Speech by SEC Staff:
Corporate Governance in the USA against the Background of Recent Developments
Remarks to the 7th German Corporate Governance Code Conference
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 27, 2008
Ladies and Gentlemen, good morning and thank you for the invitation to address the 7th German Corporate Governance Code Conference. It is a privilege to discuss a topic of utmost significance to the capital markets — namely, that relationship between management and shareholders that we in English (and now actually in German) call corporate governance. I am pleased to be here to discuss recent developments in corporate governance in the United States, with my good friend and colleague, Special Envoy C. Boyden Gray. Many thanks to Dr. Gerhard Cromme for this wonderful opportunity.
And, I hope that you will forgive my inevitable mistakes in your beautiful, but difficult, mother tongue.
It is hard to believe that five years have passed since I accepted the invitation of Dr. Cromme to address the 2nd German Corporate Governance Code Conference. At the time, I was a new member of the U.S. Securities and Exchange Commission.1
In 2003, the Government Commission on the German Corporate Governance Code was hardly two years old. Under the leadership of Dr. Cromme and with the efforts of his colleagues, the Commission adopted the inaugural version of the German Corporate Governance Code in less than five months. The objectives of the Code were simple and bold: to make Germany’s corporate governance rules transparent and to strengthen investor confidence. The Code sought to impose changes to corporate governance, not as a government mandate, but as a voluntary undertaking — one that would be respected and hopefully rewarded by the capital markets.
Not only did the Government Commission complete its work swiftly, but in the following years it has engaged in a methodical review of the Code, to revise and improve it. The success of the Code is reflected in part by the high level of recognition and acceptance of its guidelines by German corporations.
Now Dr. Cromme, and two of his colleagues — Dr. Rolf-Ernst Breuer and Prof. Dr. Marcus Lutter — will leave the Government Commission at the end of June. I have enjoyed very much working with them over the years and value their contributions to improving corporate governance in Germany and for their efforts to strengthen the global capital markets. To my friend Dr. Klaus-Peter Müller and his colleagues, I wish much luck and success with this important work.
I, too, will be leaving the U.S. Securities and Exchange Commission once my successor takes office after confirmation by the United States Senate. It has been an exciting and interesting six-year tenure, but I look forward to returning to the private sector because so much has happened and changed during the past six years.
During my period on the SEC, we have lived through various crises of one form or another. At the beginning, we saw a few very large public corporations, such as Enron and WorldCom, collapse in part from financial fraud and overstatement of income and results.
Likewise, today we see the fallout from the subprime crisis, where liquidity has all but evaporated for many financial products, causing significant mark-downs in asset valuations as well as a significant increase in aversion to risk. Bear Stearns, a large, well-known Wall Street investment bank that had never had a negative quarter since before the stock market crash in 1929, fell from a classic run on the bank. We and our counterparts at other financial regulatory agencies have taken steps to avoid similar events.
Financial crises have always created an impetus, especially by politicians, to “do something.” Back in 2002, this impulse came from the U.S. Congress in the form of the Sarbanes-Oxley Act. “Doing something,” however, did not always result in restoring confidence in the financial markets in the most cost-effective manner. A prime example is Section 404 of the Sarbanes-Oxley Act, which has become infamous in the international community. Section 404 requires management to assess annually the effectiveness of internal controls for financial reporting and requires a company’s outside auditor to attest to, and report on, management’s assessment.
At the time the Sarbanes-Oxley Act was passed, few, if any, people expected Section 404 to be the most controversial provision or that it would impose any significant burden. Section 404 was copied almost word-for-word from a provision that had already applied to U.S. banks for more than ten years.
Instead of a principles-based approach aimed at management, we ended up with a very process-intensive, document-oriented approach focused on tiny details. A control failure for a $500 error could be just as significant as for a $500 million error. Individual companies were told to document, analyze, and create process charts for literally tens or hundreds of thousands of supposedly key internal controls.
The initial implementation of Section 404 was highly flawed and extremely burdensome for public companies. Shareholders ultimately paid the price. The issue was not with the principle that management should have reasonable controls that provide assurance as to the integrity of the financial statements, but rather with the flawed implementation of Section 404. Simply put: the benefits of the new rules should exceed the costs.
One explanation for the flawed implementation might be that we had a newly-appointed accounting regulator — the Public Company Accounting Oversight Board (PCAOB). This regulator sought to improve upon existing accounting guidance on internal controls, but instead created an over-engineered framework that smothered companies with unneeded regulatory burdens.
Ultimately, it took the SEC and PCAOB nearly five years to get the implementation of Section 404 right. Last year, the SEC issued interpretive guidance on Section 404, and the PCAOB repealed its much criticized initial rule and replaced it entirely with new rule that better reflected the original intent of Section 404. While the full effects of these new revisions are still unknown, I have received far fewer complaints about the new regulatory requirements than I received on the old requirements. So I remain somewhat more optimistic that we perhaps have found a proper balance between benefits and costs for those companies subject to Section 404. For those smaller companies that are not yet subject to Section 404, the SEC is in the process of studying whether the costs outweigh the benefits.
The lessons learned from our experience with Section 404 must be applied to future actions that are being considered in response to the current financial crisis. If we develop rules, they must be workable — we must find a balance between the benefits to the capital markets against the costs of compliance. It is not easy to draft such rules; however, in our haste to “do something,” we must not unintentionally impose measures that create more negative effects than positive effects.
The federal Sarbanes-Oxley Act was also notable for imposing a number of legal requirements regarding corporate governance. This was significant because in the American legal system, the development of corporate governance laws has been largely left to the states. Corporations are chartered by any one of the 50 states. This is different from most other countries, where the chartering of a corporation is done by the national government.
The American system is distinctive. A corporation can be chartered in one state, but conduct business throughout the country and — indeed — the world. But the laws governing the relationship between corporations and their shareholders are governed exclusively by the state of incorporation. This legal concept, called the “internal affairs doctrine,” has been recognized by the U.S. Supreme Court.2
In the United States, the most popular state of incorporation for publicly-traded corporations is Delaware. Delaware is a small state on the East Coast of the United States. At approximately 6,450 square kilometers, it is the second smallest of the fifty states in area. With 780,000 inhabitants, it is slightly larger than the German state of Bremen.
Despite its small size, Delaware has attracted the largest number of publicly-traded corporations. One important reason is that it is perceived as investor-friendly. Investors have confidence that their relationship with the corporation, its board, and its management will be subject to a legal framework that is favorable to vindicating their rights. Another reason is the presence of a specialized business court — called the Delaware Chancery Court — that can speedily resolve legal issues affecting corporate governance.
The American system also promotes competition among the states for the most favorable corporate governance structure for investors. The capital markets are the ultimate arbiter as to value-added by a particular corporate governance framework. To the extent that other states provide a better corporate governance framework than Delaware, the markets should place a premium on the valuation of companies incorporated in such other jurisdiction.
One good example is the following statute: the North Dakota Publicly Traded Corporations Act, which was enacted last year. This statute requires, among other things, majority votes in the election of directors, advisory shareholder votes on executive compensation, the direct board-member nomination right for a 5% representation of shareholders, and the separation of the roles of chairman and chief executive officer. Only time will tell as to how the markets will react to this law. If these corporate governance provisions are truly value-added provisions, then I would predict that either more companies will be incorporated in North Dakota or that other states will adopt similar provisions to those mandated by North Dakota.
More importantly, the actions in North Dakota represent only one example of the on-going effort in the states to improve corporate governance. Given these activities, the federal securities laws should work to complement, not replace, state laws on corporate governance.
The drafters of the federal securities laws — most notably the Securities Act of 1933 and the Securities Exchange Act of 1934 — specifically designed the statutes to be disclosure-based. These laws did not allow the SEC to intervene in the internal corporate governance of corporations; rather, the statutes provided limited authority to the SEC to require companies to provide disclosure about various aspects of their corporate governance.
One area that the SEC has been particularly active in mandating disclosure has been with respect to conflicts of interest between management and shareholders. Recognition of the potential for conflict has been long recognized. In 1776, Adam Smith wrote about the agency problem of management in the Wealth of Nations; when it comes to money, he said, managers “cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private [partnership] frequently watch over their own.”
Mandating disclosure — as opposed to attempting to regulate substantive behavior that is better left to state corporate governance law — is an important restriction on the federal securities laws. By remaining neutral, it allows corporate boards of directors, management, and shareholders to reach an accommodation as to what particular framework works best for a particular corporation’s circumstances. By requiring disclosure, it allows transparency for all market participants.
These days there is much discussion regarding the role of credit rating agencies and how they are regulated. Like accounting firms, credit rating agencies have conflicts of interest that they must manage to maintain the integrity of their product. For example, they are paid by those whom they rate, and with structured products especially, their income is affected if they decide that they cannot give the highest rating to a new product.
In the United States, the U.S. Congress in the Credit Rating Agency Reform Act of 2006 directed the SEC to oversee these firms by providing for registration, setting clear rules of expected conduct, mandating disclosure of the ratings process and history of ratings, and examining the firms to check on compliance. Ratings are opinions — they are fallible, and they are also protected by our constitutional right to freedom of speech. Investors should treat them as one informed insight in making investment decisions. The government should not pass on the “accuracy” of ratings or the methodology of determining ratings. That can never and should never be our expertise. In fact, such a role would raise a grave hazard for investors. If the government is checking on the accuracy of ratings, does that mean that the investor can rely on them more? What if the rating turns out to be “wrong”? Should the government be liable to investors? What bureaucrat could — or would — take on that responsibility?
The public policy in the U.S. since the 2006 statute is that we should increase transparency, encourage more competition in the industry, mandate disclosure of conflicts of interest, and demand that the firms take steps to deal with the inevitable conflicts, rather than attempt to prescribe special organizational attributes or directly supervise the ratings process. In addition, on Wednesday, the SEC proposed to remove references to ratings in approximately 40 rules. Over the years, ratings have been accorded special treatment in our rules and have become a convenient crutch for regulators. We should not encourage blind trust in these opinions.
Ladies and Gentlemen, thank you for your attention. This year marks the 60th anniversary of the authorization by the U.S. Congress of the Marshall Plan for the reconstruction of Europe, as well as the 60th anniversary of the Berlin airlift. Looking back in retrospect, we can truly appreciate the foresight of those two efforts. Collectively, the people of Germany and the people of the United States have re-built a bond previously separated by conflict. Today, the trans-Atlantic relationship between our two countries is more important and tighter than ever before.
It has been an honor and a privilege for me to be part of sustaining and furthering the German-American relationship and to take part in your conference. Thank you.
1 As I also said then, I must note that the views that I express here are my own and not necessarily those of the Commission or my fellow Commissioners.
2 See CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89-90 (1987)