Speech by SEC Commissioner:
The Sarbanes-Oxley Act of 2002: Goals, Content, and Status of Implementation
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
University of Cologne, Germany
February 5, 2003
These remarks reflect the personal views of Commissioner Atkins and do not necessarily reflect the views of the Commission or its individual members.
Professor Dauner-Lieb, Professor Henssler, Professor Hobe, ladies and gentlemen, it is a great honor and an enormous privilege to be here with you today. Germany and each of the Member States of the European Union are crucial allies of the United States. Our friendship and mutual respect is of the utmost importance as we look to the future in these very uncertain and difficult times. Although the events of September 11th occurred more than a year ago, the citizens of the United States and their friends around the world recognize a continuing threat. These tragic events demonstrated the fragility of our lives, our economic structures, and our very way of life. To this day, in the United States, we still appreciate the tremendous outpouring of support and assistance that we received from Germany and all of the members of the EU.
Of course, September 11th was followed by a handful of spectacular failures of large corporations, primarily in the energy and telecom area: Enron, WorldCom, Global Grossing, etc. However, U.S. investors are not alone in experiencing recent profound failures, some of which were caused by questionable accounting practices, bad management, and/or poor internal controls. Names like Phillip Holzmann, Babcock-Borsig, Kirch, Polly-Peck, Comroad, and MobilCom come to mind. Therefore, restoring investor confidence by strengthening corporate governance is of great importance to the world's financial markets. It is not an issue unique to the U.S. or the E.U.
The corporate problems came at the same time as a general realization among investors of an overcapacity in the telecom and high-technology area. I believe that it is no coincidence that the burst of the telecom bubble came shortly after the end of a binge of corporate and government spending on computer improvements because of year 2000 fears. As all of us know, many investors lost confidence in equity securities, and equity securities fell around the world. There is a significant amount of money sitting on the sidelines waiting for the "right time". 2002 will be the first year since 1988 that U.S. investors took more money out of stock mutual funds than they put into them.
Financial crises have yielded a legislative reaction many times in the past. Dr. Robert Higgs, a noted Stanford University professor, wrote a book a few years ago called Crisis and Leviathan. His primary thesis is that government's command-and-control system of resource allocation expands at the expense of the private, cost efficient, market economy when government responds to an insistent but ill-defined public demand that it "do something" about a crisis. He traces a number of crises in American history some financial, some military and reveals how the market sector has given way in those cases.
Last year, in fact, the market decline and large corporate failures led to just such a general sense that politicians should "do something". The impending November 2002 congressional elections, which had been said to be very close, gave added urgency to legislative action. Because these corporate failures stemmed from lax accounting and corporate governance practices, "Corporate Responsibility" became an important political issue in the United States, for the first time in perhaps 70 years. In late July of 2002, Congress passed the Sarbanes-Oxley Act, with only 3 members voting "no." Corporate responsibility is still a critically important political issue in America. Just last week in his State of the Union address, the President, referring to Sarbanes-Oxley, said that "tough reforms" were passed to "insist on integrity in American business".
Sarbanes-Oxley contains many advances for corporate governance, although it also represents what formerly would have been an unimaginable incursion of the U.S. federal government into the corporate governance area. Historically, the States had exclusive jurisdiction over corporate governance matters. The Act attempts to provide fundamental mechanisms to prevent the misdeeds that led to investor losses. These mechanisms are intended as best practices. Many are not outright requirements, but are requirements on corporations to disclose aspects and then let the market decide what importance to put on that disclosure.
The SEC is the government agency charged with implementing most of the provisions of Sarbanes-Oxley. I should here mention how the SEC fits into our government. The SEC is an "independent agency," which means that it has aspects of all three branches of our government: executive, legislative and judicial powers. The SEC has civil (not criminal) enforcement powers against people who violate the securities laws and our rules; it has power to write rules pursuant to statute; and it acts like an appellate court in reviewing appeals from sanctions that the stock exchanges and the professional organization of brokers levy against their members.
The Sarbanes-Oxley Act required the SEC to make many rules within specific time limits. In the United States, the SEC is bound by law to give people subject to our rules fair notice of what rules the SEC plans to adopt and to have an opportunity to send to us comments on and objections to those rules. We are required by law to take those comments into account and say why we accept or reject those objections. With respect to Sarbanes-Oxley, because the time given us by Congress was so short, we decided to leave the wording of the rules rather general and stayed in most cases very close to the statute's wording, even though Congress gave us some discretion to be more flexible in some cases. We hoped that the comments and objections would help us tailor our rules to make them workable in the U.S. and abroad. Ultimately, we received a great deal of comment, much of it from non-U.S. commenters. I believe, and hope that you agree, that the final rules that we have adopted demonstrate our responsiveness to those comments.
The final result of Sarbanes-Oxley and our rules, after all of the back and forth of recent months, is a positive step for general corporate governance. Through the comment process, we have been able to craft something more than just a political reaction to a crisis.
Fundamentally, the Act acknowledges the importance of stockholder value. Without equity investors and their confidence, our economic growth and continued technological innovations would be slowed. Sarbanes-Oxley strengthens the role of directors as representatives of stockholders and reinforces the role of management as stewards of the stockholders' interest.
A lesson from the recent corporate failures in America is the importance of corporate culture and what we call the "tone from the top". A CEO's tolerance or lack of tolerance of ethical misdeeds and a CEO's philosophy of business conveys a great deal throughout the organization. The role of directors is to monitor and oversee that situation on behalf of stockholders. Directors are not and can never become full time employees. There will always be a natural tension between directors as business advisors a vital role and their role as monitors of management on behalf of the stockholders' ownership interests.
It is my hope that Sarbanes-Oxley may indirectly help directors in this regard. The law's effect will be to make board members be more inquisitive. Therefore, questions that might have seemed to be "hostile" to management two years ago will now be seen to be in furtherance of a director's function. Since some of the recent problems concerned corporate managers using the corporation as a personal "piggy bank" or other theft by management of corporate assets, the Act's emphasis on a board's oversight function is certainly a step in the right direction.
While acknowledging these benefits and in pursuing our primary mission to protect investors, we have to be mindful of the special considerations and needs of our non-U.S. issuers. For many years, U.S. investors have been seeking opportunities to invest in the securities of non-U.S. issuers, including German issuers. The SEC has long recognized the importance of the globalization of the securities markets both for investors looking for increased diversification and international entities looking for capital-raising opportunities in different, and sometimes larger, markets. In addition, allowing non-U.S. issuers access to the U.S. securities markets gives these non-U.S. issuers "acquisition currency" to make acquisitions in the U.S.
Over 1,300 non-U.S. corporations from 59 countries file reports with the SEC, as compared with approximately 400 issuers from less than 30 countries in 1990. Most of our non-U.S. issuers are from Canada. The second largest number are from the U.K. Currently, approximately 30 German corporations report to the SEC the largest ones being DaimlerChrysler AG, E.ON AG, Deutsche Bank, and SAP. In our efforts to create a global marketplace, we want to encourage more German corporations to participate in the U.S. securities markets, and we always welcome your comments and advice as to how we might improve the situation.
Of course, Sarbanes-Oxley generally makes no distinction between U.S. and non-U.S. issuers. The Act does not provide any specific authority to exempt non-U.S. issuers from its reach. The Act leaves it to the SEC to determine where and how to apply the Act's provisions to foreign companies. The SEC is well aware that new U.S. requirements may come into conflict with requirements on non-U.S. investors issuers. As we move forward to implement Sarbanes-Oxley, we have tried and we will continue to try to balance our responsibility to comply with the Act's mandate with the need to make reasonable accommodations to our non-U.S. issuers.
Europeans and Americans have fundamentally the same goals with respect to strengthening corporate governance. Despite the general thrust of Sarbanes-Oxley, the basic philosophy in the United States is for the States and the stock exchanges to determine their corporate governance requirements. Similarly, a group set up by the European Commission did not propose harmonization of corporate governance standards among the Member States. Instead, the group recommended that the Member States should each set forth minimum standards of conduct. The proffered rationale for this approach is that the corporate governance standards of the Member States are necessarily different and flexibility is critically important.
The European approach generally stresses the importance of the non-executive Chairman of the Board. While it certainly may be beneficial, depending on the company, to separate the board chairman from the company's chief executive for oversight purposes, the separation of these two positions will not necessarily cure all corporate governance issues. For example, I would note that Enron and WorldCom had a non-executive chairman and, of course, this separation did not prevent corporate failures.
As for accounting practices, the European approach has been to stress "principles-based" accounting standards. In concept, the E.U. and the U.S. are not far apart on this issue. As you know, GAAP means "generally accepted accounting principles". But, over the years, accountants have relentlessly sought greater certainty as the accounting issues and demands of the marketplace became more complex. Accordingly, by necessity, our rules have become more complex and legalistic. Whether or not this evolutionary process is good for the accounting profession or investors is a debate for another time.
The SEC is interested in finding the "common ground" between the U.S.'s and the E.U.'s approach to these issues. Since the passage of Sarbanes-Oxley, the SEC has hosted two interactive rountables on the application of the Act to non-U.S. issuers. We have met with foreign delegations and European securities regulators. I think I can state with confidence that the process is working and that your active participation in our rule-making process is helping the SEC understand the particular needs of non-U.S. issuers. Just because our approaches are different does not mean that they cannot work together effectively.
If a foreign company considered a U.S. listing before Sarbanes-Oxley, neither the Sarbanes-Oxley Act nor our rules implementing the Act should dissuade the company from doing so. Not surprisingly, there will be new regulations and calls for disclosure. A primary goal of the SEC is to make it inviting for global businesses to offer and list their securities in our markets. Sarbanes-Oxley does not have an effect on this goal.
Let me briefly discuss some of the specific issues raised by Sarbanes-Oxley and some of the rules that we have recently released and proposed and their implications to non-U.S. issuers:
The Act directed us to create a new Public Company Accounting Oversight Board to oversee the accounting profession and public company audits. It was created because of deep failings in the U.S. accounting profession's ability to regulate itself. The Oversight Board is a non-governmental, nonprofit corporation and must consist of five full-time independent members.
Of understandable concern to you is the fact that the Act requires foreign public accounting firms that audit SEC-registered issuers, including non-U.S. issuers, to register with the Oversight Board and be subject to its oversight. Ultimately, our decision must balance the fundamental regulatory objectives of Sarbanes-Oxley with our role as one of many regulators in the community of nations.
One of the most significant aspects of Sarbanes-Oxley is expanding the role and responsibilities of audit committees. Sarbanes-Oxley requires the audit committee to be responsible for the outside auditor relationship, including the responsibility for the appointment, compensation, and oversight of a company's outside auditor. And, the Act requires that members of the audit committee be "independent" from company management. The SEC released proposed audit committee rules last month and the Act requires final rules by late April of this year.
I think it is worth mentioning at this point that seeking "independence" of board members is not a new concept in the U.S. As early as 1972, the SEC recommended audit committees of "outside directors". In 1976 a Congressional committee reported a need for directors that are "detached" from "management and from any other conflict of interest". More recently, a SEC-led committee on improving the effectiveness of audit committees recommended that all audit committee members be independent from corporate management.
Many non-U.S. issuers already have independent audit committees as part of their corporate governance structure and the global trend appears to be toward setting up such audit committees. I have often stated that a one-size-fits-all never works, and this is especially true in the non-U.S. issuer context. However, there is almost universal support for some form of independent check on company management by a disinterested board. Indeed, the German corporate governance code makes recommendations regarding obtaining more independence of the supervisory board members from company management. In the U.K., the value of independent directors is emphasized in the recommendations of Derek Higgs regarding corporate governance, building on the earlier work of the Cadbury Commission.
Non-U.S. issuers have provided the SEC with critically important information regarding corporate governance. Through our comment process, we incorporated necessary changes to accommodate the German requirement of non-management employees' serving as members of a company's audit or supervisory board. These employees would often not meet our definition of independence. The SEC has no interest in creating conflicts with local law, especially when these employees actually represent non-management interests. Accordingly, in our rule proposal, we provided that, under certain circumstances, these individuals would be exempt from the independence requirements.
We have also made similar exemptions for the unique needs of other countries' practices. For example, we made accommodations for representation of controlling shareholders on audit committees. Similarly, acknowledged the practice where foreign governments sit on audit committees, even if they do not satisfy SEC independence requirements.
The SEC is a disclosure-based agency, not a merit regulator. Information powers the marketplace, which, I believe, is the only acceptable merit regulator. In keeping with our disclosure tradition, we have proposed that if a non-U.S. issuer utilizes an exemption to audit committee independence, this information must be disclosed to U.S. investors. The most effective regulator, the marketplace, will determine whether a country's differing independence standards are relevant to U.S. investors.
Sarbanes-Oxley also directs the SEC to adopt rules requiring the disclosure of whether a company has a "financial expert" on its audit committee and to define a "financial expert". We have recently released rules in response to this directive. I think it is beyond debate that it is beneficial to have financially literate directors. Indeed, studies show that companies that have board members with significant financial knowledge need to restate the financial statements less than companies with less-experienced board members.
In the final rule, every issuer, including a non-U.S. issuer, will need to disclose whether it has a financial expert on its board and whether the financial expert is independent from management. However, non-U.S. issuers will not be required to make this disclosure until the final rules regarding audit committees that I just discussed are in place. We decided to delay the disclosure requirement because we recognize that our non-U.S. issuers have never been subject to independent audit committee disclosure. We acknowledge that imposing this financial expert disclosure requirement on non-U.S. issuers in such a short timeframe would be unfair. We trust that non-U.S. issuers will be more comfortable with this disclosure requirement by the time the overall audit committee rules are effective.
The SEC was directed by Sarbanes-Oxley to adopt final rules regarding "minimum standards of professional conduct" for attorneys. We acknowledge that we are in unchartered waters with these new rules. They have been referred to as the first significant effort by Congress to mandate the U.S. federal regulation of lawyers.
We proposed rules in December, 2002. We received approximately 170 comment letters regarding our proposal, including over 40 from foreign parties. Our proposed rule was controversial in many ways. It took an expansive view of who could be found to be "appearing and practicing" before the SEC. It reached attorneys licensed in foreign jurisdictions, whether or not they were also admitted in the United States. And it raised issues of jurisdiction and enforceability.
Our recently released final rule is less controversial. It has been significantly modified because of the many thoughtful comments and suggestions that we received. We have exempted from the rule certain foreign attorneys. We call them "Non-Appearing Foreign Attorneys". If an attorney falls within this definition, that attorney is not subject to the rule's requirements. In order to satisfy the Non-Appearing Foreign Attorney test, the individual must (1) be admitted to practice outside the U.S.; (2) does not give advice or hold himself out as practicing U.S. federal or state securities laws; and (3) conducts activities that would constitute appearing and practicing before the SEC only incidentally to, and in the ordinary course of, the practice of law in a jurisdiction outside the U.S.; or appears and practices before the SEC only in consultation with a U.S. attorney. We have also specifically stated that even if an attorney is subject to our new rule, this attorney shall not be required to comply if our rule conflicts with local law. Again, I would like to emphasize that your input in the comment process and at our various SEC roundtables was critical in reaching this reasoned and balanced approach to Congress' directive in Sarbanes-Oxley.
We have issued a new proposal with respect to the "reporting-out" or "noisy withdrawal" aspects of Sarbanes-Oxley's attorney directive. We received many comments on our proposal that required an attorney to disclose material violations of securities laws to the SEC. Not surprisingly, we received many strong objections to this requirement. We are now asking for comment whether it makes sense for the company to disclose when an attorney resigns because he believes the company did not respond adequately to a material violation of securities law. This new approach would not require the attorney to disclose any information other than to his client. As proposed this new requirement would apply to non-U.S. issuers. It would also require rapid reporting to the SEC two business days from receipt of the notice.
Revelations of corporate mismanagement, malfeasance, and/or incompetence have undermined the world's financial markets in a profound way. As we address this profound effect on the markets, we need to be mindful of the fact that morality and ethics cannot be legislated into existence. Government controls alone too often paternalistic will never be a solution if individuals and individual firms are not upholding their own end of simple business ethics through their own effective compliance. Internal controls and the culture of an organization are basic structural aspects to reinforce the inherent nature of most people to do the right thing.
These are trying times for the investing public. As we try to reach the other side of this period of strain, I would like to quote a statement made by then SEC Chairman William O. Douglas on January 7, 1938: "By and large, government can operate satisfactorily only by proscription. That leaves untouched large areas of conduct and activity, some of it susceptible of government regulation but in fact too minute for satisfactory control; some of it lying beyond the periphery of the law in the realm of ethics and morality. Into these areas self-government, and self-government alone, can effectively reach."
These wise words uttered within a relatively short period of time after the largest financial markets crisis in the United States crystallize the difficult task at hand. We have, I believe, made significant steps over the last year to restore worldwide confidence in the U.S. financial markets. We are working hard to be more vigilant and more faithful defenders of the public trust. The cooperative spirit between our nations that has served us so well in the past must be our guiding principle as we attempt to accomplish our collective goals. I am here today to continue the SEC's tradition of asking for assistance and guidance, as we strive to improve and further globalize our financial markets.
Thank you very much.