Speech by SEC Commissioner:
Remarks before the Tenth Annual Conference on SEC Regulation Outside the United States
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
February 23, 2006
Thank you, Mark. This is the third year I have had the opportunity to address this conference. Therefore, as most of you know, I have to give a standard disclaimer. That is, the views I express today are my own and do not necessarily reflect the views of the Commission or its staff.
It is a pleasure to be back in London. Of all the conferences I attend, this is the only one that reserves time for "tea" in between panels. The others schedule "breaks," which to me implies that the conference host believes the audience needs relief from the speakers. I'll try to be informative and brief, in hopes that you will look forward to taking tea with me, and not a break from me.
I want to thank you for your invitation and also commend you on this, your tenth annual conference. Congratulations to you, Mark, and all of your organizers and long-standing attendees on achieving this milestone. At your first meeting, the cutting-edge issues were the new anti-manipulation rules governing securities offerings and sales of securities outside the U.S. made without registration. Among these and other topics, you were discussing how the SEC relates to foreign companies and the SEC regulation of fund managers.
Ten years later, these topic areas are still important, but the underlying issues have changed significantly. Since 1996, we have seen increased internationalization and growth of the global capital market. In the United States, the number of non-U.S. companies with Exchange Act reporting obligations has increased by over 30% in the last decade. The number of American Depository Receipt issues traded on the NYSE has increased over 60% during that time. In Europe and Asia, the last decade has been one of great political and economic change, and the capital markets have experienced dramatic ebbs and flows. In the last half of the 1990s, we witnessed an historic bull market and favorable business environment, with the Dow Jones Industrial Average rising from 6,500 at the end of 1996 to its peak of 11,900 in January of 2000, while the first few years of this decade saw a dramatic market slowdown and bursting of the Internet bubble.
Unfortunately, these years were marred by corporate and accounting scandals. In the United States, we had Enron, Worldcom and others. Here in Europe, you had Parmalat, Royal Ahold and others. In Asia, there is Livedoor. The result in the U.S. was the passage of the Sarbanes-Oxley Act of 2002, which imposed new obligations and restrictions on public company directors and executive officers. It also required the Commission to promulgate new rules requiring additional and more timely public company disclosure. Audit committees were to become more independent and establish new procedures, and the Public Company Accounting Oversight Board (PCAOB) was created to oversee auditing firms both within and outside the U.S. that audit public companies in the U.S. In light of these scandals, regulatory change was important to restoring investor confidence. I believe most of the new requirements have helped to achieve that end. However, Sarbanes-Oxley and the rules and regulations that are its progeny did not come without unintended consequences. There remains room for improvement.
One provision that has been criticized profusely is Section 404, which requires company management to assess and publicly report on the effectiveness of a company's internal controls. The PCAOB's Audit Standard No. 2 (AS2) imposes the additional requirement that auditors not only publicly attest to management's assessment, but also provide a separate opinion on the effectiveness of the internal controls. Section 404 and AS2 are, of course, measures whose purpose is to ensure that financial statements are accurate. Laudable as these intentions are, there has been widespread criticism of the unnecessary burdens and costs of implementation.
In April of last year, a Roundtable that the Commission sponsored of public company officers, directors, investors and auditors made abundantly clear that the implementation of Section 404 had often inappropriately shifted the focus from a top-down, risk-based management perspective to a bottom-up, check the box auditor perspective. After the Roundtable, the Commission and the PCAOB issued new guidance reminding management and auditors to use reasoned judgment and a risk-based approach in the process. I was hopeful that the SEC and PCAOB messages would re-focus companies and their auditors on a more appropriate approach to 404 in the second year of compliance, but that remains to be seen.
We have twice extended the Section 404 compliance date for larger foreign issuers, although we expect them to comply for fiscal years ending after July 15, 2006. In addition, we have extended the compliance date for smaller issuers, both foreign and domestic (those with less than a $75 million worldwide public float), by an additional year to July 15, 2007. While postponing deadlines is helpful, eventually we have to ask how the process can be improved. I believe that a prescriptive, one size fits all approach is not only not required, but ineffective. To implement the requirements efficiently and effectively, auditors should set the scope of their evaluations according to the level of risk. Such an approach would incorporate the proper context, namely management's perspective as to what is important to the business and the financial reports.
To evaluate whether year two of 404 compliance has improved and whether the guidance has been embraced or whether we need to take additional steps, the Commission and the PCAOB have scheduled a Roundtable in May. As I have stated repeatedly, I remain receptive to recommendations for improvement of the 404 process for domestic and foreign issuers, including possible changes to AS2.
Given the compliance burdens of Sarbanes-Oxley, especially Section 404, some non-U.S. issuers have indicated that they may forgo registering with, or seek to de-register from, the SEC. However, we have been told that our current rules can make it very difficult to deregister and leave. The rules generally require issuers to meet their SEC reporting obligations if they have more than 300 U.S. resident shareholders. This 300 holder requirement was adopted in 1968, when there was much less cross-border investment activity. The purpose of this rule, of course, is to protect U.S. investors.
I am pleased to report that in December, we proposed new rules that would make it easier for foreign private issuers to deregister. Under our proposed rules, a foreign private issuer that meets specified criteria designed to measure U.S. market interest for its securities can exit our reporting system. Since looking only at the number of record holders to determine whether deregistration is appropriate may be too limiting, our proposed rules would consider other factors such as threshold percentages of U.S. versus worldwide trading volume and float ownership. Further, the proposed rules would make it easier for non-U.S. issuers to terminate, as opposed to suspend, their filing obligations.
In my view, making it easier to exit our reporting system would actually encourage more non-U.S. firms to register their securities in the United States. Under the proposed rules, non-U.S. issuers would be able to enter our reporting system knowing that if U.S. investor interest wanes relative to non-U.S. investor interest, there are more flexible standards to get out. I look forward to receiving and evaluating comments in this area. We have already heard from European Union officials and others that our proposals may not go far enough in loosening restrictions.
Another area in which Sarbanes-Oxley has had a significant impact is on the Commission's civil penalties. The Act provides that penalties levied in Commission civil actions can be directed to so-called Fair-Funds for the benefit of investors who suffered harm from the fraud. Since I have been a Commissioner, the level of corporate penalties in our enforcement actions has escalated, largely in response to corporate accounting scandals. As the penalty level rose higher and higher, so did my concern about the consequences of what we were doing. Since penalties are paid indirectly by shareholders, I questioned whether in many of these accounting fraud cases we were in fact benefiting investors who had suffered harm or were really further harming them.
The history of our authority in this area is relatively brief. It was only in 1990 that Congress gave the Commission the power to impose civil penalties on corporations. The legislative history notes, and I fully agree, that civil penalties against corporations should only be assessed when shareholders get an improper benefit from the conduct underlying the securities law violation for which the penalty is imposed. Congress' further guidance also makes a lot of sense to me - namely, that the Commission and courts should take into account whether shareholders who have been the victims of the violative conduct would bear the brunt of paying the penalty.
When Chairman Cox came on board, he made it a priority to deal with the issue of corporate penalties. After much discussion, review and analysis, on January 4th we issued guidelines regarding whether and to what extent to impose civil penalties against a corporation. Our guidelines identify two principal considerations. First, recognizing that it is the shareholders who ultimately pay corporate penalties, we will consider whether the shareholders benefited from the fraud or were its victims. If they benefited from the fraud, through the corporation's increased revenues or reduced expenses, for example, a penalty may be appropriate. However, if shareholders were victims of the fraud, then a penalty may not be appropriate. Second, we will consider the degree to which a penalty could be used to recompense innocent victims of the fraud or whether it would simply further harm shareholders.
Overall, I am very pleased with the guidelines. They recognize that in most cases corporate penalties make little sense when imposed on shareholders already victimized by a fraud. I want to note, however, that the guidelines are not about penalties levied against individuals for wrongdoing, but acknowledge that penalties on individuals are an extremely important deterrent.
Shifting away from Sarbanes-Oxley, I would like to discuss some other developments and initiatives from my side of the pond that I think may be of interest to you and your clients. Some emanate from changes in the global capital market. Others concern challenges that have existed for at least the last decade during which you have been holding your conferences.
First, a very hot topic, executive compensation, has generated spirited academic discourse and news headlines for quite some time now. CEO compensation has increased dramatically over the last 20 years. The gap between CEO pay and pay of average workers has also widened during that time. Seemingly high executive compensation is of particular concern when a company's performance is poor.
In January, we proposed changes to our rules on executive and director compensation disclosure. While the Commission should not be setting compensation levels, we proposed rules designed to make sure that disclosure regarding executive compensation is clear and comprehensive. This would better enable the market to evaluate the appropriateness of a firm's compensation of its senior management and directors. I fully support the effort to update and improve the disclosure of executive compensation.
Our proposed rules would revise the current tabular disclosure and require a new plain English Compensation Discussion and Analysis. They would also streamline and consolidate the related party transaction disclosure rules and rules regarding director independence, and make other changes. Of particular note, the new rules would require that an issuer disclose the amount of total compensation it pays to its CEO, CFO and the three other highest paid executive officers, its directors, and in certain cases, three other highly compensated non-executives (note, these last three persons would not be identified). As to foreign private issuers, our proposed rules retain many of the mechanisms currently available to comply with our executive compensation and related party transactions disclosure requirements. As our current rules provide, a foreign private issuer could still fulfill its disclosure obligations by providing individual disclosure only when other markets' rules require or it otherwise does it.
I expect that the proposal will generate significant comment. One area about which I have specific questions relates to options. As part of the total compensation calculation, option awards have to be valued. These valuations must be reasonable. As proposed, the rules call for issuers to account for forfeitures using the employee turnover assumptions used for FAS 123R stock option expensing. I have asked whether, for inter-firm comparability purposes, an assumption of no turnover would make sense - realizing that this would raise the reported value of options. The proposed rules also require that the full fair value of an option that has been repriced be reported in the tables as if it were a new grant. In this case, I have asked whether the incremental compensation cost would better reflect the correct valuation and avoid the potential for double-counting -- once when the option is issued and again when it is repriced. Depending on the comments, there may need to be some fine tuning regarding these and other issues. I encourage comments on these issues and hope we can be in a position to consider action on a final rule quickly.
Another initiative I want to discuss briefly is the hedge fund adviser registration rule that went into effect earlier this month. As I said last year, in my view, the Commission adopted this rule to combat perceived evils, i.e. retailization and growing fraud, which I do not believe had been demonstrated even after an extensive staff review was completed in 2003. In my view, the registration requirement for hedge fund advisers we adopted (and that I voted against) was not well thought out. Had we approached the hedge fund issue more analytically at the outset - deciding what information we really needed and how best to get it - I believe we would be in a much better position today to provide effective monitoring and to see red flags. Further, we should have considered alternatives, such as raising the financial qualification criteria for eligible investors, especially if we were really concerned about retailization.
Not surprisingly, the rule has had unintended but totally predictable consequences. One immediate problem is that there is no clear definition of what a hedge fund is, so there is no simple way to check a box on the registration Form ADV to identify which forms are being filed by hedge fund advisers. Rather, that information has to be derived from answers to several questions. Also, advisers to funds with fewer than 15 underlying U.S. investors do not have to register, nor do advisers to funds with lock-ups of over two years or advisers whose funds are closed to new investors. The unintended yet totally predictable outcome here is that global funds are excluding U.S. investors and that U.S. domestic funds are lengthening their lock-up periods or closing their funds. This inhibits U.S. investors from participating in a global capital market that the Commission has properly acknowledged is becoming more internationalized. In addition, the imposition of longer lock-ups reduces liquidity. Overall, I was never quite clear as to what the real objectives of this rule were, so it's very hard to tell whether or not we are accomplishing them.
Moving on, as the capital markets become more global, the need for more consistent accounting methodologies and disclosure requirements is imperative. This is particularly true in the case of the international convergence of accounting standards. Since October 2002, the Financial Accounting Standards Board (FASB), the standard setter for U.S. Generally Accepted Accounting Principles (U.S. GAAP), and the International Accounting Standards Board (IASB), the standard setter for International Financial Reporting Standards (IFRS), have been engaged in a project to converge U.S. GAAP and IFRS. I support the goals of this project. While I know there will likely be transition issues, having consistent approaches to the most common and most important accounting questions will result in financial reports telling more comparable stories. That would be more efficient for issuers and more useful for investors.
The other significant issue on the international accounting front is reconciliation. As you well know, in their SEC filings, companies that use IFRS or other accounting standards have to reconcile their financial statements to U.S. GAAP. I fully support what has become known as the "roadmap" to achieving the acceptance of IFRS in the U.S. without reconciliation. Basically, our staff is looking to see the nature and scope of the reconciliations and the consistency of IFRS implementation across countries. While our staff has already begun planning the initial phase of the roadmap, we really cannot get started evaluating the 2005 results of the IFRS/U.S. GAAP reconciliations until mid-year, because IFRS has only been recently implemented in many countries for the first time.
Many topics I have discussed today have been longstanding issues. I want to mention briefly a new initiative that most of us probably could not have envisioned a decade ago, i.e., the submission of SEC filings using Extensible Business Reporting Language, more commonly known as XBRL. XBRL is an interactive data format that makes financial information easier to locate and analyze. XBRL enables filers to use special definitions to "tag" various items in their financial reports. I analogize tagged interactive data to Lego building blocks - investors can use the data to construct for themselves financial, operating ratio or other meaningful information about companies just as Lego blocks can be used to build a variety of different structures. Users can retrieve the tagged data through computer searches and analyze it quickly and easily with other computer software tools. Doing this electronically saves time and money and ensures better accuracy - ultimately resulting in more robust and efficient analyses.
U.S. regulators have begun to experiment with and use XBRL. The FDIC has made progress toward a web-based system for regulatory reporting by banks. Last year, the SEC launched a voluntary XBRL pilot program. The program presents registrants the opportunity to explore the costs and benefits of this new approach. So far, nine filers have participated, and I encourage more non-U.S. filers to consider participating. Recently, we announced a new program with incentives to encourage additional voluntary filings under XBRL. I am confident that this powerful technology could make the information that registrants file with us more useful to investors and other global market constituents.
While I know it's not tea time just yet, it is time for me to wrap up and give you a break. Over the last decade, your conferences have attracted several thousand attendees, from most continents and dozens of countries. That alone highlights the importance of continued dialogue across borders. We can all learn much from one another. My hope is that we can continue to work together to gain a heightened awareness of important issues so they can be resolved effectively for all stakeholders worldwide. Thank you.