give guidance as people deal with this.
Senator Allard. Mr. Chairman, my time has expired. Thank
you.
Chairman Shelby. Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman, and I want to
thank you for holding this hearing, and I want to thank
Chairman Donaldson for always being available to us as well as
for the job he is doing.
I think these are very difficult times to be a regulator
for many reasons, but you have a changing world. You have
technologies that come in and move very quickly, and the trick
is not to overreact but at the same time to update, and the
trick is also to make sure that the basic framework that our
markets and our whole economy has existed under for a long
time, which has been overwhelmingly successful, keeps the basic
balance between efficiency, fairness, and openness, and I think
you have done a good job there.
Particularly, I think you have done a good job on something
of great concern to me, which is market structure. I think the
original staff proposal made by the SEC on Regulation NMS,
makes a great deal of sense. On the one hand, you have to
update things; there is no question, and speed does matter. But
there is an overall guiding principle we have here, which is
that the markets be fair, be deep, be liquid, and serve the
small investor as well as the big guys. The day our markets are
not regarded as being on the level is the day they begin to
decline.
There are many individual interests who say do it my way,
because I understand that, they make more money doing it that
way, or it serves their interests. They would rather not have
their trades be known. But I think if you study history, if you
go for the short-term interests of one little group or another,
you end up having real trouble in the markets that ends up
hurting everybody.
I would urge you, Mr. Chairman, the SEC, and everyone else
to resist the short-term impulse to say, hey, I want to do it a
different way, because I benefit, because we have a much
broader, deeper principle, which is the functioning of the
markets, the caring for the small investor as well as the large
investor, et cetera.
So, I was pleased to read what you said in your statement.
I just want to--and I think we are updating our markets. There
is no question speed matters, but speed is not the--we should
not go for speed uber alles, even though some want it. And I
think, again, you have reflected that balance in this NMS
solution. I would argue to you if you make exceptions, you will
undo the whole rule. An exception swallows the rule that you
would make, because once everyone is not tied to the same
rules, the outliers can prevail and undo the whole system. And
so, I would strongly urge you not to seek exception and not to
allow exception. Let everybody play by the same rules. At the
same time, I do think, you know, if you go too far, you will
end up with fragmented markets, go to a CLOB. That will end up
fragmenting the markets. If you do not go far enough, somebody
will come in who is more efficient and dominate.
Again, I want to compliment you on where you are headed. I
would say, you know, I think I know the Chairman asked about
somebody who was opposed, I think TIAA-CREF. I would just like
to note that there are lots of companies like TIAA-CREF who are
for this rule such as the Investment Company Institute, which
represents the mutual fund industry, T. Rowe Price, Vanguard,
Barclay's, as well as the people who favor the small investor:
Consumer Federation of America and groups like that have been
supportive of your proposal.
Let me ask you this: Testimony given by some said that
there was not a trade-through problem in, say, Nasdaq stocks.
And then, your Office of Economic Analysis, which detailed in
the Reg NMS reproposal, said that characterization was not
true, that there was that kind of problem there. And now, the
people who originally proposed this are trying to discredit the
staff report. Have they made any valid objections? Do you still
stand by that staff report?
Chairman Donaldson. Yes, we still stand by that judgment.
We have taken those comments that have come in to us. We have
reanalyzed some of the statistics that we put forth in the
original
national market system data, and the data does not show that
trading in Nasdaq stocks is more efficient than trading in New
York Stock Exchange stocks; rather, both these markets have
some pluses and minuses, strengths and weaknesses, but an
effective trade-through rule is needed in both markets to
promote best execution of retail orders.
I do not want to get too far into the statistics here, but
the fact of the matter is that the trade-throughs, depending on
how you measure them, the effect of trading through best bids
and offers in the Nasdaq market and broad cross-section of
stocks is bigger than it is at the New York Stock Exchange, and
this causes all the problems that I talked about in terms of
not honoring the best bid and offer and not, in effect, paying
people for being willing to give this option, if you will, of
putting a bid or an offer out there.
Senator Schumer. Right; just a second question on a
different subject. Is my time up, Mr. Chairman? I know we have
a vote.
Chairman Shelby. Yes, but go ahead.
Senator Schumer. Okay; soft dollars. You have been
consistent in assuring the market that in your opinion,
independent research will be treated under the same rules as
proprietary research, that the definition of what constitutes
research, of course, needs to be more precisely defined so you
do not write off things as research like trips to the Bahamas
where they might make a phone call and call someone and ask
their judgment.
[Laughter.]
Senator Sarbanes. Do they call someone in the Bahamas or
someone somewhere else?
Senator Schumer. No, they go to the Bahamas to call someone
in New York and call it research.
[Laughter.]
But the basic core of research is very much needed, and
that is why I joined with my colleague, Senator Sununu, in
sending you a letter yesterday asking you for an update and
time lines as to when we could expect the rulings here. I agree
with, again, your basic thrust that we do need to preserve
independent research, and we cannot just eliminate it. When
will a new rule be proposed, and can you expand on what the SEC
is considering as the definition of research?
Chairman Donaldson. Yes; in early 2004, I established a
task force within the SEC to look at the issue of soft dollars.
I think we should change that name.
Senator Schumer. It is like privatization. It is going to
stick no matter what somebody tries to do.
Chairman Donaldson. It has a pejorative image to it, but
nonetheless, soft dollars.
Chairman Shelby. What would you call it other than soft
dollars?
Chairman Donaldson. The task force has been meeting
continuously. It has come up with a number of recommendations,
but of all of these recommendations, I have asked the staff to
focus on three areas. One is clarifying the scope of brokerage
and research services that are eligible for soft dollar
payment. What exactly is in this modern day, when the original
intent here was to have soft dollars pay for research, now,
research comes in electronic forms. It comes with equipment to
deliver the electronic forms, et cetera, et cetera; what is
allowable under 120(a)(d)?
Number two is requiring that broker and investment advisor
records of soft dollar activity are clarified, so that inside
the
mutual fund, if you will, the new independent directors and
independent chairman can see an analysis of just exactly the
composition of those soft dollars and how much is going for
what.
Senator Schumer. Right.
Chairman Donaldson. And then, a third component is relating
this, advisors relating this to their clients. Mutual fund
managers, mutual funds themselves, are relating this
information in a clear form so people see exactly how those
soft dollars are being used.
I might just say that I believe that with the Global
Settlement and the rise now of independent research, you know,
I believe that anything we would do to inhibit independent
research from being done and to limit research only to being
done by major investment firms would be a mistake.
Senator Schumer. I agree.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
I outlined three items that I would talk about. I think we
have discussed the deregistration thing sufficiently in your
responses to Senator Sarbanes, so let me move on to the other
two in the time that we have remaining before we have to go
vote.
Naked short selling: You put out a new rule in January to
deal with naked short selling, and as nearly as I can tell from
my constituents who feel victimized by this, it is not working.
There is a story that appeared on Friday in the Financial Wire
on naked short selling that summarizes it perfectly. A Michigan
man, if I can quote from it, I will give you a copy of it, a
Michigan man, Robert C. Simpson, who claims to have acquired
100 percent of the issued and outstanding stock of Global Links
Corporation is likely to become the poster boy for those
opposed to illegal naked short sales.
It goes on and talks about this. This, for those who may
not know is where a brokerage house sells shares it does not
own and has not borrowed. Short selling is a perfectly
legitimate activity in the market, but it requires that the
person who sells the share he does not own, borrows those
shares so that he can buy them back when it becomes necessary.
All right; Simpson filed an SEC Commission Schedule 13(d) on
February 3 showing his purchase of and voting power for
1,158,209 shares of the corporation, yet the day after he
purportedly stuck every last corporate certificate for Global
Links in his sock drawer, the company traded 37,044,500 shares.
And the next day, it traded 22,471,600 shares. And Thursday of
last week, it traded 199,616 shared.
Quoting the article, it says: ``Simpson is said to have
gone back to his sock drawer and despite the fact that a sock
or two, as is always the case, were missing, all 1,158,209
Global Links certificates were still there.'' There were no
shares available to be borrowed, and yet, in 2 days, there were
over 50 million shares traded. And I have constituents who say
trading since the rule was adopted in our stock has exceeded
the available float by four or five times on a daily basis.
Now, your staff is going to come in, we are going to have a
briefing on this in depth, and I will not go into it in greater
depth here, but this article, just last Friday in a national
publication, indicates that people are still selling short
shares they do not have and are clearly never going to acquire
if the one fellow has acquired every share. And I am told that
the way that it works is that one brokerage house sells short,
has 13 days under your rule under which to acquire the shares,
and in that 13-day period hands the whole transaction off to
another brokerage house, and they just keep moving it around,
and nobody ever has to settle, and they use the 13-day period
to avoid the rule, and you end up with this kind of
circumstance.
Thirty-three million shares traded in a single day when
there are only 1 million shares outstanding, and one investor
has filed a statement with you saying that he has all of them;
that is clearly something that needs work.
Chairman Donaldson. Senator Bennett, thank you for that
observation. As you, yourself, note, short selling is not
illegal.
Senator Bennett. I approve of short selling. It is the
naked short selling we are going after.
Chairman Donaldson. And when you get into naked short
selling, the Regulation SHO, which was adopted in 2004, has
three primary rules that address the problem with extended
settlement failures: The location requirement, the close-out
requirement, and the borrowing requirement.
Senator Bennett. Excuse me; I do not want to go into that,
we have got a vote and my time is running out, and you are
going to give me a briefing on that. So let me move to the
other area very quickly.
Chairman Donaldson. And we would like to give you a
briefing on our oversight in this area.
Senator Bennett. My main message here is that the evidence
is that the Reg SHO is not working. So that is what we need to
get into in detail.
I am one who endorses the idea that stock options should be
expensed. I agree that they have a cost. But I have been
tremendously disappointed--that is an understatement--about the
way FASB has handled this. Basically, they have punted on the
most difficult and important question, which is valuation. They
have said okay, you can use Black Scholes, or you can use
binomial, or you can make up something else if you get to these
experts that you referred to in your response to Senator
Schumer, and that is fine.
What kind of accounting standard is that, when FASB says
you have to expense them, but we do not particularly care what
valuation you put on them? And what you are going to see,
indeed, are seeing now, if you and the SEC are not the
gatekeeper to bring some sanity to this debate are three, in my
view, bad results which are not mutually exclusive. You can
have all three of them: Number one, which we are already
seeing, no more options. There are companies that are saying we
just cannot deal with this, and so, the safe thing for us to do
is to opt out of offering stock options. Dell cuts options for
employees by 60 percent, ``To curb option grants, companies are
using a variety of strategies. Others are simply reducing
option grants without offering a replacement. That is the case
at Dell, which awarded employees 51 million options in 2004,
down from 126 million 2 years earlier.'' That is a February of
this year statement from Business Week online.
In The New York Times, February 19, 2005: ``Time Warner
said yesterday it would no longer grant stock options to most
employees, citing new accounting rules.'' Aetna, from the
Boston Globe, January 2005: ``While the new ruling will not
prevent companies from granting options, doing so will reduce
their reported earnings. Many fear management increasingly will
limit options to top executives. Last month, in fact, Hartford
insurance giant Aetna, Inc., once known for its generous stock
options, said it would no longer offer them to rank and file
employees under the new accounting standards.''
Pfizer, February 28, 2005: ``Pfizer said in the U.S.
Securities and Exchange Commission filing that in response to
new accounting rules requiring employee stock options to be
expensed, it plans in 2005 to reduce the number of options
granted, except for the most senior Pfizer management'' and so
on.
The prediction was made that people would stop giving
options to anybody but the top executives, and that is coming
true. If they could get a valuation system that made sense, I
think that would not be the way, but if I were running a
company again, I do not want to run the risk, which leads to
the second reality that I am afraid is coming is going to be
lawsuits.
If you can, under FASB, pick Black Scholes, binomial, or a
third one that is developed by your own experts, you are
automatically setting yourself up for a lawsuit from somebody
like Bill Orack, who is going to say you picked the wrong one,
and therefore, we are going to sue you. So you have no safe
harbor here. As long as there are these alternatives that says
that FASB says you can choose, you are fair game for every
predatory trial lawyer out there who wants to come after you,
particularly if you are a big company like the ones I have
mentioned, and I think they have sat down, and they have said
look, we could come up with a valuation that might make some
sense, but we do not want to have to defend it in court, and
the easiest, smartest, and simplest thing for us to do is to
cut out the options.
And then, the third thing that is going to happen that we
see examples of is that the analysts are not going to pay any
attention to these earnings reports. They are going to look at
the earnings reports and say these valuations are meaningless;
we want to compare performance of company X of 2005 to
performance of company X in 2004. The earnings report in 2004
did not include any expensing for options, so in our analysis
in 2005, we will not examine
expensing for options. There were always footnotes available to
us before; we will treat them as footnotes available again.
So you have the situation where the analysts are paying no
attention to the accounting, and yet, the accounting
requirements are stifling the granting of options and setting
up a situation for lawsuits. You, sir, are the last gatekeeper
against this kind of insanity. We have not been able to get
FASB to deal with the question of intelligent valuation of
stock options. I am pleading with you and your accountants to
find some way through this thicket that will allow a company to
issue options with a safe harbor, knowing that they are not
going to get sued, and will allow the analysts to examine the
accounting in a way that makes some sense, because we are
setting ourselves up for the worst of all possible worlds.
Chairman Donaldson. Senator, I know we are running out of
time, but let me just try and give a couple of quick responses
to that.
Senator Bennett. Please.
Chairman Donaldson. Number one and perhaps most important
is I would like to, if you have the time, have our experts
brief you on this.
Senator Bennett. For this, I have all the time you need.
Chairman Donaldson. Well, we would like to do that.
Number two is that the problem that was being addressed
here was the excessive use of options, largely because no
expense was attributed to them. That was the issue.
Senator Bennett. Yes.
Chairman Donaldson. So clearly, we have moved in the right
direction in terms of saying that this is an expense, and it
must be counted.
Senator Bennett. With that, I fully agree.
Chairman Donaldson. What is the expense?
Senator Bennett. That is the problem.
Chairman Donaldson. We have gone through--I should say FASB
has gone through--as you indicated--a series of very intense
attempts to get at a single model, and in fact, they have come
up with a couple of models. I am told, and this is why I want
you to talk to our experts, that those models come up with
amazingly similar results when applied, generally speaking.
That is point number two.
Point number three, and this is the most important one, and
as a former analyst, I can say this, that if I were still an
analyst, I would be reading the footnotes that indicate what
model is being used and what the inputs in that model are being
used, and I do not want to make a judgment on enforcement now,
but I would say that, if somebody follows a model that has been
approved, discloses the model, discloses how they have used it,
and what the inputs have been, the chances of, certainly,
litigation coming from us is zero.
Senator Bennett. I am not worried about litigation coming
from you. I am worried about Bill Orack.
Chairman Shelby. Senator Sununu, you have the last word as
long as you can hold the vote on the floor.
STATEMENT OF SENATOR JOHN E. SUNUNU
Senator Sununu. When Bill Orack starts suing people for
using double declining balance depreciations that have straight
line depreciation or some of the digits depreciation, I will
start worrying a lot more about the legal implications of
expensing stock options.
I want to ask a few questions about the trade-through rule.
In your opening statement, you talked about, and I do not know
if it was the most important value, one of the values of the
proposed trade-through provisions being that they will create
an incentive to display more limit orders.
Chairman Donaldson. I am sorry?
Senator Sununu. Create an incentive to display more limit
orders. Is that the most important value?
Chairman Donaldson. It is an important value.
Senator Sununu. Certainly one of the principal goals.
And I would agree with that, the general premise that more
information displayed, offered up in these markets is of value.
But it would seem to me that if that were, if the proposal to
extend trade-through to other markets would really help
encourage the display of limit orders, then, you would expect
more limit orders to be displayed currently on the New York
Stock Exchange than are currently displayed at Nasdaq, and my
understanding is that that is not the case, that there are more
limit orders on Nasdaq than the NYSE. Does that not seem to
defeat the argument?
Chairman Donaldson. No, I do not think so, because
basically, the ITS trade-through rule as it exists at the New
York Stock Exchange has not been effective in preventing trade-
throughs. The existing rule----
Senator Sununu. So you are saying it has not been
effective, the existing one has not been effective, and you
believe that this one would be more effective.
Chairman Donaldson. Absolutely, because this is totally
different. The existing rule is seriously flawed because of
block trade exceptions and because it only provides a
satisfaction remedy rather than actually preventing trade-
throughs.
Now, the new trade-through rule, if the Commission were to
agree to put it in, applies only to an electronic market, an
instantaneous market, and it relies upon not a 25-year-old ITS
system, but it relies upon the most modern system in the way
the orders get there and the way they are executed at the
exchange.
Senator Sununu. Good, clear answer, but it raises a concern
with me that you are admitting that you have not been able to
design an effective trade-through rule in the past. You think
this is a better one. I am always inclined to give you the
benefit of the doubt. Why not apply this on a trial basis on
the New York Stock Exchange in order to find out whether your
hopes, dreams, and aspirations for improving the display of
limit orders come to fruition?
Chairman Donaldson. I will tell you, to use a poor analogy,
the ITS system, which was devised by the stock exchange and
particularly the New York Stock Exchange, is a horse and buggy
system. I mean, it is like saying your horse and buggy could
not go 100 miles an hour. This is a very different concept and
a very different system, and insofar as, you know, the option
of applying it temporarily and so forth, that is something we
have looked at.
The other side of it would be why not put the system in,
and, if it does not work, you can see why it does not work and
modify it? You are not going to know in a small sample. You are
definitely not going to know unless you apply it to all NMS
stocks.
So, you know, but again, I think the concept of trying
something out works in certain instances. We will see if it
does here. I do not want to prejudge what the Commission will
decide on this, but I will just leave it there.
Senator Sununu. Are you saying you may consider applying it
to only the New York Stock Exchange?
Chairman Donaldson. We are, again, you have to be talking
to me now and not the Commission. We have to define whether you
are talking to our staff; you are talking to me; you are
talking to----
Senator Sununu. I am sure that they appreciate the fact
that you never force them to sit up here. You take all the
heat. You are very good about that.
Chairman Donaldson. But, you know, I want to be very clear
that the Commission has not voted on this. I also want to be
very clear that the staff has spent years getting to this,
seminars, et cetera. And I believe that the staff feels very
strongly that this should be applied to both markets, that
there is no difference between the stocks that are traded, and
that to not apply it to both markets opens up the door to
regulatory arbitrage. If you have different systems, then you
have different incentives for traders and so forth. So, I think
the staff feels very strongly that way. I am trying to keep an
open mind about this in terms of my own personal view, as I
believe the rest of the Commissioners are.
Chairman Shelby. Senator Sununu, I know you want to keep
going, but they are holding our vote. Our time has expired on
the floor, and we have four straight votes.
Go ahead.
Senator Sununu. Thank you.
[Laughter.]
The Chairman did not pass you that note, did he?
Chairman Shelby. No, I have a few questions for the
Chairman, too. I might have to go on the record or have to be
brief.
Senator Sununu. No, I will finish up so you can ask one or
two. My guess is we have about 5 or 10 more minutes here before
they really get serious about closing the vote.
Chairman Shelby. I hope you are right.
[Laughter.]
Senator Sununu. Let me put it this way: They are not going
to vote without you. They may vote without me, but they are not
going to vote without you.
Chairman Shelby. Okay.
Senator Sununu. I think the cost estimate for the top of
book proposal was $167 million. The depth of book proposal, it
would seem to me, is going to be a lot more expensive than
that. Can we expect the Commission to put forward a more
detailed estimate of the cost of these new regulations so that
we can make a judgment as to whether or not the projected value
is really worth it?
Chairman Donaldson. Yes, I think you can expect us to
juxtapose projected costs against projected savings for
investors and that that will be part of the process of
presenting this to the Commission and, in turn, presenting it
to the public.
Senator Sununu. Thank you. I just want to reiterate that
given that the number of trade-throughs on New York is the same
as the number or percentage of trade-throughs at Nasdaq, given
the fact that that points to a point you made, the existing
trade-through rule has not been effective, given the fact that
there is a lot of difference of opinion about what kind of an
approach is best suited here, I just have real concerns about,
one, rewriting the trade-through rule and then, two, once that
is done, expanding its application when I do not know that
there were really a lot of comments and input to the Commission
advocating for expanding the application of the trade-through
rule.
I would like to think that these changes will have the
positive effect that you describe, because I agree, more
information, more limit orders displayed on automated exchanges
is a good thing, but I would like to think that we can find a
way to apply this kind of a concept, prove its value, which is
less expensive and less risky before we dramatically try to
expand it.
Thank you, Mr. Chairman.
Chairman Shelby. Mr. Chairman, I would like to pose a
question for you, and you can get back to me if you choose: The
credit rating agencies, the NRSRO's, how can we work with you
to complement your effort? Specifically, do you need additional
legislative authority, and if so, would you get back with us
and talk to us? We want to make sure you have the authority,
unquestioned, to deal with the credit rating agencies. Some
people say you might need legislation. If you do, we want to
give it to you.
Will you get back with me on that, or do you want to just
answer that now?
Chairman Donaldson. Sure, no, I would like to get back to
you. I would just say very quickly that we are continuing to
pursue the voluntary route to see how far we can go; not
optimistic on that, answering some of the----
Chairman Shelby. Why do we not do a parallel, then? You
pursue the voluntary, and let us think about what authority you
need because this Committee wants to make sure you have the
authority to do your job.
Chairman Donaldson. Thank you. We would be delighted to do
that.
Chairman Shelby. Thank you, Mr. Chairman.
The hearing is adjourned.
[Whereupon, at 11:54 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI
Chairman Donaldson, welcome back to the Senate Banking Committee.
As this is your first hearing with us in the new Congress, I am sure
your testimony and the following discussion will touch on many issues
before the Commission. I look forward to your input on these matters
today and in the months ahead.
There are a couple of issues in particular that come to mind. As
you know, there is a problem right now on our military bases at home
and abroad. Unscrupulous salespersons are selling our military
servicemen and women unsuitable financial products and charging
outrageous fees for them. This practice must be stopped. I am glad that
the SEC is taking this situation seriously and that the sales and
marketing regulations regarding these products is being duly enforced.
I also look forward to the conclusion of any ongoing investigations
into these matters that you may be conducting. It is important that
this situation not be allowed to continue any longer. I hope that you
and the other Members of the Committee share my sense of urgency in
this matter.
I was also pleased to see that the SEC has worked to address the
implementation effects of the Sarbanes-Oxley Act. As an original
cosponsor of this Act, I believe that the accounting reforms that it
contains are crucial to the well-being of our Nation's markets and the
confidence of its investors. However, it is clear that some companies,
especially smaller ones, are having a difficult time becoming compliant
by the original deadline. It was encouraging to see the SEC extend that
deadline last December. As the SEC continues to implement these
important accounting reforms, I would hope that they will make full use
of their recently established Advisory Committee on Smaller Public
Companies to gain important perspective from our Nation's small
companies.
These are just two of many important issues that you will address
today and in subsequent hearings before this Committee. I am eager to
continue working with you and the Members of this Committee on all of
them. Chairman Donaldson, I look forward to your testimony.
----------
PREPARED STATEMENT OF WILLIAM H. DONALDSON
Chairman, U.S. Securities and Exchange Commission
March 9, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, thank you for inviting me to testify today on the state of
the securities industry. I am glad to have the opportunity to answer
any questions you may have concerning the securities industry
generally. I understand, though, that you are particularly interested
in the Commission's recent initiatives regarding market structure,
credit rating agencies, mutual funds, and the implementation of the
Sarbanes-Oxley requirements, and I plan to address these in detail in
my opening remarks. As you know, the Commission has been devoting
considerable resources to initiatives in each of these areas over the
past few years. I welcome your continuing interest in these issues of
such fundamental importance to the fairness and efficiency of the U.S.
securities markets.
Regulation NMS
I will begin with a status report on Regulation NMS, a broad set of
proposals designed to modernize and strengthen the regulatory structure
of the U.S. equity markets. At present, the Commission is in the final
stages of a particularly extensive and open rulemaking process that
included publication of the original Regulation NMS proposal in
February of last year, public hearings in April, a supplemental request
for comment in May, and a reproposal in December. In fact, Regulation
NMS is the product of more than 5 years of study and hard work by the
Commission that included multiple public hearings and roundtables, an
advisory committee, three concept releases, the issuance of temporary
exemptions intended in part to generate useful data on policy
alternatives, and a constant dialogue with industry participants and
investors. The comment period on the reproposal of Regulation NMS
expired on January 26, and the staff is in the midst of evaluating the
comments and preparing a final package of rules for Commission
consideration. I would expect the Commission to take action on
Regulation NMS within the next several weeks.
In developing Regulation NMS, the Commission has been guided by the
fundamental principles for the National market system that were
established by Congress in 1975. In particular, the national market
system is premised on promoting fair competition among markets, while
at the same time assuring that all of those markets are linked
together, through facilities and rules, in a system that promotes
interaction between the orders of buyers and the orders of sellers in a
particular security. As a result, the national market system
incorporates two distinct types of competition--competition among
markets and competition among orders. Over the years, the Commission's
often difficult task has been to maintain the right balance between
these two types of competition as technology and trading practices
evolve.
The Commission has expended considerable effort to strike the
appropriate balance in developing the proposals in each of the four
substantive areas addressed by Regulation NMS--trade-throughs, market
access, sub-penny quoting, and market data. Of these, the proposed
trade-through rule has by far generated the most attention, and I would
like to focus my remarks on that aspect of Regulation NMS. I would
note, however, that the Commission has not yet taken final action on
any part of Regulation NMS, and my fellow Commissioners and I are in
the process of weighing and considering a number of different policy
considerations, which each of us must do in deciding how ultimately to
vote on the Regulation NMS proposals when they are put before the
Commission.
Let me begin by emphasizing three important policy goals I believe
would be furthered by the trade-through rule. First, the rule would
provide an effective backstop, on an order-by-order basis, to a
broker's duty of obtaining best execution for market orders. Retail
investors typically expect their market orders to be executed at a
price no worse than the relevant quotation at time of order execution,
yet it can be difficult for investors to monitor whether their orders
in fact are executed at the best price. The trade-through rule, in
combination with a broker's duty of best execution, is designed to
benefit retail investors by generally prohibiting the practice of
executing orders at inferior prices.
Second, the trade-through rule is designed to promote fair and
orderly markets and investor confidence by providing greater assurance
that limit orders displaying the best prices are not bypassed by trades
at inferior prices. Retail investors, in particular, may feel unfairly
treated when they are the ``most willing'' buyer or seller and yet
their best-priced limit orders are traded through. By protecting the
best-priced orders, the rule is designed to promote a fair playing
field for both small and large investors in the U.S. equity markets.
Finally, the trade-through rule is designed to encourage the use of
limit orders and thereby contribute to greater market depth and
liquidity. Displayed limit orders are the building blocks of public
price discovery and efficient markets. Although there are many types of
liquidity, displayed limit orders represent, by far, the most
transparent and readily accessible source of liquidity. They also
provide an essential benchmark that guides the use of other types of
liquidity, such as undisplayed trading interest, matching systems, and
dealer capital commitments. As a result, the enhanced displayed
liquidity and public price discovery elicited by the trade-through rule
should contribute to more efficient trading throughout the equity
markets.
Turning to the proposed rule itself, I should stress that the
trade-through rule, if adopted by the Commission, would take a
substantially different and more comprehensive approach than the
existing SRO and ITS trade-through rules. The trade-through rule would,
for the first time, establish a uniform trade-through rule for all
national market system (NMS) stocks. As a uniform rule, it would cover
both exchange-listed stocks, which are governed by existing SRO trade-
through rules, and Nasdaq stocks, which have never been subject to a
trade-through rule. Furthermore, the rule would only protect automated
quotations--in essence, those quotations against which an incoming
order can execute immediately and without human intervention. It would
not protect manual quotations. In so doing, the trade-through rule
would correct a significant problem with the existing trade-though
rules, which treat all quotes alike and effectively force fast markets
to route orders to slow markets, where they can sometimes languish
unfilled while the market moves away. The reproposed trade-through rule
also would incorporate a series of discrete exceptions--including those
that accommodate sweep orders, address rapidly changing or
``flickering'' quotes, and allow for ``self-help'' when a market
experiences a systems malfunction--that are designed to assure the rule
works in a relatively frictionless manner. Finally, the trade-through rule
would eliminate significant gaps in the coverage of the existing
trade-through rules--such as the exemptions for off-exchange block trades
and 100-share quotes--that have seriously undermined the extent to which
the SRO rules protect limit orders and promote fair and orderly trading.
I should note that the reproposal asked for comment on two
alternatives to the scope of the automated quotations in each market
that would be protected. The first alternative--the ``Market BBO''
alternative--would protect the best displayed bids and offers on each
exchange, Nasdaq, and the NASD's Alternative Display Facility. The
second alternative--the ``Voluntary Depth'' alternative--would protect
not only the best quotes, but also orders below the best bid and above
the best offer that a market voluntarily chooses to display in the
consolidated quotation stream.
That said, I should point out that some Commissioners and
commenters have questioned the need for a trade-through rule on the
listed markets, where they believe that the current trade-through rule
is ineffective. These same Commissioners and some commenters question
whether the trade-through rule should be extended to Nasdaq, which they
believe operates well without one. In their view, improved access to,
and connectivity among, the competing markets, coupled with vigorous
enforcement of best execution obligations, will best achieve fair,
efficient, and liquid markets, and make a trade-through rule
unnecessary. I have asked the staff to give serious consideration to
all viewpoints as they develop final recommendations for Commission
consideration.
Commission staff is in the midst of evaluating the more than 1,500
comment letters received on the two trade-through rule alternatives, as
well as other aspects of the Regulation NMS reproposal. As I noted
earlier, I have asked the staff to complete their analysis and prepare
a recommendation for Commission consideration in short order. While the
issues raised by the trade-through rule and other components of
Regulation NMS are extremely complex and, in some cases, controversial,
they have been thoroughly analyzed and debated over the course of many
years, and I believe the time for action has arrived. I can assure you
that the Commission will carefully consider the comments received on
Regulation NMS--including many from you and your colleagues--and that
we are committed to achieving a result that furthers the important
policy objectives I have described without burdening the efficient
operation of the markets.
Credit Rating Agencies
I will now turn to the Commission's recent work with respect to
credit rating agencies. By way of background, the Commission originally
used the term ``Nationally Recognized Statistical Rating Organization''
or ``NRSRO'' with respect to credit rating agencies in 1975 solely to
differentiate between grades of debt securities held by broker-dealers
as capital to meet Commission capital requirements. Since that time,
ratings by NRSRO's have become benchmarks in Federal and State
legislation, domestic and foreign financial regulations and privately
negotiated financial contracts.
In the last few weeks, (1) the Commission staff has issued a no-
action letter to A.M. Best, a privately owned and operated credit
rating agency; (2) the Commission has proposed a rule that would define
the term ``NRSRO'' with the goal of providing greater transparency to
the process for identifying NRSRO's; and (3) the current NRSRO's are
discussing with Commission staff a voluntary framework of standards to
address important issues such as potential conflicts of interest. I
will now discuss each step in detail.
A.M. Best
Last Thursday, on March 3, the Commission staff issued a no-action
letter to A.M. Best providing assurance that the staff will not
recommend enforcement action if ratings from A.M. Best are used by
broker-dealers for purposes of the net capital rule. In effect, the no-
action letter adds A.M. Best to the group of credit rating agencies
considered ``NRSRO's.'' Prior to A.M. Best, eight credit rating
agencies had received NRSRO no-action letters from the Commission
staff. However, consolidation during the 1990's, reduced the number of
pre-A.M. Best NRSRO's to four firms: Dominion Bond Rating Service;
Fitch; Moody's; and Standard & Poor's.
Proposed Rule Defining NRSRO
On March 3, the Commission voted to issue a rule proposal that
would define the term ``NRSRO'' for purposes of Commission rules. The
goal of the proposal is to provide greater clarity and transparency to
the process of determining whether a credit rating agency's ratings
should be relied on as NRSRO ratings for purposes of Commission rules.
The definition and interpretations of the definition would provide
credit rating agencies with a better understanding of whether they
qualify as an NRSRO.
The rule proposal builds on earlier Commission work with respect to
the role of credit rating agencies. This work included public
Commission hearings, a report required by the Sarbanes-Oxley Act, and a
2003 concept release. Panel participants at the public hearings
included NRSRO's, non-NRSRO credit rating agencies, broker-dealers,
buy-side firms, issuers, the academic community, and SEC Commissioners.
Most participants favored the regulatory use of credit ratings issued
by NRSRO's as a simple, efficient benchmark of credit quality, and
stated that standards for NRSRO's were necessary for this concept to
have meaning.
In addition, the Commission conducted a study of credit rating
agencies and submitted a report to the President and Congress under the
Sarbanes-Oxley Act of 2002 on January 24, 2003. The report considers
the role of credit rating agencies and their importance to the
securities markets, impediments faced by credit rating agencies in
performing that role, measures to improve information flow to the
market from credit rating agencies, barriers to entry into the credit
rating business, and conflicts of interest faced by credit rating
agencies.
Finally, the Commission issued a concept release in June 2003 to
further study issues raised in the Sarbanes-Oxley report. The concept
release examined whether credit ratings should continue to be used for
regulatory purposes under the Federal securities laws, and, if so, the
process of determining whose credit ratings should be used, and the
level of oversight to apply to such credit rating agencies. One
conclusion that the Commission has drawn from its examination of the
topic is that market participants would be well served by a clearer set
of standards for determining whether or not a credit rating agency is
an NRSRO.
The Commission's rule proposal of March 3 responds to a number of
issues raised by commenters to the concept release. The proposal
retains the NRSRO concept and proposes a definition of ``NRSRO.''
Moreover, the Commission would interpret the elements of the definition
to provide greater clarity as to the meaning of the term. In addition,
in light of the longstanding reliance by broker-dealers, issuers,
investors, and others on the existing no-action process, if the
Commission adopted a definition of NRSRO, the Commission plans to
continue to make its staff available to provide no-action letters, as
appropriate. No-action letters would be granted for a specified period
of time, after which the no-action relief would need to be
reconsidered.
The Commission notes that this proposal is intended only to address
the meaning of the term ``NRSRO'' as it is used by the Commission; it
does not attempt to address many of the broader issues raised in
response to the 2003 Concept Release, such as whether the NRSRO
designation raises barriers to entry to the credit rating business,
except for making clear that credit rating agencies that confine their
activities to limited sectors of the debt market or to limited (or
largely non-United States) geographic areas can qualify as NRSRO's. The
Commission believes that to conduct a rigorous program of NRSRO
oversight, more explicit regulatory authority from Congress is
necessary. We believe that a well-thought-out regulatory regime could
provide significant benefits in such areas as record-keeping and
addressing conflicts of interest in the industry. It will be important
to ensure that the public does not misconstrue any regulatory authority
over credit rating agencies as a statement that the Government has
vouched for the accuracy or quality of a credit rating.
The Voluntary Framework
Finally, the current NRSRO's have sought to craft a framework for
voluntary oversight by the Commission. Discussions are ongoing
concerning the precise terms of a framework. It is not clear at this
time what form that framework might take. It is hoped that the
framework will enhance oversight of NRSRO's from current levels by
providing a means by which the Commission staff can assess on an
ongoing basis whether an NRSRO continues to meet the ``NRSRO''
definition.
It is important to recognize that even if the industry does adopt
such a framework, it would not give the Commission the same authority
that actual legislative authority could. For example, if a credit
rating agency failed to observe a provision of the voluntary framework,
the Commission would not be able to bring an enforcement action.
Moreover, the framework does not envision direct inspections by
Commission staff, and the Commission would instead be in a position of
relying on
inspections conducted by third parties hired by the credit rating
agencies. Accordingly, if Congress believes more extensive Commission
oversight is appropriate than possible with a voluntary framework,
legislation may be needed even if the industry does in fact adopt a
voluntary framework.
Congressional attention would be especially useful because the
question of whether to impose a regulatory regime on the credit rating
industry raises a number of important policy considerations that would
need to be examined, including First Amendment issues. The Commission
welcomes Congressional attention and, of course, would stand ready to
work with Congress on crafting appropriate legislation if Congress
determines that such legislation is necessary.
Mutual Fund Rulemaking
I turn now to another area of significant Commission focus and
reform activity--mutual funds. Last year, in the wake of the mutual
fund late trading and market timing scandals, the Commission undertook
an aggressive mutual fund reform agenda. The reforms were designed to
(1) improve the oversight of mutual funds by enhancing fund governance,
ethical standards, and compliance and internal controls; (2) address
late trading, market timing, and certain conflicts of interest; and (3)
improve disclosures to fund investors, especially fee-related
disclosures. It is my hope and expectation that, taken together, these
reforms will minimize the possibility of the types of abuses we
witnessed in the past 18 months from occurring again.
When I last testified before this Committee on mutual fund reform
on April 8, 2004, we had taken final action on just two of our mutual
fund reform initiatives, although many were in the proposal stage.
Today, I am pleased to announce that we have adopted 10 of our
initiatives and expect to complete the few remaining matters on our
reform agenda in the coming months. I would like to review for you the
significant steps we have taken to strengthen and improve the mutual
fund regulatory framework.
Enhancing Internal Oversight
Fund Governance Reforms: With respect to enhancing mutual fund
governance and internal oversight, a centerpiece of the Commission's
reform agenda was the fund governance initiative. In July 2004, the
Commission adopted reforms providing that funds relying on certain
exemptive rules must have an independent chairman, and 75 percent of
board members must be independent.\1\ In addition, the independent
directors to these funds must engage in an annual self-assessment and
hold separate ``executive sessions'' outside the presence of fund
management. The Commission also clarified that these independent
directors must have the authority to hire staff to support their
oversight efforts. These fund governance reforms will enhance the
critical independent oversight of the transactions permitted by the
exemptive rules. Funds must comply with these requirements by January
16, 2006.
---------------------------------------------------------------------------
\1\ Commissioners Glassman and Atkins dissented, raising several
concerns regarding the need for and effectiveness of this rulemaking.
---------------------------------------------------------------------------
As I have said before, I believe that a management company
executive who sits as chair of a fund's board is asked to do the
impossible--serve two masters. There are times when the executive's
duties to the management company and its shareholders simply conflict
with what is in the best interest of fund investors. This is the case,
for instance, when fund boards review many of the transactions
permitted by our exemptive rules. I believe that an independent
chairman and a 75 percent majority of independent directors level the
playing field on behalf of fund investors and blunt the control and
dominance that many management companies historically have exerted in
fund boardrooms. Our fund governance reforms will also facilitate the
effective implementation of other mutual fund initiatives the SEC has
adopted and will put forward.
Compliance Policies and Procedures and Chief Compliance Officer
Requirement: One of the most important of these initiatives, adopted in
December 2003, requires that funds and their advisers have
comprehensive compliance policies and procedures and appoint a chief
compliance officer. In the case of a fund, the chief compliance officer
is answerable to the fund's board and can be terminated only with the
board's consent. The chief compliance officer must report to the fund's
board regarding compliance matters on at least an annual basis. Funds
and advisers were
required to comply with these new requirements beginning October 5,
2004. We believe that making these changes to the mutual fund
compliance infrastructure, and the increased focus on compliance that
comes from the new chief compliance officer requirement will help to
minimize the kinds of compliance weaknesses that led to the mutual fund
scandals.
Code of Ethics Requirement: In July 2004, the Commission adopted a
new rule that requires registered investment advisers, including
advisers to funds, to adopt a code of ethics that establishes the
standards of ethical conduct for each firm's employees. The code of
ethics rule represents an effort by the Commission to reinforce the
fundamental importance of integrity in the investment management
industry. Investment advisers were required to comply with the new code
of ethics requirement as of February 1, 2005.
Addressing Late Trading, Abusive Market Timing and Directed Brokerage
for Distribution
Late Trading/Hard 4:00 Proposal: To address the problems associated
with late trading (which involves purchasing or selling mutual fund
shares after the time a fund prices its shares--typically 4:00--but
receiving the price that is set before the fund prices its shares), the
Commission proposed the so-called ``hard 4:00'' rule. This rule would
require that fund orders be received by the fund, its designated
transfer agent or a clearing agency by 4 p.m. in order to be processed
that day.
We have received numerous comments raising concerns about this
approach. In particular, we are concerned about the difficulties that a
hard 4:00 rule might create for investors in certain retirement plans
and investors in different time zones. Consequently, our staff is
focusing on alternatives to the proposal that could address the late
trading problem, including various technological alternatives. The
technological alternatives could include a tamper-proof time-stamping
system and an unalterable fund order sequencing system. These
technological systems could be coupled with enhanced internal controls,
third party audit requirements and certifications.
Our staff has been gathering information from industry
representatives to better understand potential technological systems
that could be used to address the late trading problem. Given the
technological implications of any final rule in this area, it is
important that we get it right. Thus, I have instructed the staff to
take the time necessary to fully understand the technology issues
associated with any final rule. Consequently, the Commission likely
will not consider a final rule in this area until mid-2005.
Market Timing/Redemption Fee Rule: Last week, the Commission
adopted a ``voluntary'' redemption fee rule, which permits (but does
not require) funds to impose a redemption fee of up to 2 percent. The
rule requires that fund boards consider whether they should impose a
redemption fee to protect fund shareholders from market timing and
other possible abuses. The voluntary rule represents a change from the
``mandatory'' approach proposed by the Commission. Many commenters
opposed a mandatory redemption fee rule because of concerns that
investors would inadvertently trigger the fee's application and because
a 2 percent redemption fee may not be appropriate in all cases.
When the Commission adopted the new rule, we also requested comment
on whether to require that any redemption fee imposed by a fund conform
to certain uniform standards. This standardization may facilitate
imposition and collection of redemption fees throughout the fund
industry. I am hopeful that we will quickly reach a decision on this
part of the rule, after we hear back from commenters.
The new rule also mandates that funds be able to access information
from intermediaries operating omnibus accounts, so that funds can
identify shareholders in those accounts who may be violating a fund's
market timing policies. Under these arrangements, the intermediaries
and funds would share responsibility for enforcing fund market timing
policies. I should also note that fair value pricing remains critical
to eliminating arbitrage opportunities for market timing.
Directed Brokerage Ban: In September 2004, the Commission adopted
amendments to Rule 12b-1 under the Investment Company Act to prohibit
mutual funds from directing commissions from their portfolio brokerage
transactions to broker-dealers to compensate them for distributing fund
shares. The Commission's concern was that this practice can compromise
best execution of portfolio trades, increase portfolio turnover,
conceal actual distribution costs, and inappropriately influence
broker-dealer recommendations to investors. In adopting the ban, the
Commission determined that directing brokerage for distribution
represented the type of conflict that was too significant to address by
disclosure alone. The directed brokerage ban went into effect December
13, 2004.
Improving Disclosures to Fund Investors
Improved mutual fund disclosure--particularly disclosure about fund
fees, conflicts and sales incentives--has been a stated priority for
the Commission's mutual fund program throughout my tenure as Chairman,
even before the mutual fund scandals came to light. As such, disclosure
enhancements have been an integral part of our reform initiatives. As
part of our mutual fund reform agenda, we have adopted the following
disclosure reforms, all of which have become effective.
Shareholder Reports: In February 2004, the Commission adopted
significant revisions to mutual fund shareholder reports. These
revisions include dollar-based
expense disclosure, quarterly disclosure of portfolio holdings, and a
streamlined presentation of portfolio holdings in shareholder reports.
These requirements became effective in August 2004.
Disclosure Regarding Market Timing, Fair Valuation, and Selective
Disclosure of Portfolio Holdings: In April 2004, the Commission adopted
amendments requiring funds to disclose (1) market timing policies and
procedures, (2) practices regarding ``fair valuation'' of their
portfolio securities and (3) policies and procedures regarding the
disclosure of their portfolio holdings. Each of these disclosures
specifically addresses abuses that came to light in the mutual fund
scandals. These requirements became effective in May 2004.
Breakpoint Discounts: In June 2004, the Commission adopted rules
requiring mutual funds to provide enhanced disclosure regarding
breakpoint discounts on front-end sales loads, in order to assist
investors in understanding the breakpoint opportunities available to
them. This initiative addresses the failure on the part of many broker-
dealers to provide sales load discounts to mutual fund investors who
were entitled to them. The requirement became effective in July 2004.
Board Approval of Investment Advisory Contracts: Also in June 2004,
the Commission adopted rules requiring that shareholder reports include
a discussion of the reasons for a fund board's approval of its
investment advisory contract. The disclosure is intended to focus
directors' and investors' attention on the importance of the contract
review process and the level of management fees. This requirement
became effective in August 2004.
Disclosure Regarding Portfolio Manager Conflicts and Compensation:
In August 2004, the Commission required that funds provide additional
information regarding portfolio manager conflicts and compensation,
including information about other investment vehicles managed by a
fund's portfolio manager, a portfolio manager's
investment in the funds he or she manages and the structure of the
portfolio manager's compensation. These requirements became effective
in October 2004.
Point of Sale/Fund Confirmations: In addition to these adopted
reforms, last week, on March 1, the Commission requested additional
comment on a proposal requiring brokers to provide investors with
enhanced information regarding costs and broker conflicts associated
with their mutual fund transactions. The proposal would require
disclosure at two key times--first at the point of sale, and second at
the completion of a transaction in the confirmation statement. We
tested our proposal with investor focus groups, and based on the very
helpful feedback we received from these focus groups, we issued our
request for additional comment. We also are sensitive to the concerns
expressed by brokerage industry commenters about the costs associated
with our original proposal. Our staff therefore is examining more cost-
effective methods of providing investors with the disclosures they
need. I am hopeful that the Commission can move quickly on this
initiative after we have an opportunity to review the comments that
respond to our recent request for input.
Upcoming Mutual Fund Initiatives
Having outlined the Commission's progress on our mutual fund reform
agenda, I would like to highlight some additional mutual fund related
initiatives that are on the horizon.
Portfolio Transaction Costs Disclosure: In December 2003, the
Commission issued a concept release requesting comment on measures to
improve disclosure of mutual fund transaction costs. In many cases,
investors do not understand how the costs associated with the purchase
and sale of a mutual fund's portfolio securities affect their bottom-
line investment in the fund. These transaction costs can include the
payment of commissions and spreads as well as costs associated with
soft dollars and other brokerage arrangements. Transaction costs also
can encompass costs that are difficult to quantify, such as opportunity
costs and market impact costs. Using feedback that we received in
response to our concept release, our staff is preparing a proposal to
improve disclosure of mutual fund transaction costs.
Soft Dollars: I believe it is necessary to examine the nature of
the conflicts of interest that can arise from soft dollars, which
involve an investment adviser's use of brokerage commissions to
purchase research and other products and services. Consequently, I have
formed a Commission task force that is reviewing the use of soft
dollars, the impact of soft dollars on our Nation's securities markets
and whether soft dollars further the interests of investors. In
addition, the task force is reviewing whether we can improve disclosure
to better inform investors about the use of soft dollars and whether
there are enhanced disclosures that can be made to fund boards to
enable them to better evaluate funds' use of soft dollars. The Task
Force also is examining the definition of ``research'' as used in
Section 28(e) of the Securities Exchange Act of 1934. Soft dollar
arrangements present many of the same concerns irrespective of whether
research is provided on a proprietary basis, or by an independent
research provider, and I expect that any recommendations from the staff
would accord similar treatment to both types of arrangement.
Rule 12b-1: When the Commission proposed to ban directed brokerage
for distribution under Rule 12b-1, it also requested comment on the
broader question of whether Rule 12b-1 (which allows mutual fund assets
to be used to promote the sale of fund shares) should be revised more
broadly or even eliminated. The Commission received numerous comments
on this issue. The Commission adopted Rule 12b-1 over 20 years ago, and
the mutual fund industry has evolved significantly since then. The idea
of using Rule 12b-1 fees as a substitute for a sales load--which in
many cases they have come to be--is different than the use of 12b-1
fees for advertising and marketing purposes, which was envisioned when
the Rule was adopted. In light of these changes in the industry and in
the use of 12b-1 fees, the future of Rule 12b-1 is a topic that should
receive a thorough and reasoned review.
Mutual Fund Disclosure Reform: As I outlined above, the Commission
has adopted a number of new mutual fund reform initiatives designed to
improve the disclosures made to fund investors. Each of these
disclosure reforms was merited. However, I believe it is time to step
back and take a top-to-bottom assessment of our mutual fund
disclosures. I have asked the staff to carry out a comprehensive review
of the mutual fund disclosure regime and how we can maximize its
effectiveness on behalf of fund investors. The staff also will examine
how we can make better use of technology, including the Internet, in
our disclosure regime. Throughout this review process, we will solicit
input from mutual fund investors.
Sarbanes-Oxley Implementation
Two years ago, when I came on board at the Commission, the country
was still reeling from its disappointment with cooked books,
indefensible lapses in audit and corporate governance responsibilities,
and intentional manipulation of accounting rules. These lapses led to
staggering financial losses and a crisis in investor confidence. The
resulting Sarbanes-Oxley Act called for the most significant reforms
affecting our capital markets since the Securities Exchange Act of
1934. The Act established the foundation necessary to improve financial
reporting and the behavior of companies and gatekeepers, and we have
completed the rulemaking to implement these critically important
reforms. Key requirements have taken hold including:
CEO and CFO certifications of the material completeness and
accuracy of SEC periodic filings;
Enhanced disclosure of off-balance sheet transactions;
Electronic reporting within two business days of insider
transactions;
Increased disclosure of material current events affecting
companies;
Strengthened rules regarding the independence of auditors and
audit committees;
Establishment of the PCAOB;
Issuance of the first PCAOB inspection reports on the large
accounting firms;
Issuance of important auditing standards by the PCAOB; and
For the first time, as required by Section 404 of the Act,
public reporting on internal controls and their effectiveness--by
both management and auditors.
I would like to focus for a moment on the Section 404 requirement
for management and a company's auditor to report on the effectiveness
of internal controls over financial reporting. This Section of
Sarbanes-Oxley may have the greatest long-term potential to improve
financial reporting. It may also well be the most urgent financial
reporting challenge facing a large share of corporate America and the
audit profession in 2005. I expect that we will begin to see a number
of companies announce that they or their auditors have been unable to
complete their assessments or audits of controls, and additional
companies announce that they have material weaknesses in their
controls.
For this initial pass, that result should not, by itself,
necessarily be motivation for immediate or severe market reactions.
Section 404 is a disclosure provision, and investors will benefit from
receiving full disclosure regarding any material weaknesses that are
found--full disclosure about the nature of any material weakness, their
impact on financial reporting and the control environment and
management's plans for remediating them. This disclosure will allow
investors and markets to make the appropriate judgments about what
companies and auditors find. Section 404 will work as intended if it
brings this information into public view, and in that event the
disclosure of material weaknesses in internal controls should be the
beginning and not the end of the analysis for investors and markets.
The goal should be continual improvement in controls over financial
reporting and increased investor information and confidence. This
should lead to better input for management decisions and higher quality
information being provided to investors.
While these benefits are clear, it is also important that we
evaluate the implementation of our rules and the auditing standard
issued by the Public Company Accounting Oversight Board (PCAOB) to
ensure that these benefits are achieved in the most sensible way. We
have been very sensitive to the implementation of all aspects of the
Sarbanes-Oxley Act, and especially to this very significant aspect.
This has included several measured extensions over this past year to
accommodate the first wave of reporting.
In addition, in order to assess SEC and PCAOB rules for Section 404
now that we will have the first year of actual experience under the
rules, the Commission will hold a roundtable discussion this April and
is currently soliciting written feedback from the public regarding
registrants' and accounting firms' implementation of these new
reporting requirements. Through the roundtable and this feedback, we
will be closely listening to and assessing the experiences with the
management and auditor internal control requirements, including seeking
to identify best practices for the preparation of these reports and
evaluating whether there are ways to make the process more efficient
and effective, while fully preserving the benefits of the requirements.
Throughout this process the Commission and its staff will closely
coordinate with the PCAOB and its staff, and we will seriously consider
whether any additional guidance is necessary or appropriate. We are
actively engaged in other activities to evaluate and assess the effects
of the recent reforms, including the internal control reporting rules.
For example, we have announced we are establishing the Securities and
Exchange Commission Advisory Committee on Smaller Public Companies. The
advisory committee will conduct its work with a view to protecting
investors, considering whether the costs imposed by the current
regulatory system for smaller public companies are proportionate to the
benefits, and identifying methods of minimizing costs and maximizing
benefits. In addition, and at the request of Commission staff, a task
force of the Committee of Sponsoring Organizations (COSO) has been
established and anticipates publishing additional guidance this summer
in applying COSO's framework to smaller companies. Our actions have not
been limited to smaller companies. We also are cognizant of the
regulatory challenges our foreign registrants face. For all of these
reasons, we recently extended the compliance date for internal control
reporting for an additional year for smaller and foreign public
companies. Review of the first year experiences of our larger
registrants also should help smaller and foreign issuers in preparing
their first reports.
Conclusion
This testimony covers a broad spectrum of serious and very complex
issues the Commission is currently dealing with. There are a number of
other substantive activities underway at the Commission as well, but I
have tried to limit my update to the things I understand are foremost
on your minds. I thank the Members of this Committee for your interest
and attention to the important issues affecting the securities markets
today, and for the support you have shown the Commission and its staff.
Together, we have made significant progress over the last several years
in rebuilding public confidence in our markets. This concludes my
prepared testimony. I would be glad to try and answer any questions you
may have.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM WILLIAM H. DONALDSON
Q.1. I have been contacted by representatives of the National
Treasury Employees Union Chapter 293 representing 2,800
employees at the U.S. Securities and Exchange Commission
expressing concerns about the parity of benefits paid to SEC
employees. As you are aware, Section 8 of the Investor and
Capital Markets Fee Relief Act, Public Law 107-123, provides
that ``In setting and adjusting the total amount of
compensation and benefits for employees, the Commission shall
consult with, and seek to maintain comparability with, the
agencies referred to under Section 1206 of the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 (12
U.S.C. 1833b).''
In relevant part, the union chapter has written the
following:
[W]hy [does] the SEC refuse . . . to give employees a
Supplemental 401(k) with 5 percent employer match--a comparable
FIRREA benefit?
Pay Parity Lite--SEC Chairman Pitt testified in April 2002
that his $76 million pay parity request ``is lower than the
amount that we believe would be required to match what several
of the banking agencies currently provide. A fully implemented
system identical to the FDIC model, for example, could easily
cost more than $100 million.'' See paragraphs 6 & 8, April 17,
2002 testimony by Chairman Pitt before Subcommittee on
Commerce, Justice, State, and the Judiciary, Committee on
Appropriations, U.S. House of Representatives.
The Supplemental 401(k) benefit is the major difference
between the SEC and FDIC:
FDIC: Supplemental 401(k), 5 percent match
OCC: Supplemental 401(k), 3 percent match
FHFB: Supplemental 401(k), 3 percent match
OTS: Supplemental 401(k), 2 percent match
SEC: No Supplemental 401(k) plan
Management has advanced 2 arguments against the
Supplemental 401(k):
too expensive and
conflict of interest by SEC retaining a ``regulated
entity'' 401(k) Administrator.
Regarding the ``too expensive'' argument, management
refuses to provide any cost information to justify their
position--blithely ignoring both: (1) the statutory
requirement\1\ of comparable pay and benefits with FIRREA
agencies and (2) Federal Service Impasses Panel Order \2\
requiring SEC to provide NTEU with relevant pay and benefit
information. Further, we note that the SEC returned $125
million of its budget over the past 2 years.
---------------------------------------------------------------------------
\1\ 5 U.S.C. Sec. 4802. Similarly, SEC is ignoring the same statute
by failing to report annually to Congress how it is maintaining pay
parity with the FIRREA's.
\2\ See In the Matter of SEC v. NTEU, Case No. 02 FSIP 122 (2002)
which reads, in part: ``The parties agree to establish a Labor/
Management Committee for the purpose of sharing information that is
reasonably available and necessary for a full and proper discussion,
understanding, and negotiations of benefits and compensation.'' Page 10
Item VII. Benefits and Compensation.
---------------------------------------------------------------------------
Regarding the ``conflict of interest'' argument, we told
SEC management about Pentegra Group, who is not subject to SEC
jurisdiction and administers the OTS Supplemental 401(k).
Moreover, the conflict of interest issue has not stopped the
SEC from purchasing goods and services from hundreds of SEC
registrants (that is, Microsoft, Dell, and Dreyfus to name a
few). Management's failure to support their arguments or
consider union solutions speaks volumes.
Recently, SEC managers proposed a substitute in lieu of the
Supplemental 401(k) program that would require Congressional
legislation amending the Federal Employee Retirement System
statute to specifically allow SEC to increase its contribution
to Thrift Savings Plan accounts from the government-wide 5
percent cap to 7 percent. In response to this proposal, the
union requested:
copies of their draft legislation;
list of Congressional sponsors;
a list of the Congressional Committees approached by
the SEC regarding the proposed legislation;
whether OMB had considered and approved SEC
initiative;
whether SEC was aware of the FERS statute being
amended to allow other agencies to do what the SEC
proposed;
timeline for completing the legislation and
implementing the Supplemental 401(k).
Management was either unable or unwilling to provide any
information to the above information request. Given the
embryonic and problematic state of management's proposal, the
union questioned why the Pentegra Administered Supplemental
401(k) program option is not being pursued . . . .
In sum, . . . why [is it that the] SEC refuses to provide
SEC employees with a Supplemental 401(k) and 5 percent Employer
Match, considered to be the ``crown jewel'' of comparable
FIRREA benefits.
I would appreciate your reviewing these concerns and
providing an appropriate response in light of the Act.
A.1. The Commission is fulfilling the Congress' mandate that it
provide its employees with overall pay and benefits comparable
to those provided by the ``FIRREA agencies.'' Looking to the
full panoply of benefits that agencies provide, rather than a
single benefit like a 401(k) plan, data from 2004 shows the
Commission provided benefits that average 28 percent of an
employee's salary, above an average of 26.5 percent of salaries
provided by other financial regulators. The pay and benefits
that the Commission provides have greatly enhanced staff
retention, a primary goal of pay parity. For fiscal year 2004,
the last year for which complete data is available, the SEC's
turnover rate was approximately 6 percent, which is comparable
with the turnover rates for fiscal years 2002 and 2003 and well
below the Agency's prepay parity rates of the late-1990's.
Within the constraints of the Commission's budgets, the
Commission is committed to continuing to enhance its overall
employee benefits to maintain comparability and sustain its
success in employee retention.
As part of maintaining overall comparability, the
Commission is interested in being able to adjust the retirement
benefits for its employees. Conflict-of-interest concerns,
however, make it far more difficult for the Commission to
fashion a Supplemental 401(k) than it was for the FIRREA
agencies. Unlike the FIRREA agencies, the Commission has
regulatory authority over any firm that would serve as an
investment adviser. Such conflict-of-interest concerns are not
present, that is, in the Commission's dealings with other
vendors, such as Dell, Microsoft, or Dreyfus (over whose day-
to-day business practices the Commission does not have such
regulatory authority).
The Commission is exploring the feasibility of increasing
matching contributions to employees' TSP accounts. This
approach would avoid the 401(k) conflict-of-interest issues
discussed above and result in far lower administrative costs--
costs that would provide no direct benefit to SEC employees--
than a stand-alone 401(k). However, since 5 U.S.C. 8432(c)(2)
currently caps agency TSP contributions at 5 percent, it
appears that additional legislative authority would be needed
before we would be able to implement this approach. The
Commission staff is available to show your staff how 5 U.S.C.
4802 could be amended to override that cap, which the
Commission would suggest setting to an increased level of 7
percent.
Separately, 5 U.S.C. Section 4802(d)(1)(B)(ii) states that
the Commission shall include, ``the effects of implementing the
plan . . . in the annual program performance report submitted''
to Congress. The primary effect of pay parity that the SEC
currently measures is the Agency's turnover rate, as discussed
above. The SEC has provided this information to Congress in the
Performance Budget chapter of its fiscal year 2006
Congressional Budget request. In addition, this information
also has been included in the Agency's fiscal year 2004
performance and accountability report.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR ALLARD
FROM WILLIAM H. DONALDSON
Q.1. I am aware that at the December 15 meeting of the SEC,
staff responding to a question by Commissioner Campos indicated
that a solution might be at hand to move Nasdaq's exchange
application forward.
Could you comment on these developments and perhaps give us
an update on this process?
A.1. In December, Nasdaq filed a proposal that would change its
Nasdaq Market Center Execution Service, formally known as
SuperMontage, to require that all trades executed in the Nasdaq
Market Center Execution Service be executed in price/time
priority. This proposal has been published and is on our
website (http://www.sec.gov). While neither I nor the
Commission have come to any conclusions about this filing, I
believe this proposal is a significant step in Nasdaq's
exchange application process.
As currently proposed, the Nasdaq Exchange would not have
price priority rules, in contrast to the requirements of all
other U.S. exchanges. Price priority rules promote order
interaction, which facilitates the price discovery process. The
lack of price priority rules in Nasdaq's exchange application
raised profound market structure issues that could have had
implications for all of our registered exchanges and ultimately
investors. The proposal filed in December is intended to
address this concern
The staff is also working with Nasdaq and the NASD to
resolve how over-the-counter trades will be reported once they
are no longer printed on Nasdaq's Market Center Execution
Service. I anticipate that the NASD will be filing a proposal
shortly, which the Commission will publish. Once the issue of
price priority rules is resolved, I expect that the Commission
would be in a position to act on Nasdaq's exchange application.
Q.2. The New York Stock Exchange would say that the hybrid
market proposal is their response to customer demands for
greater speed and certainty as well as providing more choices
to execute their orders. Would you agree that the NYSE proposal
demonstrates the benefits of competition between markets?
I was hoping you could tell me the status of the SEC's
consideration of the NYSE's hybrid market filing?
A.2. The New York Stock Exchange (NYSE) has proposed to
significantly alter its existing auction market structure by
expanding automatic executions on its market. This proposal
reflects the impact of both competition and regulation on the
markets.
Among other things, the NYSE proposes to automatically
execute in its Direct+ system all marketable limit orders,
market orders, and ITS commitments, regardless of size. The
details of enhanced auto-ex capabilities and other changes
contemplated by the NYSE's Hybrid proposal can be found at
http://www.sec.gov/rules/sro/nyse/3450667.pdf.
The NYSE Hybrid proposal was most recently published for
comment in November 2004. The Commission has received a total
of25 comments to the proposal. On May 25, the NYSE submitted an
amendment to its Hybrid proposal. The Commission is currently
reviewing this recent submission and will soon publish the
amended Hybrid proposal for another round of public comment
before taking any final action.
Q.3. Nasdaq and the NYSE currently have some structural
differences.
With the trade-through rule being changed from its current
function to having a fast/slow component, I am hoping to get
your
insights on whether the Commission has considered initially
retaining a reformed trade-through rule for NYSE stocks.
Perhaps then, that would allow for an extended amount of time
to study and analyze the results with the NYSE, complimented by
hybrid fast/slow system, as they have proposed.
Would it be feasible for the Commission to allow Nasdaq to
continue to rely on best execution, and come back to trade-
through in a few years and decide if either market or both
markets need a trade-through rule?
A.3. As you know, the Commission voted to adopt Regulation NMS
on April 6, 2005. Prior to adopting Regulation NMS, the
Commission considered the need to extend the Order Protection
Rule to Nasdaq stocks. The Commission received comment both
supporting and opposing applying the Rule to Nasdaq stocks.
Many commenters strongly supported the adoption of a
uniform rule for all NMS stocks to promote best execution of
market orders, to protect the best displayed prices, and to
encourage the public display of limit orders. They stressed
that limit orders are the cornerstone of efficient, liquid
markets and should be afforded as much protection as possible.
They noted, for example, that limit orders typically establish
the ``market'' for a stock. In the absence of limit orders
setting the current market price, there would be no benchmark
for the submission and execution of marketable orders. Focusing
solely on best execution of marketable orders (and the
interests of orders that take displayed liquidity), therefore,
would miss a critical part of the equation for promoting the
most efficient markets (for example, the best execution of
orders that supply displayed liquidity and thereby provide the
most transparent form of price discovery). Commenters
supporting the need for an intermarket trade-through rule also
believed it would increase investor confidence by helping to
eliminate the impression of unfairness when an investor's order
executes at a price that is worse than the best displayed
quotation, or when a trade occurs at a price that is inferior
to the investor's displayed order.
Other commenters, in contrast, opposed any intermarket
trade-through rule. Some commenters who were opposed to any
trade-through rule expressed the view that there is a lack of
empirical evidence justifying the need for intermarket
protection against trade-throughs in that market. They noted,
for example, that trading in Nasdaq stocks has never been
subject to a trade-through rule, while trading in exchange-
listed stocks, particularly NYSE stocks, has been subject to
the ITS trade-through provisions. Given the difference in
regulatory requirements between Nasdaq and NYSE stocks, many
commenters relied on two factual contentions to show that a
trade-through rule is not needed: (1) fewer trade-throughs
occur in Nasdaq stocks than NYSE stocks; and (2) trading in
Nasdaq stocks currently is more efficient than trading in NYSE
stocks. Based on these factual contentions, opposing commenters
concluded that a trade-through rule is not necessary to promote
efficiency or to protect the best displayed prices.
The Commission carefully evaluated the views of these
commenters on both the original proposal and the reproposal. In
addition, Commission staff prepared several studies of trading
in Nasdaq and NYSE stocks to help assess and respond to
commenters' claims, which are available on the Commission's
website. In general, the Commission found that current trade-
through rates are not lower for Nasdaq stocks than NYSE stocks,
despite the fact that nearly all quotations for Nasdaq stocks
are automated, rather than divided between manual and automated
as they are for exchange-listed stocks. Moreover, the majority
of the trade-throughs that currently occur in NYSE stocks fall
within gaps in the coverage of the existing ITS trade-through
rules that will be closed by the Order Protection Rule.
Consequently, the Order Protection Rule, by establishing
effective intermarket protection against trade-throughs, will
materially reduce the trade-through rates in both the market
for Nasdaq stocks and the market for exchange-listed stocks.
In addition, the commenters' claim that the Order
Protection Rule is not needed because trading in Nasdaq stocks,
which currently does not have any trade-through rule, is more
efficient than trading in NYSE stocks, which has the ITS trade-
through provisions, also is not supported by the relevant data.
The data reveals that the markets for Nasdaq and NYSE stocks
each have their particular strengths and weaknesses. In
assessing the need for the Order Protection Rule, the
Commission has focused primarily on whether effective
intermarket protection against trade-throughs will materially
contribute to a fairer and more efficient market for investors
in Nasdaq stocks, given their particular trading
characteristics, and in exchange-listed stocks, given their
particular trading characteristics. Thus, the critical issue is
whether each of the markets would be improved by adoption of
the Order Protection Rule, not whether one or the other
currently is, on some absolute level, superior to the other.
The Commission believes that effective intermarket protection
against trade-throughs will produce substantial benefits for
investors in both markets and, therefore, adopted the Order
Protection Rule for both Nasdaq and exchange-listed stocks.
Some commenters argued that competitive forces alone would
achieve the fairest and most efficient markets. In particular,
they asserted that reliance on efficient access to markets and
brokers' duty of best execution would be sufficient without the
need for an intermarket rule against trade-throughs. This
argument, however, fails to take into account two structural
problems--principal/agent conflicts of interest and ``free-
riding'' on displayed prices.
Agency conflicts may occur when brokers have incentives to
act otherwise than in the best interest of their customers. For
example, brokers may have strong financial and other interests
in routing orders to a particular market, which may or may not
be displaying the best price for a stock. Moreover, the
Commission has not interpreted a broker's duty of best
execution for retail orders as requiring that a separate best
execution analysis be made on an order-by-order basis.
Nevertheless, retail investors generally expect that their
small orders will be executed at the best displayed prices.
They may have difficulty monitoring whether their individual
orders miss the best displayed prices at the time they are
executed and evaluating the quality of service provided by
their brokers. Given the large number of trades that fail to
obtain the best displayed prices (for example, approximately 1
in 40 trades for both Nasdaq and NYSE stocks), the Commission
is concerned that many of the investors that ultimately
received the inferior price in these trades may not be aware
that their orders did not, in fact, obtain the best price. The
Order Protection Rule will backstop a broker's duty of best
execution on an order-by-order basis by prohibiting the
practice of executing orders at inferior prices, absent an
applicable exception.
Just as importantly, even when market participants act in
their own economic self-interest, or brokers act in the best
interests of their customers, they may deliberately choose, for
various reasons, to bypass (for example, not protect) limit
orders with the best displayed prices. For example, an
institution may be willing to accept a dealer's execution of a
particular block order at a price outside the NBBO, thereby
transferring the risk of any further price impact to the
dealer. Market participants that execute orders at inferior
prices without protecting displayed limit orders are
effectively ``free-riding'' on the price discovery provided by
those limit orders. Displayed limit orders benefit all market
participants by establishing the best prices, but, when
bypassed, do not themselves
receive a benefit, in the form of an execution, for providing
this public good. This economic externality, in turn, creates a
disincentive for investors to display limit orders and
ultimately could negatively affect price discovery and market
depth and liquidity.
As demonstrated by the current rate of trade-throughs of
the best quotations in Nasdaq and NYSE stocks, these structural
problems often can lead to executions at prices that are
inferior to displayed quotations, meaning that limit orders are
being bypassed. The frequent bypassing of limit orders can
cause fewer limit orders to be placed. The Commission therefore
believes that the Order Protection Rule is needed to encourage
greater use of limit orders. The more limit orders available at
better prices and greater size, the more liquidity is available
to fill incoming marketable orders. Moreover, greater displayed
liquidity will at least lower the search costs associated with
trying to find liquidity. Increased liquidity, in turn, could
lead market participants to interact more often with displayed
orders, which would lead to greater use of limit orders, and
thus begin the cycle again. We expect that the end result will
be a national market system that more fully meets the needs of
a broad spectrum of investors.
Q.4.a. This question pertains to the trade-through rate at
Nasdaq versus the trade-through rate at NYSE--I remember it
came up last July when you and various market participants
testified before this Committee. I have been told that Nasdaq
and NYSE have similar trade-through rates of about 2 percent.
What is the Commission's justification for imposing the trade-
through rule to Nasdaq when there remains little to no evidence
that the rule yields measurable results?
A.4.a. One principal factual contention of commenters on the
original proposal who were opposed to a trade-through rule is
premised on the claim that there are fewer trade-throughs in
Nasdaq stocks, which are not covered by any trade-through rule,
than in NYSE stocks, which are covered by the ITS trade-through
provisions. To respond to these commenters, the Commissions
staff reviewed public quotation and trade data to estimate the
incidence of trade-throughs for Nasdaq and NYSE stocks. In
general, the Commission has found that current trade-through
rates are not lower for Nasdaq stocks than NYSE stocks, despite
the fact that nearly all quotations for Nasdaq stocks are
automated, rather than divided between manual and automated as
they are for exchange-listed stocks. Moreover, the majority of
the trade-throughs that currently occur in NYSE stocks fall
within gaps in the coverage of the existing ITS trade-through
rules that will be closed by the Order Protection Rule.
Consequently, the Commission believes that the Order Protection
Rule, by establishing effective intermarket protection against
trade-throughs, will materially reduce the trade-through rates
in both the market for Nasdaq stocks and the market for
exchange-listed stocks.
Some commenters questioned whether the trade-through rates
found by the staff study were significant enough to warrant
adoption of the trade-through reproposal. The Commission does
not agree that the trade-through rates found in the staff study
are insignificant, nor does it believe that the total number of
trade-throughs is the sole consideration in evaluating the need
for the Order Protection Rule. A valid assessment of their
significance and the need for intermarket protection against
trade-throughs must be made in light of the Exchange Act
objectives for the NMS that would be furthered by the Order
Protection Rule, including: (1) to promote best execution of
customer market orders; (2) to promote fair and orderly
treatment of customer limit orders; and (3) by strengthening
protection of limit orders, to promote greater depth and
liquidity for NMS stocks and thereby minimize investor
transaction costs. The staff study examined trade-through rates
from a variety of different perspectives, including percentage
of trades, percentage of total share volume, percentage of
share volume of trades of less than 10,000 shares, and
percentage of total share volume of traded-through quotations.
In evaluating the need for the Order Protection Rule, the
different measures vary in their relevance depending on the
particular objective under consideration.
For example, the percentage of total trades that receive
inferior prices is a particularly important measure when
assessing the need to promote best execution of customer market
orders. The staff study found that 1 of every 40 trades (2.5
percent) for both Nasdaq and NYSE stocks have an execution
price that is inferior to the best displayed price, or
approximately 98,000 trades per day in Nasdaq stocks alone.
Investors (and particularly retail investors) often may have
difficulty monitoring whether their orders receive the best
available prices, given the rapid movement of quotations in
many NMS stocks. Furthering the interests of these investors in
obtaining best execution on an order-by-order basis is a
vitally important objective that warrants adoption of the Order
Protection Rule.
The percentage of total trades that receive inferior prices
also is quite relevant when assessing the need to promote fair
and orderly treatment of limit orders for NMS stocks. Many of
the limit orders that are bypassed are small orders that often
will have been submitted by retail investors. One of the
strengths of the U.S. equity markets and the NMS is that the
trading interests of all types and sizes of investors are
integrated, to the greatest extent possible, into a unified
market system. Such integration ultimately works to benefit
both retail and institutional investors. Retail investors will
participate directly in the U.S. equity markets, however, only
to the extent they perceive that their orders will be treated
fairly and efficiently. The perception of unfairness created
when a retail investor has displayed an order representing the
best price for an NMS, yet sees that price bypassed by 1 in 40
trades, is a matter of a great concern to the Commission. The
Order Protection Rule is needed to maintain the confidence of
all types of investors that their orders will be treated fairly
and efficiently in the NMS.
The third principal objective for the Order Protection Rule
is to promote greater depth and liquidity for NMS stocks and
thereby minimize investor transaction costs. Depth and
liquidity will be increased only to the extent that limit order
users are given greater incentives than currently exist to
display a larger percentage of their trading interest. The
potential upside in terms of greater incentives for display is
most appropriately measured in terms of the share volume of
trades that currently do not interact with displayed orders. It
is this volume of trading interest that will begin interacting
with displayed orders after implementation of the Order
Protection Rule.
The share volume of trade-throughs, rather than the number
of trade-throughs, is most useful for assessing the effect of
the Order Protection Rule on depth and liquidity because very
small trades represent such a large percentage of trades in
today's markets, but a small percentage of share volume. For
example, the staff study found that, for Nasdaq stocks, 100-
share trades represented 32.7 percent of the number of trade-
throughs, but only 0.8 percent of the share volume of trade-
throughs. Thus, the number of trade-throughs is useful for
assessing the number of investors, particularly retail
investors, affected by trade-throughs, while the share volume
of trade-throughs is useful for assessing the extent to which
depth and liquidity are affected by trade-throughs. For
example, 41.1 percent of the share volume of trade-throughs in
Nasdaq stocks is attributable to trades of greater than 1,000
shares that bypass quotations of greater than 1,000 shares.
Addressing the failure of this substantial volume of trading
interest to interact with significant displayed quotations is a
primary objective of the Order Protection Rule.
In contrast, the share volume of quotations that currently
are traded-through grossly underestimates the potential for
increased incentives to display because it reflects only the
current size of displayed quotations in the absence of strong
price protection. As a result, the relatively low share volume
of traded-through quotations is a symptom of the problem that
the Order Protection Rule is designed to address--a shortage of
quoted depth--rather than an indication of the benefits that
the Order Protection Rule will achieve. For example, when many
Nasdaq stocks can trade millions of shares per day, but have
average displayed size of less than 2,000 shares at the NBBO,
it will be nearly impossible for trade-throughs of displayed
size to account for a large percentage of total share volume--
there simply is not enough displayed depth. Small displayed
depth is evidence of a market problem, not market quality.
Every trade-through transaction in today's markets
potentially sends a message to limit order users that their
displayed quotations can be and are ignored by other market
participants. The cumulative effect of such messages over time
as trade-throughs routinely occur each trading day should not
be underestimated. When the total share volume of trade-through
transactions that do not interact with displayed quotations
reaches 9 percent or more for many of the most actively traded
Nasdaq stocks, this message is unlikely to be missed by those
who watched their quotations being traded through. Certainly,
the routine practice of trading through displayed size is most
unlikely to prompt market participants to display even greater
size.
Thus, the Commission believes that the percentage of share
volume in a stock that trades through displayed and accessible
quotations is a useful measure for assessing the potential
increase in incentives for display of limit orders after
implementation of the Order Protection Rule. In particular, the
dual measurements of percentage of share volume of traded-
through quotations (an overall 1.9 percent for Nasdaq stocks)
and the percentage of share
volume of trades that bypass displayed quotations (an overall
7.9 percent for Nasdaq stocks) likely represent the lower and
upper bounds for a potential improvement in depth and liquidity
after implementation of the Order Protection Rule.
Q.4.b. Have you and the other Commissioners or SEC staff
discussed the cost implications on the securities industry for
imposing a trade-through rule on the trading of Nasdaq-listed
securities?
A.4.b. The Commission discussed the estimated costs of the
Order Protection Rule in both the Proposing and Reproposing
Releases. In the Reproposing Release, the Commission noted the
concerns of some commenters over the anticipated cost of
implementing the original trade-through proposal. These
commenters argued that the Order Protection rule would be too
expensive and that the costs associated with implementing it
would outweigh the perceived benefits of the Rule. Some
commenters were concerned about the cost of specific
requirements in the proposed rule, particularly the procedural
requirements associated with the proposed opt out exception
(for example, obtaining informed consent from customers and
disclosing the NBBO to customers).
Some of the commenters based their concerns about
implementation costs on the estimated costs included in the
Proposing Release for purposes of the Paperwork Reduction Act
of 1995 (PRA). In the Reproposing Release, the Commission
revised its estimate of the PRA costs associated with the
proposed rule to reflect the streamlined requirements of the
Rule as reproposed, and to reflect a further refinement of the
estimated number of trading centers subject to the rule. In
particular, the Order Protection Rule as reproposed did not
(and as adopted does not) contain an opt out exception, as was
originally proposed. Therefore, the concerns expressed by
commenters relating to the costs of implementing an opt out
exception are not applicable, and were not included in the
Reproposing Release and the final rule as approved by the
Commission. In the Reproposing Release, the Commission also
refined its estimate of the number of broker-dealers that would
be required to establish, maintain, and enforce written
policies and procedures to prevent trade-throughs.
Taken together, these changes substantially reduced the
estimated costs associated with the implementation of and
ongoing compliance with the rule. Specifically, the estimated
PRA costs associated with the reproposed Order Protection Rule,
as discussed in the Reproposing Release, were $17.8 million in
start-up costs and $3.5 million in annual costs. In addition,
the estimated implementation costs discussed in the Reproposing
Release for necessary systems modifications were $126 million
in start-up costs and $18.4 million in annual costs.
Accordingly, the total estimated costs discussed in the
Reproposing Release were $143.8 million in start-up costs and
$21.9 million in annual costs.
Although a number of commenters generally expressed the
view that there would be significant costs associated with
implementing and complying with the reproposed Order Protection
Rule, they did not discuss the specific estimated cost figures
included in the
Reproposing Release or include their own estimates. Many
commenters expressed concerns with the costs associated with
implementing the Voluntary Depth Alternative, believing that
the costs of implementing the Voluntary Depth Alternative would
be substantially greater than the Market BBO Alternative. As
you know, the Commission voted to adopt the Market BBO
Alternative and not the Voluntary Depth Alternative.
The Commission does not believe that the changes made to
the Order Protection Rule as adopted, including the inclusion
of a stopped order exception, will materially impact the
estimated costs included in the Reproposing Release. The
Commission continues to estimate implementation costs for the
Order Protection Rule as adopted of approximately $143.8
million and annual costs of approximately $21.9 million.
In assessing the implementation costs of the Order
Protection Rule, it is important to recognize that much, if not
all, of the connectivity among trading centers necessary to
implement intermarket price protection has already been put in
place. Trading centers for exchange-listed securities already
are connected through the ITS. The Commission understands that,
at least as an interim solution, ITS facilities and rules can
be modified relatively easily and at low cost to provide the
current ITS participants a means of complying with the
provisions of the rule. With respect to Nasdaq stocks,
connectivity among many trading centers already is established
through private linkages. Routing out to other trading centers
when necessary to obtain the best prices for Nasdaq stocks is
an integral part of the business plan of many trading centers,
even when not affirmatively required by best execution
responsibilities or by Commission rule. Moreover, a variety of
private vendors currently offer connectivity to NMS trading
centers for both exchange-listed and Nasdaq stocks.
Commenters also expressed concern that applying the trade-
through proposal to the Nasdaq market would harm market
efficiency and execution quality. The Commission, however,
stated in the Reproposing Release, and continues to believe,
that a rule that serves to limit the incidence of trade-
throughs will improve market efficiency and benefit execution
quality.
RESPONSE TO A WRITTEN QUESTION OF SENATOR STABENOW
FROM WILLIAM H. DONALDSON
Q.1. I appreciate your comments regarding the trade-through
proposal. I have a few thoughts regarding this issue because
many interested parties have visited my office with concerns.
In recent years, the United States has moved from trading
in fractions to trading in decimals. While decimalization has
been a boon to investors by reducing spreads, it has
drastically reduced the amount of liquidity they can see at the
national best bid and offer. Where investors used to be able to
see liquidity over a span of 12 cents, today the national best
bid and offer shows them liquidity at only a penny.
As a policy matter, it is hard to argue that decimalization
should leave investors with less transparency and liquidity.
However, wouldn't it make sense to consider updating the
rules governing the display of market data to compensate for
the reduction in transparency caused by decimalization?
In other words, is not it possible that restoring this lost
transparency would facilitate finding the ``best price'' and
achieve some of the goals of the trade-through proposal, but do
so in a way that is less intrusive and more reliant on market
forces?
(For example by extending the limit order display rule to
require exchanges, market makers, and other market centers to
publish customer orders within 5 cents of their best published
quotations.)
A.1. The Commission received a few comment letters suggesting
that, rather than reducing the consolidated display
requirement, the Commission should expand the requirement to
include additional information on depth-of-book quotations,
because the NBBO alone has become less informative since
decimalization. The Commission does not believe, however, that
streamlining the quotations included in the consolidated
display requirement will detract from the quality of
information made available to investors. The adopted
consolidated display rule will continue to require the
disclosure of basic quotation information (for example, prices,
sizes, and market center identifications of the NBBO).
Particularly for retail investors, the NBBO continues to retain
a great deal of value in assessing the current market for small
trades and the quality of execution of such trades. For
example, statistics on order execution quality for small market
orders (the order type typically used by retail investors)
reveal that their average execution price is very close to, if
not better than, the NBBO. The adopted consolidated display
requirement will allow market forces, rather than regulatory
requirements, to determine what, if any, additional quotations
outside the NBBO are displayed to investors. Investors who need
the BBO's of each SRO, as well as more comprehensive depth-of-
book information, will be able to obtain such data from markets
or third party vendors. Commenters that discussed this aspect
of the proposal generally agreed that the proposal would
benefit investors and vendors by giving them greater freedom to
make their own decisions regarding the data they need.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI
FROM WILLIAM H. DONALDSON
Q.1. A brokerage firm has a program in place to rebate 50
percent of the 12b-1 fees that it receives for mutual funds to
its customers who invest in those funds. This can represent a
real cost savings for investors. But some mutual funds are
refusing to participate, in part because they believe that
rebating of 12b-1 fees to investors may not be permitted under
(the existing interpretation of) Federal securities laws.
I understand that the SEC staff has taken a look at this
issue. Will you provide guidance to the marketplace as to
whether or not it is permissible to rebate 12b-1 fees to
investors? Where will this task stand on the SEC's list of
priorities?
A.1. Some funds may be concerned that a broker-dealer's rebate
of 12b-1 fees to fund investors would violate Rule 12b-1 under
the Investment Company Act and/or Section 22(d) of that Act. As
discussed below, however, Rule 12b-1 does not prohibit broker-
dealers from rebating 12b-1 fees to their customers, and such
rebates may be paid by broker-dealers in a manner consistent
with Section 22(d).
Rule 12b-1: Rule 12b-1 is an exemptive rule that permits a
fund to pay for distribution expenses using fund assets under
certain conditions. Among other things, a fund must make such
payments pursuant to a written plan of distribution (12b-1
plan), and the fund's board of directors must determine, when
implementing and continuing the plan, that there is a
reasonable likelihood that the plan will benefit the fund and
its shareholders.
The staff recently provided interpretive guidance
concerning fund directors' duties under Rule 12b-1 in
connection with rebates of 12b-1 fees by broker-dealers. The
staff stated that a fund's board of directors should consider
any rebates of 12b-1 fees by broker-dealers to their customers
when determining whether to implement or continue the fund's
12b-1 plan.\1\ Some apparently have misinterpreted this staff
guidance to mean that a fund's board could never determine that
there is a reasonable likelihood that a 12b-1 plan would
benefit the fund and its shareholders if a broker-dealer
rebated 12b-1 fees to its customers. I understand that the
staff intends to provide additional guidance in the near future
to clarify that Rule 12b-1 does not prohibit fund shareholders
from receiving rebates of 12b-1 fees from broker-dealers.
---------------------------------------------------------------------------
\1\ See Edward Mahaffy (pub. avail. Mar. 6, 2003). See also
Southeastern Growth Fund, Inc. (pub. avail. May 22, 1986).
---------------------------------------------------------------------------
Section 22(d): Section 22(d) prohibits a fund, its
principal underwriter, and dealers from selling fund shares at
a price other than the current offering price set forth in the
fund's prospectus. Thus, for example, the staff has taken the
position that a dealer is generally prohibited from providing a
benefit to its customers that would directly offset a portion
of the offering price of fund shares.\2\ In general, however,
the staff believes that Section 22(d) does not prohibit dealers
from paying or making available certain benefits to their
customers so long as the benefits are not directly related to
the purchase of fund shares.\3\
---------------------------------------------------------------------------
\2\ See Murphy Favre, Inc., SEC No-Action Letter, May 22, 1987
(stating that a broker-dealer's proposal to provide coupons for
discount travel to investors in connection with their purchase of fund
shares generally would violate Section 22(d)); The Alger Fund, SEC No-
Action Letter, May 4, 1990 (stating that a broker-dealer's proposal to
provide free airline mileage credits to persons exchanging shares of
one fund for shares of other funds would violate Section 22(d)).
\3\ See, that is, Portico Funds, Inc., SEC No-Action Letter, April
11, 1996 (stating that a bank's proposal to provide certain benefits to
its customers who, among other things, held specified minimum balances
in fund shares purchased through their brokerage account at a bank
affiliate would not violate Section 22(d)).
---------------------------------------------------------------------------
Whether a broker-dealer's rebate of 12b-1 fees to its
customers would directly offset the offering price of fund
shares in violation of Section 22(d) would depend on the
particular facts and circumstances. In general, however,
rebates of 12b-1 fees by a broker-dealer that are not directly
related to the purchase of fund shares would not violate
Section 22(d). I have been informed that the staff intends to
provide additional guidance in the near future to clarify this
point.
Q.2. Chairman Donaldson, I read a recent press release that
stated that the Commission has added 19 members to the Advisory
Committee on Smaller Public Companies. What is the next step
that will be taken by the Advisory Committee?
We filled the 19 openings on the Advisory Committee on
March 7, 2005. The Advisory Committee held its first meeting,
its organizational meeting, on April 12. At that meeting, the
committee decided to issue a release seeking public comment on
its proposed agenda. The release was issued on April 26 and
published in the Federal Register on April 29. The public
comment period ended on May 31. After consideration of the
public comments, the committee will finalize its agenda.
The committee is not waiting until the public comment
period is over, however, to begin its work. The Co-Chairs have
established four subcommittees, where they expect most of the
fact finding to occur. The subcommittees are:
Internal Control Over Financial Reporting
Corporate Governance and Disclosure
Accounting Standards
Capital Formation
The subcommittees have begun their work and will be
providing periodic reports to the Co-Chairs and the full
Advisory Committee. The next meeting of the full committee is
scheduled for mid-June in New York City, with follow up
meetings scheduled for August in Chicago and September in San
Francisco. The Co-Chairs expect to take public testimony at
those meetings. The fact-finding phase of the committee's
efforts is scheduled to be completed at the end of September.
The committee's Master Schedule and proposed agenda, as
well as other information on the committee, are available on
its web page, which can be found on the Commission's website at
http://www.sec.gov/info/smallbus/acspc.shtml.
Q.3. How do you see the role of the Advisory Committee on
Smaller Public Companies evolving as you implement the
provisions of Sarbanes-Oxley? Will the Commission be involved
in other rulemaking processes?
A.3. I expect that the role of the Advisory Committee will
evolve somewhat as the Commission continues to implement
Sarbanes-Oxley, including the internal control provisions of
Section 404. The Commission may resolve some of the near-term,
smaller public company implementation issues before the end of
the committee's 13-month term in April 2006. Similarly, the
committee may make some interim recommendations before the end
of its term. I suspect, however, that most of the committee's
recommendations will involve longer-term issues involving the
structure of the SEC's program for regulating smaller public
companies, and that the committee will issue those
recommendations in April 2006. We intend to give serious
consideration to all the Advisory Committee's recommendations,
whether they involve rulemaking or other administrative action.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM WILLIAM H. DONALDSON
Q.1. Though I applaud the Commission's decision yesterday to
delay the implementation of Regulation B, the delay does not
change the fact the regulation is fundamentally flawed. As you
know, the Commission recently received a letter from 14 Members
of this Committee, you have also received a bipartisan letter
from our House colleagues and a joint letter from the Federal
Reserve, FDIC and OCC all voicing opposition to this
regulation. Will the Commission revise the regulation, rather
than simply delay it?
A.1. The Commission proposed Regulation B for public comment in
June 2004. We received over 100 comments, including many
thoughtful comments from banks and the banking regulators. To
ensure that we have adequate time to fully consider the
commenters' concerns, the Commission granted banks and savings
associations an exemption from broker registration, which
otherwise would be required by the Gramm-Leach-Bliley Act,
through September 30, 2005.
This delay should give us time to craft a set of rules that
will implement the bank broker provisions of the GLBA, and
achieve functional regulation, in a way that works for the
industry. Our primary goal is to clarify the reach of the
statutory exceptions. However, we are also mindful that banks
engage in other securities activities that are outside of those
exceptions but that nonetheless may raise limited investor
protection concerns. We plan to address those activities, not
by bending the statute to the breaking point, but by providing
targeted exemptions designed to ensure that the investor
protection concerns remain limited. We believe we are making
good progress in finalizing bank broker rules that will strike
the right balance.
As we move forward, we will continue to work with the
banking regulators and with the industry. We believe we can
fulfill our investor-protection mandate while responding to the
industry's need for flexibility and the bank regulators'
objective of ensuring the safety and soundness of the national
banking system. On a related note, I recently met with the
heads of the banking agencies to learn more about their
specific concerns and expect to receive additional information
from them.
Q.2. In your testimony you told us you are still working on the
final rule after-hours trading. What kind of message is sent to
investors when you come out with rules on independent chairs,
months ago, even though many argue if that is a problem or not,
and we still do not have a final rule on one of the real abuses
in the mutual fund industry?
A.2. The independent chairman provision, in the Commission's
view, was necessary to address the conflicts of interest
involved in the recent enforcement actions.
The Commission proposed to address late trading abuses in
December 2003, a few months after the mutual fund scandals
first were made public. The Commission's proposal (the Hard 4
close) would permit same-day pricing only for orders to
purchase or redeem fund shares that are received by the fund, a
single designated transfer agent for the fund, or a registered
clearing agency by the fund's pricing time (which for most
funds is 4 p.m. Eastern Time).
Currently, fund intermediaries (including broker-dealers,
banks, and retirement plan administrators) must accept orders
to purchase or redeem a fund's shares on behalf of the fund,
but may submit those orders to the fund after 4 p.m. Funds rely
on intermediaries to separate orders received before 4 p.m.,
which should receive same day pricing, from orders received
after 4 p.m., which should receive next-day pricing.
Unfortunately, we have found that on numerous occasions,
intermediaries permitted late trading by bundling post-4 p.m.
orders with pre-4 p.m. orders for same-day pricing.
The Hard 4 close proposal was designed to reduce the
potential for late trading by limiting the entities that could
accept an order for same-day pricing. Many commenters objected
to the proposal, however, because it would require a large
number of intermediaries to change the way they do business,
thus imposing substantial costs on them. Other commenters
expressed serious reservations about the impact of the rule on
fund shareholders in Western time zones, and on shareholders
who invest through pension plans. Since the end of the comment
period, Commission staff has been evaluating comments the
Commission has received on the proposal, including proposed
alternative approaches to the Hard 4 close. Our staff continues
to research and evaluate other approaches to the problem.
Q.3. Can you give me an update on the Nasdaq exchange
application. Does it bother you that it has taken so long to
approve/disapprove their application?
A.3. Please see the response to Senator Allard's question 1 for
an update on the status of Nasdaq's exchange's application.
Q.4. Do you believe that delaying implementation of Section 404
of Sarbanes-Oxley for foreign companies for a year puts
American companies, who must incur those costs now, at a
competitive disadvantage?
A.4. No. The Commission provided for this delay because many
companies outside the United States, particularly in Europe,
are facing the significant burden, not faced by U.S. companies,
of converting their accounting systems in 2005 to conform to
International Financial Reporting Standards, or ``IFRS. '' In
some cases, these companies and their auditors are well on
their way to completing the processes necessary to report on
their internal controls. In many other cases, however, it would
be a significant strain on both company and accounting firm
resources to undertake the conversion to IFRS and the
initiation of internal control reports at the same time.
Allowing foreign issuers the time to work through the IFRS
conversion process before implementing internal control
reporting requirements should provide for more effective
implementation of both the conversion to IFRS and the internal
control reporting requirements, and ultimately benefit
investors.
Q.5. Are you concerned that the options that FASB gives
corporations for expensing models will confuse investors?
A.5. Investors should benefit from the new standard because,
for the first time, issuers will expense the cost of all
employee stock options. While different models may be used to
calculate that expense, the model selected must comply with the
general criteria set forth in the standard. Overall, the new
standard should improve the comparability of financial
statements.
Both the new FASB accounting standard and the Commission
staff guidance published in Staff Accounting Bulletin No. 107
(SAB 107), however, emphasize the need for companies to explain
to investors the methods and models used for expensing the cost
of employee stock options. In SAB 107, the Commission staff
also notes that companies should explain any significant
differences between the financial statements before and after
implementation of the new accounting standard, including
differences that result from refinements in a company's
estimates or assumptions that are used in its model. These
disclosures will be an important part of the information
provided to investors.
Q.6. Are you concerned about the number of 3-2 votes the
Commission has taken during your tenure?
A.6. Much has been made about the very few votes in which the
Commission has not reached consensus. I would like to set the
record straight.
In over 98 percent of all instances in which we have had a
Commission vote during my tenure, we have had consensus. We
always seek to reach consensus, but sometimes reasonable people
can differ, particularly on very complex or difficult matters.
But let me explain how I reach a decision on these issues.
I do not view any market issues as ``Republican'' or
``Democratic'' issues. I approach each issue based on my over
30 years experience with the securities industry--as the
founder of a major Wall Street brokerage firm, the Chairman of
a stock exchange, and a CEO of a listed company. Those
experiences give me a perspective that guides me in my
determinations. I advocate what I believe is best for our
marketplace, without regard for political labels. Obviously,
there are many issues in which consensus can be reached through
compromise. But on major issues, some of which have languished
for years at the Commission, I am driven by my understanding of
the need for markets to have certainty and closure.
Fortunately, the areas where we disagree are few and far
between, but above all we must each cast a vote in compliance
with our mandate--to protect investors and ensure that our
markets are fair and orderly.
Q.7. Are you concerned that the U.S. capital markets are not as
attractive to foreign issuers as they once were, and most of
the new hires in the financial services sector last year were
accountants, auditors, lawyers, and compliance officials?
A.7. The SEC's responsibility to create results in U.S. markets
that are attractive to U.S. and other investors necessitates a
regulatory system that is designed to promote investor
protection. I believe that both issuers and investors will be
attracted to high quality markets, and that keeping the U.S.
markets at the highest quality is imperative, both from a
policy perspective as well as from our statutory mandate.
Accordingly, the regulatory efforts of the past 3 years will
have the long-term effect of assuring the continued viability
and strength of the U.S. markets.
The enactment of the Sarbanes-Oxley Act has required both
U.S. and foreign issuers to refocus on the need to have strong
accounting and financial reporting systems. This increased
attention to financial reporting may be a reason for any
increase in the hiring of accountants, auditors, lawyers, and
compliance officials. As noted in response to question 4, many
foreign private issuers also are in the process of converting
from the use of home-country accounting standards to
International Financial Reporting Standards. While this process
has not been easy for many companies, in the long-run it should
lead to significant improvements in the quality and integrity
of the financial information that fuels our securities markets.
Q.8. Nasdaq and NYSE have similar trade through rates of about
2 percent. What is the justification for imposing a rule, when
we see that it does not necessarily have any measurable
results. What are the cost implications for the securities
industry for imposing a trade-through rule on the trading of
Nasdaq-listed securities?
A.8. The Commission believes that the Order Protection Rule, by
establishing effective intermarket protection against trade-
throughs, will significantly reduce the trade-through rates in
both the market for Nasdaq stocks and the market for exchange-
listed stocks. Please see my answer to Senator Allard's
question 4 for the complete response to this question.
Q.9. What significant current and recent enforcement actions
have been taken against NYSE specialists by the SEC? Press
reports indicate other problems, without naming the firms; can
you explain the functional problems likely to be revealed?
A.9. In March 2004, the Commission settled administrative
enforcement proceedings against the five largest NYSE
specialist firms. The terms of the settlements required the
five firms to, among other things, disgorge profits and pay
fines of approximately $240 million, collectively.
In July 2004, the Commission settled administrative
proceedings against the remaining two NYSE specialist firms.
The terms of the settlements required these two firms to, among
other things, disgorge profits and pay fines of approximately
$5 million.
On April 12, 2005, the Commission instituted an
administrative proceeding, which is still pending, against 20
former NYSE specialist individuals in connection with the same
conduct: David A. Finnerty, Donald R. Foley II, Scott G. Hunt,
and Thomas J. Murphy--formerly of Fleet Specialist, Inc.; Kevin
M. Fee and Frank A. Delaney IV of Bear Wagner Specialists LLC;
Freddy DeBoer--formerly of LaBranche & Co. LLC; Todd J.
Christie, James V. Parolisi, Robert W. Luckow, Patrick Murphy,
and Robert A. Johnson, Jr.--formerly of Spear Leeds & Kellogg
Specialists LLC; and Patrick J. McGagh, Jr., Joseph Bongiorno,
Michael J. Hayward, Richard P. Volpe, Michael F. Stern, Warren
E. Turk, Gerard T. Hayes, and Robert A. Scavone, Jr.--formerly
of Van der Moolen Specialists USA, LLC. Simultaneously, the
U.S. Attorney's Office for the Southern District of New York
filed criminal charges against 15 of these specialists in
connection with the same conduct.
In the pending action against the former NYSE specialists,
the Division of Enforcement alleges that between 1999 and mid-
2003 these specialists pervasively engaged in fraudulent and
other improper trading by executing orders for their firms'
proprietary accounts ahead of executable public customer or
``agency'' orders that were placed through the NYSE's
electronic trading system known as the DOT system. The
complaint states that, through these transactions, these
specialists violated their basic obligation to match executable
public customer buy and sell orders, and not to fill customer
orders through trades from their firms' proprietary accounts
when those customer orders could be matched with other customer
orders. The Division also alleges that, through this improper
trading, these specialists caused customer losses in the
millions of dollars during the years in question. The Division
alleges that through this course of fraudulent trading, the
specialists willfully violated Section 17(a) of the Securities
Act of 1933, Sections 10(b) and 11(b) of the Securities
Exchange Act of 1934, and Rules 10b-5 and 11b-1 thereunder, and
various NYSE rules. The proceedings will determine what relief,
if any, is in the public interest including disgorgement,
prejudgment interest, civil penalties, and other remedial
relief.
Also on April 12, 2005, the Commission settled an
administrative proceeding against the NYSE in connection with
its failure to adequately regulate its specialists' trading.
Under the terms of the settlement, the NYSE is required to,
among other things, set aside $20 million to fund a third-party
regulatory auditor to conduct four regulatory audits of the
Exchange through 2011.
As the Commission's April 12 press releases noted, the
staffs investigation of individuals is on-going. The staff is
continuing to investigate to determine whether it is
appropriate to recommend the institution of additional
administrative proceedings against other individual specialists
in connection with the same conduct.
In addition, the staff is continuing to investigate the
conduct of the NYSE regulatory staff to determine whether it is
appropriate to recommend the institution of administrative
proceedings against any NYSE employees in connection with the
NYSE's failure to adequately regulate specialist trading.
Q.10. In studying the comments submitted to the SEC on Reg.
NMS, many in the industry, except for the NYSE and some
specialist firms, had serious concerns about the economic work
by the SEC to justify a trade-through rule on Nasdaq. In fact,
Commissioner Glassman, an economist, decried the SEC economic
work in the December 15 open meeting to discuss the revised
trade-through proposal. Do you share these concerns?
A.10. These economic studies tell me that while both primary
equity markets have great strengths, they both have weaknesses
that could be improved with enhanced incentives for order
display. The studies also support the comments we received--
that the problem of trade-throughs is a real one, particularly
for small investors who cannot easily monitor the behavior of
their agents.
Many of the criticisms of the staff studies generally
related to possible reasons why the staff studies might have
overestimated trade-through rates, particularly for Nasdaq
stocks. In response to these comments, Commission staff
analyzed and supplemented its trade-through study, and found
that these studies continue to support the need for enhanced
protection of limit orders as a means to promote greater depth
and liquidity in NMS stocks.
Q.11. All regulations should clearly define the problems that
they are attempting to solve. In the case of extending a trade-
through rule to Nasdaq, what problem is the SEC is trying to
solve? I have heard it said that a trade-through rule would
encourage the posting of limit orders, but according to
statistics from retail brokers (whose customers consist of many
individual investors), individual investors prefer to post
limit orders in Nasdaq instead of the NYSE. Since Nasdaq does
not have a trade-through rule and the NYSE has a trade-through
rule, it does not appear that the theory of encouraging limit
orders can be upheld.
A.11. By strengthening price protection in the NMS for
quotations that can be accessed fairly and efficiently, the
Order Protection Rule is designed to promote market efficiency
and further the interests of both investors who submit
displayed limit orders and investors who submit marketable
orders. Price protection encourages the display of limit orders
by increasing the likelihood that they will receive an
execution in a timely manner and helping preserve investors'
expectations that their orders will be executed when they
represent the best displayed quotation. Limit orders typically
establish the best prices for an NMS stock. Greater use of
limit orders will increase price discovery and market depth and
liquidity, thereby improving the quality of execution for the
large orders of institutional investors.
Some commenters asserted that the large number of limit
orders in Nasdaq stocks indicates that sufficient incentives
exist for the placement of limit orders in such stocks.
Strengthened intermarket trade-through protection, however, is
designed to improve the quality of limit orders in a stock,
particularly their displayed size, and thereby promote greater
depth and liquidity. This goal is not achieved, for example, by
a large number of limit orders with small sizes and high
cancellation rates.
Strong intermarket price protection also offers greater
assurance, on an order-by-order basis, to investors who submit
market orders that their orders, in fact, will be executed at
the best readily available prices, which can be difficult for
investors, particularly retail investors, to monitor. Investors
generally can know the best quoted prices at the time they
place an order by referring to the consolidated quotation
stream for a stock. In the interval between order submission
and order execution, however, quoted prices can change. If the
order execution price provided by a market differs from the
best quoted price at order submission, it can be particularly
difficult for retail investors to assess whether the difference
was attributable to changing quoted prices or to an inferior
execution by the market. The Order Protection Rule will help
assure, on an order-by-order basis, that markets effect trades
at the best available prices. Finally, market orders need only
be routed to markets displaying quotations that are truly
accessible.
In addition, commenters' claim that the Order Protection
Rule is not needed because trading in Nasdaq stocks, which
currently does not have any trade-through rule, is more
efficient than trading in NYSE stocks, which has the ITS trade-
through provisions, also is not supported by the relevant data.
This conclusion is particularly evident when market efficiency
is examined from the perspective of the transaction costs of
long-term investors, as opposed to short-term traders. The data
reveals that the markets for Nasdaq and NYSE stocks each have
their particular strengths and weaknesses. In assessing the
need for the Order Protection Rule, the Commission has focused
primarily on whether effective intermarket protection against
trade-throughs will materially contribute to a fairer and more
efficient market for investors in Nasdaq stocks, given their
particular trading characteristics, and in exchange-listed
stocks, given their particular trading characteristics. Thus,
the critical issue is whether each of the markets would be
improved by adoption of the Order Protection Rule, not whether
one or the other currently is, on some absolute level, superior
to the other. It is also worth noting that many of the trade-
throughs in listed stocks involve trades not subject to the
existing ITS trade-through rule. These trade-throughs involve
100 share quotes and blocks executed off an exchange, which are
excluded from the ITS rule.
For these reasons, the Commission believes effective
intermarket protection against trade-throughs will produce
substantial benefits for investors in both markets and,
therefore, voted to adopt the Order Protection Rule for both
Nasdaq and exchange-listed stocks.
Q.12. Extending the trade-through rule to Nasdaq would create
significant changes to that market. I have heard much
controversy over this proposed rule. It appears that the
Commission is divided on the trade-through rule and many market
participants are very much opposed to it. Would it not be best
to find a way that could have more consensus, both among the
industry and the Commissioners, before moving forward with such
a dramatic rule change? After all, such changes could have a
significant impact on the capital markets.
A.12. Regulation NMS raises complex, difficult issues that go
to the heart of our national market system. The problems raised
by these issues have beset the marketplace for years, to the
detriment of investors. The adoption of Regulation NMS is the
culmination of a deliberative and open process undertaken by
the Commission that included more than 5 years of study,
multiple public hearings and roundtables, an advisory
committee, three concept releases, a constant dialogue with
industry participants and investors, a proposing release,
supplemental release, and reproposing release. In addition, in
response to its various solicitations of comment, the
Commission received over 2,400 comment letters. The insights of
these commentators on the proposal, as well as those of
panelists at the public hearings, were carefully considered by
the Commission and have informed Regulation NMS as adopted. I
believe that this comprehensive, transparent, and iterative
process was in the best tradition of Commission rulemaking.
It is important to recognize that the views of the various
participants in the market structure debate can, and do, differ
on the policy issues raised by Regulation NMS. This difference
is reflected in the many comments letters received by the
Commission, both supporting the imposition of a trade-through
rule for all NMS stocks and opposing such a rule. This lack of
consensus among the industry and investors is not, however,
surprising. We cannot expect all market participants to agree
on issues as complex and fundamental as those raised by
Regulation NMS. Given the lack of consensus among the many
commenters, it also is not surprising that the Commissioners
themselves hold different policy views on these complex and
important issues.
Although I recognize the importance of achieving consensus,
I do not believe that allowing the status quo to continue any
longer would have been in the best interests of investors and
the national market system. With respect to the fundamental
issues raised by Regulation NMS, we cannot expect that any
action taken by the Commission to resolve the issues will ever
satisfy all market participants. The Commission must instead
focus on taking the right steps for investors and the national
market system, and I strongly believe that is what we have done
by adopting Regulation NMS.
Q.13. Several of the comment letters filed with the Commission
cast doubt on the reliability of the study done by the
Commission's staff into actual ``trade-throughs'' on the New
York Stock Exchange and Nasdaq. In particular, they questioned
whether the electronic communications networks' ``reserve''
functions had skewed the results? Would a failure to account
for this reserve function lead to false positives? Is there a
sound factual basis for extending the proposed trade-through
rule to Nasdaq at this point or would it be better to defer
consideration of that possibility?
A.13. Several commenters asserted that the study by Commission
staff overestimated trade-through rates because it failed to
consider the existence of reserve size and sweep orders in the
Nasdaq market, which could have caused ``false positive''
trade-throughs. In theory, order routers could intend to sweep
the market of all superior quotations before trading at an
inferior price, but if they did not effectively sweep both
displayed size and reserve size, the superior quotations would
not change and the staff study would report a false indication
of a trade-through when the trade in another market occurred at
an inferior price. In practice, however, those who truly intend
to sweep the best prices are quite capable of routing orders to
execute against both displayed and estimated reserve size,
thereby precluding the possibility of a false positive trade-
through. Indeed, although commenters asserted that the staff
study failed to consider the existence of reserve size for
Nasdaq stocks, the validity of their own argument is premised
on the failure of sophisticated market participants to consider
the existence of reserve size when routing sweep orders.
It currently is impossible to determine from publicly
available trade and quotation data whether the initiator of a
trade-through in one market has simultaneously attempted to
sweep better-priced quotations in other markets. The data can
reveal, however, the extent to which false-positive indications
of a trade-through were even a possibility by examining trading
volume at the traded-through market. If the accumulated volume
of trades in that market did not equal or exceed the displayed
size of a traded-through quotation, it shows that a sweep
order, even one attempting to execute only against displayed
size, could not have been routed to the market that was traded-
through. Commission staff therefore has supplemented its trade-
through study to check this possibility and to help the
Commission assess and respond to commenters' criticisms. It
found that this possibility rarely occurs--a finding that fully
supports an inference that market participants are capable of
effectively sweeping the best prices, both displayed and
reserve, when they intend to do so. Thus, it is very unlikely
that the existence of reserve size and sweep orders caused a
significant number of false positive trade-throughs in Nasdaq
stocks.
Q.14. Will the Commission will move forward with its Regulation
NMS before the contours of the NYSE's hybrid market proposal
have been fully determined and vetted? Would it be preferable
for the Commission to take that up before getting to final
approval of its Regulation NMS?
A.14. As you know, on April 6, the Commission voted to adopt
Regulation NMS. Over the past several months, Commission staff
have been working with the NYSE on the NYSE's proposal to
become a ``hybrid'' electronic-floor based market. On May 25,
the NYSE submitted an additional amendment to its Hybrid
proposal. The Commission plans to publish the NYSE's recent
amendment for another round of comments before taking any final
action.
Q.15. Would the proposed trade-through rule, in either
alternative form, provide sufficient flexibility for the large
State pension funds, and the large mutual funds, to get best
execution of their block orders? What I am concerned about is
whether those large blocks, if they exceed the total amount of
displayed liquidity, would be disadvantaged in some way, to the
detriment of the many thousands of small pensioners and mutual
fund investors--school teachers, police officers, fire
fighters, for example--whose investment stake often is less
than the minimum stake a brokerage firm would require to open
an account.
A.15. Although the adopted Order Protection Rule does not
provide a general exception for block orders, it addresses the
legitimate interest of large investors, such as State pension
funds and the large mutual funds, in obtaining an immediate
execution in large size (and thereby minimizing price impact)
by including an exception for ``intermarket sweeps'' that
allows broker-dealers to access multiple price levels
simultaneously at different trading centers to continue to
facilitate the execution of block orders. Specifically, the
exception allows the entire size of a large order to be
executed immediately at any price, as long as the broker-dealer
routes orders seeking to execute against the full displayed
size of better-priced protected quotations. The size of the
order therefore need not be parceled out over time in smaller
orders that might tip the market about pending orders. By both
allowing immediate execution of the large order and protecting
better-priced quotations, the adopted Order Protection Rule is
designed to appropriately balance the interests for investors
on both sides of the market.
The exception is fully consistent with the principle of
protecting the best displayed prices because it is premised on
the condition that the trading center or broker-dealer
responsible for routing the order will have attempted to access
all better-priced protected quotations up to their displayed
size. Consequently, there is no reason why the trading center
that receives an intermarket sweep order while displaying an
inferior-priced quotation should be required to delay an
execution of the order.
In addition, the adopted Order Protection Rule includes
exceptions for executing volume-weighted average price (VWAP)
orders and stopped orders. The exception for VWAP orders, as
well as other types of orders that are not priced with
reference to the quoted price of a stock at the time of
execution and for which the material terms were not reasonably
available at the time the commitment to execute the order was
made, will serve the interests of marketable orders and is
consistent with the principle of protecting the best displayed
quotations. The use of stopped orders represents a common and
valuable form of capital commitment by dealers that inures to
the benefit of investors. The adopted exception will apply to
the execution of so-called ``underwater'' stops, in order to
prevent abuse of the exception. Specifically, the exception
applies to the execution by a trading center of a stopped order
when the price of the execution of the order was, for a stopped
buy order, lower than the national best bid in the stock at the
time of execution or, for a stopped sell order, higher than the
national best offer in the stock at the time of execution. To
qualify for the exception, the stopped order must be for the
account of a customer and the customer must have agreed to the
stop price on an order-by-order basis.
Q.16. Like Senator Bennett, I am very concerned about naked
short selling. I know you have offered to brief Senator Bennett
on this problem but could you tell the Committee for the record
what steps you are taking to combat naked short selling?
A.16. The term ``naked short selling,'' which is not
specifically
defined in either the Federal securities laws or Self-
Regulatory Organization (SRO) rules, generally describes
selling short without borrowing the necessary securities to
make delivery, thus potentially resulting in a ``fail to
deliver'' securities to the buyer. When dealing with claims
about naked short selling, it is important to know which
activity is the focus of discussion.
Selling stock short without having located stock that
can be available for delivery at settlement. This activity
would violate Rule 203(b)(1) of Regulation SHO, except for
short sales by market makers engaged in bona fide market
making. Market makers are not required to locate stock
before selling short, because they need to be able to
provide liquidity and price efficiency.
Selling stock short and failing to deliver shares at
the time of
settlement. This activity is not per se illegal. Broker-
dealers in general must impose a contractual obligation on
short sellers to deliver stock at the time of settlement,
and a failure to deliver may result in a contractual
breach. However, generally it does not result in a rule
violation, with the possible exception of a fraudulent
course of conduct of selling short with no ability or
intention to deliver the stock (although we are not aware
of recent cases brought on this basis).
Selling stock short and failing to deliver shares at
the time of settlement with the purpose of driving down the
security's price. This manipulative activity, in general,
would violate various securities laws, including Rule 10b-5
under the Securities Exchange Act of 1934 (although not
Regulation SHO).
To the extent there is evidence of illegal naked short
selling, the staff pursues cases vigorously.\1\ However, to
recommend enforcement action, the staff needs some evidence
that stocks are being targeted illegally. Not all short sales
are illegal, or evidence of illegal activities. Not all open
fails to deliver are fraudulent, or evidence of fraud.
---------------------------------------------------------------------------
\1\ See Rhino Advisors, Inc. and Thomas Badian, SEC Litigation
Release No. 18003 (Feb. 27,2003); see also Pinnacle Business
Management, Inc., Vincent A. La Castro, and Jeffrey G. Turino, SEC
Litigation Release No. 17507 (May 8, 2003).
---------------------------------------------------------------------------
There appears to be confusion on the part of some investors
about the operation of Regulation SHO and what the Commission
is doing to address alleged abusive naked short selling.
Commission staff is seeking to address investor confusion in a
number of ways. For example, in addition to the staff's
availability to respond to investor inquiries on a daily basis,
the staff has published on the Commission's Internet website
``Key Points for Investors about Regulation SHO,'' which
addresses the questions and complaints of individual investors
(http://www.sec.gov/spotlightlshortsales.htm). The staff has
also published on the website ``Frequently Asked Questions
Concerning Regulation SHO.'' These materials address a number
of the commonly asked questions and concerns regarding
Regulation SHO.
Preliminary data indicate that Regulation SHO is having the
intended impact on failures to deliver. From the time
Regulation SHO went into effect in January 2005 through the end
of April 2005, the average daily aggregate fails to deliver has
declined by 29.9 percent, the average daily number of threshold
securities has declined by 29 percent, and the average daily
fails of threshold securities has declined by 40.0 percent.
Regulation SHO appears to be effectively reducing fails to
deliver without causing disruption to the markets. On an
average day, approximately 1 percent of all trades by dollar
value fail to settle. Put another way, 99 percent of all trades
by dollar value settle on time without incident.
The staff is continuing to monitor the operation of
Regulation SHO and is continually communicating with the legal
and compliance groups of the SRO's to monitor and enforce
compliance. The staff of the Commission's Office of Compliance,
Inspections and Examinations, together with the SRO's, has
commenced a targeted examination program of market participants
to assess compliance with Regulation SHO.
In addition, the staff is active in pursuing information
about abuses or noncompliance with its rules and regulations.
The Commission has investigated, and will continue to
investigate, complaints and allegations of short sale rule
violations. The staff will not hesitate to recommend Commission
action where sufficient evidence exists of a failure to comply
with the provisions of Regulation SHO or other short selling
violations.
RESPONSE TO A WRITTEN QUESTION OF SENATOR CARPER
FROM WILLIAM H. DONALDSON
Q.1. Chairman Donaldson, I understand one brokerage firm has a
program in place to rebate 50 percent of the 12b-1 fees that it
receives for mutual funds to its customers who invest in those
funds. This can represent a real cost savings for investors.
But some mutual funds are refusing to participate, in part
because they believe that rebating of 12b-1 fees to investors
may not be permitted under (the existing interpretation of)
Federal securities laws.
I understand that the SEC staff has taken a look at this
issue. My question for you is--will you make it a priority to
provide guidance to the marketplace as to whether or not it is
permissible to rebate 12b-1 fees to investors?
A.1. Please see my answer to Senator Enzi's question 1 for the
complete response to this question.