Donaldson exit interview... NYT

[Miklos Vasarhelyi <miklosv@andromeda.rutgers.edu>]

July 23, 2005
 
 
Arthur Mount

Donaldson: The Exit Interview

I came with a
mission," William H. Donaldson said the other day, reflecting on his
tenure as chairman of the Securities and Exchange Commission. In
retrospect, that was the big surprise. Mr. Donaldson, who stepped down
late last month after two and a half tumultuous years, was never supposed
to be a man with a plan. 

Let's rewind. It's December 2002, and Mr. Donaldson has just been named
to the post. The stock market has been reeling since March 2000, when the
Internet bubble burst. Enron,


WorldCom
, Tyco: the list of companies
embroiled in major scandals is large and getting larger. Eliot Spitzer,
the New York attorney general, has exposed the way Wall Street analysts
promoted lousy companies to win investment banking business - and he's
several months away from bringing the mutual fund timing scandal to
light.

Mr. Donaldson's predecessor, Harvey L. Pitt, who came to the office
promising a "kinder, gentler" agency, has managed to make
matters oh-so-much worse with his lethal combination of arrogance and
ineptitude. The country's faith in the integrity of the markets - and of
the S.E.C. itself - is shaken. 

"It seemed to me a period not dissimilar to 1929," Mr.
Donaldson said. "Except that back then, relatively few people were
investors. By the time I became S.E.C. chairman, over half the population
was in the market one way or the other." And really, all the Bush
administration wanted him to do - this 71-year-old pillar of the Wall
Street establishment, who, among other things, had spent five years not
rocking the boat in the 1990's as the head of the New York Stock Exchange
- was calm everybody down, rebuild morale at the S.E.C. and restore some
measure of confidence in both the markets and in the companies whose
stocks and bonds we all buy and sell. 

"I remember saying that he was going to be a consensus builder,
because that's what he'd been for most of his career," said James D.
Cox, a professor of securities and corporate law at Duke University.
"I didn't think there would be much controversy on his watch. Boy,
did I miss the mark on that prediction." 

As it turns out, Mr. Donaldson did help restore faith in the markets. He
did so in part by making peace with, and working alongside, Mr. Spitzer.
He helped get Sarbanes-Oxley, the corporate reform act, up and running.
He expanded the agency's enforcement staff, and backed its efforts to
become genuinely tough with companies that had violated the rules; the
commission imposed a staggering $5.3 billion in fines on his watch.
"He revived an institution that had been failing to address its
mandate," Mr. Spitzer said.

BUT as Mr. Donaldson, now 74, returns to private life, his efforts to do
what President Bush - and all of us - needed him to do seem like so much
ancient history. It's his other ideas, the ones no one knew he had, that
people are talking about. About four months into his watch, he proposed a
rule that would force largely unregulated hedge funds to register with
the S.E.C. for the first time. (The new rule will take effect early next
year.) He was behind a new national market system that will cause the New
York Stock Exchange and Nasdaq to operate under the same set of rules
(though, alas, it still gives advantages to the outmoded floor brokers
and specialists at the stock exchange). 

His S.E.C. proposed a plan that would have allowed shareholders to
nominate corporate directors on their own, without management's
involvement. (It died because the commissioners disagreed on how, or
whether, to carry out the idea.) And he pushed through a regulation
stipulating that every mutual fund board have directors who are
independent of the management company that operates the fund, including
an independent board chairman. Until now, mutual fund boards have largely
consisted of executives of the fund's management company.

As it became clear that Mr. Donaldson had a far more activist bent than
anyone suspected, he became the subject of increasingly strident
criticism. The hedge fund industry complained that registration was the
first step toward out-and-out regulation, which, in turn, would stifle a
vibrant and growing sector of Wall Street. The chairman of Fidelity
Investments, Edward C. Johnson III, was a vociferous critic of the mutual
fund rule - lobbying fiercely against it, and even writing an op-ed
article in The Wall Street Journal that was both pointed and personal.
The Chamber of Commerce went so far as to sue the commission over the
mutual fund rule, which Mr. Donaldson pushed through at a contentious
S.E.C. meeting last month.

The partisanship that has affected the rest of Washington seeped into the
commission. Mr. Donaldson was viewed by many conservatives as a turncoat
because he voted so often with the two Democratic commissioners - and
against the two Republicans. He was labeled "an overzealous
regulator," and a high-handed chairman who didn't consult with his
colleagues. The Republican commissioners began writing biting dissents to
commission rulings. 

Mr. Donaldson sighed when I asked him about the criticism. "I was
surprised at the extent of the doctrinaire thinking that was so rigid it
couldn't accept the obvious conclusion that in a number of important
areas we needed at least some mild regulation," he said. And for all
the talk about his being a lover of regulation, that is how he saw
himself: a mild regulator who was trying to make sure the playing field
was level for the small investor. "In other countries," he
said, "the disparity of treatment between institutional investors
and individuals is gross. Here, we have institutions and individuals
trading side by side, and the individual doesn't get trampled. I don't
see how you do that without some regulation."

Indeed, his ideas for how to improve the system stemmed precisely from
his lifetime of experience on Wall Street, running an investment firm.
(He was a co-founder of Donaldson, Lufkin & Jenrette.) He knew
exactly the places in the system where individual investors were getting
short-shrift. Which is to say, he knew where the bodies were
buried.

Mutual funds - to focus on the example that has generated the most recent
heat - were one such place. The argument put forth by Mr. Johnson and
others in the fund industry is that fund management executives are the
ones in the best position to serve the interests of a fund's
shareholders. In his op-ed article, Mr. Johnson proudly wrote of his dual
role as a fund company executive and an investor in Fidelity's mutual
funds. Appointing a board chairman unconnected to the management company
- "requiring that every ship have two captains," as Mr. Johnson
wrote -would create far more problems than it would solve.

When you listen to Mr. Donaldson, though, you realize what hogwash this
argument is. In his view, mutual funds were being run more for the
benefit of the fund's management company than for the fund's investors.
"Somewhere along the line," he said, "the name of the game
became gathering a lot of assets. If it can bring in a lot of assets, a
fund company can make money no matter how the funds themselves perform
for investors." 

To Mr. Donaldson, the conflict of interest in having fund management
executives oversee the funds themselves is glaring. "The company
executives have a fiduciary responsibility to their shareholders that is
quite different from the responsibility the fund itself has to perform
for its investors. When the board decides to raise fees, it may be acting
in the best interest of the management company's shareholders, but it's
not necessarily acting in the best interest of the fund's
investors."

Surely, the fund timing scandal is proof that Mr. Donaldson is right.
Fund company executives succumbed to the temptation to allow select
insiders to late-trade their funds because it generated revenue for the
company - even though it hurt the fund's investors. Indeed, one could
make an argument that if, say, Fidelity Magellan had an independent
chairman, the directors might well be less tolerant of Magellan's
pathetic performance the last five years, when it has significantly
underperformed the Standard & Poor's 500. And they might not care so
much that the fund's $50 billion-plus in assets generates tens of
millions of dollars annually for Mr. Johnson's company. If anything, the
new S.E.C. rule seems a pretty small step toward fixing what ails the
fund industry.

I can't say I agree with everything Mr. Donaldson did. But in the end, he
did a lot of good, and we should acknowledge that fact before he fades
too far into the sunset.

Take a bow, Mr. Donaldson. You deserve it.

Miklos A. Vasarhelyi
KPMG Professor of AIS
Rutgers University
Director Rutgers Accounting Research Center
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