Speech by SEC Commissioner:
Remarks Before the ALI-ABA Sarbanes-Oxley Institute
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
Westin Embassy Row Hotel
October 12, 2006
Thank you so much for inviting me to speak today at ALI-ABA's Sarbanes-Oxley Institute. I would especially like to thank Richard Swanson and the faculty for putting together this important conference on the Sarbanes-Oxley Act. As I am sure you will agree, the Act represents one of the most significant reforms to our federal securities laws since the passage of the Securities Act and Securities Exchange Act in 1933 and 1934. With the preparation of annual reports on the horizon for many public companies, the topics of this conference seem particularly timely - especially the implementation of Section 404. I thought I would reflect on that subject within the context of our experience this past year. However, before I get started, let me remind you that my remarks represent my own views and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.1
As you know, Congress passed the Sarbanes-Oxley Act in 2002 as a reaction to the notorious financial frauds in the beginning of this decade at companies like WorldCom and Enron. The Sarbanes-Oxley Act was aimed at preventing the next WorldCom or Enron by strengthening corporate governance. This was one of the most productive rulemaking periods in the Commission's history. As a result of the Act, the Commission adopted more than fifteen separate rules prepared by the Commission's Division of Corporation Finance and Division of Enforcement, some proposed and adopted as quickly as thirty days after the passage of the Act. Virtually all were adopted within six months of the Act. This concentrated burst of rulemaking activity included the rules requiring certification of accuracy and completeness of company reports by CEOs and CFOs, accelerated electronic filing of insider trading reports, and listing standards mandating independent audit committees with increased responsibilities.
But lately, the area of Sarbanes-Oxley that has generated the most public comment is Section 404, which directed the Commission to adopt rules requiring public companies to include assessments of internal controls with their annual reports. The reports are required to include both management's assessment of internal controls over financial reporting and an independent auditor's opinion of management's assessment. The Commission adopted rules in June of 2003 to require the annual management report and auditor attestation.
The first phase of implementation effected accelerated filers. Accelerated filers have been required to comply with Section 404's reporting requirements for the last two years. Non-accelerated filers have not yet had to comply with Section 404's internal control provisions, although ultimately all public companies will need to comply. As accelerated filers work on compliance with Section 404, and non-accelerated filers contemplate compliance, the Commission has solicited feedback and received hundreds of comments. I encourage you to continue sending us comments about your experiences, including your critiques or recommendations. To date, comments have ranged from criticisms about the costs of compliance, to compliments about improvements in controls over financial reporting that might not have been made but for Section 404. The Commission has taken these comments to heart and has begun the process of addressing your concerns. I believe that, as a whole, Section 404 is a sound addition to our federal securities laws. We are only at the beginning of our collective experience with 404, and while we have discovered some issues that require fine-tuning, we have also discovered many benefits. Ultimately, I believe that the adoption of 404 will strengthen our securities markets through more rigorous corporate governance standards.
The Commission has taken several steps toward fine-tuning Section 404. As an important first step, the Commission has gathered information from issuers regarding their experiences with Section 404. Second, the Commission has begun the process of issuing guidance. Third, the Commission is working with the Public Company Accounting Oversight Board, or the PCAOB, on amending Auditing Standard No. 2, which addresses the auditor's opinion of management's assessment. Finally, the Commission is working with other entities, such as the Committee of Sponsoring Organizations of the Treadway Commission, known as COSO.
The Commission's first step, gathering information, began with two Section 404 Roundtables, held in each of the last two years. About fifty participants came to the Commission to share their experiences and views about the 404 process. Before each Roundtable, we invited and received written submissions from the public. The participants in the Roundtables have provided invaluable information which has helped the Commission identify the areas in which 404 has worked and the areas in which more guidance is necessary.
When I attended the May 2006 Roundtable, I found it very useful to hear about the experiences of a wide range of companies - large and small, foreign and domestic - as well as accounting firms, investor groups, legal counsel, and others. All of these viewpoints inform the debate about how to make 404 more efficient, cost-effective, and scalable. One recurrent theme at the Roundtables was the request for additional guidance from the Commission about how to conduct the assessment of internal controls. For example, while a number of companies indicated that they were attempting to implement a "top-down" approach to their assessment, many still struggled with the concept of company-level controls and how such controls could impact the need for testing at the transaction level. However, the participants listed several benefits as well - such as management's renewed sense of ownership of controls, newfound ways to make controls more efficient, better financial reporting and disclosure, and the detection of problems before they become more serious, to name just a few. All of these benefits improve investor confidence and improve the integrity of our markets. And the benefits are reflected in stock prices - more than one participant in the Roundtable referred to a Lord and Benoit study released in May showing that the stock price performance of companies complying with Section 404 is significantly better than the performance of non-compliant companies.
The Commission also received feedback from a number of other sources concerning Section 404, especially with respect to small businesses. In April 2006, the Government Accountability Office issued a Report to the Committee on Small Business and Entrepreneurship of the U.S. Senate, which recommended that the Commission evaluate the available guidance on management's assessment and determine whether it is sufficient. That same month, the SEC Advisory Committee on Smaller Public Companies issued its final report on Section 404. That Committee was established to focus in particular on the concerns of smaller companies. Among other things, the Advisory Committee recommended that certain smaller companies be exempted from the requirements of Section 404 unless or until an internal control framework is developed that recognizes the characteristics and needs of smaller companies. I share the Advisory Committee's concern about the particular burdens that Section 404 imposes on smaller companies. However, I do not think that a wholesale exemption for smaller companies from Section 404 is an appropriate solution. I believe that we should issue guidance to allow for the flexible and scalable application of 404 for all companies - there should not be a second-tier for the integrity of a company's internal controls.
As I mentioned earlier, the Commission's second step involves the process of issuing additional guidance to issuers and their management. Shortly after the May 2006 Roundtable, the Commission issued a press release setting out the actions that we planned to take with respect to Section 404, and we began to implement our plans this past summer. The Commission issued a concept release in July which raised questions important to future Commission guidance for management, including questions about assessing risks, identifying controls, evaluating effectiveness of internal controls, and documenting the basis for the assessment. The concept release sought public input on the issues and questions raised, including how much guidance to issue, whether it would be useful to all companies, and particular areas that the guidance should address. The comment period, which closed on September 18, generated comment letters from over a hundred and fifty entities and individuals. We are in the process of carefully considering the comments, but my initial impression is one of optimism - a majority of comments support the development of principles-based guidance. Some comments held up as an example the staff's May 2005 Statement on Management's Report on Internal Control over Financial Reporting and the staff's October 2004 Frequently Asked Questions Statement, stating that they should be incorporated into the forthcoming guidance.
We recognize that many companies have already invested substantial resources to establish and document programs and procedures for their assessment, and I expect that any guidance that we issue would be just that - guidance - that would be available to assist companies but not dictate any particular method that must be followed. I also expect that the guidance will follow in the best tradition of Commission guidance - that is, it will be based on principles that allow for flexibility according to the particular facts and circumstances faced by an issuer.
In addition to seeking feedback and creating guidance, the Commission staff is working closely with the PCAOB on its planned revisions to Auditing Standard No. 2, which establishes professional standards for conducting audits of internal controls over financial reporting. The PCAOB's plans follow up on its 2005 guidance, which emphasized the importance of efficiency in AS 2 audits. The upcoming revisions are intended to focus auditors on areas that pose a higher risk of fraud or material error. In addition, the PCAOB announced in May that it would try to reinforce auditor efficiency through PCAOB inspections. In that vein, the Commission's oversight of PCAOB inspections will focus on whether the inspections have been effective in encouraging firms to follow the PCAOB's 2005 guidance on ways to achieve cost-saving efficiencies in their audits. Both the PCAOB's initiative to reinforce auditor efficiency and the SEC's oversight of PCAOB inspections hopefully will help address concerns that auditors are engaged in auditing "over-kill" in part because they fear that PCAOB inspectors would otherwise find their audits insufficient. The PCAOB itself has stated that such over-kill is not desirable.
The Commission also monitors the work of other entities, including the work of COSO, which published guidance this past July on using its framework to assess the internal controls of smaller companies. The guidance is aimed toward promoting efficiencies and turning what some have viewed as liabilities for smaller companies into strengths for the purpose of assessing internal controls. The guidance also recognizes that compliance with 404 by smaller companies can enhance their ability to access the capital markets. I hope this guidance will prove useful to companies of all sizes in understanding and applying the COSO framework to internal control over financial reporting.
It will take some time for the Commission to develop the appropriate guidance, especially when it comes to the application of 404 to smaller companies. The Sarbanes-Oxley Act was passed with urgency in the wake of scandal - but we now have the opportunity to address implementation concerns with deliberation and prudence. With that in mind, we issued two companion releases in August to provide relief for non-accelerated filers and for certain foreign private issuers. One release extended the Section 404(b) compliance date for foreign private issuers that are accelerated filers (but not large accelerated filers). These companies will not have to provide an auditor's attestation report on internal control over financial reporting until fiscal years ending on or after July 15, 2007. In other words, this group of foreign issuers will have an extra year to comply with the auditor attestation requirement of Section 404. However, they will begin including management's report on financial controls for fiscal years ending on or after July 15, 2006.
Non-accelerated filers were covered under a second release, which proposed an extension of the Section 404(a) and (b) compliance date for all non-accelerated filers. Under this proposal, the initial compliance date for non-accelerated filers to provide their management's assessment of internal controls would be moved from fiscal years ending on or after July 15, 2007 to fiscal years ending on or after December 15, 2007. Additionally, the Commission has proposed extending the date of compliance with the auditor attestation requirement to fiscal years ending on or after December 15, 2008. In other words, non-accelerated filers would have one year in which they would be able to file the management guidance without the auditor's attestation. We set out this proposal intending to offer some cost-savings to smaller companies as well as to give them the opportunity to gain experience in the 404 process before they are required to have an auditor attestation. It is worth noting that this proposal would apply to all non-accelerated filers, including foreign non-accelerated filers. This release also included our proposal to provide transition relief to all newly public companies. Under our proposal, companies would not be required to provide the management or auditor reports on internal control over financial reporting until their second annual report is filed with the Commission. This proposal is intended to help alleviate the initial costs and burdens that Section 404 compliance might pose for some newly public issuers. We will consider very seriously the public comments we have received on this proposal.
In conclusion, future SEC guidance for management, the PCAOB's forthcoming amendments to AS 2, and the new COSO guidance should help minimize the costs and burdens of Section 404 while maintaining the benefits both for companies and their investors. I also hope that focusing Commission oversight of PCAOB inspections on our concern about the efficiency and cost-effectiveness of AS 2 audits will reassure auditors that they should follow the risk-based principles that the PCAOB has set forth, not simply try to check every box on a set list.
With all of the attention that Section 404 has received in recent years, I find it important to also reflect on the other provisions of the Sarbanes-Oxley Act, which have pioneered substantial benefits to our regulatory framework and investor protection. Much has been achieved as a result of that legislation, such as:
- The creation of the PCAOB to register and inspect public accounting firms, as well as establish auditing standards for public companies;
- Increased responsibility for financial reports by individual corporate officers through mandatory certifications by the CEO and CFO;
- More stringent criminal penalties for fraud offenses; and
- Allowing civil monetary penalties to be used to recompense defrauded investors.
Now, as some of the immediate uproar over frauds like WorldCom and Enron has faded, some may argue that Congress went too far, and that the cost of Sarbanes-Oxley exceeds its benefits. I disagree. Recently, one of the loudest complaints has had to do with the perception that Section 404 has deterred companies from listing on U.S. exchanges. Contrary to that common misperception, listing on U.S. exchanges still provides the lowest cost capital. As Charles Niemeier, a PCAOB board member, recently remarked, companies listed in the U.S. have a competitive advantage because they have access to the deepest capital pool at the least expense. The net savings in the cost of capital and the net valuation premium outweighs the costs of complying with our investor protections, and even outweighs the more expensive U.S. underwriting fees. More than in any other country, that cost savings and access to capital is provided by individual American investors - individual investors who must have confidence in our markets.
There also has been a perception that Section 404 and Sarbanes-Oxley have caused a decline in U.S. IPOs. In reality, U.S. IPOs have declined due to lower interest rates, the availability of private equity in the U.S., and the nature of the companies that are going public at this point in time. The companies that are going public are more often international companies or state-owned entities that are being privatized. Those international companies may choose to conduct their IPOs in markets that are closer to their headquarters for a variety of political and cultural reasons. Finally, the total number of IPOs worldwide has declined dramatically, from about 375 in 2000 to 100 in 2001. But the percentage of American companies which conduct their IPOs in the U.S. has remained steady.
The United States historically has been a leader in the area of corporate governance. In fact, other countries are beginning to adopt regulations similar to portions of Sarbanes-Oxley. That having been said, I believe that Sarbanes-Oxley could benefit from some fine tuning, particularly within Section 404. As I have discussed, the Commission is taking steps in this area. Although we may have experienced the growing pains of innovation, they are the pains of maintaining our status as the strongest capital market in the world. We need to continue to adapt our regulations and our standards to technology as well as to other changes that continue to occur around us. Beyond Sarbanes-Oxley and Section 404, we have substantially updated our rules for securities offerings, have adopted significant reforms in the area of executive compensation disclosure, and, of course, set in train very important market reforms via Regulation NMS. All of these efforts point to one underlying principle. We cannot let our rules stagnate lest they become impediments to progress and to investment in America's capital markets.