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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
SEC Initiatives Under the Sarbanes-Oxley Act of 2002


Commissioner Cynthia A. Glassman

U.S. Securities and Exchange Commission

College of Business and Economics, California State University
Fullerton, California
January 28, 2003

Good morning. Thank you, Betty, for your kind introduction, and thank you, Vivek Mande, for inviting me.. It is a pleasure to be here. First, let me make the standard disclaimer: The views I express are my own and not the official positions of the Commission or its staff.

Your invitation to speak today about SEC initiatives under the Sarbanes-Oxley legislation could not have been more timely -- for three reasons. The first reason is that today is the one-year anniversary of my swearing-in as a commissioner of the SEC. It has been an exciting year, but I hope, for all our sakes, that 2003 is a little less exciting - in fact, a lot less exciting! The second reason is that it has been really cold in Washington - I love your weather!

The third reason - and the focus of my remarks -- is that the Commission has just adopted a number of important new rules pursuant to the Sarbanes-Oxley Act of 2002. The law was enacted in July in response to financial frauds at Enron, WorldCom and other corporations and the realization that many of the "gatekeepers" responsible for preventing fraud had fallen down on the job. Congress recognized that dramatic steps were needed to right the system and restore investor confidence. Congress directed the Commission to adopt rules to increase the accountability of CEOs and CFOs, improve the quality of financial reporting and raise professional, legal and ethical standards for the gatekeepers of our financial system -- analysts, auditors, audit committees, boards and attorneys.

The legislation gave the Commission 90 days to implement some rules and 180 days - until January 26, 2003 -- to implement several more key rulemakings and conduct several studies, and there is more to come. You may not realize it, but 180 days did not give the Commission very much time to propose new rules in a number of different areas, analyze all the comments we received, modify rule proposals where necessary, adopt final rules and conduct several special studies. But we did it!

By the end of the 90-day deadline, we adopted rules accelerating the filing of quarterly and annual reports for certain issuers, requiring CEOs to certify quarterly and annual reports, and speeding up the disclosure of personal securities trading by corporate insiders.

During January, we adopted 11 new rules, nine of which were required by Sarbanes-Oxley. We received over 9,000 comment letters, each of which was read, carefully considered, and included in a comment summary that you can find on the Commission's website. While some of the releases were still being finalized when I left for California, I have some unofficial statistics relating to the Commission's rulemaking efforts in January. Our adopting releases for the 11 rules totaled over 1,000 pages (double-spaced, 10-point font) (only lawyers could take a thousand pages to write 11 releases), and they contained over a quarter-million words. I am told - off the record - that we reviewed over 113 different drafts, held over 2,700 man-hours worth of meetings, ate over 1,100 meals at our desks, and drank more than 4,800 cups of coffee. I can't wait to see what February brings!

All kidding aside, though, the Commission's staff worked incredibly hard, and showed why you will not find a better, more dedicated group of public servants in any corner of government. Thanks to their hard work, we were able to adopt rules requiring heightened standards of auditor independence, the disclosure of off-balance sheet arrangements, and the inclusion of a reconciliation to generally accepted accounting principles for earnings releases and other financial information prepared on a pro forma basis. We also adopted rules requiring companies to disclose whether they have codes of ethics for executive officers, and whether they have designated an "audit committee financial expert" on their audit committees. We published for comment a rule directing the exchanges and Nasdaq to prohibit the listing of the securities of any issuer that does not comply with the audit committee requirements of Sarbanes-Oxley, and we approved rule changes by the New York Stock Exchange and the NASD dealing with research analyst conflicts. Finally, we adopted rules requiring securities lawyers to report evidence of fraudulent corporate conduct "up the ladder" to the chief legal or chief executive officer of the corporation or, if necessary, the board of directors. We have had a lot on our plates!

As an economist, an important part of my evaluation of proposed rulemakings is normally a cost/benefit analysis. The rulemakings under Sarbanes-Oxley required even more focus on an expanded cost/benefit analysis - are the benefits of the rule worth the costs it will entail? - but one constrained by very specific legislative requirements.

While we obviously want to do everything possible to prevent future Enrons and WorldComs, it is important to maintain a balanced approach. We must make sure that our rules target the root causes of the problems of the recent past without overreaching our objectives or creating negative unintended consequences. In analyzing the Commission's new rules, I looked to several factors. What are we really trying to accomplish with this rule? Will the rule be effective in achieving its purpose or is it merely cosmetic? Does it make practical sense? Does it serve the purpose for which it was intended? Do the benefits outweigh the costs? Does the rule go too far or not far enough? And finally, will it raise unrealistic expectations or create unintended consequences?

I will take you through this analysis with some of our new rules, starting with the research analysts. Analysts came into the Sarbanes-Oxley spotlight for several reasons. As investment banking revenues became a bigger component of brokerage firm profits, pressure was put on analysts to provide research that was favorable to issuers whose business the investment banks wanted to attract and retain. Additional conflicts of interest arose where analysts had personal holdings in stocks they were recommending, which was not disclosed, and where research reports to boost buying interest in a stock were issued just prior to the expiration of lock-up periods when personal or proprietary holdings could be sold. The impact of these conflicts became especially apparent in the aftermath of Enron, WorldCom, Tyco and others. Analysts were still recommending these stocks as the companies' prospects were deteriorating, and retail investors bore the brunt of the misleading recommendations. The infamous emails uncovered in subsequent investigations - in which analysts jokingly disparaged their public recommendations - confirmed what most sophisticated investors already suspected.

Sarbanes-Oxley required the SEC to direct the New York Stock Exchange and the NASD to adopt rules dealing with analyst conflicts. The NASD and NYSE have adopted rules requiring analysts and brokerage firms to provide more disclosure about potential conflicts, and they're working on additional rules.

I particularly support the requirement in the new rules that research reports include price charts that track the price movements of the stock over a historical period relative to the analyst's recommendation. This will give investors a basis to evaluate the accuracy and quality of an analyst's recommendation. If an analyst was recommending a buy while the stock was tanking, that will be apparent to investors who are thinking about trusting the analyst's views in the future.

The Commission will soon consider a $1.4 billion settlement with several Wall Street firms with respect to analyst conflicts of interest. The agreement in principle reached in the global settlement requires structural separation between the research and investment banking divisions within brokerage firms by prohibiting analysts' compensation from being based on investment banking revenues. In addition, for a five-year period, brokerage firms will be required to contract with independent research firms to provide independent research reports to their customers along with brokerage firm research.

The goal of structural reform is to realign incentives, and the purpose of independent research is to provide retail investors with unbiased, alternative views. I am hopeful that these measures will contribute to reducing analyst conflicts, although we will have to wait and see whether the hoped-for benefits of these measures materialize. However, I don't want to create an expectation that the quality of independent research, although not compromised by bias, is necessarily better than firm research. Just because research is independent doesn't guarantee that it is good.

I am more hopeful about the additional disclosures required under the global settlement --disclosures cautioning investors to take research "with a grain of salt" and advising them not to base their investment decisions solely on a research report. But I think the best thing we will do for investors through the proposed settlement is to require the disclosure of an analyst's performance over an extended period. Whether or not the research is characterized as "independent," the accuracy of the analyst's prior recommendations is something that I, as an investor, would want to know to assess a particular analyst's recommendations.

But no matter how much good information is available, it won't have an impact unless investors can make appropriate use of it. That's why I'm proud to say that I was a major proponent of the settlement providing for $85 million to be used for investor education. This is more money than we have ever had for investor education, and we want to use it wisely. The details have yet to be worked out, but we expect to create a foundation with strict accountability standards that will fund proposals for investor education programs from both the public and private sectors.

Let me turn now to the auditors. Auditor independence is another area in which the Commission recently adopted rules to carry out the Sarbanes-Oxley mandate. In the 1990's, changing business conditions placed pressure on auditors to diversify the services they offered public companies. At the same time, company management, which was increasingly being compensated through incentive-based stock and option packages, placed pressure on auditors to go along with whatever it took to meet Wall Street expectations. The pace of SEC enforcement actions against auditors - primarily individual auditors -- quickened towards the end of the 1990s, and the recent demise of Arthur Andersen focused attention on the role of the public independent auditor as never before.

As a result, Sarbanes-Oxley created the Public Company Accounting Oversight Board, and called on the Commission to adopt new auditor independence standards. The auditor independence rule we have just adopted is intended to make sure that auditors are truly independent of management. The new rule requires a five-year rotation for the lead partner of the audit team and the concurring partner, and a seven-year rotation for the lead partners of audit teams of major subsidiaries and other partners with a close relationship with the issuer. The rule also requires auditors to report to the audit committee about critical accounting policies, among other things, and subjects audit and permitted non-audit services to pre-approval by the audit committee.

Our original rule proposal went far beyond the Sarbanes-Oxley requirements, for example, by requiring rotation not just for the lead and concurring partners and other partners who performed audit services for the issuer, but also a number of other partners not on the engagement team, including those who advise in specific substantive areas such as derivatives or tax. In the final rule, however, the Commission decided to revise its proposal in light of the practical complications and costs our rule would have created. While partner rotation provides the benefit of a "fresh set of eyes" and objectivity, I was not convinced that the expanded audit team rotation requirement we originally proposed represented the correct balance between costs and benefits. Not only would it have imposed huge human resource and monetary costs, but it would, in my opinion, have led to confusion and, most likely, a decline in the quality of audits, especially in foreign jurisdictions - certainly, an outcome that would have been counterproductive.

Besides, no matter how frequently partners rotate, there will be no improvement in the audit process if the concerns identified by members of the audit team are ignored by more senior partners within the accounting firms if their chief motivation is to keep the client at all costs. Obviously, the audit team must be able to spot the issues. But the "tone at the top" is just as critical. We have seen too many cases in which an auditor identifies a concern, but influential partners higher up the ladder direct the auditor to look the other way on accounting irregularities.

Audit committees are another focus of Sarbanes-Oxley. Too often, we have seen examples of audit committees that failed abysmally in their oversight responsibilities. Sarbanes-Oxley responded by requiring the Commission to adopt rules to make sure that audit committee members are qualified to oversee the auditing and the financial reporting process and can do so independent of management and from the perspective of public shareholders.

A rule in this area that I would put into the "helpful, but not sufficient" category is the audit committee financial expert designation. The listing standards of the exchanges and Nasdaq require audit committee members to be independent and financially literate and require one member with financial expertise, as they define that term. The Commission's new rule does not mandate that a company have a financial expert serving on its audit committee, but only to disclose whether or not it has one. If the company does have an expert, it has to name the person and state whether the person is independent of management. The practical effect of the rule is, however, that boards will likely feel compelled to designate an expert.

Based on the comments we received and other public reaction, our original proposal clearly defined "financial expert" too restrictively. You read the press reports, I'm sure, about how neither Alan Greenspan nor Warren Buffett would have qualified as experts under the proposed rule. So we expanded the definition and did a reality check to make sure that the kind of person with the expertise we're looking for - a person who has an understanding of, and experience with, financial reporting and U.S. or home country GAAP - satisfied the definition, and I think we came out about right.

Still, no matter how financially expert an audit committee member is, he or she must also be truly independent. And I'm not just referring to the technical definition of independence contained in exchange listing standards. I have in mind a person with the intelligence, experience and understanding to know the right questions to ask of management or the auditors and the forcefulness and tenacity to ask a direct question and insist on a straight answer. Ideally, of course, all audit committee members would have these qualities.

And finally, the lawyers. Sarbanes-Oxley directed the Commission to adopt minimum standards for lawyers of public companies, including an "up-the-ladder" reporting mechanism for securities law violations. The Commission's rule proposal required attorneys, including foreign attorneys, "appearing and practicing before the Commission in the representation of an issuer" to report evidence of material violations of the federal securities laws and breaches of the fiduciary obligations up the ladder to the chief legal counsel or the chief executive officer. If the chief legal or executive officer failed to respond appropriately, the attorney would be required to report the evidence to the audit committee, another committee of independent directors or the full board.

Commenters, almost exclusively from the bar, raised objections to the breadth of the categories of lawyers subject to the rule and highlighted other procedural and substantive problems that would make it difficult for them to comply with the rule. Commenters saved their principal ire, however, for the Commission's proposal to require an attorney to make a "noisy withdrawal" when the board of directors failed to make an appropriate response. For you non-lawyers, and I am one of you, a "noisy withdrawal" means that, under these circumstances, the attorney must withdraw from his or her representation of the company and report publicly to the Commission that the withdrawal occurred as a result of a material violation by the company. Commenters pointed out that the "noisy withdrawal" provision went beyond the requirements of Sarbanes-Oxley, and that, by turning lawyers into whistleblowers, it would require them to breach the attorney-client relationship and "chill" communications between client and attorney.

Our heightened governance standards may ultimately eliminate situations in which a lawyer would have to withdraw from representing a client and report the withdrawal to the Commission. I continue to believe, however, that the "noisy withdrawal" proposal would be an important safeguard for shareholders. When a board is corrupt or otherwise fails to respond appropriately, I do not believe that shareholders would want the attorney, who in representing the company represents the shareholders as a whole, to do nothing to correct the situation.

Nonetheless, I was persuaded that the issue was sufficiently complex and its consequences for attorneys sufficiently problematic that the mandatory withdrawal and "noisy withdrawal" parts of the proposal should be deferred. We proposed an additional 60-day comment period on the "noisy withdrawal" as well as an alternative whereby the issuer would file notice of its attorney's withdrawal, not the attorney. As I stated at our open meeting, I feel strongly that we should readdress this issue soon.

Regarding all of our new rules, the bottom line is that while the new Sarbanes-Oxley rules were probably necessary, technical compliance with them will not be sufficient to cure the problems of the past. The ultimate effectiveness of all of the new corporate governance rules will be determined by the "tone at the top." Adopting a code of ethics means little if the company's chief executive officer or its directors make clear, by conduct or otherwise, that the code's provisions do not apply to them. Designating a financial expert means little if the person designated, while technically qualified, does not possess the personal qualities required to do the job effectively. Auditors must be truly independent of management and carry out their responsibilities from the perspective of the public shareholder. Lawyers should take their up-the-ladder reporting responsibilities seriously and support and encourage their corporate clients to do the right thing, not just avoid doing the wrong thing.

As companies begin to develop appropriate compliance systems and procedures for all the new rules that we have adopted in recent months, they may want to consider designating what I refer to as a "corporate responsibility officer." This is an idea that I've mentioned elsewhere, and it's not required by Sarbanes-Oxley or by the Commission's rules. Provided that he or she is given adequate resources and unfettered access to senior management and the audit committee, a corporate responsibility officer would signal the company's commitment to complying with both the letter and the spirit of the highest corporate governance standards.

It is clear to me that good governance is not an end in itself, but simply the means to an end - which is good performance for shareholders. We are seeing growing evidence that the marketplace thinks governance pays - just as an aside, this would be a good dissertation topic. Companies are publicizing that their governance standards exceed the standards required by the exchanges, Nasdaq and the SEC. If these companies didn't believe that there was a value to adopting governance procedures early or going beyond the minimum requirements, they wouldn't do it.

I would like to conclude by mentioning a few thoughts about the important role that you in the fields of business and economics have to play in the work of the Commission. I know I speak for all my fellow commissioners when I say that the Commission would benefit from your input into the policy-making process. We are always in need of comments from economists, accountants and other experts on issues on which they are uniquely qualified to speak. We usually have no shortage of commenters on our rule proposals. But the quality of comment letters is far more important to me than the quantity of comments.

Finally, you can help us in the area of investor education. The number of frauds of all types that come across my desk every day is astounding and appalling. We had a case recently in which investors put money into a scheme promising a 3000% annual return. How people can hand over their hard-earned dollars to promoters and their "get rich quick" schemes is beyond me, but it happens all the time, and the victims are not limited to the unsophisticated.

The only way to fight this is through investor education. We must do a better job in educating the public about basic investment principles. A while ago, the Commission created a website advertising a scam that guaranteed outrageous profits. When eager investors tried to sign up, they clicked onto a screen revealing that the offering was designed by the SEC as a way to educate investors about the dangers of investing in quick money schemes. We got over two million hits on that website, making it the most viewed piece of investor education we have ever undertaken. And while we got many letters and emails supporting our investor education efforts, we also received several hundred angry letters from people who were furious that the offering wasn't real.

But it is not just the Commission that needs to promote investor education. As academic economists and accountants, you have a responsibility to promote financial literacy and investor education on your campuses and within your communities. The business, economics and accounting departments of colleges and universities can develop programs for students in other disciplines to help prepare them to be educated investors as they enter the job market. You can help develop curricula for high school, junior high, and even grade schools that incorporate the key concepts that investors need to understand:

  • Start saving early to reap the benefits of compounding
  • Diversify your investments, and
  • If it sounds too good to be true, it is.

You can also be helpful through volunteer work to help individuals of all ages and incomes - from low-income families to the senior citizen community - to understand the basics of sound investing.

Investors cannot make wise decisions pertaining to their savings and retirement unless they are financially literate. Congress and the Commission are trying to create the appropriate incentives and to get the right disclosures from issuers, their advisers and the gatekeepers, but we need help from the academic community to get investors sufficiently educated to understand the information available to them, to ask the right questions and make the right decisions on how and when to invest. Once that happens, our job will be much easier!

Thank you. I'd be happy to take your questions.



Modified: 04/09/2003