[Senate Hearing 108-611]
[From the U.S. Government Publishing Office]
S. Hrg. 108-611
THE IMPACT OF THE GLOBAL SETTLEMENT
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
ON
THE EFFECTS OF, AND COMPLIANCE WITH, THE TERMS OF THE GLOBAL RESEARCH
ANALYST SETTLEMENT AMONG THE U.S. SECURITIES AND EXCHANGE COMMISSION,
THE NEW YORK STOCK EXCHANGE, NATIONAL ASSOCIATION OF SECURITIES DEALERS
(NASD), THE NEW YORK ATTORNEY GENERAL, OTHER STATE REGULATORS AND TEN
WALL STREET FIRMS
__________
MAY 7, 2003
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
U.S. GOVERNMENT PRINTING OFFICE
95-946 WASHINGTON : 2004
_________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866)512-1800;
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Washington, DC 20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Douglas R. Nappi, Chief Counsel
Bryan N. Corbett, Counsel
Dean V. Shahinian, 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, MAY 7, 2003
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 4
Senator Bennett.............................................. 6
Senator Johnson.............................................. 7
Senator Dole................................................. 9
Prepared statement....................................... 63
Senator Bunning.............................................. 9
Senator Corzine.............................................. 10
Senator Sununu............................................... 11
Senator Carper............................................... 12
Senator Enzi................................................. 13
Prepared statement....................................... 63
Senator Crapo................................................ 13
Senator Dodd................................................. 14
Senator Chafee............................................... 16
Senator Bayh................................................. 63
WITNESSES
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission..................................................... 16
Prepared statement........................................... 64
Response to written questions of:
Senator Sarbanes......................................... 103
Senator Dole............................................. 109
Eliot Spitzer, Attorney General, the State of New York........... 37
Prepared statement........................................... 72
Richard A. Grasso, Chairman and CEO, New York Stock Exchange,
Inc............................................................ 40
Prepared statement........................................... 74
Response to written questions of Senator Sarbanes............ 114
Robert Glauber, Chairman and CEO, National Association of
Securities
Dealers........................................................ 44
Prepared statement........................................... 83
Response to written questions of Senator Sarbanes............ 124
Christine A. Bruenn, President, North American Securities
Administrators Association..................................... 45
Prepared statement........................................... 87
Stephen M. Cutler, Director, Division of Enforcement, U.S.
Securities
and Exchange Commission........................................ 49
Response to a written question of Senator Sarbanes........... 129
(iii)
THE IMPACT OF THE GLOBAL SETTLEMENT
----------
WEDNESDAY, MAY 7, 2003
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:05 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Richard C. Shelby,
(Chairman of the Committee), presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The Committee will come to order.
On Monday, April 28, 2002, State and Federal regulators
announced the settlement of enforcement actions against 10 Wall
Street firms and two individuals. This global settlement was
the culmination of a year-long investigation into conflicts of
interest in Wall Street research departments during the late
1990's.
The court papers that memorialize the global settlement
describe how research analysts were subject to intense pressure
from investment bankers that compromised their independence.
The findings show that the intertwining of analysts and
investment banking has led to a situation in which objectivity
took a backseat to the whims of potential underwriting clients
with ``buy'' recommendations. Research materials have become
nothing more than ``selling tools for investment banking.''
In order to attract and retain investment banking clients,
investment bankers pressured analysts to issue exaggerated
reports that they knew were false or omitted crucial negative
information. Analysts published recommendations that
characterized stocks as ``strong buys,'' while disparaging them
as ``pigs'' and ``dogs'' in private e-mails.
To ensure that analysts remained focused on investment
banking revenues, managers compensated analysts according to
the amount of investment banking business that they generated.
Firms were also paid at the request of a company going public,
to publish research reports in order to create greater market
credibility.
Former Salomon analyst Jack Grubman best described the
banking environment at the time when he declared: ``What used
to be a conflict is now a synergy.''
These cozy relationships helped drive up the stock of
unworthy companies and generated vast wealth for the bankers,
brokers, and their CEO clients. These insiders knew the rules
of the Wall Street game and benefited handsomely. Institutional
investors knew that something was rotten and ignored the
hyperbole.
The only one who was not dealt in on the game was the
``little guy''--that is, the ordinary retail investor.
The little guy invested his wages and retirement savings in
the stock market based on the reportedly objective information
and recommendations provided by brokers and research analysts.
Analysts had too much to gain from inflating stock prices and
issuing favorable research opinions. Therefore, the ordinary
investor who was unschooled in Wall Street's ways, was misled
and lost out.
The issue before this Committee today is whether the global
settlement will reform the culture of Wall Street, restore the
integrity of stock analysts, and regenerate investor
confidence. Although the $1.4 billion settlement produced
record monetary sanctions, I have serious doubts that the
monetary sanctions will have a big impact on Wall Street's
bottom line.
For example, Citigroup agreed to make the biggest payment
of $400 million, but it received $10\1/2\ billion from
investment banking revenues between 1999 and 2001, a monetary
sanction of less than 4 percent of its investment banking
revenues. It is questionable whether such a relatively small
payment will serve as a deterrent to future improper conduct.
I fear that the cost of settlement will be seen as the cost
of doing business. I fear that firms will perform a cost/
benefit analysis and determine that a settlement payment is a
small price to pay for the huge sums to be gained from
exploiting conflicts of interest.
The consent decrees that the firms executed contain the
standard legal boilerplate whereby the defendant neither admits
nor denies any wrongdoing. But in this case, it is particularly
telling. I believe the firms are less than contrite and simply
consider the fines and penalties as a means to put the issue
behind them and move on.
I am concerned that banking executives themselves have
expressed a lack of contrition for their actions. In the last 3
years, we have literally seen trillions of dollars of market
capitalization evaporate.
Millions of investors lost billions of dollars on
investments that were influenced by the euphoric environment
fostered by misleading advice. Despite the overwhelming
evidence of wrongdoing presented in the findings, Morgan
Stanley's CEO is quoted as saying, ``I do not see anything in
the settlement that will concern the retail investor about
Morgan Stanley.''
If executives fail to acknowledge pervasive conflicts of
interest and continue to minimize the sanctions and reforms
mandated by the global settlement, I do not see how the
settlement can have any meaningful impact on the Wall Street
culture.
I believe that the Wall Street culture must change from the
top down, and I am not convinced that the global settlement has
done enough to change attitudes at the top of these banks.
During the bull market, executives were praised for
increasing earnings and producing higher stock prices. A ``cult
of the CEO'' developed as certain CEO's were deemed
indispensable and paid accordingly. As corporate wrongdoings
have come to light, however, many of these superstar CEO's have
escaped culpability for the improper actions they took to fuel
market growth.
Without holding executives and CEO's personally accountable
for the wrongdoing that occurred under their watch, I do not
believe that Wall Street will change its ways or that investor
confidence will be restored.
The SEC enforcement staff has informed the investing public
that we should ``just wait'' as the SEC conducts additional
investigations that may possibly lead to charges against
managers who supervised the research and investment banking
divisions of banks. While I fully understand the need to act
deliberatively and to follow the evidence, I do not believe
that investors can wait too long.
The settlement seeks to minimize future conflicts of
interest by establishing certain structural reforms that the
banks must implement in order to further separate research and
investment banking. Firms must locate research and investment
banking in different offices and create separate reporting
lines, budgets, and legal staffs.
These reforms attempt to better insulate analysts from
intimidation and investment bankers, making it harder for
bankers to pressure analysts for favorable research or to
retaliate against them for unwanted negative reach.
Unfortunately, I do not believe that the structural reforms can
eliminate the conflicts of interest, which seem to be an
inescapable part of the banking marketplace.
Because analysts do not generate their own profits, they
must rely on investment banking revenues to help pay their
compensation. The reforms continue to allow research and
investment banking to operate as divisions within the same firm
and allow analysts to consult with investment bankers on
transactions in a large variety of circumstances.
While these conflicts are being minimized, they will
continue to exist. This cannot be helped, because we cannot
legislate morality or legislate away greed. We can, however,
seek to ensure that the SEC and the self-regulatory
organizations vigilantly police the firms and act to implement
any necessary reforms.
This settlement is the first step in exposing conflicts,
sanctioning illegal conduct and reforming the system, but it
cannot be the last. As a result of the settlement, the
investing public has received notice as to how the Wall Street
game works. Notice, however, is insufficient to restore
investor confidence.
Investors will need proof that markets are once again a
place where they can safely invest their money without the fear
that they are the unknowing victims of a scam.
This hearing is the beginning of the public's evaluation of
the global settlement. The real value of the settlement will
not be known until we see whether the penalties and reforms
mandated by the settlement have changed the behavior on Wall
Street.
The American public has numerous questions regarding the
negotiation of the global settlement, the mechanics of the
settlement, and the process for returning funds to investors
who collectively lost billions of dollars as a result of the
conflicts of interest on Wall Street.
I look forward to the answers to these and other questions
throughout the hearing. I look forward to the testimony of each
of the witnesses.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Mr. Chairman, I want to thank you for
scheduling this very important hearing on the global settlement
in such a timely manner. This may well be one of the most
significant securities settlements in history. It addresses
issues at the heart of our markets and the structure of our
financial system. It responds directly to the exploitation and
manipulation of investor clients by stock analysts and their
firms. It reveals a pattern of conduct that violates
fundamental principles of a security firm's responsibilities to
its clients and systemic conflict of interest within the
industry.
This was not a matter of a few ``bad actors,'' but rather,
it
involved major firms and was a fundamental breakdown in the
system. The magnitude of the abuses disclosed in the global
settlement cannot be overstated. As a press release announcing
the
settlement reads, ``The regulators found supervisory
deficiencies at every firm.'' Every firm.
The documents released by the Commission present a stark
picture of the ways in which individual investors were given
short shrift, or worse, held in contempt by the analysts and
firms on whom they relied for guidance and advice in making
investments. They include references of breathtaking cynicism
about the ``little guy'' who did not understand the ``nuances''
of Wall Street, and ``John and Mary Smith who were losing their
retirement.'' As the Financial Times wrote in an editorial on
April 29, ``It is difficult to imagine anything worse in
business than trusted professionals pushing toxic products at
gullible consumers. That is the shameful picture that emerges
from the evidence published yesterday behind the global
settlement.'' Gretchen Morgenson, writing in The New York
Times, also on the same date, April 29, said, ``Wall Street
firms, in pursuit of investment banking fees, put the interests
of their individual clients dead last.''
These are harsh assessments of our capital markets, whose
high standards of market integrity and investor protection have
traditionally made them the envy for the world. We enacted
reform legislation last year to ensure that our markets would
again adhere to high standards, and deserve the confidence of
investors, and I very much hope that the global settlement will
take us further in that direction. I want to commend the
regulators, especially the New York State Attorney General
Eliot Spitzer, and SEC Enforcement Director Stephen Cutler, for
their perseverance and determination in carrying out their
investigations. They have made a singular contribution to the
public interest.
At the same time, however, it remains clear that much needs
to be done. The issue is not closed. An editorial in The
Baltimore Sun on April 30 observed, ``Wall Street doubtless
hopes this deal marks the last chapter in this debacle. Like
many stock ratings, that is far from the truth.''
Today's hearing gives us an opportunity to focus
specifically on some of the many issues raised by the
settlement, and I look forward to exploring with our witnesses
some of the following questions: How is it possible that the
regulators could have missed for so long the supervisory
problems at 10 of the Nation's top investment firms? What steps
are the SEC and the self-regulatory organizations taking to
prevent a reoccurrence?
Given that supervisory deficiencies were found at every
firm, why have none of the supervisors in any of those firms
been held accountable in the settlement? Can we be confident
that this global settlement will result in lasting change?
Does Wall Street, in fact, care about the interests of the
individual investor any more? Where were the self-regulatory
organizations? How adequate are the self-regulatory mechanisms
on which our securities markets rely? The Director of Investor
Protection at the Consumer Federation of America pointed out,
that we have a whole system in place that is designed to
prevent these abuses, and it is not as though there wasn't
evidence of a problem. Yet, she argues, ``the self-regulatory
organizations took no action until pushed by this
investigation.''
How can the relationships between State and Federal
securities regulators be strengthened so that the States are
given adequate credit for and encouraged to pursue
investigations wherever they may lead?
Given the magnitude of the conflicts of interest that were
exposed, is further independent fact-finding needed to assess
exactly what went wrong and what further needs to be done?
A number of eminent securities lawyers, including Judge
Stanley Sporkin, former SEC Director of Enforcement, Irv
Pollack, former SEC Commissioner and head of the Division of
Enforcement and Market Regulation, and Dean Joel Seligman of
the Washington University School of Law in St. Louis, have
suggested a broad review of our securities markets on the model
of the SEC Special Study of the markets initiated in 1961. And
I urge the SEC to give serious consideration to this
suggestion.
As a number of people have said, this global settlement
marks the beginning and a first step toward restoring investor
confidence in our markets.
Finally, while Chairman Donaldson was confirmed after most
of the global settlement had already been negotiated, I want to
recognize and commend him on his leadership at the Commission
to date. There is a story in the morning paper, titled, ``New
Strength At The SEC's Helm,'' and describing his tenure thus
far, and I commend the Chairman for the actions he has taken.
One thing that I am particularly encouraged is that Chairman
Donaldson seems to ``get it'' in terms of what the crisis of
confidence is that faces us with respect to our capital
markets, unlike, I regret to say, some of the leaders on Wall
Street.
The New York Times on May 1 wrote an editorial, ``Wall St.
Revisionism.'' And it talked about, ``There is a cynical
revisionism taking hold in some Wall Street quarters. The
thesis is that investors have only themselves to blame for
their losses during the stock market, not duplicitous research.
The thesis further holds that little will change as a result of
the settlements reforms.''
And it goes on to cite an op-ed piece that was written by
the head of one of the major firms arguing that regulatory
attempts to remove risk from the marketplace threaten the very
nature of capitalism.
The Times goes on to say, ``As a broad Economics 101
principle, we would agree, hurray for risk. But risk is not
normally defined as embracing deliberate deception by brokers
who twist their research to curry favor with investment banking
clients, thereby abusing investors' trust.''
And it goes on to say, ``This essay is only one of several
signs that Wall Street remains in deep denial about the degree
to which it betrayed investors' trust.''
Chairman Donaldson wrote a very sharp letter to the head of
another major Wall Street firm on that very point.
They have to get with the program. You pick up the paper
every day and we see this drumbeat with respect to whether
ordinary people can put their confidence in these capital
markets.
A crisis of trust on Wall Street. Here's a book review,
``Not Even Fuzzy.'' The author reveals an acute shortage of
math on Wall Street.
Business Week ``Sweeping Up the Street.''
The internal e-mails and memos released as part of the deal
show a callous disdain for individual investors that goes
beyond anything revealed to date.
Those who said that Wall Street's problems stem from just a
few bad apples are now confronted with proof that the
corruption of the financial system was systemic and did serious
harm to America's equity culture.
Many retail brokers protested that the analysts's reports
on telecom and dot.com companies were deliberately misleading
their clients and causing them to lose large amounts of money.
These protests went to senior managers who chose to ignore
them.
And finally, ``If the people on Wall Street cannot be
sensitized to what is happening, then obviously, the regulators
are going to have to sensitize them in any event. But, surely,
they need to awaken.''
This is from The New York Times Book Review: ``Business
Ethics and Other Oxymorons''--business ethics and other
oxymorons.
Three books about hubris, greed, corruption, and
incompetence. And yet we have this denial. I just want to close
this out by--sometimes the message is told effectively in these
political cartoons.
This is Wall Street talking to I guess the ordinary
investor. This was out of Newsday.
Remember how ``buy'' secretly meant ``hold'' and ``hold''
meant ``sell?'' Then he says, ``Well, now `buy' actually means
`buy' and `sell' means `sell.' '' And then the ordinary
investor says, `` `Buy' means `buy' and `sell' means `sell?' ''
Right.
And then he says, ``Boy, that's confusing.''
[Laughter.]
Chairman Donaldson, you have a big job ahead of you there
and we wish you the very best as you pursue it and we are
looking forward to hearing from you this morning and also from
the panel that will follow, Attorney General Spitzer, Bob
Glauber from the NASD, Richard Grasso from the New York Stock
Exchange.
We also have the head of the State securities
administrators, Christine Bruenn from Maine.
Thank you very much.
Chairman Shelby. Senator Bennett.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you, Mr. Chairman. I won't go back
over the ground that you and Senator Sarbanes have already
covered. But I do have one thought which probably will not
produce any testimony here today, but which Chairman Donaldson,
I would hope somebody, somewhere in the bowels of the SEC can
do a study on and help me out with as you go through this
rather sorry chapter in American history.
Around here, we spend a lot of time talking about the
markets, and particularly about the Dow and how the Dow used to
be at 12,000 and then it fell to 7,000, and whose fault that
was.
And usually, we try to assign the blame, on the basis of
which political party we are in and which political party the
target is in, on whom we wish to put the blame.
It occurs to me as I go through this and listen to this
analysis, that maybe there is a possibility of assessing where
the Dow actually should have been as a measure of the value of
corporate America if you can back out that portion that can be
attributed to the phenomenon just described by Senator
Sarbanes.
In other words, an artificial inflation. If we had not had
the artificial inflation of values coming by virtue of these
analysts, would the Dow in fact have been at 10,000 rather than
12,000?
I am just picking numbers out of the air. I have no
empirical basis for picking those numbers.
But as we try to analyze the effect of all of this, is
there any way that it can be quantified or come close to
quantifying it, so that if we decide that we really are at the
position that Senator Sarbanes' cartoon suggests, that buy now
means buy and sell now means sell, and the market is now, we
hope, responding to accurate analysis, is there any way that we
can adjust for not typical inflation in the economic term, but
adjust for analyst inflation, to say that the fall of the Dow
is not from 12,000 to 7,000, but adjusted for analyst inflation
number that was 10,000 or 11,000 or whatever?
Or if we decide that in fact, without the analyst's
inflation of expectations here, the Dow would have gone to
12,000 anyway, that would be a useful piece of information to
have if indeed it is discoverable.
Now in the Iraq war, we have learned from Secretary
Rumsfeld's vocabulary, one of his favorite words is unknowable.
We keep asking him questions in our secret briefings and very
often, the answer is--that is unknowable.
And it may be that what I am asking for here falls into the
category that Secretary Rumsfeld would label as unknowable.
But, if anybody can come up with a study of what really
happened to the overall valuation of America's listed
corporations as a result of the analyst actions, I would very
much like to get my hands on that number.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Johnson.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. First, welcome to Mr. Donaldson.
Chairman Shelby and Ranking Member Sarbanes, I want to
thank you for holding today's hearing on global settlement
which was finalized, of course, just this last week.
Millions of American investors relied on what they believed
to be an objective investment advice from at least 10 of this
Nation's largest Wall Street firms.
As we know, in far too many instances, this advice was
tainted. These firms weren't looking out for their retail
customers. They were looking our for themselves.
Investors who understood that investment risk is an
essential part of our market assumed that that risk was going
to be taken in the context of integrity, and they were wrong.
The integrity was not there.
Now it is important to note that the majority of the
workers on Wall Street are honest. They are honest actors, but
all of whose reputations are now tarnished by association.
Time will tell whether the structural reforms and the
global settlement will reduce such outrageous violations in the
future. But it troubles me that an industry that is based on
self-regulation was so late to the game in turning itself in.
One reason our system works is because, at least in theory,
firms understand the need to maintain their reputations.
Without the trust of their clients, full-service Wall Street
firms have little to offer. The Sarbanes-Oxley bill, which we
passed last year, is a great step forward. And I cannot let
this moment pass without acknowledging the extraordinary
leadership of Senator Sarbanes on that issue.
In addition, I am pleased that the agencies before us have
recently increased their activity to address the lack of
confidence that American and foreign investors now have in our
markets.
The reality is, however, that our economy continues to
falter. No matter what the White House might say, it is clear
that Americans have not pulled out of the stock market because
they do not like paying tax on their dividends. They are
staying out of the market in large measure because they have no
confidence that our system rewards honest business practices.
They believe in too many instances that the fix is on, that
this is not a capitalist market. It has been too much a robber
baron market.
Thanks to Attorney General Spitzer, we have proof that Wall
Street firms spent far too much time trying to dupe their own
clients for short-term gain. And what they have learned, I
trust, is that the long-term consequences far outweigh what
immediate benefit they thought they were gaining from such
unethical behavior.
The Administration should take a lesson from the global
settlement. Short-term greed is bad business. While some people
may be fooled by slick sales tactics, eventually the truth will
catch up. And when the American people realize that our
problems relative to Wall Street, relative to budget strategies
that we face this week will lead to dire long-term
consequences, I think there will be a price to be paid.
But I thank the Chairman for this hearing. This will be a
very valuable contribution to the debate, and hopefully, this
will lead to still further restoration of a sense of integrity
and public confidence in what once was regarded as the world's
greatest market.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Dole.
COMMENT OF SENATOR ELIZABETH DOLE
Senator Dole. In the interest of time, I will submit my
statement for the record, Mr. Chairman.
Chairman Shelby. Without objection, it will be made part of
the record.
Senator Stabenow--she's gone.
Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman. Thank you for
holding this very important hearing. I would also like to thank
our witnesses for testifying today.
As we all know, there has been a great deal of uncertainty
in our equity markets. The retail investor has been especially
hurt by the actions of a few, greedy criminals. Some of these
criminals were on Wall Street, some in Houston, some in
Mississippi, and others all over the country. We have had
problems on a much smaller scale in Kentucky as well. Greedy,
sweetheart deals have fleeced billions out of our economy and
it has not recovered from the damage.
We desperately need to restore investor confidence. Over
half the households in the country own stocks. But the average
investor is sitting on his money. They are keeping it in
savings accounts, buying safe government bonds, and I would
guess some are even hiding it in their mattresses. It is fine
that Americans are putting their money in less risky
investments, such as IRA's, CD's, T-bills. I would, however,
caution against mattresses. It is good to diversify your
investments, but we need to get people investing back in the
equity markets. To achieve that, investors once again have to
believe in the equity markets. I believe this global
settlement, along with the passage of Sarbanes-Oxley and the
aggressive--I say aggressive--prosecution of corporate
criminals is another step in achieving that confidence.
I am deeply worried about this economy. We have had some
growth, but no new jobs are being created. We need to increase
investment. Increasing investment creates capital, capital
creates jobs. This is also why we must pass a real stimulus
package. We must create jobs immediately.
As my colleagues on the Committee know, I worked in the
securities industry for over 25 years. I can assure you there
were no Chinese walls, firewalls, stonewalls, Berlin walls, or
any other kind of walls when I worked in the industry. That was
in 1961 when I started.
One side knew exactly what the other side was doing at all
times and there was no prosecution and there was no
investigation in 1960, 1970, 1980, and finally in the year
2003, we finally got some action.
Maybe a junior associate had a copy of Pink Floyd's ``The
Wall,'' but that would be as close as we came. If someone was
doing an IPO, everyone in the firm was aware of it. It is my
hope that this settlement will construct real walls that keep
different divisions of businesses separate. The investment
banking division cannot--I say cannot--influence the analysis
division.
I hope this independent research fund will truly be
independent. It is critical for our investors' confidence.
Investors must know that they are getting sound advice and not
just being told to buy in order to inflate the price of a stock
that the other side of the firm is pushing. Confidence must be
restored. If investors do not have confidence, they will not
come back to the market.
I think we need this oversight hearing to see if this
agreement will work. If it doesn't, we can always come back and
revisit it. But I think right now, the markets need to be able
to sort this agreement out and implement it. We need to see if
it works. If it doesn't, there will be ample time to fix it.
We all know that firms have paid out large penalties. I am
sure that some will argue too much. And I have heard some argue
way too little. But the firms who have been guilty have been
hurt much more by investors pulling out of their firms. The
markets are punishing them. That is why we have agreed to these
steps. They, more than anyone, know that confidence must be
restored.
Once again, Mr. Chairman, I want to thank you for holding
this important oversight hearing. We had this oversight hearing
in Government Affairs last year and got the same answers from
the Wall Street firms last year that I am afraid if we brought
them in this year, they would give us the exact same, that they
were totally separated and all of a sudden we find out now,
$1.4 billion later, that they weren't totally separated.
Thank you.
Chairman Shelby. Senator Corzine.
STATEMENT OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman, and Ranking
Member Sarbanes. I compliment you on holding this hearing. It
is one of obvious importance, as evidenced by a terrific set of
witnesses we have assembled. It is more important, though,
because of the need to restore investor confidence and redress
the wrongs that have obviously been revealed through the
investigation.
It goes without saying that I think all of us are deeply
appreciative of the focus and effort that all of the
individuals here today and others and their staffs have put in
to developing the global settlement and the resulting
enforcement actions.
Each of the regulatory bodies represented here, the SEC,
New York Stock Exchange, NASD, State securities regulators, as
well as the New York State Attorney General's office, are to be
commended for the serious and responsible manner with which
they sought to address the failure of market participants to
properly manage and disclose conflicts of interest by research
analysts, a failure that led some to engage in deceptive, if
not fraudulent, business practices that worked to the serious
detriment of investors.
Regrettably, firms and individuals in the investment
banking industry, one that I will note that I was a member of
for the better part of 30 years as well, allowed themselves to
step on to the slippery slope of irrational exuberance.
Ultimately, that slope led down a path where business
decisions reflected infectious greed as much, if not more so,
than the interest of the client.
In my life, I have met and worked with thousands of men and
women employed in the financial markets and I have no doubt
that the vast majority are honorable, hard-working individuals
who add value to our markets, our economy, and to our Nation.
Regrettably, this hearing is about the individuals and the
organizations that chose the wrong path--those who abused the
public trust, those whose missteps undermined the integrity of
our markets and caused harm to unsuspecting investors.
This hearing is appropriately about the vigilance of
Federal, State, and other regulators who sought to bring an end
to egregious conflicts and the penalties for those who engaged
in them, and it is about redressing the financial loss of those
who are harmed. I compliment those who have worked on this
effort.
This settlement is a very significant step in redressing
the banking and securities industries' missteps of the late
1990's and restoring public investor confidence. It is an
acknowledgement that
investors were harmed by undisclosed conflicts and mismatches
of published versus actual opinion.
Investors should be aware of the honest risks of investing.
The market risks have true valuations, corrections, and
business dips. Sarbanes-Oxley was, to its positive
contribution, an important step in addressing those issues. But
investors do not and should not, however, be forced to accept
the risks of a stacked deck. That is what this settlement is
about and I compliment those who have put it together.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Sununu.
STATEMENT OF SENATOR JOHN E. SUNUNU
Senator Sununu. Thank you, Mr. Chairman.
Welcome, Mr. Chairman. I appreciate the fact that you have
taken the time to put together a hearing that delves into the
details of this global settlement and I will submit my written
statement for the record. But I did want to highlight two
points.
The first is, with regard to the settlement.
I think it is important to recognize that we are embarking
on new territory in establishing an investor restitution fund.
It was one of the most important pieces of the Sarbanes-Oxley
legislation last year. It set up that fund to make sure that
when there are fines or disgorgements, that we find a way to
get that money back to investors.
And I will be interested to hear from our various panelists
the ways and the mechanisms through which we intend to see that
that happens.
We have the Federal fund. We are going to be providing a
lot of this money back to the States. The States aren't
necessarily prepared to handle these payments in a way that
ensures that they get to investors. Different States have
different rules and regulations. And while I think it is
appropriate that there be restitutions or the fines, penalties,
disgorgement paid back to the States, I think we want to look
at the details of what is going to happen, not just at the
Federal, but at the State level, to make sure that those
investments see some return or some benefit from such an
important settlement.
Second, I want to encourage a little bit of perspective
here.
This is a very important settlement. It is impressive to
see the level of cooperation by the SEC, the State of New York,
the New York Stock Exchange, the NASD, and a lot of others to
make this settlement happen.
It is a very complex settlement. It deals with important
violations of the law, fraudulent behavior and ethical lapses.
And I think for anyone to draw a comparison somehow for
political purposes to the current budget debate, where we have
legitimate differences of opinion and tax and spending issues
that we are asked to deal with every day, is not just a little
disingenuous. But I think it is taking a step that is
unnecessary and that adds a lot of coarseness to the debate of
issues other than the legal framework and the settlement that
is at hand.
So, I hope we can focus on the value that has been provided
through the settlement, the opportunity that exists in the
settlement, and of course, focus on holding those who have
broken the law, who have engaged in fraudulent behavior
accountable.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Carper.
STATEMENT OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman. To our witness and
the other witnesses who follow, we thank you for being here.
Those of you who have worked to bring us to this point
today, thank you for your efforts and for your stewardship.
I do not have a long statement. I do have a couple of
questions that are on my mind and perhaps on the minds of some
of our colleagues. I just want to mention a few of those,
starting with you, Mr. Donaldson, at the SEC.
One of the questions that I will be interested in is how
will the SEC provide to make permanent the pact that has been
negotiated? Do you have the resources to do so? How long is
that likely to take?
I think in the global settlement, a couple of analysts have
been barred from working in the securities industry for life. I
am interested to know, are there likely to be others? Are there
likely to be actions brought against senior officials within
the companies that have been named or other companies that have
not been named?
I have some interest in the after-tax costs to those that
have been named in these settlements. What kind of benefit will
they gain from the tax code. Is there anything that we should
consider doing with respect to the tax code as a result of
that?
And finally, I understand that the amounts of monies that
may be involved in the class-action lawsuits brought against
some of these companies are far greater than the monies that
are involved in this global settlement. And I would be
interested in knowing what is the likelihood that some further
punitive actions will be taken in the costs incurred by the
companies that have been named, or others in the industry?
Those are some of my questions that I look forward to
asking and I hope we will hear some answers.
Thanks, Chairman Shelby.
Chairman Shelby. Senator Enzi.
COMMENTS OF SENATOR MICHAEL B. ENZI
Senator Enzi. Thank you, Mr. Chairman. I appreciate your
holding this very important hearing. And to expedite it, I
would ask that my complete statement be a part of the record.
Chairman Shelby. Without objection, your statement will be
made a part of the record.
Senator Enzi. Thank you. And then I can concentrate on just
one small part, which is the bill that you and I have
introduced to streamline the process for getting certain key
employees.
We have asked that there be an expedited process so that
CPA's could be hired as easily as lawyers to be able to do the
enforcement process that is necessary. It is held up in an
extremely complicated process. We are trying to streamline
that. And I hope that everyone here will help that piece of
legislation to go forward or to include it in something else so
that we can get that done and get some of the enforcement
expedited.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman. I will be
brief also.
A number of the Members of the Committee, both Democrat and
Republican, have clearly identified the problem and indicated
how strongly they feel about it, and I share their concerns.
My focus today in the hearing is going to be on whether we
have solved the problem and what we need to do from here to
make sure that we have.
Consumer confidence has been raised by a number of people
and, clearly, that is the end result that we want to achieve
here. We want to have that strong market that America is proud
of and we want to make sure that Americans can really be
confident in that market so that they can start making the
kinds of investment decisions that will help bring us back to a
strong recovery.
We all know the parade of events that have occurred over
the last few years that have seemingly, repeatedly shocked the
confidence of the American people in our markets. And just as
we get to the point where we think, okay, maybe we are going to
be able to start recovering now, we have yet once again another
shock.
Last year, we dealt with the issues raised in Sarbanes-
Oxley to make sure that the financial information which listed
firms are reporting is accurate. And now we are dealing with
the question of whether what is done by analysts and investment
firms with that financial information is accurate or
manipulated.
And it seems that in one context of another, we continue to
have these hits, which I believe it is this Committee's
responsibility and duty through these oversight hearings to
evaluate and make certain that we deal with correctly.
We want to make sure that we have the correct statutory and
regulatory systems and procedures in place, and the correct
self-governing procedures in place to make certain that these
kinds of things do not continue to happen.
I am also going to be interested as we go through the
hearing to be looking at the remedy side of things. Has there
been a complete disgorgement of illicit profits obtained? Or is
it going to turn out that after all we are doing and saying and
talking about this $1.4 billion figure and so forth, that it
still would be profitable to engage in the activities that are
the issue of the day.
And if that is the case, and I realize that we have class
action lawsuits that may be another aspect of this. But if it
is the case, that it is still going to be profitable to engage
in this kind of conduct when the day is done, then I do not
think we have done our business and we need to pay attention to
the remedy here as well.
A number of us, Senator Bunning most eloquently, have
talked about the concept of independence or, as he put it, the
walls that need to be established.
I am going to be looking to see whether we have truly put
into place and are headed toward achieving the kind of
independence and the kind of analysis of financial information
and the recommendations that are made with regard to the stocks
that are traded, that make it clear that that advice can be
relied upon, and whether it is a Chinese wall or whatever other
kind of wall, that that independence is firmly established.
There are a number of other remedy issues as well. But as I
said, Mr. Chairman, my focus today is going to be on making
certain that we do our part to be sure that the statutory, the
regulatory, and the self-governing systems that need to be in
place are in place, and they are effectively enforced, that the
incentives for taking profit out of this kind of conduct are
removed, and that we do everything that is necessary to restore
the confidence throughout the world in our markets.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Dodd.
STATEMENT OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you, Mr. Chairman.
First of all, let me join my collegues in thanking you, Mr.
Chairman and Senator Sarbanes, for holding the hearing today.
I know that, normally, having a lot of opening statements
here delays this process. But I think it is important today and
I want to commend my colleagues on both sides here for their
comments.
The point that Senator Sarbanes made, Senator Shelby has
made, and others have made from the outset about the issue of
confidence is the most critical issue for all of us here.
The fact that Democrats and Republicans here can oftentimes
disagree about various things, are expressing a common sense of
outrage from this side of the dais, I think is important.
And so I apologize to our witnesses for taking a little
time, but I think in the interest of trying to mobilize the
kind of action that you are hearing from those of us up here is
critically important.
So, I appreciate, Mr. Chairman, you are giving each of us
the opportunity to be heard. Although this is taking a little
time, I think it is worthwhile.
Second, I want to join my collegues in thanking to those
who have been involved in this settlement, putting this all
together and the work that they have done.
But I want to join in expressing some deep concerns on how
this is viewed and what happens now. I am still interested in
the issue of the settlement itself. I am particularly
disturbed, I will tell you, when I find that about a third of
this $1.4 billion is actually a penalty. Two-thirds of it may
be tax-deductible or may be covered by insurance.
In a sense, we may be talking about $400 million plus that
is actually a penalty and the rest of it may be subsidized by
American taxpayers, in a sense, by allowing it to be written
off.
And if that is the case, then there is going to be a
stronger sense of outrage and this may turn out to be not quite
as important as first thought.
We have lost $5 trillion in lost capitalization in the down
market--$5 trillion--a lot of which was lost as a result of the
point that has been made here this morning, as a result of
people having no confidence in this market, whether they put
it, as Senator Bunning has suggested, in a mattress or some
other place.
Whether you want to attribute a half of that or a third of
it, whatever else, the fact is there has been a lot more lost
than even remotely comes close to the penalty we are actually
talking about here, and that is a matter that I am going to be
very interested in pursuing with our witnesses.
But certainly, the settlement does, as has been said by
Senator Sarbanes and others, represents a failure of the
Securities and Exchange Commission. It represents a failure of
the State securities regulators. It certainly represents a
failure as well to the self-regulatory organizations, as others
have pointed out. To some extent, it represents a failure of
those of us sitting on this side of this dais.
We want to point the finger of blame in a sense of who
dropped the ball--part of it was dropped here, as an oversight
committee. So all parties, in my view, both regulators,
certainly the 10 firms involved in the settlement may want to
put this chapter and ugly history behind them, and I would
understand that.
However, I believe that this hearing and the testimony that
we receive today is merely the start--or I hope it is, anyway--
of renewed vigilance in restoring the trust that the American
people have lost in the securities industry.
We should expect more from the leaders of the financial
services industry. Investors certainly deserve a lot more, and
the future success of our economy will depend upon it in many,
many ways.
There has been much written and said about the conduct of
the 10 firms who are the subject of this investigation. And
while some practices may only skirt and not overtly violate
securities laws, they are nevertheless fundamentally dishonest.
And I, like many others, are surprised that the pervasive
misconduct has yielded only a few individuals being barred from
the industry.
I am hopeful that the ongoing investigations will lead to
the appropriate prosecution of bad actors. Certainly removing
the most egregious violators in this area is just part of the
answer. We must fundamentally evaluate as well and change
standards and change the codes of conduct acceptable in this
industry.
In truth, this settlement may raise nearly as many
questions as it answers. I certainly have concerns that the
structural reforms initiated by the settlement may not go far
enough. And I am concerned that the evidence of only a few
clear-cut violations of our security laws indicate that we must
ask if further statutory guidance is needed to prevent against
future malpractice of this kind.
Amazingly, some have tried to characterize this issue as
the simple result of unhappy retail investors who have lost
money in the downturn in the markets. It is my fervent hope
that those in industry truly understand the depth of mistrust
that their actions have caused.
This Congress and the regulators who appear before us today
must be prepared, in my view, to ensure that understanding. It
is during times of down markets when investors most need the
protections afforded by our securities laws and regulations.
This is fundamentally why the world comes to our U.S.
markets to invest--the belief that in good times or in bad, the
process in the United States is fair and it is transparent.
More than ever, investors have a greater mistrust and
insecurity about the advice provided to them by financial
experts.
I do not blame them. Collectively, we have a difficult road
before us in restoring the integrity of the marketplace. And
this global settlement is the first step in that journey.
So, again, Mr. Chairman, I thank you and Senator Sarbanes
for having the hearing.
Chairman Shelby. Thank you.
Senator Chafee.
COMMENT OF SENATOR LINCOLN D. CHAFEE
Senator Chafee. Pass. Thank you, Mr. Chairman.
Chairman Shelby. Chairman Donaldson, we welcome you again
to the Committee. We appreciate your indulgence, but we believe
that this, as has been said, is a very important oversight
hearing.
Your written statement will be made a part of the record in
its entirety. You can proceed as you wish.
STATEMENT OF WILLIAM H. DONALDSON
CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Chairman Donaldson. Chairman Shelby, Ranking Member
Sarbanes, Members of the Committee, thank you for inviting me
to testify today concerning the recently announced global
research analyst settlement among the Commission, the New York
Stock Exchange, the NASD, the New York Attorney General, other
State regulators, and 10 Wall Street firms. I appreciate having
the opportunity to discuss this important subject with you.
Last weeks' unified actions brought to a close a period
during which the once-respected research profession became
nearly unrecognizable to earlier generations of investors and
analysts.
As many of you may know, I helped found an investment firm
that bore my name and which was originally dedicated to
research. For that reason, I spoke very personally when I said
last week, and I will say again today, that I am profoundly
saddened and angry about the conduct that is alleged in the
Commission's complaints.
There is absolutely no place for it in our markets, and it
cannot be tolerated.
To impress upon the firms the seriousness with which we
regard their misconduct and to help restore investors' faith in
the objectivity of research, the global settlement employs a
multipronged approach, including both monetary and nonmonetary
forms of relief.
The monetary relief is substantial, totalling, as you know,
$1.4 billion. Collectively, the 10 firms will disgorge illegal
proceeds of nearly $400 million and pay well in excess of $400
million in civil penalties.
I am pleased to note that the penalties alone are among the
largest ever obtained in civil enforcement actions under the
securities laws. The $150 million penalty imposed against one
firm is the largest ever imposed in an SEC action.
I am confident this enforcement action delivers a message
that the firms won't soon forget. Moreover, the Commission is
continuing to investigate roles played by individual security
analysts and their supervisors.
The Federal regulators--the Commission, the NASD, and the
New York Stock Exchange--will place their share of the
penalties and disgorgement, approximately $400 million, into a
Distribution Fund for payment to harmed investors.
While there are challenges and difficulties in
administering such a fund, the Commission feels strongly that
those challenges and difficulties are worth taking on and that
any funds paid by the settling firms should be used to
compensate the investors harmed most directly by the misconduct
uncovered in our investigations.
We believe this is the right thing to do, and it is
consistent with the message sent by Congress when it recently
authorized us to use penalties to repay investors.
Although the monetary relief secured in the settlement is
substantial, unfortunately, as many of you have noted, the
losses that investors suffered in the aftermath of the market
bubble that burst far exceeds the ability to compensate them
fully. They can never be fully repaid. Their loss was more than
monetary, in my view. It is a loss in confidence and the loss
of the hopes and the dreams that built up over a lifetime.
And, although the monetary relief obtained in the
settlement is record-breaking, the structural reforms required
by the settlement are, in my view, more significant and far-
reaching.
The numerous obligations we impose on the defendants, taken
altogether, will fundamentally change the role and perception
of research at Wall Street's firms. Indeed, I believe these
reforms will go a long way toward restoring the honorable
legacy of the research profession.
Let me just take a moment to highlight a few of the most
meaningful among them.
In order to eliminate the conflicts that arise when the
banking function has the opportunity or means to influence the
objectivity of research analysts, the settlement first requires
firms to have separate reporting and supervisory structures for
their research and banking operations.
Second, it requires that research analysts' compensation be
totally unrelated to the investment banking business, and
instead, be tied to the quality and accuracy of this research.
Third, it prohibits investment banking personnel from
evaluating the performance of research analysts and requires
decisions concerning compensation of analysts to be documented
and reviewed by an independent committee within the firm.
Fourth, it prohibits research analysts from soliciting
investment banking business or participating in so-called road
shows.
And, fifth, it prohibits communications between firms'
research and banking operations, except as necessary for an
analyst to advise the firm concerning the viability of a
proposed transaction.
The settlement also imposes several disclosure requirements
that will benefit investors by providing them with better
information concerning the limitations of research. An
additional innovative and forward-looking aspect to the
agreement is the requirement that firms purchase independent,
third-party research for their customers over the next 5 years.
Each firm must retain an independent research monitor, in
consultation with the regulators, who will oversee this process
to ensure the research is independent, of high quality, and
useful to the firm's various customer bases.
To better arm investors to cope with the risks inevitably
associated with participating in the capital markets, the
settlement also provides for the establishment of an investor
education fund of some $80 million.
The Federal portion of this fund will support educational
efforts addressed to a broad range of issues associated with
informed investing.
The research analyst cases reflect a sad chapter in the
history of American business, a chapter in which those who
reaped enormous benefits based on the trust of investors
profoundly betrayed that trust.
They also are an important milestone in our ongoing effort
to address these past abuses and to shore up investor
confidence and public trust by making sure that these abuses do
not happen again.
I cannot close without noting, however, that as significant
as the global settlement is, it is but one of a broad range of
activities and initiatives that the Commission is undertaking
to restore investors' faith in the fairness of the markets.
We are starting to see a positive change in conduct and in
attitude because of these efforts. Auditors, board members,
corporate officers, and others are bringing a greater diligence
and sensitivity to tasks that were previously treated as
routine or insignificant.
Nevertheless, recent remarks by some business leaders and a
proxy season of disclosures of compensation packages that bear
little relationship to managerial performance, lead me to worry
that some, as you said, Senator, just do not get it.
While I certainly hope and think that many do get it, let
me say very clearly, we are not just going to assume that Wall
Street or the business community gets it.
We are going to be vigilant. We are going to be watching
for compliance, not only within the terms of the settlement,
but also with all statutory and legal requirements. And
importantly, conformity with the spirit of the need for reform.
Where somebody crosses over the line, we will act swiftly and
decisively to bring that person to justice.
As we persist in our efforts to restore investor
confidence, be assured that the Commission will continue to
move forward on multiple fronts, to aggressively combat
financial fraud, to keep a close eye on practices on Wall
Street, to oversee the start-up of the Public Company
Accounting Oversight Board, and to implement the Sarbanes-Oxley
Act, to mention just a few of our priorities.
Thank you for inviting me to speak on behalf of the
Commission, and I would be happy to answer any questions you
may have.
Thank you.
Chairman Shelby. Thank you, Chairman Donaldson.
Mr. Chairman, in the settlement papers relating to Salomon,
Smith, Barney, and I use them by way of example only here,
there are references to hundreds of e-mails from the Salomon
retail brokers that criticize Grubman's conflict of interest.
For example, one e-mail states, ``Investment banker or
research analyst? He should be fired.''
And another one reads, ``Grubman has made a fortune for
himself personally and for the investment banking division.
However, his investment recommendations have impoverished the
portfolio of my clients and I have had to spend endless hours
with my clients discussing the losses Grubman has caused
them.''
These e-mails were sent to Salomon's management as part of
Grubman's annual reviews. Management knew of the dilemma
produced by Grubman's involvement with investment banking.
If these abuses were so widespread, as we found out, Mr.
Chairman, how is it that the regulators failed to catch them
until so late in the day? How could the regulators miss such a
systemic problem on Wall Street?
Chairman Donaldson. That is a good question, Senator. I
think that the bottom line is that there is enough blame to go
around for all of us in terms of what is happened in the last
decade, and particularly the last 5 years.
I think there has been a general erosion in ethics, and I
think there has been a general erosion in----
Chairman Shelby. There might be a lot of blame to go
around, but everybody wasn't cheating and stealing.
Chairman Donaldson. Well, I do think that the detection of
some of these instances could have been sooner. And I think
that I am as horrified by some of the e-mails you cite.
And I can assure you that from this day forward, the
vigilance of our Commission will be there in spades.
Chairman Shelby. Mr. Chairman, as many of us noted during
your confirmation hearing, you bring a great deal of experience
and knowledge of the securities markets, an industry that you
now oversee. I think that that is a real plus for you.
And as a veteran of Wall Street, you built your own firm on
the strength of its research. What can you tell us about the
conduct sanctioned in this settlement? Do you really think that
this type of behavior was a common practice? How long has this
conduct been going on, in your own judgment?
I know too long.
Chairman Donaldson. Too long is the simple answer. But I
think that if you want to trace the history, I think that with
the elimination of fixed minimum commissions back in 1975----
Chairman Shelby. Is that the beginning?
Chairman Donaldson. --the wherewithal to pay for research
was substantially reduced. Research departments turned to
become the handmaiden of the investment banking business.
So the beginnings of this go way, way----
Chairman Shelby. That is the roots.
Chairman Donaldson. I think that is the root cause. As time
went on, the actual payments, if you will, for the research
department becoming the handmaiden of the investment banking
side of the business were considerable.
Chairman Shelby. How can the SEC under your jurisdiction
and your leadership change the examination and compliance
programs in order to discover and to investigate these types of
securities law violations in the future?
Chairman Donaldson. Well, in terms of the global
settlement, you can be sure that we will be monitoring
according to the terms of the settlement the various devices
that have been installed to separate research from the
investment banking business.
My own feeling is, if I can editorialize a bit----
Chairman Shelby. Sure.
Chairman Donaldson. --that the quality of research, aside
from the malfeasance inherent in those cables, the quality of
research deteriorated over the years because it really wasn't
research, as many know it. It was statistical reporting and
cheerleading.
My hope is that with the research monies being put into the
outside independent fund, and the return of, hopefully,
research to its roots, we will see research that is really
worth something.
Chairman Shelby. Mr. Chairman, the monetary sanctions here
equal a fraction, just a fraction, of the vast sums that
investment banking firms generated during the late 1990's.
In light of the relatively small monetary penalties, small
considering the profits, do you believe that the settlement
truly punishes Wall Street for its wrongdoing?
I know it punishes it some. But Senator Dodd raised the
question earlier, who's going to pay for this settlement? Is it
going to be punishment or are they going to be compensated for
it through insurance? Is some of it going to be deductible and
so forth?
I think it was a very good observation.
Chairman Donaldson. I think the sentiment you are
expressing is on a number of people's minds. Let me give you my
reaction.
Number one, I think that you cannot dismiss the fact that
these are the largest fines that have ever been given.
Number two is that this is not the end. This is just the
beginning. We have come against these firms and in two
instances, against specific analysts. But very much on our
agenda is the whole area of supervisory responsibility. And we
intend to pursue that as the days and months go on.
Number three is there is considerable civil liability out
there in terms of the courts and the people who have been
wronged and their access to arbitration and so forth.
I suspect that you will see--this is not a prediction --but
I suspect that you will see sums of money that will be
attributed to this that perhaps exceed the penalties being
paid.
And finally, in my view, not least, the cost in reputation
that these acts have brought forth is incalculable in terms of
the damage done to these institutions and the years and monies
that were spent to establish their reputations.
I think that is maybe the greatest cost to some of these
firms.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Chairman Shelby.
Chairman Donaldson, I was struck by the phrase you just
used in responding to Chairman Shelby when you said, ``This is
not the end, this is just the beginning,'' describing the
settlement and so forth. I think it is extremely important that
that be understood. This is in a sense a very large first step
along the way of getting to where we have to go, and I wanted
to ask you about just a couple of aspects of that.
First of all, the SEC, of course, is involved in putting
into place a regulatory structure now that responds to the
situation with which we are confronted.
You have issued a number of rules. The self-regulatory
organizations are addressing the problem. Actually, the
Sarbanes-Oxley Act requires that by July 30 of this year,
regulations be promulgated with respect to stock analysts and
their conflicts.
What is the Commission's thinking as it moves ahead in
terms of harmonizing and rationalizing a comprehensive set of
rules that apply in this area, which of course is, in a sense,
almost the foremost responsibility of the Commission?
Chairman Donaldson. Right. I would say two things, Senator.
Number one is that we are very much in the process of
gearing up, if you will, to review the rules and the
regulations already on the books, gearing up to take a look at
what new rules have to be written.
I think the issue is one of where those rules reside, for
example, we also have the self-regulatory rules that we oversee
and the disposition of those rules as between the self-
regulatory organizations and ourselves is very much on our
minds.
And two, we will obviously conform to the requirements of
the Sarbanes-Oxley Act. But we are clearly in for a rulemaking
review looking at the settlement and based on the experience we
have going forward.
Senator Sarbanes. I urge the Commission to go forward. I
know in your statement that accompanied the global settlement,
and you said, ``The Commission intends to review the
implementation of the settlements, along with reforms adopted
by the Commission and the NASD and New York Stock Exchange over
the last 2 years to evaluate whether additional harmonizing or
superceding rules are appropriate.'' We need to get a full
comprehensive set of national rules that then become the
reference point for people that are in the industry, and I urge
you on in that effort.
Let me ask, coming down to the individual level, Business
Week, on May 12, in an editorial stated, ``Many who failed at
this task of supervising fairly and properly were not held
accountable in the settlement and remain in charge. It is now
up to the SEC to follow up and ensure that Wall Street is led
by people with integrity.''
This is in an editoral titled, ``Sweeping Up The Street.''
Where are we on that issue about addressing further
individuals for their conduct and holding them responsible?
Chairman Donaldson. Well, as I said, the central thrust of
the settlement was on malfeasance by the firms themselves. The
ongoing actions by the SEC will be directed toward the
supervisory chain of command, if you will, and by the
individual malfeasors.
We have new resources thanks to all of you in terms of our
additions of people and systems so that we can double our
efforts, if you will, and we plan to do just that.
We will have more aggressive examinations than we have ever
had. We will have continuing reviews of compliance. I think it
is important to just note that we must see some of these rules
in action, if you will. I think we have to be careful that we
do not write rules prematurely. I think we have to see where
they are working and where they are not.
But it is on our agenda.
Senator Sarbanes. Over the past few years, there have been
a number of cases where firms or individuals have been charged
with obstruction of justice for destroying or altering evidence
relating to a Government investigation. Arthur Andersen is one
obvious example where a jury convicted Andersen of obstruction
for shredding work papers and other documents.
As recently as April 23, a former investment banker, Frank
Quattrone of Credit Suisse First Boston, was arrested and
charged with obstruction of justice for reportedly telling
colleagues to, ``clean up,'' their files, despite knowing some
of those documents were being sought by subpoenas or document
requests from three different regulators.
Do you think that investment banking and accounting firms
have gotten the message that destroying or altering evidence
related to a Government investigation will not be tolerated?
And do you intend to, and are you, vigorously prosecuting all
cases where these issues arise?
It is fundamental that destroying evidence is a very
serious matter and opens you up to serious charges. And yet, we
have these instances where these high flyers making huge
amounts of money, holding very responsible positions, are
engaged in these practices.
Chairman Donaldson. I think I would make just some comments
on that.
We have civil enforcement capabilities, if you will. The
Justice Department has criminal enforcement mandates. We work
closely with the Justice Department. There are no secrets
between us and the Justice Department where instances such as
you cite are brought our attention. And the particular instance
that you mentioned is one in which the Justice Department has
moved on it.
Senator Sarbanes. Well, you would agree, though, that
destroying or altering evidence related to a Government
investigation simply cannot be tolerated.
Chairman Donaldson. Absolutely.
Senator Sarbanes. Yes.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
I want to go back to the issue that I raised in my opening
statement and to which Senator Dodd also referred. And while I
would be interested historically in any kind of analysis
anybody should make, I think it would be more valuable if we
talked prospectively.
It is my conviction and experience that the market always
gets it right. That is, the market evaluates what a company is
worth. But it doesn't always get it right on time.
There can be times when it has the company vastly
overpriced or vastly underpriced, and those are equally
misleading. But over time, ultimately, it all shakes out and
the market, whether it is the Dow or the Nasdaq or whatever,
ultimately puts a fair market cap on what the company is really
worth.
The problem is, of course, finding that point in time when
the market has come there and not the premature time when it is
overpriced or underpriced.
And what we are talking about here is the degree to which
analysts have distorted that market function and caused a
stock, we think, to be primarily overpriced. But it may be that
current analysts are causing stocks or the appropriate market
caps to be underpriced.
Is there any kind of device whereby an analyst can be
tested and those test results published against any kind of
measure? Or is this thing so subjective that it becomes
impossible to say, well, this fellow is right most of the time?
Warren Buffet has achieved a mythic reputation of being
right. And yet, you read his extremely well written reports to
his shareholders and they are filled with mea culpas where he
admits to being spectacularly wrong a number of times in a
number of areas.
And his willingness to admit how often he is wrong frankly
adds to the aura of inevitability of his being right because he
gives us an honest evaluation of what he does.
I know of no way of knowing, and it may just be my
ignorance, of the track record of any of these analysts. I
cannot look up in a directory somewhere and say, well, Grubman
was right this many times or he hit it properly that many
times.
I do know, strictly anecdotal, of one analyst in a
particular industry who was consistently wrong. And I wondered
why her firm did not fire her because I was following a stock
and following her reports on the stock, and I knew enough about
the company to know that she did not get it.
Ultimately, the company's stock did go to where it belonged
and she was in fact fired because she was perpetually
optimistic that they finally turned the corner, they were
finally going to do it. Then the firm filed for bankruptcy, and
she lost her job.
As I say, I want to focus forward here because enough of my
colleagues are focusing on the past and what has been done, and
I share their outrage. I do not want anybody to think I am
giving anybody a pass on this.
But to be as useful as possible for the future, can you
respond to this plea about some measure, some track record,
some way of monitoring where we go in the future with analysts?
Mr. Levitt, your predecessor, says in this morning's Wall
Street Journal, that it doesn't really matter in a bear market
because the bear market squeezes all of the excesses out. But,
hopefully, in my words, we are on the threshold of a bull
market.
We have had it with this bear. He's been around for more
years than bears usually stay. Is it in fact that when we get
back into a bull market, we are going to have no way of knowing
who's being correct and who's not being correct?
Chairman Donaldson. Senator, you ask a number of very
interesting and provocative questions.
First, I would start by saying that the boom/bust, the
overvaluation, the undervaluation is the nature of the beast.
There is also a psychological and an emotional factor to the
marketplace, and I think that is always going to be there, the
swings up and swings down.
Second, I would say that we throw this word ``analyst''
around too loosely.
I believe that the type of work that has been done in the
recent years is much more statistical reporting than it is true
analysis.
I believe that true analysis is a lot closer to what a
quality management consulting firm would do in terms of the
long-term
appraisal of the way a company is organized and so forth, much
closer to that than the game that has been played for the last
couple of years as to what the earnings are going to be the
next quarter. Are they going to be up two pennies or down two
pennies?
Third, I would say that, as a part of our settlement, there
is now a new requirement for transparency and a valuation of
what you are talking about within the firms. That is part of
the settlement.
And then, fourth, I think that you are going to see an
increased attention by the world out there, the business world,
to rank analysts, independent rankings and independent
followings.
Some of that has gone on in the past. I think there is
going to be more attention to the educational qualifications of
the people who are doing the work. They may have the chartered
financial analyst designation which came in and assures a
minimal level of professional competency.
I think that the bottom line, though, of your question is
the stock market just a game, just a casino, or is there some
fundamental value take-off point?
And there is.
Senator Bennett. I would quickly--my time is gone--but I
would quickly agree with that. I believe that the stock market
does in fact, as I said in my opening comment, reflect real
value.
Chairman Donaldson. Yes, and it will centralize and adjust
around, let's say, the values inherent in a risk-free
investment like a short-term government bond. And then the
discount rate of earnings will take off from that.
But the analytical business is not an easy business. It is
an art. It is not a science. If it weren't, there would be an
awful lot of very wealthy analysts around, legitimately
wealthy, if you could be perfect every time.
Senator Bennett. Thank you.
Chairman Shelby. Senator Corzine.
Senator Corzine. Thank you, Mr. Chairman.
Let me begin by saying that I want to identify with the
remarks that Chairman Donaldson is off to an extraordinary
start. This process in selecting a new Accounting Oversight
Board Chairman, both transparent and I think the conclusion,
quite effective.
I feel that the testimony here today is reflective of the
thoughtfulness which you bring to this effort. Now that you
have the resources at the SEC, or at least significant enhanced
resources, maybe some of the checks and balances that were
expected will be able to be executed on an effective basis.
I want to focus on an issue of restitution. The issue, I
think many people would say $1.4 billion is a lot of money and
some people would say it is not enough in this instance. But I
think that many would believe that the fund set up for
restitution looks thin relative to the overall losses.
The first question is, was there a presumption built into
this global settlement that the arbitration and court processes
would perform much of that role as we go forward. That is a
macroquestion. And then I have serious issues or concerns about
moving forward, which I have worked with Mr. Glauber at NASD
and others on, and spoken about the arbitration process and
making sure that it is a fair, efficient, and effective system.
I suspect that the system is about to get into massive
overload as we go forward. And therefore, needs to be attended
to, that it is a fair and effective way to get to the judgments
of restitution.
My second question, are you satisfied and think that the
kinds of steps that the NASD board is taking with regard to
dealing with public arbitrators and their independence in that
process, is appropriate? Do you think we have gone far enough?
Are there other things that we should be accomplishing?
I know that there has been improvement in the actual pay-
outs and settlements, but it is still not everywhere anyone
would want.
Are you reviewing the arbitration process consistent with
what is going on in NASD?
The third question is, are you confident that, and do you
understand it the way I think I do, that people can pursue
arbitration outside of the restitution fund at the same time,
or even legal processes for restitution, at the same time that
they are applying to the fund?
And fourth and finally, maybe most importantly, how do you
feel about mandatory arbitration as a part of how you sign up
to do business with a broker-dealer?
Chairman Donaldson. Well, to answer your first question, as
to the size of the settlement and the adequacy or inadequacy of
the monetary penalties.
I think when you step back from it and again, I was not in
on the original settlement. But we have examined the processes
that led us to where we are.
In the final analysis, it is a negotiation. The penalties
and the size of the penalties depend upon the egregiousness of
the offense. The threat is that if you do not reach an
agreement, that the whole thing gets thrown into court. And
thrown into court means 3, 4, or 5 years before remedies are
arrived at.
So constantly, there is the thought that we have to have a
settlement here. It is a reasonable settlement, one probably
that dissatisfies both sides.
We maybe wanted to get more money and the firms wanted to
pay less. But the overwhelming desire is to get the settlement
so that we can move forward with the reform.
As far as a number of your questions on arbitration, yes, I
believe that in the minds of our enforcement division and in
the minds of the others who worked on this settlement, and I
think the Attorney General has spoken to this point, there is a
lot of information that has been released purposely by all of
us that's out there. And there are mechanisms of which
arbitration is a principal one, where recovery can be achieved
in a court system. My suspicion is that a lot of people will go
after that and do it.
And as far as the arbitration process itself, I believe it
is a good process. I believe it is a fair process. I believe
that the statistics show that there is not a bias one way or
the other.
Although it is managed by the industry itself, the results
are not skewed one way or another. It is managed by
professional arbitrators who know the business and know the
issues and so forth.
Senator Corzine. A number of the arbitrators, though, are
sometimes presumed to have had either economic relationships or
other relationships with some of the parties, which I think is
one of the big concerns for public confidence.
Chairman Donaldson. Yes. I think that is a critique that
has been made.
I think about the benefits of the arbitration system, that
the people who are running the arbitrations understand the
business. They are not in a courtroom where there is lack of
experience. They have processed hundreds and hundreds of these
cases.
I am still a great believer in the arbitration system.
There has been some criticism for arbitration payments that
have not been made. They have been awarded, but have not been
made.
But it is important to recognize that the consequences for
nonpayment in arbitration is expulsion from membership. And
many of the judgments that have not been made had been by firms
that went belly up.
Those statistics are a little misleading. But I think the
arbitration system works well. I think there is going to be a
large new caseload coming out of this settlement, and well
there should be.
Senator Corzine. The mandatory piece, mandatory
arbitration.
Chairman Donaldson. Well, until someone can convince me
that there is something wrong with mandatory arbitration, I
guess I still think it is the way to go. But I have an open
mind on that.
I haven't thought to date that the elimination of the
mandatory aspect of it was the way to go.
Senator Corzine. I would only suggest again, as you well
can understand in a practical context, this arbitration process
is going to be very much one of those areas where the public is
going to look for the fairness that will be tied to whether
there is a restoration of public confidence in the process.
If it is not one that is both transparent and fair-minded,
for those that participate, then they feel like that the
process doesn't come out in aggregate with a fair response to
investors' complaints.
I think we will not have had all of the benefits that were
intended by the efforts of global settlement.
Chairman Donaldson. Well, I think you make a good point.
Chairman Shelby. Thank you, Senator.
Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman.
Chairman Donaldson, I appreciate your testimony and the
additional information provided in the longer statement.
There are some more specific questions. I think the global
settlement requires firms to post the results of the analysts'
research on the firm's web site. Since the settlement doesn't
mandate the specific criteria to evaluate the analysts'
research, how do you believe that the firms will conduct these
evaluations?
Do you think the evaluations will cut across industries or
differ from firm to firm?
Chairman Donaldson. Well, I think that the way the analysts
are analyzed, if you will, and reported upon probably will take
a number of different forms.
I suspect that good business practices will develop in
certain firms where there will be a real effort to get at that
evaluation a lot of different ways.
I think the free market will work there. I think a phony
evaluation, in an attempt to buffer bad performance, I think
that that will show through. But only time will tell how
effective it is.
Senator Enzi. So you do not anticipate at this point in
time any more specificity on how that report----
Chairman Donaldson. Well, it is something new, and a new
approach. And we have set it up so that there is an
independence to that appraisal.
We have an oversight responsibility ourselves to look at
how it is done, to make sure that it is done. And we will step
in if we do not think that it is being done correctly.
Senator Enzi. Do you see any legislative changes that are
necessary to implement the global settlement? And do you think
the legislation will be necessary once the 5-year period on
independent research has expired?
Chairman Donaldson. I do not see the need for legislative
action now. I think we need to see how the settlement plays
out.
And I think that I would say to you unequivocally that we
will be back to you all if we think that we see a need for
legislation. I do not think we see it right now.
Senator Enzi. How has the coordination effort between the
SEC and the SRO's progressed with respect to the stock research
rules that are promulgated?
Chairman Donaldson. I think we have had outstanding
relationships with the SRO's. I think that our oversight
responsibility is being met with a responsibility on the other
side.
I think that the self-regulatory concept, even though it is
under a little bit of fire right now, is still a pretty sound
concept. We have had excellent cooperation with the
organizations that we oversee.
Senator Enzi. Thank you.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Dodd.
Senator Dodd. Thank you very much, Mr. Chairman.
Thank you, Chairman Donaldson, for your work.
And let me also join with those who commend you for the
good start you have had at the SEC, and those on your staff.
You have an awful lot on your plate.
Even though you are getting additional resources and I know
you are trying to staff up, there is an awful lot going on that
you have to grapple with.
We have to show some patience in your ability to sort all
of this out and get moving. So I appreciate that.
And let me add, too, Senator Corzine said something and I
think it was important to state, because in my opening comments
and those that others have made here, there are an awful lot of
people who work in this industry who do a very fine job every
single day.
I think part of what we are trying to say here is the
message that we are sending to that younger generation of
people who are choosing this as a profession and a career
coming in.
I think you made the excellent point about lost reputation,
trying to put a valuation on that is almost impossible. It may
vastly exceed anything we have come up with or you have come up
with. Those who reach this global settlement have been able to
attribute a value to.
It would be unfair if we did not make that point, all of us
here today. And I know that you have similar views, having
worked in the industry for so many years, the literally
hundreds of people that you have met who do a very good job all
the time.
I want to come back to the settlement itself. I want to ask
you about this. You are familiar enough with it and I just want
to break it out, just based on what I know of the $1.4 billion.
You correct me where I am wrong in this, but this is what I
have been told.
Of the $1.4 billion, $487.5 million is in penalties. None
of that is tax-deductible or covered by any insurance at all,
as I understand it. Three hundred eighty-seven million dollars
in disgorge-
ments is likely to be tax-deductible, I am told is the case.
And it is unclear whether or not with respect to insurability.
And $432 million for independent research and $80 million for
investor education. Unclear as to both tax deductibility and
insurability.
So there is some vagueness in here that I would like to get
sorted out. And again, I do not argue with your point. This is
a big deal. And even $487 million, I guess, although if you
apportion that among 10 firms, and while I know it is not done
that way, you are talking a little more than $40 million. And
all of a sudden, the $1.4 billion begins to shrink down, at
least potentially.
So clarify if you can for me, how much of this is tax
deductible, in your mind? How much is insurable? And how much
are actually penalties that are not going to be able to be
written off, either borne by the taxpayer or by insurance
policies, which have their own economic impact in those
industries.
Chairman Donaldson. Well, I would begin by saying that the
clarity runs from very clear to not so clear in terms of the
tax deductibility and the insurability of these settlements.
On the very clear, we have put into the settlement a
prohibition on seeking tax deductibility on the penalty side.
It is clear. It is the first time that we put that into an
agreement, and that is iron-clad and black and white.
Senator Dodd. The $487.5 million.
Chairman Donaldson. Yes. The penalty payments are $487
million. There is disgorgement of $387 million. Again, that's a
function of the tax laws. And there are probably arguments as
to whether that, under the tax laws, can be deducted. It
probably can be.
Senator Dodd. Can or cannot be?
Chairman Donaldson. It probably can be deducted.
Senator Dodd. Yes.
Chairman Donaldson. Can be deducted.
Senator Dodd. Right.
Chairman Donaldson. And I say probably because there is
some legal advice and rulings out of the IRS that cloud that a
bit.
I want to assure you that the other categories here, the
money going into independent research and the investor
education portion of this, we have called that exactly what it
is.
In other words, we have not jockeyed around the definition
of those payments in order to achieve particular result--we aim
for truth in what we call these things.
Now, I think that on the insurance side, it becomes a
little muddier. As you know, the insurance industry, and you
know is particularly well with your Connecticut background----
Senator Dodd. You know it pretty well, too.
[Laughter.]
Chairman Donaldson. The insurance industry is regulated at
the State level. There are all sorts of different regulations
on the kinds of policies that can be written.
There are policies that have been written that insure
against some kinds of fraud. And although I might, and we
might, disagree with that, nonetheless, that is not in our
purview, and it is not in our purview to undo legitimate
contracts that have been made.
So that, as a matter of public policy, my own personal
view, and not necessarily the Commission's, my own personal
view is that these kinds of things shouldn't be insurable.
Senator Dodd. Should not be.
Chairman Donaldson. Should not be. But that is a
complicated question. That is a simple answer to a complicated
question.
And I would leave it to the insurance regulators and to,
really, the Congress of the United States to decide whether
they want to write some laws that override State laws.
Senator Dodd. Well, I would be interested in your comments
on that. I would invite you to, over the next month or so,
again, having said earlier how much of a load you have got.
But I would be very interested in the SEC's analysis of
that very question. And it is an obvious one that people
watching this, the idea somehow that we have talked about a
$1.4 billion penalty for fraudulent, illegal, highly unethical
behavior.
And then to discover that, potentially, two-thirds, in
fact, certainly in one area, but potentially, two-thirds of
that figure, almost a billion dollars of the $1.4 billion may
be tax deductible and may be insurable, which means that others
are going to end up paying one way or the other for this. And
that is the point that sticks in people's craw.
Chairman Donaldson. Right. Well, we would be glad to come
back to you.
Senator Dodd. I wish you would on that because I would be
interested in how that might work. Obviously, there are
questions for Eliot and others about how you arrived at this
number and the debate that went on in terms of how you
proportion the penalties and disgorgement and the like, which I
will pursue at a later point.
Last, maybe you answered this for Senator Enzi. Did I hear
you say, and I apologize if I did not pick this up when Mike
asked the question. That as I understood it, most of the
violations that occurred here were not violations of fraud
statutes, but, rather, were of the SRO violation types, NASD
and New York Stock Exchange violations.
Is that correct, what you talked about here?
Chairman Donaldson. I am not sure of that. I am not sure
what you are referring to, Senator.
Senator Dodd. I am told, other than on a relatively few
violations of the fraud statutes, most of the violations were
of SRO regulations.
Chairman Donaldson. Right, which are regulations that we
have overseen and continue to oversee.
Senator Dodd. Yes. But they come out of the SRO's. They do
not come out of the SEC.
Chairman Donaldson. Most of them come out of the SRO's.
Senator Dodd. So the question is whether or not, I do not
know if there is some analysis, and Mike may have asked this
question and I may have missed it, whether or not you would
recommend that there be some statutory response to that or some
steps that we might take up here in some way to close this gap
if you perceive the necessity to do so.
Chairman Donaldson. Yes.
Senator Dodd. In light of that fact.
Chairman Donaldson. Good point. And I think that this one
that is very much on our mind now as we look at--as I said
earlier, we are going to review the rules. We are going to
write some new rules, I suspect. And we are going to have to
make the recommendation in doing that as to whether those rules
are installed at the SRO level or at the Federal level.
Senator Dodd. Yes.
Chairman Donaldson. And we haven't really determined that.
Senator Dodd. No. And I would like to hear back, though, if
we could because it seems to me that we are talking about
future steps that we may take to avoid this kind of thing.
And just, last, I would be interested in your observations
as to whether or not any of the provisions of the Sarbanes-
Oxley Act, do they go far enough? Do they need refinements, in
your view, in light of this particular set of circumstances?
I do not know if you are prepared to answer that at this
particular moment. But if you are, I would be interested in
whether or not you have made any observations about that. And
if not, then we can certainly receive your answer at a later
point.
Chairman Donaldson. As to the efficacy of Sarbanes-Oxley?
Senator Dodd. To the extent whether or not, in analyzing
this particular situation, looking back at Sarbanes-Oxley, are
there any areas where you think we could, where that Act needs
to be tinkered with in any way to address this particular
situation.
Chairman Donaldson. I think we have most of the authority
that we need to do the job we have been given.
And I would like to again reserve the right to reverse
myself as things play out.
Senator Dodd. I understand that. Thank you. And I thank
you, Mr. Chairman. I took a little more time and I apologize.
I apologize to my colleague from Idaho.
Chairman Shelby. Thank you.
Senator Crapo.
Senator Crapo. Thank you.
Thank you, Mr. Chairman. I appreciated Senator Dodd's line
of questioning. It is generally the line I wanted to pursue.
I realize that we are running very late in this hearing and
we have another panel coming, but I did have a couple of
questions I wanted to pursue in that line.
First of all, I understand that the analysts now are not
going to be allowed to attend pitch sessions where the
transactions are being pitched on road shows and the like.
I understand that the analysts' compensation is not going
to be allowed to be connected to the profitability of the
offerings of the investment side of the operations.
One question I have is, under the settlement agreement, and
you may have gone through this, I apologize if I missed it. Who
makes the decision in terms of whether to initiate research
coverage on a matter? Is the analyst allowed complete freedom
to do that?
Chairman Donaldson. Well, what an analyst is going to
cover, essentially, under the new scheme--and theoretically,
under the old scheme, but it broke down--is the responsibility
of the research department and the supervisory authority there.
That has to do with a judgment on what industry you want to
cover and what analytical capabilities you want to build into
your organization. But the responsibility for the analyst's
work and assignment and so forth belongs in the research
department, which is separate.
Now the one exception to that in our rules is that the
analyst will be allowed to talk to the investment bankers about
the quality of the proposed offering.
In other words, they will be allowed to consult with the
investment bankers as they try to make a determination of
whether they want to underwrite something.
What they won't be allowed to do is then to become a road
show participant and write analytical work and so forth.
Senator Crapo. Are the analysts going to be allowed to
share their ratings and research reports with the investment
bankers and issuers prior to the issuance?
Chairman Donaldson. Absolutely not. There should be no
communication and no connection, if you will, with the
underwriting function and the research function.
Senator Crapo. All right. And there is a lot more we could
go through in that regard, but as we look at this entire
picture, the settlement agreement only relates or only binds
the firms and individuals who were part of the settlement.
Correct.
Chairman Donaldson. At present, that is correct.
Senator Crapo. And this gets into the area I think that
Senator Dodd and several others were getting at. We want to see
the consumer confidence in the entire industry following these
things.
And the question comes down to, where are we going to go
next from the settlement to making certain that we have the
proper statutory, regulatory, and self-governing procedures and
requirements in place?
Chairman Donaldson. We have a job ahead of us in terms of
formalizing the rules so that they extend to those that were
not covered in the settlement, and we will be doing that.
In the interim, there is going to be a gap in time as we
move to do that. And I guess my answer to that would be that,
if I were running an investment banking firm today, I would be
very aware of the terms of the settlement, and I would be very
careful.
Senator Crapo. I can assume that those who are not part of
the settlement are paying very close attention to it.
Chairman Donaldson. I would assume so.
Senator Crapo. I know you have answered this question at
least twice that I have heard, and so I won't ask you to answer
it again. But it is my understanding that you believe that you
currently have the authority at the SEC to make the necessary
regulatory changes, whether they be at the regulatory level or
at the self-governing level.
Chairman Donaldson. Yes.
Senator Crapo. And I am sure that this happens. And you
will come to us if you feel that you need further authority.
Chairman Donaldson. Absolutely.
Senator Crapo. Mr. Chairman, I have a lot of other
questions, but I believe that I will hold back. I am interested
in the next panel as well, so I will finish at this point.
Thank you.
Chairman Shelby. Thank you.
Senator Schumer.
Senator Schumer. Thank you. And thank you, Mr. Chairman for
holding this timely hearing. I want to thank our witness. I
want to thank Mr. Donaldson, and the SEC, for doing an
excellent job.
We are glad you are there. I know it is a big, big job,
particularly now, but I am glad you are there.
I want to praise our New York State Attorney General, Eliot
Spitzer, who we will hear from on the next panel, who has
really done an incredibly good job here, not only in this area,
but in many areas. We just had a great settlement on
electricity as well.
As well as our many New Yorkers here. We have, I see, the
head of the New York Stock Exchange, Dick Grasso, Mr. Glauber,
the head of NASD.
So, welcome. This is a New York industry and we have a lot
of fine New Yorkers here.
Senator Sarbanes. We thought it was a national industry
that was just headquartered in New York.
[Laughter.]
Senator Schumer. That is true, Mr. Chairman. Becoming more
so, I regret to say.
In any case, I have a couple of questions, Mr. Chairman and
I thank you.
The first, as you know, and we talked about this once
before--and I just want to say, I think the settlement was an
excellent settlement. It sends a message to the investing
public that their interests are going to be safeguarded and
that markets can be trusted.
And we always have cycles in capitalism. And we had the
1990's, and they were a go-go-go time. There are always
readjustments.
And what is happened, I guess, in the last hundred years is
that Government has modulated the booms and busts some, and
that is good. People are hurt less. That is why we need
Government regulation. But at the same time, we cannot
eliminate them.
So we go through cycles here. And I guess my question is
related to some of those cycles. But first, I want to say that
I think the settlement is excellent. I think that wrong-doers
have to continue to be punished. I think that the best thing
our markets have going for us is the faith that the rest of the
world and the rest of the country has in them, and every so
often, we have to polish them up and make that faith shine once
again.
And you are in the process of doing it, as has Attorney
General Spitzer and the others who have been involved.
But let me ask you about these cycles because sometimes the
pendulum goes one way and sometimes it goes the other way. So,
I want to ask you your opinion on three questions.
First, on the fractionalization of the markets, the
balkanization of the markets.
I have worried, and we have talked about this before, that
if we do not have one national regulator, it is very, very
difficult to do any kind of financial services business.
In fact, I have been working on legislation that would
create one national insurance regulator, which the State
insurance regulators do not like, but that is where the
business is heading.
So given the push and pull here, do you think the
settlement has put aside any worries that we might have about
balkanization of the markets, that there would be too many
different founts and places of regulation, both between the
national government and the States and among the national
regulators?
Chairman Donaldson. Well, I think that we have had amazing
cooperation between the regulators at both the Federal and the
State level.
I was going to say, and I will say now in answer to your
question, although I am the mouthpiece here, there are people
sitting behind me who were into this thing from the beginning,
including, but not limited to, the NASD, the New York Stock
Exchange, and the Attorney General from New York. And I think
the cooperation has been terrific. They have done a great job.
And I think that, as far as the issue of balkanization, on
the one hand, we need all the help we can get. We are working
with the Department of Justice, we are working with State
regulators. We need all the help we can get in terms of running
down crime.
Having said that, I think that once the crime is run down,
the solutions must fit into a national pattern. Here I think we
need Federal regulation of the markets.
Senator Schumer. Okay. The second also relates to the idea
of do not throw out the baby with the bath water kind of thing.
Senator Corzine mentioned, and I want to second that, that
the vast majority--and he knows them better than I do--of the
people who work on Wall Street are hard-working people, honest
people, and do a great national service in creating great
capital markets to allocate capital fairly. And yet, of course,
we have to go after wrong-doers.
At the same time, as we go after wrong-doers, we do not
want the investing public, in terms of investor confidence, to
have the impression that everything that goes on on Wall Street
is bad, that these are the bad apples of the bunch and not the
whole bunch.
And so, given that, given the fact that we have lost
hundreds of thousands of jobs in New York and then around the
country in terms of financial service industries, given the
fact that we always worry about competition from overseas
markets, and there is always a careful balance between
regulation and keeping the markets here, how would you deal
with those types of issues?
And one other related issue. We want to see our markets
stay entrepreneurial and vigorous. We want people to take risks
and we want people to push the envelope and do new kinds of
things.
How do you prevent the pendulum from swinging too far over
where, instead of just going after the wrong-doers, we tar a
lot of people who are doing the right thing and hurt our
markets, employment, as well as the capital formation with
investors here in America and around the world?
Chairman Donaldson. Right. Well, you bring up a very
interesting point. I think that the trick here is that we
regulate to the point where we get at the wrong-doers, but we
have to be very careful that we do not regulate to the point
where we inhibit free enterprise and the entrepreneurial nature
of this country. I think this is a delicate balance. It is one
that we are very conscious of.
I will steal a phrase from Bill McDonough at a press
conference he had, Bill McDonough, who is heading up the PCAOB.
Somebody asked him, how will you measure whether you have done
a good job or not at the end of the day? And he said, I will
measure that by, at that point where college graduates all over
the country want to go into the accounting business again.
I thought that was a pretty good answer, and I am going to
paraphrase that and say that I think we will be doing a good
job when people are once again proud of being part of this
industry and want to get into it. That will signify that we
have hit the right balance, I believe.
Senator Schumer. Thank you, Mr. Chairman.
Chairman Shelby. Mr. Chairman, is the SEC looking at other
potential areas where conflicts could result in abuses, such as
tying of financial services? And if not, why not?
Chairman Donaldson. Yes. We are obviously aware of the
potential for conflict in a number of different areas. We are
about to have a major look at hedge funds, and in 2 weeks time,
we have a major undertaking here where there could be
potential----
Chairman Shelby. And all forms of tying.
Chairman Donaldson. Every place where the rubber hits the
road in terms of conflict, we are looking at in.
Chairman Shelby. Mr. Chairman, this global settlement that
we are talking about here, this is a civil settlement.
Is that correct? It is a civil settlement. Civil. It is
civil in nature. Is that correct?
Chairman Donaldson. Yes.
Chairman Shelby. Okay. Does this settlement in any way
preclude future criminal investigations, prosecutions, should
the Justice Department, or even the State, if there are State
laws broken, find that the evidence or the facts lead you to
such action on the merits?
In other words, people haven't been paying this fine and
paying this settlement to preclude any future criminal
investigations and/or prosecutions should the evidence merits
that, as goes on, because you do not know what will come out in
the future.
Chairman Donaldson. Right.
Chairman Shelby. You may have a lot of information, but you
may not have it all yet, as you well know.
Chairman Donaldson. Right.
Chairman Shelby. Go ahead, sir.
Chairman Donaldson. I do not believe it does prevent us
from the kind of action. When I say us, I mean the Federal
Government.
Chairman Shelby. The Federal Government. Or the State.
Chairman Donaldson. State. Justice. I am hoping at the next
panel, you will talk to them.
Chairman Shelby. We will ask that question later, too.
Chairman Donaldson. Enforcement Director Cutler has assured
me that it doesn't preclude it in any way.
Chairman Shelby. Absolutely. I think that is an important
point because if there is further investigation or further
revelations, which there will be, of wrong-doing, of criminal
conduct, those people should be prosecuted, whoever they are,
wherever they sit.
Is that correct?
Chairman Donaldson. Absolutely. We are totally free to do
that.
Chairman Shelby. Senator Sarbanes, do you have any other
questions?
Senator Sarbanes. Mr. Chairman, I will be very brief
because I know we have the other panel that has been waiting
quite a while.
I just wanted to make two observations.
First of all, Chairman Donaldson, this was not on your
watch, but I think it is clear that there was a vacuum in
addressing important issues, and Attorney General Spitzer of
the State of New York and his associates in other States moved
into that vacuum.
My own view is I do not think you ever would have had a
settlement and we wouldn't be reviewing it here today if they
had not become involved. And I think that that only underscores
the point you made about you need all the help you can get. I
think was the phrase you used.
We have traditionally been able to work with a cooperative
system of Federal and State in addressing securities matters,
recognizing, of course, the SEC's national role.
I see no reason why we cannot continue along that course,
which I think, by and large, has served us well in the past.
There are some now who want to change that in a rather
dramatic way. I see going around and trying to come through the
back door, not being able now to get through the front door.
Chairman Shelby. Or side doors.
Senator Sarbanes. Side door, whatever, yes. We are going to
be very alert to that, I think.
Chairman Shelby. That is right.
Senator Sarbanes. And I just wanted to make that point.
The other point I want to make as you depart, Senator Leahy
and I have written to you about a provision that is in the
bankruptcy proposal that is pending in the Congress, which
would delete investment banks from the exclusion of being able
to be bankruptcy trustees.
Since 1938, they have been considered not to be
disinterested parties. If you were the investment banker for a
firm that then went into bankruptcy, particularly in a
reasonable period of time before that happened, you could not
then be a trustee in bankruptcy because, obviously, there is a
provision now in this legislation that somehow has entered in
there quietly, as it were, which would remove this, and we are
very much concerned about that.
The Dean of the University of Houston Law Center has
written in opposition to this provision and made the following
point. I would just quote her very quickly.
One of the duties of the debtor in a bankruptcy case is to
take a good hard look at the repetition behavior of those who
dealt with or ran the debtor to see whether that behavior
contributed to the downfall of the debtor.
Another one of the duties is to see how the debtor can
raise new post-petition funds in order to finance an effective
reorganization.
Both of these duties would be compromised if the same
investment bankers that were involved with the pre-petition
debtor were allowed to serve as the objective post-petition
investment bankers.
And we have written to you asking for the views of the SEC
on that. We would be anxious to receive them.
But it seems to me that, while on the one hand, we are
trying to tighten these things up and eliminate these
conflicts, they are coming along on the other hand and
reintroducing a rather pretty raw and bold example of a
conflict.
I hope the Commission will give its close attention to this
matter.
Chairman Donaldson. I am not speaking for the Commission
now. We have your letter. We have talked a lot about it. We
have reached no conclusions on it.
I am not an expert on bankruptcy law. However, I will stick
my neck out and say that, personally, at a time like this where
investor confidence is as fragile as it is, I would want to
proceed very cautiously before loosening any of the conflict of
interest restrictions that we have.
Senator Sarbanes. All right.
Chairman Donaldson. And that is not to say that, over the
long haul, that something might be done to modify that, to
enable people who are clearly not doing business with the
bankrupt company or haven't done business for a long period of
time, to allow them to come in and bring that expertise in.
But right now, I think that, personally, it would be a
mistake to change that law.
Senator Sarbanes. Yes. And I appreciate the attitude that
is reflected in that response. We need to tighten the whole
system up and get it working right. Then down the road, we can
look at whether adjustments need to be made.
But this effort now that is going on in some areas, to make
the adjustments which move in the opposite direction from the
whole thrust of tightening up the system, it seems to me, are
just not going to work. And they should be laid to one side.
It goes back to the point that I made in the opening
statement about whether people were really getting the message
in terms of what needs to be done at this particular time.
Thank you.
Chairman Shelby. Thank you. Chairman Donaldson, we
appreciate your appearance. We also appreciate the leadership
you are showing as Chairman of the SEC.
We will, as a Committee, continue to work with you and we
will be vigorous.
Thank you.
Chairman Donaldson. I look forward to it. Thank you.
Chairman Shelby. Yes, sir. We will call up the second
panel. First, we have Eliot Spitzer, the Attorney General for
the State of New York; Richard Grasso, Chairman of the New York
Stock Exchange; Robert Glauber, Chairman and CEO, National
Association of Securities Dealers; Christine Bruenn, President,
North American Securities Administrators Association.
We welcome all of you to the Committee, and we look forward
to your testimony.
And we also have, Mr. Stephen Cutler, Director, Division of
Enforcement, U.S. Securities and Exchange Commission, who will
accompany and be part of this panel.
Your written testimony will be made part of the record, all
of it, each one in its entirety. We know this has been a
protracted hearing, but it is a very important one.
We will start with Mr. Eliot Spitzer, the Attorney General,
State of New York.
Welcome, Attorney General Spitzer.
STATEMENT OF ELIOT SPITZER
ATTORNEY GENERAL, THE STATE OF NEW YORK
Mr. Spitzer. Thank you, Mr. Chairman.
Let me just begin by--I think it was Senator Bunning who
began with the reference to Pink Floyd and ``The Wall.'' I was
a little surprised to hear the reference to Pink Floyd, but I
think maybe he got the wrong album.
I think the right album to refer to today because it refers
to where the executives and most regulators were, would be
``Dark Side Of The Moon.''
That is where, unfortunately, they were when all this was
going on and things that should have been seen and clearly
observable were not.
I was taken by your opening comments, sir, because I think
it sounded precisely like the comments that I was making a year
ago. I think it is wonderful that we now begin with the premise
that the articulation of the problem that you began with is
correct.
I would like to set this in a slightly different context,
though, today. I refer to Senator Dodd's comment. He said that
there is a fair amount of blame to go around.
I think we need to put this in the context of an
overarching effort to deregulate the financial services
industry over the last 20 years. I think we may now be paying
the price for that deregulation.
I think we may now be seeing that the constant refrain from
financial institutions of every sort and every stripe and not
just investment banks. I guarantee you that. I guarantee you it
is not just investment banks, that you can trust us. We were
being waylaid and led down a garden path. And those in the
halls in Congress who believed that mantra are partially to
blame.
For years, when Arthur Levitt came up here and said, we
have problems, he was ignored. He was defunded. He fought
battles. There was push back from lobbyists who simply
outgunned him. I think today we are seeing the price and we are
seeing a very changed attitude in the halls of Congress. But,
quite frankly, sir, it is too late. It is much too late.
You should have listened years ago when people came up here
and said, there is a problem. And yet, nobody wanted to pay
attention. We are now paying the price for that.
And I think that much of what we are discussing now is an
effort to reconstruct something that was there in the first
instance. And had we enforced the rules, had we given the SEC
the power, had we done what people knew should have been done,
we wouldn't be sitting here.
The single most important message for the American public
and for Congress is that self-regulation failed. And I say that
with due apology to those people to my left who speak for the
SRO's and the self-regulators.
It was a complete, abject failure.
What went on, and that is why I referred to ``The Dark Side
Of The Moon.'' You had to be on the dark side of the moon not
to see it. It was there. Journalists saw it. The investment
bankers saw it.
You referred to the e-mails that were sent up the chain
within some of these institutions. Those who were on the front
lines dealing with the retail customer knew what was going on,
and nothing happened.
And yet, in that context, we repealed those limitations,
tore down those walls that might have served to protect the
public and we took away the authority of the SEC.
In that context, I want to, as always, applaud Senator
Sarbanes, who has been such a voice of reason on these issues,
when he highlighted at this moment the effort to repeal a
provision in the bankruptcy code that would once again have
prevented and saved the public.
As we speak, there has been an ongoing effort to repeal a
provision of law that has been in place for 70 years, for good
reason--to protect the public from another conflict of interest
that the industry now wants to take advantage of.
When the leadership of this industry said, trust us, we
know how to mediate these conflicts, they were wrong. They were
dead wrong. Unfortunately, we are all now paying the price for
that, and it is something we have to understand and we need to
move forward aggressively to correct.
Let me make a few more points, if I could, please.
I think that there are always cycles. And I think, as
Senator Schumer from New York, my senior Senator, wonderful
Senator, said, there are cycles in regulation. There are cycles
in our effort to back off from the industry to ensure the
dynamism of the capital markets. And the settlement that we
negotiated was an effort to strike just that balance.
However, the pendulum may have swung too far. It may have
swung too far and that is why I think Senator Sarbanes is
correct again. We should exercise incredible caution as we
forward and once again deregulating those sectors that would
want to move into these voids and once again take advantage of
conflicts of interest.
Let me make two final points, if I could.
There has been much effort to preempt the States. I think
that would be an egregious mistake. One of the first reactions
on the part of the investment houses was to come down to
Washington and say, we do not need them meddling in the
marketplace.
In an ideal world, they would be right. This is not an
ideal world. There was fraud in these investment houses. And
their first reflexive response was to come down here and say,
we want to get the cop off the beat.
That would be wrong. There are 100 million American
investors who know it is wrong. And I will lead that fight,
day-in, day-out, to prevent preemption, whether it is this
year, next year, or 10 years from now. We will be there to say
that you cannot keep the States out of this mandate.
We have since day one, before the Federal securities laws
were there, regulated the securities markets to make sure there
would not be fraud.
The concern of balkanization is a red herring. When it came
time to ensure that there was consistency, that there were
rules pursuant to which people could conduct business, we
worked with the SEC. We made sure that there was that
consistency and we said that we understand the mandate that
there be uniformity to preserve the integrity of the capital
markets.
However, preemption of the States would be an egregious,
egregious mistake.
Let me make a point which has not been discussed so far,
and that is one of the collateral consequences of the boom and
bust cycle that was, to a certain extent, driven by the false
and knowingly false analytical work that was generated. And
that is the misallocation of capital.
If you want to talk about harm to our economy, the
misallocation of capital that flowed into certain sectors that
were favored because the investment banks saw that they could
do underwriting, and the consequent increase in cost of capital
to other sectors, some of our core economic sectors, that is an
enormous cost to the competitive nature of our economy and
should not be forgotten.
Many of the sectors where there were not incipient IPO's,
where there were not people coming up with new paradigms, could
not get the attention of the investment houses and their cost
of capital increased. They could not raise the money and we
lost market share.
I think anybody who wants to understand and question what
is happening to our economy has to focus on that because that
is a cost that is borne not just by the investors who lost the
valuation of their shares, but by the entire economy and our
capacity to compete with our overseas competitors.
That is one of the collateral consequences we haven't yet
focused on sufficiently. I hope, sir, that we will.
Let me make one last point. And I know that Senator Dodd in
particular will focus on the tax implications, and rightfully
so. But let me say this about that issue. There will be, and I
am sure, I hope questions about how we determined what the
appropriate fines would be and what the relative fines were and
how we arrived at those numbers.
We were not going to play games with what we called these
impositions of penalties, fines, or restitution.
Pursuant to various statutes that you have passed, some of
these monies needed to be restitution. We were going to call it
that. Pursuant to other obligations, we were going to impose
fines. We were going to impose the obligation for research that
we can talk about.
We were not going to play or participate in what would have
been an accounting gimmick to have a tax impact.
If you rightfully believe that many of these funds that are
going to be paid by the banks should not be tax-deductible,
please amend the tax code. We would like that. If you believe
these should not be insurable, pass a statute that forbids it.
We were deeply involved in an effort to try to see what
would be insurable, what would not be insurable. We do not
write the insurance policies. Many of those who are now
claiming that they should not be forced to pay pursuant to
those insurance policies, they took the premiums for many years
without complaining. There are two sides to every contract.
So, I think if we want to examine that issue, both sides
should be examined.
Thank you.
Chairman Shelby. Our next witness is Richard Grasso,
Chairman, New York Stock Exchange.
STATEMENT OF RICHARD A. GRASSO
CHAIRMAN AND CEO, NEW YORK STOCK EXCHANGE, INC.
Mr. Grasso. Chairman Shelby, Ranking Member Sarbanes,
Senator Dodd, thank you for inviting me to testify today on
behalf of the New York Stock Exchange to discuss the global
settlement, which addresses conflicts of interest between
research and investment banking at 10 of the largest, most
influential investment firms in the country.
The settlement is historic, Mr. Chairman, in many ways, in
its breadth and depth, in the severity of penalties imposed,
the level of cooperation among the securities regulators and,
most importantly, in its impact upon the business model of
integrated financial services going forward.
The last point is most significant in my view, toward
restoring the public's trust and confidence, and importantly,
sending a message to 85 million Americans who own the great
companies that we are privileged to trade, that there have been
lessons learned, that Wall Street gets it, that reform is more
than just waiting for a market upturn. There were severe
mistakes and egregious violations. We have to stand up,
recognize that, and correct those very, very dark breaches of
fiduciary responsibility to customers.
The regulators that sit before you, Mr. Chairman, conducted
extensive probes of the firms' research practices, including
review of hundreds of thousands of pages of documents, e-mails,
interviews with employees and customers. It was extensive and,
given its extraordinary size, swift.
The penalties imposed constitute some of the largest ever
levied in the history of securities regulation, which sends a
clear and strong message about the seriousness of the firms'
misconduct.
The settlement mandates new procedures that will forever
change the way analysts do their work, the way investment
bankers do their work and, most importantly, maintaining a
separation between the two.
In short, the settlement ushers in a new era in which the
quality, integrity, and reliability of Wall Street research is
protected for the benefit of investors. The settlement marks
only the beginning, Mr. Chairman, of a new era. There is still
more work to be done.
Firms and investors alike should be aware that the
regulators, both self-regulators and those at the State and
national level, will continue to take all necessary measures to
protect the integrity of the marketplace and will hold
accountable anyone who breaches the public's trust.
Our regulatory group is committed to making certain, Mr.
Chairman, that all penalties for violations of rule, policy,
practice, or law, will be swift and significant.
In the joint regulatory partnership that sits before you,
an unparalled spirit of cooperation was delivered to the
American public and, most importantly, delivered to those who
are in the American marketplace.
The task force which was formed in April 2002, consisting
of those orgainizations at this table, was designed to bring
together those who were determined to make certain that our
markets remain the most admired in the world.
Early in that investigation, it became apparent that all of
the firms that we were looking at utilized business practices
that compromised the independence of the research analysts.
These conflicts were identified and our task force in a matter
of months was able to uncover significant evidence that each
firm under investigation had engaged in misconduct.
One of the most disturbing findings by the task force was
the lack of effective supervision at each of these firms. The
task force determined that each firm encouraged a culture and
an environment in which research analysts were repeatedly
subjected to an inappropriate influence by investment bankers
and in which the objectivity and independence of their product
was compromised as a result of that influence.
These supervisory deficiencies manifested themselves in
numerous ways, including how research analysts were
compensated, how they freely were utilized in soliciting
investment banking business, and in the absence of effective
review of the content of the research product, the
recommendations, and ratings which were issued.
The settlement, Mr. Chairman, is one and only one element
of our collective intent to continue to work and address these
findings. Another important element is rulemaking.
In May 2002, the SEC approved new Exchange and NASD rules
that represent an important step in insulating research
analysts from conflicts of interest and improving the
objectivity of their published products.
In June 2002, the Exchange initiated a special exam program
in coordination with similar programs at the SEC, the NASD and
the State overseers to ensure that firms were complying with
the obligations and restrictions imposed in the new rules.
In October 2002, the Exchange and the NASD submitted to the
SEC for comment and approval, additional rules to further
expand the restriction on firms' research activities.
We are currently in the process of drafting and approving
new rules pursuant to the requirements of the Sarbanes-Oxley
Act of 2002. These rules, which will be submitted to the
Commission shortly, will further prevent conflicts, thereby
ensuring that public research will be objective.
Furthermore, these rules will require published research to
contain disclosures and other information designed to help the
public make informed decisions about the quality of
recommendations.
It was always of paramount importance to the task force,
not only to identify and punish those who had violated the
public trust but also to impose a system of prospective relief
that would require firms to change their business model.
As set forth in the settlement, firms that engage in
investment banking services will no longer operate with the
unfettered participation of research analysts. Equally
important, investment bankers will not be permitted to pressure
research analysts to place favorable ratings on client stocks.
Accordingly, the firms will be required to make independent
research available to their customers and to make payments into
an investor education fund that will be used to inform
investors about the risks and opportunities available in equity
investment.
Additionally, the 10 firms have entered into a voluntary
agreement prohibiting ``spinning.'' This term is used to
describe the
improper allocation of shares of hot IPO's to executive
officers and directors of public companies in an effort to
attract their investment banking business. This prohibition
will promote fairness in the allocation of IPO shares.
The Exchange, in partnership with the SEC, the NASD, and
the States, is currently investigating the IPO allocation
process at the firms participating in the settlement to
determine whether improper conduct occurred.
The Exchange and NASD formed a joint committee at the SEC's
request in August 2002 to pursue such an investigation, to make
recommendations to the two SRO's and, ultimately, to the
Commission, on proposed rulemaking or, if needed, further
legislation.
In addition, the Exchange, through its examination program,
will review the 10 firms' compliance with the undertakings
required by the settlement, with the new requirements of NYSE
Rule 472 and with Regulation AC, which requires that analysts
certify that their research reports represent and reflect their
personal views.
Each firm has a responsibility to establish, maintain, and
enforce a system of supervision designed to ensure compliance
with applicable laws, regulations, and rules. The Exchange, the
SEC, the NASD, and the States will develop joint examination
programs to make certain that compliance departments of the
largest broker-dealers are in a position to ensure that the
violations of the past do not become practices of the future.
The Exchange will regularly examine each of its member
organizations to ensure that its supervisory systems and its
management are in compliance with applicable rules and
securities laws and that the firms are conducting their
business in accordance with the highest ethical standards.
The Exchange will bring actions that it deems warranted
with respect to the management of these firms, individual
supervisors of the research and banking departments, as well as
individual analysts who may have engaged in improper conduct.
Mr. Chairman, let me emphasize again that the settlement's
remedial sanctions are the largest ever levied in the history
of the securities industry, and the prospective relief
constitutes an unprecedented framework for reforming Wall
Street research.
The settlement delivers a strong and clear message that the
interests of the investing public will not come second to
anything or anyone, including the generation of investment
banking business.
We achieved the goals of the investigation with speed, hard
work, and partnership at the regulatory level, both State and
national. But the work is not finished. There is more to be
done.
Eighty-five million investors and the entire country will
watch carefully to measure and determine the answer to the
question posed by the Committee earlier--does Wall Street get
it?
Wall Street, from this settlement, must take a message that
change, designed to return to the basic principle that the
customer comes first, is the only way to build a business.
Anything less would be unacceptable for investors, for our
great country, and for the efficiency of the capital market
system.
Thank you, Mr. Chairman.
Chairman Shelby. Mr. Glauber.
Senator Dodd. Mr. Chairman, before you proceed, I must
apologize to our panel of witness who are obviously going to go
longer.
I cannot stay much longer on this. I am going to submit
some questions to people.
Chairman Shelby. We will submit the questions for the
record.
Senator Dodd. If I can do that.
Chairman Shelby. Absolutely.
Senator Dodd. I am particularly interested in the issue
about the tax-deductibility part of this. I will submit that to
all of you.
I thank you for coming and I apologize again.
Thank you all, and thank you, Mr. Chairman.
Chairman Shelby. Mr. Glauber.
STATEMENT OF ROBERT GLAUBER
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
NATIONAL ASSOCIATION OF SECURITIES DEALERS
Mr. Glauber. Chairman Shelby, Senator Dodd, Senator Crapo,
thank you for inviting me to testify about the important
milestone we passed last week in finalizing the global
settlement.
NASD played an important role in that historic agreement.
Let me spare you repeating what has already been said and let
me concentrate mainly on NASD's role.
In completing this settlement, all of the regulators took a
large and necessary step on the road to renewing investor
confidence. No one believes this agreement alone will reverse
the effects of more than a year of scandals involving
accounting that was unaccountable and corporate governance that
simply did not govern, as well as the analyst and IPO abuses
that were the subject of last week's announcement.
But this settlement has sent a number of important messages
that we believe investors, as well as security firms, do
understand and must understand.
The sanctions in this settlement are among the strongest
and most substantial in the history of the securities
environment and enforcement. But in addition to the $1.4
billion price tag that made the headlines around the world, we
have forced meaningful change in the way Wall Street does
business, and will do business in the future.
What have we done?
We have sent an unmistakable signal that analyst research
cannot be a tool of investment banking. We have told Wall
Street that hot IPO's cannot be doled out to corporate insiders
as virtual commercial bribes. And we have demonstrated, I
believe, that firms act through individuals and that
individuals too will be held accountable for their misdeeds.
Underscoring these principles, NASD has investigated and
brought charges in more than a dozen important analyst and IPO
allocation cases against individuals, as well as firms.
Indeed, the most significant case against an individual in
the global settlement, Jack Grubman, stemmed from an
investigation started by NASD almost 2 years ago. Charges
brought by NASD in September 2002, against Jack Grubman for
misleading research were settled and wrapped into the final
agreement. Mr. Grubman paid $15 million in fines and is now
barred from the securities industry for life.
In addition, investigations against Salomon, Smith, Barney,
Credit Suisse First Boston, Merrill Lynch and its star analyst,
Henry Blodget, resulted in the largest firm and individual
sanctions in the global settlement.
NASD was already policing this beat when the bubble was
still a bubble. By beginning in 2000, we started building a
landmark IPO profit-sharing case against CS First Boston that
we, along with the SEC, finally settled at the beginning of
last year--that is 2002--for $100 million in sanctions.
We caught CSFB carrying out a systematic scheme whereby, in
exchange for dishing out shares of lucrative hot IPO's to
chosen customers, it demanded and received paybacks of between
33 and 65 percent of the customers' trading profits in those
IPO shares.
In addition, NASD has been working with Congressional
champions of analyst and IPO reforms for more than 2 years,
including Members of this Committee, and we are redoubling our
effort under the new agreement to ensure that the system works
to protect investors.
Specifically, and in an answer to Senator Crapo's earlier
question, NASD and the New York Stock Exchange have issued two
sets of analyst rules to make analysts more independent and
investors more informed.
These rules will apply beyond the 10 global settlement
firms throughout a diverse industry of over 5,300 firms, and
they will protect investors whether they live in Birmingham,
Baltimore, Brooklyn, or Berkeley.
We have also issued a proposed set of rules making explicit
the prohibitions against the most common IPO abuses and will
soon release with the New York Stock Exchange, the results of a
joint blue ribbon panel recommending additional reforms of this
vital part of the capital formation process.
Finally, we are hopeful that the global settlement will
make it easier for investors to recover their losses through
arbitration. NASD dispute resolution is currently administering
more than a hundred cases involving analyst issues. We expect
this number to grow substantially, perhaps as high as 4,000, as
evidence from the settlement can and does become used to make
the case for recovery of investor losses.
In conclusion, if last week's global settlement proves one
thing after all, it is that playing by the rules and putting
investors first is more than good ethics. It is good business.
For the firms and individuals involved in this settlement,
that is a hard lesson, but one I believe they surely understand
well now. And that is good news for every investor who wants to
participate in the most liquid and developed capital markets in
the world.
Let me just add one comment if I might, Mr. Chairman. Very
simply, I do not agree with Attorney General Spitzer that these
events reflect the failure of self-regulation.
Of course, in hindsight, we could have, I am sure, been
better focused, not gone down some blind alleys. But I think
the evidence of our record, part of which I have recited, makes
clear that we do have a very credible record of effectiveness
as a self-regulator.
Thank you very much.
Chairman Shelby. Ms. Bruenn.
STATEMENT OF CHRISTINE A. BRUENN
PRESIDENT, NORTH AMERICAN SECURITIES
ADMINISTRATORS ASSOCIATION, INC.
Ms. Bruenn. Chairman Shelby, Ranking Member Sarbanes, and
Members of the Committee, I am Christine Bruenn, Maine
Securities Administrator and President of NASAA.
I would like to start by acknowledging the role that this
Committee and its House counterpart played in this matter.
Congressional hearings shined an early light on Wall Street
practices that were an important guide for regulators.
From the outset of the investigations, State securities
regulators have had three goals--to fundamentally change the
way business is done on Wall Street, impose meaningful
penalties for illegal behavior, and to provide harmed investors
with the information they need to pursue arbitration cases.
If the industry follows both the letter and the spirit of
this agreement, investors, not investment banking fees, will
come first. And analysts will be beholden to the truth, not the
IPO business.
Let me give you a brief overview of State securities
regulation. The securities administrators in your States are
responsible for the licensing of firms and investment
professionals, the registration of small securities offerings,
branch office sales practice audits, investor education and
most importantly, the enforcement of State securities laws.
Because they are closest to the investing public, State
securities regulators are often first to identify new
investment scams and to bring enforcement actions to halt and
remedy a wide variety of investment-related violations. They
also work closely with criminal prosecutors at the Federal,
State, and local levels to punish those who violate our
securities laws.
While the global settlement is most important for its
impact on Wall Street and investors, it is remarkable for
another reason as well. I believe it represents a model for
State and Federal cooperation that will serve the best
interests of investors nationwide. As we did with the penny
stock fraud, with microcap fraud, day trading and other areas,
the States helped to spotlight a problem and worked with
national regulators on marketwide solutions. It bears
repeating--the States historically and in the current cases,
investigate and bring enforcement actions. They do not engage
in rulemaking for the national markets. That is rightly the
purview of the SEC and the SRO's.
None of the regulators who are involved in this global
settlement could have done this on their own. That is why there
must be cooperation and division of labor among the State,
Federal, and industry regulators.
Over the past several years, NASAA members have been active
participants in the rulemaking and legislative process in the
area of analysts' conflicts of interest. The States worked
closely with the SEC and the SRO's to formulate new, marketwide
rules that were needed to fix the analyst problem.
Many of our original proposals were incorporated in the
final rule. Also, NASAA was strongly supportive of Title V in
S. 2673, which became the Sarbanes-Oxley Act of 2002.
You have heard about the global settlement and I want to
explain how the States fit in. Last spring, as the New York
Attorney General was wrapping up his Merrill Lynch
investigation, NASAA felt that it would be beneficial to all
concerned to settle the cases simultaneously for all the States
as a group. Eliot agreed and negotiated on those terms.
A few weeks before the Merrill Lynch agreement, the NASAA
Board met to form the Analyst Task Force. Its Steering
Committee was charged with investigating whether problems
discovered at Merrill Lynch were industrywide. The Steering
Committee assigned one State to lead the investigation of each
firm. Many other States signed on to assist in the
investigations. Further, the Task Force agreed to work in
collaboration with the other regulators.
Each firm was assigned a lead State and a Federal
counterpart. The investigations continued into the fall, at
which time all regulators determined to pursue a global
resolution of the cases, as was described in earlier testimony.
An important question faced by State securities regulators
was how best to use the penalty monies. A primary and routine
objective of State securities regulators is to obtain
restitution for investors as part of its enforcement actions.
In reporting year 2002,
restitution ordered through administrative or civil actions at
the State level was $309 million. At the same time, roughly $71
million was ordered in fines and penalties.
When considering restitution, we ask ourselves, can we
identify the victims? Can we quantify the loss? And can we make
meaningful distribution?
As a fraud on the market, we struggled to identify the
victims. We considered starting with the customers who
purchased through the firms. But what about those who saw Henry
Blodget on TV and purchased the stocks online? Or bought stocks
from a firm that purchased research from one of the 10 firms?
And what about mutual fund investors? In our view, a fraud on
the market harms all investors. In light of these issues, we
believe decisions regarding the funds are best made at the
State level so that they can be tailored to the unique
circumstances of each State.
The settlement also requires some of the firms to
contribute funds over the next 5 years for investor education.
The NASAA Board directed the State portion of these payments to
a separate fund of the Investor Protection Trust, a public
charity. The fund will be distributed pursuant to a grant
process, supporting and creating financial literacy programs,
with materials tailored to the needs of local communities, and
conducting research.
The analysts' conflict of interest was a big story in the
financial press. But it was hardly the only focus of State
securities regulators. There are many types of violations that
State securities regulators continue to fight.
NASAA has published a list each year of top 10 scams to
highlight problem areas for investors. Attached to my written
testimony is a list of some of our ongoing initiatives.
Mr. Chairman, in closing, I would like to offer you my
personal opinion based upon 16 years as a securities regulator.
I believe that now is the time to strengthen, not weaken,
our unique complementary regulatory system of State, Federal
and industry regulation. Eighty-five million investors, many of
them wary and cynical, expect us to remain vigilant, to stay
the course, to make sure that Wall Street puts investors first.
I pledge the support of the NASAA membership to work with
you and your Committee to provide you with any additional
information or assistance you may need.
Thank you for the opportunity to testify and I look forward
to continuing the NASAA's excellent working relationship with
this Committee.
Chairman Shelby. Thank you.
Attorney General Spitzer, what specific actions initially
triggered your investigation into Merrill Lynch in 2001?
Mr. Spitzer. Sir, I am not sure there was a specific
action. I think that, and this is why I disagree with Mr.
Glauber fundamentally, and others, there was such a wealth of
information out there, that this was a crisis screaming to be
addressed.
It did not take a detective and, frankly, Inspector
Clouseau could have seen it. It is embarrassing that those who
should have seen it did not. And that is why I said, you had to
be on the dark side of the moon not to understand it. There was
evidence all over the place. There were articles written by
superb journalists that defined the issue. And yes, there may
have been isolated, atomized cases that had been brought.
Nobody had asked the question, is this a structural problem?
Knowledge of this problem went to the very top of the
investment banks.
The compliance departments, and Bob, my criticism is not
just directed at the NASD. It is also the internal compliance
departments of these firms. They may ensure that things are
filed in triplicate, but they did not ensure that there wasn't
fraud being
committed. So the internal compliance departments of these
firms were a joke as well.
Chairman Shelby. Mr. Grasso and Glauber, how is it that the
blatant conflicts of interest were not detected through
internal compliance procedures instituted by the SRO's?
Mr. Grasso.
Mr. Grasso. Well, Mr. Chairman, I think that it is with the
benefit of hindsight that I look back and say, you are
absolutely correct in your presumption that it should have been
detected.
It should have been detected at the firms. It should have
been detected by the self-regulators. And it simply was not.
I think that, if you set it contextually in the period----
Chairman Shelby. Was it because so much money was being
made and everybody was exuberant?
Mr. Grasso. I think, Mr. Chairman, I was about to go there
in response to your question. You have to forgive me. I was the
old economy at the time.
Chairman Shelby. Okay.
Mr. Grasso. But there was an enormous wealth creation in
the period, 1995 through 2000, through the peak in 2000.
As you look back at the IPO process with the benefit of
hindsight, or if you look back at the rising levels of equity,
both in the two primary markets, the New York Stock Exchange,
and the Nasdaq there was, to use Chairman Greenspan's
observation, an irrational exuberance.
No one was asking the question, what is fundamental
valuation of a security? People were simply asking the
question--if I buy it, at what price may I sell it? And
therein, I think, is the breakdown in the traditional valuation
model.
I would say, finally, Mr. Chairman, that as we go forward,
and I think that I am in the middle, of course, between the
great Attorney General of the State of New York and my
colleague in the self-regulatory community, it is unfortunate
that no one can turn the clock back. We certainly can look
prospectively with the benefit of history and ask all of the
tough questions that perhaps we hadn't asked in the period.
Such as, Mr. Chairman, at a time when equity values were
rising just about daily, and as Chairman Donaldson observed in
his commentary, there were more cheerleaders than there were
analysts. Perhaps it would have been again, with the benefit of
hindsight, smart to impose different levels of margin on
securities, and specifically targeted margin, for those
securities that literally overnight were doubling, tripling,
and doing even more than that based on their initial offering
prices.
So, I would say to you, Mr. Chairman, that there are lots
of lessons learned, and I am not going to suggest that anyone
should be proud of their record in the period, 1995 to 2000.
I can only hope and commit that, looking forward, we will
be proud of how we proceed and enforce this new business
paradigm.
Chairman Shelby. Mr. Glauber.
Mr. Glauber. Mr. Chairman, first of all, I think your
comment is spot on. The financial enticements for stepping over
the line were at unprecedented levels and obviously, more
people did step over the line.
Chairman Shelby. Greed.
Mr. Glauber. I think you could use the word.
On the issue of self-compliance, again, I think you have
put focus on the right issue. I do not believe self-compliance
did the job that it should have.
Since the time I have come to the NASD, we have emphasized
self-compliance. We have worked to give self-compliance
officers in the firms more tools so that they can do their job
better. And most recently, 2 weeks ago, our board voted to put
out for comment and the SEC, a provision where we will require
that the CEO and the chief compliance officer of every firm
certify that the policies and procedures are in place to
enforce our rules.
Chairman Shelby. How did the Federal and State regulators
organize the joint task force to investigate the wrongdoing?
How were the lead Federal and State regulators paired up?
Mr. Cutler, do you want to comment on that?
COMMENTS OF STEPHEN M. CUTLER
DIRECTOR, DIVISION OF ENFORCEMENT
U.S. SECURITIES AND EXCHANGE COMMISSION
Mr. Cutler. Yes, Senator. Mr. Chairman, what we did on the
Federal side is allocate the lead investigative position to
each of the three Federal regulators.
That is, of the 12 firms, and we did start by looking at 12
firms here, there were 4 as to whom the SEC took the lead
responsibility, 4 as to whom the New York Stock Exchange took
the lead responsibility, and 4 as to whom the NASD took the
lead responsibility.
We, all of us, worked together on these investigations, and
although we designated one entity as the lead, it wasn't as
though any of us abdicated our responsibility and we worked
together in closely keeping each other apprised of the evidence
that we were gathering and the legal analysis that we were
going through.
At the same time, the States, and I will let Ms. Bruenn
comment on this, and Mr. Spitzer, designated lead investigative
States that matched the Federal side. We combined our resources
to conduct this investigation.
Chairman Shelby. Do you want to comment, Ms. Bruenn?
Ms. Bruenn. Yes, Senator. The lead States on the State side
were organized in the spring, and it was based upon a group of
States plus the regulators who worked for those States who had
some experience in doing large multistate actions.
And a lot of the leadership came from the New York AG's
office. We were paired up with the Federal regulators from that
point.
Chairman Shelby. Okay. Personal accountability--we have
been talking about that.
All 10 of the firms were charged with failure to supervise
their research and investment banking divisions, which means
that specific managers and executives failed to take the
appropriate actions to eliminate the conflicts.
Several executives did more. These executives actively
pressured analysts to make certain recommendations. I believe
the papers regarding Citigroup and Jack Grubman are
particularly instructive because they give some insight into
the personal dynamics at play here.
It is apparent that Grubman himself felt enormous, enormous
pressure, to write reports that pleased the head of the
investment banking and Citi Chairman, Sandy Weill.
Even the head of global research expressed, ``A legitimate
concern with the objectivity of research with the head of
Salomon, to no avail.''
``Grubman was reacting to the business needs of investment
bankers. It appears that he was fulfilling the wishes of those
in his organization who outranked even the head of the research
department.''
``Yet Grubman is the only named individual.''
Attorney General Spitzer----
Mr. Spitzer. Well, sir, I would----
Chairman Shelby. Well, let me finish my question.
Mr. Spitzer. Sorry. I thought that that was the question.
Chairman Shelby. Sure.
[Laughter.]
Why did you not name any individuals at Salomon or Merrill
Lynch? Did the buck stop with Messrs. Grubman and Blodget?
Mr. Spitzer. Can I answer the first question?
Chairman Shelby. Yes, go ahead.
Mr. Spitzer. We examined the evidence under the laws that
we enforce, the Martin Act. I know that there has been a
general view that the Martin Act is rubber-banded with
continuous elasticity. But there is not a crime or a violation
under the Martin Act for failure to supervise.
Chairman Shelby. Okay.
Mr. Spitzer. Whether there is a possibility of having
investigations under other statutory structures that would
pursue that charge, I will leave to others.
I have said quite clearly that we looked at the evidence
relating to Mr. Grubman and Mr. Weill and brought the charge
against Mr. Grubman because we believed we could prove that
charge, which is how we do things.
Chairman Shelby. Okay.
Mr. Spitzer. There was no charge to be brought against Mr.
Weill under New York State law. And that was the determination
we made.
The general observation you make about failure to supervise
throughout the industry, obviously is one that not only do I
share, but I also imagine my colleagues share.
Chairman Shelby. Attorney General Spitzer, your office
chose not to pursue charges against Blodget. When you settled
your case with Merrill Lynch, did you agree not to pursue
charges against individuals at Merrill?
Mr. Spitzer. Yes, sir, and I will tell you exactly why.
Chairman Shelby. If so, why did you make this concession?
Mr. Spitzer. I will tell you exactly why.
There was, in my mind, a concerted strategy underlying the
efforts of last year. I was of the view that the problems that
we diagnosed at Merrill Lynch were not unique to Merrill Lynch.
Indeed, I believed that the business model that permeated
Merrill that led to the subservience of analytical work to
investment banking was replicated elsewhere.
I was of the view that this issue needed to be examined
elsewhere in the industry and each of the major firms. I was of
the view that we needed a settlement with Merrill Lynch to
define the problem, set it out in this glare of public
discourse before Congress and the SEC.
Hence, I said, we will make that deal. There are other
regulators who in due course will proceed against individuals.
But I believed it was critical that we resolve that issue with
Merrill Lynch, move on to inquiries relating to other
investment houses and in due course, there will be fair
opportunity for others.
And indeed, there are other prosecutorial offices that
contacted me immediately after our settlement and said, we are
interested.
We provided to them the information and the data. They are
free to proceed as they wish.
Chairman Shelby. What about principal violations under the
Martin Act?
Are you familiar with--is it the Martin Act?
Mr. Spitzer. The Martin Act, yes, sir.
Chairman Shelby. That takes care of investment banks.
Mr. Spitzer. But by principal violations, you mean, what?
Chairman Shelby. Well, any of them, principal violations.
In other words, were there principal violations by higher
people?
Mr. Spitzer. Oh, sure. We have not given immunity, other
than at Merrill Lynch to principals at any of the firms.
With respect to Sandy Weill, I have said, we examined that
fact----
Chairman Shelby. To hardly anybody.
Mr. Spitzer. Well, there are continuing investigations in
my office and in other offices and it has been eminently clear
since day one that these settlements with the institutions.
Chairman Shelby. Sure.
Mr. Spitzer. Other than, as you point out, with respect to
Messrs. Grubman and Sandy Weill. I investigated that case and
made a determination that there was no case under the Martin
Act with respect to his dynamic with Mr. Grubman.
Chairman Shelby. Mr. Glauber.
Mr. Glauber. Yes, sir.
Chairman Shelby. In the negotiation of the settlement,
there were press reports that efforts were being made to,
``tone down,'' the wording in the orders.
Specifically, an article in The Wall Street Journal on
January 16 of this year, suggested that Attorney General
Spitzer requested that the NASD tone down its description of
some of the alleged wrongdoing.
Can you describe your perspective on this? In particular,
how the various regulators collectively negotiated the various
documents.
Mr. Glauber. Certainly, Mr. Chairman.
I must say I was a bit bemused by the article. I do not
want to speak for Attorney General Spitzer. The fact was, we
drafted the original language and sent it to Attorney General
Spitzer's office.
Chairman Shelby. But you are familiar with the phrase, tone
down, aren't you?
Mr. Glauber. Oh, I am.
Chairman Shelby. Absolutely.
Mr. Glauber. But let me tell you the facts. The fact is
that we sent it over. I never talked to the Attorney General
nor, in fact, at the time that that article was written, had we
heard anything back from the Attorney General's office.
So it would be hardly true to say that there was a dispute
going on at that point about toning down the language. And if
you look at the final language, I think it is pretty tough.
Chairman Shelby. Senator Sarbanes, you have waited
patiently.
Senator Sarbanes. Thank you, Mr. Chairman.
First of all, I thank the panel. I know you have had to
wait through the full morning, but we obviously had a number of
things to discuss with Chairman Donaldson.
Everyone says, in retrospect or in hindsight, maybe we did
not do what we should have done, but we were doing a good job
all along. And it is a heightened standard to come along in
retrospect and look back and say, well, you missed this or you
missed that.
Of course, the Attorney General reminded us in his opening
statement that we missed a lot of things here as well.
That is fair enough.
But let's not do it in retrospect. I want to take it right
now. And I want to ask particularly Mr. Grasso and Mr. Glauber,
what are we to make of what is happening right now by some of
the leading figures on Wall Street, members, presumably, of
your organizations, which lead The New York Times to say in an
editorial, ``Investors should keep a wary look along this self-
denial and lack of contrition. It may suggest that the
revisionists are on to something when they say that nothing
will change on Wall Street.''
And of course, they are referring, first of all, to an op-
ed piece in The Wall Street Journal by the chief executive of
one of the major brokerage firms, in which he says, and I am
now quoting the article, ``But if we attempt to eliminate risk,
to legislate, regulate, or litigate it out of existence, the
ultimate result will be economic stagnation, perhaps even
economic failure. To teach investors that they should be
insulated from these forces, that if they lose money in the
market, they are automatically entitled to be compensated for
it, does both them and the economy a disservice.''
That is the part of the article written by the head of one
of the major brokerage firms.
Now this is what The New York Times says about that: ``As a
broad Econ 101 principle, we would agree, hurrah for risk. But
`risk' is not normally defined as embracing deliberate
deception by brokers who twist their research to curry favor
with investment banking clients, thereby abusing investor
trust.''
And then they make the point whether the head of one of
these, could have forgotten these e-mail notes of one of his
leading analysts ridiculing the very companies the analyst was
urging the clients to invest in, from his own company.
They go on to say that, ``Of course, that is not the lesson
that Mr. Spitzer and other regulators are trying to teach.''
Namely, that, ``If they lose money in the market, they are
automatically entitled to be compensated.''
These investors are not asserting that. I have talked to a
lot of these angry investors and they know the risks they were
taking. And that is not what they are arguing. They are
screaming mad about being misled and deceived.
Then the Times goes on to say, ``This essay is only one of
several signs that Wall Street remains in deep denial about the
degree to which it betrayed investors' trust.''
And then they go on and deal with another investment house
which got a very sharp retort from Chairman Donaldson just the
other day.
Now what are we to make of this? It is one thing to come in
and say, well, in hindsight, we would have done it differently
and so forth and so on. There is no hindsight here. This thing
is out here on the table. A settlement has been reached, the
most far-reaching ever. These egregious practices have been
detailed.
I have in here, if I can find it, the complaint that the
Commission filed in the Grubman case. You read through the
nature of the complaint by the SEC against Grubman.
You read through enough of this and it is just a horror
story.
Mr. Grasso. Senator.
Senator Sarbanes. And yet, in the face of all of this, we
are getting leading figures in Wall Street, in effect, in
denial. And the Times says, ``Investors should keep a wary eye
on this self-denial and lack of contrition.''
What are we to make of this?
Mr. Grasso. Senator Sarbanes.
Senator Sarbanes. Yes.
Mr. Grasso. I think it is a tragic mistake for anyone to
try to create a revisionist account of what happened.
Investors understand, in my view, the difference between
risk and breach of agency responsibility. I can tell you as
recently as a month and a half ago, I spent a Saturday morning
with 1,600 American investors at a conference in Boston. They
weren't asking for a promise of profit. They were asking for a
promise of fairness.
And that is what the failure was, the fairness. The failure
to adhere to the fundalmental rule that the customers'
interests should always come before the proprietary interests
of a firm. I think any attempt to recast what has happened is a
tragic mistake.
You saw the sharp criticism that Chairman Donaldson offered
up last week. I believe that anyone in my business, any leading
manager who would attempt to suggest that that is the risk of
the market, when you are putting the firm's interests before
the customers' interests, will have failed to have gotten the
message.
The question was asked earlier, does Wall Street get it?
And that type of thinking cannot ever be allowed to be in the
mainstream of serving customers.
I would say to you finally, Senator, that it is difficult
to separate the period from the malfeasance. But it should have
been done. There is no question. There were remedies that were
available.
What the global settlement does do is draw a very bright
line declaration of what is the expected performance and
conduct going forward. And I believe there is no ambiguity
there. If people fail to get it, they won't be in the business.
Nothing more complicated than that.
Senator Sarbanes. Mr. Glauber.
Mr. Glauber. Senator Sarbanes, first of all, fraud is not
risk. So there is no confusion.
I think there are some people in the industry right now who
do not get it. You read statements to suggest it. I think there
are many who do get it.
The ones who do not get it are going to get it. They are
going to get it because of the rules that have been put in
place and the enforcement of those rules. They are going to get
it because of the actions that will be brought by individual
investors against those firms.
I think they are going to have ample opportunities to get
it. I believe they will. They have to get it, because if they
do not get it, investors aren't going to trust these markets.
They aren't going to come back into these markets, and that
would be the greatest of all tragedies.
Senator Sarbanes. Mr. Grasso, let me ask you, because both
you gentlemen have to deal with boards of directors. You have
to deal, in your SRO's, with the very institutions that you are
regulating, by definition, which complicates your task. No
question.
But now, in the New York Stock Exchange Board, do I
understand you have a distinction between members of the board
who represent the public and members who represent industry?
Mr. Grasso. There are 24 nonmanagement members of the
board, Senator. Twelve are from the securities industry, 12 are
nonsecurities industry. They are deemed to be other than
securities industry representatives and described as public
representatives, but not public in the sense they may not be
from the corporate community or major institutional investors
in equity securities.
In fact, of that second 12, the constitution and charter of
the Exchange require that one must be a representative of a
large equity investment pool.
Senator Sarbanes. I am interested in terms of getting it,
the message. And I am not now looking back. I am dealing with
where we are now, how the Exchange could have selected as one
of the nonsecurity industry representatives, Sandy Weill,
especially if I read this material that has been laid out here
before us.
Now how did that happen?
Mr. Grasso. Senator, I can only say, and I will have to
look back, for purposes of answering your question, at the
independent nominating process at the Exchange, which is not to
be confused with an independent nominating committee of a board
of directors. The mechanism itself is wholly separate and apart
from the Board of the Stock Exchange. Although they are similar
in constituency, one may not sit on the Board of the Exchange
and be a member of the nominating committee.
I think if the nominating committee chair or the entirety
of that committee were here today, they would say to you, as I
am about to say, it was a mistake to have offered it. I think
Mr. Weill would say if he were here, it was a mistake to have
accepted it.
If you look at the Martin report, not to be confused with
the Martin law in the State of New York, but a refernce to
William McChesney Martin, Jr., our first President at the
Exchange, later to become Chairman of the Federal Reserve, and
then later to come back to the New York Stock Exchange as a
special advisor in the early 1970's, you will see how he
structured the new composition of the board.
There is separation of the chief executive from that
nominating process. But I would say to you, with the benefit of
all we know now, and certainly with the good counsel of the
great Attorney General of the State of New York, it never would
have happened.
Senator Sarbanes. Well, I have to say to you that it defies
understanding, given what was out there on the record. I looked
over your list. You have hardly any what I would call public
directors. Panetta obviously would be a clear example.
Mr. Grasso. Correct.
Senator Sarbanes. But most of the others are all out of the
industry, are they not?
Mr. Grasso. Senator, on the nonsecurities industry side, we
have a mix of CEO's of listed companies and former CEO's of
listed companies.
Senator Sarbanes. What kind of pressure does all of this
put you under if--let's assume that you are trying to tighten
things up and improve standards, and that you see problems that
you want to address. But here's a board of directors that is
very heavily weighted in terms of where it comes from, and
presumably, what its interests are.
Now, as the Chairman and Chief Executive Officer of the New
York Stock Exchange, how does that circumscribe or curtail your
capacity to do what has to be done?
Mr. Grasso. Senator, I would say that when those 24
nonmanagement directors walk into that room, they have one and
only one constituency to whom they are accountable, and that is
85 million investors in this country.
Whether you come from a listed company, whether you come
from a broker-dealer, whether you are the Comptroller of the
State of New York, Carl McCall, as he was when elected to our
board, you must take off your respective team jersey, be it a
corporate team or a financial team, and recognize that the real
owners of the New York Stock Exchange, the real owners of our
markets in this country are the investors and consumers who use
our markets.
And if you cannot accept the fact that you put aside your
own proprietary interests, just as we have said in this global
settlement that the customers' interests must come before the
firms' interests, then you cannot serve on that board.
Senator Sarbanes. Well, have they been doing that?
Mr. Grasso. Absolutely, in my opinion, Senator.
Senator Sarbanes. Well, why have we had such a run of
problems, then?
Mr. Grasso. Senator, I would not deny what you have read. I
would tell you that in my experience, and I have been a
director now for longer than any person in modern history--15
years since I became President and Chief Operating Officer--
there has never been a time, be it a Leon Panetta or a Carl
McCall or a Juergen Schrempp, when they come into that room,
where they do not understand, in my view, that they represent
investors, people who use the market, and whether it is a
disciplinary proceeding that we are about to hear in appellate
format, or it is the institution of a new rule, policy, or
practice, they measure everything against one simple test--is
it right for the least sophisticated user of the market?
If we can answer that affirmatively, we will have done a
good job, Senator, and I think we will have served our
investors well.
Senator Sarbanes. You use McCall and Panetta as examples of
people who take that attitude when they, walk into this board
room of yours, where other attitudes get shed away.
But I am looking at your board composition in 2002. Five of
the members of your board were the head of the very companies
that are part of this global settlement.
Mr. Grasso. That is correct, Senator.
Senator Sarbanes. Now, how about in that instance? How do
we break through this situation?
Do you face the same problem, Mr. Glauber?
Mr. Grasso. Let me just say, if I might, on those five
individuals, Senator, that the disciplinary proceedings of the
Stock Exchange are insulated from the board itself.
I believe, we have a very well balanced judicial process
when we bring charges against anyone who violates rule, policy,
or practice. And that whole hearing apparatus is separate from
the board itself.
When an adjudication is rendered, it can be appealed to the
board. But if it involves any of those board members, they
clearly must recuse themselves from any action.
Senator Sarbanes. No, I am concerned about the broader
question of an attitude and an approach to these problems.
Have you confronted a situation in which you saw things and
you said, ``Well, we really should do something about that?''
But then you ran into a board that said, ``Well, now, wait a
second. That is not the culture in which we are operating.''
``What has happened to Richard Grasso here now? He's trying
to cause a lot of trouble.'' Or maybe you did not try to cause
any trouble, so you never encountered the problem.
Mr. Grasso. Senator, if you look at the track record,
particularly the Exchange's actions well before the legislation
on corporate governance which came to be Sarbanes-Oxley, if you
looked at the Exchange's actions with respect to the problems
in financial services firms in the 1980's and 1990's, I do not
think there has ever been an instance, certainly not in my time
as a senior member of the management of the Exchange, where any
board member from the industry in any way suggested that that
was not what we were about to advance, was not consistent with
the way they were doing business and therefore, we should not
go forward.
Senator Sarbanes. Let me ask the Attorney General.
What about these compliance and legal departments at these
firms covered by the global settlement? Where were they through
all of this?
Mr. Spitzer. I wish I knew, Senator. And I think when I
speak about the failure of self-regulation and compliance,
those are precisely the departments I speak of. Each one of
those departments is exponentially larger than my investor
protection bureau.
We have a total of 10 to 15 lawyers who work in this area.
Each of the firms who is a signatory to the global settlement,
certainly the bulge bracket firms at the top, have compliance
departments that are vast with hundreds of lawyers, thousands
of employees. And yet, at the very top, even though information
was flowing up, I could not agree more with your premise that
there simply was not an articulation and willingness to
articulate the notion that the very business model was leading
astray millions of Americans.
And that is why I say, and I began with the point that
there was a failure of self-regulation, and we need to question
the very premise whether or not it will work.
Senator Sarbanes. Mr. Glauber, did you want to address the
question I put earlier?
Mr. Glauber. Well, only to say that, as a self-regulatory
organization, we have in our governance, properly, I think, a
mixture of industry and public people. There are benefits to
having industry people and benefits to self-regulation.
We have, by our charter by-laws, a requirement that the
majority be nonindustry public people.
Senator Sarbanes. What do you mean by public?
Because Mr. Grasso says, industry people in his case, as I
understand it, are people in the securities business. Public
people can be, and most of them are, as I look over the list,
heads of major corporations, issuers, I take it.
And people that would meet what I think most of us would
ordinarily think of as a public member are--well, we mentioned
McCall, we mentioned Panetta, but not many.
Now what is your definition of public?
Mr. Glauber. Let me make one distinction for you.
We do not own exchanges. We do not have listed companies.
Remember, we are just a regulator.
Senator Sarbanes. Yes.
Mr. Glauber. So our public members would be what you would
call public. They would include, they could include the head of
a corporation, again, in our setting because we do not have
listed companies. Paul O'Neill, the former Secretary of the
Treasury, was a public member of our board until the Government
took him away.
I believe our voice is dominated by public interest, by
public members. I think there is a value in a self-regulatory
organization to having industry voice. That is the idea. That
makes it different from Government.
Obviously, the dominant interest of the self-regulatory
organizations has to be the public interest, and I believe it
is.
Senator Sarbanes. Can I ask one more question?
Chairman Shelby. Go ahead. You go ahead. I have some more
questions, too.
Senator Sarbanes. Ms. Bruenn, I wanted to ask you your view
from the States' level.
There are some now who are trying to preempt the States
from being involved in enforcing the securities laws. Now, as I
recall your testimony here earlier, you acknowledged that the
framework of statute and regulation that set the standards by
which business should be conducted would be essentially done at
the Federal level, which would give you a national structure,
but there was an important role to be played by the States in
enforcing those standards.
Is that essentially your position?
Ms. Bruenn. Senator, my position is that the States are
your early warning system. We are the ones that are close to
your citizens in each of your States.
When Mr. and Mrs. Smith has a problem in their account,
they pick up the phone and they call an office like mine, where
one of my staff members says, sure, come on in and bring your
grocery bag full of account statements and we will see if we
can figure out what happened.
I think we are the ones that hear about problems first. I
think we are a little bit of a test tube in the sense that we
tend to be smaller organizations. We tend to have a little more
flexibility than some of the larger Federal regulators and we
have the opportunity to try different ideas out.
But we readily concede that this is a national market and
that rulemaking for the whole marketplace must happen at the
national level. But that should not undermine our ability to
stand up and say, hey, there is something wrong here. Or here's
some information, SEC or SRO's, that you should be taking
account of.
We see ourselves as being a necessary piece of a
complementary system where we each play our own role and are a
necessary part of an integral system.
Senator Sarbanes. You do not see any reason why we should
make some radical change in this complementary system that has
been the prevailing model now for decades and decades, do you?
Ms. Bruenn. No, I do not. I would hope that you would not
make any radical changes.
I think what we have demonstrated in the past year is we
are essential to the system, that we can be the ones close to
the investors and stand up if we see that something is not
going right.
Senator Sarbanes. Mr. Glauber.
Mr. Glauber. Senator Sarbanes, if I just might, let me just
clarify one point I made earlier.
We are in the process of divesting our ownership of Nasdaq
and of the Amex. They have separate boards. And so, we are not
responsible for the kinds of issues that they have to deal
with, particularly the corporate governance and listing issues.
It was really that point that I would wish to make.
Senator Sarbanes. All right. Attorney General Spitzer, did
you want to address any of these issues that I put to Ms.
Bruenn?
Mr. Spitzer. No, sir, I think she stated it perfectly. And
I think that we have, as she said, a complementary relationship
and I think that what proves this is that within the space of
several months, we all collectively were able to generate
resolution to some of the thorniest issues. Resolution that
obviously is triggering substantial discussion and debate, as
it should. But there was no tension or conflict between or
among the various entities.
Senator Sarbanes. I want to ask Mr. Cutler again on this
question--you have obviously very important and substantial
responsibilities as the Director of Enforcement. There is a
long tradition at the SEC in that regard and some
extraordinarily able people have held that post.
I asked Chairman Donaldson this question about obstruction
of justice, destroying or altering evidence relating to a
Government investigation.
I am very much concerned about that because if people are
thumbing their nose and you come along to do an investigation--
Quattrone tells his colleagues to ``clean up'' their files,
knowing that some of these documents were being sought by
subpoenas and document requests from three different
regulators. That is pretty outrageous conduct.
Where do you think you are on communicating the message
that destroying or altering evidence relating to Government
investigations will not be tolerated? And is the Commission
pursuing all instances in which that matter has arisen?
Mr. Cutler. I think you have put your finger, Senator
Sarbanes, on an issue that is critical to us.
You cannot run an effective enforcement investigative
program where you cannot get the evidence you are entitled to
get.
Starting I would say about 18 months ago, we made a
concerted effort to talk to our counterparts in U.S. attorneys'
offices around the country about the importance to us of
criminally prosecuting obstruction conduct, whether it be
destruction of records, whether it be false testimony, anything
that goes to the heart and the integrity of the investigative
process.
And we have seen not just the prosecution that you have
identified, Senator, but a number of criminal prosecutions of
obstruction of SEC processes. And they are, first and foremost,
on the list of items that we try to bring to the attention of
our counterparts at the Department of Justice around the
country.
Senator Sarbanes. Good.
Are you getting good cooperation from the Justice
Department?
Mr. Cutler. Absolutely. I think that they have made it a
priority of theirs.
Senator Sarbanes. Good.
Thank you, Mr. Chairman.
Chairman Shelby. To the panel. Do you believe that this
settlement adequately compensates the average investor for the
financial damage that he or she has suffered?
We will start with you, Mr. Attorney General.
Mr. Spitzer. It was not intended to.
Chairman Shelby. Okay. So the answer is no, then.
Mr. Spitzer. Let me be perfectly clear about this, and I
have said this repeatedly. But since there has been so much
questioning about it from the panelists today, I think it bears
repeating.
Chairman Shelby. Absolutely.
Mr. Spitzer. The settlement imposes the largest fines in
history and provides to the investing public the information
needed to obtain redress through litigation.
That is the system we have created in our judicial process.
That is all we could do. That is what we designed to do.
The information is there. That information will permit them
adequate redress. The deal itself cannot and was not designed
to.
Chairman Shelby. Mr. Grasso.
Mr. Grasso. I would certainly second the Attorney General's
comment. As you know, Mr. Chairman, $4 trillion has melted out
of this market. There are going to be private rights of action.
There are going to be arbitrations designed to take the
evidence, designed to go after that money.
Chairman Shelby. Mr. Glauber.
Mr. Glauber. We are gearing up for a large arbitration
load. We believe there will be a lot of actions brought, as
there should be.
As the Attorney General said, this settlement document
spells out a roadmap to those.
Chairman Shelby. Ms. Bruenn.
Ms. Bruenn. Thank you, Senator. I think this settlement is
an important first step. I think it puts the structural changes
in place.
Chairman Shelby. But it is only a first step, isn't it?
Ms. Bruenn. I think it is just a first step. It gives the
information to investors and as my colleagues have said, the
arbitration process here is the next very big, important piece.
As the State securities regulators we are committed to
helping investors understand how the information the regulators
produced fits into their own personal situation. We will be
monitoring how the arbitrations proceed and trying to help
investors understand how to use it.
Chairman Shelby. Mr. Cutler.
Mr. Cutler. Of course, and I want to echo Chairman
Donaldson in this regard, investors here have lost much more
than money. They have lost their faith in the integrity of our
markets. And that is why the forward-looking part of this
settlement is so critical.
It is that part of the settlement that I hope and believe
will ensure that research analysts do not continue to serve as
cheerleaders for investment banking and are an important part
of our ongoing effort. And it is an ongoing effort, to restore
the faith of the investing public. We did think, Mr. Chairman,
that it was important to get as much money as we could back to
investors, in the context of the settlement. And no, it will
not restore investor losses.
Chairman Donaldson has said there are lots of challenges
and difficulties in doing that. We thought it was worth
undertaking those challenges and difficulties and setting up a
restitution fund. But it is only part of the restoration
process and as my colleagues have said, the important part of
the landscape is private litigation.
Chairman Shelby. To the panel, do you believe that the
settlement imposes the punishment and mandates the reforms that
are necessary to change the Wall Street culture and restore
investor confidence in the markets? Or is it just the
beginning?
Attorney General Spitzer.
Mr. Spitzer. The answer is both. It is the beginning. But
the answer is yes, it puts in place the structural pieces. We
will work hard. But, Senator, I think I will take a leap of
faith in speaking for everybody, we all know, only time will
tell.
Chairman Shelby. Absolutely.
Mr. Spitzer. And I was as deeply distressed as the public
record makes clear, that some of the evidence that some of the
leadership hasn't yet internalized these values and we will be
there like hawks. I stand behind the principles in this deal.
We think it is right. It is the next best step. And we are
going to keep pushing.
Chairman Shelby. Does the panel agree with the Attorney
General. Do you have a different view?
Mr. Glauber. I agree with everything that was said. I just
would add that the next step, of course, is for us to write
rules with the SEC that will apply to the other 5,300 firms in
the industry.
Chairman Shelby. Mr. Grasso.
Mr. Grasso. Mr. Chairman, I agree with both Bob Glauber and
Attorney General Spitzer. I would also say that anyone who
doesn't get the message of a new day, just doesn't get it and
won't be in this business.
Chairman Shelby. Ms. Bruenn.
Ms. Bruenn. Yes, it is an important first step. We need to
put investors, not investment banking fees, first.
Chairman Shelby. Mr. Cutler.
Mr. Cutler. Let me just say about people who do not get it,
we are not going to assume that they do get it. And it is my
job and it is the job of this agency and the job of everyone of
us to ensure that they do get it over the next couple of years.
I believe most do. But I am not going to assume that.
Chairman Shelby. And if they do not, they will, won't they?
Mr. Cutler. They will hear from us.
Chairman Shelby. Okay. Mr. Cutler, could you describe
briefly how the Federal portion of the monetary sanctions will
be distributed to investors? How long do you anticipate this
process taking? And what criteria will be applied to determine
which investors are entitled to restitution?
Mr. Cutler. The final judgments in each of these cases
contemplate the appointment of a Distribution Fund
Administrator, to be approved by the court. That Distribution
Fund Administrator will come up with a plan of distribution,
will focus on investors who have invested in the securities
referenced in the complaints, and will be limited to investors
who lost money and were customers of the firms that are
defendants in these complaints.
It will take some time to develop that plan. I believe it
is 6 months before a plan would be submitted to the court. It
is complicated and as I said before, there are challenges and
difficulties in doing it, but we think it is worth doing.
Chairman Shelby. Mr. Cutler, what is the scope of the ban
on Mr. Grubman and Blodget? Can they still work in the capital
markets in an unregistered intermediary like a hedge fund?
Mr. Cutler. My understanding is he cannot work in any
investment adviser, whether registered or unregistered. And he
cannot work in a broker-dealer firm, whether registered or
unregistered.
Chairman Shelby. How permanent is the ban? Can he ask for
reinstatement?
Mr. Cutler. One of my predecessors once said about
permanent bars at the SEC, that permanent means permanent.
Chairman Shelby. Permanent means permanent. Good.
I want to thank you. This has been a long hearing. It is a
very important hearing and we appreciate your patience. I want
to thank you for your participation in today's hearing. I think
the hearing has been extremely informative and insightful. I
believe that we have all learned a great deal more about the
terms of the settlement, the process for negotiating the
settlement, and how regulators intend to police conflicts of
interest as we move forward.
The announcement of the settlement last week and today's
hearing, as we all know, is not the final chapter in this sad
story. It is the beginning, hopefully, of a real end. I believe
that if last Monday's roll-out was the final chapter in the
effort to remedy these problems, then this has been an exercise
in futility.
But I do not believe it is. I think it is the beginning.
The jury is still out on the value of the settlement.
Ultimately, the value of this settlement will depend on the
vigilance of regulators who must make sure that Wall Street
embraces the spirit of the settlement.
But I see no contrition. Perhaps most people, they are only
sorry that they got caught. They are sorry they got exposed.
As a punitive measure, the settlement is relatively mild.
Few individuals were named and the money payments, while
unprecedented, are dwarfed by the investment banking revenues
that these firms earned. In fairness to the regulators, that
was no easy task. I know that, to try to punish without
completely destroying institutions that play a critical role in
our capital markets.
The remedial value of the settlement to the victims of the
fraud that has been perpetrated upon our capital markets is
likewise minimal. But there is a future there, perhaps. In all
likelihood, we will never know with certainty the extent of the
damage that these conflicts of interest created. And specifying
the victims of the fraud will be a daunting challenge.
This settlement's primary value to date, I believe, has
been one of education. By exposing the conflicts that have
jaundiced so much of the research, I believe it served to put
the average investor on notice--let the buyer beware. That is a
phrase that comes down to us from Ancient Rome. It has survived
because, basically, it is good advice. In a retail capital
market like ours, notice and warnings, though, are not enough.
In order to return to a bull market we would like to see, we
must regain the trust of the retail investor. And to do that,
there must be vigilant surveillance and enforcement of the law
against all guilty parties. I believe that there has been too
much greed, too much fraud, for just too long.
The hearing is adjourned.
[Whereupon, at 1:55 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR ELIZABETH DOLE
We are here today to learn more about the recent completion of
enforcement actions against 10 of the Nation's top investment firms.
These actions finalized the global settlement announced by regulators
last December. The conflicts of interest between the investment bankers
and securities analysts in these firms harmed investors who never
suspected that the ratings and price targets were, to quote the words
of one analyst, `` . . . fairly meaningless . . . .'' This analyst went
on to write `` . . . the little guy who is not smart about the nuances
may get mislead, such is the nature of my business.''
Starting with the House Financial Services hearings during the
summer of 2001, case after case has revealed the largest investment
firms viewed their securities analyses, not as a vehicle to attract
investors, but as a tool to attract investment banking business. This
has been repeatedly demonstrated through common practices such as
``investment banking bonuses'' and other financial compensation purely
based on the amount of investment banking business an analyst could
bring to the firm. Example after example has been uncovered of analysts
who knew there was no truth to their reports and rarely, if ever, wrote
a negative report on a company.
We are all thankful that this settlement contains strong
improvements of investment firms to dramatically reform their future
practices, including separating the research and investment banking
departments at the firms, how research is reviewed and supervised, and
making independent research available to investors. However, I am
concerned that only half of the fines and disgorgements are going to
compensation funds to benefit defrauded investors. For instance, though
North Carolina law directs these fines toward investor education,
unfortunately most other States do not ensure that such funds are used
to benefit investors.
It would be my hope that more States could follow the example of
North Carolina and use this money for greater investor education
efforts and to assist investors who have been harmed.
I want to thank you all for the considerable time and effort it
took to arrive at this settlement. I hope the fines and reforms are
enough to ensure that fraud of this nature and magnitude can be
prevented in the future.
----------
PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI
The actions by certain Wall Street firms to use stock research to
mislead investors cannot be condoned. Our public markets need faith and
confidence that the system is fair. Last year, as allegations of biased
stock research and abuses in the initial public offering markets were
hitting the headlines we took action in the Sarbanes-Oxley Act to
require new rules to cover the way research is conducted and used. It
is my understanding that these rules should be finalized within the
next couple of months.
The global settlement before us today sends another message that
Wall Street cannot treat ethical lapses and lax supervision as everyday
behavior. These firms have a moral obligation to treat investors fairly
and honestly.
It also sends a message that we need to be more vigilant in the
future to identify and stop practices like these before they have a
chance to become accepted or tolerated worldwide.
Recently, I introduced legislation with Senator Shelby to
streamline the hiring process for certain key employment positions in
the SEC to assist in enforcement efforts on the oversight of publicly
traded companies and the securities markets. I hope that we can move
this legislation forward so that the SEC can be fully staffed to
prevent future events such as those that lead up to the global
settlement.
I look forward to hearing the testimony from our distinguished
panel.
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PREPARED STATEMENT OF SENATOR EVAN BAYH
I would like to thank Chairman Shelby and Senator Sarbanes for
holding today's hearing to review the impact of the global settlement
on our national economy and on investor confidence.
I congratulate SEC Chairman William Donaldson, New York State
Attorney General Eliot Spitzer, New York Stock Exchange Chairman Dick
Grasso, Chairman and CEO of the NASD Robert Glauber, and Christine
Bruenn, who negoiated on behalf of the State Securities Adminsitrators,
for their hard work in settling these cases and protecting the
financial security of millions of individual investors across the
country.
The settlement embodies the very vitality of our economy--the
amount of investment that will take place in the economy and the number
of jobs that will be created. It involves the standing of America in
the international economy--whether we will continue to be a safe haven
for investments from those abroad, attracting the capital that helps us
build a strong foundation for America's economy.
The reforms required under the global settlement send a loud and
clear signal. Cheating will no longer be tolerated. The clear
separation of reseach and investment banking divisions at firms will
insulate analysts and provide investors with meaningful information.
New mechanisms for providing independent research to investors at no
cost to them will help them make more informed decisions. Transparent
rating information, a ban on IPO spinning, independent monitors for
each firm, and investor education will good a long way toward restoring
investor confidence and strengthening our markets.
As the largest monetary penalty in Wall Street history, it is, more
than anything else, an important step in the direction of ensuring that
those Americans who have worked hard and saved their money, who have
played by the rules, and are honest are able to get ahead in this
society.
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PREPARED STATEMENT OF WILLIAM H. DONALDSON
Chairman, U.S. Securities and Exchange Commission
May 7, 2003
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, thank you for inviting me to testify today concerning the
recently announced global research analyst settlement among the
Commission, the New York Stock Exchange (NYSE), National Association of
Securities Dealers, (NASD), the New York Attorney General (NYAG), other
State regulators and 10 Wall Street firms. I appreciate having the
opportunity to discuss this important subject with you.
Introduction
Last week, the Commission announced enforcement actions against,
and simultaneous settlements with, 10 broker-dealers and two
individuals for failing to ensure that the research they provided their
customers was independent and unbiased by investment banking
interests.\1\ The settlements of these actions, which were brought in
conjunction with proceedings by the NASD, the NYSE, the NYAG, and other
States extract significant monetary relief from the firms, including
penalties that rank among the highest ever paid in civil securities
enforcement actions. These landmark penalties reflect the serious
nature of the misconduct, as well as the Commission's belief that
securities firms must hold the interests of their customers paramount.
The Commission is continuing to investigate the roles played by
individual securities analysts and their supervisors.
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\1\ The 10 firms are: Bear, Stearns & Co. Inc. (Bear Stearns),
Credit Suisse First Boston LLC (CSFB), Goldman, Sachs & Co. (Goldman),
Lehman Brothers Inc. (Lehman), J.P. Morgan Securities Inc. (J.P.
Morgan), Merrill Lynch, Pierce, Fenner & Smith, Incorporated (Merrill
Lynch), Morgan Stanley & Co. Incorporated (Morgan Stanley), Citigroup
Global Markets Inc., f/k/a Salomon Smith Barney Inc. (SSB), UBS Warburg
LLC (UBS), and U.S. Bancorp Piper Jaffray Inc. (Piper Jaffray). The
individuals are Jack B. Grubman and Henry M. Blodget.
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Although the monetary relief secured in the settlements is
substantial, unfortunately the losses that investors suffered in the
aftermath of the market bubble that burst far exceed the ability to
compensate them fully. They can never fully be repaid. Moreover, their
loss was more than monetary. It was also a loss of confidence and a
loss of the hopes and dreams they had built over a lifetime. And
although the monetary relief obtained in the settlements is record-
breaking, the structural reforms required are, in many ways, more
significant and far-reaching. In that regard, the settlements include
important requirements designed to insulate research analysts from
pressures by investment banking.\2\
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\2\ Under the terms of the settlements, injunctions will be entered
against each of the firms and individuals, enjoining them from
violating the statutes and rules that they are alleged to have
violated. The proposed Final Judgments in the SEC actions are subject
to Court approval.
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The research analyst settlements also require firms to provide
investors with independent, third-party research whenever they solicit
investors to purchase securities that are covered by a firm's own
research. Certain firms will provide funding for investor education
initiatives designed to arm investors with the knowledge and skills
they need to make informed investment decisions. Taken together, the
numerous obligations the Commission imposes on the defendants will
fundamentally change the role and perception of research at Wall Street
firms. These reforms will go a long way toward restoring the honorable
legacy of the research profession.
The research analyst settlements mark an important milestone in the
Commission's investigation, and in its regulatory initiatives to help
ensure that research provided to investors is objective. They bring to
a close a period during which the once-respected research profession
became nearly unrecognizable to earlier generations of investors and
analysts. However, the settlements are but one component of the
Commission's ongoing efforts to restore investors' faith in the
fairness of the securities markets. The Commission continues to move
forward aggressively in combating financial fraud, overseeing the
start-up of the Public Company Accounting Oversight Board, and
implementing the Sarbanes-Oxley Act, to mention just a few of the
Commission's other priorities.
With that overview, I would like to use the remainder of the
testimony to: (1) Review the Commission's activities in the analyst
conflicts area; (2) describe the charges filed last week; (3) explain
the terms of the settlements in some detail; and (4) discuss the
Commission's ongoing regulatory activities in this area.
Background
The Commission's involvement in the area of research analyst
conflicts, of course, predates the global settlement. The SEC began to
examine this issue in 1999. The Commission staff was concerned that
analysts, who had became veritable media stars, appearing ubiquitously
on television financial programs, did not disclose their own conflicts
of interest so that investors could evaluate their recommendations
against their possible biases. Accordingly, in the summer of 1999,
staff from the SEC's Division of Market Regulation began a review of
industry practices regarding disclosure of research analyst's conflicts
of interest. Then, the staff from the Office of Compliance Inspections
and Examinations (OCIE) conducted examinations of the largest full-
service firms on the Street. The examinations focused on analysts'
financial interests in companies they covered, as well as analyst
compensation arrangements and reporting structures, in particular
whether analysts reported to investment banking personnel. The SEC
reported the findings of those examinations in summer 2001 at a hearing
of the House Financial Services Subcommittee on Capital Markets
entitled ``Analyzing the Analysts: Are Investors Getting Unbiased
Research from Wall Street?''
The findings outlined in the Commission's testimony included:
It was commonplace for research analysts to provide research
reports on companies that the analysts' employer firm underwrote.
Many firms paid their analysts largely based upon the
profitability of the firms' investment banking units.
Investment bankers at some firms were involved in evaluating
the firm's research analysts to determine their compensation.
Some firms maintained policies prohibiting analysts from
owning stock in companies they covered. Other firms permitted
analysts to own stock in companies they covered but prohibited them
from executing personal trades that were contrary to the analysts'
outstanding recommendations.
Compliance with Self Regulatory Organization (SRO) rules that
require firms to monitor the private equity investments of
employees, including analysts, was poor. Firms did not always know
whether their research analysts owned stock in companies about
which their analysts issued research reports.
As a result of the Commission's examination findings, and given the
serious concerns about the conflicts of interest analysts face that may
taint or bias their recommendations, in fall 2001, the Commission
called on the NASD and NYSE to work together to craft new rules
intended to restore investor confidence in analysts' work. These rules
were designed to address the conflicts of interest identified by the
SEC. They were first proposed and aired for public comment in February
2002.
Then, on May 10, 2002, the Commission approved sweeping rule
amendments by the NYSE and NASD addressing analyst conflicts. The
amendments closed a number of regulatory gaps and took considerable
steps toward promoting greater independence of research analysts by,
among other things:
prohibiting tying analyst compensation to specific investment
banking transactions;
restricting personal trading by analysts in securities of
companies followed by the analyst;
prohibiting offering favorable research to induce firm
business;
restricting investment banking review of research reports; and
defining quiet periods on the issuance of research reports.
The Commission enacted or approved additional rules to bolster the
integrity of analyst research, which are described in the Regulatory
Actions to Address Analyst Conflicts and IPO Spinning section below.
The Commission was also concerned that investors were simply not
aware of these conflicts of interest. To help address this problem, in
2001, the Commission issued an Investor Alert highlighting the numerous
biases that may affect analyst recommendations. The Alert, called
``Analyzing Analyst Recommendations,'' explained to investors the
relationships between securities analysts and the investment banking
and brokerage firms that employ them, and educated investors about
potential conflicts of interest analysts may face.
On April 8, 2002, New York Attorney General Eliot Spitzer commenced
an action in New York State Court pursuant to New York's Martin Act
against Merrill Lynch & Co. Inc., Henry M. Blodget, and several other
Merrill Lynch analysts. In papers filed with the State Court, the NYAG
alleged that since late 1999, the Internet research analysts at Merrill
Lynch had published ratings for Internet stocks that were misleading in
that, among other things, the reports did not reflect the analysts'
true opinions and Merrill Lynch did not disclose that the ratings were
affected by conflicts caused by the analysts' ties to investment
banking. The NYAG included with his filing dozens of exhibits,
including internal Merrill Lynch e-mails demonstrating the analysts'
conflicts of interest.
The NYAG reached a settlement with Merrill Lynch on May 21, 2002,
pursuant to which the firm agreed to pay a penalty of $100 million and,
among other things, to sever the link between compensation for analysts
and investment banking, prohibit investment banking input into
analysts' compensation, create a new investment review committee
responsible for approving all research recommendations,
establish a monitor to ensure compliance with the agreement, and
disclose in Merrill Lynch's research reports whether it received or was
entitled to receive any compensation from a covered company over the
previous 12 months.
In the meantime, on April 25, 2002, the Commission announced that
it had commenced a formal inquiry into market practices concerning
research analysts and the potential conflicts that can arise from the
relationship between research and investment banking. The inquiry was
to be conducted jointly with the NYSE, the NASD, the NYAG, the North
American Securities Administrators Association (NASAA), and the States.
The purpose of the inquiry was to determine whether any laws had been
violated as well as the necessity of additional rulemaking.
In October 2002, the Commission, the NYAG, the NYSE, the NASD, and
NASAA announced a joint effort to bring to a speedy and coordinated
conclusion the various investigations concerning research analysts and
IPO allocations. The Commission and other participating regulatory
entities intended, based on the evidence they had compiled, to
formulate a common plan to address conflict-of-interest and other
issues pertaining to research analysts and IPO allocations. The plan
was to be used as a template to structure appropriate settlements with
the firms that were currently under investigation and/or to provide a
sound basis for proposing industry-wide rules and regulations
(including structural reforms).
In December 2002, then-Chairman Harvey L. Pitt, New York Attorney
General Spitzer, NASAA President Christine Bruenn, NASD Chairman and
CEO Robert Glauber, NYSE Chairman Dick Grasso, and State securities
regulators announced an historic settlement-in-principle with the
Nation's top investment firms to resolve issues of conflict of interest
at brokerage firms. Following the announcement, the Commission staff
worked diligently with other regulators and the firms to finalize the
settlement-in-principle. The broad principles agreed to in December are
reflected in the terms of the final settlements approved by the
Commission, and announced last week. The following sections describe
the charges against the defendants and the terms of the settlements.
The Charges Filed Against the 12 Defendants
Charges Against the Firms
The charges against the 10 firms, which the firms neither admit nor
deny, are summarized below.
The Commission's complaints charge that CSFB, Merrill Lynch, and
SSB issued fraudulent research reports in violation of Section 15(c) of
the Securities Exchange Act of 1934 as well as various State statutes.
For example, according to the complaint filed against CSFB, internal e-
mail correspondence among research analysts regarding a particular
company shows that the pressure imposed by investment bankers on
research analysts to initiate or maintain favorable coverage was not an
isolated problem at CSFB. In May 2001, a technology research analyst
wrote an e-mail to the Head of Technology Research, complaining of
``Unwritten Rules for Tech Research: Based on the following set of
specific situations that have arisen in the past, I have `learned' to
adapt to a set of rules that have been imposed by Tech Group banking so
as to keep our corporate clients appeased. I believe that these
unwritten rules have clearly hindered my ability to be an effective
analyst in my various coverage sectors.''
In another example, according to the complaint filed against SSB,
on the same day that SSB and Jack Grubman published a research note
rating a particular company as a 1 (Buy), Grubman e-mailed two
colleagues that he believed that company should be rated a 4
(Underperform). In the e-mail, he also characterized the company as a
``pig.''
The Commission's complaints charge that Bear Stearns, CSFB,
Goldman, Lehman, Merrill Lynch, Piper Jaffray, SSB, and UBS Warburg
issued research reports that were not based on principles of fair
dealing and good faith and did not provide a sound basis for evaluating
facts, contained exaggerated or unwarranted claims about the covered
companies, and/or contained opinions for which there was no reasonable
basis in violation of NYSE Rules 401, 472, and 476(a)(6), NASD Rules
2110 and 2210, as well as State ethics statutes.
The Commission's complaints further charge that UBS Warburg and
Piper Jaffray received payments for research without disclosing such
payments in violation of Section 17(b) of the Securities Act of 1933 as
well as NYSE Rules 476(a)(6), 401, and 472 and NASD Rules 2210 and
2110. Those two firms, as well as Bear Stearns, J.P. Morgan and Morgan
Stanley, are charged with making undisclosed payments for research in
violation of NYSE Rules 476(a)(6), 401, and 472 and NASD Rules 2210 and
2110 and State statutes.
CSFB and SSB are also charged with engaging in inappropriate
spinning of hot IPO allocations in violation of SRO rules requiring
adherence to high business standards and just and equitable principles
of trade, and the firms' books and records relating to certain
transactions violated the broker-dealer recordkeeping provisions of
Section 17(a) of the Securities Exchange Act of 1934 and SRO rules
(NYSE Rule 440 and NASD Rule 3110).
All 10 firms are charged with failing to maintain appropriate
supervision over their research and investment banking operations in
violation of NASD Rule 3010 and NYSE Rule 342.
Charges Against the Individuals
The charges against the two individual defendants, Henry M. Blodget
and Jack B. Grubman, which they neither admit nor deny, are summarized
below.
The SEC alleges that, during 1999 through 2001, Blodget issued
research reports that were materially misleading because they were
contrary to his privately expressed negative views. The SEC also
alleges that Blodget issued research reports that were not based on
principles of fair dealing and good faith, did not provide a sound
basis for evaluating facts regarding the subject companies, and
contained exaggerated or unwarranted claims about those companies.
As to Grubman, the SEC alleges that, during 1999 through 2001,
Grubman issued several fraudulent research reports that contained
misstatements and omissions of material facts about the companies,
contained recommendations contrary to his actual views regarding the
companies, overlooked or minimized the risk of investing in these
companies, and predicted substantial growth in the companies' revenues
and earnings without a reasonable basis. The complaint against Grubman
further alleges that he issued numerous research reports that were not
based on principles of fair dealing and good faith, did not provide a
sound basis for evaluating facts regarding the subject companies, and
contained exaggerated or unwarranted claims about those companies.
Terms of the Settlements
To impress upon the firms the seriousness with which the Commission
and other regulators regard their misconduct, and to help restore
investors' faith in the objectivity of research, the settlements employ
a multipronged approach, including both monetary and nonmonetary forms
of relief.
Monetary Relief
Collectively, the settling firms will pay disgorgement and civil
penalties totaling $875 million, including Merrill Lynch's previous
payment of $100 million in connection with its prior settlement with
the States. Under the settlement agreements, half of the $775 million
payment by the firms other than Merrill Lynch will be paid in
resolution of actions brought by the SEC, NYSE, and NASD, and will be
put into funds to benefit customers of the firms (the Distribution
Funds). The remainder of the funds will be paid to the states. The
Commission has invited the States to contribute their portions of the
civil penalties and disgorgement to the funds for investors as well.
Penalties
The civil penalties in these actions, which total $487.5 million,
are among the highest--and the $150 million civil penalty against
Salomon Smith Barney is the highest--ever imposed in civil securities
enforcement actions. Pursuant to the settlements, the firms may not
seek to treat the civil penalties as tax deductible or eligible for
reimbursement under their insurance policies. In addition, the
Commission intends that the Federal regulators' portion of the civil
penalties be added to the Distribution Funds, pursuant to the Fair
Funds provision of the Sarbanes-Oxley Act, for repayment to harmed
investors.
Disgorgement
The 10 settling firms will pay $387.5 million in disgorgement. The
Federal regulators' portion of these funds will be used to establish
Distribution Funds to provide recompense to harmed investors.\3\ While
there are challenges and difficulties in administering such Funds, the
Commission feels strongly that those challenges and difficulties are
worth taking on and that any funds paid by the settling firms should be
used to compensate the investors harmed most directly by the misconduct
uncovered in the investigations. The Commission believes this is the
right thing to do, and is consistent with the message sent by Congress
when it recently authorized the Commission to use penalties to repay
investors.
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\3\ The total amount of the Distribution Funds will be $399
million, which includes the Federal regulators' share of the
disgorgement and penalties paid by the firms and by the two individual
defendants.
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The Distribution Funds will be administered by a Court-appointed
``Distribution Fund Administrator,'' who will distribute them in an
equitable, cost-effective manner to customers who purchased equity
securities of companies referenced in the complaint against the firm
through which the customer bought the securities. However, the funds
will not necessarily be allocated (i) with respect to purchases of
stock of each company identified in the SEC's complaints; or (ii) to
all purchasers of stock of a company identified in the complaints.
Under the settlement agreements, it is intended that there be an
equitable--but not necessarily equal--distribution of funds and that
those who are allocated funds receive meaningful payments from the
Distribution Funds. A recipient of funds from these settlements is not
precluded from pursuing, to the extent otherwise available, any other
remedy or recourse against a firm.
All of the Distribution Fund Administrator's fees, costs, and
expenses, including all the fees, costs, and expenses of persons the
Distribution Fund Administrator hires to assist him or her, will be
paid by the settling firms and not from the Distribution Funds.
Investors will not have to bear any of this expense. The only amounts
from the Distribution Funds that will not be paid to investors are
income taxes on the interest earned by the Distribution Funds and an
additional amount, also payable from the interest earned by the
Distribution Funds, to be paid to the Court. Both of these payments are
required by law.
Tax and Insurance Issues Relating to the Settlement Payments
Some Members of Congress have expressed interest in and concern
about the tax and insurance treatment of the settlement payments. As
alluded to above, the Commission included language in these settlements
that expressly prohibits the firms from taking a tax deduction or
seeking to recover from an insurance carrier the penalty portions of
their payments. The SEC has never imposed such requirements before, and
to our knowledge, no other civil enforcement program typically does
this. It was important to do this here, however, because when it comes
to penalties, the public policy imperative--in the tax code and in
court decisions interpreting insurance policies--is very clear:
penalties should be paid by those upon whom they are imposed and should
not be deductible.
With respect to the tax treatment of disgorgement payments--which
are a well-accepted remedy in civil enforcement actions and whose
treatment under the tax code has long been understood by Congress--we
did not think it wise for us to substitute our judgment for that of
Congress or the IRS. With respect to the tax treatment of the
independent research and investor education payments, it did not seem
appropriate to call them something that they were not in order to
obtain a particular tax treatment or insurance result. In this regard,
during the negotiation of the settlement, the Commission staff at no
time engaged in ``horse trading'' by agreeing to lower penalty or
disgorgement payments in return for higher independent research or
investor education payments.
As for the insurability of disgorgement and the independent
research and investor education payments, the issues are complicated
and it likely will be up to the courts to determine, as a matter of
State law, whether they are insurable.
Structural Reforms
Although the monetary relief obtained in the settlement is record-
breaking, the structural reforms required by the settlement are,
arguably, more significant and far-reaching. Specifically, the
settlements include important requirements designed to insulate
research analysts from pressures by investment banking. For instance,
the firms will separate research and investment banking, including
physical separation, completely separate reporting lines, separate
legal and compliance staffs, and separate budgeting processes. In
addition, under the terms of the settlement, analysts' compensation
cannot be based directly or indirectly upon investment banking
activities or input from investment banking personnel. Investment
bankers cannot evaluate analysts, and an analyst's compensation will be
based in significant part on the quality and accuracy of the analyst's
research. To help ensure compliance, decisions concerning compensation
of analysts will be documented.
Moreover, there will be no overlap between the jobs of investment
bankers and research analysts. Investment bankers will have no role in
determining what companies are covered by the analysts, and research
analysts will be prohibited from participating in efforts to solicit
investment banking business, including pitches and road shows. Firms
also will implement policies and procedures reasonably designed to
assure that their personnel, including banking personnel, do not seek
to influence the contents of research reports for purposes of obtaining
or retaining investment banking business.
To ensure the separation between investment banking and research is
comprehensive, firms will create and enforce firewalls between the two
operations reasonably designed to prohibit improper communications
between the two. Communications will be limited to those enabling
research analysts to fulfill a ``gatekeeper'' role.
To ensure that these reforms are executed and implemented in a
meaningful way, each firm will retain, at its own expense, an
independent monitor who is acceptable to the SEC to conduct a review of
the firm's compliance with the structural reforms. This review will be
conducted 18 months after the date of the entry of the final judgment,
and the independent monitor will submit a written report of his or her
findings to the SEC, NASD, and NYSE within 6 months after the review
begins.
Enhanced Disclosures
The settlements also impose a series of requirements that will
benefit investors by providing them better information concerning the
limitations of research. In that regard, each firm will include a
disclosure on the first page of each research report stating that it
``does and seeks to do business with companies covered in its research
reports. As a result, investors should be aware that the firm may have
a conflict of interest that could affect the objectivity of this
report.'' In addition, when a firm decides to terminate/coverage of an
issuer, it will issue a final research report discussing the reasons
for the termination. To enhance investors' power as consumers, each
quarter, each firm will publish on its website a chart showing its
analysts' performance, including each analyst's name, ratings, price
targets, and earnings per share forecasts for each covered company.
These disclosures will fuel development of private services to
transform such raw data into investor-friendly report cards on the
accuracy of the firms' research, which should enable customers to
comparison-shop for research.
Independent Research
Another innovative and forward-looking aspect of the settlement
agreements is the requirement that the firms purchase independent,
third-party research for their customers. For a 5-year period, each of
the firms will be required to contract with no fewer than three
independent research firms that will make available independent
research to the firm's customers. Firms will notify customers of the
availability of independent research on their customer account
statements, on the first page of research reports, and on the firm's
website. An independent consultant for each firm will have final
authority to procure independent research, and will report annually to
regulators concerning the research procured. Payments for independent
research will total $432.5 million.
Investor Education
To better arm investors to cope with the risks inevitably
associated with participating in the capital markets, the settlement
also provides for the establishment of an Investor Education Fund of
$80 million. This initiative is particularly important because it has
meaning beyond the context of this investigation. The SEC, NYSE and
NASD have authorized that $52.5 million of these funds be put into an
Investor Education Fund to support programs designed to equip investors
with the knowledge and skills necessary to make informed investment
decisions. The court will appoint an SEC-recommended Investor Education
Fund Administrator to establish a nonprofit grant administration
program to fund worthy and cost-efficient investor education programs.
The remaining $27.5 million will be paid to State securities
regulators, which they will use for investor education purposes.
Voluntary Initiative Regarding Initial Public Offerings
In addition to the terms imposed by the regulators, the firms have
collectively entered into a voluntary agreement restricting allocations
of securities in ``hot'' IPO's--offerings that begin trading in the
aftermarket at a premium--to certain company executive officers and
directors, a practice known as ``spinning.'' The Commission intends to
evaluate the need for specific rulemaking in this area, in light of
these and other recent Commission enforcement actions that indicate
abuses in the IPO allocation process.
Individual Settlements
The terms of the settlements with the individual defendants are as
follows:
Former Merrill Lynch analyst Henry M. Blodget, in settlement of the
charges against him,\4\ which he neither admits nor denies, has agreed
to pay $2 million in penalties (which he may not treat as tax
deductible or seek to recover from an insurance carrier or other third
party) and an additional $2 million in disgorgement (all of which will
be placed in the Distribution Funds). Blodget also has agreed to a
Federal court order that will enjoin him from future violations of the
Federal securities laws and NASD and NYSE rules. Blodget also will be
censured and permanently barred from associating with any broker,
dealer, or investment adviser.
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\4\ The action against Henry Blodget is being brought in
conjunction with actions by the NASD and NYSE.
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Former SSB analyst Jack B. Grubman, in settlement of the charges
against him,\5\ which he neither admits nor denies, has agreed to pay
$7.5 million as disgorgement and an additional $7.5 million in
penalties (which he may not treat as tax deductible or seek to recover
from an insurance carrier or other third party). One-half of these
amounts will be placed in the Distribution Funds. Grubman also has
agreed to a Federal court order that will enjoin him from future
violations of the Federal securities laws and NASD and NYSE rules.
Grubman also will be censured and permanently barred from associating
with a broker, dealer, or investment adviser.
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\5\ The action against Jack Grubman is being brought in conjunction
with actions by the NASD, NYSE, and NYAG.
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Regulatory Actions to Address Analyst Conflicts and IPO Spinning
In addition to its enforcement activities, the Commission and the
self-regulatory organizations have taken action through rulemaking to
require securities firms to better minimize, manage, and disclose
analyst conflicts. These rules are designed to improve the objectivity
and independence of research analysis and ensure that conflicts of
interest that may affect research are disclosed to investors.
Regulatory Initiatives Relating to Research Analysts
As described in Section II, in May 2002, the Commission approved
sweeping rule amendments by the NYSE and NASD addressing analyst
conflicts. Early this year, the Commission published a second set of
proposed rule changes filed by the NYSE and NASD to further strengthen
their analyst conflicts rules. The Commission expects to act on those
proposed amendments by the end of July.
The proposed amendments would, among other things:
further reduce the influence of investment banking on analyst
compensation;
prohibit the issuance of research reports by the manager or
co-manager of a securities offering for 15 days prior to and after
the expiration of lock-up agreements (booster shots).
restrict analyst involvement in solicitation activities with
issuers (pitch meetings); and
provide investors with notice of a firm's intention to
terminate coverage of a company.
As you know, on July 30, 2002, President Bush signed into law the
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act directs the
Commission to implement rules designed to further address research
analyst conflicts of interest. The Act requires that such rules must be
adopted by the end of July. The Commission has been working with the
SRO's to meet the directives of the Act.
In addition to SRO rule changes, the Commission adopted its own
rule, Regulation Analyst Certification, which became effective on April
14 of this year.
Regulation AC requires that broker-dealers, and certain associated
persons who distribute research reports, obtain certifications from
their research analysts that the views expressed in research reports
and public appearances accurately reflect the analyst's personal views
and whether the analyst received compensation for their recommendations
or views.
Regulatory Initiatives Relating to IPO Spinning
As you are aware, the IPO underwriting process has come under
considerable scrutiny during the past year--especially with regard to
perceived abuses in the allocation of IPO shares. During the
technology-stock boom of the late 1990's, it was not uncommon for a
``hot IPO'' to quadruple in value on its first day of trading (in some
cases increasing by as much as 700 percent). These IPO's were typically
heavily oversubscribed and participation in these IPO's became
immensely valuable for both underwriters and customers.
This hot commodity produced not only huge first-day returns for
those who received allocations in the IPO's, but also led to abusive
conduct, including a practice known as ``spinning.'' Spinning involves
the allocation of ``hot'' IPO shares to senior executives in the belief
or expectation of receiving future investment banking business from
their companies. The problem with IPO spinning is that the broker-
dealer is not distributing all the shares of hot IPO's into the market,
but is using some shares to entice investment banking business from
insiders of other corporations. Spinning increases the public
perception that IPO allocations are an insiders' game. Spinning also
raises serious questions about whether the corporate insiders who take
hot IPO shares in exchange for their firms' investment banking business
are breaching their fiduciary duties to their shareholders.
The global settlement includes a voluntary ban on the allocation of
``hot'' IPO's to executive officers and directors of public companies.
The Commission is reviewing industry practices regarding the allocation
of IPO shares with the goal of restoring investor confidence and public
trust.
In addition, last fall, at former Chairman Pitt's request, the NYSE
and NASD convened a blue ribbon panel of business and academic leaders
to conduct a broad review of the IPO process, including the role of
issuers and underwriters in the pricing and allocation process, and
recommend ways to improve the underwriting process. We understand that
the panel hopes to report on its findings shortly.
The NASD recently sought comment from its members on its proposed
new rules regarding the regulation of IPO allocations and
distributions.
These rules are intended to better ensure that members avoid
unacceptable conduct when they engage in the allocation and
distribution of IPO's. Among other things, the rules would prohibit
allocations to company CEO's and directors on the condition that they
send their companies' investment banking business to the NASD member.
In the months ahead, the Commission will continue to examine the
IPO practices of the industry to determine whether further Commission
or SRO action is necessary, including the possibility of revising
existing rules or proposing new rulemaking.
Conclusion
In conclusion, let me assure you throughout the research analyst
investigation and the process of negotiating the global settlement, the
goals of the Commission and its staff have been to protect investors
and restore confidence in our securities markets. The Commission will
monitor carefully the effects of, and compliance with, the terms of the
settlement, and take actions as appropriate to ensure that these
objectives are achieved.
In addition, the Commission intends to review the implementation of
the settlement, along with reforms adopted by the Commission and the
NASD and NYSE over the last 2 years, to evaluate whether additional
harmonizing, or superseding rules are appropriate.
Thank you again for inviting me to speak on behalf of the
Commission. I would be happy to answer any questions that you may have.
PREPARED STATEMENT OF ELIOT SPITZER
Attorney General, the State of New York
May 7, 2003
Thank you Chairman Shelby, Senator Sarbanes, and distinguished
Members of the Committee, it has been almost a year since I last
testified on Capitol Hill about issues of great concern to the
investing public. At that time, my office had just revealed in court
documents the raw reality of Wall Street research, and imposed a
previously unimaginable $100 million dollar fine on Merrill Lynch for
promoting its investment banking clients by touting stocks to the
public that it internally had labeled ``junk'' and even less flattering
4-letter words. In negotiating the Merrill Lynch settlement, I was
frequently told by members of the investment banking community and
shockingly, even by some members of the securities regulation community
that (1) ``all investment banks raise capital like this;'' (2)
``there's nothing wrong with it;'' and, most astounding, (3) ``there is
no other way.''
Well, they were right on the first point. We now know that Merrill
Lynch was not alone amongst investment banks that would go to the ends
of the earth to produce favorable research for investment banking
clients--regardless of underlying realities--whether the bank wrote the
research itself or paid another bank to do so. But we also now know
that this practice IS wrong. It is illegal. It yielded research that
was fraudulent at worst and misleading at best. It cost individual
investors their mortgages, their college funds, and their retirement
money, and it had to stop. There IS another way--and that is what the
global resolution we announced last week is all about.
The global settlement resulted from a productive collaboration
between State and Federal regulators. I entered into this collaboration
with three goals, and I was gratified to learn that my co-regulators
shared them. Those goals were (1) structural reform, (2) availability
of restitution to investors, and (3) individualized liability.
The first and third goals, while not mutually exclusive, had to be
dealt with in order. In other words, it was crucial to change the rules
of the game and not merely substitute players. These players were
operating in a system that allowed investment bankers to determine what
purportedly ``objective'' research analysts said, and when the
analysts' research would be initiated and terminated (without notice to
investors) with the same favorable rating in place. These players were
operating in a system where the most significant component of a
purportedly ``objective'' research analyst's evaluation and
compensation was the amount of investment banking revenue attributable
to that analyst. The players were operating in a system where analysts
were expected to accompany bankers on pitches and roadshows, and yet
did not have to disclose prominently on their research reports that
they were trying to satisfy and woo investment banking fees from the
very same companies about which they were writing.
To allow the system that I just described to remain in place while
merely ousting its current participants would have been a fruitless
endeavor. So our foremost goal was to reform the system to remove
investment banking concerns from the research analyst's paycheck and
ultimate work product, and to require meaningful disclosures that will
better equip investors to evaluate both the objectivity of a particular
piece of research, as well as the track record of an individual analyst
over time. Finally, the mandate that each settling firm provide
research that is not only independent, but also not produced by yet
another conflicted investment bank, should ensure that individual
investors have at least one piece of research available to them that is
not written by someone who stands to gain--directly or indirectly--from
an investment banking mandate. It is, as my colleague Steve Cutler
described it last week, a necessary ``belt and suspenders'' approach.
That being said, I do not wish to imply that individual wrongdoers
have not been or will not be held responsible for their actions. We
simply first had to remove some of the systemic flaws that enabled
improper conduct to flourish. As you know, a number of individuals have
been charged--both civilly and criminally--and I suspect that
examinations of individuals will increase in the coming months.
Individual wrongdoing was not covered by the global settlement--
rendering individual conduct fair game not only for the SEC and the
SRO's, but also for State and local prosecutors as well. Obviously, it
is improper to discuss the status of ongoing individual investigations,
or to name individuals for whom a charging decision is still pending.
Much attention and criticism has been directed to the settlement's
monetary relief: Specifically, the amount and the purposes to which the
penalties and disgorgement are being directed. There are those who feel
that the penalties were not high enough that the banks ``felt no
pain,'' and there are also those who feel that more of the settlement
money should have gone to restitution. With respect to this, it is
important to keep in mind that if more of the settlement money had been
designated ``restitution,'' it would be that much less a ``penalty'' to
the extent that the banks are already obligated to make restitution to
investors who prevail in court and in arbitrations. Penalties are an
additional obligation to be paid by the banks on top of their pre-
existing obligation to make investors whole. In resolving these cases,
it was important to us that both penalties and restitution be
components of the settlement. And as we stated last week, we were not
about to engage in ``accounting gimmickry'' by calling a particular
payment something that it is not.
Even though not all monies paid by the banks will go to
restitution, the settlement will nonetheless facilitate restitution by
making the evidence readily available to anyone who can show reliance
on tainted research and who wishes to pursue a claim against a bank in
court or through arbitration. Judges and arbitrators presiding in these
fora have been resolving securities claims for years--with Congress'
blessing. Individual States are simply ill-equipped to mete out
restitution in any other manner.
With respect to where we go from here, two thoughts come to mind.
First, as a lawyer, it remains astounding to me and to many of my
colleagues the investment banks ever got into the position that they
were in when we began investigating. Where were the legal and
compliance departments? Where was the leadership at each bank? We know
from the evidence uncovered at more than one bank that senior levels of
management were cognizant of the conflicts of interest that permeated
these institutions at every level. Indeed, if they didn't know from
their personal experience, they could have read about it in the
Nation's leading newspapers and periodicals. Yet, no bank was willing
to do anything about it until, in essence, the first subpoena issued.
Indeed, it was not until I aired the Merrill Lynch e-mails that any
other bank stepped up to the plate and recognized that their internal
workings may not be so flawless, either. It should not take the threat
of direct legal action to do the right thing.
Second, I hope that this extraordinary collaboration between State
and Federal regulators has put to rest any notion that States need to
be ``preempted'' from enforcing securities laws. To the contrary, this
settlement demonstrates that Federal and State governments are capable
of pursuing common goals in record-breaking time to achieve
unparalleled relief. The States played an important role in uncovering
the misdeeds recited in the charging documents released last week, and
will continue to play an important role in policing against such
misdeeds in the future.
When I appeared before Congress less than a year ago, State
``balkanization'' of the securities laws was of concern to many
lawmakers. As we now know, no such ``balkanization'' among States
occurred. Indeed, the only danger of ``balkanization'' remaining is
that the settling banks will be alone amongst financial institutions
required to operate under the principles of fair dealing that informed
the global settlement. The ten investment banks that settled last week
should not be the only institutions required to separate research from
investment banking, provide meaningful disclosure, or make available
independent research. Nor should they be the only institutions that
must stop the pernicious practice of ``spinning'' whereby banks award
lucrative IPO shares to officers and directors of current and potential
investment banking clients in hopes of winning even more lucrative
investment banking business. There is simply no reason why any
individual should profit personally from the opportunity to direct his
or her corporation's business to a particular investment bank. To that
end, I urge Congress and the regulators to do all in their power to
promote and direct broader applicability of the provisions of the
global settlement to similarly-situated financial institutions. I urged
Congress to include the type of reforms contained the global settlement
prior to passage of Sarbanes-Oxley; it is even more important now. Only
when the rules are fair, and fairly applied to everyone can investor
confidence return to the marketplace.
I would note parenthetically in this regard that an immediate stop
must be made to the effort to amend the definition of ``disinterested
person'' under the Bankruptcy Code such that investment banks that
underwrote securities of debtor companies would subsequently be allowed
to advise those companies in bankruptcy. The inherent conflict of
interest in and perverse incentives created by such an arrangement
ought to be clear to all by now.
I am extraordinarily proud of the concrete reforms that State and
Federal regulators were able to achieve through joint efforts in less
than a year. I look forward to future fruitful collaboration, and thank
the Members of this Committee for affording me the opportunity to
expound on this process today. I will be happy to answer any of your
questions.
PREPARED STATEMENT OF RICHARD A. GRASSO
Chairman and CEO, New York Stock Exchange, Inc.
May 7, 2003
Introduction
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, I am pleased to testify today on behalf of the New York
Stock Exchange, Inc. (the Exchange) to discuss this historic $1.4
billion settlement that addresses the conflicts of interest between the
research and investment banking departments at 10 of the largest and
most influential investment firms in the country (settlement).\1\
---------------------------------------------------------------------------
\1\ In 2002, these 10 firms generated more than 70 percent of the
total investment banking revenue generated by the Exchange's member
firms.
---------------------------------------------------------------------------
The firms that participated in the settlement are Bear, Stearns &
Co. Inc. (Bear Stearns), Credit Suisse First Boston LLC (CSFB),
Goldman, Sachs & Co. (Goldman), Lehman Brothers Inc. (Lehman), J.P.
Morgan Securities Inc. (J.P. Morgan), Merrill Lynch, Pierce, Fenner &
Smith, Incorporated (Merrill Lynch), Morgan Stanley & Co. Incorporated
(Morgan Stanley), Citigroup Global Markets Inc. f/k/a Salomon Smith
Barney Inc. (Salomon Smith Barney), UBS Warburg LLC (UBS), and U.S.
Bancorp Piper Jaffray Inc. (Piper Jaffray).\2\ These firms settled
enforcement actions by the Exchange (enforcement actions) without
admitting or denying the allegations, facts, conclusions or findings
contained in the settlement documents.\3\
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\2\ The investigations of Deutsche Bank Securities, Inc. and Thomas
Weisel Partners LLC are continuing.
\3\ At the Exchange, the firms executed a ``Stipulation and
Consent,'' which is a settlement document that is approved by an
Exchange Hearing Panel.
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The settlement is historic in many ways, including in its breadth
and depth, in the severity of the penalties imposed, in the level of
cooperation between Federal and State securities regulators, and
finally but perhaps most importantly, in its impact on the way that
securities firms will do business in the future.
This investigation leading to the settlement was unmatched in terms
of its magnitude. The regulators conducted simultaneous, extensive
probes of the firms' research practices, which included taking the
testimony of numerous firm employees and reviewing hundreds of
thousands of pages of documents and e-mail. In addition, the
investigation was unparalleled in terms of the speed in which a
resolution was reached. Barely a year has passed since the
investigation was initiated.
The $1.4 billion settlement, which includes penalties of $487.5
million, disgorgement of $387.5 million, $432.5 million for independent
research, and $80 million for investor education, is the largest in the
history of securities regulation. In addition, the firms have agreed to
far-reaching new procedures that will forever change the way that
research analysts and investment bankers do their jobs.
In short, this settlement ushers in a new era in which the quality,
integrity, and reliability of Wall Street research will be protected
for the benefit of investors. Securities firms and investors alike
should be aware that the Exchange and the other regulators will take
all necessary measures to ensure the integrity of the marketplace and
to hold responsible any firm or individual who breaks the rules or
violates the law.
The Exchange's Role in Regulating the Securities Industry
Prior to my discussing the Exchange's role in this historic
settlement, I would like to emphasize the Exchange's well-established
commitment to the vigorous and the effective regulation of the
securities industry to protect investors, the health of the financial
system, and the integrity of the capital formation process. I have
cited this commitment by the Exchange many times. However, I believe
that it is important to reemphasize the depth of this commitment and to
describe the resources that the Exchange has dedicated to policing the
securities industry.
The Exchange is one of the most active self-regulators in the
securities industry and is the designated examining authority for its
more than 400 member firms, 250 of which do business with the public.
These firms include all of the major securities firms in the United
States, which hold more than 93 million customer accounts, or 85
percent of all public customer accounts handled by broker-dealers. In
addition, these firms operate more than 21,000 branch offices around
the world and employ approximately 157,000 registered personnel.
Within the Exchange, the responsibility for regulating its member
firms falls upon the Regulatory Group, which consists of the Divisions
of Member Firm Regulation, Market Surveillance, and Enforcement. The
Division of Member Firm Regulation, with a staff of approximately 265,
conducts ongoing surveillance and annual examinations of firms'
financial, operational, and sales-practice compliance. The Division of
Market Surveillance, with a staff of approximately 155, is responsible
for the oversight of all trading activities on the Exchange floor,
ensures that auction-market principles are maintained, and monitors for
abusive or manipulative trading practices, including insider trading.
The Division of Enforcement is the prosecutorial arm of the Exchange
and employs approximately 140 people, most of whom are attorneys.
Enforcement typically carries a caseload of approximately 700 matters
and initiates over 200 enforcement actions a year to enforce Exchange
rules and the Federal securities laws.
To meet its regulatory obligation, the Exchange commits substantial
resources to the Regulatory Group. Approximately one third of the
Exchange's staff works in the Regulatory Group, which has an operating
budget of approximately $142 million. In addition, the Regulatory Group
places a high priority on working with other securities regulators,
including the Securities and Exchange Commission (the SEC) and NASD
Inc. (the NASD), in investigating violations of securities laws and in
creating new rules to govern the industry. It is this spirit of
cooperation, along with a high commitment to protecting investors,
which led to the joint investigation into research analyst conflicts of
interest in April 2002.
The Exchange's Role in Investigation of Research Analyst Conflicts of
Interest
Rulemaking
The $1.4 billion settlement resulted from the efforts of the
Exchange, the SEC, the NASD, the North American Securities
Administrators Association (NASAA), the New York Attorney General's
Office, and State securities regulators (collectively, the Task Force)
pursuant to a joint investigation into the market practices of research
analysts and the conflicts of interests between the research and
investment banking departments at certain securities firms.
Prior to the creation of the Task Force, the Exchange and the NASD
(the self-regulatory organizations or SRO's), in consultation with the
SEC and the House Financial Services Committee, were working toward
modifying the SRO rules to create a comprehensive regulatory scheme to
address the activities of research analysts and to increase the level
of disclosure in research reports. As early as March 2000, the SRO's,
pursuant to discussions with the SEC, began to consider ways to enhance
the rules in this area. New rules were drafted by the SRO's and
approved by the SEC in May 2002, and these rules represented an
important step in insulating research analysts from conflicts of
interest and in improving the objectivity of published research.
Exchange Rule 472 governs the content of research reports and
communications with the public generally. The May 2002 amendments to
Rule 472 impose significant restrictions on research analysts and
require additional disclosures in research reports. These amendments
prohibit the investment banking department from supervising research
analysts and approving research reports; prohibit the linking of
analyst compensation to specific investment banking transactions;
restrict personal trading by analysts in the stock of covered
companies; and require additional disclosures in research reports.
These disclosures include a disclosure of relationships with and
ownership interests in subject companies; data relating to the firm's
stock ratings, such as the percentage of ratings issued in each of the
``buy,'' ``hold,'' and ``sell'' categories; and a price chart comparing
the rated security's closing price to the rating or price target over
time.
In June 2002, the Exchange's Division of Member Firm Regulation
initiated a special examination program, in conjunction with similar
programs at the SEC and the NASD, to ensure that firms were complying
with the obligations and restrictions imposed by the new rules. As set
forth more fully below, the Division of Member Firm Regulation will
continue to conduct examinations of member firms to ensure that the new
rules are followed.
In addition, the Exchange continues to work closely with the SEC
and the NASD to further develop the rules governing research analysts.
In October 2002, the Exchange and the NASD submitted to the SEC, for
comment and approval, additional rules that further expand the
restrictions on firms' research activities. These proposed rules
provide restrictions on the compensation of research analysts and
research analyst solicitation of investment banking business; require
notification to customers when research coverage is terminated; impose
registration and qualification requirements on analysts, broaden the
application of quiet periods, during which research may not be issued;
and require continuing education and ethics training for research
analysts.
The Exchange is in the process of drafting and approving new rules
pursuant to the requirements of Sarbanes-Oxley Act of 2002 (the Act).
The Exchange, in conjunction with the SEC and the NASD, has analyzed
the differences between the Act and the SRO rules and has determined
that further amendments are warranted. These amendments, which will be
submitted to the SEC shortly, represent yet another step in the
direction of insulating research analysts from conflicts of interest
and ensuring that published research is objective and contains
disclosures and other information to help the public make informed
investment decisions.
Rulemaking in this area is far from complete, and the Exchange is
unwavering in its commitment to develop rules that are rational,
effective, and comprehensive. The Exchange will continue to work
closely with the SEC and the NASD to ensure that the resulting
regulatory framework protects both investors and the functioning of the
securities markets.
The Investigation
In April 2002, the Office of the New York State Attorney General
(NY AG's Office) announced a court order against Merrill Lynch relating
to research analyst conflicts of interest, which was followed by a $100
million settlement with the firm in May 2002. The NY AG's Office
uncovered evidence of improper conduct by certain research analysts in
e-mail produced by Merrill Lynch. Following the announcement of this
settlement, the Exchange, the SEC, and the NASD (collectively, the
Federal regulators) initiated an investigation of the research
practices at twelve of Wall Street's top securities firms. In addition,
State securities regulators began an independent review of these
practices.
The Federal regulators' goals in this investigation were to
identify any problematic conduct, create a system to ensure that such
conduct would not occur in the future, and impose sanctions on those
who were responsible. As I sit before you today, I believe that those
goals were accomplished.
The Exchange recognized the importance of conducting this
investigation both expeditiously and effectively, and thus committed
significant resources to the task. From April to December 2002, 50
Exchange staff members and managers from the Divisions of Enforcement,
Market Surveillance, and Member Firm Regulation participated in the
investigation. Collectively, these individuals devoted more than 40,000
hours reviewing approximately 765,000 e-mails and 187,000 pages of
documents, and interviewing or deposing dozens of firm employees. In
addition, Exchange technical staff built from the ground up, an
electronic system to review, search, and catalog e-mail.
The Task Force met regularly to discuss the progress of the
investigations at each firm, to share information and findings, and to
evaluate the many ways in which the conflicts of interest were
manifested at the firms. Early on, it became apparent that all of the
firms utilized business practices and unwritten procedures that
compromised the independence of their research analysts. In a matter of
months, the Task Force uncovered significant evidence that each firm
had engaged in misconduct, and this misconduct is described in detail
in the settlement documents released on April 28, 2003.
While the investigations of the firms were ongoing, senior
officials from the
Exchange, in conjunction with the other members of the Task Force,
discussed structural reforms that would address the conflicts of
interest and insulate research analysts from investment banking
pressures. During this lengthy process, the regulators created a new
system that would protect investors while maintaining the
research analyst's traditional role as a ``gatekeeper'' in screening
companies for underwriting purposes. The result of this process is
specified ``Addendum A'' to the settlement documents. Addendum A
contains strict limitations on the activities of research analysts. As
discussed below, these limitations exceed the requirements of the
current SRO rules. While it is anticipated that there will be uniform
rules that govern the activities of research analysts at all securities
firms, the Task Force believed it was imperative that the firms under
investigation make immediate changes in the way that they conduct their
business, for the sake of protecting investors.
Cooperation With State Regulators
Shortly after the Exchange, the SEC, and the NASD commenced its
investigation, these Federal regulators coordinated their investigative
efforts with NASAA and individual State regulators. Since that time,
the Federal and State regulators worked closely by comparing and
sharing evidence, consulting on findings against the firms, and
negotiating the final settlement agreements. During settlement
negotiations with the firms, the Federal and State regulators spoke
with one voice and presented the firms with an opportunity to resolve
the State and Federal claims simultaneously. The level of communication
and cooperation among the Federal and State regulators was noteworthy.
Enforcement Actions Relating to Failure to Retain Electronic
Communications
During the course of the investigation, the Exchange, the SEC, and
the NASD determined that 5 of the 12 firms under investigation--
Deutsche Bank, Goldman Sachs, Morgan Stanley, Salomon Smith Barney, and
Piper Jaffray--did not preserve electronic communications in a manner
consistent with the recordkeeping and supervisory requirements of
Section 17(a) of the Securities Exchange Act of 1934, Rule 17a-4
thereunder, and Exchange Rules 440 and 342.
Between 1999 and 2001, the firms failed to retain electronic
communications related to their business for 3 years and/or, to the
extent they did retain electronic communications, failed to keep those
communications in an accessible place for 2 years. In addition, these
firms failed to have systems and procedures to ensure that the
electronic communications were preserved for the requisite period of
time, and this failure amounted to supervisory deficiencies in
violation of Exchange Rule 342.
In December 2002, the firms agreed to settle the enforcement
actions by the regulators and paid a fine of $1.65 million per firm,
for a total payment of $8.25 million. The fines were paid jointly to
the Exchange, the NASD, and the SEC. In addition, the firms agreed to
an undertaking to establish a system to properly retain electronic
communications. Presently, the firms have upgraded their systems and
have attested to their compliance with Federal law and the SRO rules
relating to the retention of electronic communications. Equally
important, securities firms have been placed on notice that they may
not disregard the requirement to maintain electronic communications
relating to their business.
It is important to note that the firms participating in the $1.4
billion settlement are required to pay substantial monetary penalties,
notwithstanding the absence of certain electronic communications.\4\
Each firm under investigation produced e-mails, research reports,
notes, and other documents, all of which provided evidence of conflicts
of interest and other violative conduct. The enforcement actions
against Salomon Smith Barney and CSFB contained fraud charges, despite
the fact that those firms did not have appropriate systems to
mechanisms or preserve electronic communications. Contrary to reports
in the press, no firm ``escaped'' from the $1.4 billion settlement
because it failed to preserve certain electronic communications as
described in the $8.25 million e-mail case.
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\4\ As noted above, the investigations of Deutsche Bank Securities,
Inc. and Thomas Weisel Partners LLC are continuing.
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The Enforcement Actions
Issuance of Fraudulent Research
At several of the firms participating in the settlement, the
evidence revealed that certain analysts, including Henry Blodget of
Merrill Lynch and Jack Grubman of Salomon Smith Barney, drafted
research reports that contradicted their privately held views of those
companies, as those views were expressed to others in e-mail.
Issuance of Exaggerated and/or Unwarranted Research
The Task Force's review of e-mail uncovered numerous instances in
which research analysts issued research reports that appeared to be
more positive than the analysts' views expressed in e-mails to friends,
family, preferred customers, and co-workers. In certain instances, this
overly positive research was attributable to direct pressure from
investment banking personnel. In addition, certain research analysts
acknowledged that the covered company's status as a current or
prospective investment banking client was as a factor in drafting the
positive research.
Compensation of Research Analysts
The Task Force determined that each firm compensated its research
analysts in a manner that created a conflict of interest between
receiving high levels of compensation, often linked to investment
banking business, and the responsibility to issue objective research.
Research analysts at these firms were paid base salaries that ranged
from $125,000 to $200,000, and bonus compensation often totaled
millions of dollars. Bonus compensation was based, in varying degrees,
on the level of investment banking business generated by companies and/
or sectors covered by the analysts. In some instances, research
analysts were paid a percentage of investment banking fees generated by
companies in covered sectors. By linking research analysts'
compensation to the generation of investment banking business, the
firms utilized a compensation system that created an improper incentive
for analysts to issue research that was overly positive, inaccurate, or
otherwise lacked objectivity.
Furthermore, it was a common practice at all of the firms for
research analysts' performance reviews to include input from investment
bankers. As a result, research analysts understood that their
contribution to the firms' investment banking business was a factor in
their compensation.
Research Analysts' Participation in Soliciting Investment Banking
Business
At all of the firms, research analysts typically assisted
investment bankers in preparing ``pitch'' materials for presentation to
prospective investment banking clients. The pitch materials frequently
identified the analyst who would provide research coverage of the
company after the investment banking transaction and described the
research coverage that would be provided. Research analysts frequently
attended pitch meetings with investment bankers, and during these
meetings, analysts discussed their view of the company and the research
coverage they intended to issue. In some instances, firms touted their
research analysts' ``voice'' in the marketplace by showing the increase
in covered companies' stock price in response to favorable research
issued by the analysts. Participation by research analysts in the pitch
process created a conflict of interest for the analysts who, early in
the process, expressed their support of investment banking clients.
Initiation and Dropping of Coverage
In general, research coverage was issued on companies for which a
firm acted as a lead- or co-manager in an underwriting. The firms
considered research coverage to be a service to the companies as well
as a service to the firm's customers who purchased shares of the
companies. However, in some instances, firms gave their investment
banking clients a durational ``warranty'' of research coverage for
periods ranging from 18 months to 3 years.
In addition, the investigation revealed that research analysts
frequently initiated research coverage, in conjunction with input from
investment banking personnel, to generate investment banking business
from the covered companies. At many of the firms, research analysts
were pressured to refrain from dropping coverage on investment banking
clients unless approval was received from the investment banking
department. Also, there was evidence that research analysts dropped
research coverage in retaliation against companies that engaged an
outside firm for an investment banking transaction.
Maintenance of Positive Coverage
The investigation revealed that the firms maintained favorable
ratings on the majority of all stocks covered research. Even as the
dot.com bubble began to burst and stock prices began to fall in 2000
and 2001, research analysts maintained their positive ratings on
investment banking clients. Further, the investigation uncovered
numerous instances in which investment banking personnel pressured
research analysts to issue positive research and/or to raise price
targets and recommendations.
Payments for Research
The evidence revealed that some firms made payments to and/or
received payments from outside firms for published research. These
``research payments'' were typically made in connection with an
underwriting transaction in which the lead underwriter made payments to
firms that did not participate in the transaction. The receiving firms
failed to disclose these payments in the published research reports.
Spinning
The evidence revealed that at least two of the firms, Salomon Smith
Barney and CSFB, engaged in ``spinning,'' which is the improper
allocation of ``hot'' IPO shares to executives of investment banking
clients with the expectation that these executives would steer
investment banking business to the firm.
Supervision and Bad Business Practices
Another significant component of the Task Force's investigation was
scrutiny of the firms' supervisory policies and practices. The Task
Force determined that each firm encouraged a culture and environment in
which research analysts were repeatedly subjected to inappropriate
influence by investment bankers, and the analysts' objectivity and
independence was compromised as a result of that influence. These
supervisory deficiencies manifested themselves in numerous ways,
including the following:
Certain firms did not adequately supervise the work of their
research analysts, the content of research reports, and the
reasonableness of published ratings and recommendations;
Certain firms failed to establish policies and procedures
sufficient to prevent investment bankers from pressuring research
analysts to initiate or drop coverage and/or to upgrade
recommendations and raise price targets;
Certain firms failed to establish policies and procedures
reasonably designed to ensure that ``pitch'' materials did not to
implicitly suggest that favorable research would be provided if the
firm were selected for an investment banking transaction;
Certain firms failed to establish policies and procedures
sufficient to prevent or detect instances in which research
analysts provided drafts of research reports to covered companies
for review, including research reports that contained price targets
and ratings or recommendations;
Supervisors at certain firms failed to detect that some
research analysts held private views that differed from their
published research, even though these analysts communicated these
private views to others, and failure led to the publication of
exaggerated, unwarranted and, in some cases, fraudulent research;
and
Supervisors at the firms knew that the research analysts'
contribution to the firms' investment banking business was a
significant factor in determining the analysts' bonus compensation
and, in some instances, research analysts were guaranteed by
contract a certain percentage of the investment banking fees
generated by the transactions on which they worked.
Supervisors at the firms encouraged research analysts to assist in
the solicitation of investment banking business and did so without
systems and procedures in place to ensure the independence and
objectivity of the research product. The firms' policies and procedures
failed to address the significant investment banking influences that
developed, and more importantly, the firms failed to manage the
conflicts of interest that existed between the research and investment
banking departments.
The Task Force determined that the lack of adequate supervision
constituted a structural deficiency that was best addressed by
including supervision violations in the enforcement actions against
each of the firms. By restructuring the way that research analysts and
investment bankers are permitted to interact--both through the
undertakings specified in Addendum A and through the new rules--it is
intended that the supervisory deficiencies at these firms will be
corrected.
The Exchange, as a member of the Task Force, will continue to
monitor and review evidence of misconduct in this area and will bring
actions, as warranted, against the management of these firms,
individual supervisors of the research and investment banking
departments, and individual research analysts who engaged in improper
conduct. As set forth more fully below, the Exchange's Division of
Member Firm Regulation will conduct periodic examinations to ensure
compliance with the settlement's undertakings and the new rules in this
area.
The Terms of the settlement
Restitution
The $1.4 billion settlement includes a restitution payment of
$387.5 million, which will be returned to harmed investors. This $387.5
million payment represents the entire amount attributed to the
Exchange, the SEC, and the NASD. No funds paid by the firms will be
directly held or received by the Federal regulators. An administrator
appointed by the SEC will administer the restitution fund.
Furthermore, while the $387.5 million in restitution is not
intended to fully reimburse the losses of investors, the detailed
description of the evidence uncovered by the investigations will assist
individual investors in recovering some of their losses through civil
remedies such as arbitration and class action suits.
Penalties
The $1.4 billion settlement also includes a collective payment of
$487.5 million in penalties. These penalties constitute some of the
largest fines ever levied in the securities industry and thereby send a
strong message about the seriousness of the firms' misconduct. These
penalties constitute the collective payment that will be made by the
firms to the States, and no members of the Task Force will receive any
payment of penalties.
Investor Education
As part of the settlement, 7 out of the 10 firms will also pay a
total of $80 million for investor education, as described in more
detail below.
Prospective Relief
As discussed above, it was always of paramount importance that the
Task Force not only identify and punish past misconduct, but impose a
system of ``prospective relief'' that would require the firms to change
the way they did business in order to provide immediate protection to
the investing public. This goal was accomplished through the inclusion
of ``Addendum A'' to each of the firm settlement documents. Addendum A
addresses the complicated problem of how to manage the inherent
conflicts of interest between research analysts and investment bankers
in a manner adequate to protect individual investors while still
allowing research analysts to continue their essential role in the
capital formation process.
Under this aspect of the settlement, the firms are required to
sever the links
between research and investment banking, including prohibiting analysts
from receiving compensation for investment banking activities, and
prohibiting analysts' involvement in investment banking ``pitches.'' In
order to ensure the feasibility of promptly implanting the new system,
the firms participated in discussions pertaining to the design of this
new model for research and investment banking. In sum, the firms have
agreed to curtail certain acts and practices that called into question
the credibility of published research and to safeguard research
analysts' role in the capital formation process and in providing
services to their clients.
Significant Changes to the Firms' Business Models
The impact of the settlement, and particularly Addendum A, will be
significant. No longer will firms that engage in investment banking
services be able to operate with the unfettered participation of
research analysts. Equally important, those firms will not be permitted
to pressure research analysts to place a favorable ratings or
recommendations on stocks. Specifically, Addendum A requires the
following:
The firms will physically separate their research and
investment banking departments to prevent the flow of information
between the two groups.
The firms' senior management will determine research
department budgets without input from investment banking and
without regard to specific revenues
derived from investment banking.
Research analysts' compensation may not be based, directly or
indirectly, on
investment banking revenues or input from investment banking
personnel, and investment bankers will have no role in evaluating
analysts' job performance.
Research management will make all company-specific decisions
to terminate coverage, and investment bankers will have no role in
company-specific coverage
decisions.
Research analysts will be prohibited from participating in
efforts to solicit investment banking business, including pitches
and roadshows. During the offering
period for an investment banking transaction, research analysts may
not participate in roadshows or other efforts to market the
transaction.
The firms will create and enforce firewalls restricting
interaction between investment banking and research except in
specifically designated circumstances.
Each firm will make its analysts' historical ratings and price
target forecasts publicly available.
Independent Research
To ensure that individual investors get access to objective
investment advice, the firms will be obligated to make independent
research available. For a 5-year period, each of the firms will be
required to contract with no fewer than three independent research
firms. Customers will be given notice on account statements and trade
confirmations that independent research is available at no cost. An
independent consultant for each firm will have final authority to
procure independent research. Under the terms of the final judgments,
the firms will individually incur the cost associated with retaining an
independent consultant.
Independent Monitors
Each firm is required to retain an independent monitor, acceptable
to the Task Force, for a period of 5 years. Under the terms of the
final judgments, the firms will individually incur the cost associated
with retaining an independent monitor. The independent monitor's
function is to conduct a review to provide reasonable
assurance of the implementation and effectiveness of each firm's
policies and procedures designed to achieve compliance with the terms
of Addendum A. The independent monitor will provide a written report
concerning each firm's compliance and will continue to monitor the
firm's conduct over the 5-year period. The appointment of an
independent monitor is the first step in having the firm's compliance
with the new requirements evaluated, which is essential to be sure that
the conflicts of interest that flourished at the firms are eliminated.
Prohibition of Spinning
In addition to the other restrictions and requirements imposed by
the enforcement actions, the 10 firms have collectively entered into a
voluntary agreement prohibiting spinning. Specifically, firms will not
allocate securities in hot IPO's to executive officers and directors of
public companies in order to attract investment banking business. This
will promote fairness in the allocation of IPO shares.
The Exchange's Role Moving Forward
This settlement represents a significant step toward ensuring that
published research is untainted by conflicts of interest and that the
firms effectively manage their research and investment banking
departments. This settlement is also a significant step toward
guaranteeing that pre-IPO shares are allocated fairly and not used as a
tool for firms to generate investment banking business.
In addition to the payment of penalties and disgorgement, and
creation of a mechanism for independent research, this settlement
contains other important components that, moving forward, will help
ensure the protection of investors in this area.
Investor Education Fund
The investor education component of the settlement is particularly
important to the Exchange. The settlement requires payment of $80
million into a fund for investor education. The objective of the fund
is to support programs to provide investors with the knowledge
necessary to make informed investment decisions. Under the terms of the
final judgments entered by the SEC, the investor education funds will
be paid out in five equal installments based on the various amounts
that firm has agreed to pay.
The Exchange has been active in educating investors for decades and
sponsors several full-time programs. One such program is a teacher
workshop, which is in its 16th year. The workshop has educated more
than 2,500 teachers about investing in the stock market, so that they
can return to the classroom and pass this knowledge to their students.
The Exchange is committed to continuing these programs and working with
the SEC and NASD to make certain that the investor education funds paid
pursuant to the settlement are used productively and with the goal of
enhancing investor understanding of investing in the global securities
markets.
Compliance with the settlement's Undertakings and Exchange Rules
Pursuant to the settlement, the firms will make significant changes
to their business operations in ways that will forever impact the
securities industry. The changes are detailed in Addendum A in the
settlement documents. No longer will it be permissible for the research
department to work with the investment banking department to solicit
and generate investment banking business. Research analysts will not
report to investment bankers, will not be compensated or evaluated
based upon banking business, will not solicit investment banking
business, and will not communicate freely with investment bankers about
the companies upon which they are issuing research. The goal is to
ensure that the research and investment banking departments are indeed
separate and that research personnel publish research that is objective
and free from investment banking influence.
The Exchange, through the Division of Member Firm Regulation,
conducts regular annual examinations of the sales practice and
financial operations of member firms. Pursuant to these examinations,
Member Firm Regulation will review compliance with the undertakings
required by Addendum A. A detailed examination ``scope''--which is
listing of the operational areas that will be reviewed and the
questions that will be answered by representatives of the firm--is
being prepared that will be used to review each firm's compliance with
the undertakings required by the settlement.
In addition, the Exchange will continue to review its member firms'
compliance with Exchange Rule 472 and its amendments, which govern the
content of research reports and the activities of research analysts.
The Exchange is also reviewing its member firms' compliance with the
requirements of Regulation Analyst Certification (Reg. AC), which
requires that analysts certify that the content of research reports
represent their personal views.
The Committee should be aware that the Exchange is committed to
making sure that the firms adhere to the Exchange Rules governing
research analysts, as well as the structural requirements required by
the settlement's undertakings. Violations of Exchange Rules or the
undertakings' requirements will be referred to the Exchange's Division
of Enforcement, which will investigate and pursue formal and informal
disciplinary actions when appropriate.
Review of Compliance Departments
Our member firms have a responsibility to establish, maintain, and
enforce a system of supervision reasonably designed to ensure
compliance with applicable laws, regulations, and rules. An integral
component of such a system would be an effective and proactive
compliance department. The Exchange, the SEC, and the NASD are
developing a joint examination program that will review the largest
broker-dealers on Wall Street to determine whether those firms are
sufficiently committed to compliance. The examinations will review the
structure of the compliance department, the qualifications of its
employees, the department's staffing and budget, and most importantly,
whether the department has the tools to effectively monitor the firm's
operations.
Investigation of ``Spinning'' and Other Improper IPO Share Allocation
Practices
The Exchange is very concerned with ``spinning'' and other abusive
initial public offering (IPO) share allocation practices that not only
disadvantage small investors but also impair the capital formation
process. Pursuant to the global settlement, the participating firms
entered into an agreement that prohibits improper practices such as
``spinning,'' which is the allocation of IPO shares to the account of
an executive officer or director of certain public companies as an
incentive to direct investment banking business to the firm.
The Exchange, in conjunction with the SEC and the NASD, is
currently investigating the pre-IPO allocation practices at the firms
participating in the settlement to determine whether any improper
conduct occurred. These investigations were commenced a year ago, and
the Exchange will review the findings and pursue enforcement actions
based upon preliminary findings. It is anticipated that enforcement
actions will be brought against certain firms when these investigations
are completed. Enforcement actions involving two firms participating in
the settlement--Salomon Smith Barney and Credit Suisse--contained
violations of Exchange and NASD rules by engaging in improper IPO share
allocation practices. The Exchange, through regular examinations
conducted by the Division of Member Firm Regulation, will continue to
review the IPO share allocation practices of all member firms to ensure
that spinning and other improper conduct does not occur.
In addition, the Exchange and the NASD have created a joint
committee to review the IPO underwriting process at broker-dealers,
with a focus on IPO price-setting and share allocation, and to
recommend appropriate changes. The joint committee, which was formed
pursuant to a request by former SEC Chairman Harvey L. Pitt in August
2002, includes some of the most respected leaders in business and
academia in the country. The joint committee's recommendations, which
will be submitted to the SEC shortly, will highlight the need for
transparency in IPO pricing and prohibitions against abusive allocation
practices. The joint committee will also recommend that the code of
business conduct and ethics of listed companies should include a policy
restricting the receipt of pre-IPO shares by the company's directors
and executive officers.
Rulemaking
The Exchange will continue to review the pre-IPO allocation and
research and investment banking practices of its member firms to
determine whether additional rulemaking is required. As described
above, the Exchange is also in the process of drafting and approving
additional rules pursuant to the Sarbanes-Oxley Act.
In addition, the Exchange is at the forefront of creating and
implementing rigid corporate governance requirements that also place
much of the responsibility for ethical practices upon listed companies.
In June 2002, the Exchange created the Corporate Accountability and
Listing Standards Committee to review current Exchange listing
standards, along with proposals for reform, with the goal of enhancing
accountability, integrity, and transparency of the Exchange's listed
companies.
Forum for Arbitration Cases
A critical component of the global settlement is the disclosure of
facts and information to the public to assist aggrieved investors in
recovering through civil litigation the losses that resulted from
conflicted and fraudulent research. The Exchange provides an
arbitration forum for investors to bring actions against firms for
violations of Exchange Rules and Federal securities laws. Presently,
there are more than 50 arbitration cases pending that involve
allegations against Jack Grubman, Henry Blodget, Salomon Smith Barney,
Merrill Lynch, and the other firms participating in the global
settlement. It is estimated that, during the next few months, the
number of arbitration cases involving conduct identified in the global
settlement will increase to 1,500.
The Exchange takes seriously its role in providing a convenient,
fair, and accessible place for investors to bring their claims against
these firms, and will continue to guarantee that aggrieved investors
have the opportunity to have such claims heard in a prompt and fair-
minded way.
Conclusion
The Exchange played an active and significant role in every aspect
of the Task Force's work and has demonstrated a strong commitment
throughout the past year to accomplishing the goals of the Task Force
in an effective and expeditious manner. The Exchange is confident that
great strides have been made as a result of our
efforts over the past year to effect wide-scale reforms that will have
a dramatic impact on this industry and serve the public interest. We
will work vigorously to pursue any other indications of conflicts, by
firms, individuals, or supervisors and to accomplish our goal of a
fair, unbiased system of research coverage. The remedial sanctions are
the largest ever levied, the prospective relief constitutes a highly
specific and unprecedented framework for inclusion in a settlement of
this magnitude. By placing responsibility squarely, and appropriately,
at the feet of the largest firms on Wall Street the Exchange has
delivered a strong and clear message that the prioritization of the
firms' interests over those of the investing public will not be
tolerated. The prohibitions imposed upon analysts' activities restores
the role of the analyst to one of careful analysis and objectivity and
removes analysts from their previous role in investment banking. An
analyst is an analyst and a banker is a banker. And the two shall never
cross.
The monumental changes that have already been effected in the
industry as a result of this agreement achieved the goals that we set
for ourselves when the Task Force was initially conceived just a year
ago. We achieved those goals with great speed, with hard work and
dedication. But our work is not finished, and there is more to be done.
The Exchange's commitment to other necessary reforms and to continuing
the investigations of related areas of misconduct is unwavering.
----------
PREPARED STATEMENT OF ROBERT GLAUBER
Chairman and CEO, National Association of Securities Dealers
May 7, 2003
In December 2002, the Securities and Exchange Commission (SEC), New
York Attorney General, the North American Securities Administrators
Association (NASAA), the New York Stock Exchange (NYSE), and NASD
reached an agreement in principle with 10 of the Nation's largest
investment banks to resolve issues of conflicts of interest involving
research analysis and initial public offerings (IPO's). On April 28,
2003, regulators announced that the agreement had been finalized. This
global settlement concludes a joint investigation begun in April by
regulators into the undue influence of investment banking interests on
securities research at brokerage firms. NASD will continue to
investigate and bring cases against individuals who have neglected
their personal or supervisory responsibilities to the investing public.
The settlement, along with new rules and enforcement cases that are
in force or being developed, will go a long way toward ensuring that
these problems are effectively addressed--not only at the large
investment houses that are party to this settlement, but also
throughout a diverse industry.
NASD
This global settlement is only part of the full-court press that
NASD has been pursuing to strengthen market integrity and rebuild
investor confidence. We have been busier than ever in the area of
enforcement--punishing individuals, as well as firms, for breaking the
rules. We have been working with the NYSE on writing and preparing new
rules on analyst research and initial public offerings--and carefully
studying what additional measures are needed. We have stepped up our
investor education efforts across the board. Our dispute resolution
services have been more heavily used than ever--with almost 75 percent
of cases resulting in a monetary recovery for the investor. And we are
devoting unprecedented attention to strengthening the securities
industry's own compliance mechanisms and efforts--both with a targeted
new certification proposal and with new tools that will help brokerage
firms meet their self-compliance responsibilities.
NASD, the world's largest securities self-regulatory organization,
was established under authority granted by the 1938 Maloney Act
Amendments to the Securities Exchange Act of 1934. Every broker/dealer
in the United States that conducts a securities business with the
public is required by law to be a member of NASD. NASD's jurisdiction
covers nearly 5,400 securities firms that operate more than 92,000
branch offices and employ more than 665,000 registered securities
representatives.
NASD writes rules that govern the behavior of securities firms,
examines them for compliance with NASD rules and the Federal securities
laws, and disciplines those who fail to comply. Last year, for example,
we filed a record number of new enforcement actions (1,271) and barred
or suspended more individuals from the securities industry than ever
before (814). Our market integrity responsibilities include regulation;
professional training; licensing and registration; investigation and
enforcement; dispute resolution; and investor education. We monitor all
trading on The Nasdaq Stock Market--more than 70 million orders,
quotes, and trades per day. NASD has a nationwide staff of more than
2,000 and is governed by a Board of Governors--at least half of whom
are unaffiliated with the securities industry.
NASD Rules
Tough enforcement is only part of the equation. To prevent these
kinds of abuses in the future, it is necessary not only to punish those
who violated existing NASD rules and securities laws, but also to lay
down a comprehensive framework of rules and laws that will protect
investors and the integrity of our markets. It is important to note
that while the global settlement is limited both in time and the
participants it covers, NASD rules are not limited--they cover the
entire brokerage industry--and will form the basic scaffolding for a
national system of rules that protect investors, whether they live in
Birmingham, Baltimore, Berkeley, or Brooklyn.
NASD and the NYSE have written two sets of analyst rules toward
exactly that end. Our rules use a combination of disclosure and
outright prohibitions to assure that investors are more informed and
analysts are more independent. These rules were the model for several
global settlement provisions--including those declaring analyst
compensation cannot be influenced by any input from investment bankers.
NASD has already begun examining for compliance with these new rules.
NASD rule-writers have been active on the IPO front as well. Last
year, NASD issued proposed rules to make even more explicit the
prohibitions against such practices as ``spinning,'' ``laddering,'' and
quid pro quo arrangements. These practices were the most common IPO
abuses during the bubble of 1999- 2000--and they are among the most
likely to pose a temptation when the IPO market heats up again.
Spinning is when an investment bank parcels out oversubscribed IPO
shares so as to induce future investment banking business. Laddering is
when an IPO underwriter requires the commitment to purchase IPO shares
in the aftermarket, in order to be allocated some shares of the initial
offering. Quid pro quo arrangements are the kinds of dealings where
investment banks work out kickbacks to share in the profits of hot
IPO's with their favored customers.
The SEC has held these new IPO rules in abeyance for the time
being. In the meantime, it asked NASD and the NYSE to convene a blue-
ribbon panel to take an even more comprehensive look at the process by
which IPO's are priced, brought to market, and purchased by investors.
We have brought together a truly eminent panel of experts to do so, and
its analysis has been penetrating. The panel's report is not yet
public, but its recommendations are due soon. The SEC will then take
those recommendations, as well as NASD's proposed rules, into account
in deciding what rules to issue in this vital area of capital
formation. The global settlement explicitly contemplates that its
provisions limiting the distribution of hot IPO's will be superceded by
more comprehensive SEC rules.
NASD Enforcement Efforts
The U.S. capital markets are not only the most liquid and
developed, but overall the best run in the world. In the past decade,
more than 5,600 domestic and foreign enterprises have raised a total of
over $500 billion through initial public offerings in U.S. markets. For
companies seeking to raise capital, go public, or find a partner, the
U.S. capital-formation environment remains the most attractive
anywhere. Healthy capital markets are an engine of the U.S. economy--
and as such, nothing less than a national security asset. That is
another reason why we take our responsibility to police IPO practices
so seriously.
When the high-tech bubble burst and stock prices began to fall
dramatically in the second half of 2000, many people began to wonder
why the analyst recommendations sounded strangely the same as during
the bull market. In fact, during the excruciating slide from the top of
the market in 2000 to the low after September 11, ``strong buy'' or
``buy'' recommendations outnumbered ``sells'' by a ratio of more than
50 to 1.
Beginning in 2000, NASD began aggressively investigating IPO
practices and research analyst conflicts. To date, NASD has
investigated and brought charges in more than a dozen important analyst
and IPO allocation cases against individuals as well as firms. For
example:
NASD and the SEC brought a groundbreaking IPO case against
Credit Suisse First Boston that was finally settled at the
beginning of last year for $100 million in sanctions. We caught
CSFB carrying out a systematic scheme whereby--in exchange for
dishing out shares of hot new IPO's to chosen customers--it
demanded and received paybacks of between 33 and 65 percent of
customers' trading profits in those IPO shares, by getting vastly
inflated commissions on unrelated trades.
We have successfully reached settlements with Robertson
Stephens and two other firms, against which NASD has levied more
than $20 million in fines for IPO profitsharing violations.
NASD developed substantive spinning cases--the only Federal or
State regulator to do so--against CSFB and Salomon Smith Barney.
These cases were later made part of the global settlement.
We were the first to file charges against Jack Grubman, as
well as Salomon Smith Barney, for misleading research. In September
2002, the firm paid $5 million in sanctions; Grubman subsequently
paid $15 million; and most important, the former telecom analyst is
now barred from the securities industry for life.
NASD likewise brought the first charges against investment
banker Frank Quattrone, for failing to supervise his research
analysts and improper IPO spinning to favored executives. Mr.
Quattrone is contesting the charges. Soon after, he was indicted
for obstruction of justice of NASD's and others' earlier
investigation of IPO profit sharing.
The individual charges against dot.com analyst Henry Blodget
investigated by NASD and jointly brought with other Federal
regulators were wrapped into the global settlement. Blodget paid $4
million in fines and is barred from the securities industry for
life as well.
In all these enforcement efforts NASD has underscored several
important principles:
that analyst research cannot be a servant of investment
banking;
that hot IPO's cannot be doled out to corporate insiders as
virtual commercial bribes; and
that since firms act through individuals, individuals, too,
will be held accountable for their misdeeds.
And we are by no means done with our efforts. NASD is continuing to
investigate and develop cases against those in the securities industry
who have violated their supervisory or individual responsibilities to
the investing public.
Global Settlement Terms
The global settlement concludes a joint investigation begun in
April 2002 by regulators into the undue influence of investment banking
interests on securities research at brokerage firms. The settlement
will bring about balanced reform in the industry and bolster confidence
in the integrity of equity research.
Terms of the agreement include the insulation of research analysts
from investment banking pressure. Firms will be required to sever the
links between research and investment banking, including the direct or
indirect influence of banking on analyst compensation, and the practice
of analysts accompanying investment banking personnel on pitches and
road shows. This will help ensure that stock recommendations are not
tainted by efforts to obtain investment banking fees and that research
analysts will be insulated from investment banking pressure. Among the
more important reforms:
The firms will physically separate their research and
investment banking departments to prevent the flow of information
between the two groups.
The firms' senior management will determine the research
department's budget without input from investment banking and
without regard to specific revenues derived from investment
banking.
Research analysts' compensation may not be based, directly or
indirectly, on investment banking revenues or input from investment
banking personnel, and investment bankers will have no role in
evaluating analysts' job performance.
Research management will make all company-specific decisions
to terminate coverage, and investment bankers will have no role in
company-specific coverage decisions.
Research analysts will be prohibited from participating in
efforts to solicit investment banking business, including pitches
and road shows. During the offering period for an investment
banking transaction, research analysts may not participate in road
shows or other efforts to market the transaction.
The firms will create and enforce firewalls restricting
interaction between investment banking and research except in
specifically designated circumstances.
A complete ban on the spinning of Initial Public Offerings
(IPO's). Brokerage firms will not allocate lucrative IPO shares to
corporate executives and directors who are in the position to
greatly influence investment banking decisions.
An obligation to furnish independent research. For a 5-year
period, each of the brokerage firms will be required to contract
with no less than three independent research firms that will
provide research to the brokerage firm's customers. An independent
consultant (monitor) for each firm, with final authority to procure
independent research from independent providers, will be approved
by regulators. This will ensure individual investors get access to
objective investment advice.
To ensure that individual investors get access to objective
investment advice, the firms will be obligated to furnish independent
research. For a 5-year period, each of the firms will be required to
contract with no fewer than three independent research firms that will
make available independent research to the firm's customers. An
independent consultant for each firm will have final authority to
procure independent research.
Disclosure of analyst recommendations. Each firm will make
publicly available its ratings and price target forecasts. This
will allow for evaluation and comparison of performance of
analysts. To enable investors to evaluate and compare the
performance of analysts, research analysts' historical ratings will
be disclosed. Each firm will make its analysts' historical ratings
and price target forecasts publicly available.
The 10 firms against which enforcement actions were taken as part
of the global settlements include:
Bear, Stearns & Co. Inc. (Bear Stearns)
Credit Suisse First Boston LLC (CSFB)
Goldman, Sachs & Co. (Goldman)
Lehman Brothers Inc. (Lehman)
J.P. Morgan Securities Inc. (J.P. Morgan)
Merrill Lynch, Pierce, Fenner & Smith, Incorporated (Merrill
Lynch)
Morgan Stanley & Co. Incorporated (Morgan Stanley)
Citigroup Global Markets Inc. f/k/a Salomon Smith Barney Inc.
(SSB)
UBS Warburg LLC (UBS Warburg)
U.S. Bancorp Piper Jaffray Inc. (Piper Jaffray)
Penalties, Disgorgement, and Funds for Independent Research and
Investor
Education
Pursuant to the enforcement actions, the 10 firms will pay a total
of $875 million in penalties and disgorgement, consisting of $387.5
million in disgorgement and $487.5 million in penalties (which includes
Merrill Lynch's previous payment of $100 million in connection with its
prior settlement with the States relating to research analyst conflicts
of interest). Under the settlement agreements, half of the $775 million
payment by the firms other than Merrill Lynch will be paid in
resolution of actions brought by the SEC, NYSE, and NASD, and will be
put into a fund to benefit customers of the firms. The remainder of the
funds will be paid to the States. In addition, the firms will make
payments totaling $432.5 million to fund independent research, and
payments of $80 million from seven of the firms will fund and promote
investor education. The total of all payments is roughly $1.4 billion.
An issue that has been under close scrutiny by Members of the
Senate and that this Committee is especially interesting in includes a
provision that the firms will not seek reimbursement or indemnification
for any penalties that they pay. In addition, the firms will not seek a
tax deduction or tax credit with regard to any Federal, State, or local
tax for any penalty amounts that they pay under the settlement.
The individual penalties include some of the highest ever imposed
in civil enforcement actions under the securities laws.
Enforcement Actions
The enforcement actions allege that, from approximately mid-1999
through
mid-2001 or later, all of the firms engaged in acts and practices that
created or maintained inappropriate influence by investment banking
over research analysts, thereby imposing conflicts of interest on
research analysts that the firms failed to manage in an adequate or
appropriate manner. In addition, the regulators found supervisory
deficiencies at every firm. The enforcement actions, the allegations of
which were neither admitted nor denied by the firms, also included
additional charges:
CSFB, Merrill Lynch, and SSB issued fraudulent research
reports in violation of Section 15(c) of the Securities Exchange
Act of 1934 as well as various State statutes;
Bear Stearns, CSFB, Goldman, Lehman, Merrill Lynch, Piper
Jaffray, SSB, and UBS Warburg issued research reports that were not
based on principles of fair dealing and good faith and did not
provide a sound basis for evaluating facts; contained exaggerated
or unwarranted claims about the covered companies; and/or contained
opinions for which there were no reasonable bases in violation of
NYSE Rules 401, 472, and 476(a)(6), and NASD Rules 2110 and 2210 as
well as State ethics statutes;
UBS Warburg and Piper Jaffray received payments for research
without disclosing such payments in violation of Section 17(b) of
the Securities Act of 1933, as well as NYSE Rules 476(a)(6), 401,
and 472 and NASD Rules 2210 and 2110. Those two firms, as well as
Bear Stearns, J.P. Morgan, and Morgan Stanley, made undisclosed
payments for research in violation of NYSE Rules 476(a)(6), 401,
and 472 and NASD Rules 2210 and 2110 and State statutes; and
CSFB and SSB engaged in inappropriate spinning of ``hot''
initial public offering (IPO) allocations in violation of SRO rules
requiring adherence to high business standards and just and
equitable principles of trade, and the firms' books and records
relating to certain transactions violated the broker/dealer
recordkeeping provisions of Section 17(a) of the Securities
Exchange Act of 1934 and SRO rules (NYSE Rule 440 and NASD Rule
3110).
Under the terms of the settlement, an injunction will be entered
against each of the firms, enjoining it from violating the statutes and
rules that it is alleged to have violated.
Investor Education
Further, seven of the firms will collectively pay $80 million for
investor education. The SEC, NYSE, and NASD have authorized that $52.5
million of these funds be put into an Investor Education Fund that will
develop and support programs designed to equip investors with the
knowledge and skills necessary to make informed decisions. The
remaining $27.5 million will be paid to State securities regulators and
will be used by them for investor education purposes.
In addition to the other restrictions and requirements imposed by
the enforcement actions, the 10 firms have collectively entered into a
voluntary agreement restricting allocations of securities in hot
IPO's--offerings that begin trading in the aftermarket at a premium--to
certain company executive officers and directors, a practice known as
``spinning.'' This will promote fairness in the allocation of IPO
shares and prevent investment banking firms from steering these shares
to executive's personal accounts to attract investment banking
business.
Conclusion
The global settlement will strengthen the industry's own business
practices and ethical standards. And it will be enforced by NASD and
the other regulators with a full range of disciplinary options--which
include stiff fines and the potential for expulsion from the industry.
While the settlement does not solve all the problems revealed in recent
months, it is an important step in restoring investor confidence in the
markets.
The work of your Committee and the Congress will be vital in
addressing the myriad other issues that will arise in the wake of the
settlement. I look forward to working with you as Congress examines the
range of suitable remedies to address these issues.
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PREPARED STATEMENT OF CHRISTINE A. BRUENN
President, North American Securities Administrators Association, Inc.
Maine Securities Administrator
May 7, 2003
Chairman Shelby, Ranking Member Sarbanes and Members of the
Committee, I am Christine Bruenn, Maine's Securities Administrator and
President of the North American Securities Administrators Association,
Inc. (NASAA).\1\ I commend you for holding this timely hearing, and
thank you for the opportunity to appear before your Committee to
present the States' views on the global settlement with 10 Wall Street
firms.
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\1\ The oldest international organization devoted to investor
protection, the North American Securities Administrators Association,
Inc., was founded in 1919. Its membership consists of the securities
administrators in the 50 States, the District of Columbia, Canada,
Mexico, and Puerto Rico. NASAA is the voice of securities agencies
responsible for grass-roots investor protection and efficient capital
formation.
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I would like to start by acknowledging the role that this Committee
and its House counterpart played in this matter. Congressional hearings
shined an early light on Wall Street practices that were an important
guide for regulators.
From the outset of the investigations, State securities regulators
have had three goals: To fundamentally change the way business is done
on Wall Street, by putting investors, not investment banking, first;
impose meaningful penalties for illegal behavior; and to provide harmed
investors with the information they need to pursue arbitration cases
and legal actions against their brokerage firms.
If the industry follows both the letter and spirit of this
agreement, it has the potential to change the culture on Wall Street.
Investors--not investment banking fees--will come first. Analysts will
be beholden to the truth, not the IPO business.
Overview
Let me give you a brief overview of State securities regulation,
which actually predates the creation of the SEC and the NASD by almost
two decades. The securities administrators in your States are
responsible for the licensing of firms and investment professionals,
the registration of some securities offerings, branch office sales
practice audits, investor education and, most importantly, the
enforcement of State securities laws. Some of my colleagues are
appointed by their Governors or Secretaries of State, others are career
State government employees. Notably, only 5 come under the jurisdiction
of their States' Attorneys General. We have been called the ``local
cops on the securities beat,'' and I believe that is an accurate
characterization.
Securities regulatory offices are located in all 50 States and the
District of Columbia, and Puerto Rico. We respond to investors who
typically call us first with complaints, or request information about
securities firms or individuals. State securities regulators work on
the front lines, investigating potentially fraudulent activity and
alerting the public to problems. Because they are closest to the
investing public, State securities regulators are often first to
identify new investment scams and to bring enforcement actions to halt
and remedy a wide variety of investment related violations. They also
work closely with criminal prosecutors at the Federal, State, and local
levels to punish those who violate our securities laws.
The role of State securities regulators has become increasingly
important as Americans rely on the securities markets to prepare for
their financial futures. Today, we are indeed a ``nation of
investors.'' Over half of all American households are now investing in
the securities markets.
Investigation and Settlement Process
The investigation of the Wall Street firms was a massive
undertaking and involved the coordination of 35 States. These States
provided the staff and resources to analyze and review millions of
documents, depose and interview witnesses, and draft nine comprehensive
settlement orders, all in coordination with their Federal counterparts.
While the global settlement is most important for its impact on
Wall Street and investors, it is remarkable for another reason as
well--I believe it represents a model for State-Federal cooperation
that will serve the best interests of investors nationwide. As they did
with penny stock fraud, microcap fraud, day trading and other areas,\2\
the States helped to spotlight a problem and worked with national
regulators on marketwide solutions. It bears repeating: The States
historically and in the current cases, investigate and bring
enforcement actions--they do not engage in rulemaking for the national
markets. That is rightly the purview of the SEC and the SRO's.
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\2\ See State/Federal Dynamic Chart Attached.
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None of the regulators who were involved in this global settlement
could have done this on its own. Even with the funding increase
Congress allocated for the SEC, the Commission cannot go it alone. That
is why there must be cooperation and division of labor among State,
industry, and Federal regulators.
Over the last several years, NASAA members have been active
participants in the rulemaking and legislative process in the area of
analysts' conflicts of interest. The States worked closely with the SEC
and the SRO's both to leverage limited investigative resources and to
formulate new, marketwide rules that were needed to fix this problem.
In 2001, we commented on the NASD's original rulemaking regarding
analysts' communications to the public. We followed that with a letter
to Chairman Richard Baker during his subcommittee's public hearing
process regarding analysts' practices.
In addition, we commented on the NASD/NYSE's proposed rules
relating to research analysts. We complimented the NASD and NYSE on
their work, offered general support and made suggestions that we felt
could make the rule stronger in some areas. Many of our original
proposals were incorporated in the final rule. Also, NASAA was strongly
supportive of Title V in S. 2763 which became the Sarbanes-Oxley Act of
2002.
Last spring, as the New York Attorney General was wrapping up its
Merrill Lynch investigation, NASAA suggested to Attorney General
Spitzer that it would be beneficial to all concerned to settle the case
simultaneously for all the States as a group. He agreed, and negotiated
on those terms. The case was concluded with all 50 States, the District
of Columbia, and Puerto Rico joining in the settlement.\3\
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\3\ See NASAA Analyst Investigations Chronology Attached.
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In late April, a few weeks before the Merrill Lynch agreement, the
NASAA Board of Directors met to form the NASAA Analysts Task Force. Its
Steering Committee was charged with investigating whether problems
discovered at Merrill Lynch were industry wide. The Steering Committee
assigned one State to lead the investigation of each firm; many other
States signed on to assist in the investigations. Further, the Task
Force agreed to work collaboratively on the analyst investigation with
the SEC, the NYSE, and the NASD.
The State investigations continued into November, at which time, in
conjunction with the SEC, NYSE, and the NASD a determination was made
to pursue the resolution of the cases in a global manner. Each firm
investigation included a lead State and a Federal counterpart. Last
December, an agreement in principle was reached with 11 firms; it took
intensive negotiations with the firms to reach the final global
settlement announced last week.\4\
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\4\ See Chart of Investigated Firms and State/Federal Partnership
Attached.
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The Deutsche Bank investigation was not included in the global
settlement because the California Department of Corporations discovered
the failure of Deustche Bank to produce documents as requested by the
Department during its analyst investigation. The reasons for Deutsche
Bank's failure to produce documents and whether Deutsche Bank has, in
fact, produced all requested documents at this time remains under
investigation by the Department (and other State securities regulators
such as the District of Columbia and Maryland) in conjunction with the
SEC.
Penalties/Restitution
The $487.5 million in penalty monies to the States includes the
prior settlement between Merrill Lynch and State securities regulators.
Attached to this testimony is a State-by-State chart that lists the
distribution of the global settlement penalties based on a population
formula with a minimum allocation of 1 percent of the total.\5\ An
important question is how best to use that money?
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\5\ See Analysts Conflicts settlements Chart Attached.
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A primary and routine objective of State securities regulators is
to obtain restitution for investors as part of enforcement actions. For
example, in fiscal year 2002, restitution ordered through
administrative or civil actions was $309 million. At the same time,
roughly $71 million was ordered in fines and penalties.
In a recent case involving the illegal sale of unregistered
products, the Arizona Corporation Commission ordered the defendants to
pay over $16 million in restitution to investors. It also assessed
administrative penalties in the amount of $133,100. In another case
announced last week by the Alabama Securities Commission, the former
President of Fabtec Inc. pled guilty to two counts of fraud in
connection with the sale of securities and two counts of theft of
property in the first degree. A sentencing hearing is scheduled for
June. The former president faces up to 60 years imprisonment and the
State is seeking restitution in the amount of $1,690,000.
Throughout the 18 months of the analysts' investigations, State
securities regulators wrestled with how best to compensate investors
injured by the wrongdoing. Restitution is a viable remedy where victims
can be readily identified, where the fraud is direct and person-to-
person and where damages are subject to straightforward calculation. In
order to satisfy the expectations of the victims, there also needs to
be enough money to distribute through restitution so that the
recipients receive a sum that represents a meaningful portion of their
losses. Unfortunately, we do not believe the analyst cases readily lend
themselves to restitution.
One of the reasons we have struggled is because it is very
difficult to identify the victims of any fraud on the market. We could
start with the customers who purchased the stocks through the firms,
but what about those who saw Henry Blodget on CNBC and then purchased
the stocks online or bought stocks from a firm that purchased research
from one of the 10 firms? And what about mutual fund shareholders? In
our view, in a fraud on the market, all investors are harmed. If
restitution is available to all investors, it would be an insignificant
amount of their losses. If restitution is available to only a subset of
investors, it is arbitrary and unfair. In light of these problems, we
believe decisions regarding the funds are best made at the State level
so they can be tailored to the unique circumstances of each State.
These monies will be allocated according to the governing law in
each jurisdiction. For example, in North Carolina, it will go to an
investor education fund; in Mississippi, new investigators will be
hired for future enforcement efforts; in my State of Maine and in
Maryland, the money will go into the general fund and be used for State
legislative priorities such as education, prescription drugs, and other
State provided services. We expect the combination of monetary
penalties, injunctive provisions and the release of evidence that can
be used in private actions will deter similar conduct in the future.
Investor Education Funds
The final component of the analyst conflicts of interest
settlements requires six of the firms to contribute a total of $27.5
million over the next 5 years for investor education on the State
level. The NASAA Board of Directors determined these payments will be
directed to the Investor Protection Trust (IPT).
The IPT is a Wisconsin charitable trust, classified by the IRS as a
public charity. The IPT was created 10 years ago with $2 million as
part of a multistate securities settlement. The Trust's primary focus
in recent years has been Financial Literacy 2010 (FL2010), a program
designed to increase the amount and quality of personal finance
classroom instruction in America's high schools. This initiative gives
teachers across America the tools they need to introduce a personal
finance curriculum in the high schools. Money from the Trust has been
used to provide customized teaching guides and to train thousands of
teachers on how to use the guides in their classrooms. FL2010 has also
reached teachers through direct mail, exhibits, a quarterly newsletter,
and a website (www.fl2010.org).
In addition to FL2010, the Trust has undertaken an extensive
investor education mission, including public service announcements,
distribution of educational videos on investor preparedness and
investment fraud awareness, the Investing Online Resource Center
(www.onlineinvesting.org), an independent, noncommercial website
dedicated to serving the individual consumer who invests online or is
considering doing so, and a noncommercial investor education website
(www.investorprotec-tion.org).
The payments from the analyst conflicts of interest settlement will
be maintained in a separate, designated fund of the IPT, the Investor
Education Fund (the Fund). The Fund will be distributed pursuant to a
grant process and used to support and create financial literacy
programs and materials tailored to the needs of local communities and
to conduct research. The goal of the Trust is to equip investors with
the knowledge and skills necessary to make informed investment
decisions and to increase personal financial literacy. No principal or
income from the Fund shall inure to the general fund or treasury of any
State. The Fund will be held in a subaccount, with provisions for fund
accounting, annual audited financial statements, and regular reporting
on items such as grant applications, expenses and fees incurred.
Ongoing Enforcement Initiatives
The analyst conflict of interest case was a big story in the
financial press over the past year. But it was hardly the only focus of
State securities regulators. As always, State securities regulators
continue to vigorously pursue sales practice abuses and a variety of
scams and frauds against unsuspecting investors. There are many types
of violations that State securities regulators continue to fight. NASAA
has published a list of the ``Top 10 Investment Scams'' the past
several years to highlight problem areas for investors.\6\ I will
mention a few of our ongoing initiatives.
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\6\ See ``Top 10'' Investment Scams Listed by State Securities
Regulators Attached.
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Unregistered Securities--We are continuing to address, in
cooperation with the National Association of Insurance Commissioners
(NAIC), the chronic problem of insurance agents selling unregistered
and fraudulent securities. In hundreds of cases, scam artists are using
high commissions to entice insurance agents into selling investments
they may know little about to investors for whom they are unsuitable.
On April 17, the Indiana Secretary of State announced the
sentencing of a convicted Securities Act violator to 42 years in prison
and $110,931 in restitution. This conviction was the culmination of an
investigation initiated by the Secretary's office regarding a firm that
operated to sell unlicensed securities. The Secretary of State referred
the case to the County Prosecuting Attorney to file the criminal
charges. These offices worked together to utilize their specialized
resources and expertise to sentence a violator to jail.
Examples Unregistered Products
Viatical settlements--In the wake of a 1996 decision holding that
interests in certain viatical settlement policies sold were not
``securities'' under Federal law, there has been a proliferation of
these viatical investments sold to investors nationwide in violation of
State securities laws. A viatical settlement contract allows an
investor to purchase an interest in the life insurance of a terminally
ill person.
Almost all State securities regulators take the position that
viatical investments are ``securities'' under their respective laws.
Last fall, the NASAA membership approved guidelines for States to adopt
that apply to the offer and sale of viatical investments. Meaningful
regulation is essential to ensure that neither the lawful viators nor
investors are defrauded.
Many States have vigorously pursued enforcement actions due to
occurrences of deceptive marketing practices and numerous instances of
fraud.
Recently, the Arizona Corporation Commission revoked the
registration of a Tucson securities salesman, assessed a penalty of
$66,000 and ordered him to repay six investors over $430,000 plus
interest in a case dealing with unregistered viatical contracts.
Charitable Gift Annuities--In February 2003, the Securities
Administrator issued a Cease and Desist Order against a Tennessee-based
company, the New Life
Corporation of America, and a Maine insurance agent. The company had
offered charitable gift annuities (CGA's) in Maine through an agent and
other unlicensed financial professionals who expected to receive at
least a 6 percent commission. (Such commission-based sales of CGA's are
rare and disfavored by most charities.) Solicitations for these CGA's
allegedly misrepresented that they were guaranteed, no-risk
investments. The action prevented consummation of pending sales to
Maine consumers, one of whom, a very elderly man, was about to part
with over $1 million.
Local Enforcement
The States also continue to play an important enforcement role with
respect to the conduct of licensed broker-dealers and their registered
representatives. State securities regulators are often the first place
that investors turn when they feel they have not been treated fairly by
a broker. One reason for this is our proximity to everyday investors.
Each NASAA member has one or more offices within their State, with
contact information readily available on the web. Many investors
understandably feel that the logical place to start with a grievance is
their local State securities regulator.
And our members are quick to respond, even to individual complaints
that may not signal the type of widespread abuse of interest to our
fellow regulators at the Federal and SRO levels. Often, our members
will reach out to the firm with an informal inquiry, leading to quick
resolution of the investor's concerns without the need for an
enforcement action. In other cases, a ``for cause'' examination
prompted by the customer complaint will reveal systemic problems that
must be dealt with through more formal enforcement proceedings. These
exams complement the routine broker-dealer exams that a significant
number of our members conduct.
Closing
Mr. Chairman and Members of this Committee, in closing, I would
like to offer you my personal opinion based on 18 years as a securities
regulator. I believe that now is the time to strengthen, not weaken our
unique complementary regulatory system of State, industry, and Federal
regulation. Eighty-five million investors--many of them wary and
cynical expect us to remain vigilant, to stay the course--to make sure,
that Wall Street puts investors first. We can not and we will not let
these millions of investors down. I pledge the support of the NASAA
membership to work with you and your Committee to provide you with any
additional information or assistance you may need. Thank you for the
opportunity to testify and I look forward to continuing NASAA's
excellent working relationship with this Committee.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM WILLIAM H. DONALDSON
Supervisory Deficiencies at Every Firm--Compliance
Failures
Q.1. In your press release announcing the global settlement,
you said that, ``the regulators found supervisory deficiencies
at every firm'' covered by the settlement. Where were the
compliance breakdowns? What is being done by the firms to fix
their compliance programs?
A.1. The most significant compliance breakdown found at the
firms was the failure to manage the conflicts of interest
between the provision of investment banking services and the
integrity of the research product. Companies routinely selected
a broker-dealer to provide investment banking services based on
the promise, whether explicit or implicit, of favorable
research coverage. The companies wanted that research to
reflect positively on the companies' prospects. In addition,
research analysts were frequently compensated directly for
contributions to investment banking business. This business
dynamic created a conflict of interest that needed to be
managed to ensure the integrity of the research product. The
firms failed to recognize and address this conflict.
As a result of the global settlement, firms are severing
the links between investment banking and research, including
establishing firewalls between these departments, ceasing the
practice of compensating research analysts directly or
indirectly based upon investment banking revenue, prohibiting
analysts' involvement in ``road shows'' or ``pitch'' meetings,
and requiring all decisions regarding the initiation and
termination of research coverage to be made by senior firm
management. In addition, the firms are required to procure
independent research from outside sources and to make it
available to the firms' clients. The intent of these changes is
to cause firms to provide investors more accurate and reliable
information to assist them in making investment decisions.
Q.2. How is the SEC improving its examination and oversight
function of broker-dealer compliance programs in light of the
problems discovered in the investigation of the 10 broker-
dealers to ensure that such a breakdown does not happen again?
A.2. SEC staff is in the process of conducting an examination
sweep focused solely on broker-dealer compliance and
supervisory programs. In particular, each firm has a
responsibility to establish, maintain, and enforce a system to
properly supervise the activities of its employees to achieve
compliance with the Federal securities laws. The staff is
examining not only whether the firms have implemented effective
procedures required under the securities laws, but also the
extent to which the firms have systems in place that encourage
new issues to be identified, concerns to be communicated to
management, and responses to issues to be developed prior to
discovery by a regulator. This review includes an evaluation of
the Board's and senior management's involvement in compliance-
related functions.
As a result of the increased funding Congress has directed
to the Commission, it is expanding the number of examiners.
These
increases will allow for an increased number of targeted
examinations of broker-dealers as well as more frequent
inspections of oversight programs at the self-regulatory
organizations.
Q.3. Has the SEC identified ``red flags'' or facts that should
have signaled to the SEC that a violation of the Federal
securities laws might be occurring?
A.3. In 2000, prior to the joint investigation that led to the
global settlement, Commission staff began examining research
analysts conflicts of interest. These findings were reported in
July 2001 by then-Chairman Unger during her testimony before
the House Financial Services Subcommittee on Capital Markets.
Pursuant to these findings and SEC recommendations, the NASD
and NYSE crafted significant amendments to their analyst rules.
The SRO rule amendments were initially filed in February 2002
and approved by the Commission on May 10, 2002. The Commission
launched its joint investigation into research analyst
conflicts of interest on April 25, 2002.
The Commission staff's examinations in 2000 exposed a
number of conflicts of interest such as research analyst
compensation being significantly linked to investment banking
revenue, research analysts owning securities in companies they
covered, and research analysts executing trades that were
contrary to the recommendations published in their research
reports. Several specific instances were referred to the
Commission's Division of Enforcement for further investigation.
Q.4. What lessons has the SEC learned in this investigation
that will prompt it to act more quickly and effectively in
addressing securities violations and protecting investors in
the future?
A.4. The findings in these investigations have reinforced the
need to focus resources on areas of conflicts of interest. As
outlined below in response to question 5, the staff is
currently conducting examinations of broker-dealers targeting
other areas of conflicts of interest. In addition, the research
analyst investigation has demonstrated the investigative value
of e-mail. As a result, examination and enforcement staff are
increasingly requesting e-mail as part of examinations and
investigations of broker-dealers.
Q.5. Mr. Glauber at the hearing testified that, ``two weeks
ago, our board voted to put out for comment and the SEC [is
reviewing], a provision where we will require that the CEO and
chief compliance officer of every firm certify the policies and
procedures are in place to enforce our rules.'' What is your
reaction to this recommendation and do you believe it should be
applied more broadly?
A.5. On June 4, 2003, the NASD published Notice to Members 03-
29, which requested comment from its members on a proposal to
require each NASD member to designate a Chief Compliance
Officer, who, jointly with the member's Chief Executive
Officer, must certify annually that the member has in place
adequate compliance and supervisory policies and procedures.
The NASD has not filed the proposal with the Commission for
review. The Commission staff will carefully review this
certification proposal for consistency with the Exchange Act
when the NASD files it with the Commission.
Self-Regulation
Q.6. In his testimony, New York State Attorney General Spitzer
said, ``The single most important message for the American
public and for Congress is that self-regulation failed.'' He
went on, ``It was a complete, abject failure.'' Do you agree
with Mr. Spitzer's characterization that ``self-regulation
failed?'' What can be done to improve our self-regulatory
apparatus--by the SEC; by the SRO's?
A.6. It is a fair criticism to say that the oversight system
for broker-dealers regulators, self-regulators, and the
internal firm compliance structures--did not do enough.
Nonetheless, I do not believe that their failure to act sooner
represents a total failure of the self-regulatory system. In
fact, it is important to note that the investigation resulting
in the global settlement reflected the efforts of not only the
Commission and the States, but also the NASD and the NYSE.
The Commission maintains an inspection program that
oversees SRO's, through which Commission staff seek to ensure
that regulatory programs are adequately staffed, funded, and
independent of SRO members' business interests. The
Commission's recent increase in funding will assist Commission
staff, through additional staff resources and technological
enhancements, to provide additional oversight of SRO's and
broker-dealers.
NYSE Investigation
Q.7. On April 17, 2003, the New York Stock Exchange announced
that it is conducting an investigation ``of trading practices
at several specialist firms.'' What is the SEC's role in the
NYSE's current investigation of its specialists?
A.7. As has been reported in the media, the NYSE is currently
investigating numerous individual specialists for allegedly
engaging in conduct known as ``interpositioning,'' which is the
practice of a specialist trading for his own account with
customer buy and sell orders that could be matched at a single
price, thereby allowing the specialist to illegally profit from
the spread. Commission staff is actively overseeing the NYSE's
investigation into interpositioning. In addition, the staff is
examining the NYSE's overall regulatory program as it pertains
to specialist trading.
New York Stock Exchange Rule 342
Q.8. New York Stock Exchange Rule 342 requires each Exchange
member to submit to its Chief Executive Officer or Managing
Partner an annual report that discusses compliance efforts
regarding antifraud and trading practices, sales practices and
other matters, significant compliance problems and plans to
prevent violations and problems, and complaints and internal
investigations. After the Exchange's examinations of its
members that were parties to the global settlement, did the
Exchange bring possible misconduct to the attention of the SEC
staff ?
A.8. With respect to the global settlement, the Commission's
staff jointly conducted the investigations with the NYSE and
NASD and was, therefore, fully apprised of all potential
regulatory concerns. In addition, shortly after the NYSE's May
2002 enhancements to Rule 472 regarding research analyst
conflicts of interest, the NYSE conducted examinations of the
firms that were parties to the global settlement to assess
their compliance with these rule enhancements. Commission staff
participated in some of these examinations and, therefore, was
apprised of any potential regulatory
concerns at those firms. With respect to the remaining firms,
NYSE examiners presented Commission staff with their findings
at the conclusion of the examinations.
Q.9. Has the SEC staff conducted its own review of the
Exchange's enforcement of Rule 342 or of the Exchange members'
compliance with Rule 342? Has the SEC reviewed the New York
Stock Exchange's examination procedures or use of information
contained in the reports prepared pursuant to Exchange Rule
342? What action has the Commission taken as a result of any
such reviews?
A.9. SEC staff routinely inspect the NYSE's examination
programs. In this regard, the staff intends to conduct an
inspection focusing on the Exchange's review and enforcement of
members' compliance with NYSE Rule 342.
Conflicts of Interest
Q.10. In addition to the research analyst-underwriting conflict
of interest, what other conflicts, if any, within the
securities industry concern you?
A.10. Currently, the Commission is focusing examination
resources on additional areas of conflicts of interest. For
example, the staff is examining broker-dealers to determine
whether conflicts of interests exist in the way brokerage firms
are compensated when selling mutual funds. The examinations
focus on the various types, amounts, and sources of
remuneration that broker-dealers receive for selling mutual
funds, the manner in which broker-dealers pay their registered
representatives who sell mutual funds, and the extent these
payments are disclosed to investors. As demonstrated by the
Commission's recent enforcement action against Deutsche Asset
Management Inc., Deutsche Bank AG's investment advisory arm,
conflicts of interest also may arise in the proxy-voting
process.
Research
Q.11. A number of commentators have observed that research has
historically been subsidized and have expressed concern that
delinking banking from research [as required by the global
settlement] may create a problem in terms of the funding of
research generally. These observers, as well as representatives
of smaller companies, have raised the concern that the proposed
changes may result in these companies losing access to research
coverage entirely. Do you believe these are valid concerns and,
if so, how do you plan to address them?
A.11. The settlement's imposition of structural and
institutional separation between research and investment
banking personnel is designed to prevent promises of favorable
research coverage for companies that are banking clients of the
firm and to protect analysts from inappropriate influences.
Companies will likely continue to consider the ability to
provide research coverage as a significant factor in selecting
firms for investment banking services.
While there has been a recent decrease in research coverage
by investment banks, it is unclear how much this decrease
should be attributed to the settlement (which is not yet in
force), and how much this decrease is caused by the poor
investment banking climate. In addition, there are heartening
signs of an increase in independent research being provided to
institutional investors.
Moreover, similar to the global settlement's approach, in
the Sarbanes-Oxley Act of 2002 (the Act), Congress concluded
the best way to restore confidence in our markets is to ensure
that investors receive independent and objective research, as
opposed to allowing investment banking influenced research
reports to continue to provide investors with biased research,
particularly where conflicts of interest remained undisclosed.
The Commission has approved SRO rule amendments that implement
the requirements of the Act (and impose additional
requirements). We believe that these protections for the
integrity of research will provide incentives for firms to fund
research according to its value to the firm's customers, rather
than base funding of the production of research on
inappropriate influences within the firm.
Scope of Investigation
Q.12. In the context of the global settlement, I understand
that the regulators looked into only a sample of the analysts
and a sample of the stock recommendations at these firms. What
was the scope of your investigation and will the SEC examine
additional research reports to determine whether there are
other instances of misconduct?
A.12. The staff's investigation focused on the extent to which
research analysts: (1) Published research reports and
recommendations that did not reflect the analysts true beliefs;
(2) reported to, or had their work reviewed by, investment
banking personnel; and (3) received compensation from revenue
derived from investment banking activities. The staff selected
for investigation firms that underwrote a significant number of
technology and Internet-related IPO's. In addition, the staff
focused on IPO's (and the underwriters of those IPO's) that
rapidly increased in price and then decreased in a relatively
short period.
The staff does not currently plan to review additional
research reports in that it believes that the sampling used
during the investigations was appropriate. The staff is,
however, continuing to investigate the conduct of senior
management at these broker-dealers to determine whether it is
appropriate to sanction individuals for failing to supervise
the conduct of their employees.
Deutsche Bank
Q.13. According to press reports, Deutsche Bank admits that it
failed to produce all its e-mail to the SEC and the lead State
investigating agency, the California Department of
Corporations. What steps did the SEC take before, and what
steps is the SEC taking after, Deutsche Bank's admission to
ensure that Deutsche Bank was and is, in fact, producing all of
its e-mail and documents?
A.13. As a matter of Commission policy, I am unable to comment
on actions taken by the Commission or its staff in connection
with an ongoing investigation. However, I can assure you that
the Commission and its staff take very seriously the
obligations of parties who receive Commission subpoenas for
documents, whether the recipient is an individual or an entity.
The staff routinely obtains assurances from witnesses under
oath that they have complied fully with subpoenas, including
probing the manner in which the individual conducted the search
for relevant documents. The staff seeks similar representations
from counsel for entities concerning how and whether their
clients have complied with Commission document subpoenas.
Moreover, in instances when the staff believes that a
subpoenaed party's compliance has been inadequate, the
Commission may seek a Federal court order that the party comply
fully with the Commission's subpoena. In fiscal year 2002, the
Commission filed 19 such subpoena enforcement actions, and in
the first three-quarters of fiscal year 2003 the Commission has
brought 6 such actions.
Obstruction of Justice
Q.14. You and Mr. Cutler each underscored the importance of
criminally prosecuting obstruction of justice conduct and the
Commission's close working relationship with the Justice
Department. What is the Commission doing from a civil
perspective to deter future obstructive conduct or conduct
that, as Mr. Cutler says, ``goes to the heart and the integrity
of the investigative process'' and, in that context, is the
Commission vigorously prosecuting all matters in front of it
that involve obstructive conduct by accountants or investment
bankers?
A.14. Criminal prosecution of those who obstruct Commission
investigative processes by destroying documents or lying to the
staff is the most effective means of deterring such conduct by
others. Accordingly, the Division of Enforcement has worked
closely with the criminal authorities to make them aware of
such occurrences and facilitate the prosecution of these
offenders. We have been very pleased with the cooperation of
the Department of Justice in this regard.
Because the Commission does not have the authority to bring
actions for obstruction of justice, we employ a different
strategy to help ensure the integrity of the Commission's
processes. As noted above (in response to question 8), in
instances when the staff believes that a party is seeking to
delay or divert an investigation by refusing to comply with a
Commission subpoena, the Commission has been aggressive in
seeking Federal court enforcement of its subpoenas. Indeed,
last year, the Commission sought and obtained $1.2 million in
damages against a Dallas law firm for violating a court order
in a pending SEC civil lawsuit against one of the law firm's
former clients. The law firm had failed to produce for 18
months 27 boxes of its client's records that the court had
ordered produced to the SEC. This case illustrates the SEC's
commitment to seeking sanctions against those who interfere
with its law enforcement processes.
Similarly, the Commission has created strong incentives for
subjects of its investigations not only to comply with its
investigative processes, but also affirmatively to cooperate
with the staff to facilitate thorough and expeditious
investigations. In an October 2001 Section 21(a) Report, the
Commission articulated the benefits to parties who provide
meaningful cooperation, which includes self-policing prior to
discovery of misconduct (such as developing effective
compliance procedures and an appropriate ``tone at the top'');
self-reporting misconduct upon discovery to the public and
regulators; remediation, such as dismissing or appropriately
disciplining wrongdoers, improving internal controls and
procedures to prevent recurrence, and compensating those
adversely affected, and; cooperation with law enforcement
authorities' investigations. Those benefits may include lesser
charges or lighter sanctions.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE
FROM WILLIAM H. DONALDSON
Q.1. Chairman Donaldson, I am hoping you will share with us
your view of the mechanism to return a portion of these fines
to defrauded investors. Please explain how the Fair fund
established under Sarbanes-Oxley will enable the Commission to
return this money to investors. I understand that the
Commission invited the States to contribute their portion of
their penalties to the Fair fund--have any agreed or declined
to do so?
A.1. The Fair Fund provision of the Sarbanes-Oxley Act was a
groundbreaking measure to help the Commission return more funds
to defrauded investors. It did so by changing the law to permit
penalty amounts collected to be added to disgorgement funds in
certain circumstances. The Commission has made ample use of
this new authority, including in the global analyst research
settlement filed with the Court. Collectively, the settling
firms will pay disgorgement and civil penalties totaling $875
million, including Merrill Lynch's previous payment of $100
million in connection with its prior settlement with the
States. Under the settlement agreements, half of the $775
million payment by the firms other than Merrill Lynch will be
paid in resolution of actions brought by the SEC, NYSE, and
NASD, and will be put into funds to benefit customers of the
firms (the Distribution Funds). The remainder of the funds will
be paid to the States. The settlement has not yet been approved
by the Court so the process of establishing the Distribution
Funds has yet to commence. To date, we have received an
indication of interest from only a single State--Missouri--in
distributing its share of settlement proceeds to investors.
Q.2. Chairman Donaldson, it is my understanding that, as part
of this global settlement, a restitution fund will be
established with an administrator to allocate funds to
individual customers based primarily on whether each customer
purchased any of a limited universe of securities identified in
the Commission's complaint. Can you please discuss the
methodology for how these funds will be distributed? Does
questionable analyst research make it hard to determine who was
harmed? How much reimbursement would the average defrauded
customer receive? Would it be based on the number of shares the
individual purchased? Will mutual funds which purchased these
stocks have access to restitution?
A.2. The monetary relief included in the analyst research
settlement is substantial. Collectively, the 10 firms will
disgorge illegal proceeds of nearly $400 million, and will pay
well in excess of $400 million in civil penalties. As discussed
above, the Federal regulators--the Commission, the NASD, and
the New York Stock Exchange--will place their share of the
penalties and disgorgement (approximately $400 million) into
Distribution Funds for payment to harmed investors if
authorized by the Court. While there are challenges and
difficulties in establishing such Funds, the Commission feels
strongly that those challenges and difficulties are worth
taking on and that any monies paid by the settling firms should
be used to compensate the investors harmed most directly by the
misconduct uncovered in our investigations. We believe that
this is the right thing to do, and is consistent with the
message sent by Congress when it recently authorized us to use
penalties to repay investors.
If approved by the Court, all told, there will be 9
Distribution Funds, one for each of the 9 settling firms other
than Merrill Lynch. Merrill Lynch will not have its own
Distribution Fund because it previously paid $100 million in
penalties to the States. The amounts to be paid by Henry
Blodget, who formerly worked for Merrill Lynch, will be placed
in a separate court-administered fund for distribution to
investors. The money that Jack Grubman pays to the Court will
be put into the Distribution Fund for Citigroup Global Markets
Inc., formerly known as Salomon Smith Barney Inc., for which
Grubman previously worked.
For the firm Distribution Funds, the settlement provides
that the Commission will recommend to the Court, and the Court
will appoint, a Distribution Fund Administrator. The
Distribution Fund Administrator will devise Distribution Fund
Plans and Distribution Fund Reports that contain the complete
and final terms for distribution of funds to investors. There
will be a separate Plan and Report for each of the Distribution
Funds. These Plans and Reports will identify those who are to
receive payments from the Distribution Funds, the amount each
person will receive, and the procedures for distributing funds
to the recipients. The Distribution Fund Administrator will
initially submit his/her Distribution Fund Plans and Reports to
the SEC staff and then to the Court. The Court must approve all
the Distribution Fund Plans and Reports.
The methodology for determining which investors receive
recompense will be developed, in the first instance, by the
Distribution Fund Administrator. Although the Fund
Administrator may exercise significant discretion and judgment
in designing the Distribution Fund Plans, the settlement filed
with the Court articulates certain broad requirements and
guidelines to which the Distribution Fund Administrator must
adhere. The overarching objectives of the Distribution Fund
Plans are to provide for ``the equitable, cost-effective
distribution of funds'' to eligible recipients, and to attempt,
``to ensure an equitable (though not necessarily equal)
distribution of funds and that those who are allocated funds
receive meaningful payments from the Distribution Fund[s].''
In addition to identifying broad objectives of the
Distribution Fund Plans, the settlement provides more specific
guidelines for allocation of the funds. For each defendant, the
Distribution Fund Administrator is required to formulate a
Distribution Fund Plan ``that, to the extent practicable,
allocates funds to persons who purchased the equity securities
of companies referenced in the complaint'' against that
defendant. The settlement also specifies that eligible
investors must have purchased the equity securities in question
through a defendant firm during the relevant period identified
in the complaint, and must have suffered a net loss on his
equity securities purchases in question. The settlement also
states that the Distribution Fund Administrator may consider
(1) whether the person was a retail or institutional customer;
and (2) the proximity in time between the person's purchase of
a company's equity securities and the applicable defendant's
publication of pertinent research regarding that company.
Under the settlement, a mutual fund would not be excluded
simply because it is an institution. It will be eligible
provided it ``purchased the equity securities in question
through [a defendant firm] during the relevant period
identified in the complaint'' against that defendant, met all
the other requirements described above, and was not affiliated
with a defendant firm. A shareholder of such a mutual fund
would not be able to receive a direct payment from the
Distribution Funds but might be able to receive a payment
indirectly through the mutual fund if the Court-approved
Distribution Fund Plan in question provides for payments to the
mutual fund. As mentioned above, in identifying eligible
investors the Distribution Fund Administrator may consider
whether the person in question was a retail or institutional
customer.
Q.3. Chairman Donaldson, has there been any time frame set for
when investors can apply for restitution and do you have any
idea how long it might take for an investor with a good claim
to receive their money? If the answer is no possible follow up:
When will such time frames be set?
A.3. Potential recipients of settlement funds need not take any
action at this time in order to be eligible. Under the terms of
the settlements, the firms are obligated to provide the
Distribution Fund Administrator with all the documents and
information necessary to enable the Distribution Fund
Administrator to identify those who may be eligible to receive
a payment from the Distribution Funds. The time frame for
distributing funds is as follows:
Six months after being appointed by the Court, the
Distribution Fund Administrator will provide Distribution
Fund Plans to the SEC staff for review and comment. These
Plans will describe the process for (i) identifying and
categorizing those who may receive payments from the
Distribution Funds, (ii) determining the amount that each
of those persons shall receive, and (iii) distributing
monies to such people.
Two months after submitting the Distribution Fund
Plans to the SEC staff, the Distribution Fund Administrator
will present the Plans, with any revisions (s)he deems
appropriate, to the Court for its approval.
Within 9 months after the Court approves the
Distribution Fund Plans, the Distribution Fund
Administrator will submit Distribution Fund Reports to the
SEC staff. These Reports will identify (i) those who are to
receive payments from the Distribution Funds, (ii) the
amount that each person will receive, and (iii) the
procedures for distributing funds to the recipients.
One week after submission of the Distribution Fund
Reports to the SEC staff, the Distribution Fund
Administrator will present the Reports to the Court for its
approval.
Following Court approval, the Distribution Funds will
be distributed to investors in accordance with the
procedures set forth in the Distribution Fund Reports.
Note that because the Court has yet to approve the
settlement, this process has not yet begun.
Investors should be aware, however, that the global
settlement papers expressly provide that those who are eligible
to receive payments from the Distribution Funds are not
precluded from pursuing, to the extent otherwise available, any
other remedy or
recourse they may have. To take advantage of the legal rights
that investors may have to pursue any other remedy, individuals
must take legal action promptly or they may lose the right to
seek a remedy or recover funds. Statutes of limitations will
apply and can vary in length depending upon the claim involved
and the forum (court or arbitration) in which a claim is
pursued.
Q.4. Chairman Donaldson, according to the SEC's summary of the
settlement, the practice known as ``spinning,'' the restricting
of allocations of securities in ``hot'' initial public
offerings (IPO's) to
certain company executive officers in a potential bid for
future investment banking business, has been addressed.
However, I am not certain what reforms this settlement contains
to address this problem. Can you discuss the antispinning
reforms in the settlement and if you are considering any
further action on this issue?
A.4. The IPO underwriting process has come under considerable
scrutiny during the past year--especially with regard to
perceived abuses in the allocation of IPO shares. Separate and
apart from the global settlement to be imposed by the Court,
the firms have collectively entered into a voluntary agreement
banning allocations of securities in ``hot'' initial public
offerings (IPO's)--offerings that begin trading in the
aftermarket at a premium--to certain company executive officers
and directors, a practice known as ``spinning.'' Pursuant to
this voluntary initiative, the firms have agreed to implement
policies and procedures reasonably designed to ensure that: (1)
The firms will, not allocate securities in a hot IPO to an
account of an executive officer or director of a U.S. public
company or a public company for which a U.S. market is the
principle equity trading market; (2) in connection with any IPO
transaction in which they are seeking to become the lead or co-
lead managing underwriter, the firms will take reasonable
steps, prior to the aware of the formal mandate, to notify the
company in writing that they may have allocated hot IPO's to
the company's executive officers and directors and/or their
immediate family members; (3) the firms will not allocate
securities in an IPO in exchange for or for the purpose of
obtaining investment banking business; and (4) the firms will
not permit investment banking personnel to have input into
their allocation of securities in an IPO to a specific
individual customer. The requirements of the voluntary
initiative will sunset in the earlier of 5 years or at the time
that the Commission or the SRO's adopt rules concerning IPO
spinning.
At the same time, the Commission is reviewing the industry
practices regarding the allocation of IPO shares with the goal
of restoring investor confidence and public trust. Last fall,
at former Chairman Pitt's request, the NYSE and NASD convened a
blue ribbon Panel of business and academic leaders to conduct a
broad
review of the IPO process, including the role of issuers and
underwriters in the pricing and allocation process, and
recommend ways to improve the underwriting process. The Blue
Ribbon panel completed its report in May. The panel recommended
prohibiting the allocation of IPO shares (1) to executive
officers and directors (and their immediate families) of
companies that have an investment banking relationship with the
underwriter, or (2) as a quid pro quo for investment banking
business. The Commission will work with the SRO's to consider
changes to the rules governing the initial public offering
process, including the recommendations of the blue ribbon
panel.
Prior to the establishment of the Blue Ribbon panel, the
NASD had sought comment from its members on a proposed rule
that would prohibit allocations to company CEO's and directors
on the condition that they send their companies' investment
banking business to the NASD member. The Commission staff
expects that the NASD will revise its rule proposal in light of
the report of the blue ribbon panel and the voluntary
initiative.
Q.5. The settlement requires for securities firms to include a
disclosure on the first page of their research report a note
making it clear that the reports are produced by firms that do
investment banking business with the companies they cover. This
disclosure must acknowledge that such a relationship may affect
the objectivity of their firms' research. Is this disclosure an
acknowledgement that it may be impossible for investment
banking business in a firm not to affect firms' analysts?
A.5. As with many types of corporate disclosure, the purpose is
to make available to the public, to shareholders, or, in this
case, to consumers of research, information that they may find
relevant to their investment decisions. It is up to individual
readers of the disclosure to afford such information
appropriate weight in their decisionmaking process based on
their own preferences, risk tolerance, and judgment. Thus,
requiring disclosure of an investment banking relationship on
the first page of a firm's research report simply acknowledges
that investors may find that factor relevant in evaluating
their investment alternatives. It does not necessarily suggest
that it is impossible for investment banking business in a firm
not to affect a firm's analysts.
Q.6. How do the reforms in this settlement interact and differ
from the reforms that have been instituted since 2001--such as
the industry's own best practices that were adopted in 2001 and
the rules that were adopted by the New York Stock Exchange
during the public outcry about analyst's conflicts?
A.6. The global settlement marks the conclusion of a joint
investigation by regulators aimed at undue influence on
research
exerted by investment banking interests at brokerage firms. The
settlement includes structural and institutional safeguards
designed to protect analysts from inappropriate influences and
prevent promises of favorable research. These reforms are
consistent with continuing initiatives by Congress, the
Commission, the SRO's, and the industry to restore investor
confidence by attempting to reduce conflicts of interest and
increase disclosure of such conflicts.
The thrust of the global settlement and the SRO rules is
quite similar and certain of the global settlement's structural
elements are already incorporated in those rules. Key
similarities between the settlement and the SRO rules
(including recent amendments to those rules that implemented
the Sarbanes-Oxley Act of 2002) include the following:
Structural separation between investment banking and research
personnel; prohibitions on investment banking involvement in
determining analyst compensation; notification of a decision to
terminate research coverage; and prohibition on involvement by
research analysts in solicitation of investment banking
business for their firms, including participating in ``sales
pitches.'' The global settlement goes further than the SRO
rules in some respects by prohibiting analyst involvement in
``road shows,'' obligating firms to provide customers with
``independent research'' for 5 years, and mandating the
creation of a research oversight/monitoring committee. The
Commission and the NYSE and NASD will consider what, if any, of
these additional elements of the global settlement should be
incorporated into rules applicable for the entire industry.
The global settlement's reforms do not conflict in any way
with the SIA's ``Best Practices for Research,'' which are a
series of guidelines that urge higher ethical and professional
standards for research analysts.
Q.7. In reading accounts of conflicts uncovered one thought
frequently came to mind. These analysts did not operate in a
vacuum. There must be some accountability in the executive
suites as well. Accordingly, can you discuss whether the SEC
will hold any Wall Street executives accountable for their
failure to properly supervise their employees?
A.7. The Commission is continuing to investigate the roles
played by individual securities analysts and their supervisors
in the conduct described in the Commission's settlement papers.
I am unable to comment further on this ongoing Commission
investigation.
Q.8. What was the role of the self-regulatory organizations
such as the New York Stock Exchange and the National
Association of Securities Dealers in reaching the agreement and
hammering out the settlement?
A.8. The NASD and the New York Stock Exchange played important
roles in the investigation and settlement of the analyst
research cases. As the first-level regulators of the firms
under investigation, they brought valuable expertise and
experience to the process. These SRO's were full partners in
negotiating the settlement with the firms.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM RICHARD A. GRASSO
Q.1. In analyzing the misconduct discovered through the
investigation, has the New York Stock Exchange (NYSE)
identified, red flags' or facts that should have triggered an
earlier look into whether a violation of the securities laws
was occurring?
A.1. Initially, when the New York Stock Exchange, Inc. (the
Exchange), the Securities and Exchange Commission (the
Commission), NASD Inc. (the NASD), (the Federal regulators)
recognized that there were problems stemming from the potential
conflicts of interest resulting from research and investment
banking operating under one roof, the focus was to establish
industry-wide standards in this area through rulemaking. In
1999, the Commission, the
Exchange and the NASD determined that refinements to the self-
regulatory organization (SRO) rules governing firms' research
practices were necessary. After discussion with the SEC, the
Exchange, and the NASD began the process of drafting new rules
governing research analysts and the disclosure of the conflicts
of interest. In February 2002, the Exchange's Board of
Directors approved new amendments to Exchange Rules 472 and
351, which govern research analysts and published research.\1\
However, it was not until the recent Joint Task Force
investigation conducted by the Exchange, the Commission, the
NASD, the North American Securities Administrators Association,
the New York Attorney General's Office (NY AG's Office), and
State securities regulators (collectively, the Joint Task
Force), that the regulators discovered the extent \2\ to which
the actual conflicts of interest had compromised the integrity
of the research process. The ``red flags'' that revealed this
misconduct were uncovered after the regulators scrutinized
hundreds of thousands of internal and external e-mail
communications of analysts and other personnel at the firms
under investigation. These e-mails provided evidence of the
interrelatedness of the research and investment banking
departments, the investment banking pressures placed on
research analysts, and the interactions of research analysts
with the companies that they covered. In addition, the e-mails
provided the strongest evidence of exaggerated, unwarranted,
and fraudulent research.
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\1\ The Commission approved these amendments in May 2002. In
October 2002 and May 2003, the Exchange and the NASD submitted to the
Commission, for comment and approval, rule amendments that place even
greater restrictions on firms' research activities, including
amendments made pursuant to the Sarbanes-Oxley Act of 2002.
\2\ The firms that participated in the settlement are Bear, Stearns
& Co., Inc., Credit Suisse First Boston LLC, Goldman, Sachs & Co.,
Lehman Brothers Inc., J.P. Morgan Securities Inc., Merrill Lynch,
Pierce, Fenner & Smith, Incorporated, Morgan Stanley & Co.
Incorporated, Citigroup Global Markets Inc., f/k/a Salomon Smith Barney
Inc., UBS Warburg LLC, and U.S. Bancorp Piper Jaffray. The
investigations of Deutsche Bank Securities, Inc., and Thomas Weisel
Partners LLC are continuing.
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Although the Federal regulators were working to develop
industry-wide rules governing firms' research practices, an
earlier review of e-mail sent and received by research analysts
and investment bankers may have revealed the extent to which
investment banking pressures and conflicts of interests
affected the firms' published research. The Exchange now
utilizes e-mail review as an important regulatory tool. As
explained below, the Exchange is committed to using e-mail
review, along with rulemaking and member firm examinations, to
ensure the firms' compliance with the terms of the settlement
and to uncover and punish violations of Exchange rules and the
Federal securities laws.
Q.2. What lessons has the NYSE learned as a result of this
investigation that will make it act more quickly and
effectively to address securities violations and protect
investors in the future?
A.2. As discussed above, the investigation demonstrated the
importance of enhanced e-mail review as a regulatory tool.
Exchange rules require member firms to retain e-mail, to
provide reasonable supervision of e-mail communications, and to
develop written policies and procedures for the review of
communications with the public.\3\ Prior to the investigation,
the Exchange ensured compliance with these requirements by,
among other things, sampling and reviewing external email sent
and received by registered representatives during annual and
periodic examinations of member firms. In 2002, the Exchange
expanded its examination program to include a sampling and
review of internal and external e-mail sent and received by
other categories of employees, including research analysts and
investment bankers. In addition, as part of its investigative
program, the Exchange's Division of Enforcement will conduct
more extensive reviews of e-mail when appropriate based upon
the
nature of the alleged misconduct under investigation. In fact,
the Exchange is currently conducting such e-mail reviews in
several on-going investigations.
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\3\ See New Rules-Supervision and Review of Communications with the
Public, Exchange Information Memo 98-03 (Jan. 16, 1998) (announcing the
requirements adopted in amended Exchange Rules 342.16 and 342.17
requiring member firms to provide reasonable supervision of e-mail
communications and to develop written policies and procedures for
review of communications with the public). In November 2000, the
Exchange, in conjunction with the Commission and the NASD, fined five
firms under investigation by the Joint Task Force $8.25 million for
failing to retain electronic communications. See Deutsche Bank
Securities, Inc., Exchange Hearing Panel Decision (HPD) 02-223 (Nov.
15, 2002); Goldman, Sachs & Co., HPD 02-224 (Nov. 15, 2002); Morgan
Stanley & Co. Incorporated, HPD 02-225 (Nov. 15, 2002); Salomon Smith
Barney Inc., HPD 02-226 (Nov. 15, 2002); and U.S. Bancorp Piper Jaffray
Inc., HPD 02-227 (Nov. 15, 2002).
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The Exchange has committed significant resources to
facilitate this expanded e-mail review. The Exchange's Division
of Regulatory Technology has developed a sophisticated computer
system to review and catalog e-mail. Exchange employees in the
Divisions of Member Firm Regulation, Market Surveillance, and
Enforcement have received training in this system, which will
be used regularly in Exchange examinations and investigations.
In addition to the above changes, the Exchange has
undertaken new regulatory initiatives to target problems in the
industry. The Exchange, in conjunction with the Commission and
the NASD, are presently investigating the improper ``spinning''
of initial public offering (IPO) shares.\4\ The Federal
regulators will also be examining the operation of compliance
departments at major broker-dealers. These examinations will
review the structure of the department, the qualifications of
its employees, the department's staffing and budget, and most
importantly, whether the department has the tools to
effectively monitor the firm's operations.
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\4\ Spinning is generally known as the allocation of shares of a
``hot'' IPO to the account of an employee of a public company for the
purpose of obtaining, or in exchange for, investment banking business.
Q.3. The joint agency press release announcing the global
settlement said that, ``the regulators found supervisory
deficiencies at every firm.'' That means ``every'' major
investment bank on Wall Street covered by the settlement had
supervisory deficiencies. What is the responsibility of the
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heads of these firms to supervise their personnel?
A.3. The supervisory responsibilities of Exchange member firms
are set forth in Exchange Rule 342, entitled ``Offices--
Approval, Supervision and Control.'' This rule mandates that
every Exchange member firm provide--through designated
supervisory personnel and systems of follow-up and review--
appropriate supervisory control over its employees and business
activities to ensure compliance with all Exchange Rules and the
Federal securities laws. This obligation extends to the heads
of these firms, who are ultimately
responsible for compliance with Exchange Rules and the Federal
securities laws.
Q.4. Where were the compliance breakdowns? What is being done
to fix them?
A.4. The ``compliance breakdowns'' uncovered by the Joint Task
Force are described in great detail in the settlement
documents, which include, among other things, the finding that
the firms failed to adequately manage the conflicts of
interests and address their impact on published research.
A key focus of the investigation was a review of the
supervisory practices and procedures at the firms. This review
revealed that each firm failed to maintain supervisory control
over its business activities to ensure compliance with the SRO
rules and the Federal securities laws. In the Exchange hearing
panel decisions formalizing the settlement, each firm consented
to a finding that it violated Exchange Rule 342 for ``failing
to establish and maintain adequate policies, systems, and
procedures for supervision and control of the research and
investment banking departments reasonably designed to detect
and prevent the . . . [specified] investment banking influences
and manage the conflicts of interest, including a separate
system of follow-up and review to ensure compliance with
applicable Exchange Rules and Federal securities law.'' \5\
This finding resulted from the firms' failure to monitor
research analyst participation in pitches, road shows, and
other investment banking activities; failure to monitor e-mail
communications for evidence of investment banking pressure to
change the content of, or the recommendations contained in,
published research; failure to monitor communications with
issuers; and failure to ensure that research analyst
compensation was not linked to investment banking activities or
the profitability of the investment banking department. As
detailed in the settlement documents, each firm fostered a
culture that subjected research analysts to significant
investment banking pressures and conflicts of interests.
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\5\ Bear, Stearns & Co., Inc., BPD 03-63 (Apr. 22, 2003); Citigroup
Global Markets Inc. f/k/a Salomon Smith Barney Inc., HPD 03-72 (Apr.
22, 2003); Credit Suisse First Boston LLC, HPD 03-64 (Apr. 22, 2003);
Goldman, Sachs & Co., HPD 03-65 (Apr. 22, 2003); JP Morgan Securities
Inc., HPD 03-68 (Apr. 22, 2003); Lehman Bothers Inc., HPD 03-66 (Apr.
22, 2003); Merrill Lynch, Pierce, Fenner & Smith Incorporated, HPD 03-
67 (Apr. 22, 2003); Morgan Stanley & Co. Incorporated, HPD 03-69 (Apr.
22, 2003); UBS Warburg LLC, HPD 03-70 (Apr. 22, 2003); and U.S. Bancorp
Piper Jaffray Inc., HPD 03-71 (Apr. 22, 2003).
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To ``fix'' the compliance breakdowns, the settlement
imposes a detailed framework of requirements to ensure that
published research is the product of independent, objective
analysis by research analysts. These requirements, which are
contained in ``Addendum A'' to the settlement documents, will
forever change the way that these firms conduct business. For
example, it is no longer permissible for research analysts to
participate in pitches or otherwise solicit investment banking
business. Also, research analysts may not report to investment
bankers, may not be compensated or evaluated based upon
investment banking considerations, and are
restricted in their communications with investment bankers. In
addition, the firms are required to retain an independent
monitor to conduct a review of the policies and procedures
implemented to comply with the requirements of Addendum A. As
discussed in response to Question 1, the Exchange and the NASD
have imposed additional requirements governing research
analysts and published research through rulemaking. The new
rules and the requirements of Addendum A are intended to ensure
that the research and investment banking departments are
physically and operationally separate and that published
research is free from investment banking influences.
In addition, the Exchange is continuing to investigate the
role that supervisors at all levels played in both creating and
perpetuating the ``culture of conflicts'' that was present at
all of the firms. Additional enforcement actions in this area
are expected.
Q.5. Are you satisfied with the compliance programs at these
broker-dealers? [If not, what are you going to do to improve
them?]
A.5. It is a well-established tenet of securities industry
regulation that broker-dealer compliance is the first line of
defense against securities law violations. The size and
complexity of the industry make it critical that firms maintain
effective compliance programs to ensure adherence to SRO rules
and the Federal securities laws. This compliance obligation
arises out of Federal and SRO requirements that firms
reasonably supervise their employees and business activities.
The Commission has referred to this obligation as ``a critical
component of the Federal regulatory scheme.'' \6\ In
particular, the heads of these firms ``are responsible for
compliance with all of the requirements imposed on his firm
unless and until he reasonably delegates particular functions
to another person in that firm, and neither knows nor has
reason to know that such person's performance is deficient.\7\
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\6\ In the Matter of John H. Gutfreund, et al, Exchange Act Release
No. 31554, 51 S.E.C. 93, 108. (Dec. 3, 1992).
\7\ Id. at 112.
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In leveraging regulatory resources, the Exchange and the
other securities regulators require that firms implement
effective systems and procedures to ensure adherence to
securities rules and laws. To ensure that broker-dealers comply
with this requirement, the Exchange conducts regular
examinations of firms and initiates disciplinary actions if
these firms fall short of their compliance responsibilities.
As a result of the investigation, the Exchange, the
Commission and the NASD have initiated a joint examination
program to determine whether the largest broker-dealers are
sufficiently committed to compliance. These examinations will
review the structure of each firm's compliance department, the
qualifications of its employees, the department's staffing and
budget, and most importantly, whether the department has the
tools to effectively monitor the firm's operations. The Federal
regulators will closely examine the results of these
examinations to determine the appropriate regulatory response.
Q.6. How are you improving your own surveillance of the broker-
dealer community?
A.6. The Exchange is committed to improving its surveillance of
member firms to ensure that they are in compliance with
Exchange rules and the Federal securities laws. The Exchange
has longstanding and effective examination and investigation
programs designed to uncover and address misconduct in the
broker-dealer community. The Exchange will enhance its review
of member firms through new initiatives in its examination
program and through rigorous investigations of firms and their
employees which will include a review of e-mail when
appropriate.
One immediate change that the Exchange has made to its the
examination program is a review of the settling firms'
compliance with the significant undertakings required by
Addendum A. With respect to all other broker-dealers, the
Exchange will continue to review for compliance with Exchange
rules governing research analysts, research reports, and
communications with the public. The Exchange completed a
special examination program, conducted in coordination with the
Commission and the NASD, that reviewed firms' compliance with
the requirements imposed by the new SRO rules approved in May
2002. The Exchange will also review for compliance with the
requirements of Regulation Analyst Certification, or ``Reg.
AC,'' which requires that research analysts certify the content
of published research represents their personal views. As
described above, the Exchange is working with the Commission
and the NASD on coordinated examinations of the operations of
compliance departments at major broker-dealers. The purpose of
these examinations is to ensure that these firms are
sufficiently equipped to execute their compliance
responsibilities.
It is noteworthy that an integral component of every
investigation conducted by the Exchange's Division of
Enforcement is a review of the adequacy of supervision, and
this will continue to be a focus of the Exchange's regulatory
program. As a result, the Division of Enforcement has a
demonstrated record of disciplinary
actions against firms and individuals, including chief
executive officers (CEO's), floor brokers, high-level managers,
and branch office managers for failing to adequately supervise
a firm's operations and/or for failing to implement adequate
supervisory policies and procedures to prevent misconduct.
Exchange member firms have an obligation to ensure that
their operations adhere to securities rules and regulations.
The Exchange will continue to require that member firms provide
effective compliance programs, will conduct examinations and
investigations to ensure that those responsibilities are
upheld, and will sanction firms and individuals as warranted.
Q.7. On April 17, 2003, the NYSE announced that it is
conducting an investigating [sic] ``of trading practices at
several specialist firms.'' The press reports on the
investigation stated that it arose because the Exchange
received customer complaints and that the NYSE is examining
activity in dozens of stocks'' and that ``legal and compliance
officers at six of the NYSE's seven `specialist' firms . . .
met to discuss concerns about `front-running,' or trading ahead
of clients in the stocks that the specialists are in charge of
trading.' The Exchange issued a press release on April 22, 2003
stating that the press accounts contained errors.
The Wall Street Journal on April 23, 2003, wrote, ``We
believe our coverage has been accurate and fair . . . As for
the Exchange's criticism of our semantics, we will happily
defer to its experts on whether the proper description of the
possible misbehavior under investigation is running in front of
public investors or failing to stand out of their way.
Meanwhile, we hope that the Exchange can tell us and the public
soon the extent of the problem and what, if anything, it thinks
should be done about it.
How would the NYSE respond to the Journal saying that the
April 22 release is about a ``criticism of our semantics?''
What is the extent of the problem and what, if anything, needs
to be done about it?
A.7. In statements issued on April 17 and 22, 2003, the
Exchange made an exception to its longstanding policy not to
comment on regulatory matters in progress and confirmed the
existence of an investigation of trading at several specialist
firms. The Exchange issued these statements on the
investigation because some of the press coverage
mischaracterized the conduct under investigation and contained
inaccuracies.
The investigation was initiated pursuant to the Exchange's
ongoing program of examination and surveillance of the
activities of its specialist members. The Exchange's Division
of Market Surveillance detected suspicious trading by a
specialist in an individual stock. The Exchange then undertook
a full-scale review of trading by all of the specialist firms
to determine if other specialists were engaging in
inappropriate trading.
The Exchange's investigation involves a review of the
specialists' discharge of their responsibilities to agency
orders and their failure to comply with their ``negative
obligations.'' A specialist may appropriately act as a dealer
with respect to some orders and as an agent with respect to
other orders.\8\ A specialist has an ``affirmative obligation''
to buy and sell securities as a principal when such
transactions are necessary to minimize an actual or reasonably
anticipated, short-term imbalance between supply and demand to
avoid an unreasonable lack of continuity and/or depth in the
market. Alternatively, a specialist has a negative obligation
to permit public orders to be executed against each other,
within the current market and without undue specialist
intervention, when there are sufficient public orders.
---------------------------------------------------------------------------
\8\ See Exchange Rule 104.10 (delineating the functions of
specialists).
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The Exchange will bring appropriate disciplinary action if
the current investigation establishes that any specialist firm
or individual specialist engaged in violative conduct.
Q.8. Has the NYSE received increasing numbers of complaints
about specialists? What is the nature of these complaints?
A.8. As an SRO, the Exchange carefully reviews all inquiries
and complaints from the public, institutional investors,
professional market participants, and listed companies.
Complaints from the public involving specialists relate to a
variety of issues, including order execution, market
maintenance, general inquiries about the auction market
process, and the publication of stock prices. Inquiries and
complaints have not increased from 2002 to the present. In
2001, the first full year of trading in decimals, complaints
and inquiries increased from 2000. This was likely due to
several factors, including increased trading volume,
decimalization, and the general downturn in the securities
markets.
Of course, inquiries from the public represent just one
source of the matters subject to review and investigation by
the Exchange. Every transaction effected on the Exchange is
under continuous surveillance during the trading day. Various
surveillance programs monitor for irregular or exceptional
trading and price movement by specialists and floor brokers,
insider trading abuses, and other manipulative and prohibited
trading practices. In addition, annual and periodic
examinations of specialists are conducted to detect violations
of floor-related trading rules.
Q.9. Is ``penny jumping'' permissible under NYSE rules? What is
the difference between ``penny jumping'' and front running?
A.9. Penny jumping is generally known as trading in front of
existing orders at a penny better than those orders. It is a
term that disparages the concept of price improvement by
implying that market participants are more concerned with
making the trade than with the price paid. Brokers for certain
customers may outbid orders for other customers. Penny jumping
primarily involves trading by individuals other than
specialists. Under certain circumstances, penny jumping by
specialists may be impermissible under Exchange rules, although
the practice, unlike front running, is not illegal per se.
Specialists are not permitted to trade when there are
sufficient public buyers and sellers. They are obligated to
commit capital to trade and participate as necessary to
minimize temporary disparities between supply and demand.
In an auction market, buyers compete for available supply
to
arrive at an appropriate price at the confluence of supply and
demand. In some circumstances, specialists have an affirmative
obligation to intervene with public trading to maintain fair,
orderly, and continuous trading. A specialist in possession of
executable buy and sell orders must represent those orders by
crossing them at an appropriate price within the current market
by participating as a dealer only when there is an imbalance
between supply and demand. On the other hand, in a dealer
market, it is always acceptable for the dealer to interact with
customer orders and to profit by pennies or more on such
transactions.
Penny jumping may be distinguished from the generally
accepted definition of front running, which occurs when a
person is in possession of a large customer order and purchases
on the same side of the market and ahead of the order at a more
favorable price, with the expectation that execution of the
customer order will increase the price of the stock. After the
execution of the customer order, the fiduciary sells the stock
at a profit when the stock price increases, in violation of his
or her fiduciary duty.
The Exchange has reviewed the issue of penny jumping in
connection with its evaluation of the impact of
decimalization.\9\
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\9\ See, e.g., Robert Jennings, Getting `ennied: `The Effect of
Decimalization on Traders' Willingness to Lean on the Limit Order Book
at the New York Stock Exchange, NYSE Working Paper 2001-01 (Jun. 2001).
Q.10. As a self-regulatory organization, the NYSE is
investigating the conduct of its own specialists. You have done
this historically but given the current environment how do you
---------------------------------------------------------------------------
respond to those who raise the conflict of interest issue?
A.10. It is important to note the Exchange does not own the
specialist firms. It regulates them as it does any other member
firm.
As an auction market, the Exchange has the greatest
expertise and experience in policing its market and in ensuring
compliance with its rules, all of which have been approved by
the Commission after review, publication in the Federal
Register, and public comment. In the regulation of its market,
the Exchange operates within a system of Federal regulatory
oversight, shared jurisdiction, and regulatory cooperation, to
protect the public interest. This system has made the U.S.
securities markets the world model of liquidity, depth, and
investor protection.
The Commission has emphasized the importance of the SRO's
in enforcing the securities laws and has stated the following
with respect to the advantages of self-regulation:
Industry participants bring to bear expertise and
intimate knowledge of the complexities of the
securities industry and thereby should be able to
respond quickly to regulatory problems. Self-regulation
supplements the resources of the Government and reduces
the need for large governmental bureaucracies. In
addition, SRO's can adopt and enforce compliance with
ethical standards beyond those required by law.\10\
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\10\ Report Pursuant to Section 21(a) of the Securities Exchange
Act of 1934 Regarding the NASD and the Nasdaq Market, Securities
Exchange Act of 1934 Release No. 34-37542, 52 S.E.C. 882 (Aug. 8,
1996).
Historically, the Exchange has consistently and effectively
regulated its membership, including its specialist members, and
has always responded decisively to evidence of misconduct in
any form. Furthermore, the Exchange has a demonstrated record
of disciplinary actions against specialist firms and individual
specialists. The effectiveness of the Exchange's regulatory
program is predicated upon the Exchange's ability to recognize
changes in the marketplace and to adapt its regulatory program
in response to those changes. To accomplish this, more than one
third of the Exchange's employees are engaged in regulatory
activity, which is supported by state-of-the-art technology and
surveillance programs. Protecting investors has always been and
continues to be, the Exchange's highest priority.
There is nothing about today's ``current environment'' that
prevents the Exchange from carrying out its regulatory
responsibilities with respect to specialist firms and
individual specialists. To the contrary, it was the Exchange's
own surveillance program that
uncovered the problematic trading that prompted the current
investigation of specialist firms. The Exchange will take
appropriate regulatory action if this investigation establishes
any incidents or patterns of wrongdoing.
Q.11. Without disclosing specific details, can you describe
with some specificity what the NYSE is doing to investigate
misconduct by the supervisors of the analysts at the
organizations involved in the global settlement?
A.11. The Exchange, the Commission, and the NASD are continuing
to review for supervisory deficiencies of individual
supervisors that were employed by the firms involved in the
investigation by using a variety of methods and tools of
investigation. After a careful review of materials obtained,
and after taking testimony as needed, the Federal regulators
will determine whether disciplinary action is warranted. The
Exchange ordinarily does not discuss the nature of an on-going
investigation until and unless there is a determination to
initiate disciplinary action. Upon the conclusion of this
investigation, the Exchange will report on the investigative
steps taken and any findings, as well as any disciplinary
action taken.
Q.12. The New York Times has reported that foremost among the
unresolved questions for investors and the securities industry
is what long-term impact the settlement will have on the
culture of Wall Street, the integrity of stock analysts, and
the confidence of investors. What long-term effects do you
think this scandal will have on investor confidence and the
industry?
A.12. The misconduct uncovered by the Joint Task Force
investigation has been addressed decisively by the global
settlement. The various components of the settlement serve a
multipurpose of addressing structural problems that led to the
conflicts of interest and providing a framework for making
independent research available to customers. Some of the more
significant components of the settlement include the following:
First, the settling firms are required to institute
significant safeguards to ensure that published research is
independent, objective, and not tainted by investment banking
influences. These safeguards are set forth fully in Addendum A
to the settlement documents, and described above.
Second, the firms are required to provide independent,
third-party research, in conjunction with the published
research, for a period of 5 years.
Third, the firms are required to pay $80 million for an
investor education fund, which will be used to ensure public
understanding of these requirements and other important
investor-related issues.
In addition, as discussed in response to Question 1, the
Exchange and the NASD have imposed additional requirements
governing research analysts and published research through
rulemaking.
In sum, the result of the global settlement and the new SRO
rules is a new regulatory framework that will undoubtedly have
a positive long-term impact on the culture of Wall Street, the
integrity of published research, and investor confidence.
Q.13. NYSE Rule 342 requires each NYSE member to submit to
its Chief Executive Officer or Managing Partner an annual
report that discusses compliance efforts regarding antifraud
and trading practices, sales practices and other matters,
significant compliance problems and plans to prevent violations
and problems, and complaints and internal investigations. Did
all firms covered by the global settlement submit their
required reports over the time period covered by the global
settlement? Did the NYSE review the examination reports of the
firms covered by the global settlement? What did the NYSE
discover in the review of these reports? What allegations of
improper conduct were made in these reports? How are you
enforcing Rule 342 and the ``Annual Report'' provisions?
A.13. Exchange Rule 342.30 requires that each member firm
submit an annual report to its chief executive officer or
managing partner that details the firm's compliance efforts
during the preceding year. The Exchange's Division of Member
Firm Regulation reviews for compliance with this rule during
its annual and periodic examinations of member firms. These
reviews ensure that the annual reports contain the required
information and are submitted to the appropriate firm personnel
in a timely manner. One purpose of the annual report is for
firms to communicate compliance problems to senior management
and for management to take action to resolve those problems.
Another purpose of the annual report is to notify the Exchange
when member firms discover misconduct, and this enables the
Exchange to explore the extent of the wrongdoing and to
determine whether the firm sufficiently corrected the problem.
Thus, the annual report submitted pursuant to Exchange Rule
342.30 serves as a basis for the Exchange to conduct further
inquiry when firms uncover serious problems or otherwise raise
compliance ``red flags.''
From 1999 to 2001, each of the firms under investigation
submitted annual reports as required by Rule 342.30. During
that time, the Exchange's Division of Member Firm Regulation
noted one exception involving this rule. In 1999, during a
financial and operational examination by the Exchange, a firm
was found to have failed to provide a copy of the annual report
to the appropriate individual at the parent company. Exchange
examiners followed-up on this exception during the 2000
examination and determined that the deficiency was corrected.
The Exchange will continue to review its member firms'
compliance with Rule 342.30 and will take appropriate action
when that rule is violated.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM ROBERT GLAUBER
Q.1. In analyzing the misconduct discovered through the
investigation, has NASD identified ``red flags'' or facts that
should have triggered an earlier look into whether a violation
of the securities laws was occurring?
A.1. I believe that in hindsight, all of the regulators,
Federal and State, could have more quickly identified and
addressed the issues of research analyst conflicts of interest.
We have not identified any specific red flags or facts that
would have or should have triggered an earlier look into
whether a violation of the securities laws was occurring. Much
of the evidence that was developed in these investigations was
found among many hundreds of thousands of internal e-mails
reviewed, as well as through sworn investigative testimony.
Nonetheless, in general, mapping out the conflicts of interest
that exist in large integrated investment banks is enabling us
to think more precisely about other conflicted conduct that may
warrant regulatory attention. For example, we are currently
undergoing a review of the Fairness Opinions that are issued in
conjunction with mergers.
NASD was at the forefront of the effort to address IPO
abuses and research analyst conflicts of interest. In addition
to rulemaking that was largely completed before the settlement,
NASD was investigating IPO abuses and research analyst
conflicts of interest as far back as mid-2000. In January 2002,
NASD, along with the SEC, fined CSFB a total of $100 million
for improper IPO profit sharing. In the summer of 2001, NASD
commenced a series of research analyst investigations separate
from the global settlement investigations that have resulted
thus far in charges of misleading research and improper conduct
being made against more than 20 firms and individuals. NASD has
been and remains active in investigating supervisors and other
individuals who may be responsible for certain of the conduct
discovered during the global settlement investigations.
NASD was also the first regulator to bring charges against
Solomon Smith Barney and Jack Grubman, filing an action in
September 2002 alleging, among other things, that Mr. Grubman
and his firm published misleading research on Winstar
Communications, in violation of NASD advertising rules.
NASD was the principal investigator among the Federal
regulators responsible for the matters involving Salomon Smith
Barney, Jack Grubman, Merrill Lynch, Henry Blodget, CSFB, Frank
Quattrone, and US Bancorp Piper Jaffray. NASD responded
appropriately and aggressively to the evidence it uncovered at
these firms relating to structural conflicts of interest and
specific examples of pressure by investment banking on research
analysts or fraudulent or misleading research. As a result of
this investigation, and as part of the global settlement, SSB,
CSFB, and Merrill were the only firms charged with fraud.
Messrs. Grubman and Blodget were charged with, among other
things, aiding and abetting SSB's and Merrill's fraud
(respectively), and the firms and these two individuals paid
some of the most substantial fines on record. NASD was also the
first regulator to file an action against Mr. Quattrone, and
recently filed an action against another Merrill Lynch research
analyst, Phua Young, based on an investigation begun
independently from the joint investigation of Merrill Lynch.
Q.2. What lessons has the NASD learned as a result of this
investigation that will prompt it to act more quickly and more
effectively in addressing securities violations and protecting
investors in the future?
A.2. Investor protection can best be achieved through quick and
decisive enforcement action and effective rules and
regulations. It is clear from this group of cases, as well as
others, that the review of internal e-mail can provide
regulators with a contemporaneous record of potential volatile
conduct. In this regard, NASD, along with the SEC and the NYSE,
brought charges against five brokerages and imposed aggregate
fines of $8.25 million for the failure to retain e-mails.
NASD has also further focused its commitment to identifying
nascent investor protection issues. In this regard, NASD has
implemented its ``Ahead of the Curve'' program and provides
periodic updates to investors of potential problem areas
through our Investor Alerts. While we cannot anticipate all
problems, we learned that we need to look ahead in a more
systematic way.
Q.3. The joint agency release announcing the global settlement
said that ``the regulators found supervisory deficiencies at
every firm.'' That means ``every'' major investment bank on
Wall Street covered by the settlement had supervisory
deficiencies. What is the responsibility of the heads of these
firms to supervise their personnel?
A.3. The chief executive officer or president of each brokerage
firm has the legal responsibility to either supervise each
employee or reasonably delegate that supervision responsibility
to others. In most brokerage firms, and certainly of those of
the size involved in the global settlement, there are systems
in place to delegate' responsibility to appropriate managers.
The question in each case is whether that supervision was
appropriately carried out, and whether the president was on
notice that it was not being appropriately carried out. This
general supervisory responsibility is found in both the Federal
securities laws and NASD rules.
Thus, the head of each firm is responsible for compliance
with all of the requirements imposed on his firm, unless and
until he reasonably delegates particular functions to another
person in that firm, and neither knows nor has reason to know
that such person's performance is deficient. When alerted to
``red flags'' of possible wrongdoing, a supervisor or the head
of a firm has the responsibility to take appropriate action.
In addition, NASD Rule 3010 requires each member firm to
establish, maintain, and enforce a system to supervise the
activities of each registered representative and associated
persons and to maintain adequate written supervisory
procedures. These procedures must state who is responsible for
the supervision of each area of the firm, what that person does
to supervise that area and how such supervision is evidenced in
writing.
NASD recently proposed rules that would require the chief
executive officer and chief compliance officer of each member
firm to jointly certify annually that the firm has adequate
compliance and supervisory policies and procedures in place.
This certification is intended to enhance investor protection
by ensuring that senior management focuses increased attention
on their firm's compliance and supervisory systems and by
fostering regular interaction between business and compliance
officers.
Q.4. Where were the compliance breakdowns? What is being done
to fix them?
A.4. Each firm's system and business practices fostered
inappropriate contact and coordination between research and
investment banking. The firms essentially failed to properly
manage these conflicts and, in fact, encouraged, through their
compensation systems, conflicted conduct. For example,
investment banker evaluations and investment banking revenues
were significant factors in promoting and compensating research
analysts. In addition, investment banking influenced the
initiation, rating, and the coverage of issuers. The new NASD
research analyst rules, and the undertakings imposed in the
settlement, provide for the separation of these two functions
and seek to insulate research analysts from any improper
influence by investment bankers.
The research analyst rules that I discussed in my
testimony, and that we jointly wrote with the NYSE, use a
combination of disclosure and outright prohibitions to assure
that investors are more informed and analysts are more
independent. NASD has already begun examining for compliance
with these new rules.
Q.5. Are you satisfied with the compliance programs at these
broker-dealers? (If not, what are you going to do to improve
them?)
A.5. In conjunction with the SEC, we are engaged in a series of
top-to-bottom reviews of the compliance department of major
firms. We will require the firms to address through remedial
actions, any shortcomings identified either through these
specialized exams or in the course of the cycle exam program.
In addition, through the proposal for CEO and chief compliance
officer certification, we will have a very focused and direct
tool for requiring firms to identify and fix any gaps or
failures in their compliance programs. Finally, we will
continue to bring enforcement actions wherever there have been
breakdowns in compliance.
Q.6. How is the NASD improving the surveillance of the broker-
dealer community?
A.6. NASD broker/dealer examinations include a review for IPO
abuses and research analyst conflicts of interest. The
following is a brief outline of certain aspects of our
examination protocol that specifically address these issues.
Review of Supervision--To determine the adequacy of the
firm's supervisory system in detecting and preventing insider
trading our examiners review the firm's written supervisory
procedures to ensure that they address items such as: (1)
Monitoring of accounts (proprietary accounts, employee accounts
at the firm and at other broker/dealers, family and related
accounts); and (2) information barriers; and employee education
and certification.
Review of the Firm's Information Barriers--Here,
examinations focus on the adequacy of policies and procedures
and assessment of whether they are reasonably designed to limit
or contain the flow of material, nonpublic information to
employees who have a ``need-to-know.'' Among other things,
examiners review a firm's information barriers to verify that
they include: (1) Physical separation of the trading and sales
department from investment banking or other departments that
regularly receive confidential information; (2) supervision of
interdepartmental communications involving material, nonpublic
information; (3) investigations for possible misuse of
material, nonpublic information that includes maintaining
documentation sufficient to recreate investigations made by the
firm in connection with its information barrier procedures; (4)
standards and criteria for placing securities on Restricted/
Watch Lists; and (5) a process for employee education and
certification to impart an understanding of Federal and State
laws, SRO requirements and the firm's policies and procedures
regarding the use of material, nonpublic information.
Examiner Independent Review for Insider Trading--To detect
the possible occurrence of improper trading by the firm,
employees, or customers, our review is an examiner-conducted,
independent test of the application of the firm's own
supervisory system for information barriers.
Examiner Review for Research Analyst Conflicts of
Interest--To address the conflicts of interest that arise when
research analysts recommend equity securities in public
communications examiners conduct a review to determine whether:
(1) The firm's written supervisory procedures are adequate with
respect to conflicts of interest and related disclosures in
research reports and during public appearances; (2) there is a
relationship between the investment banking department, the
subject company, and the research department (such as whether
research analysts are under separate control and supervision
from the investment banking department; whether the firm
complies with applicable restrictions regarding submitting
research report information to subject companies; whether
favorable research, ratings, or price targets are used as an
inducement for the receipt of business); (3) analyst
compensation is tied to investment banking services
transactions; (4) an analyst's stock ownership and personal
trading is in the securities he/she covers and whether he/she
complies with required restrictions; (5) required disclosures
of potential conflicts of interest in research reports and
public appearances are made; and (6) the firm and its research
analysts comply with the requirements of Regulation AC
regarding the inclusion of required certifications in research
reports.
Examiner Review of Initial Public Offerings--To determine
that firms did not engage in any manipulative practices during
an
underwriting period or in the immediate aftermarket, as well as
to assess that a bona fide public distribution of securities
occurred examiners focus on whether the firm: (1) Made any
``quid pro quo'' agreements (such as the receipt of excessive
commissions in exchange for IPO allocations and sharing in
customer profits, undisclosed compensation paid to the firm, to
finders, to consultants, to promoters, or to any other party;
or deal paybacks); (2) solicited aftermarket orders for the
allocation of IPO shares, often referred to as ``laddering'' or
``tie-in'' agreements; and (3) allocated hot issues to the
personal brokerage accounts of corporate officers, directors,
and venture capitalists in the hopes of attracting future
underwriting or other types of corporate financing business,
often referred to as ``spinning.
Q.7. Without disclosing specific details, can you describe with
some specificity what the NASD is doing to investigate
misconduct by the supervisors of the analysts at the
organizations involved in the global settlement?
A.7. The NASD, along with the SEC and the NYSE, are
investigating the actions of the most senior supervisory
personnel in each of the firms involved in the global
settlement. The NASD has committed significant resources to
this effort, which will include the review of thousands of e-
mails and documents and the sworn testimony of numerous
individuals. In addition, NASD has been investigating several
immediate and second-level supervisors of those found in the
global settlement and elsewhere to have been engaged in
significant misconduct.
Last month, NASD, along with the SEC and NYSE, requested
additional e-mails from the 10 settling firms relating to more
than fifty of their senior level officials and supervisors for
a 3-year period. Over the coming months, we will be reviewing
hundreds of thousands of e-mails relating to supervisory
structures, responsibilities and potential culpability of
persons in the firms.
Q.8. The New York Times has reported that foremost among the
unresolved questions for investors and the securities industry
is ``what long-term impact the settlement will have on the
culture of Wall street, the integrity of stock analysts, and
the confidence of investors.'' What long-term effects do you
think this scandal will have on investor confidence and the
industry?
A.8. While it is clear that investor confidence has been shaken
badly, I believe that it will rebound. I truly hope that the
industry has learned a hard lesson from its misconduct and the
consequences that have flowed from it. If they cannot
demonstrate by their conduct that they have learned these
lessons, then I believe they will not reclaim investor faith
and they will earn regulators' quick and unforgiving response.
RESPONSE TO A WRITTEN QUESTION OF SENATOR SARBANES
FROM STEPHEN M. CUTLER
Q.1. You and Chairman Donaldson each underscored the importance
of criminally prosecuting obstruction of justice conduct and
the Commission's close working relationship with the Justice
Department. What is the Enforcement Division doing from a civil
perspective to deter future obstructive conduct or conduct
that, as you say, ``goes to the heart and the integrity of the
investigative process'' and, in that context, is the
Enforcement Division vigorously prosecuting all matters in
front of it that involve obstructive conduct by accountants or
investment bankers?
A.1. Criminal prosecution of those who obstruct Commission
investigative processes by destroying documents or lying to the
staff is the most effective means of deterring such conduct by
others. Accordingly, the Division of Enforcement has worked
closely with the criminal authorities to make them aware of
such occurrences and facilitate the prosecution of these
offenders. We have been very pleased with the cooperation of
the Department of Justice in this regard.
Because the Commission does not have the authority to bring
actions for obstruction of justice, we employ a different
strategy to help ensure the integrity of the Commission's
processes. As noted above (in Chairman Donaldson's response),
in instances when the staff believes that a party is seeking to
delay or divert an investigation by refusing to comply with a
Commission subpoena, the Commission has been aggressive in
seeking Federal court enforcement of its subpoenas. Indeed,
last year, the Commission sought and obtained $1.2 million in
damages against a Dallas law firm for violating a court order
in a pending SEC civil lawsuit against one of the law firm's
former clients. The law firm had failed to produce for 18
months 27 boxes of its client's records that the court had
ordered produced to the SEC. This case illustrates the SEC's
commitment to seeking sanctions against those who interfere
with its law enforcement processes.
Similarly, the Commission created strong incentives for
subjects of its investigations not only to comply with its
investigative processes, but also affirmatively to cooperate
with the staff to facilitate thorough and expeditious
investigations. In an October 2001 Section 21(a) Report, the
Commission articulated the benefits to
parties who provide meaningful cooperation, which includes
self-policing prior to discovery of misconduct (such as
developing effective compliance procedures and an appropriate
``tone at the top''); self-reporting misconduct upon discovery
to the public and regulators; remediation, such as dismissing
or appropriately disciplining wrongdoers, improving internal
controls and procedures to prevent recurrence, and compensating
those adversely affected, and; cooperation with law enforcement
authorities' investigations. Those benefits may include lesser
charges or lighter sanctions.