[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









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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel
     Steven B. Harris, Democratic Staff Director and Chief Counsel
                    Douglas R. Nappi, Chief Counsel
                       Bryan N. Corbett, Counsel
                 Dean V. Shahinian, 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.
                               ----------
                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.
                               ----------
               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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \4\ The action against Henry Blodget is being brought in 
conjunction with actions by the NASD and NYSE.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \5\ The action against Jack Grubman is being brought in conjunction 
with actions by the NASD, NYSE, and NYAG.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
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                  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.
                               ----------
               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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \2\ See State/Federal Dynamic Chart Attached.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \3\ See NASAA Analyst Investigations Chronology Attached.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \4\ See Chart of Investigated Firms and State/Federal Partnership 
Attached.
---------------------------------------------------------------------------
    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?
---------------------------------------------------------------------------
    \5\ See Analysts Conflicts settlements Chart Attached.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \6\ See ``Top 10'' Investment Scams Listed by State Securities 
Regulators Attached.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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 
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
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