[Senate Hearing 109-413]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-413

 
                  THE STATE OF THE SECURITIES INDUSTRY

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

                                HEARING

                               before the

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

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

 THE EXAMINATION OF THE STATE OF THE SECURITIES INDUSTRY, FOCUSING ON 
RECENT INITIATIVES REGARDING MARKET STRUCTURE, CREDIT RATING AGENCIES, 
MUTUAL FUNDS, AND THE IMPLEMENTATION OF THE SARBANES-OXLEY REQUIREMENTS

                               __________

                             MARCH 9, 2005

                               __________

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


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html



                                 ______

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

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

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                       Mark F. Oestrele, Counsel

                       Bryan N. Corbett, Counsel

                 Dean V. Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, MARCH 9, 2005

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2
    Senator Allard...............................................     3
    Senator Stabenow.............................................     4
    Senator Hagel................................................     5
    Senator Bennett..............................................     5
    Senator Schumer..............................................    19
    Senator Sununu...............................................    25
    Senator Enzi.................................................    29

                                WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission.....................................................     5
    Prepared statement...........................................    29
    Response to written questions of:
        Senator Sarbanes.........................................    38
        Senator Allard...........................................    40
        Senator Stabenow.........................................    48
        Senator Enzi.............................................    49
        Senator Bunning..........................................    51
        Senator Carper...........................................    62

                                 (iii)


                  THE STATE OF THE SECURITIES INDUSTRY

                              ----------                              


                        WEDNESDAY, MARCH 9, 2005

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:10 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    I would like to welcome back to the Committee, Chairman 
Donaldson of the Securities and Exchange Commission. Mr. 
Chairman, you spend a lot of time with us, but this is the 
nature of the Banking Committee and also the SEC, as you well 
know. I appreciate your willingness to spend time with us. This 
morning's hearing is an opportunity for the Committee to learn 
more about the SEC's current regulatory initiatives.
    For the past 18 months, the SEC has pursued an aggressive 
agenda of reform in the mutual fund industry. While continuing 
to bring enforcement actions against wrongdoers, the SEC has 
enacted a comprehensive set of new rules aimed at improving 
fund governance, eliminating market timing and late trading, 
and enhancing disclosures to investors. To date, the SEC has 
adopted 10 rules, and additional rules are pending regarding 
soft dollars, 
12b-1 fees and point of sale disclosures. In addition to 
completing its rulemaking, the SEC continues to examine other 
fund industry products and practices, such as the role of 
pension consultants, 529 education plans, and the sale of 
periodic mutual fund products to military servicemen and women. 
Clearly, there is more work to be done in this area, Mr. 
Chairman, and I look forward to hearing about recent 
developments and perhaps some future actions that you are 
contemplating.
    I commend the SEC for its response to the problems in the 
mutual fund industry. Through your leadership and the hard work 
of the SEC staff, I believe that investors have begun to regain 
their confidence, Mr. Chairman, in the mutual fund industry.
    A month ago, this Committee held a wide-ranging hearing on 
credit rating agencies. We examined the competitive landscape 
of the industry, the transparency of the ratings process, and 
the conflicts of interest. We also considered the SEC's process 
for granting the ``NRSRO'' designation and whether the SEC 
should implement an oversight regime. Last week, the SEC 
proposed a rule that would define the criteria and process for 
obtaining the NRSRO designation. This proposal, I believe, is a 
first step toward addressing some of the issues identified here 
at this Committee, but I have additional concerns regarding 
industry practices, the scope of the SEC's authority, Mr. 
Chairman, and the appropriate level of SEC regulation.
    Another prominent pending before the SEC is the adoption of 
Regulation NMS. This proposed regulation would effect the most 
significant changes in the last 30 years to the structure of 
our stock markets. Since you last testified before the 
Committee on Regulation NMS, the Commission has revised its 
proposal concerning the application of the trade-through rule. 
This debate has engendered considerable controversy, and it is 
critical that the final outcome establish a framework, Mr. 
Chairman, that enables our markets to remain fair, efficient, 
and competitive. I look forward to your discussion of 
Regulation NMS.
    Mutual funds, credit rating agencies, and Regulation NMS 
are just a few of the many important issues pending before the 
Commission. This morning, I anticipate a wide-ranging 
discussion and examination of the SEC's actions.
    Mr. Chairman, you and your staff certainly have a busy 
agenda. I appreciate your and the SEC staff 's efforts to 
protect investors and to ensure the integrity of our capital 
markets, and we look forward to your testimony here today.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you, Chairman Shelby. I join with 
you in welcoming Chairman Donaldson back before the Committee 
on today's hearings on the state of the securities industry.
    Chairman Shelby, I want to commend you on your commitment 
to having this Committee perform its oversight 
responsibilities, which is, of course, a very important part of 
our agenda, sometimes not fully appreciated by the public or 
even by some Members of Congress in terms of the role that it 
plays. This hearing provides an important opportunity to review 
developments in the securities industry and the efforts of the 
Commission to promote the integrity and efficiency of our 
markets and to ensure the protection of our investors.
    When we compare the condition of the securities industry of 
today with that of a few years ago, we see a number of 
improvements. Technological advances are increasing the speed 
and efficiency of markets while reducing costs. Securities 
underwritings are increasing. Municipal bond investors have 
access to near real-time pricing data. Corporate boards and 
managers increasingly focus on improving transparency, 
disclosure, financial integrity, and governance. As a 
consequence, investors have more confidence in our capital 
markets. I have frequently stated that I regard our capital 
markets as a major economic asset of the Nation.
    The SEC has been active in its enforcement and in its 
rulemaking as it seeks to implement recent legislation to 
address problems that continue to exist in the industry and to 
otherwise protect investors. Chairman Donaldson and his fellow 
Commissioners have improved the effectiveness and morale of the 
Commission. Chairman Shelby has instituted his Polishing the 
Jewel program and other initiatives, and I want to commend him 
on that. We understand it has had a marked uplifting impact on 
the employees of the Commission.
    Mr. Chairman, in closing, I want to commend once again the 
process that the SEC uses in developing and promulgating its 
regulations. Some people may take this for granted, but it is 
an important part of wise policymaking is to have a fair and 
open process available to all interested participants. As we 
know, the staff of the Commission considers issues, often for 
very substantial periods of time. Before recommending a 
proposed rule on a particular complex issue, a concept release 
soliciting public comment may be issued prior to formulating a 
rule proposal.
    When the SEC proposes a rule, it provides a period for 
public comment. The SEC assesses the public reaction to the 
proposal, and as it deems appropriate may extend the comment 
period or solicit additional comments on particular points. It 
did so, for example, with Reg NMS, which you made reference. 
The SEC goes through a process of carefully assessing the 
public comments. Simultaneously, it may hold public hearings or 
roundtables on the issue to gain additional information. The 
staff will meet with interested parties.
    Sometimes, the comment process leads the Commission to make 
additional proposals, and the SEC may again publish and solicit 
comment, as it did just last December with Reg NMS. Once again, 
there is careful review of the comments before a final rule is 
published.
    Actually, at a hearing last year, we had a panel before us, 
quite a number of industry participants with different views on 
Reg NMS, but all agreed, in response to question, that the 
process had been very fair and very open. And I have to say I 
think this sets a standard in terms of how to develop public 
policy, and I want to commend Chairman Donaldson, his fellow 
Commissioners, and the staff at the Commission for the 
openness, the fairness, and the thoroughness of their process, 
and as a consequences, I think the thoughtfulness that goes 
into their decisionmaking.
    These are very complex issues, and it is very rare that it 
is all one way or all the other. I mean, there is always a very 
nuanced response that has to be made, and I say to all 
interested parties, I think the process the Commission has 
developed over the years, and to which it holds, makes a very 
important contribution to working out some reasoned answers to 
very difficult problems.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman.
    I would also like to join both you and Senator Sarbanes in 
welcoming Chairman Donaldson to the Banking Committee, and I 
would like to thank you, Mr. Chairman, for holding this hearing 
to discuss several securities issues pending before the 
Securities and Exchange Commission. All of these issues are of 
great importance to the securities industry, investors, and 
could very well change the Commission's daily operations and 
interactions, and I am glad that the Committee is having this 
discussion today.
    The Commission has certainly taken on a lot in the past 
couple of years on tough issues that impact the way the 
industry operates and the manner in which the public views the 
investment world. I was pleased to hear that the Commission 
extended the compliance date for banks with respect to the 
implementation of the pushout provisions in Title II of the 
Gramm-Leach-Bliley Act. I am hopeful that this extra time for 
comment will prove beneficial as the Commission further 
considers the interests of many of the community banks and 
thrifts throughout the country as well as the State of 
Colorado.
    I have concerns, however, that while I also look forward to 
hearing from Chairman Donaldson about Regulation NMS, the 
restructuring of the national market system has been a long 
time coming, and I believe that the appropriate changes are 
necessary for our markets to keep up with the changing demands 
of technology and investors. I have concerns, however, that the 
Commission may be moving too quickly toward a final rule when 
there still seems to be so many concerns on all sides of the 
issue.
    Again, I would like to thank you, Chairman, in advance for 
appearing before the Committee today to discuss significant 
pending securities issues at the SEC, and I look forward to 
your testimony and the discussion today.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Senator Stabenow.

              STATEMENT OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Thank you, Mr. Chairman, and welcome. We 
are always glad to have you, Chairman Donaldson. I know that 
these are very busy times for you and the SEC, and I would like 
to commend you on a number of fronts for your efforts.
    The job that you and the Commission perform is absolutely 
vital to maintaining a robust and vibrant economy, as you know, 
and providing working men and women the peace of mind that they 
need to become investors in the American Dream. As you testify 
today, I will listen especially closely to your comments on 
Regulation B, the so-called ``pushout rule.'' The small and 
medium-sized banks in my State of Michigan are very concerned 
about the costs and consequences of having to implement a 
regulation that they feel runs counter to the intentions of the 
Gramm-Leach-Bliley Act.
    I understand that just yesterday, the Commission postponed 
implementation of the regulation until September 30, so between 
now and the end of September, I look forward to working with 
you and with the Commission in providing a common sense 
approach to the issue of securities activities inside our small 
and medium-sized commercial banks. I am also very interested in 
hearing your comments about how we can better secure our 
financial markets and make them fair for the common investor.
    As we continue moving toward a future where more and more 
households are invested in the market, I know that you share a 
concern that we ensure that the average investor, the investor 
who does not have access to levers of power on Wall Street, can 
invest without fear that the mutual fund they are investing in 
or the brokerage house that they hired are covertly working 
against them by gaming the system. We have seen results of this 
in 2003, and I am very glad to see that the SEC is making a 
concerted effort to address many of these problems.
    But I also believe that those efforts may be at risk 
because of budgetary pressures, and I am very committed to 
doing all that I can to fully fund the enforcement activities 
of your agency. The Budget Committee, of which I am a Member, 
is marking up the President's budget proposal today, and at the 
markup, I am going to be supporting an amendment by Senator Jon 
Corzine to protect your enforcement funds from the deep cuts 
that are, unfortunately, being proposed in so many parts of our 
Federal budget. If we are to help our constituents secure their 
retirement future and encourage the American public to save, 
then, we must give them the peace of mind of knowing there is a 
level playing field and that they are not at a disadvantage 
when putting their money into the market.
    So again, I welcome you. I appreciate all of your efforts 
and the efforts of the Commission, and I look forward to your 
testimony.
    Chairman Shelby. Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. I would just like to welcome Chairman 
Donaldson and I look forward to his testimony, Mr. Chairman.
    Chairman Shelby. Senator Bennett.

             STATEMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you, Mr. Chairman.
    Chairman Donaldson, we are glad to have you here. We always 
appreciate your willingness to subject yourself to these kinds 
of inquisitions. I will be particularly interested in 
discussing with you the questions of the implementation timing 
and specifics of the implementation of the FASB rule with 
respect to expensing of stock options. I continue to be 
concerned about naked short selling and the impact of the rule 
you have adopted. I have information, at least from my 
constituents, that the rule has not been effective in stopping 
naked short selling, and we might spend a little time on that. 
And then, I would appreciate what you might have to tell us 
with respect to deregistration on the part of European 
companies who say that Sarbanes-Oxley is simply too burdensome, 
and they would prefer to no longer be listed on American 
markets in order to avoid those expenses.
    So those are the three items that are on my mind, and I 
look forward to an exchange with you on them. Thank you, Mr. 
Chairman.
    Chairman Shelby. Chairman Donaldson, welcome again to the 
Committee. Your written statement will be made part of the 
record in its entirety. You proceed as you wish.

               STATEMENT OF WILLIAM H. DONALDSON

       CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Good morning, Chairman Shelby, Ranking 
Member Sarbanes, and Members of the Committee. Thank you for 
inviting me to testify. I am glad to have the opportunity to 
answer any questions you may have concerning the securities 
industry generally, and getting, back to your specific 
questions, I understand that you are particularly interested in 
the Commission's recent initiatives regarding market structure, 
credit rating agencies, mutual funds, and the implementation of 
the Sarbanes-Oxley requirements. I plan to address these in 
detail. As you know, the Commission has devoted considerable 
resources to initiatives in each of these areas.
    Let me begin with a status report on Regulation NMS, a 
broad set of proposals designed to modernize and strengthen the 
regulatory structure of the U.S. equities markets. The 
Commission has expended considerable effort to strike the 
appropriate balance in developing the proposals in each of the 
four substantive areas addressed by Regulation NMS: Trade-
throughs, market access, subpenny quoting, and market data.
    Of those, the proposed trade-through rule has by far 
generated the most attention, and I would like to focus my 
remarks on that aspect of Regulation NMS. I would note, 
however, that the Commission has not yet taken final action on 
any part of Regulation NMS, and my fellow Commissioners and I 
are in a process of weighing and considering a number of 
different policy issues which each of us must consider in 
deciding how ultimately to vote on Regulation NMS proposals 
when they are put before the Commission.
    Let me begin by emphasizing three important policy goals I 
believe would be furthered by the trade-through rule. First, 
the rule would provide an effective backstop on an order-by-
order basis to a broker's duty of obtaining best execution for 
market orders. Retail investors typically expect their market 
orders to be executed at a price no worse than the relevant 
quotation at the time of the order execution. Yet, it can be 
difficult for investors to monitor where their orders, in fact, 
are executed and whether they are executed at the best price.
    The trade-through rule, in combination with a broker's duty 
of best execution, is designed to benefit retail investors by 
generally prohibiting the practice of executing orders at 
inferior prices. Second, the trade-through rule is designed to 
promote fair and orderly markets and investor confidence by 
providing greater assurance that limit orders displaying the 
best prices are not bypassed by trades at inferior prices.
    Retail investors, in particular, may feel unfairly treated 
when they are the most willing buyer or seller, and yet their 
best-priced limit orders are traded through. By protecting the 
best-priced orders, the rule is designed to promote a fair 
playing field for both small and large investors.
    Finally, the trade-through rule is designed to encourage 
the use of limit orders and thereby contribute to greater 
market depth and liquidity. Displayed limit orders are the 
building blocks of public price discovery and efficient 
markets. Although there are many types of liquidity, displayed 
limit orders represent, by far, the most transparent and 
readily accessible source of liquidity. They also provide an 
essential benchmark that guides the use of other types of 
liquidity, such as undisplayed trading systems, matching 
systems, and dealer capital commitments. As a result, the 
enhanced displayed liquidity and public price discovery 
elicited by the trade-through rule should contribute to more 
efficient trading throughout our equity markets.
    Turning to the proposed rule itself, I should stress that 
the trade-through rule, if adopted by the Commission, would 
take a substantially different and more comprehensive approach 
than the existing SRO and ITS trade-through rules. The trade-
through rule would, for the first time, establish a uniform 
trade-through rule for all National Market System stocks. As a 
uniform rule, it would cover both exchange-listed stocks, which 
are governed by existing SRO trade-through rules and Nasdaq 
stocks, which have never been subject to a trade-through rule.
    Furthermore, the rule would only protect automated 
quotations, in essence, those quotations against which an 
incoming order can execute immediately and without human 
intervention. It would not protect manual quotations. In so 
doing, the trade-through rule would correct a significant 
problem with the existing trade-through rules, which treat all 
quotes alike and effectively force fast markets to route orders 
to slow markets, where they can sometimes languish unfilled 
while a market moves away.
    The reproposed trade-through rule also would incorporate a 
series of discrete exceptions--including those which 
accommodate sweep orders, address rapidly changing or 
``flickering'' quotes, and allow for self-help when a market 
experiences a systems malfunction--that are designed to assure 
that the rule works in a relatively frictionless manner.
    Finally, the trade-through rule would eliminate significant 
gaps in the coverage of the existing trade-through rules such 
as the exemptions for off-exchange block trades and 100-share 
quotes that have seriously undermined the extent to which the 
SRO rules protect limit orders and promote fair and orderly 
trading.
    I should note that the reproposal asks for comment on two 
alternatives to the scope of the automated quotations in each 
market that would be protected. The first alternative, the 
Market BBO so-called ``alternative,'' would protect the best-
displayed bids and offers on each exchange, Nasdaq, and 
Nasdaq's Alternative Display Facility. The second alternative, 
the Voluntary Depth Alternative, would protect not only the 
best quotes but also orders below the best bid and above the 
best offer that a market voluntarily chooses to display in the 
consolidated quotation stream.
    Commission staff is in the midst of evaluating the more 
than 1,500 comment letters received on the two trade-through 
rule alternatives as well as other aspects of the Regulation 
NMS reproposal. As I noted earlier, I have asked the staff to 
complete their analysis and prepare a recommendation for 
consideration in short order. While the issues raised by the 
trade-through rule and other components of Regulation NMS are 
extremely complex, and in some cases controversial, they have 
been further analyzed and debated over the course of many 
years, and I believe the time for action has arrived.
    I can assure you that the Commission will carefully 
consider the comments received on Regulation NMS, including 
many from you and your colleagues, and that we are committed to 
achieving a result that furthers the important policy 
objectives that I have described without burdening the 
efficient operation of the markets.
    On to credit agencies: I will now turn to the Commission's 
recent work with respect to credit rating agencies. By way of 
background, the Commission originally used the term 
``nationally recognized statistical rating organization'' or 
``NRSRO'' with respect to credit rating agencies in 1975, 
solely to differentiate between the different grades of debts 
held by broker-dealers as capital to meet Commission capital 
requirements.
    Since that time, ratings by NRSRO's have become benchmarks 
in Federal and State legislation, domestic and foreign 
financial regulation, and privately negotiated financial 
contracts. The definition and interpretations of the definition 
would provide credit rating agencies with a better 
understanding of whether they qualify as an NRSRO.
    The rule proposal builds on earlier Commission work with 
respect to the role of credit rating agencies. This work 
included public Commission hearings, a report required by the 
Sarbanes-Oxley Act, and a 2003 concept release. Panel 
participants at public hearings included NRSRO's, non-NRSRO 
credit rating agencies, broker-dealers, buy-side firms, 
issuers, the academic community, and the SEC Commissioners. 
Most participants favored the regulatory use of credit ratings 
by NRSRO's as a simple, efficient benchmark of credit quality 
and stated that standards for NRSRO's were necessary for this 
concept to have meaning.
    In addition, the Commission conducted a study of credit 
rating agencies and submitted a report to the President and 
Congress under the Sarbanes-Oxley Act on January 24, 2003. The 
report considers the role of credit rating agencies and their 
importance to the securities markets, impediments faced by 
credit rating agencies in performing that role, measures to 
improve information flow to the market from credit rating 
agencies, barriers to entry in the credit rating business, and 
conflicts of interest faced by credit rating agencies. Finally, 
the Commission issued a concept release in 2003 to further 
study issues raised in the Sarbanes-Oxley report.
    The concept release examined whether credit ratings should 
continue to be used for regulatory purposes under Federal 
securities laws and, if so, the process of determining whose 
credit ratings should be used and the level of oversight to 
apply to such credit rating agencies. One conclusion the 
Commission has drawn from its examination of the topic is that 
market participants would be well-served by a clearer set of 
standards for determining whether or not a credit rating agency 
is an NRSRO.
    The Commission rule proposal of March 3, last week, 
responds to a number of issues raised by commentators in the 
concept release. The proposal retains the NRSRO concept and 
proposes a definition of an NRSRO. Moreover, the Commission 
would interpret the elements of the definition to provide 
greater clarity as to the meaning of that term. In addition, in 
light of the longstanding reliance by broker-dealers, issuers, 
investors, and others on the existing no-action process, if the 
Commission adopted a definition of an NRSRO, the Commission 
plans to continue to make its staff available to provide no-
action letters as appropriate. No-action letters would be 
granted for a specific period of time, after which the no-
action relief would need to be reconsidered.
    The Commission notes that this proposal is intended only to 
address the meaning of the term NRSRO as it is used by the 
Commission. It does not attempt to address many of the broader 
issues raised in response to the 2003 concept release, such as 
whether the NRSRO designation unnecessarily raises barriers to 
entry to the credit rating business, except to make it clear 
that the credit rating agencies can confine their activities to 
limited sectors of the debt market and geographic areas.
    The Commission believes that to conduct a rigorous program 
of NRSRO oversight more explicit regulatory authority from 
Congress is necessary. We believe that a well thought-out 
regulatory regime could provide significant benefits in such 
areas as recordkeeping and addressing the conflicts of interest 
in the industry. It would be important to ensure the public 
does not misconstrue any regulatory authority over credit 
rating agencies as a statement that the Government has vouched 
for the accuracy or quality of a credit rating.
    Finally, the current NRSRO's have sought to craft a 
framework for voluntary oversight by the Commission. 
Discussions have been ongoing concerning the possible precise 
terms of such a framework. It is not clear at this time what 
form that framework might take. It is hoped that the framework 
will enhance oversight of NRSRO's from current levels by 
providing a means by which the Commission's staff can access, 
on an ongoing basis, whether an NRSRO continues to meet the 
NRSRO definition.
    It is important to recognize that even if the industry does 
adopt such a framework, it would not give the Commission the 
same authority that actual legislative authority could. For 
example, if a credit rating agency failed to observe a 
provision of the voluntary framework, the Commission would not 
be able to bring an enforcement action. Moreover, the framework 
does not envision direct inspections by Commission staff, and 
the Commission would instead be in a position of relying on 
inspections conducted by third parties hired by the credit 
rating agencies.
    Accordingly, if Congress believes more extensive Commission 
oversight is appropriate and possible with a voluntary 
framework, legislation may be needed if the industry does, in 
fact, adopt a voluntary framework. Congressional attention 
would be especially useful because the question of whether to 
impose a regulatory regime on the credit rating industry raises 
a number of important policy considerations that would need to 
be examined, including substantial First Amendment issues.
    The Commission welcomes Congressional attention and, of 
course, would stand ready to work with Congress on crafting 
appropriate legislation if Congress determines that such 
legislation is necessary.
    The mutual fund rulemaking: Let me turn now to this 
significant area of Commission focus and reform activity. Last 
year, in the wake of the mutual fund late trading and market 
timing scandals, the Commission undertook an aggressive mutual 
fund reform agenda. The reforms were designed first to improve 
the oversight of 
mutual funds by enhancing fund governance, ethical standards, 
compliance, and internal controls; second, to address late 
trading, market timing, and certain conflicts of interest; 
third, to improve disclosures to fund investors, especially 
fee-related disclosures.
    It is my hope and expectation that, taken together, these 
reforms will minimize the possibility of the types of abuses we 
witnessed in the past 18 months from occurring again. When I 
last testified before this Committee on mutual fund reform in 
April 2004, we had taken final action on just two of our mutual 
fund initiatives, although many were in the proposal stage. 
Today, I am pleased to announce that we have adopted 10 of our 
initiatives and expect to complete the remaining two matters on 
our reform agenda in the coming months.
    I would like to review for you the significant steps we 
have taken to strengthen and improve the mutual fund regulatory 
framework. With respect to enhancing mutual fund governance and 
internal oversight, a centerpiece of the Commission's reform 
agenda was the fund governance initiative. In July 2004, the 
Commission adopted reforms providing that funds relying on 
certain exemptive rules must have an independent chairman and 
75 percent of the board members must be independent. In 
addition, the independent directors of these funds must engage 
in an annual self assessment and hold separate executive 
sessions outside the presence of management. The Commission 
also clarified that these independent directors must have the 
authority to hire staff to support their oversight efforts. I 
believe that these fund governance reforms will enhance the 
critical independent oversight of the transactions permitted by 
the exemptive rule.
    As I said before, I believe that a management company 
executive who sits as chair of a fund's board is asked to do 
the impossible: To serve two masters. There are times when the 
executive's duties to the management company and its 
shareholders simply conflict with what is in the best interests 
of the fund investors. This is the case, for instance, when 
fund boards review many of the transactions permitted by our 
exemptive rules. I believe that an independent chairman and 75 
percent of independent directors level the playing field on 
behalf of fund investors and blunt the control and dominance 
that many management companies have historically exerted in the 
fund board room.
    Our fund governance reforms will also facilitate the 
effective implementation of other mutual fund initiatives the 
SEC has adopted and has put forward. These reforms, which are 
detailed in my written statement, include requirements for 
compliance policies and procedures, chief compliance officers, 
a code of ethics, a voluntary 2 percent redemption fee, a 
directed brokerage ban, and a late trading hard 4:00 proposal.
    Let me focus for just a moment on the hard 4:00 proposal. 
To address the problems associated with late trading, which, as 
you know, involves purchasing or selling mutual funds after the 
time a fund prices its shares, typically 4:00, but receiving a 
price that is set before the fund prices its shares, the 
Commission proposed the so-called ``hard 4:00 rule.'' This rule 
would require that fund orders be received by the fund, its 
delegated transfer agent, or a clearing agency by 4:00 in order 
to be processed that day.
    We have received numerous comments raising concerns about 
this approach. In particular, we are concerned about the 
difficulties that a hard 4:00 rule might create for investors 
in certain retirement plans and particularly investors in 
different time zones. Consequently, our staff is focusing on 
alternatives to the proposal that could address the late 
trading problem, including technological alternatives.
    The technological alternatives envisioned would include a 
tamper-proof time stamping system and an unalterable fund order 
sequencing system. These technological systems would be coupled 
with enhanced internal controls, third-party audit 
requirements, and certifications. Our staff has been gathering 
information from industry representatives to better understand 
the potential inherent in different technological systems that 
could be used to address this problem.
    Given the technological implications of any final rule in 
this area, it is important that we get it right. Thus, I have 
instructed the staff to take the time necessary to fully 
understand the technological issues and the alternatives 
associated. Consequently, the Commission likely will not 
consider a final rule in this area until mid-2005.
    Improving mutual fund disclosure, particularly disclosure 
about fund fees, conflicts, and sales incentives has been a 
stated priority for the Commission's mutual fund program 
throughout my tenure as Chairman, even before the mutual fund 
scandals came to light. As such, disclosure enhancement has 
been an integral part of our reform initiatives. I have 
highlighted these and other mutual fund-related initiatives in 
my written testimony.
    But let me move on to another important area that you have 
mentioned, and that is the Sarbanes-Oxley implementation. Two 
years ago, when I came on board at the Commission, the country 
was still reeling from its disappointment with cooked books, 
indefensible lapses in audit and corporate governance 
responsibilities, and intentional manipulation of accounting 
rules. These lapses led to staggering financial losses and a 
crisis in investor confidence.
    The resulting Sarbanes-Oxley Act of 2002 called for the 
most significant reforms affecting our capital markets, in my 
view, since the Securities Exchange Act of 1934. The Act 
established the foundation necessary to improve financial 
reporting and the behavior of companies and gatekeepers, and we 
have completed the rulemaking to implement these critically 
important reforms.
    Key requirements have taken hold, including CEO and CFO 
certifications of the material completeness and accuracy of SEC 
periodic filings, enhanced disclosure of off-balance-sheet 
transactions, electronic reporting within two business days of 
insider transactions, increased disclosure of material current 
events affecting companies, strengthened rules regarding the 
independence of auditors and audit committees, establishment of 
the PCAOB, issuance of the first PCAOB inspection reports on 
the large accounting firms, issuance of important auditing 
standards by the PCAOB, and, for the first time, as required by 
Section 404 of the Act, public reporting on internal controls 
and their effectiveness by both management and its auditors.
    I would like to focus for just a moment on Section 404 
requirements for management and a company's auditor to report 
on the effectiveness of internal controls over financial 
reporting. This section of Sarbanes-Oxley may have the greatest 
long-term potential to improve financial reporting. It may also 
well be the most urgent financial reporting challenge facing a 
large share of corporate America and the audit profession in 
the year 2005.
    I expect that we will begin to see a number of companies 
announce that they or their auditors have been unable to 
complete their assessments or audits of controls and additional 
companies announce that they have material weaknesses in their 
controls. For this initial pass, that result should not, by 
itself, necessarily be motivation for immediate or severe 
market reactions, in my view.
    Section 404 is a disclosure provision, and investors will 
benefit from receiving full disclosure regarding any material 
weaknesses that are found: Full disclosure about the nature of 
any material weaknesses, their impact on financial reporting, 
and the control environment and management's plans to remediate 
them. This disclosure will allow investors and markets to make 
the appropriate judgments about what companies and auditors 
find.
    Section 404 will work as intended if it brings this 
information into public view, and, in that event, the 
disclosure of material weaknesses and internal controls should 
be the beginning and not the end of the analysis for investors 
and markets. The goal should be continual improvement and 
controls over financial reporting and increased investor 
information and from that investor confidence. This should lead 
to better input for management decisions and higher quality 
information being provided to investors.
    While these benefits are clear, it is also important that 
we evaluate the implementation of our rules and the auditing 
standard issued by the Public Company Oversight Board to ensure 
that these benefits are achieved in the most sensible way. We 
have been very sensible in the implementation of all aspects of 
the Sarbanes-Oxley Act and especially to this very significant 
aspect. This has included several measured extensions over this 
past year to accommodate the first wave of reporting.
    In addition, in order to assess SEC and PCAOB rules for 
Section 404, now that we will have the first year of actual 
experience under the rules, the Commission will hold a 
roundtable discussion this April, and we are currently 
soliciting written feedback from the public regarding 
registrants' and accounting firms' implementation of these new 
reporting requirements. There will be open discussion via a 
website and then, of course, a very important set of roundtable 
discussions bringing together all of the players.
    Through the roundtable and this feedback, we will be 
closely listening to and assessing the experiences with the 
management and auditor internal control requirements, including 
seeking to identify best practices for the preparation of these 
reports and evaluating whether there are ways to make the 
process more efficient and effective while fully preserving the 
benefits of the requirements. Throughout the process, the 
Commission and its staff will closely coordinate with the PCAOB 
and its staff, and we will seriously consider whether any 
additional guidance is necessary or appropriate.
    We are also actively engaged in other activities to 
evaluate and assess the effects of the recent reforms, 
including the internal control reporting rules. For example, we 
have announced we are establishing a Securities and Exchange 
Commission Advisory Committee on Small Public Companies. The 
Advisory Committee will conduct its work with a view to 
protecting investors, considering whether the costs imposed by 
the current regulatory system for smaller public companies are 
proportionate to the benefits, and identifying methods, 
hopefully, of minimizing costs and maximizing benefits.
    In addition, and at the request of the Commission staff, 
the task force of the Committee of the Sponsoring Organization, 
COSO, has been established and anticipates publishing 
additional guidance this summer in applying COSO's framework 
for smaller companies. Our actions have not been limited to 
smaller companies. We also are cognizant of the regulatory 
challenges our foreign registrants face. For all these reasons, 
we recently extended the compliance date for internal control 
reporting for an additional year for smaller companies and for 
foreign public companies. A review of the first year 
experiences of our larger registrants also should help smaller 
and foreign issuers in preparing for their first reports.
    Mr. Chairman, Members of the Committee, I thank you for 
your indulgence. My testimony covers a broad spectrum of 
serious and very complex issues. There are a number of other 
substantive activities underway as well, but I have tried to 
limit my update to those things. I thank you all for your 
interest and attention. Together, we have made significant 
progress over the last several years in rebuilding public 
confidence.
    This concludes my prepared testimony, and I would be glad 
to try and answer any questions you may have. Thanks very much.
    Chairman Shelby. Thank you, Mr. Chairman.
    Mr. Chairman, about 2 years ago, this Committee held a 
hearing on analyst conflicts of interest in the Global 
Settlement. We examined how investment houses used research 
reports to bolster investment banking business. Some press 
reports suggested recently that these conflicts are still 
prevalent on Wall Street, particularly with respect to Fannie 
Mae, Freddie Mac, and their bankers.
    Since the announcement of the Global Settlement, do you 
think that Wall Street has adequately addressed these 
conflicts, or have firms reverted to their old ways now that 
the regulatory spotlight has moved on to other practices? These 
are concerns that we have.
    Chairman Donaldson. Well, I think the price of making new 
rules is eternal oversight, if you will. It is like going on a 
diet. You get the weight off, but once you get the weight off--
--
    Chairman Shelby. You have to keep it off.
    Chairman Donaldson. --you have to pay attention to make 
sure it stays off.
    Chairman Shelby. We want to help you to keep it off.
    [Laughter.]
    Not you but the metaphor you are using.
    Chairman Donaldson. Well, we are very concerned with 
keeping our oversight crisp and focused and----
    Chairman Shelby. Keeping people honest and keep conflicts--
--
    Chairman Donaldson. I beg your pardon?
    Chairman Shelby. Keep people honest and keep people from 
engaging in so many conflicts, perhaps?
    Chairman Donaldson. Absolutely. I think that it is 
inevitable that there are certain conflicts that are 
intolerable in the investment business. There are certain 
conflicts that are inherent to the business. When you are 
standing in between a buyer and an issuer, both want the best 
deal, and you have to resolve that conflict. So we try to do 
the best we can in writing rules around those sorts of 
inevitable conflicts.
    Chairman Shelby. But you are going to continue to be 
diligent in that area, I suppose.
    Chairman Donaldson. We will, I can assure you.
    Chairman Shelby. Go back to Regulation NMS, the trade-
through rule. It is my understanding that the proponents of the 
trade-through rule contend that the rule ensures that investors 
receive the best price when they trade their shares. Opponents 
of the trade-through rule contend, as I understand it, that 
although the rule may have served a useful function, it no 
longer makes sense in today's markets. Technological 
innovations have created new systems and programs that allow 
market participants to make instantaneous trading decisions 
with minimal human intervention in executing trades.
    What is the real problem you are trying to address here, in 
view of what I just said?
    Chairman Donaldson. Basically, we are trying to reconcile 
two different, and hopefully not mutually exclusive, 
objectives. One objective is the protection of the so-called 
``best bid or offer,'' and this is, in my view, a rock upon 
which our markets have been so successful through the years. 
That means if someone is willing, an individual investor in 
particular, to put a bid or an offer out there, they must be 
assured that somebody will not trade around them--that, in 
effect, they are offering, as the trade said, they are offering 
a free option to the marketplace. And they must be rewarded for 
that by making sure that their order will be honored.
    We are trying to reconcile that objective, and, by the way, 
the best markets are those that have the most displayed limit 
orders out there, so that incentive to put that order out there 
as opposed to keeping it in your pocket is very important.
    Chairman Shelby. Information.
    However, as you know, there are new electronic ways of 
trading faster than this on some of the floor exchanges, and 
certain buyers believe that the speed of execution and the 
integrity of their order is more important to them than 
necessarily honoring that best bid or offer. So the purpose of 
the trade-through rule--and again, I must emphasize that the 
new trade-through rule that we are talking about addresses two 
things: One, it will only be applied to an instantaneous 
quotation, for example, to an electronic quotation where the 
transaction can take place immediately, and two, it will 
basically, in applying to that transaction, it will address the 
general inefficiency of the trade-through rule as it has been 
applied in the older system currently existing in the markets, 
which was devised 20 or 30 years ago, which is like a horse and 
buggy kind of thing to identify trade-throughs.
    It is a modern, efficient way of assuring that we have both 
speed and best bid and offer priority.
    Chairman Shelby. Mr. Chairman, if the trade-through rule is 
necessary to protect buy and sell orders and promote investor 
confidence, why do such huge organizations like TIAA-CREF, a 
well-known institutional investor, oppose the trade-through 
rule? Is there a lack of consensus on this proposal among the 
investing public?
    Chairman Donaldson. As in any of these undertakings that we 
do, there are always people on all sides of this. There are 
many different interests, if you will, represented out there. 
The whole national market system proposal that we are putting 
forward will affect in one way or another a number of those 
interests. There are an equal number of large investors like 
the ones that you cited, more, as a matter of fact, that 
believe in our trade-through rule and have so stated.
    But I think that the real issue here, as I say, is that 
this is a compromise. This is a compromise between those that 
would say just speed and trade anywhere you want, and that is 
of interest to certain funds, who would love to not have to 
honor the best bid and offer and would love to trade somewhere 
without people----
    Chairman Shelby. You say it is a compromise. Is it a 
compromise to protect people other than the public? Does it 
protect some people in the status quo as opposed to new ways of 
doing business?
    Chairman Donaldson. No, what I was going to say, is that it 
is a compromise trying to get the best of both worlds, and I 
think that the most important aspect of this is that in 
addition to enforcing the trade-through rule for an electronic 
transaction, there will be no protection in the so-called 
``slow markets.'' So, if you have a market as envisioned by the 
New York Stock Exchange and some of the other markets who will 
have an electronic market and side-by-side a floor-based or a 
so-called slow market, those who choose to operate in the slow 
market will not be protected by the trade-through rule.
    Chairman Shelby. Do they have a similar situation in, say, 
Frankfurt, or is it totally electronic?
    Chairman Donaldson. In Frankfurt?
    Chairman Shelby. Yes, in Frankfurt, for example, or in 
London.
    Chairman Donaldson. We have to deal with the markets as 
they exist in this country, and I do not think the Frankfurt 
Stock Exchange in any way is similar to the New York Stock 
Exchange for a whole lot of reasons.
    Chairman Shelby. Do they have a trade-through rule, I guess 
I am asking you, on the Frankfurt exchange?
    Chairman Donaldson. Yes; well, the German and the English 
block trades go off the exchange.
    Chairman Shelby. Okay.
    Chairman Donaldson. They will not under our new rule here 
in the United States. The blocks will be forced to conform to 
the national market system rules.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Chairman Donaldson, I read this report of your speech 
earlier in the week before a securities lawyers' conference 
here in Washington in which you made the point, according to 
this article: `` `Lawyers and auditors are crucial gatekeepers 
for the integrity of the markets. Lapses over the past few 
years by outside advisors directly contributed to financial 
frauds that devastated thousands of investors. I hope you will 
not expend significant time, money, and energy devising 
structures designed at evading requirements and trying to 
achieve an accounting or disclosure result that artfully dodges 
the rule's purpose,' Donaldson said,'' and you also, as I 
understand it, talked about the conduct of auditors at 
accounting firms of all size and that Agency officials will 
continue to scrutinize auditors' relationships with their 
clients for possible violation of independence rules.
    As I understand it, the SEC has lodged enforcement actions 
against lawyers and also against auditors, particularly where 
they feel the relationship has gotten too close with their 
clients for them to render impartial reviews of financial 
reports. How serious do you regard this problem as being, and 
what do you foresee the Commission doing as we move ahead?
    Chairman Donaldson. In the ordinary course of our 
enforcement actions, we are confronted with professional 
malfeasance, and we have law requirements that allow us to 
bring actions against lawyers and accountants and to deny them 
the privilege to appear before the Commission and, in certain 
cases, more restrictive actions. What I was talking about in 
that speech was not the gross aiding and abetting actions that 
become illegal. What I was talking about was a state of mind.
    We can write all the rules we want, but what really counts 
is the state of mind of not only management but also, I 
believe, the advisors to management, and that would include 
auditors; it would include accountants; it would include 
lawyers; it would include anyone who might be considered to be 
a gatekeeper. And what I was urging was that they pay attention 
to their role, not only to show just exactly how you can walk 
up to and conform with a law and not to just figure out ways of 
legally getting around that law but also to be a counselor on 
what the intent of the law was.
    Now, that is a long answer. I believe that you know, during 
the 1990's, when a lot of these problems arose, I think there 
was a problem. I hope that, because of our actions and by 
speaking as I have, people are beginning to think twice about 
defining their role only as an executor of clever ways of doing 
things.
    Senator Sarbanes. Now, in the carrying out of Section 404 
of the Sarbanes-Oxley Act, you have given some additional time 
for the filing of the 404 reports to smaller companies and to 
foreign companies; is that correct?
    Chairman Donaldson. Yes.
    Senator Sarbanes. And that would be until some time next 
year; is that right?
    Chairman Donaldson. Yes; we approved implementation of 
Section 404 in June 2003. Last week, we extended the compliance 
date for nonaccelerated filers, that is, companies with less 
than $75 million market cap and for foreign private issuers, 
and this extension benefits roughly 65 percent of our 
registrants, and it is important to note it affects only about 
5 percent of the total U.S. market cap.
    The requirements were effective for the first time for 
companies with more than a $75 million market cap for the 
fiscal year ended December 2004. We have granted a 45-day 
extension for companies with less than $700 million market cap. 
So what we have tried to do is to adjust, if you will, for 
smaller companies and for foreign issuers, this is a big 
process, a process versus the number of people available to do 
it in small companies.
    Senator Sarbanes. So as I understand it, if you are above a 
$700 million cap, these are U.S. companies now, you are 
required to file, well, now, I mean, those reports will be 
coming out, and we will be able to take a read on whether there 
are material deficiencies.
    Chairman Donaldson. That is right.
    Senator Sarbanes. If you are between $75 million and $700 
million market cap, they have another 45 days to come in with 
their reports, and if you are under $75 million, you can go to 
next year rather than this year.
    Chairman Donaldson. That is right, 2006.
    Senator Sarbanes. And the foreign companies, I gather, is 
without relationship to the market cap.
    Chairman Donaldson. That is right.
    Senator Sarbanes. I gather part of that was pushed by the 
fact that they were all currently being required to conform 
with international accounting standards as a part of the 
process in their own respective countries and that also is, for 
some of them at least, a difficult process, and this was to 
recognize that and give them additional time; is that correct?
    Chairman Donaldson. That is correct.
    Senator Sarbanes. The ultimate objective, though, would be 
that any public company listed on a U.S. exchange would be 
meeting the same requirements. They may be delayed in when they 
get there, but eventually, they will have to get there just 
like the companies that have already moved ahead in order to 
make this analysis and make the appropriate certifications.
    Chairman Donaldson. Absolutely; the issue here has been, as 
you know, Europe and the European Union have moved to 
international accounting standards as of January 1, so they 
have to go all of a sudden from, let us say, Italian GAAP and 
German GAAP, they have to go to international accounting 
standards; and then they have to go another step to reconcile 
international accounting standards with U.S. GAAP at the same 
time that they are dealing with the stock option expensing 
item.
    So we decided that we would give the European issuers some 
time to go through this difficult process, and it is very 
difficult for them, but, ultimately, it is just a matter of a 
year extension. It is not a matter of letting them out of our 
requirements.
    Senator Sarbanes. And unless we hold everyone to it, we are 
going to be faced with the anomalous situation of having 
companies listed who are meeting different standards and 
requirements, and of course, that is not the purpose. 
Eventually, given appropriate time to work through some of 
these practical problems, and I recognize there are some 
practical problems, but eventually, all companies listed on 
American exchanges would be meeting the same standards; is that 
correct?
    Chairman Donaldson. Yes, that is correct.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Donaldson, my question is in regard to the FASB 
December 16 approval of the rule requiring the expensing of 
stock options.
    Chairman Donaldson. Yes.
    Senator Allard. I understand the SEC's response at this 
point is you are going through what you call interpretive 
guidance to assist companies with implementation. And, you 
know, for some of us, there is concern out there, because the 
stock options have been a way of increasing productivity and, 
if you are a new company, getting people into your company with 
some talent based on what they may feel is the future of that 
particular company.
    And so, I am curious as to how you are viewing the 
interpretive guidance procedure, and what are you thinking 
about as far as the interpretive guidance procedure, and in 
what way and how would that help a new company that is getting 
started?
    Chairman Donaldson. As you know, the FASB standard requires 
that options expensing begin in the third quarter of 2005.
    Senator Allard. Right.
    Chairman Donaldson. As an accounting matter, this makes 
sense, because clearly, I mean, the expensing of them makes 
sense, because the options do have a cost, and the trick here 
has been the formula to decide exactly how much should be 
expensed. That is where there are various models that have been 
approved by FASB, and our staff now is in the process of 
formulating guidance on this subject in response to a number of 
questions that have been raised. The staff plans to issue this 
guidance this month in terms of questions that we have had 
about the different models.
    Of course, the models are all contingent and dependent upon 
the numbers you put into them, the assumed rates and so forth. 
This gets to be a very complex subject. There are lots of 
entrepreneurs out there who are putting forth ways of doing 
this, if you will; economists, mathematicians, and so forth who 
are getting pretty sophisticated, and we intend to offer 
guidance in terms of the interpretation of these different 
models, and we will do that, as I say, this month.
    Senator Allard. The guidance that you are offering, is this 
guidance that is being reflected back to FASB or guidance that 
is being reflected to companies or both?
    Chairman Donaldson. I would say both. We are in constant 
touch with FASB, and our Chief Accountant and the PCAOB talk 
all the time, and certainly, the guidance that we are giving 
would be coordinated with FASB.
    Senator Allard. And those are to come out when, now? You 
say within the next month?
    Chairman Donaldson. Yes, this month.
    Senator Allard. Okay; toward the end of this month, you are 
thinking?
    Chairman Donaldson. Sometime this month.
    Senator Allard. Sometime this month.
    Chairman Donaldson. Yes.
    Senator Allard. Now, the guidance, then, it is going to be 
in the form of various approaches that you may take if you are 
a business in complying with that FASB requirement on stock 
options where you expense them?
    Chairman Donaldson. There are, as I say, different models 
that are acceptable, and there are--once you understand the 
models and understand their application to your business, you 
will be able to select a model, but you also will have to 
disclose the model that you have accepted and the inputs that 
you put into it, so that somebody from the outside will 
understand what went into your determination.
    Senator Allard. You are talking about a formula that might, 
for example, fit into a computer, and then, you just put in 
those variables that would apply to your company once you 
decide which model you would like to go with, and then, would 
that try to facilitate--I am trying to understand how this 
could be that quickly put out by the companies so they could 
comply.
    Chairman Donaldson. As I say, these models, you know, have 
been a subject of great investigation and debate by FASB. There 
are a number of Ph.D. scholars, mathematicians, and so forth, 
and economists who have been advising on these very 
sophisticated models. However, there are some very 
sophisticated consulting groups around that will help companies 
do that if they do not have the wherewithal or the talent in 
their company to do it. And we hope to be in a position, as I 
say, to give guidance as people deal with this.
    Senator Allard. Mr. Chairman, my time has expired. Thank 
you.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman, and I want to 
thank you for holding this hearing, and I want to thank 
Chairman Donaldson for always being available to us as well as 
for the job he is doing.
    I think these are very difficult times to be a regulator 
for many reasons, but you have a changing world. You have 
technologies that come in and move very quickly, and the trick 
is not to overreact but at the same time to update, and the 
trick is also to make sure that the basic framework that our 
markets and our whole economy has existed under for a long 
time, which has been overwhelmingly successful, keeps the basic 
balance between efficiency, fairness, and openness, and I think 
you have done a good job there.
    Particularly, I think you have done a good job on something 
of great concern to me, which is market structure. I think the 
original staff proposal made by the SEC on Regulation NMS, 
makes a great deal of sense. On the one hand, you have to 
update things; there is no question, and speed does matter. But 
there is an overall guiding principle we have here, which is 
that the markets be fair, be deep, be liquid, and serve the 
small investor as well as the big guys. The day our markets are 
not regarded as being on the level is the day they begin to 
decline.
    There are many individual interests who say do it my way, 
because I understand that, they make more money doing it that 
way, or it serves their interests. They would rather not have 
their trades be known. But I think if you study history, if you 
go for the short-term interests of one little group or another, 
you end up having real trouble in the markets that ends up 
hurting everybody.
    I would urge you, Mr. Chairman, the SEC, and everyone else 
to resist the short-term impulse to say, hey, I want to do it a 
different way, because I benefit, because we have a much 
broader, deeper principle, which is the functioning of the 
markets, the caring for the small investor as well as the large 
investor, et cetera.
    So, I was pleased to read what you said in your statement. 
I just want to--and I think we are updating our markets. There 
is no question speed matters, but speed is not the--we should 
not go for speed uber alles, even though some want it. And I 
think, again, you have reflected that balance in this NMS 
solution. I would argue to you if you make exceptions, you will 
undo the whole rule. An exception swallows the rule that you 
would make, because once everyone is not tied to the same 
rules, the outliers can prevail and undo the whole system. And 
so, I would strongly urge you not to seek exception and not to 
allow exception. Let everybody play by the same rules. At the 
same time, I do think, you know, if you go too far, you will 
end up with fragmented markets, go to a CLOB. That will end up 
fragmenting the markets. If you do not go far enough, somebody 
will come in who is more efficient and dominate.
    Again, I want to compliment you on where you are headed. I 
would say, you know, I think I know the Chairman asked about 
somebody who was opposed, I think TIAA-CREF. I would just like 
to note that there are lots of companies like TIAA-CREF who are 
for this rule such as the Investment Company Institute, which 
represents the mutual fund industry, T. Rowe Price, Vanguard, 
Barclay's, as well as the people who favor the small investor: 
Consumer Federation of America and groups like that have been 
supportive of your proposal.
    Let me ask you this: Testimony given by some said that 
there was not a trade-through problem in, say, Nasdaq stocks. 
And then, your Office of Economic Analysis, which detailed in 
the Reg NMS reproposal, said that characterization was not 
true, that there was that kind of problem there. And now, the 
people who originally proposed this are trying to discredit the 
staff report. Have they made any valid objections? Do you still 
stand by that staff report?
    Chairman Donaldson. Yes, we still stand by that judgment. 
We have taken those comments that have come in to us. We have 
reanalyzed some of the statistics that we put forth in the 
original 
national market system data, and the data does not show that 
trading in Nasdaq stocks is more efficient than trading in New 
York Stock Exchange stocks; rather, both these markets have 
some pluses and minuses, strengths and weaknesses, but an 
effective trade-through rule is needed in both markets to 
promote best execution of retail orders.
    I do not want to get too far into the statistics here, but 
the fact of the matter is that the trade-throughs, depending on 
how you measure them, the effect of trading through best bids 
and offers in the Nasdaq market and broad cross-section of 
stocks is bigger than it is at the New York Stock Exchange, and 
this causes all the problems that I talked about in terms of 
not honoring the best bid and offer and not, in effect, paying 
people for being willing to give this option, if you will, of 
putting a bid or an offer out there.
    Senator Schumer. Right; just a second question on a 
different subject. Is my time up, Mr. Chairman? I know we have 
a vote.
    Chairman Shelby. Yes, but go ahead.
    Senator Schumer. Okay; soft dollars. You have been 
consistent in assuring the market that in your opinion, 
independent research will be treated under the same rules as 
proprietary research, that the definition of what constitutes 
research, of course, needs to be more precisely defined so you 
do not write off things as research like trips to the Bahamas 
where they might make a phone call and call someone and ask 
their judgment.
    [Laughter.]
    Senator Sarbanes. Do they call someone in the Bahamas or 
someone somewhere else?
    Senator Schumer. No, they go to the Bahamas to call someone 
in New York and call it research.
    [Laughter.]
    But the basic core of research is very much needed, and 
that is why I joined with my colleague, Senator Sununu, in 
sending you a letter yesterday asking you for an update and 
time lines as to when we could expect the rulings here. I agree 
with, again, your basic thrust that we do need to preserve 
independent research, and we cannot just eliminate it. When 
will a new rule be proposed, and can you expand on what the SEC 
is considering as the definition of research?
    Chairman Donaldson. Yes; in early 2004, I established a 
task force within the SEC to look at the issue of soft dollars. 
I think we should change that name.
    Senator Schumer. It is like privatization. It is going to 
stick no matter what somebody tries to do.
    Chairman Donaldson. It has a pejorative image to it, but 
nonetheless, soft dollars.
    Chairman Shelby. What would you call it other than soft 
dollars?
    Chairman Donaldson. The task force has been meeting 
continuously. It has come up with a number of recommendations, 
but of all of these recommendations, I have asked the staff to 
focus on three areas. One is clarifying the scope of brokerage 
and research services that are eligible for soft dollar 
payment. What exactly is in this modern day, when the original 
intent here was to have soft dollars pay for research, now, 
research comes in electronic forms. It comes with equipment to 
deliver the electronic forms, et cetera, et cetera; what is 
allowable under 120(a)(d)?
    Number two is requiring that broker and investment advisor 
records of soft dollar activity are clarified, so that inside 
the 
mutual fund, if you will, the new independent directors and 
independent chairman can see an analysis of just exactly the 
composition of those soft dollars and how much is going for 
what.
    Senator Schumer. Right.
    Chairman Donaldson. And then, a third component is relating 
this, advisors relating this to their clients. Mutual fund 
managers, mutual funds themselves, are relating this 
information in a clear form so people see exactly how those 
soft dollars are being used.
    I might just say that I believe that with the Global 
Settlement and the rise now of independent research, you know, 
I believe that anything we would do to inhibit independent 
research from being done and to limit research only to being 
done by major investment firms would be a mistake.
    Senator Schumer. I agree.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman.
    I outlined three items that I would talk about. I think we 
have discussed the deregistration thing sufficiently in your 
responses to Senator Sarbanes, so let me move on to the other 
two in the time that we have remaining before we have to go 
vote.
    Naked short selling: You put out a new rule in January to 
deal with naked short selling, and as nearly as I can tell from 
my constituents who feel victimized by this, it is not working. 
There is a story that appeared on Friday in the Financial Wire 
on naked short selling that summarizes it perfectly. A Michigan 
man, if I can quote from it, I will give you a copy of it, a 
Michigan man, Robert C. Simpson, who claims to have acquired 
100 percent of the issued and outstanding stock of Global Links 
Corporation is likely to become the poster boy for those 
opposed to illegal naked short sales.
    It goes on and talks about this. This, for those who may 
not know is where a brokerage house sells shares it does not 
own and has not borrowed. Short selling is a perfectly 
legitimate activity in the market, but it requires that the 
person who sells the share he does not own, borrows those 
shares so that he can buy them back when it becomes necessary. 
All right; Simpson filed an SEC Commission Schedule 13(d) on 
February 3 showing his purchase of and voting power for 
1,158,209 shares of the corporation, yet the day after he 
purportedly stuck every last corporate certificate for Global 
Links in his sock drawer, the company traded 37,044,500 shares. 
And the next day, it traded 22,471,600 shares. And Thursday of 
last week, it traded 199,616 shared.
    Quoting the article, it says: ``Simpson is said to have 
gone back to his sock drawer and despite the fact that a sock 
or two, as is always the case, were missing, all 1,158,209 
Global Links certificates were still there.'' There were no 
shares available to be borrowed, and yet, in 2 days, there were 
over 50 million shares traded. And I have constituents who say 
trading since the rule was adopted in our stock has exceeded 
the available float by four or five times on a daily basis.
    Now, your staff is going to come in, we are going to have a 
briefing on this in depth, and I will not go into it in greater 
depth here, but this article, just last Friday in a national 
publication, indicates that people are still selling short 
shares they do not have and are clearly never going to acquire 
if the one fellow has acquired every share. And I am told that 
the way that it works is that one brokerage house sells short, 
has 13 days under your rule under which to acquire the shares, 
and in that 13-day period hands the whole transaction off to 
another brokerage house, and they just keep moving it around, 
and nobody ever has to settle, and they use the 13-day period 
to avoid the rule, and you end up with this kind of 
circumstance.
    Thirty-three million shares traded in a single day when 
there are only 1 million shares outstanding, and one investor 
has filed a statement with you saying that he has all of them; 
that is clearly something that needs work.
    Chairman Donaldson. Senator Bennett, thank you for that 
observation. As you, yourself, note, short selling is not 
illegal.
    Senator Bennett. I approve of short selling. It is the 
naked short selling we are going after.
    Chairman Donaldson. And when you get into naked short 
selling, the Regulation SHO, which was adopted in 2004, has 
three primary rules that address the problem with extended 
settlement failures: The location requirement, the close-out 
requirement, and the borrowing requirement.
    Senator Bennett. Excuse me; I do not want to go into that, 
we have got a vote and my time is running out, and you are 
going to give me a briefing on that. So let me move to the 
other area very quickly.
    Chairman Donaldson. And we would like to give you a 
briefing on our oversight in this area.
    Senator Bennett. My main message here is that the evidence 
is that the Reg SHO is not working. So that is what we need to 
get into in detail.
    I am one who endorses the idea that stock options should be 
expensed. I agree that they have a cost. But I have been 
tremendously disappointed--that is an understatement--about the 
way FASB has handled this. Basically, they have punted on the 
most difficult and important question, which is valuation. They 
have said okay, you can use Black Scholes, or you can use 
binomial, or you can make up something else if you get to these 
experts that you referred to in your response to Senator 
Schumer, and that is fine.
    What kind of accounting standard is that, when FASB says 
you have to expense them, but we do not particularly care what 
valuation you put on them? And what you are going to see, 
indeed, are seeing now, if you and the SEC are not the 
gatekeeper to bring some sanity to this debate are three, in my 
view, bad results which are not mutually exclusive. You can 
have all three of them: Number one, which we are already 
seeing, no more options. There are companies that are saying we 
just cannot deal with this, and so, the safe thing for us to do 
is to opt out of offering stock options. Dell cuts options for 
employees by 60 percent, ``To curb option grants, companies are 
using a variety of strategies. Others are simply reducing 
option grants without offering a replacement. That is the case 
at Dell, which awarded employees 51 million options in 2004, 
down from 126 million 2 years earlier.'' That is a February of 
this year statement from Business Week online.
    In The New York Times, February 19, 2005: ``Time Warner 
said yesterday it would no longer grant stock options to most 
employees, citing new accounting rules.'' Aetna, from the 
Boston Globe, January 2005: ``While the new ruling will not 
prevent companies from granting options, doing so will reduce 
their reported earnings. Many fear management increasingly will 
limit options to top executives. Last month, in fact, Hartford 
insurance giant Aetna, Inc., once known for its generous stock 
options, said it would no longer offer them to rank and file 
employees under the new accounting standards.''
    Pfizer, February 28, 2005: ``Pfizer said in the U.S. 
Securities and Exchange Commission filing that in response to 
new accounting rules requiring employee stock options to be 
expensed, it plans in 2005 to reduce the number of options 
granted, except for the most senior Pfizer management'' and so 
on.
    The prediction was made that people would stop giving 
options to anybody but the top executives, and that is coming 
true. If they could get a valuation system that made sense, I 
think that would not be the way, but if I were running a 
company again, I do not want to run the risk, which leads to 
the second reality that I am afraid is coming is going to be 
lawsuits.
    If you can, under FASB, pick Black Scholes, binomial, or a 
third one that is developed by your own experts, you are 
automatically setting yourself up for a lawsuit from somebody 
like Bill Orack, who is going to say you picked the wrong one, 
and therefore, we are going to sue you. So you have no safe 
harbor here. As long as there are these alternatives that says 
that FASB says you can choose, you are fair game for every 
predatory trial lawyer out there who wants to come after you, 
particularly if you are a big company like the ones I have 
mentioned, and I think they have sat down, and they have said 
look, we could come up with a valuation that might make some 
sense, but we do not want to have to defend it in court, and 
the easiest, smartest, and simplest thing for us to do is to 
cut out the options.
    And then, the third thing that is going to happen that we 
see examples of is that the analysts are not going to pay any 
attention to these earnings reports. They are going to look at 
the earnings reports and say these valuations are meaningless; 
we want to compare performance of company X of 2005 to 
performance of company X in 2004. The earnings report in 2004 
did not include any expensing for options, so in our analysis 
in 2005, we will not examine 
expensing for options. There were always footnotes available to 
us before; we will treat them as footnotes available again.
    So you have the situation where the analysts are paying no 
attention to the accounting, and yet, the accounting 
requirements are stifling the granting of options and setting 
up a situation for lawsuits. You, sir, are the last gatekeeper 
against this kind of insanity. We have not been able to get 
FASB to deal with the question of intelligent valuation of 
stock options. I am pleading with you and your accountants to 
find some way through this thicket that will allow a company to 
issue options with a safe harbor, knowing that they are not 
going to get sued, and will allow the analysts to examine the 
accounting in a way that makes some sense, because we are 
setting ourselves up for the worst of all possible worlds.
    Chairman Donaldson. Senator, I know we are running out of 
time, but let me just try and give a couple of quick responses 
to that.
    Senator Bennett. Please.
    Chairman Donaldson. Number one and perhaps most important 
is I would like to, if you have the time, have our experts 
brief you on this.
    Senator Bennett. For this, I have all the time you need.
    Chairman Donaldson. Well, we would like to do that.
    Number two is that the problem that was being addressed 
here was the excessive use of options, largely because no 
expense was attributed to them. That was the issue.
    Senator Bennett. Yes.
    Chairman Donaldson. So clearly, we have moved in the right 
direction in terms of saying that this is an expense, and it 
must be counted.
    Senator Bennett. With that, I fully agree.
    Chairman Donaldson. What is the expense?
    Senator Bennett. That is the problem.
    Chairman Donaldson. We have gone through--I should say FASB 
has gone through--as you indicated--a series of very intense 
attempts to get at a single model, and in fact, they have come 
up with a couple of models. I am told, and this is why I want 
you to talk to our experts, that those models come up with 
amazingly similar results when applied, generally speaking. 
That is point number two.
    Point number three, and this is the most important one, and 
as a former analyst, I can say this, that if I were still an 
analyst, I would be reading the footnotes that indicate what 
model is being used and what the inputs in that model are being 
used, and I do not want to make a judgment on enforcement now, 
but I would say that, if somebody follows a model that has been 
approved, discloses the model, discloses how they have used it, 
and what the inputs have been, the chances of, certainly, 
litigation coming from us is zero.
    Senator Bennett. I am not worried about litigation coming 
from you. I am worried about Bill Orack.
    Chairman Shelby. Senator Sununu, you have the last word as 
long as you can hold the vote on the floor.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. When Bill Orack starts suing people for 
using double declining balance depreciations that have straight 
line depreciation or some of the digits depreciation, I will 
start worrying a lot more about the legal implications of 
expensing stock options.
    I want to ask a few questions about the trade-through rule. 
In your opening statement, you talked about, and I do not know 
if it was the most important value, one of the values of the 
proposed trade-through provisions being that they will create 
an incentive to display more limit orders.
    Chairman Donaldson. I am sorry?
    Senator Sununu. Create an incentive to display more limit 
orders. Is that the most important value?
    Chairman Donaldson. It is an important value.
    Senator Sununu. Certainly one of the principal goals.
    And I would agree with that, the general premise that more 
information displayed, offered up in these markets is of value. 
But it would seem to me that if that were, if the proposal to 
extend trade-through to other markets would really help 
encourage the display of limit orders, then, you would expect 
more limit orders to be displayed currently on the New York 
Stock Exchange than are currently displayed at Nasdaq, and my 
understanding is that that is not the case, that there are more 
limit orders on Nasdaq than the NYSE. Does that not seem to 
defeat the argument?
    Chairman Donaldson. No, I do not think so, because 
basically, the ITS trade-through rule as it exists at the New 
York Stock Exchange has not been effective in preventing trade-
throughs. The existing rule----
    Senator Sununu. So you are saying it has not been 
effective, the existing one has not been effective, and you 
believe that this one would be more effective.
    Chairman Donaldson. Absolutely, because this is totally 
different. The existing rule is seriously flawed because of 
block trade exceptions and because it only provides a 
satisfaction remedy rather than actually preventing trade-
throughs.
    Now, the new trade-through rule, if the Commission were to 
agree to put it in, applies only to an electronic market, an 
instantaneous market, and it relies upon not a 25-year-old ITS 
system, but it relies upon the most modern system in the way 
the orders get there and the way they are executed at the 
exchange.
    Senator Sununu. Good, clear answer, but it raises a concern 
with me that you are admitting that you have not been able to 
design an effective trade-through rule in the past. You think 
this is a better one. I am always inclined to give you the 
benefit of the doubt. Why not apply this on a trial basis on 
the New York Stock Exchange in order to find out whether your 
hopes, dreams, and aspirations for improving the display of 
limit orders come to fruition?
    Chairman Donaldson. I will tell you, to use a poor analogy, 
the ITS system, which was devised by the stock exchange and 
particularly the New York Stock Exchange, is a horse and buggy 
system. I mean, it is like saying your horse and buggy could 
not go 100 miles an hour. This is a very different concept and 
a very different system, and insofar as, you know, the option 
of applying it temporarily and so forth, that is something we 
have looked at.
    The other side of it would be why not put the system in, 
and, if it does not work, you can see why it does not work and 
modify it? You are not going to know in a small sample. You are 
definitely not going to know unless you apply it to all NMS 
stocks.
    So, you know, but again, I think the concept of trying 
something out works in certain instances. We will see if it 
does here. I do not want to prejudge what the Commission will 
decide on this, but I will just leave it there.
    Senator Sununu. Are you saying you may consider applying it 
to only the New York Stock Exchange?
    Chairman Donaldson. We are, again, you have to be talking 
to me now and not the Commission. We have to define whether you 
are talking to our staff; you are talking to me; you are 
talking to----
    Senator Sununu. I am sure that they appreciate the fact 
that you never force them to sit up here. You take all the 
heat. You are very good about that.
    Chairman Donaldson. But, you know, I want to be very clear 
that the Commission has not voted on this. I also want to be 
very clear that the staff has spent years getting to this, 
seminars, et cetera. And I believe that the staff feels very 
strongly that this should be applied to both markets, that 
there is no difference between the stocks that are traded, and 
that to not apply it to both markets opens up the door to 
regulatory arbitrage. If you have different systems, then you 
have different incentives for traders and so forth. So, I think 
the staff feels very strongly that way. I am trying to keep an 
open mind about this in terms of my own personal view, as I 
believe the rest of the Commissioners are.
    Chairman Shelby. Senator Sununu, I know you want to keep 
going, but they are holding our vote. Our time has expired on 
the floor, and we have four straight votes.
    Go ahead.
    Senator Sununu. Thank you.
    [Laughter.]
    The Chairman did not pass you that note, did he?
    Chairman Shelby. No, I have a few questions for the 
Chairman, too. I might have to go on the record or have to be 
brief.
    Senator Sununu. No, I will finish up so you can ask one or 
two. My guess is we have about 5 or 10 more minutes here before 
they really get serious about closing the vote.
    Chairman Shelby. I hope you are right.
    [Laughter.]
    Senator Sununu. Let me put it this way: They are not going 
to vote without you. They may vote without me, but they are not 
going to vote without you.
    Chairman Shelby. Okay.
    Senator Sununu. I think the cost estimate for the top of 
book proposal was $167 million. The depth of book proposal, it 
would seem to me, is going to be a lot more expensive than 
that. Can we expect the Commission to put forward a more 
detailed estimate of the cost of these new regulations so that 
we can make a judgment as to whether or not the projected value 
is really worth it?
    Chairman Donaldson. Yes, I think you can expect us to 
juxtapose projected costs against projected savings for 
investors and that that will be part of the process of 
presenting this to the Commission and, in turn, presenting it 
to the public.
    Senator Sununu. Thank you. I just want to reiterate that 
given that the number of trade-throughs on New York is the same 
as the number or percentage of trade-throughs at Nasdaq, given 
the fact that that points to a point you made, the existing 
trade-through rule has not been effective, given the fact that 
there is a lot of difference of opinion about what kind of an 
approach is best suited here, I just have real concerns about, 
one, rewriting the trade-through rule and then, two, once that 
is done, expanding its application when I do not know that 
there were really a lot of comments and input to the Commission 
advocating for expanding the application of the trade-through 
rule.
    I would like to think that these changes will have the 
positive effect that you describe, because I agree, more 
information, more limit orders displayed on automated exchanges 
is a good thing, but I would like to think that we can find a 
way to apply this kind of a concept, prove its value, which is 
less expensive and less risky before we dramatically try to 
expand it.
    Thank you, Mr. Chairman.
    Chairman Shelby. Mr. Chairman, I would like to pose a 
question for you, and you can get back to me if you choose: The 
credit rating agencies, the NRSRO's, how can we work with you 
to complement your effort? Specifically, do you need additional 
legislative authority, and if so, would you get back with us 
and talk to us? We want to make sure you have the authority, 
unquestioned, to deal with the credit rating agencies. Some 
people say you might need legislation. If you do, we want to 
give it to you.
    Will you get back with me on that, or do you want to just 
answer that now?
    Chairman Donaldson. Sure, no, I would like to get back to 
you. I would just say very quickly that we are continuing to 
pursue the voluntary route to see how far we can go; not 
optimistic on that, answering some of the----
    Chairman Shelby. Why do we not do a parallel, then? You 
pursue the voluntary, and let us think about what authority you 
need because this Committee wants to make sure you have the 
authority to do your job.
    Chairman Donaldson. Thank you. We would be delighted to do 
that.
    Chairman Shelby. Thank you, Mr. Chairman.
    The hearing is adjourned.
    [Whereupon, at 11:54 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
             PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI
    Chairman Donaldson, welcome back to the Senate Banking Committee. 
As this is your first hearing with us in the new Congress, I am sure 
your testimony and the following discussion will touch on many issues 
before the Commission. I look forward to your input on these matters 
today and in the months ahead.
    There are a couple of issues in particular that come to mind. As 
you know, there is a problem right now on our military bases at home 
and abroad. Unscrupulous salespersons are selling our military 
servicemen and women unsuitable financial products and charging 
outrageous fees for them. This practice must be stopped. I am glad that 
the SEC is taking this situation seriously and that the sales and 
marketing regulations regarding these products is being duly enforced.
    I also look forward to the conclusion of any ongoing investigations 
into these matters that you may be conducting. It is important that 
this situation not be allowed to continue any longer. I hope that you 
and the other Members of the Committee share my sense of urgency in 
this matter.
    I was also pleased to see that the SEC has worked to address the 
implementation effects of the Sarbanes-Oxley Act. As an original 
cosponsor of this Act, I believe that the accounting reforms that it 
contains are crucial to the well-being of our Nation's markets and the 
confidence of its investors. However, it is clear that some companies, 
especially smaller ones, are having a difficult time becoming compliant 
by the original deadline. It was encouraging to see the SEC extend that 
deadline last December. As the SEC continues to implement these 
important accounting reforms, I would hope that they will make full use 
of their recently established Advisory Committee on Smaller Public 
Companies to gain important perspective from our Nation's small 
companies.
    These are just two of many important issues that you will address 
today and in subsequent hearings before this Committee. I am eager to 
continue working with you and the Members of this Committee on all of 
them. Chairman Donaldson, I look forward to your testimony.

                               ----------
               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                             March 9, 2005

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today on the state of 
the securities industry. I am glad to have the opportunity to answer 
any questions you may have concerning the securities industry 
generally. I understand, though, that you are particularly interested 
in the Commission's recent initiatives regarding market structure, 
credit rating agencies, mutual funds, and the implementation of the 
Sarbanes-Oxley requirements, and I plan to address these in detail in 
my opening remarks. As you know, the Commission has been devoting 
considerable resources to initiatives in each of these areas over the 
past few years. I welcome your continuing interest in these issues of 
such fundamental importance to the fairness and efficiency of the U.S. 
securities markets.
Regulation NMS
    I will begin with a status report on Regulation NMS, a broad set of 
proposals designed to modernize and strengthen the regulatory structure 
of the U.S. equity markets. At present, the Commission is in the final 
stages of a particularly extensive and open rulemaking process that 
included publication of the original Regulation NMS proposal in 
February of last year, public hearings in April, a supplemental request 
for comment in May, and a reproposal in December. In fact, Regulation 
NMS is the product of more than 5 years of study and hard work by the 
Commission that included multiple public hearings and roundtables, an 
advisory committee, three concept releases, the issuance of temporary 
exemptions intended in part to generate useful data on policy 
alternatives, and a constant dialogue with industry participants and 
investors. The comment period on the reproposal of Regulation NMS 
expired on January 26, and the staff is in the midst of evaluating the 
comments and preparing a final package of rules for Commission 
consideration. I would expect the Commission to take action on 
Regulation NMS within the next several weeks.
    In developing Regulation NMS, the Commission has been guided by the 
fundamental principles for the National market system that were 
established by Congress in 1975. In particular, the national market 
system is premised on promoting fair competition among markets, while 
at the same time assuring that all of those markets are linked 
together, through facilities and rules, in a system that promotes 
interaction between the orders of buyers and the orders of sellers in a 
particular security. As a result, the national market system 
incorporates two distinct types of competition--competition among 
markets and competition among orders. Over the years, the Commission's 
often difficult task has been to maintain the right balance between 
these two types of competition as technology and trading practices 
evolve.
    The Commission has expended considerable effort to strike the 
appropriate balance in developing the proposals in each of the four 
substantive areas addressed by Regulation NMS--trade-throughs, market 
access, sub-penny quoting, and market data. Of these, the proposed 
trade-through rule has by far generated the most attention, and I would 
like to focus my remarks on that aspect of Regulation NMS. I would 
note, however, that the Commission has not yet taken final action on 
any part of Regulation NMS, and my fellow Commissioners and I are in 
the process of weighing and considering a number of different policy 
considerations, which each of us must do in deciding how ultimately to 
vote on the Regulation NMS proposals when they are put before the 
Commission.
    Let me begin by emphasizing three important policy goals I believe 
would be furthered by the trade-through rule. First, the rule would 
provide an effective backstop, on an order-by-order basis, to a 
broker's duty of obtaining best execution for market orders. Retail 
investors typically expect their market orders to be executed at a 
price no worse than the relevant quotation at time of order execution, 
yet it can be difficult for investors to monitor whether their orders 
in fact are executed at the best price. The trade-through rule, in 
combination with a broker's duty of best execution, is designed to 
benefit retail investors by generally prohibiting the practice of 
executing orders at inferior prices.
    Second, the trade-through rule is designed to promote fair and 
orderly markets and investor confidence by providing greater assurance 
that limit orders displaying the best prices are not bypassed by trades 
at inferior prices. Retail investors, in particular, may feel unfairly 
treated when they are the ``most willing'' buyer or seller and yet 
their best-priced limit orders are traded through. By protecting the 
best-priced orders, the rule is designed to promote a fair playing 
field for both small and large investors in the U.S. equity markets.
    Finally, the trade-through rule is designed to encourage the use of 
limit orders and thereby contribute to greater market depth and 
liquidity. Displayed limit orders are the building blocks of public 
price discovery and efficient markets. Although there are many types of 
liquidity, displayed limit orders represent, by far, the most 
transparent and readily accessible source of liquidity. They also 
provide an essential benchmark that guides the use of other types of 
liquidity, such as undisplayed trading interest, matching systems, and 
dealer capital commitments. As a result, the enhanced displayed 
liquidity and public price discovery elicited by the trade-through rule 
should contribute to more efficient trading throughout the equity 
markets.
    Turning to the proposed rule itself, I should stress that the 
trade-through rule, if adopted by the Commission, would take a 
substantially different and more comprehensive approach than the 
existing SRO and ITS trade-through rules. The trade-through rule would, 
for the first time, establish a uniform trade-through rule for all 
national market system (NMS) stocks. As a uniform rule, it would cover 
both exchange-listed stocks, which are governed by existing SRO trade-
through rules, and Nasdaq stocks, which have never been subject to a 
trade-through rule. Furthermore, the rule would only protect automated 
quotations--in essence, those quotations against which an incoming 
order can execute immediately and without human intervention. It would 
not protect manual quotations. In so doing, the trade-through rule 
would correct a significant problem with the existing trade-though 
rules, which treat all quotes alike and effectively force fast markets 
to route orders to slow markets, where they can sometimes languish 
unfilled while the market moves away. The reproposed trade-through rule 
also would incorporate a series of discrete exceptions--including those 
that accommodate sweep orders, address rapidly changing or 
``flickering'' quotes, and allow for ``self-help'' when a market 
experiences a systems malfunction--that are designed to assure the rule 
works in a relatively frictionless manner. Finally, the trade-through rule 
would eliminate significant gaps in the coverage of the existing 
trade-through rules--such as the exemptions for off-exchange block trades 
and 100-share quotes--that have seriously undermined the extent to which 
the SRO rules protect limit orders and promote fair and orderly trading.
    I should note that the reproposal asked for comment on two 
alternatives to the scope of the automated quotations in each market 
that would be protected. The first alternative--the ``Market BBO'' 
alternative--would protect the best displayed bids and offers on each 
exchange, Nasdaq, and the NASD's Alternative Display Facility. The 
second alternative--the ``Voluntary Depth'' alternative--would protect 
not only the best quotes, but also orders below the best bid and above 
the best offer that a market voluntarily chooses to display in the 
consolidated quotation stream.
    That said, I should point out that some Commissioners and 
commenters have questioned the need for a trade-through rule on the 
listed markets, where they believe that the current trade-through rule 
is ineffective. These same Commissioners and some commenters question 
whether the trade-through rule should be extended to Nasdaq, which they 
believe operates well without one. In their view, improved access to, 
and connectivity among, the competing markets, coupled with vigorous 
enforcement of best execution obligations, will best achieve fair, 
efficient, and liquid markets, and make a trade-through rule 
unnecessary. I have asked the staff to give serious consideration to 
all viewpoints as they develop final recommendations for Commission 
consideration.
    Commission staff is in the midst of evaluating the more than 1,500 
comment letters received on the two trade-through rule alternatives, as 
well as other aspects of the Regulation NMS reproposal. As I noted 
earlier, I have asked the staff to complete their analysis and prepare 
a recommendation for Commission consideration in short order. While the 
issues raised by the trade-through rule and other components of 
Regulation NMS are extremely complex and, in some cases, controversial, 
they have been thoroughly analyzed and debated over the course of many 
years, and I believe the time for action has arrived. I can assure you 
that the Commission will carefully consider the comments received on 
Regulation NMS--including many from you and your colleagues--and that 
we are committed to achieving a result that furthers the important 
policy objectives I have described without burdening the efficient 
operation of the markets.

Credit Rating Agencies
    I will now turn to the Commission's recent work with respect to 
credit rating agencies. By way of background, the Commission originally 
used the term ``Nationally Recognized Statistical Rating Organization'' 
or ``NRSRO'' with respect to credit rating agencies in 1975 solely to 
differentiate between grades of debt securities held by broker-dealers 
as capital to meet Commission capital requirements. Since that time, 
ratings by NRSRO's have become benchmarks in Federal and State 
legislation, domestic and foreign financial regulations and privately 
negotiated financial contracts.
    In the last few weeks, (1) the Commission staff has issued a no-
action letter to A.M. Best, a privately owned and operated credit 
rating agency; (2) the Commission has proposed a rule that would define 
the term ``NRSRO'' with the goal of providing greater transparency to 
the process for identifying NRSRO's; and (3) the current NRSRO's are 
discussing with Commission staff a voluntary framework of standards to 
address important issues such as potential conflicts of interest. I 
will now discuss each step in detail.

A.M. Best
    Last Thursday, on March 3, the Commission staff issued a no-action 
letter to A.M. Best providing assurance that the staff will not 
recommend enforcement action if ratings from A.M. Best are used by 
broker-dealers for purposes of the net capital rule. In effect, the no-
action letter adds A.M. Best to the group of credit rating agencies 
considered ``NRSRO's.'' Prior to A.M. Best, eight credit rating 
agencies had received NRSRO no-action letters from the Commission 
staff. However, consolidation during the 1990's, reduced the number of 
pre-A.M. Best NRSRO's to four firms: Dominion Bond Rating Service; 
Fitch; Moody's; and Standard & Poor's.
Proposed Rule Defining NRSRO
    On March 3, the Commission voted to issue a rule proposal that 
would define the term ``NRSRO'' for purposes of Commission rules. The 
goal of the proposal is to provide greater clarity and transparency to 
the process of determining whether a credit rating agency's ratings 
should be relied on as NRSRO ratings for purposes of Commission rules. 
The definition and interpretations of the definition would provide 
credit rating agencies with a better understanding of whether they 
qualify as an NRSRO.
    The rule proposal builds on earlier Commission work with respect to 
the role of credit rating agencies. This work included public 
Commission hearings, a report required by the Sarbanes-Oxley Act, and a 
2003 concept release. Panel participants at the public hearings 
included NRSRO's, non-NRSRO credit rating agencies, broker-dealers, 
buy-side firms, issuers, the academic community, and SEC Commissioners. 
Most participants favored the regulatory use of credit ratings issued 
by NRSRO's as a simple, efficient benchmark of credit quality, and 
stated that standards for NRSRO's were necessary for this concept to 
have meaning.
    In addition, the Commission conducted a study of credit rating 
agencies and submitted a report to the President and Congress under the 
Sarbanes-Oxley Act of 2002 on January 24, 2003. The report considers 
the role of credit rating agencies and their importance to the 
securities markets, impediments faced by credit rating agencies in 
performing that role, measures to improve information flow to the 
market from credit rating agencies, barriers to entry into the credit 
rating business, and conflicts of interest faced by credit rating 
agencies.
    Finally, the Commission issued a concept release in June 2003 to 
further study issues raised in the Sarbanes-Oxley report. The concept 
release examined whether credit ratings should continue to be used for 
regulatory purposes under the Federal securities laws, and, if so, the 
process of determining whose credit ratings should be used, and the 
level of oversight to apply to such credit rating agencies. One 
conclusion that the Commission has drawn from its examination of the 
topic is that market participants would be well served by a clearer set 
of standards for determining whether or not a credit rating agency is 
an NRSRO.
    The Commission's rule proposal of March 3 responds to a number of 
issues raised by commenters to the concept release. The proposal 
retains the NRSRO concept and proposes a definition of ``NRSRO.'' 
Moreover, the Commission would interpret the elements of the definition 
to provide greater clarity as to the meaning of the term. In addition, 
in light of the longstanding reliance by broker-dealers, issuers, 
investors, and others on the existing no-action process, if the 
Commission adopted a definition of NRSRO, the Commission plans to 
continue to make its staff available to provide no-action letters, as 
appropriate. No-action letters would be granted for a specified period 
of time, after which the no-action relief would need to be 
reconsidered.
    The Commission notes that this proposal is intended only to address 
the meaning of the term ``NRSRO'' as it is used by the Commission; it 
does not attempt to address many of the broader issues raised in 
response to the 2003 Concept Release, such as whether the NRSRO 
designation raises barriers to entry to the credit rating business, 
except for making clear that credit rating agencies that confine their 
activities to limited sectors of the debt market or to limited (or 
largely non-United States) geographic areas can qualify as NRSRO's. The 
Commission believes that to conduct a rigorous program of NRSRO 
oversight, more explicit regulatory authority from Congress is 
necessary. We believe that a well-thought-out regulatory regime could 
provide significant benefits in such areas as record-keeping and 
addressing conflicts of interest in the industry. It will be important 
to ensure that the public does not misconstrue any regulatory authority 
over credit rating agencies as a statement that the Government has 
vouched for the accuracy or quality of a credit rating.

The Voluntary Framework
    Finally, the current NRSRO's have sought to craft a framework for 
voluntary oversight by the Commission. Discussions are ongoing 
concerning the precise terms of a framework. It is not clear at this 
time what form that framework might take. It is hoped that the 
framework will enhance oversight of NRSRO's from current levels by 
providing a means by which the Commission staff can assess on an 
ongoing basis whether an NRSRO continues to meet the ``NRSRO'' 
definition.
    It is important to recognize that even if the industry does adopt 
such a framework, it would not give the Commission the same authority 
that actual legislative authority could. For example, if a credit 
rating agency failed to observe a provision of the voluntary framework, 
the Commission would not be able to bring an enforcement action. 
Moreover, the framework does not envision direct inspections by 
Commission staff, and the Commission would instead be in a position of 
relying on 
inspections conducted by third parties hired by the credit rating 
agencies. Accordingly, if Congress believes more extensive Commission 
oversight is appropriate than possible with a voluntary framework, 
legislation may be needed even if the industry does in fact adopt a 
voluntary framework.
    Congressional attention would be especially useful because the 
question of whether to impose a regulatory regime on the credit rating 
industry raises a number of important policy considerations that would 
need to be examined, including First Amendment issues. The Commission 
welcomes Congressional attention and, of course, would stand ready to 
work with Congress on crafting appropriate legislation if Congress 
determines that such legislation is necessary.

Mutual Fund Rulemaking
    I turn now to another area of significant Commission focus and 
reform activity--mutual funds. Last year, in the wake of the mutual 
fund late trading and market timing scandals, the Commission undertook 
an aggressive mutual fund reform agenda. The reforms were designed to 
(1) improve the oversight of mutual funds by enhancing fund governance, 
ethical standards, and compliance and internal controls; (2) address 
late trading, market timing, and certain conflicts of interest; and (3) 
improve disclosures to fund investors, especially fee-related 
disclosures. It is my hope and expectation that, taken together, these 
reforms will minimize the possibility of the types of abuses we 
witnessed in the past 18 months from occurring again.
    When I last testified before this Committee on mutual fund reform 
on April 8, 2004, we had taken final action on just two of our mutual 
fund reform initiatives, although many were in the proposal stage. 
Today, I am pleased to announce that we have adopted 10 of our 
initiatives and expect to complete the few remaining matters on our 
reform agenda in the coming months. I would like to review for you the 
significant steps we have taken to strengthen and improve the mutual 
fund regulatory framework.

Enhancing Internal Oversight
    Fund Governance Reforms: With respect to enhancing mutual fund 
governance and internal oversight, a centerpiece of the Commission's 
reform agenda was the fund governance initiative. In July 2004, the 
Commission adopted reforms providing that funds relying on certain 
exemptive rules must have an independent chairman, and 75 percent of 
board members must be independent.\1\ In addition, the independent 
directors to these funds must engage in an annual self-assessment and 
hold separate ``executive sessions'' outside the presence of fund 
management. The Commission also clarified that these independent 
directors must have the authority to hire staff to support their 
oversight efforts. These fund governance reforms will enhance the 
critical independent oversight of the transactions permitted by the 
exemptive rules. Funds must comply with these requirements by January 
16, 2006.
---------------------------------------------------------------------------
    \1\ Commissioners Glassman and Atkins dissented, raising several 
concerns regarding the need for and effectiveness of this rulemaking.
---------------------------------------------------------------------------
    As I have said before, I believe that a management company 
executive who sits as chair of a fund's board is asked to do the 
impossible--serve two masters. There are times when the executive's 
duties to the management company and its shareholders simply conflict 
with what is in the best interest of fund investors. This is the case, 
for instance, when fund boards review many of the transactions 
permitted by our exemptive rules. I believe that an independent 
chairman and a 75 percent majority of independent directors level the 
playing field on behalf of fund investors and blunt the control and 
dominance that many management companies historically have exerted in 
fund boardrooms. Our fund governance reforms will also facilitate the 
effective implementation of other mutual fund initiatives the SEC has 
adopted and will put forward.
    Compliance Policies and Procedures and Chief Compliance Officer 
Requirement: One of the most important of these initiatives, adopted in 
December 2003, requires that funds and their advisers have 
comprehensive compliance policies and procedures and appoint a chief 
compliance officer. In the case of a fund, the chief compliance officer 
is answerable to the fund's board and can be terminated only with the 
board's consent. The chief compliance officer must report to the fund's 
board regarding compliance matters on at least an annual basis. Funds 
and advisers were 
required to comply with these new requirements beginning October 5, 
2004. We believe that making these changes to the mutual fund 
compliance infrastructure, and the increased focus on compliance that 
comes from the new chief compliance officer requirement will help to 
minimize the kinds of compliance weaknesses that led to the mutual fund 
scandals.
    Code of Ethics Requirement: In July 2004, the Commission adopted a 
new rule that requires registered investment advisers, including 
advisers to funds, to adopt a code of ethics that establishes the 
standards of ethical conduct for each firm's employees. The code of 
ethics rule represents an effort by the Commission to reinforce the 
fundamental importance of integrity in the investment management 
industry. Investment advisers were required to comply with the new code 
of ethics requirement as of February 1, 2005.

Addressing Late Trading, Abusive Market Timing and Directed Brokerage 
        for Distribution
    Late Trading/Hard 4:00 Proposal: To address the problems associated 
with late trading (which involves purchasing or selling mutual fund 
shares after the time a fund prices its shares--typically 4:00--but 
receiving the price that is set before the fund prices its shares), the 
Commission proposed the so-called ``hard 4:00'' rule. This rule would 
require that fund orders be received by the fund, its designated 
transfer agent or a clearing agency by 4 p.m. in order to be processed 
that day.
    We have received numerous comments raising concerns about this 
approach. In particular, we are concerned about the difficulties that a 
hard 4:00 rule might create for investors in certain retirement plans 
and investors in different time zones. Consequently, our staff is 
focusing on alternatives to the proposal that could address the late 
trading problem, including various technological alternatives. The 
technological alternatives could include a tamper-proof time-stamping 
system and an unalterable fund order sequencing system. These 
technological systems could be coupled with enhanced internal controls, 
third party audit requirements and certifications.
    Our staff has been gathering information from industry 
representatives to better understand potential technological systems 
that could be used to address the late trading problem. Given the 
technological implications of any final rule in this area, it is 
important that we get it right. Thus, I have instructed the staff to 
take the time necessary to fully understand the technology issues 
associated with any final rule. Consequently, the Commission likely 
will not consider a final rule in this area until mid-2005.
    Market Timing/Redemption Fee Rule: Last week, the Commission 
adopted a ``voluntary'' redemption fee rule, which permits (but does 
not require) funds to impose a redemption fee of up to 2 percent. The 
rule requires that fund boards consider whether they should impose a 
redemption fee to protect fund shareholders from market timing and 
other possible abuses. The voluntary rule represents a change from the 
``mandatory'' approach proposed by the Commission. Many commenters 
opposed a mandatory redemption fee rule because of concerns that 
investors would inadvertently trigger the fee's application and because 
a 2 percent redemption fee may not be appropriate in all cases.
    When the Commission adopted the new rule, we also requested comment 
on whether to require that any redemption fee imposed by a fund conform 
to certain uniform standards. This standardization may facilitate 
imposition and collection of redemption fees throughout the fund 
industry. I am hopeful that we will quickly reach a decision on this 
part of the rule, after we hear back from commenters.
    The new rule also mandates that funds be able to access information 
from intermediaries operating omnibus accounts, so that funds can 
identify shareholders in those accounts who may be violating a fund's 
market timing policies. Under these arrangements, the intermediaries 
and funds would share responsibility for enforcing fund market timing 
policies. I should also note that fair value pricing remains critical 
to eliminating arbitrage opportunities for market timing.
    Directed Brokerage Ban: In September 2004, the Commission adopted 
amendments to Rule 12b-1 under the Investment Company Act to prohibit 
mutual funds from directing commissions from their portfolio brokerage 
transactions to broker-dealers to compensate them for distributing fund 
shares. The Commission's concern was that this practice can compromise 
best execution of portfolio trades, increase portfolio turnover, 
conceal actual distribution costs, and inappropriately influence 
broker-dealer recommendations to investors. In adopting the ban, the 
Commission determined that directing brokerage for distribution 
represented the type of conflict that was too significant to address by 
disclosure alone. The directed brokerage ban went into effect December 
13, 2004.

Improving Disclosures to Fund Investors
    Improved mutual fund disclosure--particularly disclosure about fund 
fees, conflicts and sales incentives--has been a stated priority for 
the Commission's mutual fund program throughout my tenure as Chairman, 
even before the mutual fund scandals came to light. As such, disclosure 
enhancements have been an integral part of our reform initiatives. As 
part of our mutual fund reform agenda, we have adopted the following 
disclosure reforms, all of which have become effective.
    Shareholder Reports: In February 2004, the Commission adopted 
significant revisions to mutual fund shareholder reports. These 
revisions include dollar-based 
expense disclosure, quarterly disclosure of portfolio holdings, and a 
streamlined presentation of portfolio holdings in shareholder reports. 
These requirements became effective in August 2004.
    Disclosure Regarding Market Timing, Fair Valuation, and Selective 
Disclosure of Portfolio Holdings: In April 2004, the Commission adopted 
amendments requiring funds to disclose (1) market timing policies and 
procedures, (2) practices regarding ``fair valuation'' of their 
portfolio securities and (3) policies and procedures regarding the 
disclosure of their portfolio holdings. Each of these disclosures 
specifically addresses abuses that came to light in the mutual fund 
scandals. These requirements became effective in May 2004.
    Breakpoint Discounts: In June 2004, the Commission adopted rules 
requiring mutual funds to provide enhanced disclosure regarding 
breakpoint discounts on front-end sales loads, in order to assist 
investors in understanding the breakpoint opportunities available to 
them. This initiative addresses the failure on the part of many broker-
dealers to provide sales load discounts to mutual fund investors who 
were entitled to them. The requirement became effective in July 2004.
    Board Approval of Investment Advisory Contracts: Also in June 2004, 
the Commission adopted rules requiring that shareholder reports include 
a discussion of the reasons for a fund board's approval of its 
investment advisory contract. The disclosure is intended to focus 
directors' and investors' attention on the importance of the contract 
review process and the level of management fees. This requirement 
became effective in August 2004.
    Disclosure Regarding Portfolio Manager Conflicts and Compensation: 
In August 2004, the Commission required that funds provide additional 
information regarding portfolio manager conflicts and compensation, 
including information about other investment vehicles managed by a 
fund's portfolio manager, a portfolio manager's 
investment in the funds he or she manages and the structure of the 
portfolio manager's compensation. These requirements became effective 
in October 2004.
    Point of Sale/Fund Confirmations: In addition to these adopted 
reforms, last week, on March 1, the Commission requested additional 
comment on a proposal requiring brokers to provide investors with 
enhanced information regarding costs and broker conflicts associated 
with their mutual fund transactions. The proposal would require 
disclosure at two key times--first at the point of sale, and second at 
the completion of a transaction in the confirmation statement. We 
tested our proposal with investor focus groups, and based on the very 
helpful feedback we received from these focus groups, we issued our 
request for additional comment. We also are sensitive to the concerns 
expressed by brokerage industry commenters about the costs associated 
with our original proposal. Our staff therefore is examining more cost-
effective methods of providing investors with the disclosures they 
need. I am hopeful that the Commission can move quickly on this 
initiative after we have an opportunity to review the comments that 
respond to our recent request for input.

Upcoming Mutual Fund Initiatives
    Having outlined the Commission's progress on our mutual fund reform 
agenda, I would like to highlight some additional mutual fund related 
initiatives that are on the horizon.
    Portfolio Transaction Costs Disclosure: In December 2003, the 
Commission issued a concept release requesting comment on measures to 
improve disclosure of mutual fund transaction costs. In many cases, 
investors do not understand how the costs associated with the purchase 
and sale of a mutual fund's portfolio securities affect their bottom-
line investment in the fund. These transaction costs can include the 
payment of commissions and spreads as well as costs associated with 
soft dollars and other brokerage arrangements. Transaction costs also 
can encompass costs that are difficult to quantify, such as opportunity 
costs and market impact costs. Using feedback that we received in 
response to our concept release, our staff is preparing a proposal to 
improve disclosure of mutual fund transaction costs.
    Soft Dollars: I believe it is necessary to examine the nature of 
the conflicts of interest that can arise from soft dollars, which 
involve an investment adviser's use of brokerage commissions to 
purchase research and other products and services. Consequently, I have 
formed a Commission task force that is reviewing the use of soft 
dollars, the impact of soft dollars on our Nation's securities markets 
and whether soft dollars further the interests of investors. In 
addition, the task force is reviewing whether we can improve disclosure 
to better inform investors about the use of soft dollars and whether 
there are enhanced disclosures that can be made to fund boards to 
enable them to better evaluate funds' use of soft dollars. The Task 
Force also is examining the definition of ``research'' as used in 
Section 28(e) of the Securities Exchange Act of 1934. Soft dollar 
arrangements present many of the same concerns irrespective of whether 
research is provided on a proprietary basis, or by an independent 
research provider, and I expect that any recommendations from the staff 
would accord similar treatment to both types of arrangement.
    Rule 12b-1: When the Commission proposed to ban directed brokerage 
for distribution under Rule 12b-1, it also requested comment on the 
broader question of whether Rule 12b-1 (which allows mutual fund assets 
to be used to promote the sale of fund shares) should be revised more 
broadly or even eliminated. The Commission received numerous comments 
on this issue. The Commission adopted Rule 12b-1 over 20 years ago, and 
the mutual fund industry has evolved significantly since then. The idea 
of using Rule 12b-1 fees as a substitute for a sales load--which in 
many cases they have come to be--is different than the use of 12b-1 
fees for advertising and marketing purposes, which was envisioned when 
the Rule was adopted. In light of these changes in the industry and in 
the use of 12b-1 fees, the future of Rule 12b-1 is a topic that should 
receive a thorough and reasoned review.
    Mutual Fund Disclosure Reform: As I outlined above, the Commission 
has adopted a number of new mutual fund reform initiatives designed to 
improve the disclosures made to fund investors. Each of these 
disclosure reforms was merited. However, I believe it is time to step 
back and take a top-to-bottom assessment of our mutual fund 
disclosures. I have asked the staff to carry out a comprehensive review 
of the mutual fund disclosure regime and how we can maximize its 
effectiveness on behalf of fund investors. The staff also will examine 
how we can make better use of technology, including the Internet, in 
our disclosure regime. Throughout this review process, we will solicit 
input from mutual fund investors.

Sarbanes-Oxley Implementation
    Two years ago, when I came on board at the Commission, the country 
was still reeling from its disappointment with cooked books, 
indefensible lapses in audit and corporate governance responsibilities, 
and intentional manipulation of accounting rules. These lapses led to 
staggering financial losses and a crisis in investor confidence. The 
resulting Sarbanes-Oxley Act called for the most significant reforms 
affecting our capital markets since the Securities Exchange Act of 
1934. The Act established the foundation necessary to improve financial 
reporting and the behavior of companies and gatekeepers, and we have 
completed the rulemaking to implement these critically important 
reforms. Key requirements have taken hold including:

 CEO and CFO certifications of the material completeness and 
    accuracy of SEC periodic filings;
 Enhanced disclosure of off-balance sheet transactions;
 Electronic reporting within two business days of insider 
    transactions;
 Increased disclosure of material current events affecting 
    companies;
 Strengthened rules regarding the independence of auditors and 
    audit committees;
 Establishment of the PCAOB;
 Issuance of the first PCAOB inspection reports on the large 
    accounting firms;
 Issuance of important auditing standards by the PCAOB; and
 For the first time, as required by Section 404 of the Act, 
    public reporting on internal controls and their effectiveness--by 
    both management and auditors.

    I would like to focus for a moment on the Section 404 requirement 
for management and a company's auditor to report on the effectiveness 
of internal controls over financial reporting. This Section of 
Sarbanes-Oxley may have the greatest long-term potential to improve 
financial reporting. It may also well be the most urgent financial 
reporting challenge facing a large share of corporate America and the 
audit profession in 2005. I expect that we will begin to see a number 
of companies announce that they or their auditors have been unable to 
complete their assessments or audits of controls, and additional 
companies announce that they have material weaknesses in their 
controls.
    For this initial pass, that result should not, by itself, 
necessarily be motivation for immediate or severe market reactions. 
Section 404 is a disclosure provision, and investors will benefit from 
receiving full disclosure regarding any material weaknesses that are 
found--full disclosure about the nature of any material weakness, their 
impact on financial reporting and the control environment and 
management's plans for remediating them. This disclosure will allow 
investors and markets to make the appropriate judgments about what 
companies and auditors find. Section 404 will work as intended if it 
brings this information into public view, and in that event the 
disclosure of material weaknesses in internal controls should be the 
beginning and not the end of the analysis for investors and markets. 
The goal should be continual improvement in controls over financial 
reporting and increased investor information and confidence. This 
should lead to better input for management decisions and higher quality 
information being provided to investors.
    While these benefits are clear, it is also important that we 
evaluate the implementation of our rules and the auditing standard 
issued by the Public Company Accounting Oversight Board (PCAOB) to 
ensure that these benefits are achieved in the most sensible way. We 
have been very sensitive to the implementation of all aspects of the 
Sarbanes-Oxley Act, and especially to this very significant aspect. 
This has included several measured extensions over this past year to 
accommodate the first wave of reporting.
    In addition, in order to assess SEC and PCAOB rules for Section 404 
now that we will have the first year of actual experience under the 
rules, the Commission will hold a roundtable discussion this April and 
is currently soliciting written feedback from the public regarding 
registrants' and accounting firms' implementation of these new 
reporting requirements. Through the roundtable and this feedback, we 
will be closely listening to and assessing the experiences with the 
management and auditor internal control requirements, including seeking 
to identify best practices for the preparation of these reports and 
evaluating whether there are ways to make the process more efficient 
and effective, while fully preserving the benefits of the requirements. 
Throughout this process the Commission and its staff will closely 
coordinate with the PCAOB and its staff, and we will seriously consider 
whether any additional guidance is necessary or appropriate. We are 
actively engaged in other activities to evaluate and assess the effects 
of the recent reforms, including the internal control reporting rules. 
For example, we have announced we are establishing the Securities and 
Exchange Commission Advisory Committee on Smaller Public Companies. The 
advisory committee will conduct its work with a view to protecting 
investors, considering whether the costs imposed by the current 
regulatory system for smaller public companies are proportionate to the 
benefits, and identifying methods of minimizing costs and maximizing 
benefits. In addition, and at the request of Commission staff, a task 
force of the Committee of Sponsoring Organizations (COSO) has been 
established and anticipates publishing additional guidance this summer 
in applying COSO's framework to smaller companies. Our actions have not 
been limited to smaller companies. We also are cognizant of the 
regulatory challenges our foreign registrants face. For all of these 
reasons, we recently extended the compliance date for internal control 
reporting for an additional year for smaller and foreign public 
companies. Review of the first year experiences of our larger 
registrants also should help smaller and foreign issuers in preparing 
their first reports.

Conclusion
    This testimony covers a broad spectrum of serious and very complex 
issues the Commission is currently dealing with. There are a number of 
other substantive activities underway at the Commission as well, but I 
have tried to limit my update to the things I understand are foremost 
on your minds. I thank the Members of this Committee for your interest 
and attention to the important issues affecting the securities markets 
today, and for the support you have shown the Commission and its staff. 
Together, we have made significant progress over the last several years 
in rebuilding public confidence in our markets. This concludes my 
prepared testimony. I would be glad to try and answer any questions you 
may have.
       RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 
                   FROM WILLIAM H. DONALDSON

Q.1. I have been contacted by representatives of the National 
Treasury Employees Union Chapter 293 representing 2,800 
employees at the U.S. Securities and Exchange Commission 
expressing concerns about the parity of benefits paid to SEC 
employees. As you are aware, Section 8 of the Investor and 
Capital Markets Fee Relief Act, Public Law 107-123, provides 
that ``In setting and adjusting the total amount of 
compensation and benefits for employees, the Commission shall 
consult with, and seek to maintain comparability with, the 
agencies referred to under Section 1206 of the Financial 
Institutions Reform, Recovery, and Enforcement Act of 1989 (12 
U.S.C. 1833b).''
    In relevant part, the union chapter has written the 
following:

    [W]hy [does] the SEC refuse . . . to give employees a 
Supplemental 401(k) with 5 percent employer match--a comparable 
FIRREA benefit?

    Pay Parity Lite--SEC Chairman Pitt testified in April 2002 
that his $76 million pay parity request ``is lower than the 
amount that we believe would be required to match what several 
of the banking agencies currently provide. A fully implemented 
system identical to the FDIC model, for example, could easily 
cost more than $100 million.'' See paragraphs 6 & 8, April 17, 
2002 testimony by Chairman Pitt before Subcommittee on 
Commerce, Justice, State, and the Judiciary, Committee on 
Appropriations, U.S. House of Representatives.
    The Supplemental 401(k) benefit is the major difference 
between the SEC and FDIC:

 FDIC: Supplemental 401(k), 5 percent match
 OCC: Supplemental 401(k), 3 percent match
 FHFB: Supplemental 401(k), 3 percent match
 OTS: Supplemental 401(k), 2 percent match
 SEC: No Supplemental 401(k) plan

    Management has advanced 2 arguments against the 
Supplemental 401(k):

 too expensive and
 conflict of interest by SEC retaining a ``regulated 
    entity'' 401(k) Administrator.

    Regarding the ``too expensive'' argument, management 
refuses to provide any cost information to justify their 
position--blithely ignoring both: (1) the statutory 
requirement\1\ of comparable pay and benefits with FIRREA 
agencies and (2) Federal Service Impasses Panel Order \2\ 
requiring SEC to provide NTEU with relevant pay and benefit 
information. Further, we note that the SEC returned $125 
million of its budget over the past 2 years.
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    \1\ 5 U.S.C. Sec. 4802. Similarly, SEC is ignoring the same statute 
by failing to report annually to Congress how it is maintaining pay 
parity with the FIRREA's.
    \2\ See In the Matter of SEC v. NTEU, Case No. 02 FSIP 122 (2002) 
which reads, in part: ``The parties agree to establish a Labor/
Management Committee for the purpose of sharing information that is 
reasonably available and necessary for a full and proper discussion, 
understanding, and negotiations of benefits and compensation.'' Page 10 
Item VII. Benefits and Compensation.
---------------------------------------------------------------------------
    Regarding the ``conflict of interest'' argument, we told 
SEC management about Pentegra Group, who is not subject to SEC 
jurisdiction and administers the OTS Supplemental 401(k). 
Moreover, the conflict of interest issue has not stopped the 
SEC from purchasing goods and services from hundreds of SEC 
registrants (that is, Microsoft, Dell, and Dreyfus to name a 
few). Management's failure to support their arguments or 
consider union solutions speaks volumes.
    Recently, SEC managers proposed a substitute in lieu of the 
Supplemental 401(k) program that would require Congressional 
legislation amending the Federal Employee Retirement System 
statute to specifically allow SEC to increase its contribution 
to Thrift Savings Plan accounts from the government-wide 5 
percent cap to 7 percent. In response to this proposal, the 
union requested:

 copies of their draft legislation;
 list of Congressional sponsors;
 a list of the Congressional Committees approached by 
    the SEC regarding the proposed legislation;
 whether OMB had considered and approved SEC 
    initiative;
 whether SEC was aware of the FERS statute being 
    amended to allow other agencies to do what the SEC 
    proposed;
 timeline for completing the legislation and 
    implementing the Supplemental 401(k).

    Management was either unable or unwilling to provide any 
information to the above information request. Given the 
embryonic and problematic state of management's proposal, the 
union questioned why the Pentegra Administered Supplemental 
401(k) program option is not being pursued . . . .
    In sum, . . . why [is it that the] SEC refuses to provide 
SEC employees with a Supplemental 401(k) and 5 percent Employer 
Match, considered to be the ``crown jewel'' of comparable 
FIRREA benefits.
    I would appreciate your reviewing these concerns and 
providing an appropriate response in light of the Act.

A.1. The Commission is fulfilling the Congress' mandate that it 
provide its employees with overall pay and benefits comparable 
to those provided by the ``FIRREA agencies.'' Looking to the 
full panoply of benefits that agencies provide, rather than a 
single benefit like a 401(k) plan, data from 2004 shows the 
Commission provided benefits that average 28 percent of an 
employee's salary, above an average of 26.5 percent of salaries 
provided by other financial regulators. The pay and benefits 
that the Commission provides have greatly enhanced staff 
retention, a primary goal of pay parity. For fiscal year 2004, 
the last year for which complete data is available, the SEC's 
turnover rate was approximately 6 percent, which is comparable 
with the turnover rates for fiscal years 2002 and 2003 and well 
below the Agency's prepay parity rates of the late-1990's. 
Within the constraints of the Commission's budgets, the 
Commission is committed to continuing to enhance its overall 
employee benefits to maintain comparability and sustain its 
success in employee retention.
    As part of maintaining overall comparability, the 
Commission is interested in being able to adjust the retirement 
benefits for its employees. Conflict-of-interest concerns, 
however, make it far more difficult for the Commission to 
fashion a Supplemental 401(k) than it was for the FIRREA 
agencies. Unlike the FIRREA agencies, the Commission has 
regulatory authority over any firm that would serve as an 
investment adviser. Such conflict-of-interest concerns are not 
present, that is, in the Commission's dealings with other 
vendors, such as Dell, Microsoft, or Dreyfus (over whose day-
to-day business practices the Commission does not have such 
regulatory authority).
    The Commission is exploring the feasibility of increasing 
matching contributions to employees' TSP accounts. This 
approach would avoid the 401(k) conflict-of-interest issues 
discussed above and result in far lower administrative costs--
costs that would provide no direct benefit to SEC employees--
than a stand-alone 401(k). However, since 5 U.S.C. 8432(c)(2) 
currently caps agency TSP contributions at 5 percent, it 
appears that additional legislative authority would be needed 
before we would be able to implement this approach. The 
Commission staff is available to show your staff how 5 U.S.C. 
4802 could be amended to override that cap, which the 
Commission would suggest setting to an increased level of 7 
percent.
    Separately, 5 U.S.C. Section 4802(d)(1)(B)(ii) states that 
the Commission shall include, ``the effects of implementing the 
plan . . . in the annual program performance report submitted'' 
to Congress. The primary effect of pay parity that the SEC 
currently measures is the Agency's turnover rate, as discussed 
above. The SEC has provided this information to Congress in the 
Performance Budget chapter of its fiscal year 2006 
Congressional Budget request. In addition, this information 
also has been included in the Agency's fiscal year 2004 
performance and accountability report.

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

Q.1. I am aware that at the December 15 meeting of the SEC, 
staff responding to a question by Commissioner Campos indicated 
that a solution might be at hand to move Nasdaq's exchange 
application forward.
    Could you comment on these developments and perhaps give us 
an update on this process?

A.1. In December, Nasdaq filed a proposal that would change its 
Nasdaq Market Center Execution Service, formally known as 
SuperMontage, to require that all trades executed in the Nasdaq 
Market Center Execution Service be executed in price/time 
priority. This proposal has been published and is on our 
website (http://www.sec.gov). While neither I nor the 
Commission have come to any conclusions about this filing, I 
believe this proposal is a significant step in Nasdaq's 
exchange application process.
    As currently proposed, the Nasdaq Exchange would not have 
price priority rules, in contrast to the requirements of all 
other U.S. exchanges. Price priority rules promote order 
interaction, which facilitates the price discovery process. The 
lack of price priority rules in Nasdaq's exchange application 
raised profound market structure issues that could have had 
implications for all of our registered exchanges and ultimately 
investors. The proposal filed in December is intended to 
address this concern
    The staff is also working with Nasdaq and the NASD to 
resolve how over-the-counter trades will be reported once they 
are no longer printed on Nasdaq's Market Center Execution 
Service. I anticipate that the NASD will be filing a proposal 
shortly, which the Commission will publish. Once the issue of 
price priority rules is resolved, I expect that the Commission 
would be in a position to act on Nasdaq's exchange application.

Q.2. The New York Stock Exchange would say that the hybrid 
market proposal is their response to customer demands for 
greater speed and certainty as well as providing more choices 
to execute their orders. Would you agree that the NYSE proposal 
demonstrates the benefits of competition between markets?
    I was hoping you could tell me the status of the SEC's 
consideration of the NYSE's hybrid market filing?

A.2. The New York Stock Exchange (NYSE) has proposed to 
significantly alter its existing auction market structure by 
expanding automatic executions on its market. This proposal 
reflects the impact of both competition and regulation on the 
markets.
    Among other things, the NYSE proposes to automatically 
execute in its Direct+ system all marketable limit orders, 
market orders, and ITS commitments, regardless of size. The 
details of enhanced auto-ex capabilities and other changes 
contemplated by the NYSE's Hybrid proposal can be found at 
http://www.sec.gov/rules/sro/nyse/3450667.pdf.
    The NYSE Hybrid proposal was most recently published for 
comment in November 2004. The Commission has received a total 
of25 comments to the proposal. On May 25, the NYSE submitted an 
amendment to its Hybrid proposal. The Commission is currently 
reviewing this recent submission and will soon publish the 
amended Hybrid proposal for another round of public comment 
before taking any final action.

Q.3. Nasdaq and the NYSE currently have some structural 
differences.
    With the trade-through rule being changed from its current 
function to having a fast/slow component, I am hoping to get 
your 
insights on whether the Commission has considered initially 
retaining a reformed trade-through rule for NYSE stocks. 
Perhaps then, that would allow for an extended amount of time 
to study and analyze the results with the NYSE, complimented by 
hybrid fast/slow system, as they have proposed.
    Would it be feasible for the Commission to allow Nasdaq to 
continue to rely on best execution, and come back to trade-
through in a few years and decide if either market or both 
markets need a trade-through rule?

A.3. As you know, the Commission voted to adopt Regulation NMS 
on April 6, 2005. Prior to adopting Regulation NMS, the 
Commission considered the need to extend the Order Protection 
Rule to Nasdaq stocks. The Commission received comment both 
supporting and opposing applying the Rule to Nasdaq stocks.
    Many commenters strongly supported the adoption of a 
uniform rule for all NMS stocks to promote best execution of 
market orders, to protect the best displayed prices, and to 
encourage the public display of limit orders. They stressed 
that limit orders are the cornerstone of efficient, liquid 
markets and should be afforded as much protection as possible. 
They noted, for example, that limit orders typically establish 
the ``market'' for a stock. In the absence of limit orders 
setting the current market price, there would be no benchmark 
for the submission and execution of marketable orders. Focusing 
solely on best execution of marketable orders (and the 
interests of orders that take displayed liquidity), therefore, 
would miss a critical part of the equation for promoting the 
most efficient markets (for example, the best execution of 
orders that supply displayed liquidity and thereby provide the 
most transparent form of price discovery). Commenters 
supporting the need for an intermarket trade-through rule also 
believed it would increase investor confidence by helping to 
eliminate the impression of unfairness when an investor's order 
executes at a price that is worse than the best displayed 
quotation, or when a trade occurs at a price that is inferior 
to the investor's displayed order.
    Other commenters, in contrast, opposed any intermarket 
trade-through rule. Some commenters who were opposed to any 
trade-through rule expressed the view that there is a lack of 
empirical evidence justifying the need for intermarket 
protection against trade-throughs in that market. They noted, 
for example, that trading in Nasdaq stocks has never been 
subject to a trade-through rule, while trading in exchange-
listed stocks, particularly NYSE stocks, has been subject to 
the ITS trade-through provisions. Given the difference in 
regulatory requirements between Nasdaq and NYSE stocks, many 
commenters relied on two factual contentions to show that a 
trade-through rule is not needed: (1) fewer trade-throughs 
occur in Nasdaq stocks than NYSE stocks; and (2) trading in 
Nasdaq stocks currently is more efficient than trading in NYSE 
stocks. Based on these factual contentions, opposing commenters 
concluded that a trade-through rule is not necessary to promote 
efficiency or to protect the best displayed prices.
    The Commission carefully evaluated the views of these 
commenters on both the original proposal and the reproposal. In 
addition, Commission staff prepared several studies of trading 
in Nasdaq and NYSE stocks to help assess and respond to 
commenters' claims, which are available on the Commission's 
website. In general, the Commission found that current trade-
through rates are not lower for Nasdaq stocks than NYSE stocks, 
despite the fact that nearly all quotations for Nasdaq stocks 
are automated, rather than divided between manual and automated 
as they are for exchange-listed stocks. Moreover, the majority 
of the trade-throughs that currently occur in NYSE stocks fall 
within gaps in the coverage of the existing ITS trade-through 
rules that will be closed by the Order Protection Rule. 
Consequently, the Order Protection Rule, by establishing 
effective intermarket protection against trade-throughs, will 
materially reduce the trade-through rates in both the market 
for Nasdaq stocks and the market for exchange-listed stocks.
    In addition, the commenters' claim that the Order 
Protection Rule is not needed because trading in Nasdaq stocks, 
which currently does not have any trade-through rule, is more 
efficient than trading in NYSE stocks, which has the ITS trade-
through provisions, also is not supported by the relevant data. 
The data reveals that the markets for Nasdaq and NYSE stocks 
each have their particular strengths and weaknesses. In 
assessing the need for the Order Protection Rule, the 
Commission has focused primarily on whether effective 
intermarket protection against trade-throughs will materially 
contribute to a fairer and more efficient market for investors 
in Nasdaq stocks, given their particular trading 
characteristics, and in exchange-listed stocks, given their 
particular trading characteristics. Thus, the critical issue is 
whether each of the markets would be improved by adoption of 
the Order Protection Rule, not whether one or the other 
currently is, on some absolute level, superior to the other. 
The Commission believes that effective intermarket protection 
against trade-throughs will produce substantial benefits for 
investors in both markets and, therefore, adopted the Order 
Protection Rule for both Nasdaq and exchange-listed stocks.
    Some commenters argued that competitive forces alone would 
achieve the fairest and most efficient markets. In particular, 
they asserted that reliance on efficient access to markets and 
brokers' duty of best execution would be sufficient without the 
need for an intermarket rule against trade-throughs. This 
argument, however, fails to take into account two structural 
problems--principal/agent conflicts of interest and ``free-
riding'' on displayed prices.
    Agency conflicts may occur when brokers have incentives to 
act otherwise than in the best interest of their customers. For 
example, brokers may have strong financial and other interests 
in routing orders to a particular market, which may or may not 
be displaying the best price for a stock. Moreover, the 
Commission has not interpreted a broker's duty of best 
execution for retail orders as requiring that a separate best 
execution analysis be made on an order-by-order basis. 
Nevertheless, retail investors generally expect that their 
small orders will be executed at the best displayed prices. 
They may have difficulty monitoring whether their individual 
orders miss the best displayed prices at the time they are 
executed and evaluating the quality of service provided by 
their brokers. Given the large number of trades that fail to 
obtain the best displayed prices (for example, approximately 1 
in 40 trades for both Nasdaq and NYSE stocks), the Commission 
is concerned that many of the investors that ultimately 
received the inferior price in these trades may not be aware 
that their orders did not, in fact, obtain the best price. The 
Order Protection Rule will backstop a broker's duty of best 
execution on an order-by-order basis by prohibiting the 
practice of executing orders at inferior prices, absent an 
applicable exception.
    Just as importantly, even when market participants act in 
their own economic self-interest, or brokers act in the best 
interests of their customers, they may deliberately choose, for 
various reasons, to bypass (for example, not protect) limit 
orders with the best displayed prices. For example, an 
institution may be willing to accept a dealer's execution of a 
particular block order at a price outside the NBBO, thereby 
transferring the risk of any further price impact to the 
dealer. Market participants that execute orders at inferior 
prices without protecting displayed limit orders are 
effectively ``free-riding'' on the price discovery provided by 
those limit orders. Displayed limit orders benefit all market 
participants by establishing the best prices, but, when 
bypassed, do not themselves 
receive a benefit, in the form of an execution, for providing 
this public good. This economic externality, in turn, creates a 
disincentive for investors to display limit orders and 
ultimately could negatively affect price discovery and market 
depth and liquidity.
    As demonstrated by the current rate of trade-throughs of 
the best quotations in Nasdaq and NYSE stocks, these structural 
problems often can lead to executions at prices that are 
inferior to displayed quotations, meaning that limit orders are 
being bypassed. The frequent bypassing of limit orders can 
cause fewer limit orders to be placed. The Commission therefore 
believes that the Order Protection Rule is needed to encourage 
greater use of limit orders. The more limit orders available at 
better prices and greater size, the more liquidity is available 
to fill incoming marketable orders. Moreover, greater displayed 
liquidity will at least lower the search costs associated with 
trying to find liquidity. Increased liquidity, in turn, could 
lead market participants to interact more often with displayed 
orders, which would lead to greater use of limit orders, and 
thus begin the cycle again. We expect that the end result will 
be a national market system that more fully meets the needs of 
a broad spectrum of investors.

Q.4.a. This question pertains to the trade-through rate at 
Nasdaq versus the trade-through rate at NYSE--I remember it 
came up last July when you and various market participants 
testified before this Committee. I have been told that Nasdaq 
and NYSE have similar trade-through rates of about 2 percent. 
What is the Commission's justification for imposing the trade-
through rule to Nasdaq when there remains little to no evidence 
that the rule yields measurable results?

A.4.a. One principal factual contention of commenters on the 
original proposal who were opposed to a trade-through rule is 
premised on the claim that there are fewer trade-throughs in 
Nasdaq stocks, which are not covered by any trade-through rule, 
than in NYSE stocks, which are covered by the ITS trade-through 
provisions. To respond to these commenters, the Commissions 
staff reviewed public quotation and trade data to estimate the 
incidence of trade-throughs for Nasdaq and NYSE stocks. In 
general, the Commission has found that current trade-through 
rates are not lower for Nasdaq stocks than NYSE stocks, despite 
the fact that nearly all quotations for Nasdaq stocks are 
automated, rather than divided between manual and automated as 
they are for exchange-listed stocks. Moreover, the majority of 
the trade-throughs that currently occur in NYSE stocks fall 
within gaps in the coverage of the existing ITS trade-through 
rules that will be closed by the Order Protection Rule. 
Consequently, the Commission believes that the Order Protection 
Rule, by establishing effective intermarket protection against 
trade-throughs, will materially reduce the trade-through rates 
in both the market for Nasdaq stocks and the market for 
exchange-listed stocks.
    Some commenters questioned whether the trade-through rates 
found by the staff study were significant enough to warrant 
adoption of the trade-through reproposal. The Commission does 
not agree that the trade-through rates found in the staff study 
are insignificant, nor does it believe that the total number of 
trade-throughs is the sole consideration in evaluating the need 
for the Order Protection Rule. A valid assessment of their 
significance and the need for intermarket protection against 
trade-throughs must be made in light of the Exchange Act 
objectives for the NMS that would be furthered by the Order 
Protection Rule, including: (1) to promote best execution of 
customer market orders; (2) to promote fair and orderly 
treatment of customer limit orders; and (3) by strengthening 
protection of limit orders, to promote greater depth and 
liquidity for NMS stocks and thereby minimize investor 
transaction costs. The staff study examined trade-through rates 
from a variety of different perspectives, including percentage 
of trades, percentage of total share volume, percentage of 
share volume of trades of less than 10,000 shares, and 
percentage of total share volume of traded-through quotations. 
In evaluating the need for the Order Protection Rule, the 
different measures vary in their relevance depending on the 
particular objective under consideration.
    For example, the percentage of total trades that receive 
inferior prices is a particularly important measure when 
assessing the need to promote best execution of customer market 
orders. The staff study found that 1 of every 40 trades (2.5 
percent) for both Nasdaq and NYSE stocks have an execution 
price that is inferior to the best displayed price, or 
approximately 98,000 trades per day in Nasdaq stocks alone. 
Investors (and particularly retail investors) often may have 
difficulty monitoring whether their orders receive the best 
available prices, given the rapid movement of quotations in 
many NMS stocks. Furthering the interests of these investors in 
obtaining best execution on an order-by-order basis is a 
vitally important objective that warrants adoption of the Order 
Protection Rule.
    The percentage of total trades that receive inferior prices 
also is quite relevant when assessing the need to promote fair 
and orderly treatment of limit orders for NMS stocks. Many of 
the limit orders that are bypassed are small orders that often 
will have been submitted by retail investors. One of the 
strengths of the U.S. equity markets and the NMS is that the 
trading interests of all types and sizes of investors are 
integrated, to the greatest extent possible, into a unified 
market system. Such integration ultimately works to benefit 
both retail and institutional investors. Retail investors will 
participate directly in the U.S. equity markets, however, only 
to the extent they perceive that their orders will be treated 
fairly and efficiently. The perception of unfairness created 
when a retail investor has displayed an order representing the 
best price for an NMS, yet sees that price bypassed by 1 in 40 
trades, is a matter of a great concern to the Commission. The 
Order Protection Rule is needed to maintain the confidence of 
all types of investors that their orders will be treated fairly 
and efficiently in the NMS.
    The third principal objective for the Order Protection Rule 
is to promote greater depth and liquidity for NMS stocks and 
thereby minimize investor transaction costs. Depth and 
liquidity will be increased only to the extent that limit order 
users are given greater incentives than currently exist to 
display a larger percentage of their trading interest. The 
potential upside in terms of greater incentives for display is 
most appropriately measured in terms of the share volume of 
trades that currently do not interact with displayed orders. It 
is this volume of trading interest that will begin interacting 
with displayed orders after implementation of the Order 
Protection Rule.
    The share volume of trade-throughs, rather than the number 
of trade-throughs, is most useful for assessing the effect of 
the Order Protection Rule on depth and liquidity because very 
small trades represent such a large percentage of trades in 
today's markets, but a small percentage of share volume. For 
example, the staff study found that, for Nasdaq stocks, 100-
share trades represented 32.7 percent of the number of trade-
throughs, but only 0.8 percent of the share volume of trade-
throughs. Thus, the number of trade-throughs is useful for 
assessing the number of investors, particularly retail 
investors, affected by trade-throughs, while the share volume 
of trade-throughs is useful for assessing the extent to which 
depth and liquidity are affected by trade-throughs. For 
example, 41.1 percent of the share volume of trade-throughs in 
Nasdaq stocks is attributable to trades of greater than 1,000 
shares that bypass quotations of greater than 1,000 shares. 
Addressing the failure of this substantial volume of trading 
interest to interact with significant displayed quotations is a 
primary objective of the Order Protection Rule.
    In contrast, the share volume of quotations that currently 
are traded-through grossly underestimates the potential for 
increased incentives to display because it reflects only the 
current size of displayed quotations in the absence of strong 
price protection. As a result, the relatively low share volume 
of traded-through quotations is a symptom of the problem that 
the Order Protection Rule is designed to address--a shortage of 
quoted depth--rather than an indication of the benefits that 
the Order Protection Rule will achieve. For example, when many 
Nasdaq stocks can trade millions of shares per day, but have 
average displayed size of less than 2,000 shares at the NBBO, 
it will be nearly impossible for trade-throughs of displayed 
size to account for a large percentage of total share volume--
there simply is not enough displayed depth. Small displayed 
depth is evidence of a market problem, not market quality.
    Every trade-through transaction in today's markets 
potentially sends a message to limit order users that their 
displayed quotations can be and are ignored by other market 
participants. The cumulative effect of such messages over time 
as trade-throughs routinely occur each trading day should not 
be underestimated. When the total share volume of trade-through 
transactions that do not interact with displayed quotations 
reaches 9 percent or more for many of the most actively traded 
Nasdaq stocks, this message is unlikely to be missed by those 
who watched their quotations being traded through. Certainly, 
the routine practice of trading through displayed size is most 
unlikely to prompt market participants to display even greater 
size.
    Thus, the Commission believes that the percentage of share 
volume in a stock that trades through displayed and accessible 
quotations is a useful measure for assessing the potential 
increase in incentives for display of limit orders after 
implementation of the Order Protection Rule. In particular, the 
dual measurements of percentage of share volume of traded-
through quotations (an overall 1.9 percent for Nasdaq stocks) 
and the percentage of share 
volume of trades that bypass displayed quotations (an overall 
7.9 percent for Nasdaq stocks) likely represent the lower and 
upper bounds for a potential improvement in depth and liquidity 
after implementation of the Order Protection Rule.

Q.4.b. Have you and the other Commissioners or SEC staff 
discussed the cost implications on the securities industry for 
imposing a trade-through rule on the trading of Nasdaq-listed 
securities?

A.4.b. The Commission discussed the estimated costs of the 
Order Protection Rule in both the Proposing and Reproposing 
Releases. In the Reproposing Release, the Commission noted the 
concerns of some commenters over the anticipated cost of 
implementing the original trade-through proposal. These 
commenters argued that the Order Protection rule would be too 
expensive and that the costs associated with implementing it 
would outweigh the perceived benefits of the Rule. Some 
commenters were concerned about the cost of specific 
requirements in the proposed rule, particularly the procedural 
requirements associated with the proposed opt out exception 
(for example, obtaining informed consent from customers and 
disclosing the NBBO to customers).
    Some of the commenters based their concerns about 
implementation costs on the estimated costs included in the 
Proposing Release for purposes of the Paperwork Reduction Act 
of 1995 (PRA). In the Reproposing Release, the Commission 
revised its estimate of the PRA costs associated with the 
proposed rule to reflect the streamlined requirements of the 
Rule as reproposed, and to reflect a further refinement of the 
estimated number of trading centers subject to the rule. In 
particular, the Order Protection Rule as reproposed did not 
(and as adopted does not) contain an opt out exception, as was 
originally proposed. Therefore, the concerns expressed by 
commenters relating to the costs of implementing an opt out 
exception are not applicable, and were not included in the 
Reproposing Release and the final rule as approved by the 
Commission. In the Reproposing Release, the Commission also 
refined its estimate of the number of broker-dealers that would 
be required to establish, maintain, and enforce written 
policies and procedures to prevent trade-throughs.
    Taken together, these changes substantially reduced the 
estimated costs associated with the implementation of and 
ongoing compliance with the rule. Specifically, the estimated 
PRA costs associated with the reproposed Order Protection Rule, 
as discussed in the Reproposing Release, were $17.8 million in 
start-up costs and $3.5 million in annual costs. In addition, 
the estimated implementation costs discussed in the Reproposing 
Release for necessary systems modifications were $126 million 
in start-up costs and $18.4 million in annual costs. 
Accordingly, the total estimated costs discussed in the 
Reproposing Release were $143.8 million in start-up costs and 
$21.9 million in annual costs.
    Although a number of commenters generally expressed the 
view that there would be significant costs associated with 
implementing and complying with the reproposed Order Protection 
Rule, they did not discuss the specific estimated cost figures 
included in the 
Reproposing Release or include their own estimates. Many 
commenters expressed concerns with the costs associated with 
implementing the Voluntary Depth Alternative, believing that 
the costs of implementing the Voluntary Depth Alternative would 
be substantially greater than the Market BBO Alternative. As 
you know, the Commission voted to adopt the Market BBO 
Alternative and not the Voluntary Depth Alternative.
    The Commission does not believe that the changes made to 
the Order Protection Rule as adopted, including the inclusion 
of a stopped order exception, will materially impact the 
estimated costs included in the Reproposing Release. The 
Commission continues to estimate implementation costs for the 
Order Protection Rule as adopted of approximately $143.8 
million and annual costs of approximately $21.9 million.
    In assessing the implementation costs of the Order 
Protection Rule, it is important to recognize that much, if not 
all, of the connectivity among trading centers necessary to 
implement intermarket price protection has already been put in 
place. Trading centers for exchange-listed securities already 
are connected through the ITS. The Commission understands that, 
at least as an interim solution, ITS facilities and rules can 
be modified relatively easily and at low cost to provide the 
current ITS participants a means of complying with the 
provisions of the rule. With respect to Nasdaq stocks, 
connectivity among many trading centers already is established 
through private linkages. Routing out to other trading centers 
when necessary to obtain the best prices for Nasdaq stocks is 
an integral part of the business plan of many trading centers, 
even when not affirmatively required by best execution 
responsibilities or by Commission rule. Moreover, a variety of 
private vendors currently offer connectivity to NMS trading 
centers for both exchange-listed and Nasdaq stocks.
    Commenters also expressed concern that applying the trade-
through proposal to the Nasdaq market would harm market 
efficiency and execution quality. The Commission, however, 
stated in the Reproposing Release, and continues to believe, 
that a rule that serves to limit the incidence of trade-
throughs will improve market efficiency and benefit execution 
quality.

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

Q.1. I appreciate your comments regarding the trade-through 
proposal. I have a few thoughts regarding this issue because 
many interested parties have visited my office with concerns.
    In recent years, the United States has moved from trading 
in fractions to trading in decimals. While decimalization has 
been a boon to investors by reducing spreads, it has 
drastically reduced the amount of liquidity they can see at the 
national best bid and offer. Where investors used to be able to 
see liquidity over a span of 12 cents, today the national best 
bid and offer shows them liquidity at only a penny.
    As a policy matter, it is hard to argue that decimalization 
should leave investors with less transparency and liquidity.
    However, wouldn't it make sense to consider updating the 
rules governing the display of market data to compensate for 
the reduction in transparency caused by decimalization?
    In other words, is not it possible that restoring this lost 
transparency would facilitate finding the ``best price'' and 
achieve some of the goals of the trade-through proposal, but do 
so in a way that is less intrusive and more reliant on market 
forces?
    (For example by extending the limit order display rule to 
require exchanges, market makers, and other market centers to 
publish customer orders within 5 cents of their best published 
quotations.)

A.1. The Commission received a few comment letters suggesting 
that, rather than reducing the consolidated display 
requirement, the Commission should expand the requirement to 
include additional information on depth-of-book quotations, 
because the NBBO alone has become less informative since 
decimalization. The Commission does not believe, however, that 
streamlining the quotations included in the consolidated 
display requirement will detract from the quality of 
information made available to investors. The adopted 
consolidated display rule will continue to require the 
disclosure of basic quotation information (for example, prices, 
sizes, and market center identifications of the NBBO). 
Particularly for retail investors, the NBBO continues to retain 
a great deal of value in assessing the current market for small 
trades and the quality of execution of such trades. For 
example, statistics on order execution quality for small market 
orders (the order type typically used by retail investors) 
reveal that their average execution price is very close to, if 
not better than, the NBBO. The adopted consolidated display 
requirement will allow market forces, rather than regulatory 
requirements, to determine what, if any, additional quotations 
outside the NBBO are displayed to investors. Investors who need 
the BBO's of each SRO, as well as more comprehensive depth-of-
book information, will be able to obtain such data from markets 
or third party vendors. Commenters that discussed this aspect 
of the proposal generally agreed that the proposal would 
benefit investors and vendors by giving them greater freedom to 
make their own decisions regarding the data they need.

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

Q.1. A brokerage firm has a program in place to rebate 50 
percent of the 12b-1 fees that it receives for mutual funds to 
its customers who invest in those funds. This can represent a 
real cost savings for investors. But some mutual funds are 
refusing to participate, in part because they believe that 
rebating of 12b-1 fees to investors may not be permitted under 
(the existing interpretation of) Federal securities laws.
    I understand that the SEC staff has taken a look at this 
issue. Will you provide guidance to the marketplace as to 
whether or not it is permissible to rebate 12b-1 fees to 
investors? Where will this task stand on the SEC's list of 
priorities?

A.1. Some funds may be concerned that a broker-dealer's rebate 
of 12b-1 fees to fund investors would violate Rule 12b-1 under 
the Investment Company Act and/or Section 22(d) of that Act. As 
discussed below, however, Rule 12b-1 does not prohibit broker-
dealers from rebating 12b-1 fees to their customers, and such 
rebates may be paid by broker-dealers in a manner consistent 
with Section 22(d).
    Rule 12b-1: Rule 12b-1 is an exemptive rule that permits a 
fund to pay for distribution expenses using fund assets under 
certain conditions. Among other things, a fund must make such 
payments pursuant to a written plan of distribution (12b-1 
plan), and the fund's board of directors must determine, when 
implementing and continuing the plan, that there is a 
reasonable likelihood that the plan will benefit the fund and 
its shareholders.
    The staff recently provided interpretive guidance 
concerning fund directors' duties under Rule 12b-1 in 
connection with rebates of 12b-1 fees by broker-dealers. The 
staff stated that a fund's board of directors should consider 
any rebates of 12b-1 fees by broker-dealers to their customers 
when determining whether to implement or continue the fund's 
12b-1 plan.\1\ Some apparently have misinterpreted this staff 
guidance to mean that a fund's board could never determine that 
there is a reasonable likelihood that a 12b-1 plan would 
benefit the fund and its shareholders if a broker-dealer 
rebated 12b-1 fees to its customers. I understand that the 
staff intends to provide additional guidance in the near future 
to clarify that Rule 12b-1 does not prohibit fund shareholders 
from receiving rebates of 12b-1 fees from broker-dealers.
---------------------------------------------------------------------------
    \1\ See Edward Mahaffy (pub. avail. Mar. 6, 2003). See also 
Southeastern Growth Fund, Inc. (pub. avail. May 22, 1986).
---------------------------------------------------------------------------
    Section 22(d): Section 22(d) prohibits a fund, its 
principal underwriter, and dealers from selling fund shares at 
a price other than the current offering price set forth in the 
fund's prospectus. Thus, for example, the staff has taken the 
position that a dealer is generally prohibited from providing a 
benefit to its customers that would directly offset a portion 
of the offering price of fund shares.\2\ In general, however, 
the staff believes that Section 22(d) does not prohibit dealers 
from paying or making available certain benefits to their 
customers so long as the benefits are not directly related to 
the purchase of fund shares.\3\
---------------------------------------------------------------------------
    \2\ See Murphy Favre, Inc., SEC No-Action Letter, May 22, 1987 
(stating that a broker-dealer's proposal to provide coupons for 
discount travel to investors in connection with their purchase of fund 
shares generally would violate Section 22(d)); The Alger Fund, SEC No-
Action Letter, May 4, 1990 (stating that a broker-dealer's proposal to 
provide free airline mileage credits to persons exchanging shares of 
one fund for shares of other funds would violate Section 22(d)).
    \3\ See, that is, Portico Funds, Inc., SEC No-Action Letter, April 
11, 1996 (stating that a bank's proposal to provide certain benefits to 
its customers who, among other things, held specified minimum balances 
in fund shares purchased through their brokerage account at a bank 
affiliate would not violate Section 22(d)).
---------------------------------------------------------------------------
    Whether a broker-dealer's rebate of 12b-1 fees to its 
customers would directly offset the offering price of fund 
shares in violation of Section 22(d) would depend on the 
particular facts and circumstances. In general, however, 
rebates of 12b-1 fees by a broker-dealer that are not directly 
related to the purchase of fund shares would not violate 
Section 22(d). I have been informed that the staff intends to 
provide additional guidance in the near future to clarify this 
point.

Q.2. Chairman Donaldson, I read a recent press release that 
stated that the Commission has added 19 members to the Advisory 
Committee on Smaller Public Companies. What is the next step 
that will be taken by the Advisory Committee?
    We filled the 19 openings on the Advisory Committee on 
March 7, 2005. The Advisory Committee held its first meeting, 
its organizational meeting, on April 12. At that meeting, the 
committee decided to issue a release seeking public comment on 
its proposed agenda. The release was issued on April 26 and 
published in the Federal Register on April 29. The public 
comment period ended on May 31. After consideration of the 
public comments, the committee will finalize its agenda.
    The committee is not waiting until the public comment 
period is over, however, to begin its work. The Co-Chairs have 
established four subcommittees, where they expect most of the 
fact finding to occur. The subcommittees are:

 Internal Control Over Financial Reporting
 Corporate Governance and Disclosure
 Accounting Standards
 Capital Formation

    The subcommittees have begun their work and will be 
providing periodic reports to the Co-Chairs and the full 
Advisory Committee. The next meeting of the full committee is 
scheduled for mid-June in New York City, with follow up 
meetings scheduled for August in Chicago and September in San 
Francisco. The Co-Chairs expect to take public testimony at 
those meetings. The fact-finding phase of the committee's 
efforts is scheduled to be completed at the end of September.
    The committee's Master Schedule and proposed agenda, as 
well as other information on the committee, are available on 
its web page, which can be found on the Commission's website at 
http://www.sec.gov/info/smallbus/acspc.shtml.

Q.3. How do you see the role of the Advisory Committee on 
Smaller Public Companies evolving as you implement the 
provisions of Sarbanes-Oxley? Will the Commission be involved 
in other rulemaking processes?

A.3. I expect that the role of the Advisory Committee will 
evolve somewhat as the Commission continues to implement 
Sarbanes-Oxley, including the internal control provisions of 
Section 404. The Commission may resolve some of the near-term, 
smaller public company implementation issues before the end of 
the committee's 13-month term in April 2006. Similarly, the 
committee may make some interim recommendations before the end 
of its term. I suspect, however, that most of the committee's 
recommendations will involve longer-term issues involving the 
structure of the SEC's program for regulating smaller public 
companies, and that the committee will issue those 
recommendations in April 2006. We intend to give serious 
consideration to all the Advisory Committee's recommendations, 
whether they involve rulemaking or other administrative action.

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

Q.1. Though I applaud the Commission's decision yesterday to 
delay the implementation of Regulation B, the delay does not 
change the fact the regulation is fundamentally flawed. As you 
know, the Commission recently received a letter from 14 Members 
of this Committee, you have also received a bipartisan letter 
from our House colleagues and a joint letter from the Federal 
Reserve, FDIC and OCC all voicing opposition to this 
regulation. Will the Commission revise the regulation, rather 
than simply delay it?

A.1. The Commission proposed Regulation B for public comment in 
June 2004. We received over 100 comments, including many 
thoughtful comments from banks and the banking regulators. To 
ensure that we have adequate time to fully consider the 
commenters' concerns, the Commission granted banks and savings 
associations an exemption from broker registration, which 
otherwise would be required by the Gramm-Leach-Bliley Act, 
through September 30, 2005.
    This delay should give us time to craft a set of rules that 
will implement the bank broker provisions of the GLBA, and 
achieve functional regulation, in a way that works for the 
industry. Our primary goal is to clarify the reach of the 
statutory exceptions. However, we are also mindful that banks 
engage in other securities activities that are outside of those 
exceptions but that nonetheless may raise limited investor 
protection concerns. We plan to address those activities, not 
by bending the statute to the breaking point, but by providing 
targeted exemptions designed to ensure that the investor 
protection concerns remain limited. We believe we are making 
good progress in finalizing bank broker rules that will strike 
the right balance.
    As we move forward, we will continue to work with the 
banking regulators and with the industry. We believe we can 
fulfill our investor-protection mandate while responding to the 
industry's need for flexibility and the bank regulators' 
objective of ensuring the safety and soundness of the national 
banking system. On a related note, I recently met with the 
heads of the banking agencies to learn more about their 
specific concerns and expect to receive additional information 
from them.

Q.2. In your testimony you told us you are still working on the 
final rule after-hours trading. What kind of message is sent to 
investors when you come out with rules on independent chairs, 
months ago, even though many argue if that is a problem or not, 
and we still do not have a final rule on one of the real abuses 
in the mutual fund industry?

A.2. The independent chairman provision, in the Commission's 
view, was necessary to address the conflicts of interest 
involved in the recent enforcement actions.
    The Commission proposed to address late trading abuses in 
December 2003, a few months after the mutual fund scandals 
first were made public. The Commission's proposal (the Hard 4 
close) would permit same-day pricing only for orders to 
purchase or redeem fund shares that are received by the fund, a 
single designated transfer agent for the fund, or a registered 
clearing agency by the fund's pricing time (which for most 
funds is 4 p.m. Eastern Time).
    Currently, fund intermediaries (including broker-dealers, 
banks, and retirement plan administrators) must accept orders 
to purchase or redeem a fund's shares on behalf of the fund, 
but may submit those orders to the fund after 4 p.m. Funds rely 
on intermediaries to separate orders received before 4 p.m., 
which should receive same day pricing, from orders received 
after 4 p.m., which should receive next-day pricing. 
Unfortunately, we have found that on numerous occasions, 
intermediaries permitted late trading by bundling post-4 p.m. 
orders with pre-4 p.m. orders for same-day pricing.
    The Hard 4 close proposal was designed to reduce the 
potential for late trading by limiting the entities that could 
accept an order for same-day pricing. Many commenters objected 
to the proposal, however, because it would require a large 
number of intermediaries to change the way they do business, 
thus imposing substantial costs on them. Other commenters 
expressed serious reservations about the impact of the rule on 
fund shareholders in Western time zones, and on shareholders 
who invest through pension plans. Since the end of the comment 
period, Commission staff has been evaluating comments the 
Commission has received on the proposal, including proposed 
alternative approaches to the Hard 4 close. Our staff continues 
to research and evaluate other approaches to the problem.

Q.3. Can you give me an update on the Nasdaq exchange 
application. Does it bother you that it has taken so long to 
approve/disapprove their application?

A.3. Please see the response to Senator Allard's question 1 for 
an update on the status of Nasdaq's exchange's application.

Q.4. Do you believe that delaying implementation of Section 404 
of Sarbanes-Oxley for foreign companies for a year puts 
American companies, who must incur those costs now, at a 
competitive disadvantage?

A.4. No. The Commission provided for this delay because many 
companies outside the United States, particularly in Europe, 
are facing the significant burden, not faced by U.S. companies, 
of converting their accounting systems in 2005 to conform to 
International Financial Reporting Standards, or ``IFRS. '' In 
some cases, these companies and their auditors are well on 
their way to completing the processes necessary to report on 
their internal controls. In many other cases, however, it would 
be a significant strain on both company and accounting firm 
resources to undertake the conversion to IFRS and the 
initiation of internal control reports at the same time.
    Allowing foreign issuers the time to work through the IFRS 
conversion process before implementing internal control 
reporting requirements should provide for more effective 
implementation of both the conversion to IFRS and the internal 
control reporting requirements, and ultimately benefit 
investors.

Q.5. Are you concerned that the options that FASB gives 
corporations for expensing models will confuse investors?

A.5. Investors should benefit from the new standard because, 
for the first time, issuers will expense the cost of all 
employee stock options. While different models may be used to 
calculate that expense, the model selected must comply with the 
general criteria set forth in the standard. Overall, the new 
standard should improve the comparability of financial 
statements.
    Both the new FASB accounting standard and the Commission 
staff guidance published in Staff Accounting Bulletin No. 107 
(SAB 107), however, emphasize the need for companies to explain 
to investors the methods and models used for expensing the cost 
of employee stock options. In SAB 107, the Commission staff 
also notes that companies should explain any significant 
differences between the financial statements before and after 
implementation of the new accounting standard, including 
differences that result from refinements in a company's 
estimates or assumptions that are used in its model. These 
disclosures will be an important part of the information 
provided to investors.

Q.6. Are you concerned about the number of 3-2 votes the 
Commission has taken during your tenure?

A.6. Much has been made about the very few votes in which the 
Commission has not reached consensus. I would like to set the 
record straight.
    In over 98 percent of all instances in which we have had a 
Commission vote during my tenure, we have had consensus. We 
always seek to reach consensus, but sometimes reasonable people 
can differ, particularly on very complex or difficult matters. 
But let me explain how I reach a decision on these issues.
    I do not view any market issues as ``Republican'' or 
``Democratic'' issues. I approach each issue based on my over 
30 years experience with the securities industry--as the 
founder of a major Wall Street brokerage firm, the Chairman of 
a stock exchange, and a CEO of a listed company. Those 
experiences give me a perspective that guides me in my 
determinations. I advocate what I believe is best for our 
marketplace, without regard for political labels. Obviously, 
there are many issues in which consensus can be reached through 
compromise. But on major issues, some of which have languished 
for years at the Commission, I am driven by my understanding of 
the need for markets to have certainty and closure. 
Fortunately, the areas where we disagree are few and far 
between, but above all we must each cast a vote in compliance 
with our mandate--to protect investors and ensure that our 
markets are fair and orderly.

Q.7. Are you concerned that the U.S. capital markets are not as 
attractive to foreign issuers as they once were, and most of 
the new hires in the financial services sector last year were 
accountants, auditors, lawyers, and compliance officials?

A.7. The SEC's responsibility to create results in U.S. markets 
that are attractive to U.S. and other investors necessitates a 
regulatory system that is designed to promote investor 
protection. I believe that both issuers and investors will be 
attracted to high quality markets, and that keeping the U.S. 
markets at the highest quality is imperative, both from a 
policy perspective as well as from our statutory mandate. 
Accordingly, the regulatory efforts of the past 3 years will 
have the long-term effect of assuring the continued viability 
and strength of the U.S. markets.
    The enactment of the Sarbanes-Oxley Act has required both 
U.S. and foreign issuers to refocus on the need to have strong 
accounting and financial reporting systems. This increased 
attention to financial reporting may be a reason for any 
increase in the hiring of accountants, auditors, lawyers, and 
compliance officials. As noted in response to question 4, many 
foreign private issuers also are in the process of converting 
from the use of home-country accounting standards to 
International Financial Reporting Standards. While this process 
has not been easy for many companies, in the long-run it should 
lead to significant improvements in the quality and integrity 
of the financial information that fuels our securities markets.

Q.8. Nasdaq and NYSE have similar trade through rates of about 
2 percent. What is the justification for imposing a rule, when 
we see that it does not necessarily have any measurable 
results. What are the cost implications for the securities 
industry for imposing a trade-through rule on the trading of 
Nasdaq-listed securities?

A.8. The Commission believes that the Order Protection Rule, by 
establishing effective intermarket protection against trade-
throughs, will significantly reduce the trade-through rates in 
both the market for Nasdaq stocks and the market for exchange-
listed stocks. Please see my answer to Senator Allard's 
question 4 for the complete response to this question.

Q.9. What significant current and recent enforcement actions 
have been taken against NYSE specialists by the SEC? Press 
reports indicate other problems, without naming the firms; can 
you explain the functional problems likely to be revealed?

A.9. In March 2004, the Commission settled administrative 
enforcement proceedings against the five largest NYSE 
specialist firms. The terms of the settlements required the 
five firms to, among other things, disgorge profits and pay 
fines of approximately $240 million, collectively.
    In July 2004, the Commission settled administrative 
proceedings against the remaining two NYSE specialist firms. 
The terms of the settlements required these two firms to, among 
other things, disgorge profits and pay fines of approximately 
$5 million.
    On April 12, 2005, the Commission instituted an 
administrative proceeding, which is still pending, against 20 
former NYSE specialist individuals in connection with the same 
conduct: David A. Finnerty, Donald R. Foley II, Scott G. Hunt, 
and Thomas J. Murphy--formerly of Fleet Specialist, Inc.; Kevin 
M. Fee and Frank A. Delaney IV of Bear Wagner Specialists LLC; 
Freddy DeBoer--formerly of LaBranche & Co. LLC; Todd J. 
Christie, James V. Parolisi, Robert W. Luckow, Patrick Murphy, 
and Robert A. Johnson, Jr.--formerly of Spear Leeds & Kellogg 
Specialists LLC; and Patrick J. McGagh, Jr., Joseph Bongiorno, 
Michael J. Hayward, Richard P. Volpe, Michael F. Stern, Warren 
E. Turk, Gerard T. Hayes, and Robert A. Scavone, Jr.--formerly 
of Van der Moolen Specialists USA, LLC. Simultaneously, the 
U.S. Attorney's Office for the Southern District of New York 
filed criminal charges against 15 of these specialists in 
connection with the same conduct.
    In the pending action against the former NYSE specialists, 
the Division of Enforcement alleges that between 1999 and mid-
2003 these specialists pervasively engaged in fraudulent and 
other improper trading by executing orders for their firms' 
proprietary accounts ahead of executable public customer or 
``agency'' orders that were placed through the NYSE's 
electronic trading system known as the DOT system. The 
complaint states that, through these transactions, these 
specialists violated their basic obligation to match executable 
public customer buy and sell orders, and not to fill customer 
orders through trades from their firms' proprietary accounts 
when those customer orders could be matched with other customer 
orders. The Division also alleges that, through this improper 
trading, these specialists caused customer losses in the 
millions of dollars during the years in question. The Division 
alleges that through this course of fraudulent trading, the 
specialists willfully violated Section 17(a) of the Securities 
Act of 1933, Sections 10(b) and 11(b) of the Securities 
Exchange Act of 1934, and Rules 10b-5 and 11b-1 thereunder, and 
various NYSE rules. The proceedings will determine what relief, 
if any, is in the public interest including disgorgement, 
prejudgment interest, civil penalties, and other remedial 
relief.
    Also on April 12, 2005, the Commission settled an 
administrative proceeding against the NYSE in connection with 
its failure to adequately regulate its specialists' trading. 
Under the terms of the settlement, the NYSE is required to, 
among other things, set aside $20 million to fund a third-party 
regulatory auditor to conduct four regulatory audits of the 
Exchange through 2011.
    As the Commission's April 12 press releases noted, the 
staffs investigation of individuals is on-going. The staff is 
continuing to investigate to determine whether it is 
appropriate to recommend the institution of additional 
administrative proceedings against other individual specialists 
in connection with the same conduct.
    In addition, the staff is continuing to investigate the 
conduct of the NYSE regulatory staff to determine whether it is 
appropriate to recommend the institution of administrative 
proceedings against any NYSE employees in connection with the 
NYSE's failure to adequately regulate specialist trading.

Q.10. In studying the comments submitted to the SEC on Reg. 
NMS, many in the industry, except for the NYSE and some 
specialist firms, had serious concerns about the economic work 
by the SEC to justify a trade-through rule on Nasdaq. In fact, 
Commissioner Glassman, an economist, decried the SEC economic 
work in the December 15 open meeting to discuss the revised 
trade-through proposal. Do you share these concerns?

A.10. These economic studies tell me that while both primary 
equity markets have great strengths, they both have weaknesses 
that could be improved with enhanced incentives for order 
display. The studies also support the comments we received--
that the problem of trade-throughs is a real one, particularly 
for small investors who cannot easily monitor the behavior of 
their agents.
    Many of the criticisms of the staff studies generally 
related to possible reasons why the staff studies might have 
overestimated trade-through rates, particularly for Nasdaq 
stocks. In response to these comments, Commission staff 
analyzed and supplemented its trade-through study, and found 
that these studies continue to support the need for enhanced 
protection of limit orders as a means to promote greater depth 
and liquidity in NMS stocks.

Q.11. All regulations should clearly define the problems that 
they are attempting to solve. In the case of extending a trade-
through rule to Nasdaq, what problem is the SEC is trying to 
solve? I have heard it said that a trade-through rule would 
encourage the posting of limit orders, but according to 
statistics from retail brokers (whose customers consist of many 
individual investors), individual investors prefer to post 
limit orders in Nasdaq instead of the NYSE. Since Nasdaq does 
not have a trade-through rule and the NYSE has a trade-through 
rule, it does not appear that the theory of encouraging limit 
orders can be upheld.

A.11. By strengthening price protection in the NMS for 
quotations that can be accessed fairly and efficiently, the 
Order Protection Rule is designed to promote market efficiency 
and further the interests of both investors who submit 
displayed limit orders and investors who submit marketable 
orders. Price protection encourages the display of limit orders 
by increasing the likelihood that they will receive an 
execution in a timely manner and helping preserve investors' 
expectations that their orders will be executed when they 
represent the best displayed quotation. Limit orders typically 
establish the best prices for an NMS stock. Greater use of 
limit orders will increase price discovery and market depth and 
liquidity, thereby improving the quality of execution for the 
large orders of institutional investors.
    Some commenters asserted that the large number of limit 
orders in Nasdaq stocks indicates that sufficient incentives 
exist for the placement of limit orders in such stocks. 
Strengthened intermarket trade-through protection, however, is 
designed to improve the quality of limit orders in a stock, 
particularly their displayed size, and thereby promote greater 
depth and liquidity. This goal is not achieved, for example, by 
a large number of limit orders with small sizes and high 
cancellation rates.
    Strong intermarket price protection also offers greater 
assurance, on an order-by-order basis, to investors who submit 
market orders that their orders, in fact, will be executed at 
the best readily available prices, which can be difficult for 
investors, particularly retail investors, to monitor. Investors 
generally can know the best quoted prices at the time they 
place an order by referring to the consolidated quotation 
stream for a stock. In the interval between order submission 
and order execution, however, quoted prices can change. If the 
order execution price provided by a market differs from the 
best quoted price at order submission, it can be particularly 
difficult for retail investors to assess whether the difference 
was attributable to changing quoted prices or to an inferior 
execution by the market. The Order Protection Rule will help 
assure, on an order-by-order basis, that markets effect trades 
at the best available prices. Finally, market orders need only 
be routed to markets displaying quotations that are truly 
accessible.
    In addition, commenters' claim that the Order Protection 
Rule is not needed because trading in Nasdaq stocks, which 
currently does not have any trade-through rule, is more 
efficient than trading in NYSE stocks, which has the ITS trade-
through provisions, also is not supported by the relevant data. 
This conclusion is particularly evident when market efficiency 
is examined from the perspective of the transaction costs of 
long-term investors, as opposed to short-term traders. The data 
reveals that the markets for Nasdaq and NYSE stocks each have 
their particular strengths and weaknesses. In assessing the 
need for the Order Protection Rule, the Commission has focused 
primarily on whether effective intermarket protection against 
trade-throughs will materially contribute to a fairer and more 
efficient market for investors in Nasdaq stocks, given their 
particular trading characteristics, and in exchange-listed 
stocks, given their particular trading characteristics. Thus, 
the critical issue is whether each of the markets would be 
improved by adoption of the Order Protection Rule, not whether 
one or the other currently is, on some absolute level, superior 
to the other. It is also worth noting that many of the trade-
throughs in listed stocks involve trades not subject to the 
existing ITS trade-through rule. These trade-throughs involve 
100 share quotes and blocks executed off an exchange, which are 
excluded from the ITS rule.
    For these reasons, the Commission believes effective 
intermarket protection against trade-throughs will produce 
substantial benefits for investors in both markets and, 
therefore, voted to adopt the Order Protection Rule for both 
Nasdaq and exchange-listed stocks.

Q.12. Extending the trade-through rule to Nasdaq would create 
significant changes to that market. I have heard much 
controversy over this proposed rule. It appears that the 
Commission is divided on the trade-through rule and many market 
participants are very much opposed to it. Would it not be best 
to find a way that could have more consensus, both among the 
industry and the Commissioners, before moving forward with such 
a dramatic rule change? After all, such changes could have a 
significant impact on the capital markets.

A.12. Regulation NMS raises complex, difficult issues that go 
to the heart of our national market system. The problems raised 
by these issues have beset the marketplace for years, to the 
detriment of investors. The adoption of Regulation NMS is the 
culmination of a deliberative and open process undertaken by 
the Commission that included more than 5 years of study, 
multiple public hearings and roundtables, an advisory 
committee, three concept releases, a constant dialogue with 
industry participants and investors, a proposing release, 
supplemental release, and reproposing release. In addition, in 
response to its various solicitations of comment, the 
Commission received over 2,400 comment letters. The insights of 
these commentators on the proposal, as well as those of 
panelists at the public hearings, were carefully considered by 
the Commission and have informed Regulation NMS as adopted. I 
believe that this comprehensive, transparent, and iterative 
process was in the best tradition of Commission rulemaking.
    It is important to recognize that the views of the various 
participants in the market structure debate can, and do, differ 
on the policy issues raised by Regulation NMS. This difference 
is reflected in the many comments letters received by the 
Commission, both supporting the imposition of a trade-through 
rule for all NMS stocks and opposing such a rule. This lack of 
consensus among the industry and investors is not, however, 
surprising. We cannot expect all market participants to agree 
on issues as complex and fundamental as those raised by 
Regulation NMS. Given the lack of consensus among the many 
commenters, it also is not surprising that the Commissioners 
themselves hold different policy views on these complex and 
important issues.
    Although I recognize the importance of achieving consensus, 
I do not believe that allowing the status quo to continue any 
longer would have been in the best interests of investors and 
the national market system. With respect to the fundamental 
issues raised by Regulation NMS, we cannot expect that any 
action taken by the Commission to resolve the issues will ever 
satisfy all market participants. The Commission must instead 
focus on taking the right steps for investors and the national 
market system, and I strongly believe that is what we have done 
by adopting Regulation NMS.

Q.13. Several of the comment letters filed with the Commission 
cast doubt on the reliability of the study done by the 
Commission's staff into actual ``trade-throughs'' on the New 
York Stock Exchange and Nasdaq. In particular, they questioned 
whether the electronic communications networks' ``reserve'' 
functions had skewed the results? Would a failure to account 
for this reserve function lead to false positives? Is there a 
sound factual basis for extending the proposed trade-through 
rule to Nasdaq at this point or would it be better to defer 
consideration of that possibility?

A.13. Several commenters asserted that the study by Commission 
staff overestimated trade-through rates because it failed to 
consider the existence of reserve size and sweep orders in the 
Nasdaq market, which could have caused ``false positive'' 
trade-throughs. In theory, order routers could intend to sweep 
the market of all superior quotations before trading at an 
inferior price, but if they did not effectively sweep both 
displayed size and reserve size, the superior quotations would 
not change and the staff study would report a false indication 
of a trade-through when the trade in another market occurred at 
an inferior price. In practice, however, those who truly intend 
to sweep the best prices are quite capable of routing orders to 
execute against both displayed and estimated reserve size, 
thereby precluding the possibility of a false positive trade-
through. Indeed, although commenters asserted that the staff 
study failed to consider the existence of reserve size for 
Nasdaq stocks, the validity of their own argument is premised 
on the failure of sophisticated market participants to consider 
the existence of reserve size when routing sweep orders.
    It currently is impossible to determine from publicly 
available trade and quotation data whether the initiator of a 
trade-through in one market has simultaneously attempted to 
sweep better-priced quotations in other markets. The data can 
reveal, however, the extent to which false-positive indications 
of a trade-through were even a possibility by examining trading 
volume at the traded-through market. If the accumulated volume 
of trades in that market did not equal or exceed the displayed 
size of a traded-through quotation, it shows that a sweep 
order, even one attempting to execute only against displayed 
size, could not have been routed to the market that was traded-
through. Commission staff therefore has supplemented its trade-
through study to check this possibility and to help the 
Commission assess and respond to commenters' criticisms. It 
found that this possibility rarely occurs--a finding that fully 
supports an inference that market participants are capable of 
effectively sweeping the best prices, both displayed and 
reserve, when they intend to do so. Thus, it is very unlikely 
that the existence of reserve size and sweep orders caused a 
significant number of false positive trade-throughs in Nasdaq 
stocks.

Q.14. Will the Commission will move forward with its Regulation 
NMS before the contours of the NYSE's hybrid market proposal 
have been fully determined and vetted? Would it be preferable 
for the Commission to take that up before getting to final 
approval of its Regulation NMS?

A.14. As you know, on April 6, the Commission voted to adopt 
Regulation NMS. Over the past several months, Commission staff 
have been working with the NYSE on the NYSE's proposal to 
become a ``hybrid'' electronic-floor based market. On May 25, 
the NYSE submitted an additional amendment to its Hybrid 
proposal. The Commission plans to publish the NYSE's recent 
amendment for another round of comments before taking any final 
action.

Q.15. Would the proposed trade-through rule, in either 
alternative form, provide sufficient flexibility for the large 
State pension funds, and the large mutual funds, to get best 
execution of their block orders? What I am concerned about is 
whether those large blocks, if they exceed the total amount of 
displayed liquidity, would be disadvantaged in some way, to the 
detriment of the many thousands of small pensioners and mutual 
fund investors--school teachers, police officers, fire 
fighters, for example--whose investment stake often is less 
than the minimum stake a brokerage firm would require to open 
an account.

A.15. Although the adopted Order Protection Rule does not 
provide a general exception for block orders, it addresses the 
legitimate interest of large investors, such as State pension 
funds and the large mutual funds, in obtaining an immediate 
execution in large size (and thereby minimizing price impact) 
by including an exception for ``intermarket sweeps'' that 
allows broker-dealers to access multiple price levels 
simultaneously at different trading centers to continue to 
facilitate the execution of block orders. Specifically, the 
exception allows the entire size of a large order to be 
executed immediately at any price, as long as the broker-dealer 
routes orders seeking to execute against the full displayed 
size of better-priced protected quotations. The size of the 
order therefore need not be parceled out over time in smaller 
orders that might tip the market about pending orders. By both 
allowing immediate execution of the large order and protecting 
better-priced quotations, the adopted Order Protection Rule is 
designed to appropriately balance the interests for investors 
on both sides of the market.
    The exception is fully consistent with the principle of 
protecting the best displayed prices because it is premised on 
the condition that the trading center or broker-dealer 
responsible for routing the order will have attempted to access 
all better-priced protected quotations up to their displayed 
size. Consequently, there is no reason why the trading center 
that receives an intermarket sweep order while displaying an 
inferior-priced quotation should be required to delay an 
execution of the order.
    In addition, the adopted Order Protection Rule includes 
exceptions for executing volume-weighted average price (VWAP) 
orders and stopped orders. The exception for VWAP orders, as 
well as other types of orders that are not priced with 
reference to the quoted price of a stock at the time of 
execution and for which the material terms were not reasonably 
available at the time the commitment to execute the order was 
made, will serve the interests of marketable orders and is 
consistent with the principle of protecting the best displayed 
quotations. The use of stopped orders represents a common and 
valuable form of capital commitment by dealers that inures to 
the benefit of investors. The adopted exception will apply to 
the execution of so-called ``underwater'' stops, in order to 
prevent abuse of the exception. Specifically, the exception 
applies to the execution by a trading center of a stopped order 
when the price of the execution of the order was, for a stopped 
buy order, lower than the national best bid in the stock at the 
time of execution or, for a stopped sell order, higher than the 
national best offer in the stock at the time of execution. To 
qualify for the exception, the stopped order must be for the 
account of a customer and the customer must have agreed to the 
stop price on an order-by-order basis.

Q.16. Like Senator Bennett, I am very concerned about naked 
short selling. I know you have offered to brief Senator Bennett 
on this problem but could you tell the Committee for the record 
what steps you are taking to combat naked short selling?

A.16. The term ``naked short selling,'' which is not 
specifically 
defined in either the Federal securities laws or Self-
Regulatory Organization (SRO) rules, generally describes 
selling short without borrowing the necessary securities to 
make delivery, thus potentially resulting in a ``fail to 
deliver'' securities to the buyer. When dealing with claims 
about naked short selling, it is important to know which 
activity is the focus of discussion.

 Selling stock short without having located stock that 
    can be available for delivery at settlement. This activity 
    would violate Rule 203(b)(1) of Regulation SHO, except for 
    short sales by market makers engaged in bona fide market 
    making. Market makers are not required to locate stock 
    before selling short, because they need to be able to 
    provide liquidity and price efficiency.
 Selling stock short and failing to deliver shares at 
    the time of 
    settlement. This activity is not per se illegal. Broker-
    dealers in general must impose a contractual obligation on 
    short sellers to deliver stock at the time of settlement, 
    and a failure to deliver may result in a contractual 
    breach. However, generally it does not result in a rule 
    violation, with the possible exception of a fraudulent 
    course of conduct of selling short with no ability or 
    intention to deliver the stock (although we are not aware 
    of recent cases brought on this basis).
 Selling stock short and failing to deliver shares at 
    the time of settlement with the purpose of driving down the 
    security's price. This manipulative activity, in general, 
    would violate various securities laws, including Rule 10b-5 
    under the Securities Exchange Act of 1934 (although not 
    Regulation SHO).

    To the extent there is evidence of illegal naked short 
selling, the staff pursues cases vigorously.\1\ However, to 
recommend enforcement action, the staff needs some evidence 
that stocks are being targeted illegally. Not all short sales 
are illegal, or evidence of illegal activities. Not all open 
fails to deliver are fraudulent, or evidence of fraud.
---------------------------------------------------------------------------
    \1\ See Rhino Advisors, Inc. and Thomas Badian, SEC Litigation 
Release No. 18003 (Feb. 27,2003); see also Pinnacle Business 
Management, Inc., Vincent A. La Castro, and Jeffrey G. Turino, SEC 
Litigation Release No. 17507 (May 8, 2003).
---------------------------------------------------------------------------
    There appears to be confusion on the part of some investors 
about the operation of Regulation SHO and what the Commission 
is doing to address alleged abusive naked short selling. 
Commission staff is seeking to address investor confusion in a 
number of ways. For example, in addition to the staff's 
availability to respond to investor inquiries on a daily basis, 
the staff has published on the Commission's Internet website 
``Key Points for Investors about Regulation SHO,'' which 
addresses the questions and complaints of individual investors 
(http://www.sec.gov/spotlightlshortsales.htm). The staff has 
also published on the website ``Frequently Asked Questions 
Concerning Regulation SHO.'' These materials address a number 
of the commonly asked questions and concerns regarding 
Regulation SHO.
    Preliminary data indicate that Regulation SHO is having the 
intended impact on failures to deliver. From the time 
Regulation SHO went into effect in January 2005 through the end 
of April 2005, the average daily aggregate fails to deliver has 
declined by 29.9 percent, the average daily number of threshold 
securities has declined by 29 percent, and the average daily 
fails of threshold securities has declined by 40.0 percent. 
Regulation SHO appears to be effectively reducing fails to 
deliver without causing disruption to the markets. On an 
average day, approximately 1 percent of all trades by dollar 
value fail to settle. Put another way, 99 percent of all trades 
by dollar value settle on time without incident.
    The staff is continuing to monitor the operation of 
Regulation SHO and is continually communicating with the legal 
and compliance groups of the SRO's to monitor and enforce 
compliance. The staff of the Commission's Office of Compliance, 
Inspections and Examinations, together with the SRO's, has 
commenced a targeted examination program of market participants 
to assess compliance with Regulation SHO.
    In addition, the staff is active in pursuing information 
about abuses or noncompliance with its rules and regulations. 
The Commission has investigated, and will continue to 
investigate, complaints and allegations of short sale rule 
violations. The staff will not hesitate to recommend Commission 
action where sufficient evidence exists of a failure to comply 
with the provisions of Regulation SHO or other short selling 
violations.

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

Q.1. Chairman Donaldson, I understand one brokerage firm has a 
program in place to rebate 50 percent of the 12b-1 fees that it 
receives for mutual funds to its customers who invest in those 
funds. This can represent a real cost savings for investors. 
But some mutual funds are refusing to participate, in part 
because they believe that rebating of 12b-1 fees to investors 
may not be permitted under (the existing interpretation of) 
Federal securities laws.
    I understand that the SEC staff has taken a look at this 
issue. My question for you is--will you make it a priority to 
provide guidance to the marketplace as to whether or not it is 
permissible to rebate 12b-1 fees to investors?

A.1. Please see my answer to Senator Enzi's question 1 for the 
complete response to this question.
