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HEDGE TRIMMER. One way to do that: Make CEOs and directors more accountable by giving shareholders more power. Donaldson startled governance gurus by ordering a review of the barriers that investors face in putting resolutions or board candidates on proxy ballots. Current rules make it prohibitively expensive for investors to campaign for dissident directors, protecting CEOs' cherished power to hand-pick directors.
"It takes serious backbone just to address this issue," says Sarah B. Teslik, executive director of the Council of Institutional Investors. To knock down the roadblocks that keep shareholders from communicating directly with each other, for example, the SEC might let board candidates campaign on the Internet.
Hedge funds may never be the same again once Donaldson is done with them. "It's just too much money for us to know as little as we do," he says. Just as worrisome: These lightly regulated private-investment pools are increasingly accessible to unsophisticated retail investors. Donaldson is likely to require hedge managers to register as investment advisers, forcing them to spell out to the SEC and investors their trading strategies and holdings. He also may restrict access to the funds by raising the $1 million wealth threshold for investors.
SOFT BULLETIN. But even as he cracks down, Donaldson says he's "quite sympathetic" to the idea of letting better-regulated mutual funds adopt some hedging strategies, such as selling stocks short. That could boost returns, but also risk.
Mutual funds may expand their trading power, but Donaldson is in no mood to give them free rein. In the June 9 report to Congress, he steers a middle course between critics, such as Vanguard Group Inc. founder John C. Bogle, who contend that funds are overcharging investors, and fund-industry executives, who insist they're offering a bargain. Donaldson wants funds to spell out fees and expenses more clearly. He may insist that they highlight how rapidly they turn over stocks in their portfolios, since active trading drives up costs and can depress returns.
Donaldson may also ask Congress to curb so-called soft dollars. Funds overpay brokers for trading, and brokers use the excess, or soft, dollars to pay for research and other services that fund managers want. The deal moves the cost of research from fees, which investors see, to commissions, which they don't.
CORE FAILURE? "I've always had reservations" about soft dollars, says Donaldson. And he's crusading to force brokers to reveal how they are paid to sell certain funds. "We want to make sure that somebody buying a mutual fund knows why the broker is recommending it."
Still, critics say Donaldson isn't attacking the root cause of fund problems: conflicted boards. The SEC report advocates narrowing the definition of independent fund directors, which now includes recently retired fund-company execs and managers' relatives. A stricter standard would help, but the SEC should press boards to strike tougher deals with managers on costs and fees, says former Treasury Dept. official Gary Gensler, co-author of The Great Mutual Fund Trap. "The SEC still fails to address the core governance issue: fund directors' obligation to investors to get the best services at the best price," he says.
On June 11, House Capital Markets Subcommittee Chairman Richard H. Baker (R-La.) gave the critics a boost, introducing legislation that would require two-thirds of a mutual fund's board, including the chairman, to be independent.
CONSERVATIVE STREAK. For the longer term, the biggest issues facing Donaldson surround stock markets. His first venture into that terrain -- suggesting that the SEC reexamine its 2001 move to price stocks in pennies -- was a flop. Retail investors gained when the minimum price move was cut from 6.25 cents to a penny, because the gap between buy and sell prices narrowed for small lots. But some studies show that costs rose for pensions and mutual funds, which found it tougher to trade large orders.
By questioning pennies, Donaldson set off a furious debate -- and angered some White House aides. He insists now that he's agnostic: "Let's look at what the impact has been."
This same conservative streak is seen in his views on other market issues. He favors the centralized trading that's still prevalent at the NYSE -- 80% of trades in Big Board-listed shares are conducted at the exchange -- over the welter of competing trading platforms in Nasdaq stocks. "Competition between buyers and sellers is the essential competition, not the competition between market centers," he says.
LIGHTER HAND. The SEC chief also frets about the stock exchanges' ability to police themselves as they morph from member-owned clubs to for-profit, shareholder-owned businesses. Aides say he was burned by his NYSE experience: After he cut regulatory spending, floor traders got away with front-running orders for years. Pressure to cut corners would be even greater, he says, if "every time you spend a dollar on regulation, it's a dollar out of stockholders' pockets."
Donaldson's caution on fragmented trading and self-policing could spell trouble for Nasdaq, which wants its decentralized, for-profit market recognized as an independent exchange.
Such knotty questions lend themselves to Donaldson's methodical style. "He won't be rushed," says Richard H. Jenrette, who co-founded DLJ with Donaldson in 1959. Deliberation is welcome at the SEC. Donaldson "is terrifically collegial: On everything of real consequence, he asks our views," says Democratic Commissioner Harvey J. Goldschmid. That's a big change from Pitt's heavy hand.
MAKING HIS MARK. There may be less combat in the SEC's halls. But Donaldson envisions an agency modeled on the Marine Corps, capable of responding rapidly to crises. The SEC's 2004 budget will nearly double, to $842 million, compared with 2002, and it will add 710 lawyers and accountants. Donaldson wants to deploy those new troops to achieve maximum striking power. "We need to look around corners and forecast what may be about to happen in the future," he says.
Instead of having a single chief of staff, Donaldson has hired a triumvirate picked for management skills, not political credentials. Lawyer Patrick Von Bargen, a student in the first class after Donaldson founded the Yale School of Management, coordinates policy. Banker Peter Derby is loosening the paperwork logjam that kept the SEC's accountants from reviewing Enron Corp.'s filings for years. Laura Cox, a Treasury and Hill veteran, handles relations with Congress and the press.
Friends say Donaldson didn't stump for the SEC job. He was enjoying a comfortable semiretirement serving on corporate and civic boards. But once called into service, he seized the opportunity to revamp the SEC for the challenges posed by a post-Enron world. Donaldson knew that the future of regulation was up for grabs. Now that his activist side is emerging, it's up to him to leave his mark on the SEC, on the markets, and on how business is done in America.
Copyright 2003, Bloomberg L.P.
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