[Senate Hearing 108-783]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-783
 
                  THE STATE OF THE SECURITIES INDUSTRY

=======================================================================



                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

     THE RECENT INITIATIVES TO ENHANCE INVESTOR PROTECTIONS IN OUR 
    SECURITIES MARKETS, FOCUSING ON FUND ADVERTISING, PROXY VOTING, 
SARBANES-OXLEY ACT REQUIREMENTS, FUTURE MUTUAL FUND ACTIVITY, THE HEDGE 
               FUND REPORT, AND THE CANARY INVESTIGATION

                               __________

                           SEPTEMBER 30, 2003

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs










                 U.S. GOVERNMENT PRINTING OFFICE

98-781                 WASHINGTON : 2004
_________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government Printing 
Office Internet: bookstore.gpo.gov Phone: toll free (866)512-1800; 
DC area (202) 512-1800 Fax: (202) 512-2250 Mail: Stop SSOP, 
Washington, DC 20402-0001












            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

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

             Kathleen L. Casey, Staff Director and Counsel
     Steven B. Harris, Democratic Staff Director and Chief Counsel
                    Douglas R. Nappi, Chief Counsel
                       Bryan N. Corbett, Counsel
                       Dean V. Shahinian, Counsel
    Alexander M. Sternhell, Staff Director, Securities Subcommittee
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                       George E. Whittle, Editor

                                  (ii)














                            C O N T E N T S

                              ----------                              

                      TUESDAY, SEPTEMBER 30, 2003

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2
    Senator Hagel................................................     4
    Senator Enzi.................................................     4
    Senator Corzine..............................................    13
    Senator Bunning..............................................    15
        Prepared statement.......................................    30
    Senator Miller...............................................    18
    Senator Allard...............................................    18
        Prepared statement.......................................    30
    Senator Carper...............................................    25

                                WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission.....................................................     4
    Prepared statement...........................................    30
    Response to written questions of:
        Senator Sarbanes.........................................    36
        Senator Bayh and Senator Miller..........................    38
        Senator Allard...........................................    41
        Senator Chafee...........................................    43
        Senator Bayh.............................................    47
        Senator Reed.............................................    48
        Senator Schumer..........................................    48

                                 (iii)
















                  THE STATE OF THE SECURITIES INDUSTRY

                              ----------                              


                      TUESDAY, SEPTEMBER 30, 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 hearing will come to order. I would 
like to welcome back to the Committee, Chairman Bill Donaldson 
of the SEC.
    As investors slowly recover from the financial fraud and 
manipulation that characterized the pre-Sarbanes-Oxley era, 
they now confront business practices and conflicts of interest 
through which 
securities firms seem all too willing to sacrifice investors' 
interests for the sake of profits.
    We have seen a number of instances in which the Wall Street 
investment game appears rigged against the retail investor. In 
April, this Committee examined the global settlement concerning 
the conflicts of interest between investment banks and their 
research analysts. We learned that in order to attract and 
retain investment banking clients, bankers pressured analysts 
to issue exaggerated reports that they knew were false or that 
omitted crucial negative information.
    It appeared that everyone on Wall Street knew that analysts 
were issuing favorable reports in order to inflate stock prices 
and generate more banking business. The average retail 
investor, however, was unschooled in Wall Street's ways and 
lost out.
    Recently, we have learned about a number of trading 
practices involving hedge funds and mutual funds that, once 
again, profit Wall Street at the expense of average investors. 
New York Attorney General Spitzer uncovered agreements by which 
certain large mutual funds permitted a hedge fund to execute 
illegal trades in exchange for a large investment in the mutual 
funds. Simply, the mutual funds gave the hedge fund better 
prices and more information than was available to the average 
fund investor. This illegal arrangement is just one of the many 
troubling issues that has come to light in the mutual fund 
industry.
    Mutual funds have always been perceived as the safe 
investment option for average investors. Yet with the recent 
revelations regarding illicit trading techniques and additional 
criticisms concerning cost disclosure and fund sales practices, 
many have come to question the perceived fairness of the mutual 
fund industry.
    With respect to the hedge fund industry, this Committee has 
once already considered the lack of transparency and disclosure 
surrounding the operation of an industry where billions of 
dollars flow daily. I understand that the SEC has issued a 
report on the industry and made several recommendations 
concerning new regulations intended to protect investors. I 
look forward to hearing the SEC's conclusions and proposals on 
this subject.
    We have also heard a lot regarding the ability of self-
regulatory organizations to adequately protect investors' 
interests. As a result of the controversy surrounding Dick 
Grasso's compensation, investors have questioned the New York 
Stock Exchange's corporate governance standards and its 
effectiveness as a regulator for its member firms. Many contend 
that the NYSE's self-regulatory structure, in which the 
chairman is essentially paid by the industry that he oversees, 
has turned NYSE into an ineffective regulator. Given the 
current regulatory structure of our markets, I believe it is 
critical that investors have confidence that regulators are 
constantly monitoring the industry and are protecting them 
against misconduct. I understand that the SEC is reviewing the 
New York Stock Exchange's governance structure and considering 
the viability of self-regulatory organizations for the 
securities markets. I look forward to hearing an update from 
Chairman Donaldson here this morning.
    During my tenure as Chairman of the Banking Committee, I 
have expressed a great concern for investor protection and the 
need to reform the culture on Wall Street. Our markets depend 
on a transparent financial system in which investors receive 
full and timely disclosure concerning their investments and 
securities firms look out for investors' best interests. Too 
often it appears that securities firms circumvent transparency 
and neglect investors' interests in the pursuit of profit. Too 
often it seems that Wall Street treats sanctions and settlement 
costs as a cost of doing business.
    I believe that we are at a critical juncture in regulating 
the securities industry. Congress and the SEC need to reassure 
investors that our markets are a place where they can safely 
invest their money. Although we cannot legislate morality or 
legislate away greed, we can ensure that the SEC relentlessly 
pursues wrongdoing to promote trust in our markets. The purpose 
of today's hearing is to consider issues concerning investor 
protection in our securities markets and to understand how the 
SEC is addressing them. Mr. Chairman, we look forward to your 
testimony and to the round of questions that will come.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby. I 
am pleased to join with you in welcoming Chairman Donaldson of 
the SEC back before the Committee.
    Chairman Donaldson, there is a Chinese saying that one 
should live in interesting times, and I thought of that saying 
and of you when I looked at this morning's The New York Times. 
I am going to hold it up. Now, this is on C4. It really is 
rather daunting.
    ``Corporate Conduct in the Courthouse. `We are ready for 
it,' Ex-Chief of Tyco Says as His Trial Begins.'' This is 
Kozlowski. That is this story.
    Then here, ``SEC Demands Documents From Former Enron 
Chief,'' and here is a picture of Ken Lay, who refuses to 
produce records that his lawyer says are covered by the Fifth 
Amendment right against self-incrimination.
    ``Charges That Ex-Employee Lied to Hide Medco Fraud.'' That 
is a continuation from page 1.
    ``Investment Banker's Trial Begins With Scrutiny of Jurors. 
The criminal trial of Frank P. Quattrone,'' and then it goes on 
from there.
    ``Rite Aid Lawyer Falsified Earnings, Prosecutor Says.''
    And if that is not enough, over here, ``Amex Is Accused Of 
Breaking Pact,'' and I thought to myself, I wonder how that 
impacted Chairman Donaldson at breakfast when he turned inside 
and saw that.
    In addition--and I am going to ask you about this later--
there is a full-page ad in Thursday's The Wall Street Journal: 
``In the wake of scandals like Enron and WorldCom, investors 
deserve a true voice in director elections.'' And then it goes 
on and discusses the question of open access for shareholders 
as the next step.
    So, Mr. Chairman, I am pleased you are holding this 
hearing. It gives us an excellent opportunity to assess the 
status of efforts on a broad front that promote integrity in 
our markets and the confidence of our investors. And in many 
respects, this comes at a very opportune time.
    Just in the last several weeks, serious questions have 
arisen in the equities markets over the corporate governance 
practices of the New York Stock Exchange--questions involving 
possible conflicts of interest, apparent lack of transparency, 
levels of executive compensation, and, of course, they also 
involve the very important question of self-regulation, the 
traditional dual role of the NYSE as both a securities market 
and as a regulator of its members.
    We know that Chairman Donaldson met yesterday with John 
Reed, who temporarily has taken over the leadership of the 
NYSE. I would be interested in his read on where that is going.
    In the mutual funds market, the Attorney General of New 
York has brought charges against major investment companies 
that allegedly were given preferential pricing to a hedge fund, 
contrary to their policies and the law. I understand both the 
SEC and the Attorney General of New York are continuing an 
investigation of mutual fund practices.
    Many other issues remain with us, the appropriate 
regulation of hedge funds among them. Increasingly, they are 
marketed to a widening circle of investors, although they 
remain in many ways unregulated.
    We held a hearing on this earlier in the year, under your 
leadership.
    Chairman Shelby. Yes, we did.
    Senator Sarbanes. And, yesterday, the Commission released a 
staff study on hedge funds addressing questions of 
registration, valuation, sales to retail investors, and other 
concerns. They made a number of important recommendations. We 
look forward to hearing about them this morning.
    There is a whole range of other issues--the credit rating 
agencies, the suitability requirements, sale of proprietary 
mutual funds. We need to address I think, again, the adequacy 
of the Commission's funding and what we may need to do in the 
Congress about that. So we have a very full agenda here, and I 
look forward to this hearing.
    I want at the outset to commend the Commission, the 
Commission staff, and Chairman Donaldson for their dedicated 
efforts. They are facing major challenges, obviously, and 
stories of the sort that I cited here, which completely 
dominate. Every story on that page sends a negative message 
with respect to market integrity and investor confidence. We 
need to keep driving hard to clean this situation up so we do 
not get those kinds of stories dominating the press day in and 
day out.
    I think we are making important steps, and I am pleased 
that Chairman Donaldson is in place, as I have indicated in the 
past. But, obviously, he and his fellow Commissioners have 
major challenges ahead of them, and we need to work closely 
with the SEC in all respects in order to help clean up this 
situation.
    Thank you very much.
    Chairman Shelby. Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, I have no statement, and I 
appreciate your holding the hearing and look forward to the 
Chairman's testimony.
    Thank you.
    Chairman Shelby. Senator Enzi.

              STATEMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. Mr. Chairman, I appreciate your holding the 
hearing, I appreciate Chairman Donaldson being here, and I 
would submit my statement for the record.
    Chairman Shelby. Chairman Donaldson, your statement will be 
made part of the record in its entirety. You proceed as you 
wish.

               STATEMENT OF WILLIAM H. DONALDSON

       CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Chairman Shelby, Ranking Member 
Sarbanes, and Members of the Committee, thanks for inviting me 
to testify today on the Securities and Exchange Commission's 
recent initiatives to enhance investor protections in our 
securities markets. I appreciate having this opportunity to be 
here. I want to thank you and your Committee for your continued 
interest in the issues before the SEC. You are helping us to 
move our agenda forward, and that is helping to ensure that 
America's securities markets remain the strongest in the world.
    Since its creation in 1934, the SEC's mandate has been to 
protect investors and ensure the integrity of America's 
securities markets. That mandate has taken on even greater 
importance in recent years, as you indicate. With more than 95 
million Americans invested in mutual funds, representing 
approximately 54 million U.S. households, and a combined $6.5 
trillion in assets, mutual funds are a vital part of this 
Nation's economy. While much of the public focus over the last 
few years has been on the events surrounding public companies, 
the Commission has undertaken an aggressive agenda to identify 
and address challenges in the mutual fund industry, an agenda 
that helps us to protect this vital segment.
    It is critical that mutual fund investors have access to 
reliable information on which to base their investment 
decisions. In this regard, we continue to emphasize the 
importance of full and fair disclosure of fund fees and 
expenses. I would like to summarize for you several rulemaking 
initiatives that are designed to give fund shareholders a 
better understanding of their fees and expenses.
    Just last week, we adopted rule amendments to modernize the 
mutual fund advertising requirements to encourage more 
responsible advertising. The new amendments require that fund 
advertisements state that investors should consider a fund's 
fees before investing in it and must include information about 
the fund's investment objectives and risks, as well as an 
explanation that the prospectus contains this and other 
important information.
    The Commission also, last week, proposed new rules under 
the Investment Company Act that would broaden the ability of 
one fund to acquire shares of another fund, so-called ``funds 
of funds.'' The proposal included improvements to the 
transparency of the expenses of these funds to further assist 
investors.
    We have also proposed that mutual funds be required to 
disclose, in dollars and cents, the amount they effectively pay 
by being invested in a fund over the reporting period.
    We also anticipate taking actions to improve the disclosure 
of breakpoint discounts on sales loads linked to the dollar 
amount of purchases. We want to ensure that investors 
understand those discounts and are receiving them.
    Another area we are looking at is the need to increase 
investor understanding of the incentives and conflicts that 
broker-dealers have in offering mutual fund shares to 
investors. Initiatives we are considering in this area include 
a comprehensive revision to mutual fund confirmation form 
requirements to highlight these conflicts.
    While a critical component of investor protection is 
ensuring that investors have the information they need to make 
an informed investment decision, it is also important that the 
funds and their adviser have strong internal controls and 
governance structures. So, in addition to its disclosure 
initiatives, the Commission has also focused its rulemaking 
efforts on fund governance and internal compliance issues.
    In February, the Commission proposed rules aimed at 
ensuring better compliance with regulations governing mutual 
funds. These rules would mandate that funds and investment 
advisers maintain comprehensive compliance policies and 
procedures reasonably designed to prevent violation of the 
Federal securities laws. Additionally, I would note that we 
diligently have applied the provisions of the Sarbanes-Oxley 
Act to mutual funds in every way we could. While many 
characteristics of mutual funds are different from those of 
publicly held issuers, we are able to tailor our rulemaking to 
account for these differences in every case as dictated by the 
legislation.
    We have also included mutual funds in initiatives to 
increase shareholder participation in the director nomination 
process. Last month, we proposed rule changes that would 
strengthen disclosure requirements in operating companies and 
mutual funds related to the nomination of directors and 
shareholder communications with directors. The enhanced 
disclosure provided by the proposal should benefit fund 
shareholders by improving the transparency of the nominating 
process and board operations, as well as increasing 
shareholders' understanding of the funds in which they invest.
    I understand that the Committee is interested in getting an 
update on a few other issues for today's hearing, so let me 
just briefly bring you up to speed on those areas.
    Since June of last year, the SEC staff has conducted a 
comprehensive study focusing on the investor protection 
implications of the significant growth of hedge funds. Just 
yesterday, as you mentioned, the SEC staff released a report 
that outlines factual findings, identifies concerns, and 
recommends certain regulatory and other actions to improve the 
current system of hedge fund regulation and oversight. The full 
text is available through the SEC website.
    While I am looking forward to studying the staff's report 
and receiving comments from the general public in line with the 
recommendations that have been made, I will say, as I have said 

before, that I believe that the Commission needs to have a 
means of examining hedge funds and how they operate. Speaking 
only for myself, I believe that the registration of hedge fund 
advisers would accomplish this.
    While I am on the topic of hedge funds, let me update you 
about our involvement in recent allegations regarding a hedge 
fund's practices in late trading and market timing of mutual 
funds. We have put in motion an action plan to vigorously 
investigate this matter, assess the scope of the problem, and 
hold any wrongdoers accountable. And we will do so in close 
coordination with State regulators. I have also asked our staff 
to study whether we need to take additional regulatory steps to 
address these concerns.
    Now I would like to turn to an issue that is important both 
from a regulatory standpoint and from the standpoint of the 
investing public: The critical need for sound governance 
practices by self-regulatory organizations. I believe that 
self-regulatory organizations should be exemplars of good 
governance. At a minimum, SRO's should demand of themselves the 
same high standards of governance that the New York Stock 
Exchange and Nasdaq propose for their listed issuers in the 
wake of several widely publicized corporate scandals. To 
further that goal, this past March, I directed each self-
regulatory organization to undertake a review of its own 
governance practices.
    Since then, disclosure of the compensation awarded to the 
former Chairman of the New York Stock Exchange has heightened 
the scrutiny that the Commission, the securities industry, the 
investing public, and the media are paying to exchange 
governance standards that reflect the highest commitment to 
independent and transparent decisionmaking. Prior to the 
current controversy, the NYSE and a few other self-regulatory 
organizations instituted special governance committees to 
further study how their structures and processes might be 
improved. I applaud those efforts, but I believe that more 
remains to be done. I understand that the New York Stock 
Exchange's new interim Chairman, John Reed, intends to 
reexamine these governance issues in more depth. I look forward 
to working with Chairman Reed on this important initiative.
    Finally, the Committee requested an update, since my 
testimony on May 7, on the status of the research analyst 
global settlement, the SEC's portion of which was filed with a 
Federal court on April 28, 2003.
    Since the filing of the proposed settlement agreement with 
the Federal court, U.S. District Court Judge William H. Pauley, 
III has issued a series of orders requesting that the parties--
both the Commission and the participating firms--submit 
additional information to the court relating to the terms of 
the settlement. We have done that and are awaiting the court's 
action.
    That concludes my formal testimony. I would be pleased to 
answer any questions that you may have or hear any 
observations. Thank you.
    Chairman Shelby. Thank you, Mr. Chairman.
    Mr. Chairman, many press accounts have stated that it is 
untenable for a regulator to be simultaneously running a 
business. Some argue that if the business of price discovery 
and trading is the New York Stock Exchange's dominant concern, 
then it may be time for the SEC to consider whether there 
should be a separation of regulatory functions of the New York 
Stock Exchange from the business functions.
    In recent comments, Mr. Grasso reflected the predominance 
of business concerns at the New York Stock Exchange by 
characterizing himself as ``two-thirds businessman and one-
third regulator.''
    Mr. Chairman, should the New York Stock Exchange separate 
its regulatory function from its business operations?
    Chairman Donaldson. That is a complex question. As you 
know, going back to the original securities acts in the 1930's, 
I think the then-Commission implementing those acts did what 
was then a very wise thing, which was to include in the self-
regulatory organization a regulatory mechanism, build it down 
to the operating level so that the regulation would not be part 
of a large government bureaucracy. They left that to the SEC to 
oversee, basically regulation that was embedded with 
practitioners. And, through the years, that has worked pretty 
well, with some noticeable exceptions.
    However, we are at a stage now, in my view, where we really 
have to reexamine the locus of the regulatory mechanism, and 
there are many different ways of achieving that, which is now 
embedded in the Stock Exchange mechanism.
    I think the key issue here is how the regulatory mechanism 
is financed, where the funds come from, and also, where it 
reports to the governance structure. And that leads into the 
governance structure. You must have, in my view--and this is 
what the New York Stock Exchange is working on right now in the 
form of John Reed as new temporary Chairman--a broad structure 
which avoids the obvious potential conflicts of interest 
inherent in those that are being regulated riding herd on 
themselves.
    Chairman Shelby. That is hard to do, though, is it not?
    Mr. Donaldson. Pardon?
    Chairman Shelby. It is going to be hard to do. You want to 
do business, and then you are regulating, too.
    Chairman Donaldson. Yes. I think that there are a number of 
different approaches to this. I had the opportunity yesterday 
to discuss this with John Reed. We have done some thinking of 
our own. But I believe that the first step here is for the New 
York Stock Exchange to get at its own governance structure.
    Chairman Shelby. It goes to corporate governance, does it 
not?
    Chairman Donaldson. It goes to the corporate governance. It 
goes to the representation on the board by practitioners, 
security industry practitioners, the member firms. It goes to 
the independence of the directors. As you suggest, it goes to 
just how do you maintain a regulatory mechanism and yet not 
have it subjected to not only the potential conflicts of 
interest inherent in board membership, but also have it 
basically influenced, if it is, by that aspect of the Exchange 
which is a business.
    In the final analysis, the New York Stock Exchange is a 
competing market. One of the issues that we have is to make 
sure that that competition is fair competition and to make sure 
that investors are protected. But in the final analysis, within 
the rules we set down, it is a business. It is a competitive 
business, and it cannot be subjected to or sublimated, if you 
will, to the regulatory role that is resident there.
    Chairman Shelby. Mr. Chairman, many are questioning why it 
was the Attorney General of New York Eliot Spitzer and not the 
SEC that discovered and initiated the current investigation 
involving trading practices in the mutual fund industry. Does 
it concern you, as the Chairman of the SEC, that a 
whistleblower first reported a violation to a State Attorney 
General rather than to the SEC? And what are you doing to 
coordinate investigations and enforcement action with the 
States?
    Chairman Donaldson. Well, I wish the whistleblower had 
reported it to us. On the other hand, I believe that legitimate 
whistleblowers, no matter where they report, are welcome.
    I think that if your question goes to, you know, should we 
have picked up the collusive arrangements between a hedge fund 
and----
    Chairman Shelby. Or even reached out to people that would 
apprise you of such things.
    Chairman Donaldson. Well, the allegations against the 
Canary hedge fund with the mutual fund it is alleged to have 
colluded with, that was very hard to find--a design that is 
designed to cloud an illegal act between two parties. And I 
suspect that, in a normal look at mutual funds, it would have 
been tough to find that. If we--and this gets back to the hedge 
fund report by our staff--had the right to go into that fund, 
hopefully we would have combined that with the ability to 
inspect on the other side, and we would have discovered it. But 
we did not, and I suspect as we go on down here in all aspects 
of what we are doing, there will be people who have special 
knowledge of collusive and illegal acts who serve as 
whistleblowers. And I do not think we will be the recipient of 
all those pieces--I want to assure you that we do look into 
every accusation like that, but I suspect we are not going to 
get all of them.
    Chairman Shelby. Will you be looking at all the mutual 
funds to see if what has come out lately is widespread in the 
industry?
    Chairman Donaldson. Yes.
    Chairman Shelby. And do you have the people to look at it? 
And if not, why not?
    Chairman Donaldson. Basically--I was looking into the 
entire program that we underwent once that accusation was made. 
We have been in touch via letters to some--I think 75 percent 
of the mutual fund industry--requesting their comments on how 
they handle so-called trading, late trading aspects and the 
pricing aspects. We have been in touch with the various trade 
organizations asking them to go out with letters and warnings 
to the members of those trade organizations----
    Chairman Shelby. Wait a minute. Not just warnings. Will you 
be, at the SEC, doing the probing yourself to see if this is a 
widespread practice?
    Chairman Donaldson. Absolutely. That is exactly what we are 
doing. And we are putting considerable resources into that. We 
view this as a very important aspect of what we are doing. We 
want to either find out--hopefully, we do not--that this is a 
broad-based practice, or we want to find out that it is not.
    Chairman Shelby. Senator Sarbanes, thank you for your 
indulgence. I am way over my time.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Donaldson, before I get to some specific matters, 
I want to ask a question about a time frame. You are now 
looking at mutual funds--you have got an ongoing investigation. 
And you have just published a hedge fund report. Only 
yesterday, you met with the interim head of the New York Stock 
Exchange concerning the corporate governance practices and many 
other aspects of its activities.
    In March, you directed each self-regulatory organization, 
not just the New York Stock Exchange, to undertake a review of 
its own governance practices. The SEC is considering rules with 
respect to investors' ability to nominate and elect corporate 
board candidates. And there are other matters as well that I 
have not mentioned.
    When we were discussing the Sarbanes-Oxley Act and we had 
Chairman McDonough of the Public Company Accounting Oversight 
Board here just a short while ago, the general view was that by 
the beginning of next year, next calendar year, that framework 
would be fully in place, and so that all the actors would know 
the framework within which they were working.
    My question to you is: When do you realistically anticipate 
that, with all these other areas in which you are working--and 
I know as days go by new things come to light--reach the point 
where a framework has been fully into place and you can then 
say to people, well, these are the arrangements under which you 
must operate, you need to adjust your practices to conform to 
them, and then get on about your business?
    I think it is very important to try to get that settled as 
quickly as we can without giving up doing the quality work that 
is necessary. But do you have any sense in your own mind as you 
look out over the landscape when you may be able to get all of 
this into place?
    Chairman Donaldson. Are you referring----
    Senator Sarbanes. I know your staff has been working 
overtime now for more than a year, and I respect that. But we 
have to get this thing up and settled, so to speak.
    Chairman Donaldson. Are you referring specifically to the 
mutual funds, Senator, or are you referring to some----
    Senator Sarbanes. And the hedge funds, the corporate 
governance at the Stock Exchange, the shareholder--the whole 
agenda.
    Chairman Donaldson. It is a pretty broad question, and I 
think there are different timetables in different areas. Let me 
say in the mutual fund area, you know, as far as fees and 
expenses and that thing, this month we will be--we have put 
forth some specifications on mutual fund advertising rules, 
which, in effect, will get at the whole fee structure, if you 
will, in terms of public disclosure. We are looking at now a 
comprehensive revision of mutual fund confirmations. And I have 
to remind you that this--you know, we are affecting a huge 
business, and we are incurring all sorts of attitudes toward 
what must be disclosed, and we are looking at the expenses of 
doing that. You know, we are trying to act deliberately but not 
precipitously in all these areas.
    I think that in terms of the governance aspects of the 
Sarbanes-Oxley Act, in terms of the corporate world, if you 
will, all of the regulations are in place now. I mean, we have 
the independent audit committees. We have the new 
responsibility for the audit committees. We have a whole series 
of things that are there. The rules are there. PCAOB is going 
to be exercising its responsibilities in terms of the function 
of auditors and accountants and so forth. So that is in place.
    On the hedge fund report that we have just received, the 
staff has made specific recommendations, and the process now is 
for us to receive comments from all interested parties as 
against not only the report itself, but also the 
recommendations in it. And I would hope that within a 
relatively short period of time we will have gathered all of 
those comments, and then the Commission itself can make its 
decision.
    There are some uncertainties here on the hedge fund thing. 
There are uncertainties as to costs, resources, et cetera, et 
cetera. But we will be well into it in the early part of next 
year.
    Senator Sarbanes. Well, do you think the end of this year 
or the early part of next year is a reasonable timetable to get 
all these things into place?
    Chairman Donaldson. For some of these things, yes. For 
some, not. For some, we need to do more research. I cannot 
emphasize enough that we cannot be precipitous. We have to be 
careful. We have to be sure that some of the things we are 
doing do not have unintended consequences. After all, we are 
setting rules for the long haul here, so that I think we need 
to pursue this with all deliberate speed.
    I also would say that we are in the process of building our 
staff, and we are well along in that, and that is going to give 
us more resources. I would say something else in terms of some 
of the impact of some of the rules and regulations we are 
putting in, and that is that we have a management effort 
underway now to organize ourselves in two ways that I think 
will attack both our deployment of resources and the rapidity 
with which we can take action.
    In terms of the deployment of resources, we have to get a 
lot smarter than we have been in terms of looking around the 
corner and over the hill and anticipating problems. And we have 
to get a lot smarter in terms of how we deploy our resources 
and using sampling techniques and efficiency techniques--we 
have to get more efficient in the way we uncover things. We 
cannot just go out after everything. We have to get more 
efficient in the signals that we get and how we act on signals 
to concentrate our efforts in areas of high concern.
    Senator Sarbanes. May I ask one more question?
    Chairman Shelby. Go ahead.
    Senator Sarbanes. I want to ask just one more question. I 
think it is important as you are doing this to make systemic 
changes that may diminish the likelihood of abuses happening, 
in addition to punishing the bad apples. But, for instance, it 
seems to me on these late trading mutual funds, you have got to 
figure out some changes in the system that inhibit that kind of 
practice as well as go after the ones who have been engaged in 
it. And I think the industry itself needs to be thinking about 
how they can do that.
    In that regard, one systemic change that might be made with 
respect to corporate reform addresses this The Wall Street 
Journal full-page ad that was California Public Employees, the 
Connecticut Retirement Plan, New York State Common Retirement 
Fund, AFSCME, about open access for shareholders as the next 
critical step of corporate reform. And they have a number of 
proposals with respect to giving investors timely access to the 
ballot. They seem to be sensitive to guarding against corporate 
raiders or hostile takeovers, which is one concern that has 
been raised.
    I appreciate it is a complex situation, but if that can be 
structured, then the shareholders, particularly these big 
institutional 
investors, may become part of the system of assuring 
responsible behavior on the particular of management as it is 
translated through the shareholders to the board of directors 
and then to the management.
    Where is the SEC on these questions of open access for 
shareholders?
    Chairman Donaldson. Well, as you know, this is an area of 
considerable concern for us. The issue of shareholder 
participation in the election of directors has been around for 
a long time, and not a lot has been done about it. And we 
intend to propose measures to do something about it.
    Now, there is a trade-off here. There is a trade-off 
between the efficiency and effectiveness of a corporate board 
of directors constituted by people who are working in the best 
interests of the corporation, as opposed to a model that would 
have representation that has separate agendas, constituency 
interests, and so forth, which could result in a malfunctioning 
board.
    So we are trying to go down a narrow path here which says 
that there should be some measure of shareholder participation 
in the selection process of directors if there is evidence that 
large numbers of shareholders' wishes are not being reflected 
at the board level. If, in fact, in proxy materials a proposal 
is put forth year after year that receives a large number of 
shareholder votes and a corporation does not do anything about 
it, then we say that is when there should be a way that 
shareholders could propose somebody for the board. But that 
somebody for the board cannot be--has to go through the same 
thing that any board member would in terms of conflicts of 
interest. We cannot put competitors on the board, or we cannot 
put people that have some a vested interest on the board. It 
has to be a truly independent shareholder, not paid for by 
somebody else, et cetera.
    So that is a long way around saying that we are working 
very hard on a proposal. We have it out there now in terms of 
our general direction, and you will hear from us very shortly 
on some specific rule proposals that get at some of the things 
I am discussing.
    Senator Sarbanes. Mr. Chairman, I may revisit that, but 
thank you, Mr. Chairman. My time is up.
    Chairman Shelby. Thank you, Senator Sarbanes.
    Senator Hagel.
    Senator Hagel. Mr. Chairman, thank you.
    Chairman Donaldson, welcome. As you know, the SEC, OFHEO, 
and the U.S. Attorney's Office in Alexandria are looking at 
management and financial accounting issues regarding Freddie 
Mac. Can you give this Committee some sense of timing as to the 
SEC investigation, when you are anticipating to have a report, 
and maybe a status on where you are in that investigation?
    Chairman Donaldson. As you know, Senator, Freddie Mac has 
agreed to voluntary registration of its shares, and we were 
working with them to get them prepared for the voluntary 
registration of their shares.
    Up until now, we have not been their regulator, so that 
there are two things going on here. There is the internal 
investigation going on in Freddie Mac by its regulator, which 
we do not have anything to do with. There are our efforts to 
get them to a point of conformance with our registration rules 
and regulations. We do not control the timing of what is going 
on with the other regulators.
    What we do have an interest in, even though they are not 
registered with us now, is evidences of fraud. And if there is 
evidence of fraud, even though they are not registered, the 
impact on the marketplace, we would have a role there.
    Senator Hagel. Are you reviewing that now?
    Chairman Donaldson. We are looking at that right now, yes.
    Senator Hagel. Can you tell us anything more about that?
    Chairman Donaldson. No, I really cannot at this point.
    Senator Hagel. But you have it under active review--
management and accounting?
    Chairman Donaldson. Yes, we are in touch with them, and we 
are interested in any evidence of fraud that there might be or 
might not be.
    Senator Hagel. Thank you.
    As you know, the Nasdaq market has been in the process of 
trying to complete its separation from the NASD for 3 years. I 
know they have an application in with the SEC. Can you give us 
a sense of where that is?
    Chairman Donaldson. Basically, the NASD and the Nasdaq 
market itself has applied to be classified as a stock exchange, 
and there are certain qualifications under the Securities Act 
as to what constitutes a stock exchange, and part of that--
without getting too detailed--it has to do with opportunities 
for order interaction and pricing improvements such as exist on 
the New York Stock Exchange. And right now they do not qualify. 
And we have been in discussions with them to see if we can get 
some modification in their approach. We also are concerned, as 
we are with the issue of public ownership. The Nasdaq market 
has, in effect, backed into public ownership. I mean, there is 
public ownership of the Nasdaq market, and that brings into 
focus what oversight or board governance measures one would 
have if it should happen in the future that there would be a 
large external owner of that--what protections could be built 
into the board of directors and in the event of more extensive 
ownership, and with some other securities markets, perhaps even 
total ownership by somebody other than the members of the 
Exchange. And that is an area that we are working on very hard 
right now.
    But I assure you that we are not just sitting on the Nasdaq 
application. We are trying to integrate that and our concerns 
with it, with our concern for the overall market structure 
issue. We are in a period now where, with the advent of 
nanosecond-trading, with the advent of the ECN's and so forth, 
we are in a period where the whole market structure issue needs 
to be reviewed, and we are in the process of doing that. And 
that is going to take some time because it is a very complex 
issue, and I think this gets back to Senator Sarbanes' 
question.
    When we step back from all of this, when we step back from 
the press reports and look at the American market system, 
including the New York Stock Exchange, the Nasdaq, the regional 
exchanges, the ECN's, and so forth, we still have the best 
system in the world. And we have to be very careful, as we try 
to change it and modernize it and accommodate the technology 
that has come into being, that we do not make some false steps 
here that would destroy our market and have it go somewhere 
else. And that is why we want to pursue all of this with 
deliberate speed but not haste with the unintended consequences 
we would regret.
    Senator Hagel. Thank you.
    Mr. Chairman, thank you.
    Chairman Shelby. Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman. Thank you for 
holding this hearing, and I welcome Chairman Donaldson. Like 
many others, I think you are doing at outstanding job, but the 
array of issues is pretty remarkable, as we have discussed as 
we have gone through.
    I am going to focus on the mutual fund industry primarily 
today, but it is not because I do not have interest in the 
kinds of things that Senator Hagel and others are talking 
about, because they are really key. But it strikes me that when 
we look at the issues that are on the table with regard to 
mutual funds, they have a lot of overlap in the kinds of issues 
that preceded Sarbanes-Oxley and corporate America and other 
places with regard to corporate governance and now we see 
echoed in the New York Stock Exchange.
    Isn't it time when the requirement is only that 40 percent 
of the directors of mutual funds be independent and that there 
is no independence question with regard to the chairman and 
that many of the mutual funds are embedded in organizations 
that benefit both from sales practices and as the discussion on 
fee disclosure shows, is not it time for independence to be 
brought to the corporate governance structure? And are you 
pursuing that? Do you believe that is the direction that needs 
to be taken along with--and I will follow this up--another 
element that I think is a model or circumstance that flowed 
from Sarbanes-Oxley? Do we have enough staff to actually 
provide the checks and balances from the regulatory side to be 
able to look at the mutual fund industry in a consistent way 
that we do not run into a situation where we think we are 
regulated, but we are really not because we do not have the 
ability to actually go through and bring the kind of discipline 
to the process that is necessary?
    So it is really on two fronts: First, the governance 
concepts, which I think really gets at a whole series of 
things, whether it is fees, whether it is the intermixing of 
hedge funds and mutual funds management. I would like to hear 
your views on that. And then, second, with regard to do you 
have enough staff to be able to apply the same kinds of 
standards that you might in other areas? We certainly had to 
grow staff when we are talking about looking at implementing 
Sarbanes-Oxley. We looked at the number of accountants, the 
number of people that were involved in the enforcement area, 
whether it was adequate. Is it adequate today with respect to 
the mutual fund industry?
    Chairman Donaldson. Well, let me address the staff issue 
first, Senator. As you know, we are in a major build-up of 
staff. We are trying to do that again, deliberately. We are not 
just out hiring willy-nilly. We have a system going now in 
which we are going to be very quality conscious. And I am 
pleased to report that, you know, we really could only get 
going on some of the nonlawyer hiring as recently as July. And 
we now are going full blast, and we are hiring. So we will have 
additional resources.
    Are those resources adequate to do all the tasks before us? 
I would reemphasize what I said before, and that is that we 
have to be more effective in the way we use our staff because 
we have to have--to put it in industrial terms--a productivity 
improvement, if you will, so that we are concentrating our 
people on areas of high risk, high need, and high potential for 
investor problems. And I think that we have only just begun to 
concentrate on that.
    So, I cannot answer you yet in terms of do we have enough 
people. I think we do--I think we will have by the end of this 
year, and I think we will have implemented some of the things 
that I am talking about in terms of early warning systems and 
so forth that will help us be more efficient.
    Senator Corzine. When you are looking at your priorities, 
though, is the mutual fund industry one of those areas where 
you believe that there is need for additional staff and----
    Chairman Donaldson. On which part?
    Senator Corzine. In the mutual fund industry itself. It is 
a specialization that is somewhat different than----
    Chairman Donaldson. I think that right now we are pleased 
with the build-up that we are having in that staff right now. 
We think it is going to be adequate to what we have on our 
agenda.
    The Investment Company Act rules require a majority of 
independent directors. I am now getting into your second 
question here. And I would like to make a general statement, 
which is that in addition to the rules and regulations that are 
in the Investment Company Act, in addition to the changes that 
we either have made or are not making, I believe we are 
heightening the awareness of the directors of mutual fund 
companies. I think we are heightening awareness of the 
responsibility similiarly for just regular industrial 
corporations. And the real impetus that will reduce the need 
for our staff to expand and expand and expand is if the mutual 
fund industry and corporate America will take it upon 
themselves not to just wait for the rules to come along, but to 
change their processes, to realize where there are conflicts, 
to realize where there is too little sunshine in terms of 
disclosing, what, you know, the costs of mutual funds are, et 
cetera. I mean, that is the old saw of corporate 
responsibility, in this case mutual fund management 
responsibility. And I am hopeful that we are going to see some 
changes in that area that are self-imposed rather than thrust 
upon them by rules.
    Senator Corzine. Do you have a view on the independence of 
the chairman in mutual funds?
    Chairman Donaldson. On the?
    Senator Corzine. The independence of the chairman of a 
mutual fund board?
    Chairman Donaldson. My own personal view on that is to try 
to make myself available and listen to the arguments on both 
sides. The industry believes that there is a certain efficiency 
involved with a chairman that is intimately involved with a 
number of funds and knows--as opposed to somebody totally 
independent with no knowledge of the industry, somebody that is 
familiar with a fund group and how it operates. There is some 
merit to that.
    I feel ultimately that there needs to be more independence 
in that chairman role, but we are balancing that and looking at 
it.
    Senator Corzine. Thank you, Mr. Chairman.
    Chairman Shelby. Mr. Chairman, before I call on Senator 
Bunning, I think that you are absolutely right that we have 
raised--everybody, the public, the media, and the people--the 
level of debate on all of the issues involving integrity, 
conflicts of interest, and self-dealing in the capital markets, 
including mutual funds, perhaps. The question is: Where do we 
go from here? And how long is it going to take? I was thinking 
of some questions Senator Sarbanes was asking.
    Senator Bunning.

                COMMENTS OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman, for holding the 
hearing. And thank you, Chairman Donaldson, for being here.
    In your staff report on hedge funds released yesterday, the 
staff looks at requiring hedge fund managers to register with 
the SEC as investment advisers. Does the SEC have the resources 
to take on this new responsibility, especially in light of the 
fact that there could be up to about 3,000 new registrations?
    Chairman Donaldson. Right. Well, I think that the first-
level response to that is that we would--if the Commission does 
decide to require registration, it would be the regular--the 
forms and what information we are requiring would be tailored 
to particular interests that we would have in the hedge fund 
industry. So that is the first level.
    Senator Bunning. Well, wouldn't transparency be the number 
one issue that all of us are looking for, according to The Wall 
Street Journal, according to the general consensus of the 
American people, a little more sunlight into what really hedge 
fund--what function they perform?
    Chairman Donaldson. Well, that is a very important part of 
what we are interested in. However, I would say that what we 
have not concluded is that certain of the proprietary 
techniques used in hedge fund management, some of the ways the 
funds are managed--you know, we do not feel that it would be 
fair to require disclosure of that in a competitive 
environment, unless we saw evidence of the fact that the 
techniques were somehow impacting the marketplace in a way that 
needs to be regulated. There are other things that we are 
interested in.
    Senator Bunning. But we have evidence, obviously, or at 
least there is very strong evidence that hedge funds have been 
bending the rules, in fact, stepping over the line as far as 
mutual funds purchases. Anybody that is at all familiar with 
investments knows that if you buy after the close at the close 
price and then you can sell in the morning at the morning 
opening, you have a chance to build in a profit.
    Senator Sarbanes. You are telling me.
    [Laughter.]
    Senator Bunning. Big time.
    Now, if that is what a hedge fund is doing, you should be 
able to stop that. You are not the regulator, but you should be 
the regulator of hedge funds.
    Chairman Donaldson. Well, there are two parts to that. It 
takes two to tango. It takes the hedge fund, and it takes the 
mutual fund that it is dealing with.
    Senator Bunning. That is correct.
    Chairman Donaldson. You are absolutely right in terms of 
both sides need--the mutual funds have made their own efforts 
to close down the kind of trading that you talk about by higher 
fees, redemption fees, et cetera. The issue here is whether 
they have tried hard enough, and an even bigger issue is 
whether they have aided or abetted those kinds of transactions. 
And there is some evidence, at least in one fund--and we are 
looking at it. Whether it is more widespread or not remains to 
be seen.
    On the hedge fund side, I think that what we are looking at 
is the registration of the hedge funds so that we can go in and 
see what they are doing. And, again, on the Canary situation, 
had we been able to be on both sides of that, we would have had 
a much higher probability perhaps of catching it. And I do not 
wish to imply that we are going to catch every----
    Senator Bunning. I only get 5 minutes, so let me----
    Chairman Donaldson. Go ahead.
    Senator Bunning. Let me get into derivatives, because I 
worry daily about derivatives and their use in our markets 
today. Now, I know there are certain investors who have big 
concerns about derivatives, and I know that the Chairman of the 
Federal Reserve thinks they are wonderful things. But I worry 
about the regulation of derivatives, the same as I worry about 
the regulation of hedge funds.
    What is the SEC doing to make sure that derivatives are 
used properly?
    Chairman Donaldson. I share your concern about the use of 
derivatives and the risks that are out there and the lack of 
knowledge that exists. Clearly, the Federal Reserve is involved 
in this, was intimately involved in the Long-Term Capital 
instance where derivatives almost caused--or did cause--a big 
flap.
    Senator Bunning. Yes.
    Chairman Donaldson. And almost a major failure.
    I think that we are doing everything we can to understand 
the impact of derivatives and the potential impact that they 
can have. But it is not just we that can do it, I mean, because 
they are so pervasive into areas that we do not regulate--
foreign banks and other entities which use these instruments. 
And I think it is a matter of concern. We have the President's 
Task Force where the Chairman of the Federal Reserve, the 
Chairman of the SEC, and the Chairman of CFTC get together and 
their staffs get together, and this is one of the issues that 
is discussed at those meetings.
    Senator Bunning. All I can tell you, Mr. Chairman, is that 
the American investor who had implicit confidence in the 
markets at one time, they do not now. And unless the Securities 
and Exchange Commission in their regulatory function can 
instill back that confidence by doing something and overseeing 
the markets better, we are never going to have the same 
confidence that we had 30 years ago, 20 years ago in our 
markets, and that is absolutely essential if this country is 
going to move forward. We cannot have the productivity of the 
American worker and our GDP advancing with a no-growth-job 
economy unless people trust our regulators. And I am just 
saying that as a matter of fact. And not only you as a 
regulator, but also all those who are regulating everything 
else government-wise.
    So, please, please, with haste and with due diligence, get 
your job done.
    Chairman Donaldson. Senator, if I can, I believe that goal 
is the top goal for me and for the Commission, and that is 
trust in us as a regulator.
    I just have to say, as an aside on derivatives themselves, 
that there are aspects of derivatives that are helpful. Insofar 
as derivatives shift and share risk, the case could be made 
that we have avoided a lot of disasters because of the 
judicious use of derivatives to lay off risk and spread it 
around.
    So we have to be very careful that we do not throw out the 
good with the bad.
    Senator Bunning. One of the smartest investors in this 
country said, ``It is a ticking time bomb.'' And I do not have 
to tell you who that is.
    Chairman Donaldson. And he had another very smart investor 
on the other side, who currently is Chairman of the Federal 
Reserve, who disagrees with him.
    Senator Bunning. Well, it is easy to invest in Government 
bonds.
    Chairman Shelby. Senator Miller.

                COMMENTS OF SENATOR ZELL MILLER

    Senator Miller. Thank you, Mr. Chairman, for holding this 
hearing, and Mr. Chairman, thank you for being with us and for 
the job you are doing and the way that you have responded to 
the questions.
    The questions that I came prepared to ask have already been 
asked, but I think I would ask: Would you care to comment on 
the current working relationship between the SEC, the State 
securities administrators, and the State attorneys general on 
resolving the various enforcement issues that have arisen, and 
do you think there are any changes that may be needed to be 
made in the SEC's relationship with the States?
    Chairman Donaldson. It is an excellent question. It is one 
that we are very concerned about. Let me just say this, that we 
need and encourage all the help we can get from local 
regulators in the securities industry at the local level where 
they can uncover and investigate things that go beneath our 
screen, so that if there is malfeasance or fraud or whatever at 
a local level, we welcome the local administrators and 
securities administrators.
    At another level, and that is the level of the structure of 
the markets themselves, we believe and I believe very strongly 
that we cannot have 50 different structural solutions, we 
cannot have 50 different ways, perspectives as they are put 
out, and trading rules and so forth. So that, if the solution 
or the fine is followed by some structural change. I believe 
that that has to be done by the Federal administrators.
    Having said that, we need to and we have cooperated with 
local securities regulators. Just 2 weeks ago in connection 
with the chairwoman of the State regulators trade association, 
we agreed to enter into a joint arrangement with them to see if 
we could not improve communication and cooperation. That will 
go a long way.
    I will say it again and in frank answer to what you said, 
there are areas where a local authority can step in too late to 
an investigation that is already under way and in so doing 
interrupt a carefully put-together investigation by a Federal 
functionary, and this is where I think we get into trouble, 
where there is considerable work that has been done, cases 
being built, and someone comes in from left field and does not 
really add anything and in fact might create an environment 
where the accused will get off because of a technicality.
    Senator Miller. Thank you.
    Chairman Shelby. Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, thank you very much. I have a 
statement here that I would like unanimous consent to be 
included in the record.
    Chairman Shelby. Your statement will be made part of the 
record, Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    I would like to explore a little bit the Investment Company 
Act of 1940 and whether or not any amendments may be needed to 
bring it up-to-date or whether it is okay the way it is.
    I understand that in order to manage a mutual fund 
effectively, generally, what is required is that the SEC has to 
grant about 8 to 10 exemptions from the Investment Company Act 
and that many times, the SEC may or does impose conditions of 
its own as a condition of granting those exemptions.
    Am I correct in that?
    Chairman Donaldson. I did not get the last part, Senator.
    Senator Allard. That in addition to the 8 or 10 exemptions 
from the Act, you have your own conditions that you also place 
on the applicant and in the management of the mutual fund.
    Am I correct in that?
    Chairman Donaldson. Yes.
    Senator Allard. Okay. If so many exemptions from the 
present Act are required to do business, do you think the Act 
should be brought up-to-date to reflect present-day realities?
    Chairman Donaldson. At the present moment, we think we have 
the authority, rulemaking authority, under the Investment 
Company Act to do what we think needs to be done. That could 
change, but at this juncture, we do not think we need----
    Senator Allard. The exemptions that you grant on a fairly 
regular basis, is the nature of these exemptions time and time 
again, or are they variable depending on----
    Chairman Donaldson. Yes. A perfect example of that would be 
the rules that will allow the so-called ``fund of funds'' to 
not require an individual exemptive under, would allow a mutual 
fund to buy another fund that might have a different 
objective--a mutual fund that might own stocks and want to buy 
a money market fund. Right now, we give exemptions for that 
being done, and we are changing that now so that that can be 
done without the----
    Senator Allard. Where they use the money market funds more 
or less as a holding fund, and then you have your investment 
fund over here.
    Chairman Donaldson. Right.
    Senator Allard. The Investment Company Act gives the SEC 
explicit authority to sue investment company management for 
charging excessive fees and imposing a fiduciary obligation on 
the adviser with relation to receiving these fees. How many 
times has the SEC used this statutory authority?
    Chairman Donaldson. I cannot tell you that off the top of 
my head, but I will get the answer to you, Senator.
    Senator Allard. I think it is--
    Chairman Shelby. You may furnish that for the record.
    Senator Allard. We would like to have that as a part of the 
Committee record, if you would, please.
    Chairman Donaldson. Sure.
    Senator Allard. Now, the same power is given to any 
shareholder of the fund and to the SEC to intervene in any such 
action, and you may not know how often this has occurred, but 
if you do, I would like to have you share that with the 
Committee now; if not, we would like to have that as a part of 
the record also.
    Chairman Donaldson. We will be glad to give you that.
    Senator Allard. Thank you.
    Given the extensive enforcement powers provided to the SEC 
under the Investment Company Act, do you find the need for 
amendment of the Act to empower the SEC further? I think you 
answered that question earlier, and the answer is ``No''--you 
are comfortable with what you have. Is that correct?
    Chairman Donaldson. Right.
    Senator Allard. Okay. I have one other area that I might 
explore with you a little bit. Middle-class and individual 
investors have seen a rapid expansion of the investment 
opportunities available to them and particularly many more 
individuals are investing in mutual funds which can help them 
save for their children's college education or for their 
retirement.
    Has the Commission considered in its new initiatives 
regarding mutual funds how important is the balance between 
individual investors and large institutional investors, such as 
what was brought up here by the Senator from Maryland?
    Chairman Donaldson. What do you mean by ``balance,'' 
Senator?
    Senator Allard. We have individual investors out here, and 
then you have the whole, large mutual, bloc investors, retail. 
How do you balance their interests?
    Chairman Donaldson. Well, there are two parts to that 
question. One is the interests in terms of access to a 
different source of investment vehicles, if that is what you 
are talking about.
    Senator Allard. Yes.
    Chairman Donaldson. And I think that is a balance that is 
brought up in the hedge fund report by the staff in terms of 
the various safeguards there for minimum assets and earning 
power and so forth for individual investors getting into the, 
``hedge fund'' kind of vehicle. I think you are talking about 
the issue, as you move from retail into larger and larger 
purchases, there are discounts allowed, and trying to make sure 
that people are protected as they get to be larger investors by 
the discounts they get for buying more.
    That is one whole side of your question. The other side is 
the protection of individual investors in the marketplace 
itself trying to buy and sell stocks versus large institutions 
trying to buy and sell stocks. I think the hallmark of our 
system has been the protection of the individual investor, the 
protection that allows the individual investor to compete but 
to compete fairly with people who have more muscle. And that 
gets to market structure, it gets to issues such as price 
improvement, and it gets to the way the central marketplaces 
are organized, and that is what we are working very hard on, to 
make sure that the individual investor is protected.
    Senator Allard. Thank you.
    I see my time has expired, Mr. Chairman.
    Chairman Shelby. Thank you, Senator.
    Senator Allard. It is amazing how fast it runs when I have 
questions, but I am sure it is balanced.
    I want to thank you for holding this hearing and 
reemphasize what so many Members of this Committee have said 
previously, that we have to maintain the confidence of the 
investor--that is what it is all about--and if we do not do 
that, we all suffer.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Chairman Donaldson, back to mutual funds, if we can. The 
mutual fund industry has come under scrutiny, as we all know, 
as investors learn more about the business practices of mutual 
funds and their brokers. For example, many investors do not 
realize that their brokers may receive bonuses for selling them 
certain funds. Are these payments breaches of the fiduciary 
duties owed by brokers to shareholders, or are investors simply 
unaware of these common practices?
    Do you think that investors believe that brokers have a 
greater fiduciary duty to them than is currently required by 
law? Do we need some changes there?
    Chairman Donaldson. This has been an area of inquiry for 
us, the so-called ``incentives,'' if you will, or rather, the 
hidden incentives, for a broker to sell one fund versus 
another, and we are on a trail of bringing some sunlight to 
these practices.
    Chairman Shelby. Good.
    Chairman Donaldson. The individual investor has the right 
to know that if a broker is recommending a particular fund, 
what outside of the performance and suitability of that fund is 
inducing the broker to recommend it, and we believe that there 
needs to be more disclosure there than there is right now.
    Senator Sarbanes. Would you yield on that, Mr. Chairman?
    Chairman Shelby. Go ahead, Senator Sarbanes.
    Senator Sarbanes. I think that is a very limited answer. I 
understood--and the NASD has just disciplined one of its 
investment banking firms--that there are certain practices that 
they have a rule about that you are just not supposed to do it, 
not that you should just disclose it. I mean, they had brokers 
of theirs promoting the sale of their own mutual funds, 
proprietary mutual funds, and they were giving them tickets to 
Britney Spears and Rolling Stones concerts, tickets to the NBA 
Finals--listen to this one--tuition for a high-performance 
automobile racing school, and trips to resorts.
    The NASD said this was prohibited under their rules, and 
they levied a heavy fine on them. So, I do not think disclosing 
it is enough; I think those are practices that just ought not 
to take place. It is a tremendous inducement to these brokers 
not to pay attention to the interests of their investors, is it 
not?
    Chairman Donaldson. There are many different aspects of the 
way that mutual funds are sold, and I think the first level of 
understanding here on our part is to understand what those 
inducements are that the customer does not understand. Now, 
whether it is illegal to give baseball tickets to a customer of 
yours, I would really wonder about that. I mean, that is 
commerce, that is business; you entertain customers, you do 
whatever you can to get them to do business with you.
    Where it reaches some level of illegality, I think is 
something that we would certainly look at. But I think what I 
tried to respond to Senator Shelby's question was that it is 
not the baseball tickets so much as it is the fact that somehow 
either the mutual fund company or the brokerage firm is 
rewarding, paying, the broker to push a particular fund. I 
think that is kind of a different issue than the broker having 
baseball tickets.
    Senator Sarbanes. For whom?
    Chairman Donaldson. Well, again, I think customer 
entertainment is part of American business life.
    Senator Sarbanes. You mean a baseball ticket for the 
investor?
    Chairman Donaldson. Yes. I mean, if----
    Senator Sarbanes. What about a baseball ticket for the 
broker from his brokerage firm, which creates a competition and 
says to them, ``We want to push these proprietary mutual funds; 
these are our mutual funds''? Was the NASD wrong in what they 
did here? They fined an investment house $2 million and 
censured them, and they fined a supervisor $250,000 and 
censured him because they did not have proper monitoring 
practices. And then it says--this is their release, the NASD--
``In enacting the noncash compensation rules, the SEC and NASD 
recognize that the types of sales contests seen in this case 
increase the potential for investors to be steered into 
investments that are less suitable than some alternatives. 
These rules were designed to prevent the conflicts of interest 
that might arise for the broker when faced with such a 
choice.''
    Chairman Donaldson. Senator, I misunderstood your question. 
I thought you were talking about the broker himself giving 
baseball tickets to his client. You are talking about----
    Senator Sarbanes. No, no. I am talking about the investment 
house running a competition----
    Chairman Donaldson. Yes, you are talking about non-
monetary----
    Senator Sarbanes. --and saying to the brokers, ``If you can 
push a certain number of our own proprietary funds, you will 
get these Britney Spears tickets'' or tuition for a high-
performance automobile racing school, so the broker ceases then 
to meet the suitability test for his clients.
    Chairman Donaldson. Sure. You are talking about nonmonetary 
compensation. You are talking about even monetary compensation 
that is not disclosed. And I agree obviously that is a 
violation of the NASD rule and a violation of our rules, and it 
is quite correct that action be taken against them. But I 
misunderstood what you were talking about in terms of whom it 
was being given to and from whence it was coming.
    Chairman Shelby. Chairman Donaldson, in prior hearings on 
hedge funds here in the Banking Committee, you addressed 
problems concerning--which you have alluded to already--the 
retailization of hedge funds and the conflicts of interest 
inherent when advisors manage both a hedge fund and a mutual 
fund.
    Chairman Donaldson. Right.
    Chairman Shelby. Describe how the report's recommendations 
address these concerns or will address these concerns.
    Chairman Donaldson. Again, the conflict of interest would 
be a fund group, let us say, or a manager that on the one hand 
is running a mutual fund and being compensated for doing that 
with fees, and on the other hand is running a hedge fund where 
the compensation normally is not only fees but also a 
participation in the profits, and the potential conflict of 
interest as to where securities that you buy or sell are put. 
Does an attractive IPO that is bound to go up in price get put 
in a hedge fund as opposed to put in a mutual fund.
    Chairman Shelby. Yes; obvious conflict.
    Chairman Donaldson. And that is an obvious conflict.
    Chairman Shelby. Mr. Chairman, some people contend that 
further SEC regulation of hedge funds will drive capital 
offshore. What is your perspective on this?
    Chairman Donaldson. I do not think that is a worry, because 
if you have more than 14 U.S. investors, no matter where you 
are located, you still come under our purview. You cannot 
escape it.
    Chairman Shelby. They have to do what is right, do they 
not?
    Chairman Donaldson. Yes. If you have U.S. investors there, 
it would fall under our jurisdiction.
    Chairman Shelby. I have a couple of things left. The New 
York Stock Exchange--we hope to hear from you and Mr. Reed when 
the governance review is complete on the New York Stock 
Exchange--when do you expect the New York Stock Exchange to 
deliver its report on corporate governance practices, and when 
do you expect the New York Stock Exchange to designate a 
permanent CEO?
    Chairman Donaldson. Mr. Reed, very wislely, has wanted to 
take a look at the work that the Stock Exchange has done on 
corporate governance before releasing it or giving it to us in 
answer to our request, and I think that is done with my total 
concurrence, because I think that there are issues involved in 
the corporate governance paper, if you will, that will be 
changed as a result of a totally new, independent person coming 
in and having a fresh look at it.
    So this is a complex subject that Mr. Reed has undertaken 
in terms of how to organize the governance of the Stock 
Exchange to avoid some of the things that have happened here in 
the last period of time.
    I want to emphasize that we should not confuse the 
governance issues with other aspects of the Stock Exchange 
management and particularly its regulation. Again, I do not 
think we should be too hasty to throw the baby out with the 
bath water. I think the Stock Exchange is going to have to come 
up with a structure----
    Chairman Shelby. Sometimes you need to give the baby a 
bath, though, do you not, daily, so to speak?
    [Laughter.]
    Chairman Donaldson. I think the Stock Exchange is going to 
have to come up with a governance structure that guarantees the 
independence of the regulatory aspect of what they are doing 
but somehow keeps its proximity so that it is not just a 
bureaucracy out here somewhere that does not really understand 
how difficult it is to conform to, let us say, trading 
regulations.
    Chairman Shelby. Sure. Mr. Chairman, you have already 
described a lot of the priorities on your agenda at the SEC 
that you are doing to help bring confidence back to the 
investor, and to the people. Are there other types of conflicts 
of interest that you are looking at, that your enforcement 
division is investigating? For example, in prior testimony 
before this Committee, you mentioned a concern with tying 
activities. Where are we there?
    Chairman Donaldson. On what, Senator?
    Chairman Shelby. Tying; tying activities.
    Chairman Donaldson. Tying, yes. Well, we have a set of 
priorities, if you will, and clearly you are seeing some of 
them emerge here in terms of the hedge fund study, in terms of 
the market structure study, in terms of the work we are doing 
in mutual funds, in terms of all the other things that we are 
doing in terms of enforcing the Sarbanes-Oxley mandates.
    In terms of tying, I think that this is an issue that 
concerns me in terms of the relationship between providing 
certain services in order to get other business, and it is a 
very sophisticated subject. It is one that I think we have to 
have a constant look at. I think the bank regulators have to 
have a constant look at it. I do not want to say it is not a 
priority, but I want to say that it is something that we 
continue to gather information on.
    Chairman Shelby. I know that it has not reached the 
priority status such as accounting fraud, corporate fraud, 
corporate mismanagement, now mutual funds, and so forth. When 
will you have some type of perspective on how wide and deep the 
mutual funds problem is?
    Chairman Donaldson. You are not talking tying now; you are 
back on----
    Chairman Shelby. No. We are talking about mutual funds and 
the problems that have arisen lately. How deep is that and how 
wide is it, and if you do not know now, when will you know?
    Chairman Donaldson. I have four or five pages here of 
different aspects of mutual fund regulation where we are either 
putting rules in now, contemplating rules, or investigating, so 
it is hard for me, without getting very specific as to what the 
timetable on each one of these items is. But I would say that 
it is a top priority for us to resolve some of the issues we 
have been talking about this morning. I would think that we are 
going to work--we have already put into effect a number of 
things, and we will roll these out over the immediate future.
    Will we be finished by the end of 2004? I do not know.
    Chairman Shelby. I believe you are up to the challenge. I 
just know that a lot of things are in your basket, and they 
have not been resolved yet, and when one thing seems to be 
coming along, then we have another scandal or something close 
to a scandal, conflicts of interest in dealing with mutual 
funds or capital markets or corporate fraud or something else, 
and it just undermines investor confidence, as you well know.
    Chairman Donaldson. I am well aware of that. I think a lot 
about it in terms of investor confidence. It is regrettable 
that some of the enforcement actions we bring are from the 
past--in other words, we have finally caught up with it--and it 
is not new malfeasance, but it is something that happened 
months or years ago, and yet it hits the newspapers and is 
greeted as something new.
    The thing that upsets me more than that is malfeasance that 
appears on I would say my watch right now, the continuing to 
look under a leaf and see things that we do not think should be 
there. That bothers me.
    Chairman Shelby. You plan to look under the tree and the 
leaves, don't you?
    Chairman Donaldson. Yes.
    Chairman Shelby. Okay.
    Senator Carper.

              COMMENTS OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Welcome, Chairman Donaldson. In the SEC staff report that 
was issued yesterday, the report notes that there are several 
benefits that inure from hedge funds, and the report says, 
``Hedge funds play an important role in a financial system 
where various risks are distributed across a variety of 
innovative financial instruments. By reallocating financial 
risk, this market activity provides the added benefit of 
lowering financial costs shouldered by other sectors of the 
economy.''
    It goes on to say: ``The absence of hedge funds from these 
markets could lead to fewer risk management choices and a 
higher cost of capital.''
    That is just part of what the report says, and this is my 
question: Given the importance of hedge funds in capital 
markets today and thus the broad market implications of hedge 
fund regulation, including registration, do you plan to consult 
with the President's Working Group on Financial Markets prior 
to any regulatory action that the SEC may take with respect to 
hedge funds?
    Chairman Donaldson. Well, as I mentioned earlier, the state 
we are in now is the investigative work has been done over a 
year; we put out the staff's conclusions with recommendations. 
The next step is that we would hope to get reactions back from 
various interested parties, and one of the reactions we would 
hope to get back is the reactions from the President's Working 
Group. We would hope to hear their reactions to what our staff 
has suggested before we make any final decision. So the answer 
is yes, I would plan to present that to the President's Working 
Group.
    Senator Carper. Good. Thanks.
    The second question is one dealing with SEC's regulatory 
structure. At other times when you have been before our 
Committee, I have asked you about the moneys, the additional 
appropriations that we have provided to the SEC to hire new 
staff to enable you to meet your statutory responsibilities. In 
your speech this summer before the National Press Club, I 
believe you mentioned that you have created a new management 
structure operating out of the office of the Chairman to help 
you manage your expanded agenda and expanding resources while 
promoting cooperation amongst the SEC's various divisions and 
offices.
    You noted that this structure would help the Agency to 
anticipate issues, not just to react to them. Could you explain 
a bit more about this new structure and maybe share with us--
even though it has not been in place for very long--examples of 
issues that the Agency has anticipated due to this new 
structure?
    Chairman Donaldson. Yes. I would begin with a focus from 
the Chairman's Office on Management itself, and the first step 
in that has been to change the structure of my office and to 
bring in three people to perform the role that a chief of staff 
used to perform----
    Senator Carper. Say that again--bring in what kind of 
people?
    Chairman Donaldson. People to perform chief of staff 
junctions. One of the managing executives in my office has most 
of the functions that the chief of staff used to have in terms 
of the relationship of the Chairman's office with the other 
Commissioners and the Commissioners' staffs. That is a chief of 
staff kind of role.
    One of the other managing executives is responsible for our 
external affairs, to include our relationships with the public 
and the press and so forth and our relationships with you on 
the Hill.
    The third managing executive is the executive for internal 
management. This gentleman, Peter Derby by name, brings a long 
history of operating a very successful new bank in Russia, of 
all places, where he started a de novo bank and built it to 
great prominence, known for its integrity, and so forth. And 
Peter Derby is in charge of effecting some of the things that I 
have been talking about in terms of management of the Agency 
itself--to wit, we are attempting to get more synergism and 
cross-fertilization going between the five divisions of the 
Agency, and I do not have time, and I would be glad to 
elaborate on that, but we are trying to get much more 
information-sharing and collaborative work and so forth than 
perhaps has existed in the past.
    Second, we are organizing a series of management controls, 
if you will, which for lack of a better word, we are calling 
``dashboards.'' These are mutually agreed-upon standards of 
performance in the various divisions. The word ``dashboard'' is 
where we are able, at the senior levels in the Agency, to see 
what progress is being made in a number of different areas in 
terms of the amount of time it takes to get projects out, how 
much progress we are making in the hiring that we have to do, 
et cetera. It is a way of looking at progress against--I will 
not say deadlines, but against mutually agreed-upon objectives.
    Third and perhaps most important is an attempt to organize 
a risk assessment or policy planning group outside of the 
various divisions whose role is to--and I used the words 
before, and I will use them again--look over the hill and 
around the corner and try to anticipate problems coming down 
the pike and to see if we cannot somehow get involved in those 
problems before hand instead of just playing a mop-up game.
    And this is not to imply that we do not have that kind of 
risk assessment in each one of the divisions, but this will 
stimulate that work within each division, and we will have a 
little bit of a longer view. And again, I do not want to 
promise too much in terms of this effort, but it basically will 
heighten our anticipatory capabilities so, rather than just 
reacting to something that has happened or a tip that has come 
in or whatever, we are out there trying to anticipate what is 
the next problem area and what can we do about it now.
    Senator Carper. All right. Thanks for sharing that with us.
    Thanks, Mr. Chairman.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Chairman Donaldson, I have not done it recently, but last 
year at one point, I reviewed the authorities and powers of the 
SEC under the Securities Acts of the early 1930's, and my 
recollection is they are quite broad, and you really have very 
plenary authority.
    Now, a considerable delegation of that authority has been 
exercised by the SEC with respect to the self-regulatory 
organizations, but my recollection of the statute is that the 
ultimate decision in a sense rests with you, and it leads me to 
this question--whether there is any power or authority that you 
think you need that you do not have to enable you to enforce 
the policies and programs that you believe a self-regulatory 
organization should be pursuing--for example, the New York 
Stock Exchange or the Nasdaq.
    Chairman Donaldson. At this juncture, Senator, I would say 
that I do not see the need for new powers now. However, we are 
facing, as the subject matter this morning illustrates, a lot 
of challenges in a lot of areas. I am sure there is going to 
be--I should not say I am sure--I would anticipate that there 
probably will be pushback in certain areas that we are trying 
to change, and my hope is that we can convince any who might 
push back that we do have the authority to effect change.
    Now, the New York Stock Exchange is a pretty good example 
of how I believe we should exercise that authority. I believe 
it is up to the New York Stock Exchange to straighten out its 
own internal governance situation, and that is probably going 
to require actions inside the Stock Exchange amongst the seat-
holders and so forth who are willing to give their vote to have 
that happen. And I am not making any prejudgment on what that 
is, and I believe it should rest with the Stock Exchange board 
and right now with the new leader of that board to figure out 
exactly what governance structure will fit that institution. It 
is up to us to have oversight on that.
    Senator Sarbanes. I think it is important for you to send a 
message that this perhaps semi-slumbering lion, the SEC, having 
been fed a very good meal with the Congressional appropriation 
and having been disturbed by these things that are happening, 
is now up and about and prowling around, and that these various 
delegations and so forth need to be exercised in a way to 
protect the investor, and they need to get moving.
    I agree with you that we have to be prudent in what we do, 
and this Committee last year was certainly prudent; we did not 
fly off the handle when we tried to deal with the legislation. 
We took it step-by-step. So, I am not for throwing the baby out 
with the bath water, but I thought Chairman Shelby was right on 
the mark when he said sometimes you have to give the baby a 
bath; I thought that was a very appropriate observation. They 
have really got to shape up their ship, don't you think?
    Chairman Donaldson. That is what we are trying to do, and I 
would like to assure you that we will use every power that we 
have to try to clean up whatever it is out there.
    Senator Sarbanes. But at the moment, you do not see a 
problem in terms of your power in getting the Exchange to 
enforce and carry out the policies and programs you think they 
should carry out; is that right?
    Chairman Donaldson. I do not think right now that we have 
any need for additional powers, but----
    Senator Sarbanes. Let me urge you again to take a look at 
this ad in The Wall Street Journal by the largest public 
employee retirement systems in the country with respect to 
timely access for shareholders to the board of directors. I 
think that is an important source of additional support the SEC 
could gather--it is a way of structuring the system so that 
built into the system is the oversight that is desirable, so it 
gives the shareholders a chance to exercise that kind of 
overview, and I think that is very important. I know you are 
looking at those rules right now, as I understand it.
    The final point I would like to leave with you, that I made 
reference to earlier, is how hard I thought the SEC staff have 
been working. I know they have been under enormous pressure now 
for more than a year; ever since the legislation was passed, 
they have had to go on fast-forward to move those things. Now 
these other issues keep arising, and they are doing studies, 
making recommendations, then you have to promulgate rules, then 
you have to review the comments, then you have to put the rules 
into place--all of that. So, I would urge you again to try to 
finally resolve this pay and benefit parity issue for your 
employees.
    We provided in the statute that ``the Commission shall seek 
to maintain comparability with such agencies regarding 
compensation and benefits.'' It seems to me that clearly, you 
should be comparable with the other various financial 
regulatory agencies. I mean, you are demanding an awful lot of 
your people. You have a staff of dedicated people. They are 
facing major challenges, and I think it is important to try to 
resolve it. I know you have made some advances on that front, 
but my understanding is it is not yet completed, and I would 
urge you to carry on through and get that settled so that it is 
not a distraction--so it is not an impediment within developing 
a real, forward-moving esprit de corps at the SEC as it faces 
its challenges.
    Chairman Donaldson. Right. Let me thank you for your 
compliment to the staff of the SEC. They are doing an 
outstanding job, and they are working very hard at it, and they 
deserve every kind of support that we can give them.
    We have moved ahead on pay parity, as you know, and now we 
are working to resolve the other issues of benefits and so 
forth, and we are not there yet, but we are working on it, and 
it is a very high priority for us.
    Senator Sarbanes. Thank you.
    Chairman Shelby. Mr. Chairman, I am not one to propose too 
much regulation on anybody, but sometimes it seems that some 
people cannot regulate themselves. We have seen it in the 
accounting profession and others. A lot of us have gone through 
colleges and universities where you had an honor system, and 
you knew to heed the honor system because there were 
consequences--huge consequences--among other things. Maybe the 
universities and colleges did not look at you every day, but 
you were in a sense self-regulatory to a point but not 
ultimately, because if you cheated in colleges and 
universities, you paid an awful price.
    It seems that people are cheating, big time, people out of 
millions if not billions of dollars, and I am not sure they are 
paying a price for it. Part of your job, as you well know, as 
the top regulator over the securities market is to seek out 
these people who abuse the system, and I think you are off to a 
good start. But it is troubling again to me that we have not 
brought the investor confidence back to the level that we need 
to, and I think, what you do at the SEC will depend a lot on 
how fast investor confidence comes back.
    People have to believe in the system, and as Senator 
Bunning lamented earlier, so many do not today, and for good 
reason. And we do not need that. It undermines everything. It 
undermines our economy, it undermines our country, does it not?
    Chairman Donaldson. I think that from my point of view, we 
will exercise our authority and responsibility as firmly and as 
swiftly as we possibly can.
    I believe that a major step in investor confidence will 
come from the conviction that the SEC itself is on the job.
    Senator Sarbanes. Prowling around, as they say.
    Chairman Donaldson. Yes, exactly--and that we are on the 
job. And I agree with you that investor confidence is at a low 
point. Confidence in American business is at a low point--not 
just investor, but the American public--that has rubbed off on 
them. And I think we are going to do everything in our power to 
restore that.
    Chairman Shelby. I believe you are doing that. I think you 
are on the right road. I believe Senator Sarbanes and I agree 
that you are on the right road. It is just a tortuous road to 
travel.
    Thank you, Mr. Chairman.
    Chairman Donaldson. Thank you.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 11:57 a.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follows:]
               PREPARED STATEMENT OF SENATOR JIM BUNNING
    Thank you, Mr. Chairman, for holding this important hearing and I 
would like to thank Chairman Donaldson for testifying today.
    The markets are doing much better since you came before this 
Committee for your nomination hearing. Consumer confidence is up, and 
the economy seems to be turning around. Job growth is still not where 
it should be but the strong growth in the markets is usually a 
precursor to economic growth. So, overall things look pretty good in 
our equities markets. We seem to have weathered the recession that 
started in 2000, the attack of September 11, the corporate scandals and 
2 wars.
    You started at a very difficult time for the SEC, when there was a 
real lack of confidence. There were a lot or problems at the SEC when 
you took over. Your predecessor was a very good attorney, but he lacked 
some political skills. I think he was also blamed for a lot of things 
that started before he became Chairman. But things seem to be turning 
around now and I believe the American people have much more confidence 
in the SEC.
    I think seeing a few perp walks by the heads of some of our 
corporations who broke the law really helped in that regard.
    During the question period, I will get into this a little more and 
ask your assessment on how the SEC is doing and where you think it can 
be improved. I would also like to talk a little about the hedge funds 
report the SEC staff put out yesterday.
    Hopefully, we are coming out of this recession and the markets are 
leading the way. There are a lot of things that can pull us back and I 
trust you will remain vigilant at the SEC to make sure nothing in your 
area of responsibility does pull us back.
    Once again, thank you Mr. Chairman for holding this hearing and 
thank you Chairman Donaldson for testifying today.
                               ----------
               PREPARED STATEMENT OF SENATOR WAYNE ALLARD
    I would like to thank Chairman Shelby for holding this hearing to 
learn about recent initiatives to enhance investor protections in our 
securities markets. I am particularly pleased with the Commission's 
diligence in the past months in identifying and addressing challenges 
in the mutual fund and hedge fund industries. I look forward to hearing 
Chairman Donaldson's comments about the state of our securities 
industry, particularly as it relates to ways in which we can further 
protect the investor and encourage participation in our securities 
markets. I also anticipate hearing your thoughts on the recent 
recommendations of the Commission staff.
    The role of the Securities and Exchange Commission has taken on 
even greater importance in recent years with the increasing number of 
Americans investing in equities. Middle class Americans invest in 
mutual funds to plan for retirement, to fund their children's 
education, or to purchase a home. More sophisticated investors like 
foundations, endowments, and pension plans utilize hedge funds to 
pursue positive returns, regardless of whether the securities markets 
are declining or rising. The opportunity for different levels of 
investors in the securities markets is integral to allowing Americans 
participation in the growth and development of our economy. Likewise, 
we must maintain the protection of investors and ensure the integrity 
of America's securities markets so that investment continues, and our 
economy remains healthy.
    Thank you, Chairman Donaldson for appearing before the Committee 
today to discuss an issue that is essential to the health of the 
American economy. I look forward to your testimony and the discussion 
today.
                               ----------
               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                           September 30, 2003
Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today on the Securities 
and Exchange Commission's recent initiatives to enhance investor 
protections in our securities markets. Since its creation in 1934, the 
SEC's mandate has been to protect investors and ensure the integrity of 
America's securities markets. That mandate has taken on even greater 
importance in recent years, as increasing numbers of people have become 
equity investors. With more than 95 million Americans invested in 
mutual funds, representing approximately 54 million U.S. households, 
and a combined $6.5 trillion in assets, mutual funds are a vital part 
of this Nation's economy. While much of the public focus over the last 
few years has been on events surrounding public companies, the 
Commission has undertaken an aggressive agenda to identify and address 
challenges in the mutual fund industry, an agenda that helps us to 
protect this vital segment of our investing public.
    I would like to highlight some important actions we have recently 
taken to help ensure that mutual fund investors have the information 
they need to make their investment decisions.
Fund Advertising
    Just last week, we adopted rule amendments to modernize mutual fund 
advertising requirements to encourage more responsible advertising. The 
new amendments require that fund advertisements state that investors 
should consider a fund's fees before investing. The amendments also 
require advertisements to include information about the fund's 
investment objectives and risks, as well as an explanation that the 
prospectus contains this and other important information about the 
fund. The amendments also strengthen the antifraud protections that 
apply to fund advertising and encourage fund advertisements to provide 
information to investors that is more balanced and informative, 
particularly in the area of investment performance, so that investors 
have access to up-to-date performance information.
    In addition to rulemaking initiatives, the Commission has engaged 
in educational efforts to caution investors against the dangers of 
overemphasizing fund performance in investment decisions. These efforts 
included publishing an investor alert on the Commission's website that 
explains the importance of looking beyond past performance in making 
investment decisions. We also placed a ``cost calculator'' on our 
website that allows investors to compute the impact of fees and 
expenses of various funds on their performance and facilitates 
comparison of funds.
Fund of Funds
    The Commission also last week proposed for public comment new rules 
under the Investment Company Act that would broaden the ability of one 
fund to acquire shares of another fund, so called ``funds of funds.'' 
These funds often are used as asset allocation vehicles for a fund to 
gain exposure to a sector of the market by investing in another fund. 
This proposal also included recommended amendments that would improve 
the transparency of the expenses of funds that invest in other funds by 
requiring that the expenses of the acquired funds be aggregated and 
shown as an additional expense in the fee table of the acquiring funds, 
thereby giving investors in these funds more complete information about 
expenses.
Proxy Voting
    In January, the Commission adopted rules that require mutual funds 
to disclose their proxy voting records. These rules enable fund 
shareholders to monitor their funds' involvement in the governance 
activities of portfolio companies. Under the rule, funds are required 
to file their proxy voting record with the Commission, which will make 
it publicly available through the EDGAR system. The rules also require 
mutual funds to disclose in their registration statements the policies 
and procedures they use to determine how to vote proxies related to 
portfolio securities. Funds have already begun complying with this 
requirement, and they are required to start filing their proxy voting 
reports next year.
Sarbanes-Oxley Requirements
    In addition to Commission initiatives, mutual funds also are 
subject to the corporate governance requirements of the Sarbanes-Oxley 
Act. In each rule we have proposed and/or adopted under the Act, we 
have applied the corporate governance requirements to both operating 
companies and mutual funds, with some tailoring for the unique aspects 
of mutual funds. These rules include the rules on CEO and CFO 
certification requirements, code of ethics requirements, disclosure of 
audit committee financial experts, auditor independence and, most 
recently, audit committee listing standards. This last rule, adopted as 
part of a broader rulemaking regarding audit committee standards, 
applies only to listed companies and therefore includes only exchange-
traded funds, or listed closed-end funds. The rule directs the 
exchanges and Nasdaq to prohibit the listing of any security of an 
issuer in violation of new standards of audit committee responsibility 
and independence.
Future Mutual Fund Activity
    In addition to these rulemaking activities, we have a number of 
other initiatives in the pipeline.
Breakpoint Disclosure
    We anticipate taking action to improve the disclosure of breakpoint 
discounts, which are discounts on front-end sales loads based on the 
aggregate amount of purchases of a fund's shares. Funds that offer 
breakpoint discounts must disclose the breakpoints and related 
procedures in their offering documents. Brokers that sell shares of 
funds that offer discounts have an obligation to help ensure that 
shareholders are receiving those discounts. Late last year, however, 
the staffs of the NASD and the SEC identified concerns regarding 
breakpoints. The staffs discovered that many fund investors were not 
receiving the appropriate discounts. The SEC and NASD took swift 
action--reminding funds and brokers of their obligations, requiring 
brokers to assess the extent of the problem, and directing the industry 
to convene a task force to address the problem. In July, a Joint NASD/
Industry Report on Breakpoints was released containing recommendations 
to assure that investors receive available discounts on mutual fund 
shares subject to front-end sales loads.
    The Breakpoint Report contains a number of recommendations to limit 
the problems associated with the provision of breakpoint discounts, as 
well as to improve the disclosure of breakpoint opportunities. I have 
directed the staff to draft a rule for Commission consideration 
consistent with these recommendations to help ensure that investors 
receive the appropriate discounts in the future. In addition, the NASD 
and SEC staffs continue to monitor and quantify the problem and have 
directed firms that have failed to provide the appropriate breakpoints 
in the past to compensate and make whole any affected investor. We and 
the NASD will continue to investigate, and where warranted, will bring 
enforcement actions in this area.
Shareholder Report Disclosure of Operating Expenses
    We have also proposed additional disclosure to increase investors' 
understanding of the expenses they incur when investing in a mutual 
fund. Under this proposal, mutual funds would be required to disclose 
in their shareholder reports the ``dollar amount'' of fund expenses 
paid by shareholders on a prescribed investment amount--based on both 
the fund's actual expenses and return for the period, as well as the 
fund's actual expenses for the period based on an assumed return of 5 
percent per year. By using both these measures, the dollar disclosure 
would enable investors to determine the amount of fees they paid on an 
ongoing basis, as well to compare the amount of fees charged by other 
funds. The goal of the proposal is to educate investors and to 
encourage cost competition among funds. This proposal also would 
require more frequent disclosure of portfolio holdings (for example, 
quarterly rather than semi-annually) to enhance investor understanding 
of the securities in the fund's portfolio so investors can make better 
asset allocation decisions. I expect the Commission to consider 
adopting these new requirements in the near future.
Highlighting Broker Incentives and Conflicts of Interest
    Another area we are looking at is how to increase investor 
understanding of the incentives and conflicts that broker-dealers have 
in offering mutual fund shares to investors. Initiatives we are 
considering in this area include a comprehensive revision of mutual 
fund confirmation form requirements. I envision a revised confirmation 
would include information about revenue sharing arrangements, 
incentives for selling in-house funds and other inducements for brokers 
to sell fund shares that may not be immediately transparent to fund 
investors.
    In addition to its disclosure initiatives, the Commission has 
focused its rulemaking efforts on fund governance and internal 
compliance issues. Although we have focused on these issues for some 
time, recent events in the mutual fund industry underscore the 
importance of funds' maintaining appropriate measures to ensure their 
adherence to both the letter and spirit of the Federal securities laws.
Mutual Fund Compliance Rule
    In February, the Commission published for comment proposed rules 
aimed at ensuring better compliance with regulations governing mutual 
funds. These rules would mandate that funds and investment advisers 
maintain comprehensive compliance policies, and procedures reasonably 
designed to prevent violations of the Federal securities laws. The 
rules also require that funds designate a chief compliance officer. 
While the proposal does not enumerate specific elements funds must 
include in their compliance programs--as funds are too varied in their 
operations for us to impose a single list of required elements--it is 
designed to ensure that policies and procedures are in place to lessen 
the likelihood of securities law violations and detect any violations 
that do occur.
    Consequently, we would expect funds to have policies and procedures 
to address pricing of portfolio securities and fund shares; processing 
of fund shares on a timely basis; portfolio management processes, 
including allocation of investment opportunities among clients; the 
accuracy of disclosures made to investors in fund prospec-
tuses (disclosures that would include representations regarding market 
timing policies and procedures); and processes to value client holdings 
and assess fees based on those valuations.
    While we expect that these rules would help protect investors by 
improving day-to-day compliance with the Federal securities laws, the 
rules should also increase the efficiency and effectiveness of the 
Commission's mutual fund examination program. Our oversight is 
predicated on the assumption that those who manage mutual funds have 
procedures to comply with the law. While the proposal would codify the 
prudent compliance practices already followed by most fund complexes, 
in some cases mutual funds have few compliance controls in place or 
have gaps in their controls. These proposals are intended to raise the 
standard of compliance among all mutual funds, and I expect the 
Commission will consider adoption of these requirements later this 
fall.
Director Nomination Rules
    We have also included mutual funds in initiatives to increase 
shareholder participation in the director nomination process. Last 
month, we proposed rule changes to strengthen disclosure requirements 
relating to the nomination of directors and shareholder communications 
with directors. The proposals apply to both operating companies and 
mutual funds.
    The proposals would require a fund to disclose additional 
information regarding its process of nominating directors, including 
whether members of the nominating committee are ``interested persons'' 
of the fund; a fund's process for identifying and evaluating 
candidates; whether a fund considers candidates for director nominees 
put forward by shareholders; and whether a fund has rejected candidates 
put forward by large long-term shareholders or groups of shareholders. 
The proposals would also require a fund to disclose information 
regarding shareholder communications with directors, including whether 
the fund has a process for such communications and the procedures 
shareholders should follow; whether the communications are screened; 
and whether material actions have been taken as a result of shareholder 
communications in the last fiscal year.
    The proposed rules implement the first part of the recommendations 
of a Commission Staff Report issued on July 15, 2003, regarding 
improvements to the proxy process. The enhanced disclosure provided by 
the proposal should benefit fund shareholders by improving the 
transparency of the nominating process and board operations, as well as 
increasing shareholders' understanding of the funds in which they 
invest. The Staff Report also recommends under certain circumstances 
that major long-term shareholders, or groups of shareholders, be 
provided access to proxy materials to nominate directors where there 
are objective criteria indicating that shareholders may not have had 
adequate input in the proxy process. I expect that we will propose 
rules to implement this recommendation shortly, and that they will 
apply with equal force to mutual funds.
Updates On Other Issues
    I understand the Committee is interested in getting an update on a 
few other issues for today's hearing, so let me briefly bring you up to 
speed in those areas.
Hedge Fund Report
    Since June of last year, the SEC staff has conducted a 
comprehensive study focusing on the investor protection implications of 
the significant growth of hedge funds in recent years. As part of that 
study, the staff reviewed documents from 65 hedge fund advisers 
managing more than 650 different hedge funds with more than $160 
billion of assets. The staff also visited hedge fund advisers and prime 
brokers and conducted a series of examinations of registered funds of 
hedge funds. Finally, the staff benefited from views expressed at a 
highly successful two-day Roundtable we held at the Commission, during 
which a variety of experts discussed key aspects of hedge fund 
operations, as well as the views contained in approximately 80 public 
letters we received commenting on the roundtable discussion and hedge 
fund issues.
    When I testified before you in April, the study was still at the 
fact-gathering stage and the staff had not reached any conclusions. 
Just yesterday, however, the Commission released a staff report (the 
Report) that outlines the staff's factual findings, identifies concerns 
and recommends certain regulatory and other actions to improve the 
current system of hedge fund regulation and oversight.
    Let me emphasize at this time that this is a staff report. The next 
step is for the Commission to consider these recommendations to 
determine how we may wish to proceed. Any recommendation that the 
Commission determines to act upon will require us to go through the 
appropriate administrative process, so rest assured that investors, 
market participants, and other interested persons will have ample 
opportunity to comment upon any of the recommendations that the 
Commission chooses to pursue. However, I would like to highlight for 
you today some of the staff's findings and its primary recommendation.
    In its Report, the staff identifies a number of areas of concern 
regarding hedge funds: (i) lack of Commission information about hedge 
funds and their advisers' activities; (ii) lack of prescribed and 
uniform disclosure by hedge fund advisers; (iii) valuation and other 
conflict of interest issues; (iv) the potential for increased 
investment by less sophisticated investors, directly or indirectly, in 
hedge funds; and (v) despite the relatively low absolute number, an 
increase in the number of enforcement actions regarding hedge fund 
advisers. Many of these concerns arise from the unregulated status of 
hedge funds, which generally allows them to operate without Commission 
oversight. Consequently, the primary recommendation of the staff is 
that the Commission should consider revising its rules to require that 
hedge fund advisers register under the Advisers Act. While I am looking 
forward to studying the staff's Report and the recommendations 
contained in it before drawing any conclusions, I will say, as I have 
before, that I believe that the Commission needs to have a means of 
examining hedge funds and how they operate. Speaking only for myself, I 
believe that registration of hedge fund advisers would accomplish this.
Canary Investigation
    While I am on the topic of hedge funds, let me update you about our 
involvement in recent allegations regarding a hedge fund's practices in 
late trading mutual funds, as well as questions concerning funds' 
permitting market timers to arbitrage the funds, which underscore the 
importance of the SEC's ongoing review of the hedge fund and mutual 
fund industries. Both of these activities have the potential to harm 
long-term investors in mutual funds.
    The conduct alleged in the case involving Canary Capital, an 
unregistered hedge fund, is reprehensible and in violation of fiduciary 
principles. We have put in motion an action plan to vigorously 
investigate this matter, assess the scope of the problem and hold any 
wrongdoers accountable, and we will do so in close coordination with 
State regulators.
    Already, we have filed a civil action against Theodore Sihpol, a 
salesperson at Bank of America Securities, who was Canary Capital's 
primary contact at Bank of America. Our examiners and enforcement staff 
are actively investigating this matter, not only the extent to which 
the allegations in this particular case are true, but also whether this 
conduct occurs at other firms in the securities industry. I want to 
emphasize that we will aggressively pursue those who have injured 
investors as a result of illegal late-trading and/or market-timing 
activity and, where possible, to seek recompense for these investors in 
connection with mutual fund transactions.
    Additionally, the Commission's staff has sent detailed information 
requests to registered prime brokerage firms, other large broker-
dealers, transfer agents, and the 80 largest mutual fund complexes in 
the country seeking information on their policies and practices 
relating to market timing and late trading. Specifically, we are using 
our examination authority to obtain information from mutual funds and 
broker-dealers regarding their pricing of mutual fund orders and 
adherence to their stated policies regarding market timing. We also 
have sought information from mutual funds susceptible to market timing 
regarding their use of fair value pricing procedures to combat this 
type of activity.
    More broadly, I believe that the industry must take steps to review 
its own conduct. To that end, I sent letters to major trade 
associations for the mutual fund and broker-dealer industries asking 
them to notify their members to review and reassess their procedures 
relating to the handling of mutual fund investments in accordance with 
applicable law.
    While our enforcement efforts are a key tool in protecting the 
Nation's investors, another critical tool is regulation to minimize the 
potential for abuses to occur in the first place. We will consider what 
we learn from the investigation to determine whether we should pursue 
additional regulatory measures to thwart this type of activity. 
Specifically, our staff is studying whether we need to take additional 
steps to (1) pursue measures to prevent the circumvention of forward-
pricing requirements for fund shares and market timing restrictions, 
(2) require funds to have written policies and procedures to address 
short-term trading in their shares, (3) require improved disclosure 
regarding market timing procedures, (4) provide funds with additional 
tools to deter market timing activity, and (5) address concerns related 
to the selective disclosure of fund portfolio information.
NYSE / Corporate Governance
    I would now like to turn to an issue that is important both from a 
regulatory standpoint and from the standpoint of the investing public: 
the critical need for sound governance practices by self-regulatory 
organizations. I believe that self-regulatory organizations should be 
exemplars of good governance. At a minimum, SRO's should demand of 
themselves the same high standards of governance that the New York 
Stock Exchange and Nasdaq proposed for their listed issuers in the wake 
of several widely publicized corporate scandals. To further that goal, 
this past March I directed each self-regulatory organization to 
undertake a review of its own governance practices.
    Since then, disclosure of the pay package awarded to the former 
Chairman of the New York Stock Exchange has heightened the scrutiny 
that the Commission, the securities industry, the investing public, and 
the media are paying to exchange governance standards that reflect the 
highest commitment to independent and transparent decisionmaking. Prior 
to the current controversy, the NYSE and a few other self-regulatory 
organizations instituted special governance committees to further study 
how their structures and processes might be improved. I applaud these 
efforts but I believe that more remains to be done. I have assurances 
that the NYSE's new interim Chairman, John Reed, will reexamine these 
governance issues in more depth. I look forward to working with Mr. 
Reed on this important initiative.
    Our securities markets are the strongest in the world. They have 
earned this position not only because they have the largest issuers, 
the greatest depth and liquidity, the most capital, and efficient 
execution systems--but they also have a high degree of investor 
confidence. I intend to assure that investors can have a strong sense 
of trust and confidence in our exchanges. To this end, the Commission 
and its staff will be working diligently with the SRO's to craft a 
regulatory environment that sets a high bar for sound and rigorous 
governance practices.
Global Settlement
    Finally, the Committee requested an update, since my testimony on 
May 7, on the status of the research analyst global settlement, the 
SEC's portion of which was filed with a Federal court on April 28, 
2003. As described in the Commission's May 7 testimony, the global 
settlement would impose significant monetary relief, require the firms 
to make structural reforms to their research and investment banking 
operations, require the firms to provide customers with independent 
third-party research, and establish an investor education fund.
    Since the filing of the proposed settlement agreement with the 
Federal court, U.S. District Court Judge William H. Pauley, III has 
issued a series of orders requesting that the parties--both the 
Commission and the participating firms--submit additional information 
to the Court relating to the terms of the settlement. Those orders, 
dated June 2 and July 3, address a range of issues. Among the issues 
addressed were:

 the implications for the proposed Federal settlement should 
    any State determine not to settle with a firm, and whether there is 
    a timeframe in which each state must act on the proposed State 
    settlements;
 the allocation of the settlement payments between disgorgement 
    and penalties, and whether any firms intend to seek Federal tax 
    deductions or third-party indemnification for settlement payments;
 the operations of the Distribution and Investor Education 
    Funds, such as the identity of potentially relevant securities and 
    time periods, the number of shares of each potentially relevant 
    security purchased by each firms' customers, the total dollar 
    volume of such purchases, and whether the Investor Education Fund 
    should have audit procedures.

    The Commission and the firms filed responses to the Court's orders, 
and the proposed global settlement remains pending before the Court. 
Nevertheless, the Commission staff believes that, in anticipation of 
the Court's approval of the settlement, firms are moving forward with 
preparations to implement the settlement requirements. Moreover, the 
staff of the Commission will respond to any future inquiries from the 
Court, and will work to have the global settlement implemented as soon 
as possible.
Conclusion
    Thank you again for inviting me to speak on behalf of the 
Commission and the investing public. We, at the Commission, take our 
responsibility of protecting our Nation's investors very seriously. I 
welcome the opportunity to share our current initiatives with you, and 
I would be pleased to answer any questions that you may have.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 
                   FROM WILLIAM H. DONALDSON

Q.1. Some witnesses in testimony to the Banking Committee have 
recommended that public companies boards of directors have a 
majority of independent directors and that their nomination and 
compensation committees be composed totally of independent 
directors. The New York Stock Exchange and the National 
Association of Securities Dealers have proposed corporate 
governance reforms that would require listed companies to have 
a majority of independent directors on their boards of 
directors and to have all independent directors on their 
nomination and compensation committees, subject to an exception 
for controlled companies in which a group has voting control. 
The exception would apply both where a group owns a majority of 
the equity, and where a group owns a minority of the equity 
position. The Federal securities laws require the Commission to 
approve only rules of an SRO that it finds are not designed to 
permit unfair discrimination between issuers. What is the 
rationale for requiring some issuers to establish minimum 
independence qualifications for directors, but not others?

A.1. In the NYSE and Nasdaq proposals, a ``controlled 
company''--defined as a company of which more than 50 percent 
of the voting power is held by an individual, a group, or 
another company--was excepted from the requirement of having a 
majority of independent directors on its board and having 
nominations and compensation determined exclusively by 
independent directors.
    The rationale for this exception is that majority 
shareholders, including parent companies, have a right to 
select directors and control certain key decisions by virtue of 
their ownership rights. Any company in which such a majority 
prevailed would be entitled to this exception.
    In addition, the NYSE stated in its summary of comments on 
the recommendations of its committee that developed its 
corporate governance proposals that more than half of 
commenting companies noted that the majority independent board 
requirement would create insuperable difficulties for companies 
controlled by a shareholder or parent company.
    It is also important to note that through the associated 
disclosure requirements of these proposals, the company would 
be required to put investors on notice that it is using the 
controlled company exception. In addition, a controlled company 
would not be exempt from--and would still need to comply with--
all the audit committee requirements mandated by the Sarbanes-
Oxley Act, including the requirement to have an audit committee 
comprised solely of independent directors.

Q.2. An article in the September 23, 2003, The New York Times 
entitled ``Worry Over a New Conflict for Accounting Firms,'' 
indicates that auditors are citing language in the Commission's 
releases implementing Section 404 of the Sarbanes-Oxley Act to 
justify providing services in connection with the internal 
controls of public company clients, despite the fact that such 
advice may place auditors in the position of auditing their own 
work, in light of the auditor attestation called for by Section 
404. The same point was made in the testimony before the 
Committee on September 23 by Edward Nusbaum, the CEO of Grant 
Thornton.

    The Commission's release on internal controls indicates 
that:
    Because the auditor is required to attest to management's 
assessment of internal control over financial reporting, 
management and the company's independent auditors will need to 
coordinate their processes of documenting and testing the 
internal controls over financial reporting. Nos. 33-8238; 34-
47986; IC-26068, Part II.B.3.b (Auditor Independence).
    The Commission's auditor independence release states that

    ``[an] accountant would not be precluded [by the 
prohibition on `[d]esigning, implementing, or operating systems 
affecting the financial statements]'' from making 
recommendations on internal control matters to management or 
other service providers in conjunction with the design and 
installation of a system by another service provider. Release 
No. 33-8183; 34-47265; 35-27642; IC-25915; IA-2103, FR-68, Part 
II.B.2 (Financial Systems Design)[Emphasis supplied.]

    How do you respond to the criticism that the Commission's 
rules can allow an auditor to attest to its own work insofar as 
internal control systems are concerned? What is the line 
between an auditors' ``assisting in documenting internal 
controls'' and its ``designing and installing'' such a system? 
Is the Commission considering clarifying the distinction 
between the two activities, or engaging in fact finding about 
the services accounting firms are offering to their audit 
clients in connection with the new internal controls rules?

A.2. The Commission's rules prohibit an auditor from auditing 
his/her own work, acting as a member of management and, more 
specifically, performing the internal audit function, through 
an outsourcing arrangement, for an audit client that files 
financial statements with the Commission. The auditor of a 
public company's financial statements, therefore, shouldn't 
design or implement that company's internal controls over the 
financial reporting process.
    During an audit of a company's financial statements, 
however, an auditor must obtain an understanding of the 
company's internal control system. Investors benefit if the 
auditor informs management of any deficiencies in the controls 
that are noted during the audit and is able to recommend 
improvements in those controls. In fact, auditing standards 
require that such communications occur. Management, however, 
must decide whether or how to implement those recommendations.
    As noted in the question above, Section 404 of the 
Sarbanes-Oxley Act requires that managements now assess and 
report on the effectiveness of the company's internal controls 
and that the auditor report on management's assessment. In 
preparing for the initial operation of Section 404, managements 
of many companies have asked the auditors of their financial 
statements to assist company employees by, among other things, 
providing templates to be used in documenting controls and 
finding areas where management might want to improve the 
controls. Auditors generally may provide these types of 
assistance provided management makes all decisions regarding 
the design, implementation, and operation of the company's 
internal controls. For example, an auditor's independence would 
be impaired if the auditor decided what tests management should 
perform on the internal controls, chose the samples or even the 
size of the samples of transactions to be tested, or provided 
management with software that directed a conclusion about the 
effectiveness of the company's internal controls.
    The SEC staff has discussed this issue with several 
accounting firms and has cautioned those firms against assuming 
a management role or taking any action that would lead to the 
auditor having a vested interest in the design, selection, or 
operation of the 
internal control system.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BAYH AND 
            SENATOR MILLER FROM WILLIAM H. DONALDSON

Q.1. As you may know, I have been following the Nasdaq exchange 
registration application with interest for several years. At 
our September 30 hearing you stated that Nasdaq does not 
qualify for exchange registration because it does not provide 
opportunities for order interaction and price improvement. This 
statement surprised me. As I understand it, in 1998, the 
Commission stated that ``Nasdaq performs what today is 
generally understood to be the functions commonly performed by 
a stock exchange,'' and that ``Nasdaq's use of established, 
nondiscretionary methods bring it within the revised 
interpretation of `exchange' in Rule 3b-1.'' \1\ Please provide 
me with the analysis that now leads you to conclude that Nasdaq 
does not qualify as an exchange and why diversion from your 
predecessors' conclusion is warranted.
---------------------------------------------------------------------------
    \1\ Securities Exchange Act Release No. 40760 (December 8, 1998), 
63 FR 70844, 70852 (December 12, 1998). See also, Securities Exchange 
Act Release No. 44201 (April 18, 2001) at note 22 (The Commission has 
found that Nasdaq falls within the definition of ``exchange'' under 
Section 3(a)(1) of the Act.).

A.1. Prior to the adoption of Regulation ATS in December 1998, 
the Commission had defined the term ``exchange'' somewhat 
narrowly as a system that utilized the capital of specialists 
in a marketplace ``generally understood'' to be an exchange. 
Through Regulation ATS, the Commission established a framework 
that would allow an alternative trading system (ATS) to choose 
whether to be a market participant and register as a broker-
dealer, or to be a separate market and register as a ``national 
securities exchange.'' The primary goal of the new regulation 
was to integrate ATS's into the National Market System (NMS). 
The Commission's objective of incorporating ATS's into the NMS 
was accomplished through an expansion of the definition of 
exchange found in Securities Exchange Act Rule 3b-16. The 
expanded definition covered most ATS's, but exempted ATS's from 
national securities exchange registration if they chose to 
register pursuant to Regulation ATS.
    As you accurately note, the expanded definition of exchange 
required the Commission to address the definition's 
applicability to Nasdaq, a subsidiary of the only registered 
``national securities association.'' Specifically, the 
Commission stated in the Regulation ATS adopting release that 
Nasdaq did, in fact, fit within the new expanded definition of 
exchange and that it could apply for registration as a national 
securities exchange. Moreover, the release stated that the 
requirements for registration as a national securities 
association were ``virtually identical'' to those of a national 
securities exchange. Notwithstanding the adopting release 
language, the Commission has always been wary of the critical 
distinction between the operation of national securities 
exchanges and the Nasdaq interdealer market. Specifically, 
Nasdaq does not offer intramarket price priority, while 
national securities exchanges require a degree of order 
interaction and potential price improvement beyond what is 
available at the national best bid and offer (NBBO).
    Thus, the Commission is currently reflecting upon 
intramarket price priority in the context of Nasdaq's pending 
application to 
become a national securities exchange. The Commission is 
particularly concerned that, if Nasdaq is permitted to operate 
as a national securities exchange without intramarket price 
priority, other national securities exchanges will surely 
follow. This raises the question of how important is 
intramarket price priority and is it in investors' interests 
for it to no longer be offered by national securities 
exchanges. Clearly, these are key market structure issues that 
have implications well beyond whether Nasdaq's registration 
application is granted.

Q.2. You also stated concern about public ownership of an 
exchange and what kinds of protections can be built into such a 
structure. I understand that at the request of the Commission, 
Nasdaq prohibits any one shareholder from voting more than 5 
percent of the shares outstanding, regardless of the percentage 
of shares owned by a shareholder. In addition, the SEC reviews 
and approves all changes to Nasdaq's articles of incorporation 
and by-laws, which would give the SEC the ability to review any 
changes to Nasdaq's corporate structure. Aren't a number of 
exchanges around the world (including the Chicago Mercantile 
Exchange) publicly owned public companies? I am not aware of 
any problems from this structure, is the SEC? As I understand 
it, the key value of public ownership is transparency and 
accountability since public companies are subject to all the 
disclosure rules and things are not secret and clubby. They 
must file quarterly disclosure reports, detailed information on 
executive compensation and their business, and audited 
financials so all the world, including SEC can monitor what 
they are doing.

A.2. You are correct that there has been a recent global trend 
toward the demutualization of financial exchanges. The Chicago 
Mercantile Exchange completed its demutualization and became 
the first publicly traded U.S. financial exchange in December 
2002, when its shares began trading on the New York Stock 
Exchange, Inc. (NYSE). In addition, the National Association of 
Securities Dealers, Inc. (NASD) is in the process of 
demutualizing the Nasdaq Stock Market, Inc. (Nasdaq) and has 
applied to register it as a national securities exchange. The 
NYSE announced its desire to demutualize in 1999, but has not 
made significant progress in that regard to date. A number of 
overseas exchanges have also moved toward demutualization, 
including the Stockholm Stock Exchange, the Amsterdam Stock 
Exchange, the London Stock Exchange, and the Deutsche Bourse.
    You are also correct that the periodic reporting 
requirements, imposed upon public companies, benefit investors 
in a number of ways, including by making public companies' 
financial conditions and corporate governance practices 
transparent. Moreover, Nasdaq has argued that it should be 
permitted to offer its shares to the public in order to compete 
effectively. Specifically, Nasdaq has asserted that going 
public would unlock its inherent value and provide it with 
capital for use in competing with the nimble electronic 
communications networks (ECN's). Nasdaq believes that 
demutualization and registration as a national securities 
exchange will help it compete by streamlining its corporate 
decisionmaking.
    While benefits may be gained from the demutualization of 
financial exchanges and from the public trading of exchange 
shares, these issues raise potential problems. For instance, a 
commercial self-regulatory organization (SRO), engaged in 
developing its business and competing with other SRO's, may not 
be able to police its members effectively. Some argue that 
inherent conflicts of interest exist in the demutualized 
exchange environment between the SRO's goal of serving profit-
driven shareholders and the SRO's obligation to act as a front 
line enforcer of the Federal securities laws. These conflicts 
could present themselves in a variety of ways, including 
discrimination through the imposition of disciplinary sanctions 
on members, unfairness in what services are offered to 
different types of members, and discriminatory fee setting. 
Moreover, profit-driven SRO's may be tempted to maximize 
shareholder profit, by making overly aggressive reductions in 
self-regulatory spending. In addition, a market, like Nasdaq, 
could be confronted with the difficult decision of either 
submitting to the listing standards of another market, like the 
NYSE, or listing shares on its own market. If Nasdaq selected 
the latter option, it would find itself in the tenuous position 
of being regulated by its own listing standards regulatory 
staff. Thus, the Commission is in the process of considering 
whether the traditional nonprofit SRO model is still effective, 
but is wary of the potential problems that can result from 
permitting exchanges to go forward as for-profit entities.

Q.3. You also stated that Nasdaq had ``backed into'' its status 
as a for-profit company. Is it not true that the Commission was 
involved and engaged in every step of that process and the 
plans were approved by the Commission? What did you mean by 
``backed into?''

A.3. During my testimony before the Subcommittee, I indicated 
that Nasdaq had ``backed into'' its current status as a for-
profit entity. Your inquiry as to how I could characterize 
Nasdaq's actions as such when the Commission has overseen the 
actions taken by Nasdaq is well taken. By way of background, 
the NASD was completely reorganized in 1996 in the aftermath of 
a Department of Justice and Commission investigation into 
anticompetitive practices by OTC market makers. This 
reorganization resulted in the creation of a parent holding 
company and two operating subsidiaries--Nasdaq and NASD 
Regulation, Inc. Encouraged, in part, by the lofty market 
valuations of public companies in the late 1990's and the 
global trend of demutualization, NASD explored the possibility 
of demutualizing Nasdaq, registering it as a national 
securities exchange, and raising capital for Nasdaq through a 
public 
offering.
    In that regard, on April 14, 2000 the membership of the 
NASD voted overwhelmingly to turn Nasdaq into a for-profit 
company and alter its ownership structure. This ongoing 
transformation is being accomplished in two stages. In the 
first stage, up to 49 percent of Nasdaq's common stock was 
offered in a private placement to NASD members, Nasdaq issuers, 
institutional investors, and strategic partners. After a 
further sale of Nasdaq stock in the second phase and the 
triggering of certain warrants, NASD will own a minority stake 
of Nasdaq, but will retain significant voting rights held in a 
voting trust until such time as Nasdaq is registered as a 
national securities exchange. NASD has stated that the purpose 
of the demutualization of Nasdaq is to permit the NASD to focus 
more intently on its primary task of member regulation, to 
streamline Nasdaq's corporate decisionmaking process, and to 
unlock Nasdaq's inherent value through a public offering.
    As recent events have indicated, potential conflicts of 
interest may arise when there are insufficient barriers between 
regulatory staff and commercial pressures. While the Commission 
generally has supported the NASD's efforts to insulate its 
operations from commercial pressures by demutualizing Nasdaq, 
there are, as outlined above, very serious issues raised by 
Nasdaq being a publicly traded national securities exchange.

Q.4. Mr. Chairman, the Commission held public hearings on 
market structure issues earlier this year and part of last 
year, I think. What is going to be the outcome of those public 
hearings and what is the time frame for it?

A.4. As you correctly note, the Commission held public hearings 
in late 2002 to address a wide variety of complex market 
structure issues, including the quoting and trading in subpenny 
increments, the fair and efficient access among different types 
of market centers, the appropriateness and level of access 
charges between market participants, the protection of prices 
across different types of markets and its relationship with 
best execution, the sale and distribution of revenue generated 
by market data, and the criteria for registration as a national 
securities exchange. The overriding theme derived from the 
hearings was that the principle of a centralized National 
Market System, as set forth in Section 11A of the Securities 
Exchange Act of 1934, remains valid today and is worth 
preserving with some modernization. Having considered industry 
views, the Commission is now in a position to take action. In 
that regard, we are crafting Commission proposals for 
rulemaking that will be published for public comment in the 
Federal Register. We anticipate that proposals on access to 
markets (including access fees and the trade through rule) and 
market data will be published in early 2004. Thereafter, we 
would expect to issue proposals addressing other market 
structure issues, including those relating to the self-
regulatory system and the criteria for registration as a 
national securities exchange.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR ALLARD 
                   FROM WILLIAM H. DONALDSON

Q.1. The Investment Company Act gives the SEC explicit 
authority to sue investment company management for charging 
excessive fees and imposing a fiduciary obligation on the 
adviser with relation to receiving these fees. How many times 
has the SEC used this statutory authority?

A.1. Section 36(b) of the Investment Company Act of 1940 
(Investment Company Act) authorizes the Commission to institute 

enforcement actions against investment advisers for charging 
investment companies excessive fees. Section 36(b) imposes on 
an investment adviser to an investment company a fiduciary duty 
with respect to the receipt of compensation for services, or of 
payments of a material nature, paid by the investment company 
or its shareholders to the adviser or its affiliated persons. 
The Commission and investment company shareholders may 
institute an action in Federal district court against the 
investment company's investment 
adviser and its affiliated persons ``for breach of fiduciary 
duty in respect of such compensation or payments'' paid by the 
investment company or its shareholders.\1\ Congress adopted 
Section 36(b) in 1970 in response to concerns that investment 
company advisory fees were not subject to the normal 
competitive pressures prevalent in other areas of commerce 
because investment companies typically are organized and 
operated by their investment advisers.\2\
---------------------------------------------------------------------------
    \1\ Section 36(b) of the Investment Company Act. An investment 
adviser's duty under Section 36(b) relates to all of the compensation 
that the adviser and its affiliated persons receive from the investment 
company, including any distribution payments such as Rule 12b-1 fees.
    \2\ See SEC, Report on the Public Policy Implications of Investment 
Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. 10-12, 126-27, 
130-32 (1966). Section 36(b) was adopted in response to Congress's 
recognition that the Investment Company Act, as originally enacted, 
``did not provide any mechanism by which the fairness of management 
contracts could be tested in court.'' Investment Company Amendments Act 
of 1970, S. Rep. No. 91-184, 91th Cong., 1st Sess. 5 (1969).
---------------------------------------------------------------------------
    The Commission has instituted two enforcement actions under 
Section 36(b) against investment advisers, among others, for 
breach of their fiduciary duties with respect to the receipt of 
compensation. In SEC v. American Birthright Trust Management 
Co., the Commission alleged that the compensation paid by an 
investment company to its investment adviser for advisory and 
related services was excessive in light of the services 
actually performed by the investment adviser, and that most of 
the advisory services provided to the investment company were 
actually provided by a subadviser retained by the adviser.\3\ 
In addition, in SEC v. The Fundpack, Inc., the Commission 
alleged that an investment adviser and its affiliates breached 
their fiduciary duty under Section 36(b) by operating 
investment companies in a manner designed to generate 
benefits for themselves at the direct expense of the investment 
companies and their shareholders.\4\
---------------------------------------------------------------------------
    \3\ See SEC v. American Birthright Trust Management Co., Lit. Rel. 
No. 9266 (December 30, 1980).
    \4\ See SEC v. The Fundpack, Inc., et al., Lit. Rel. No. 8698 
(March 22, 1979).
---------------------------------------------------------------------------
    Investment company shareholders have instituted numerous 
actions under Section 36(b). The seminal case under Section 
36(b) is Gartenberg v. Merrill Lynch Asset Management, Inc.,\5\ 
in which the court interpreted Section 36(b) as involving an 
evaluation of whether the compensation that is paid to an 
investment adviser is ``so disproportionately large that it 
bears no reasonable relationship to the services rendered and 
could not have been the product of arm's length bargaining.'' 
\6\ The court identified several factors (commonly referred to 
as the ``Gartenberg factors'') that should be evaluated when 
determining whether a breach of fiduciary duty has occurred.\7\ 
Courts generally have evaluated subsequent Section 36(b) 
actions using the Gartenberg factors.
---------------------------------------------------------------------------
    \5\ 694 F.2d 923 (2d Cir. 1982).
    \6\ Id. at 928.
    \7\ These factors generally include: (1) the nature and quality of 
all of the services provided by the investment adviser (either directly 
or through affiliates), including the performance of the investment 
company; (2) the investment adviser's cost in providing the services 
and the profitability of the investment company to the adviser; (3) the 
extent to which the investment adviser realizes economies of scale as 
the fund grows larger; (4) the ``fall-out'' benefits that accrue to the 
investment adviser and its affiliates as a result of the adviser's 
relationship with the investment company (for example, soft dollar 
benefits); (5) the performance and expenses of comparable investment 
companies; (6) the expertise of the independent directors, whether they 
are fully informed about all facts bearing on the investment adviser's 
service and fee, and the extent of care and conscientiousness with 
which they perform their duties; and (7) where relevant, the volume of 
transaction orders that must be processed by the investment adviser.
---------------------------------------------------------------------------
    To date, investment company shareholders have had mixed 
success in litigating Section 36(b) actions. In certain Section 
36(b) cases, the investment advisers to investment companies 
have chosen to settle the litigation, and some of these 
settlements have 
resulted in lower investment company advisory fees. In the 
remainder of the cases, however, the investment advisers have 
prevailed. The Commission staff monitors these actions.
    The Commission's staff continues to evaluate potential 
actions under Section 36(b) according to the standards set 
forth in Gartenberg. The staff typically examines the minutes 
of investment company board of directors' meetings to determine 
what factors the board considered in evaluating the company's 
advisory fees. In addition to examining board minutes, the 
staff also considers any other information relied upon by 
directors in assessing the investment company's advisory 
fees.\8\
---------------------------------------------------------------------------
    \8\ Under Section 15(c) of the Investment Company Act, it is the 
duty of directors of a registered investment company to request and 
evaluate, and the duty of an investment adviser to such company to 
furnish, any information that may reasonably be necessary for the 
directors to evaluate the terms of any investment advisory contract 
with the investment company.
---------------------------------------------------------------------------

       RESPONSE TO A WRITTEN QUESTION OF SENATOR CHAFEE 
                   FROM WILLIAM H. DONALDSON

Q.1. While the Sarbanes-Oxley Act and other Federal laws make 
it clear that electronic data and other information must be 
preserved at the initiation of a formal investigation, it is 
not clear what steps a company should take to preserve and 
protect electronic data when it becomes aware of an informal 
SEC investigation or inquiry.
    Electronic data, including e-mail, is often routinely 
deleted in order to manage the large volume of information 
generated in the normal course of business. As a result, there 
is the potential that critical evidence is being routinely 
deleted between the time a company becomes aware of an informal 
investigation and the notification of a formal investigation.
    Are you concerned that such data loss is having a negative 
impact on the SEC's ability to enforce the Sarbanes-Oxley Act? 
If so, should the Commission study the issue to determine 
whether its enforcement function would be improved by 
developing specific guidelines regarding what electronic data 
must be preserved when a company becomes aware that it is the 
subject of an informal investigation?

A.1. E-mail and other electronic records are important to SEC 
investigations of potential wrongdoing by securities firms, 
public companies, accounting firms, individuals, and others. 
The Sarbanes-Oxley Act and other laws and rules impose record 
retention and preservation requirements on certain entities or 
persons in various circumstances. Indeed, some of these 
requirements are applicable even prior to the initiation of a 
formal Commission investigation.
    In the case of broker-dealers, for instance, Rule 17a-
4(b)(4) under the Securities Exchange Act of 1934 requires that 
broker-dealers retain, among other records, ``originals of all 
communications received and copies of all communications sent 
(and any 
approvals thereof) by the member, broker, or dealer (including 
interoffice memoranda and communications) relating to [their] 
business as such . . . .'' The Commission interprets this rule 
as covering electronic records, including e-mail. The required 
retention period is ``not less than 3 years,'' and the 
obligation to preserve records applies whether or not the 
Commission is conducting an investigation of the broker-dealer 
or its employees. Violations of this rule have resulted in 
enforcement action. For example, in December 2002, the SEC, New 
York Stock Exchange, and NASD filed joint actions against five 
broker-dealers for violations of recordkeeping requirements 
concerning e-mail communications. The firms consented to the 
imposition of fines totaling $8.25 million, along with a 
requirement to review their procedures to ensure compliance 
with recordkeeping statutes and rules. The firms--Deutsche Bank 
Securities Inc., Goldman, Sachs & Co., Morgan Stanley & Co. 
Incorporated, Salomon Smith Barney Inc., and U.S. Bancorp Piper 
Jaffray Inc.--agreed to be censured and to pay fines of $1.65 
million per firm to the U.S. Treasury, NYSE, and NASD. Section 
802 of the Sarbanes-Oxley Act imposes a similar requirement on 
public company auditors to routinely retain audit or review 
workpapers. The Commission's rules promulgated pursuant to 
Section 802 specify that accounting firms must retain for 7 
years certain records relevant to their audits and reviews of 
issuers' financial statements. The records to be retained 
include an accounting firm's workpapers and certain other 
documents that contain conclusions, opinions, analyses, or 
financial data related to the audit or review. Compliance is 
required for audits and reviews completed on or after October 
31, 2003. This preservation requirement applies whether or not 
the Commission is conducting an investigation.
    Section 802 of the Sarbanes-Oxley Act also includes a 
provision addressing the handling of records in Federal 
investigations and bankruptcy. Specifically, the provision 
makes it a felony for a person to destroy or create evidence 
with the intent to obstruct an investigation or matter that is 
within the jurisdiction of any Federal agency.\1\ In one of the 
first uses of Section 802, on September 25, 2003, the U.S. 
Attorney's Office for the Northern District of California, the 
Federal Bureau of Investigation, and the SEC jointly announced 
that a former Ernst & Young partner who allegedly altered and 
destroyed audit working papers, was arrested on criminal 
charges for obstructing investigations by both the Office of 
the Comptroller of the Currency and the SEC. Also in connection 
with the document destruction, a former Ernst & Young senior 
manager pled guilty to one count of obstructing the examination 
of a financial institution. The SEC instituted administrative 
proceedings in which the Division of Enforcement alleged that 
the partner and a former audit manager engaged in unethical and 
improper professional conduct in violation of SEC Rule of 
Practice 102(e) as a result of their alteration and destruction 
of documents. The SEC also instituted a settled administrative 
proceeding against the former senior manager for his role in 
the document destruction.\2\
---------------------------------------------------------------------------
    \1\ The Sarbanes-Oxley Act also includes a provision making it a 
felony punishable by a fine and up to 20 years in prison to corruptly 
alter, destroy, mutilate, or conceal a record or document, or attempt 
to do so, with the intent to impair the object's availability for use 
in an official proceeding. Sarbanes-Oxley Act, Section 1102, codified 
at 18 U.S.C. 1512(c).
    \2\ A recent Commission action against the accounting firm 
PricewaterhouseCoopers provides another example involving document 
alteration and destruction prior to the commencement of a formal SEC 
investigation. In that proceeding, the Commission concluded that it was 
appropriate to sanction the firm for an audit failure caused by the 
firm's audit partner because prior to the commencement of the SEC's 
investigation the firm made undocumented changes to its audit working 
papers and discarded other documents relevant to its audit. 
Accordingly, the Commission charged the firm with engaging in improper 
professional conduct in violation of Commission Rule of Practice 
102(e).
---------------------------------------------------------------------------
    The language of Section 802 also covers acts of destruction 
either in contemplation of or in relation to matters within the 
jurisdiction of a Federal agency. The author of this provision, 
Senator Patrick Leahy, stated:

    This statute is specifically meant not to include any 
technical requirement, which some courts have read into other 
obstruction of justice statutes, to tie the obstructive conduct 
to a pending or imminent proceeding or matter by intent or 
otherwise. It is also sufficient that the act is done ``in 
contemplation'' of or in relation to a matter or investigation. 
It is also meant to do away with the distinction, which some 
courts have read into obstruction statutes, between court 
proceedings, investigations, regulatory or administrative 
proceedings (whether formal or not), and less formal government 
inquiries, regardless of their title. Destroying or falsifying 
documents to obstruct any of these types of matters or 
investigations, which in fact are proved to be within the 
jurisdiction of any Federal agency are covered by the statute. 
[emphasis added]

    A recent ruling in a criminal case, U.S. v. Kim, is 
illustrative of the concerns expressed by Senator Leahy about 
other obstruction statutes. Kim was charged with making a false 
statement to the SEC staff that were investigating possible 
insider trading by Kim. The false statement was made on 
September 12, 1999 while the staff had open a preliminary 
inquiry. On September 23, 11 days after Kim made his statement 
to the staff, the staff closed the preliminary inquiry and 
opened a formal investigation. A jury subsequently convicted 
Kim of making a false statement to the staff in violation of 18 
U.S.C. Sec. 1001.\3\
---------------------------------------------------------------------------
    \3\ This section makes it a felony to knowingly and willfully make 
a false statement in matters within the jurisdiction of the executive, 
legislative, or judicial branch of the Government of the United States.
---------------------------------------------------------------------------
    At sentencing in January 2003, the district court applied 
the sentencing guideline applicable to fraud and violations of 
18 U.S.C. Sec. 1001. The U.S. Attorney had requested a harsher 
sentencing guideline applicable to violations involving 
obstruction of justice under 18 U.S.C. Sec. 1505. Section 1505 
prohibits anyone from corruptly ``endeavor[ing] to influence, 
obstruct, or impede the due and proper administration of the 
law under which any pending proceeding is being had before any 
department or agency of the United States.'' In order to apply 
the requested guideline, the district court determined that it 
would have to find that the conduct set forth in Kim's 
conviction satisfied the requirements of Sec. 1505.
    In declining to apply the requested harsher guideline, the 
district court held that ``no `proceeding' [within the meaning 
of the term in Sec. 1505] was pending at the time of the 
interview.'' Reasoning that Congress ``understood there to be a 
point at which Section 1505 took effect--and by extension, a 
prior period during which Section 1505 did not apply,'' the 
court was unable to conclude that the Section . . . plainly and 
unmistakably proscribe[s]' false statements made to Federal 
agents prior to the commencement of formal agency 
proceedings.'' [emphasis in original] [citation omitted]. The 
court relied on the fact that Kim's false statement was made 
prior to the Commission's authorization of a formal 
investigation and that no request for formal investigative 
authority was pending. The court concluded that prior to the 
authorization of a formal investigation, ``the activities of 
SEC investigators are more in the nature of an `informal 
inquiry.' '' With the Commission's strong support, the 
Department of Justice has appealed this ruling to the Court of 
Appeals for the Ninth Circuit, arguing that several appellate 
courts have held that Federal regulatory agency investigations 
are ``proceedings'' for purposes of the Federal obstruction 
statutes without regard to whether such investigations are 
preliminary, formally authorized, or conducted only by agency 
staff. The appeal is pending.
    In light of the language of Section 802 of Sarbanes-Oxley, 
as well as its legislative history, it would appear that under 
that provision, when an entity or person is aware of even an 
informal Commission inquiry, the destruction or alteration of 
documents prior to the initiation of a formal Commission 
investigation, would be a violation of law. Notwithstanding the 
Kim ruling, even prior to enactment of the Sarbanes-Oxley Act, 
there were circumstances in which the destruction or alteration 
of documents before the commencement of a formal Commission 
investigation was found to be improper and/or to constitute 
obstruction of justice.\4\ Under pre-existing law, if entities 
or persons were aware of a likelihood that the Commission staff 
would investigate their conduct, it would have been improper 
for them to destroy relevant records. Such a circumstance could 
arise, for example, if an entity was aware of an SEC informal 
inquiry relating to its conduct, if during an informal inquiry 
the Commission staff instructed the entity or person to 
preserve relevant records, if an entity voluntarily self-
reported violative conduct to the Commission staff, or if 
professional standards imposed an independent requirement that 
documents be retained.
---------------------------------------------------------------------------
    \4\ Cf., U.S. v. Cisneros, 26 F.Supp.2d 24, 39 (D.D.C. 1998) 
(stating with respect to 18 U.S.C. 1505, which prohibits obstruction of 
proceedings before departments, agencies, and committees, that ``it is 
established that the statute protects preliminary and informal 
inquiries against obstruction as well as formal proceedings.'') 
[citation omitted]; ``It is established . . . that the statute protects 
preliminary and informal inquiries against obstruction as well as 
formal proceedings.'' United States v. Poindexter, 725 F.Supp. 13, 22 
(D.D.C. 1989) [citations omitted]; ``Congress clearly intended to 
punish obstruction of the administrative process . . . in any 
proceeding before a governmental agency--at any stage of the 
proceeding.'' Rice v. United States, 356 F.2d 709, 712 (8th Cir. 1966).
---------------------------------------------------------------------------
    Indeed, the Department of Justice's obstruction of justice 
case against accounting firm Arthur Andersen, LLP was based on 
Andersen's destruction of documents relating to its audits of 
Enron after the firm learned that the SEC had begun an inquiry 
into Enron. The document destruction described in the Andersen 
indictment occurred after the SEC had begun an informal inquiry 
of Enron, but prior to the commencement of its formal 
investigation. Nevertheless, Andersen was convicted of 
obstruction in violation of 18 U.S.C. 1512(b)(2).\5\
---------------------------------------------------------------------------
    \5\ This statute, which predates Sarbanes-Oxley, provides in 
relevant part that: Whoever knowingly uses intimidation, threatens, or 
corruptly persuades another person, or attempts to do so, or engages in 
misleading conduct toward another person, with intent to cause or 
induce any person to (A) withhold testimony, or withhold a record, 
document, or other object, from an official proceeding; (B) alter, 
destroy, mutilate, or conceal an object with intent to impair the 
object's integrity or availability for use in an official proceeding; 
(C) evade legal process summoning that person to appear as a witness, 
or to produce a record, document, or other object, in an official 
proceeding; or (D) be absent from an official proceeding to which such 
person has been summoned by legal process shall befined under this 
title or imprisoned not more than 10 years, or both.
---------------------------------------------------------------------------
    The Division of Enforcement does not believe that the 
unavailability of records disposed of prior to the initiation 
of formal investigations has substantially undermined the 
Commission's overall enforcement efforts. Nevertheless, the 
loss of any potentially relevant documents is a serious matter. 
The best way to address such conduct is through serious 
sanctions that serve a deterrent function. Accordingly, the 
Division of Enforcement intends to continue to vigorously 
enforce existing document preservation and retention rules, and 
work closely with the criminal authorities when it appears that 
parties take steps to obstruct SEC investigations by destroying 
or altering records.

        RESPONSE TO A WRITTEN QUESTION OF SENATOR BAYH 
                   FROM WILLIAM H. DONALDSON

Q.1. With all of the recent conflict of interest scandals on 
Wall Street, little has been said about the practice of 
internalization which involves brokerage firms trading against 
their own customers' orders because they view them as 
profitable trading opportunities. We understand that this 
growing controversial practice in the listed options markets 
may soon be systematized and taken to a new level if the SEC 
approves a pending proposal from the Boston Stock Exchange 
called ``BOX.'' If the SEC is concerned about conflicts and has 
publicly called for greater study of the adverse effects of 
internalization, why would the SEC approve any aspects of the 
proposal that furthers internalization?

A.1. Internalization in the options market is not new. Each of 
the five options exchanges permits firms to internalize a 
portion of their customers' orders. The Boston Stock Exchange's 
proposed new options facility--BOX--would also permit members 
to internalize customer order flow.
    BOX's trading rules were published for comment in January 
and the comments we received raise a number of concerns. BOX 
proposed to address many of these concerns in amendments 
published recently. Commission staff is now analyzing the 
comment letters received on these amended trading rules. The 
Commission staff is closely analyzing BOX's trading rules, 
together with the thoughtful comments received, to determine 
whether BOX would reduce price competition in the options 
market by permitting internalization to take place to a greater 
extent than it does today.
    It is very important that the Commission's review of 
significant new market innovations, such as the BOX, not impede 
the entrance of new competitors to our marketplace. At the same 
time, we are obligated to ensure that any proposal will be 
consistent with the Federal securities laws, including the 
protection of investors and the public interest.

        RESPONSE TO A WRITTEN QUESTION OF SENATOR REED 
                   FROM WILLIAM H. DONALDSON

Q.1. As you know, e-mail and other electronic records have 
become critical evidence in SEC investigations of fraudulent or 
inappropriate behavior by securities firms. Sarbanes-Oxley and 
other regulations require the preservation of these records 
when a formal 
investigation is initiated, but some critical records seem to 
be lost between the onset of an informal investigation and that 
of a formal one. What can you attribute this loss to? Are 
standard practices in the administration of corporate data 
processing systems to blame? If so, is the SEC considering any 
steps to mitigate this loss, such as developing guidelines 
identifying what data must be preserved when an informal 
investigation is initiated?

A.1. Please see the answer to the preceding question submitted 
by Senator Evan Bayh.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER 
                   FROM WILLIAM H. DONALDSON

Q.1. Mr. Donaldson, the SEC has recently come out with some 
proposals on hedge funds--that they be better regulated, that 
they register with the Investment Advisors Act of 1940, and 
that the eligibility requirements for smaller investors be 
increased.
    I do not know whether you would agree with this summary, 
but it has been pointed out to me that the thinking behind the 
1940 Act was, in short, that if you were marketing to smaller, 
less ``sophisticated'' investors you needed to register. And if 
you were marketing to wealthy, ``sophisticated'' investors it 
was expected that the investor had the wherewithal and 
experience to judge the risk himself, so no registration and 
looser standards.
    By that logic, the SEC's proposal could be seen to 
contradict the thinking behind the 1940 Act.
    Finally, I would like to get your views on whether, if 
hedge funds are performing well and attracting some of the best 
investment talent, how can we increase the average person's 
ability to invest with them. Currently we are raising the 
threshold, but if the performance is there, perhaps we can also 
consider ways to enable average investors to benefit from hedge 
fund performance.

A.1. Two questions are posed. First, you inquire as to whether 
the recommendations that the staff made in its September 29, 
2003 report to the Commission, Implications of the Growth of 
Hedge Funds,\1\ contradict the rationale behind the regulatory 
framework of the Investment Company Act of 1940 (Investment 
Company Act). Second, you seek my views on whether the 
Commission should consider making hedge fund investments 
available to a wider universe of investors.
---------------------------------------------------------------------------
    \1\ Implications of the Growth of Hedge Funds (September 2003), 
available at http://www.sec.gov/news/studies/hedgefunds0903.pdf (Hedge 
Fund Report).
---------------------------------------------------------------------------
    Hedge funds generally avoid regulation under the Investment 
Company Act by relying on one of two exclusions from the 
definition of an investment company set forth in that statute. 
Section 3(c)(1) of the Investment Company Act excludes from the 
definition of an investment company any issuer whose 
outstanding securities are beneficially owned by not more than 
100 persons and which does not presently propose to make a 
public offering of its securities (Section 3(c)(1) hedge fund). 
Section 3(c)(1) reflects Congress's view that investors in 
small, privately placed investment companies are able to access 
the type of information necessary to protect their own 
interests.\2\
---------------------------------------------------------------------------
    \2\ Although Section 3(c)(1) does not specifically require any 
level of financial sophistication for an investor to be eligible to 
invest in a Section 3(c)(1) hedge fund, many such hedge funds rely on a 
safe harbor provided under the Securities Act of 1933 (Securities Act) 
to offer and sell their securities. See Regulation D under the 
Securities Act. Under Regulation D, hedge funds may offer and sell 
their securities to accredited investors and no more than 35 
nonaccredited investors. In general, accredited investors are 
individuals who have a net worth above $1,000,000, or who have income 
above $200,000 in the last 2 years (or $300,000 with spouse) and have a 
reasonable expectation of reaching the same income level in the year of 
investment.
---------------------------------------------------------------------------
    Section 3(c)(7) of the Investment Company Act excludes from 
the definition of an investment company any issuer that does 
not propose to make a public offering and whose securities are 
owned 
exclusively by ``qualified purchasers.'' Qualified purchasers 
are generally individuals with $5 million in investments and 
others who own or invest at least $25 million in investments. 
Section 3(c)(7) reflects Congress's view that certain highly 
sophisticated investors do not need the protections of the 
Investment Company Act because those investors are in a 
position to appreciate the risks associated with pooled 
investment vehicles.\3\
---------------------------------------------------------------------------
    \3\ Section 3(c)(7) was added to the Investment Company Act in 
1997. See S. Rep. No. 293, 104th Cong., 2d Sess. 10 (1996).
---------------------------------------------------------------------------
    The staff 's Hedge Fund Report makes no recommendations 
with respect to Section 3(c)(1) or 3(c)(7), nor does it 
recommend any regulatory action under the Investment Company 
Act that would 
affect who may invest in hedge funds. In fact, the staff 's 
report essentially recommends maintaining the current 
regulatory approach that investors in hedge funds that are 
generally smaller or are owned by highly sophisticated 
investors do not require the protections of the Investment 
Company Act.
    Under the staff 's primary recommendation, hedge fund 
advisers would be required to register with the Commission 
under the 
Investment Advisers Act of 1940 (Advisers Act). Unlike the 
Investment Company Act, which imposes a comprehensive 
regulatory 
regime on investment companies, the Advisers Act is a 
disclosure-oriented regulatory scheme that requires investment 
advisers to disclose certain information, including, for 
example, information about their organizational structure, 
assets under management, nature of the services they provide, 
and how they address certain conflicts of interest. The 
Advisers Act does not regulate the sophistication of an 
investment adviser's clients.\4\
---------------------------------------------------------------------------
    \4\ The Advisers Act differentiates among advisory clients based on 
the types of fees that they are charged by prohibiting registered 
investment advisers from charging performance-based fees (for example, 
fees based on a percentage of the fund's capital gains and capital 
appreciation) to their less wealthy clients. Most hedge funds charge 
these types of fees. Under rules adopted by the Commission under 
Section 205 of the Advisers Act, an investor must have $750,000 
invested with the investment adviser or generally have a net worth of 
$1.5 million to be eligible to invest in a Section 3(c)(1) hedge fund 
that pays a performance fee. If the Commission were to require the 
registration of hedge fund advisers under the Advisers Act, this rule 
would have the effect of raising the minimum net-worth or investment 
required for investment in Section 3(c)(1) hedge funds that pay 
performance-based fees to their advisers.
---------------------------------------------------------------------------
    You also seek my views on whether the Commission should 
increase the availability of hedge funds for less sophisticated 
investors. In the Hedge Fund Report, the staff identified some 
of the differences between hedge funds and registered 
investment companies and expressed its view that such hedge 
funds have characteristics that may provide certain benefits, 
including increased diversification, to less sophisticated 
investors. The staff concluded that while it did not believe 
that these investors should invest directly in hedge funds, it 
was worth inquiring into whether there may be benefits of 
having registered investment companies engage in the types of 
strategies that are currently being utilized by hedge funds. 
The staff recommended that the Commission consider issuing a 
concept release with a view toward determining whether hedge 
fund strategies may be effectively deployed in registered 
investment companies and what types of relief might be 
necessary under the Federal securities laws to effectuate this 
goal.
    As you know, the Commission has the staff 's 
recommendations under consideration, but has not yet made any 
decisions as to which recommendations it may direct the staff 
to proceed upon. We look forward to taking up these 
recommendations for consideration in the near future.

Q.2. Mr. Donaldson, information drives the health of our 
securities markets, and I want to ask you about one of the most 
critical pieces of information--how much money a company 
actually earns.
    A recent article (Sunday, September 21, 2003) in The New 
York Times on the many different ways to measure a company's 
earnings is titled, ``Counting the Ways to Count Earnings.'' 
Perhaps the title says it all.
    Last time you testified I asked you about yet another 
differential--the differences between book and tax income--and 
I appreciated your willingness to consider that issue.
    What can or should the SEC do to clear through this 
confusion on earnings?
    In your view, do we have a risk to the long-term health of 
the securities markets if the most critical number driving 
those markets--earnings--is such a source of debate and varying 
standards?

A.2. The newspaper article cited in your question refers to 
three measures of corporate earnings based on a particular 
company's financial results. These are operating earnings, 
reported earnings, and core earnings. The article defines 
reported earnings to be earnings calculated using generally 
accepted accounting principles (GAAP). Operating and core 
earnings, as referred to in the article, add or remove items 
from reported earnings.
    Because companies may manipulate such ``pro forma'' 
earnings to create a desired result, Congress, in Section 
401(b) of the Sarbanes-Oxley Act of 2002 (Act), directed the 
Commission to write rules that would require disclosures of 
``pro forma'' earnings to be presented in a manner that (1) 
does not contain an untrue statement of a material fact, or 
omit to state a material fact necessary to make the ``pro 
forma'' financial information, in light of the circumstances 
under which it is present, not misleading, and (2) reconciles 
the disclosure with the financial condition and results of 
operations of the issuer prepared in accordance with GAAP. On 
January 22, 2003, the Commission announced, in Securities Act 
Release No. 8176, adoption of the rules required by section 
401(b).
    These new rules take a three-part approach to the 
disclosure of ``pro forma,'' or ``non-GAAP'' information. 
Consistent with Section 401(b) of the Act, these rules impose 
requirements on the disclosure of non-GAAP information, rather 
than prohibiting that disclosure.

 The first part of this approach--new Regulation G--
    imposes the requirements of Section 401(b) of the Act on 
    any public disclosure or release of material information 
    (regardless of whether that disclosure or release is filed 
    with the Commission) that contains non-GAAP financial 
    measures. The measures discussed in the cited article--
    ``operating earnings'' and ``core earnings'' are examples 
    of non-GAAP financial measures.
 The second part of the approach imposes additional 
    requirements regarding the inclusion of non-GAAP financial 
    measures in filings with the Commission. Among other 
    things, these additional requirements obligate companies to 
    disclose clearly how management uses each disclosed non-
    GAAP financial measure and why that measure is useful to 
    investors.
 The third part of the approach requires companies to 
    furnish their earnings releases to the Commission on Form 
    8-K and, in addition to complying with Regulation G, 
    disclose clearly how management uses each non-GAAP 
    financial measure included in the earnings release and why 
    that measure is useful to investors.

Q.3. In the development of the Sarbanes-Oxley Act, there was 
considerable debate regarding the appropriateness of funding 
accounting standard-setters through voluntary private sector 
contributions. The Act creates a system of levies on publicly 
traded companies for the Financial Accounting Standards Board 
(FASB). Currently, the FASB's international counterpart and 
partner, the International Accounting Standards Board (IASB), 
is funded largely through voluntary contributions. Do you have 
any thoughts regarding whether the FASB approach is appropriate 
for the IASB?

A.3. The Trustees for the International Accounting Standards 
Committee (IASC) Foundation, which currently raises funds for 
the IASB, are reviewing alternatives for the future funding of 
the IASB, including alternatives that could reduce reliance on 
voluntary contributions. While approaches such as the Sarbanes-
Oxley Act provisions for funding for the Financial Accounting 
Standards Board through ``support fees'' assessed on issuers of 
securities might be considered, significant differences exist 
between the IASB and FASB and the IASB situation is more 
complex. One important difference is that the goal of the IASB 
is to set global accounting standards. The standards it sets 
are or will be the mandated accounting standards for the 
European Union countries beginning in 2005 and for a number of 
other countries that have decided to adopt international 
accounting standards. It is possible that some of these 
countries might have competitive interests in the outcome of a 
specific IASB project. Care would have to be taken, therefore, 
to assure that those countries with companies or other sources 
(for example, nonvoluntary sources, if such approaches are 
adopted) providing the most funding for the IASB would not seek 
added influence with the IASB.
    In any event, we believe that the IASC Foundation Trustees 
should be allowed to complete their review and, after 
appropriate consideration of all the issues, present their 
conclusions and recommendations for public consideration.

Q.4. Your testimony states that the global settlement is still 
being reviewed by the U.S. District Court. Does the SEC intend 
to further revise its rules affecting stock analysts to impose 
additional safeguards to all securities firms?

A.4. The court gave final approval of the global settlement on 
October 31, 2003.
    The Commission is currently determining whether regulatory 
gaps still remain in the area of analyst research, and is 
considering what, if any, additional analyst rules are 
appropriate for the entire industry, including whether there 
are additional elements of the settlement that should be 
incorporated into industry-wide rules.



