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| Author: | William H. Donaldson |
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May 19, 2005
Council on Foreign Relations
Speaker: William H. Donaldson, chairman, Securities and Exchange Commission
Presider: Robert E. Rubin, director and chairman of the executive committee, Citigroup; former U.S. secretary of the Treasury
Council on Foreign Relations
New York, N.Y.
May 19, 2005
ROBERT RUBIN: May I have your attention please? I think we're ready to begin our program. I'm Bob Rubin, vice chairman of the Council on Foreign Relations [CFR], and it is my privilege to introduce our distinguished speaker this evening, the 27th chairman of the Securities and Exchange Commission [SEC], William H. Donaldson.
A little bit of housekeeping first, and those of you who have been here for others of these kinds of things will know exactly what it is, but let me do it anyway. This session has been organized by the Council's Corporate Program, which involves some 200 companies here and abroad, and it's part of C. Peter McColough series on international economics. The meeting will be on the record. The format will be the chairman's remarks, then there will be a brief conversation between the chairman and myself, and then most of the session will be thrown open to questions from the audience. Please turn off your cell phones, BlackBerries, and whatever other devices one might have. For the Q&A session, there will be a microphone. Please stand, state your affiliation. Please ask only one question, and do so briefly so that we can have as many questions as possible. And we will adjourn on time, which is a hallowed Council on Foreign Relations tradition. In addition, I'm going fly fishing immediately after this, so I want to get out of town. But it is a hallowed tradition notwithstanding.
The chairman's resume is in your materials, so I will not repeat any of that. Let me simply say that when I first came to Wall Street a long, long time ago, Bill Donaldson was an important name, because his firm was on the cutting edge of the business of that day— the institutional business and the professionalization of research. And here we are, 40 years later, and Bill Donaldson's name is still and even more centrally important on Wall Street as the nation's lead regulator for the securities industry, and as a policy-maker central to our economic system.
I served on the board of the New York Stock Exchange when Bill was president, and I can tell you from that first-hand experience that he was an outstanding choice to be chairman of the Securities and Exchange Commission with his practical experience, his business experience, and his regulatory experience, at a time of enormously complicated issues in our financial system and our economy. So without further ado, I am privileged to introduce our nation's distinguished 27th chairman of the Securities and Exchange Commission, and a friend of many of us in this room, William H. Donaldson. Bill. [Applause]
WILLIAM DONALDSON: Thanks, Bob. This is a great evening for me. I thank you for the nice introduction. And thanks to the Council on Foreign Relations for inviting me to speak. I've been a member of the CFR for a long time. I have tremendous respect for the work that's done here, and I appreciate very much having the opportunity to come and to discuss some of the issues that are facing our financial markets, and they are considerable.
Before I proceed, I'm obligated to give the standard disclaimer that the views I express are mine and mine alone, and do not necessarily represent those of the commission or the staff.
The last three years have been an extraordinary active time for the commission, a period that may well be remembered as the most productive and consequential in the commission's history since its founding in 1934. As a matter of fact, it's kind of interesting to compare the events that led up to 1929, and then the formation of the SEC and the '33 and ‘34 Act, compare that with the period we went through in the ‘90s ending in the early 2000. Beginning with the corporate scandals that astonished the public in 2002, and continuing with the mutual-fund crisis that followed the next year, investor confidence was sorely shaken, in most of you, with a dangerous potential, in my view, for long-term consequences for the well-being of our capital markets.
In passing the Sarbanes-Oxley Act of 2002, Congress expanded our tools to combat the root causes of corporate breakdown. And the increased funding we began to receive shortly thereafter has been invaluable in helping us to address the wide-ranging malfeasance. Working with the additional authority and resources provided by Congress, the commission has responded forcefully to these scandals with targeted rule-making and precedent enforcement action. Over the same period of time, the commission has pursued long-needed structural reforms in the operation of our securities market, and through its enforcement program has addressed serious shortcomings in the behavior of a range of market participants.
One might think of our rule-making and enforcement efforts in terms of securities on the one hand and exchanges and markets on the other hand— after all, we are the Securities and Exchange Commission. First, as to securities, we've worked to improve the disclosure and governance associated with securities investment, in order to help investors make more informed decisions and better monitor the activities of their agents and intermediaries. In the context of specific securities investments, these include corporate managers, boards of directors, and investment advisers.
Second, as to the exchanges and markets, we've looked to improve the overall operation of the markets where securities are traded, again, through measures designed to ensure that investment interests are given primacy over the interests of their agents and intermediaries, in this case, market-setters, exchange specialists, market-makers, and broker-dealers.
Let me just give you a few examples in each category as background for our later discussion: I'll focus first on securities, second on exchanges and markets. We've worked to make sure that the investment represented by security is managed in a way that puts the interests of the investor first. We sought to achieve these enhanced disclosure requirements that bring a greater degree of clarity and accuracy to the information available about the security, and through our work have strengthened the governance associated with the issuer, which not only reinforces sound disclosure practices but also addresses conflicts between the interests of investors and those of their intermediaries, but focused on strengthening corporate governance.
As [Federal Reserve Board Chairman] Alan Greenspan said just a few weeks ago in a commencement address at Wharton [Business School at the University of Pennsylvania], he said the principles that the corporate managers should be working on behalf of shareholders to allocate business resources to their optimum use is a way to reinforce that principle.
Our efforts to improve corporate governance include implementing the audit committee independence and responsibility requirements of the Sarbanes-Oxley Act. Strengthening the role of the audit committee has been at the center of our efforts to improve corporate governance. And since the audit committee takes responsibility for overseeing the auditor, it's also a linchpin in our efforts to ensure an auditor's independence at public companies.
In addition, we've successfully encouraged the listing markets to upgrade their corporate governance in ways that recognize the importance of independent checks on management including requirements related to majority independent boards, independent nominating compensation and audit committees, board approval of related party transaction, and shareholder approval of equity-compensation plans.
We implemented the CEO0 [chief executive officer] and CFO [chief financial officer] certification provisions of the Sarbanes-Oxley Act, building on an initiative that was proposed before the enactment of that act. We believe these certifications have been instrumental in emphasizing in a very direct and very personal way the responsibility of management for their company's disclosures, and thereby improving— hopefully— the tone at the top of our public corporations.
A key piece of our corporate governance reform effort has been the adoption of rules by the commission and approval of the public company accounting oversight board rules requiring that management report on the effectiveness of their system of internal controls, and that the auditor attests to management's report. These rules, required by Section 404 of the Sarbanes-Oxley Act, have, I believe, perhaps the greatest long-term potential to improve the quality and usefulness of corporate reporting of any of this era's corporate reforms.
At the same time, implementation of these requirements for the first time, in connection with the 2004 reporting cycle, has resulted in significant costs, some portion of which may have been driven by a lack of clear risk-based focus by participants in the process. We believe the implementation of Section 404 rules needs to be improved going forward.
And last Monday our staff sat with PCAOB [Public Company Accounting Oversight Board], issued significant new guidance addressing ways for making that process more efficient. I'd sum it all up by saying, do a risk-based audit and use some common sense in doing it, and you're not going to be in trouble with us.
The reforms I've just outlined are targeted primarily at operating companies. We've also pursued a record number of enforcement actions against advisers to mutual funds who have found to have violated their customers' trust. To address the governance weaknesses in this industry that may have contributed to the breakdown, we've worked to reshape the internal fund-governance framework. The most significant change, and to some critics the most controversial, is the commission's requirement that a fund relying on certain core [inaudible] rules have a chairman and three-quarters of the board independent of the management company. The rule helps to address the inherent conflict that exists between the interests of a fund's shareholders, who want to limit fees and expenses and other items, and the interests of the fund manager, whose goal is to maximize revenues and the profits of another— for another set of shareholders.
A final example of our aim to help ensure that the interests of investors precede the interests of those managing the investment is our decision to require hedge-fund investment advisers to register with the commission beginning in early 2006. Among other things, registration of advisers in this market, which is rapidly approaching a trillion dollars in assets, will require hedge-fund managers to adopt basic compliance controls, and should ultimately improve the overall quality of disclosure made to investors. It's not enough for securities investments to be managed in the investors' interest, because they are then traded in a marketplace where the interests of intermediaries are given precedence. For that reason, we've also worked to make sure that in the exchanges and markets themselves, investor interests come before the interests of their agents and intermediaries. As with our efforts to enhance investor protection with respect to particular securities, rule-makings and enforcement actions reaffirm that basic principle.
Our most significant rule-making effort, aimed at exchange and markets, has been the adoption of regulation NMS, National Market System, an integrated set of reforms that update the regulatory apparatus governing U.S. equity markets. A central component of regulation, NMS is the so-called trade-free rule, a rule designed to ensure that when an investor sends an order to a trading center the order will be filled at the best price then immediately available anywhere in the national market system. Among its benefits, this rule should protect individual investors who may not be able to monitor the order routing decisions of their intermediaries, whose decisions could be affected by factors such as payment for other quarter flow and other effects, if you will, that are not necessarily in the best interests of the person whose order is being executed.
We've also proposed reforms to the system of SRO [self-regulatory organization] governance, designed to ensure that the critical regulatory functions of our nation's security markets are not compromised if the markets become subject to heightened competitive pressure, and as the markets increasingly become subject to public ownership. And forceful actions directed at curbing abuses that harm the markets have included cases involving improper trading by specialists on the nation's exchanges, unhealthy practices in IPO [initial public offering] allocations, and conflicts of interest in the research analysts' profession. The common thread in each of these cases has been market intermediaries who put their own financial business interests ahead of the interests of investors.
I'd be happy to discuss any of these topics in more detail with you in a few minutes, but let me just turn for a minute to the future. The overarching question of why we've been so active in the last two to three years, active of course because of what resulted from the boom years in the ‘90s, but many observers have complained that the pace of regulatory activity, and I quote, is "damaging long-term competitiveness of U.S. companies and the U.S. capital markets." Notably, mind you, these complaints do not seem to come from those with the greatest economic interests in the long-term health of our public companies and markets. Indeed, investors have overwhelmingly supported our agenda. Investor protection is our statutory mandate, and it's a goal worth pursuing for its own sakes. But it's important to realize that the benefits of strong investor protection reach far beyond the important principles of ensuring that investors, whether individual or institutional, are dealt with fairly.
Maintaining investor confidence through strong investor protection is the surest, and I would say perhaps the only way, to ensure that the U.S. capital markets remain the best place in the world for corporations to raise capital. As an old friend and long-time member of the Council, [former Citicorp President and Chairman] Walt Wriston, once very sagely observed, capital will always go where it's welcome, and will stay where it is well treated. And it's the simplicity of that statement that is so true. Those remarks could not be more relevant in light of two distinct developments that are unfolding around us. In keeping with my theme, one of these developments will affect securities, and the other will affect exchanges and markets. Both developments visibly illustrate the true mobility of capital is becoming a reality in ways that were difficult to say even a few years ago, if not a few months ago. They underline our national interest in providing a premier venue where capital is welcome and well treated.
Focusing first on securities, we are witnessing real progress toward international convergence of accounting and disclosure standards. True convergence will ultimately make it easier for investors to compare competing security investment opportunities with little concern about geographical boundaries, and decide on which offers the best potential returns. Investors will drive the push toward convergence around a transparent system of accounting because the market will penalize investments whose features are not well understood. And if a biotech company in Bangalore offers a better product than a biotech company in Boston and it is transparent in telling its story, common accounting and disclosure standards should make it easier for investors to understand where their capital is likely to be better treated.
Focusing, then, on exchanges and markets, and on investors to deploy capital without significant geographical constraints, would be enhanced by developments clearly on the horizon. The transactions recently announced by the New York Stock Exchange, Archipelago [Holdings], NASDAQ and Instinet [Group], and even the unsuccessful Deutsche Bourse-London stock exchange transaction, foreshadow in my view a world where competition among market centers breaks through geographic borders and becomes truly global in nature. And it's coming on very fast.
It's a simple proposition, but one that perhaps explains why we've been so focused on improving the governance and disclosure associated with securities and improving the way investors are treated on our securities markets. If you have the resources to invest, are you going to invest in a well-understood, fairly managed asset, that trades in a transparent and efficient market, or are you going to invest in an asset that lacks reliable information or is perhaps not clearly managed in your interests or trades in a market where you can't discern the role of the intermediary.
I'll stop there, and pause on that note. I of course will be happy to continue the conversation with all of you, but first with Bob, who I know has thought long and hard and has tremendous experience about some of the issues that we've discussed tonight. So thanks very much. [Applause]
RUBIN: Thank you, Bill. Those were very thoughtful comments and very practical comments about, I think, a very complicated set of questions. What I'll do is start out with a couple of questions, and then we'll turn it over to the audience, and that'll be the rest of our evening. Let me start with this, Bill. You made some very practical comments about the need, as Walt Wriston said, to have an environment that is welcoming and all well-treating of capital. On the other hand, I think there is a broad-based feeling that there's been enormous reallocation of the time of management and boards away from business strategy and toward governance. One of America's best-known former [inaudible] said to me not recently that it used to be when they got together [laughter], what they talked about was strategy and growth, and now they talk about governance.
So I guess the question is, recognizing that there were very serious issues in the corporate community that needed to be addressed, have we found the right balance and the right set of trade-offs? Or has the pendulum swung too far the other way and we need to get back into some different place on the spectrum?
DONALDSON: Key question, and— is this on? [Laughter] The— you know, if you step back a minute—
RUBIN: Is it on now?
UNKNOWN: No.
RUBIN: Mine is on. We didn't mean to censor the chairman. [Laughter] It was not a deliberate [Laughter]--
DONALDSON: Am I supposed to push something? Wait a minute. Did that do it?
RUBIN: You got it. There we go.
DONALDSON: [Laughter] Mechanical devices.
RUBIN: [Laughter] That's how DLJ [Donaldson, Lufkin, and Jenrette] developed its technological exploits [Laughter] under the chairman's leadership, but that was a while ago. [Laughter]
DONALDSON: Touche. [Laughter] You know, if you step back and think about what happened in the last three or four years in this country, the Sarbanes-Oxley Act was passed in a fit of anger, if you will. Enron and then WorldCom was the last straw, and that bill went through the Congress with almost 100 percent approval, with none of the vetting that normally goes for legislation of that importance. And this legislation is the most important that's come down the pike since the Securities Act of [inaudible].
So then it was put in the hands of the SEC to write the rules, and put in the hands of the SEC to form the PCAOB, again under great time pressure, legislative time pressure to get it done. So if we then fast forward to the first real year of operating under Sarbanes-Oxley, I think that a couple of things have happened. First of all, all the corporations in America— and I will overstate this— were surrounded by a battery of lawyers and accountants, at $500 an hour, surrounding the audit committee and the board. And everybody was pussyfooting around—
RUBIN: I think we'd settle at $500 an hour if you can find us a few at that price. [Laughter]
DONALDSON: OK. [Laughter] And by the way, along with that human advice came manuals of what you can and cannot do, interpreted in this new law. And I think that the good that has come from that is that the central focus of corporate America has now shifted back to where it should be, and that's with the board of directors. I mean, we went through a period in the ‘90s where the CEO had his board, and now we have a period of time when the corporate directors have their CEO, and set the tone and run the company, not on a day-to-day basis.
Now I think that's been a very healthy thing. I think that the independent-audit committee, the independent-compensation committee— we can talk about that— the independent-nominating committee, all of these things are forcing corporate America to be a lot more responsible than they've ever been in discharging these duties. That's resulted in a lot more work at the corporate level, a lot more time being spent— correctly— on governance, and it's been exacerbated by people who are feeling their way through on the act itself. And I think that many of the other parts of the act have been tremendously helpful.
However, the real distress has been centered in on the 404, Section 404. And for those of you that are not living with that day in and day out, the essential principle of this is that the CEO and the chief financial officer must attest to the veracity of their controls and of the numbers that they're putting forth. And this has been— and the penalties for attesting to something that isn't there are severe. And this has caused a great deal of nervousness on the part of corporate America. This also caused a procedure that has inherent in it a lot of inefficiencies. It was a startup year for everyone trying to conform with this law, and as a result, we are well aware of all the horror stories associated with it, well aware of what you were talking about in terms of the amount of time spent. The auditing, in many cases, was not just a auditing of controls, but a complete re-audit of the company, tying up huge amounts of people and outside advisers and so forth.
We've now been through that year, and we now can take the steps that we believe are necessary to cut the brush away, if you will, and cut out the redundancy and inefficiency, and come to this proposition beginning right now, and— as a result of what we did a month ago. We brought together, in roundtable format, six very distinguished roundtables of corporate leaders, accounting leaders, anybody— many people who were involved in this, many of our severest critics. We gave them all an opportunity to put their major gripes on our website, their horror stories, so that we didn't have to discuss them in this meeting. And we had an extremely positive meeting, and at that meeting we committed— we and the PCAOB committed to giving new guidance from the SEC and from the PCAOB, and we did that this week.
And we published two major papers that, as I eluded to in a rather flip way, basically tell the accountants and tell corporate America that you've got to have not a check-the-box kind of approach to this, but you've got to have a risk approach to it. You've got to make your own judgments on what really can impact corporate reporting, and that doesn't mean that you have to check the paper clips. It means that you have to use your head. And basically, the implication is— and it's not more than an implication— it's that if you do this and use your head and have a risk-based approach, you're not going to get in trouble with the authorities.
We estimate— even if we didn't do this, we estimate that the cost of conforming to 404 will go down some 30 [percent] to 35 percent even without these new directions, and that will be because the accounting firms have been through the startup phase. I mean, they had to out and hire a bunch of people to do this, and they've been through their startup phase, as has corporate America. So we think the cost will go— and then, we hope that they're going to go down.
Now, I have to qualify this by saying that the minute that we suggested that we were going to do this, the arrows started flying from investor groups saying don't you dare touch Sarbanes-Oxley, don't you dare do this thing. It's a good law and it shouldn't be changed, and don't you guys mess around with it. And [laughter] we're willing to accept those slings and arrows because we're not going to mess around with the purpose of the laws. We're going to try and get them in.
And then one further thing— it's a longer answer than you wanted— but we've also formed a small business group, advisory group, which will be in existence— it's in existence now, will be in existence for a year. It's shared by small-business people. Its mandate in advising us is not just 404 for small companies, but also the whole Sarbanes-Oxley routine. Because it's not that easy, let's say, to get independent, three independent directors on an audit committee, or to get— to conform in many ways is fine for a big company and not— and this one-suit-fits-all, one-size-fits-all approach has had a devastating affect on some small companies where, you know, a million dollars' worth of auditing expense is a big expense.
RUBIN: Well, that very practical response is why we should all hope Bill Donaldson remains chairman of the SEC for a long, long time. [Laughter] Let me ask you one more question, and we can turn it over to the audience. You had mentioned risk-based auditing and common sense, which, it seems to me, makes a lot of sense. But as you know, one of the concerns that people have is that what looks like risk-based auditing and common sense today, five years from now, if things go wrong, in hindsight can be judged a very different way. Is there any way to try to give people more assurance against that risk, which I do think is deterring people from doing things they might otherwise do that are sensible for companies to do?
DONALDSON: Yeah. Well, you know, it's very, very hard to talk about these things without it being misinterpreted. And clearly, the line that I'm trying to articulate here is one in which our actions will prove more than anything else; prove more than my rhetoric, more than the commission's rhetoric; our actions in dealing with corporations reporting to us over the next year.
Having said that, there still are major areas of accounting and professional slippage, if you will, that are still out there. And for those of you in the securities business, I think you know that during a period of the 1990s, with this crazy earnings-per-share game that we all got into, where the game came to be what's going to be earned this quarter by pennies, and if it— a few pennies less or more determines where the stock is going to go— that has brought a terrible temptation to corporate America, to financial vice presidents, to accountants, and so forth to serve up those pennies per share that you need with a devastating effect on expenditures and investments by companies who don't want to make those investments because it will mess up the earnings-per-share program. And we all know that I don't think anything grows like that, including human beings and plants and [laughter] organisms don't grow— they grow like that; the sound ones do.
And so, we've sort of had an artificial mold, and Wall Street and Wall Street analysts have been part of the problem here. I think the fact that rewards, particularly option awards, which have not been expensed, have increased that focus on short-termism, and it's a syndrome that's out there that I feel has to be turned around. And it's going to take a tripartite effort to do that. And that would be the analytical Wall Street investor community, who need to instruct companies that they are interested in long-term growth and are interested when they go and talk not about learning what their next quarter earnings are going to be, but what are you going to do over the next five years to make this a great company. It's going to take management, who are willing to provide that kind of strategic guidance. And it's going to take, I think, an investor telling companies that we want to make long-term investments, and we're willing to live with your sidewise movements, and if we have confidence in what you're doing, and you are a unique company, then we'll buy more stock, if your stock goes down; we won't sell them.
RUBIN: Sounds good to me. [Laughter]
DONALDSON: Sounds good, doesn't it? [Laughter] It's not going to be easy to get there.
RUBIN: Now, why don't we— we'll take questions from the audience, and I will repeat them to make sure that they— everybody can hear them. Yes, sir?
QUESTIONER: Mr. Donaldson, I want to say something before I ask my question. When you were fumbling with that little thing—
RUBIN: Could you identify yourself and your—
QUESTIONER: Oh, I'm [inaudible] Investment Group.
RUBIN: Yep. Carl, you push the button on the side there if you want to—
QUESTIONER: Yeah, yeah. Thank you very much. [Laughter] That's what I was going to refer to. When you were fumbling with that, your daughter leaned over to me and said, "You should see him with a TV monitor." [Laughter] Anyway, do you think the changes that were recently implemented are strengthening Wall Street, strengthening the New York Stock Exchange, and they're going to produce a much more powerful one? Or how do you think the effects of all these changes are going to end up on the New York Stock Exchange?
DONALDSON: Yeah. You know, this is a relatively complicated subject for those of you that are not aficionados of the central marketplace and how it works. But, in essence, what we've had is a marketplace of floor-based trading specialists and so forth that has been very successful for many, many years. However, new ways of trading have come in, particularly the electronic markets, for whom getting the best price is less important than the speed of their execution, and not having their execution broken up by the floors of the stock exchanges, most particularly the New York Stock Exchange.
Thirty seconds is an eternity in the marketplace today, and if I'm trying to execute an order for an institution and I'm forced to take it to the floor of the New York Stock Exchange because of the old trade-through rule and the floor trades against that, by the time my order is down there for 30 seconds, the bid has disappeared, somebody stepped in and broken up the order, and I, the electronic executor, don't want to put up with that.
So what we've done is to change and to cause the New York Stock Exchange to change to develop an electronic capability themselves, and they are proposing a hybrid market. And what I mean by that is that they will have an electronic capability that's being built right now that will execute, instantaneously, at the speed of light, totally competitive with all the other electronic markets. And as that market comes in to being, we've reinstituted now the trade-through rule, because there's no excuse not to have it now. If the order is put in an electronic market, there's no excuse to trade through the best-bidden offer to go somewhere else until you execute.
Now having said that, the stock exchange is also proposing, in its hybrid system, to keep the old floor operation. However, it will be used only by people who want to use it. In other words, you will not be forced to put your order in on the floor of the stock exchange. Why should it be saved? Well, those who believe in the auction market, and those who believe that, in times of stress, the liquidity that comes from having capital and human beings there as opposed to machines is extremely important. So people will be able to put their orders— who don't want to go on the electronic market— will be able to put their orders in the old auction market, if you will, and get those benefits.
I'll go one-step further. In our national market-system proposal, and now is a rule, we insisted that the trade-through rule be applied to both the New York Stock Exchange and the floor-based markets and NASDAQ. And our simple proposition was and is that there's no reason for a Microsoft and an IBM to have different rules surrounding their trading. A stock is a stock, and what difference does it make if it's traded on NASDAQ or on the New York Stock Exchange? So we insisted that the trade-through rule be applied to NASDAQ, and of course, there was a lot of static on that. Two weeks later, the revolution has come whereby New York Stock Exchange is proposing to acquire Archipelago, and NASDAQ of course is acquiring another over-the-counter dealer or marketplace.
What this means is that new competition will come in to both markets. Now the New York Stock Exchange holding company is going to have to fight to keep its share of market in the New York stock— list of stocks, and NASDAQ is going to be able to trade those stocks. And by the same token, the New York Stock Exchange, through Archipelago, is going to be able to trade NASDAQ stock.
So we now have a total blurring of the lines, a totally even regulatory field, a playing field that's equal. This is going to cause major change in some traditional ways of doing business, but the person or people that are going to benefit are individual shareholders who are going to be entering into a period of highly competitive execution strategies, and they're going to be protected— I don't want to be getting into too much detail. But I think that the— you know, the best market in the world is where you have two kinds of competition. I mean, the best market in the world is where you can aggregate all buy and sell interests in a single place electronically or otherwise. And that's how you really discover the best price. We have been able to combine in this country that sort of competition with the competition between marketplaces. OK?
And so the structure now is such that we hope and expect that, although a duopoly has been created here if it all goes through, those who are critical say, "What does that do about the little guy? What does that do about the person who wants to start up a new market?" And the answer to that, I think, is that— Archipelago didn't exist seven years ago. And as we sit here in this room, I don't think we can imagine what new ways of trading are going to come in very rapidly. And so the competitive force of competition between markets, and entrepreneurialism and so forth, I think is going to make further changes down the road.
RUBIN: Yes, sir.
QUESTIONER: Thank you. Mr. Chairman, agreeing with your comments on the borderless movement of capital, do you think that— going forward— that there are risks associated with the borderless ownership of our exchanges, particularly in times of economic distress? Oh, Patrick Durkin, Credit Suisse.
DONALDSON: I had that same question put to me by a senator not that long ago, in an open hearing. And we are roughly now, with the whole governance aspect of it, as the exchanges go public, as public ownership— and you bring the competing forces here, who are going to compete, if you will, on a regulatory side, I mean, how do we protect the regulatory side of the exchanges? How do we make sure that the new special interests, which are outside shareholders, don't upset the regulatory funds and so forth that are needed to make the places run correctly? So we are wrestling now with the corporate governance in the new publicly owned— to be publicly owned exchanges. And that ranges from— and the basic philosophy here is that the exchanges ought to have, the markets ought to have the same sort of transparent government that they insist listed companies have.
So we're wrestling now with making very specific about that, about having a majority of outside directors, about having independent committees, about being totally transparent as to the compensation, the corporations are.
And along with that comes a concern about ownership, aggregate ownership, how far should we go in restricting who can own stock in an exchange. And we have already put rules in that say that people who are part of the marketplace cannot own more than 20 percent of a publicly held exchange.
To date, we have not ruled on any kind of restriction for foreign ownership. And again, I don't want to prejudge what the commission is going to decide to do, but I expect we will not be doing anything in that area. I expect that, typically, we will seek to have corporations owned by anybody that wants to own one. But what we must do, is, if we follow that route, is make sure that the books and records of the exchanges, and the regulatory mechanism, is in this country so that, no matter who owns it, it will be regulated in accordance with U.S. regulations.
RUBIN: Yes, sir.
QUESTIONER: Mr. Chairman, my name is Roland Paul, I'm a lawyer, I practice securities law as well as other. You mentioned in your remarks and also in your resume, your bio, that one of your goals and focuses is to provide further, clearer information and disclosure so that investors can make better judgments of their investment choices.
Some experts say the plethora of information which the SEC has called for, for many years and has expanded now, investors don't read it. The only people who read it are striped-suit plaintiffs' lawyers. And so I wonder how you would answer that. Plus, some say, on the other hand, Sarbanes-Oxley, maybe 404 is healthy, but the rest of it is kind of palliative and won't really get around the cronyism that many corporations have among its top board and the management. Thank you.
DONALDSON: Let me take the second part of your question, which is— and I throw it to all of you who are in the business world— I believe that the atmosphere around the corporate board has changed. I think people are taking their duties a lot more seriously. I think that the old cronyism on the board and on committees and so forth is out the window. I think people are realizing that they can't sit on a lot of boards, because the responsibilities, the more they sit on, are such that they have to deal with. So I think that is improving.
But in terms of data flow that is evident from the papers that have to be filed, you're absolutely right. And we've taken a number of steps to try to address that. Most particularly because of the troubles in the mutual-funds industry, the disclosure of conflicts of interest, the expenses associated with the running of a mutual fund, and so forth, we are wrestling right now with how to get the information across so that people understand it.
And we've taken to having focus groups look at some of the legal gobbledygook that we dream up. And we're making some progress in terms of what I'll call a simplified plain English kind of piece of paper that people can understand. We also think that there is great potential for using the Internet and the ability to take that plain piece of paper and dig all the way down on the Internet into great detail if you're so inclined. And we— you'll see us moving in that direction in the mutual-fund industry.
On the corporate side, we put out— and I think it's little noticed, but it is a result of a lot of work— a whole new set of instructions, if you will, on the [inaudible] part of the offering circular, the— in an attempt to get away from the boilerplate, in an attempt to get companies to really talk about, in plain English, what their plans are, what they're doing, how they're doing it, how are they managing it. And if you think about it— and again, this is something I hope we're working towards; it's not easy to do— if you think about it, some of the information in the [inaudible] section, it's all past information, it's all relative to this earnings-per-share thing, and it's not the kind of information that, let's say, a leveraged-buyout buyer would look at. It doesn't really talk about— not in accounting terms— talk about the guts of the company and so forth.
And you'd hope to have an ability here in the reporting papers, the [inaudible] forms and so forth, to get at less boilerplate and more helpful information. It's not easy, and it's startling how ill-informed the public [is]. I mean, we have a large education effort at the SEC. And people that invest a lot of money, and they really don't know much about what they're investing in. And you're dealing with that vast audience out there. As we go to the baby boom getting older and 401[k]s and all of this, an awful lot of people are going to have a lot of money, and somehow we're going to have to teach them.
RUBIN: I'm not going to ask the chairman how he reconciles the concerns about the inadequate knowledge that most people have to invest their money with private accounts and Social Security. No, I'm not going to ask the chairman that question. Who would like to ask that question? Yes, sir.
QUESTIONER: Larry McQuade, River Capital. Is there anything that could be done or anything that should be done about the astronomic levels of executive compensation, as first— a general question. And second, you might use the New York Stock Exchange as an example.
DONALDSON: Look, this is a tremendously important subject in my view. My comments about the boards working better and the committees working better, there is a long ways to go, in my view, in terms of how the finance committee, the compensation committee, should operate. And the first step they need has been to get the independent-compensation committee, to have all independent directors.
The second step is to arm that committee with expert advice that they hire, that's not hired by management, that's brought in independent of management. And then thirdly, for that committee to sit down and think about what corporate performance is all about. And what I mean by that is that, to my way of thinking, we're way over too far on the simple financial goals, hitting the targets, hitting the earnings-per-share, et cetera, et cetera. We pay far too little attention to those dimensions, those qualitative dimensions, which make for a really good company, make for really good management, product quality, or research, or a whole package of things that distinguish them as really great companies. And I believe those things can be part of what's measured, and part of the goal that the CEO accepts to be measured by. And those of you who have sat on corporations, and we all have, I don't see much of that on the compensation committees that I sat on, that subject. And I think we've got to head that way.
One other thing, which is that I don't think we have any business-setting compensation. And for those of you who follow things closely, particularly here with our attorney general here in New York, where on the mutual fund late-trading market timing thing, Attorney General [Eliot] Spitzer insisted as part of the settlement fees— in this case not salaries, but fees— be regulated down. And the SEC proceeds to do that, even in our settlement. And so we're not going to treat one thing by regulating something else.
So I think the SEC is absolutely confirmed, is very firm in the concept of disclosure, disclosure, disclosure, that ultimately will get corporate compensation to where it should be, but they've got to be helped by the compensation committees.
RUBIN: Yes, sir.
QUESTIONER: Tobias [inaudible], with Handelsblat, the German newspaper. How concerned are you about recent turbulences in the hedge-fund world? And might there be a time when regulators have to step in, as they did a couple of years ago?
DONALDSON: Well, good question. Obviously, I personally have felt very strongly about the hedge-funds movement as a place in the financial world— first of all, hedge funds, we need a definition here, because any pool of capital is now a hedge fund. And for those of you— I'll show my age— I mean, one of the earliest clients of Donaldson and Lufkin was A.W. Jones, who invented the whole hedge-funds operation. But I'll tell you back then A.W. Jones & Company was a hedge, and was a pure hedge fund, and very successful. But as you all know, any pool of capital now that wants to do anything is a hedge fund. So that any pool of capital, generally speaking, is being rewarded, the managers of, by two percent of the fee and 20 percent of the profits, or three percent fee and 25 percent of the profits. And that kind of an inducement for compensation is such that we had this mad gold rush into the hedge-fund business.
And if you believe, as I do, that the ability to choose returns that would justify that kind of compensation is going to get people further and further out on thin ice in attempting to achieve those returns, that's why we moved to, for the first time, to register hedge funds. It's a $1 trillion industry now. It's growing like a weed. It has people going into it, many of whom have never managed money before, I mean intelligent people, people with research backgrounds, financial experts, but they never lent money before. And you have them out on thin ice, many of them following the same strategies. I believe it's an accident waiting to happen. And we were severely criticized by the Hedge Fund Association, among others, when we pushed for this regulation and registration.
I want to be very clear. What we're doing is not legislating those funds under the Investment Company Act [of 1940], but under the Investment Advisers Act [of 1940]. And the distinction there is that, under the Investment Company Act, we have the power and the responsibility to regulate concentrations, what you can invest in, et cetera, et cetera, et cetera. We don't have [this] under the Investment Advisers Act. Under the Investment Advisers Act, we are not interested in how much leverage the fund has or what they can invest in or so forth and so on. What we are interested in is, first of all, figuring out who's out there. And if we don't know— nobody knows— the size of this industry. We have no control or no knowledge of the people in it. So we're asking the hedge funds to register under the Advisers Act, which it's some very simple beginning stuff. We'll know about the records, the enforcement records, if you will, of people loaning money who maybe shouldn't be loaning money.
More important than that, you will cause, under the Advisers Act, for there to be accurate accounting in those funds. You'll cause the pricing of those funds to be done fairly, and again, for those of you who run hedge funds, it's hard to talk about these things without condemning everybody. I don't intend to. Some of my best friends are hedge-fund managers. But the temptation to price your securities at month-end or year-end, when you're getting 2 percent and 20 percent, is considerable.
A lot of people, as I said— and by the way, there will be somebody inside the hedge fund who will be charged with being a— an officer charged with obeying the rules and regulations. A simple thing that's been in the mutual-fund industry forever— I mean insider trading or advantaging yourself versus the ones you're managing.
One of the main criticisms of our registering hedge funds has been the people who have enough money to put into the hedge fund [who] don't need the protection of the SEC. You know, a million dollars, or whatever the— there are two different categories. But the point is that there are an awful lot of people out there who have a good chunk of money who didn't earn it in the investment world and earned it by selling their business or their store or whatever, and so they need protection. No. 2, the idea that the SEC only protects one class of investors as opposed to another is silly.
Another criticism has been that you're going to give the hedge-fund industry sort of a good housekeeping seal of approval; "If they're registered, gee, the SEC thinks"— you know, it's a stamp of approval. But of course, that has never been the SEC's standard. The SEC has never made a judgment on why something is a good or a bad investment.
Now I'll make one further comment, because I think it needs to be made. And that is, if you think about it, every time a hedge fund does a transaction, there's another side of the trade. They're dealing with the marketplace. They're dealing with individual investors, they're dealing with pension funds, they're dealing with everybody out there. And we are concerned that the methods being used to achieve those returns should perpetrate a fraud on the market as such.
RUBIN: That was a terrific answer. I think we have reached 7:00 o'clock. Let me just say, having been around the securities industry for a long, long time, I think the hour we just spent with the chairman— I said this before, but I'll say it again— shows you why it is so enormously important to have a chairman who not only is deeply committed to the regulatory purposes of the commission, but understands the industry in the way that this chairman does so that you get practical, sensible solutions or approaches to what are a very complex set of questions. Bill, you were terrific here this evening, and we are very lucky to have you. [Applause]
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