Speech by SEC Commissioner:
Remarks Before the Council of Institutional Investors
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
March 27, 2003
Good Morning. I'd like to thank Sarah Teslik and the other Council officers, as well as you, the members, for inviting me to speak to you this morning. It is a great honor and an enormous privilege to be here with you. Before I begin, I must first note that the views I express today are my own and do not necessarily reflect those of the SEC as an institution or of the other Commissioners.
With the completion of most of the Sarbanes-Oxley initiatives, I have looked forward to getting up here to speak about the matters that we at the SEC now have before us - I'm used to giving speeches about what we've done regarding Sarbanes Oxley, so it's a pleasant change of pace to talk about other issues before the SEC. Certainly, as you all know, we now have a new Chairman, and at our agency, the Chairman, in large part, drives our agenda and initiatives. So, to be clear, our current issues will likely change, depending upon the direction that Chairman Donaldson elects to go.
In many ways, my time in government reminds me of the movie Groundhog Day. That's the movie in which Bill Murray plays the guy who is doomed to wake up and relive Groundhog Day over and over, regardless of all that he tries to do to change the outcome and get off what seems to be a hamster wheel.
As Sarah mentioned, I guess that I am what you might call a recidivist SEC employee - in 1990, I came to work at the SEC under Richard Breeden, stayed on with Arthur Levitt, then came back to work with Harvey Pitt and now Bill Donaldson. A dozen years ago, the major issues that we faced at the SEC included corporate governance, proxy reform, shareholder communications, executive compensation disclosure, accounting for stock options, harmonization between US GAAP and international accounting standards, accounting for and valuation of financial instruments, revenue recognition, dual regulation of securities products by the SEC and the CFTC, and … this is the real kicker … the effect of the war in the Persian Gulf on the markets. Any of that sound familiar? Each one of those is still with us today, either never having left, or like a boomerang or Jason in Friday the 13th, back again.
This past weekend at home, by eerie coincidence, I came across a speech by Richard Breeden when he spoke to this Council on April 2, 1990 on - guess what? - Corporate Governance and the growing role of institutions in the markets. That speech basically kicked off what was a very effective couple of years of the SEC's dealing with those issues and, I think that the record shows, making great progress on proxy-related issues.
Frankly, it is also bittersweet as you will see it shows how much further we have to go.
Just to indicate how much the world has changed in the past decade, the statistics that then-Chairman Breeden cited in his speech seem almost quaint. U.S. equity markets had grown during the 1980s by about 400% to $3 trillion. Even after the bursting of the 1990s bubble, the market stands today at a capitalization of about $17˝ trillion. The size of the 1990s bubble itself, at about $7 trillion, was more than twice the entire market cap of 1990. Back in 1990, some questioned whether American economic competitiveness was up to the challenge from the Japanese and Europeans. Believe it or not, some people even advocated aspects of the Japanese corporate governance model as a paradigm for the U.S., despite Boone Pickens' Japanese experience. What a difference time makes.
The makeup of the marketplace has continued the trends established in the 1980s. Institutions hold a greater percentage of equities - the Fed estimates it at 49%, up from 41% in 1991 and four times what it was 40 years ago. Management owns around 21%. While the percentage of individual ownership of equities continued to decrease in favor of institutions, the greatest change during the 1990s was the number of households that own equities, basically through growth of mutual funds and holdings in pension funds and 401(k) plans. Today about 52% of households own stock; while in 1989, it was only 32%. That is a stunning increase and helps to explain why corporate governance is such a hot political topic in the wake of Enron, WorldCom, and now HealthSouth, for probably the first time in 70 years. Thousands of Americans have lost their jobs, savings, and retirement prospects.
If anyone ever had doubts, the past couple of years have been the best indication that corporate responsibility is essential for a strong stock market. The end of the bubble of overexuberance, especially in the telecom and technology sectors, was certainly inevitable. But, the instances of corporate mismanagement, malfeasance, incompetence, and outright criminality that came to light - like flotsam and debris that is left on a beach as the tide recedes - have exacerbated the understandable reluctance of investors to go back into the market. There certainly is a lot of money on the sidelines. The ability of the market to regain its footing and become less volatile will depend largely on three factors:
- Investors' belief in the transparency and reliability of the financial data they receive;
- Investors' belief that management, who are supposed to be acting as stewards of stockholder property, have integrity and are acting in the owners' interests to maximize value, not in their own interest to fill their pockets at the owners' expense; and
- Investors' belief that the directors as elected representatives of the owners of the corporation - and the auditors as their hired watchdogs - minding the business as if they owned it.
The problem, of course, is that our model of corporate governance has systemic problems that have been developing for years. Oftentimes, directors have been too beholden to management. Ross Perot once quipped at an SEC conference on corporate governance that we held in 1992: "Again and again in big corporate America . . .[managers] pick a bunch of house cats that will not cause any trouble…[Management] will bring you in, and show you a slide projector saying: the world is square, there is no gravity . . . everybody in favor say 'aye.' Aye. The motion carries." Consistent with our Groundhog Day theme, recent problems have demonstrated that this issue has yet to be solved.
It is a fundamental economic principle - one reason that communism is such an abject failure - that nothing beats private ownership rights for the effective management of assets. Owners care about their property. That is the reason that it is so important to have the interests of those who manage property on behalf of owners aligned with the interests of owners. That is a benefit of the Sarbanes-Oxley Act. Fundamentally, the Act acknowledges the importance of stockholder value. It takes steps to strengthen the role of directors as representatives of stockholders and reinforces the role of management as stewards of the stockholders' interest.
An engaged, "house-cat-free" board of directors would have less of a chance of being subject to a CEO's stealing shareholder property by using the company as a personal piggybank or management's being tempted to use questionable accounting practices. However, this approach will only be successful if the investing public is aware of the importance of qualified, owner-oriented, and business savvy directors and the risks associated with different levels of internal safeguards designed to prevent manipulation and to protect the shareholders.
I do not think anyone here would dispute the critical role of directors in our system of corporate governance. A less clear consideration is what is the appropriate role of a company's shareholders? As our economy has grown, ownership has become even more dispersed. And, in our economy, the bottom line is that most shareholders own stock for investment, not for operational control. Yet, critical management decisions affect that investment. So, shouldn't shareholders have more say than simply whether they should buy, hold, or sell their stock? Just as with socialism, the danger is that if a large number of dispersed people supposedly own something, then in reality no one owns it and oversees it.
Digging back into history again, a dozen years ago the SEC had received rulemaking petitions from CalPERS and the United Shareholders Association recommending a restructuring of the proxy rules to (1) establish confidential voting in order to protect shareholders from management efforts to coerce their vote, (2) afford shareholders access to corporate proxy statements to nominate board candidates and influence other fundamental aspects of corporate governance, and (3) establish clear guidelines that would permit shareholders to communicate among themselves without fear of violating these rules.
Again, is this Groundhog Day? You all know that CalPERS and AFSCME have asked us to refuse no action requests regarding resolutions that would allow groups of shareholders owning at least 3% of a company's stock to be able to place a nominee on the proxy for a board seat. We as a commission will be considering this issue shortly, so I cannot comment directly on it.
But I can say this: at the heart of all of these current proposals and those of a dozen years ago lie strong shareholder concerns that management is free under current rules to dominate the proxy agenda, influence shareholder votes through its exclusive ability to examine balloting results, and unilaterally use corporate funds to subsidize solicitations.
Because the proxy system provides the principal mechanism for exercising corporate voting power in this country, the proper functioning of the Commission's proxy rules is an important part of preserving the attractiveness of corporate equity in our financial markets.
The Commission has taken steps through its rulemaking authority in the past to try to strike a balance between freer shareholder communications and investor protection concerns, including under the Williams Act. Are those concerns still balanced, given market and governance developments over the past decade? Did we ever have an appropriate balance to begin with? I am a firm defender of constitutional protections for freedom of speech and private property rights. Should we take this opportunity to re-examine the proxy process and especially 13(d), (f) and (g)? The challenge in this connection is for us is to come up with a mechanism to separate those shareholders who do not have a control intent from those who do, especially since undisclosed accumulation of financial power has long been a congressional concern.
One thing that I know for sure: the SEC will remain vigilant to protect the rights of shareholders to exercise the corporate franchise through the proxy process.
This brings me to the issue of the current shareholder proposal process. While I am not aware that there is a formal initiative to reassess the role of shareholders in corporate matters and the rules governing shareholder communications with boards, I personally believe that the time may be ripe to re-examine this area.
I understand that your briefing materials refer to Rule 14a-8 under the Securities Exchange Act of 1934 as "the rule everyone loves to hate." While I hate to use the word "hate," I must confess that I, too, have misgivings about the current state of the shareholder proposal process. Simply put, stockholders own the corporation and should have the ability to have their opinions aired to their employees in management, including at the annual stockholders' meeting. That does not seem too much to ask.
In addition, there is an inordinate amount of resources - both public and private - that is devoted each year to determining whether proposals may be excluded from the shareholder proxy statement. As an example, since the start of the current fiscal year on October 1, 2002, the SEC staff has received approximately 474 letters from corporations asking us to agree that they may exclude shareholder proposals from proxy statements. This number exceeds the total number of letters the SEC staff received in the entire prior fiscal year. To address and respond to this overwhelming level of no-enforcement requests, the Division of Corporation Finance must utilize significant staff time during proxy season. These staffers typically otherwise spend their time reviewing corporate filings, an area in which the SEC is chronically short on resources. So, I'd like to see us address whether there are means of removing - or more realistically reducing - the need of SEC staffers acting as referees in the shareholder proposal process.
Then, there is the "ordinary business exception," which corporations can use to exclude shareholder proposals that otherwise comply with appropriate procedural requirements. The policy underlying the "ordinary business exception" is consistent with the policy of most state corporate laws: the resolution of ordinary business problems should be confined to management and the board of directors because it is impracticable for shareholders to decide how to solve such problems at an annual shareholders meeting. My misgivings regarding this exception have nothing to do with its purpose - I recognize that every corporate decision cannot realistically be taken by shareholders without paralyzing the corporation - but, instead, I feel that often this exception has been relied upon, long after a matter can any longer be deemed "ordinary."
Clearly, the concerns that I raise regarding the shareholder proposal process are not new. Should the taxpayers be funding a referee in essentially private disputes between shareholders and their employees? We certainly are cheaper overall than sending the disputes to the courts. On the other hand, considering that we have enforcement authority and these are no-action requests, taking ourselves entirely out of the process probably is unrealistic.
Certainly, in principle, shareholders should have a general right to have their proposals presented in their proxy ballots; yet, the reality is that all shareholder proposals simply cannot be placed on proxy ballots. It is my understanding that the cost of a page in a proxy solicitation can be several hundred thousand dollars - even up to a million dollars for some companies. So, despite my preference, the SEC is, unfortunately, in the middle and must do its best to ensure that shareholder interests are addressed, yet balanced against the costs imposed.
Now that I've expressed my misgivings, what can be done to reform the process? Well, I must confess that people with a better understanding of the process than I, have given reform a gallant try many times -- most recently in 1997 and 1998. So, standing before you today I do not have the answer. A dozen years ago I probably was a bit crazy to have suggested a process modeled on the voter petition and ballot initiative procedures found in a number of States; now, with the growth of the Internet, something like web-based referenda may be achievable, although there are many obstacles. Under such a format, management would explain, in the following year's proxy statement, whether and how the company addressed any referendum issue that obtained a sufficient level of support. Such a process could be balanced with changes to the current Rule 14a-8 process. Still, others have advocated a "lottery" or "first in" system to determine whether to include "shareholder proposals" in proxy statements. And, of course, the most meaningful issue regarding shareholder proposals is real access by shareholders to nomination of directors.
The viability of these ideas must be fleshed out through the appropriate processes. I do, however, hope that this is an area that the SEC can take up again, and, if we do, I look forward to the input of all of you here in helping to fashion a better process.
I know that another area that is of great interest to many of you and that has received significant attention in the press is the SEC's initiative concerning hedge funds. There has been significant growth recently in the United States, as well as the world, in the number of private investment funds and in the amount of assets in these funds. Because these funds typically are not registered as investment companies with the SEC, and frequently, their investment advisers are also not registered, there is not much that we know about this area. To gain a better understanding of the issues currently affecting these funds, the Commission last June commenced a formal fact-finding investigation in this area. This investigation sought to enhance our understanding of these vehicles and their operations.
The Division of Investment Management is currently in the process of this fact-finding, and, just yesterday, the Chairman announced that there will be two days of roundtable hearings on hedge funds on May 14th and 15th. Going forward, I expect the staff will have a comprehensive record to present to us in the near future.
Mutual Fund Oversight
Recently, we issued a release seeking comment on additional ways in which mutual funds and investment advisers would be encouraged to comply with the federal securities laws. In particular, we asked for comment on such possibilities to supplement SEC oversight of mutual funds and investment advisers, including:
- requiring that advisers and funds obtain periodic compliance audits from third party compliance experts;
- relying on independent public accountants that audit fund financial statements to examine fund compliance controls in connection with the audit;
- the formation of one or more self-regulatory organizations to oversee the activities of funds and/or advisers; and
- a requirement that advisers obtain fidelity bonds.
I am aware that the Council has concern over this request - your briefing materials indicate "alarm" over the self-regulatory comment request. I, too, have concerns regarding this concept - not the least of which is whether we have authority to empower a new self-regulatory organization for advisers. Still, the number of funds, advisers, and assets under their control has grown significantly. The SEC's resources and the resources we have been able to allocate to our fund and adviser programs have not grown commensurately. Accordingly, even though I may, too, have some concerns, I believe we would be remiss not to at least raise the issue, and seek input from the public. The comment period on this matter is still open - as I always do, I encourage your input and hope that you will express your "alarm" publicly.
Public Company Accounting Oversight Board
Finally, while I noted earlier that we have completed the bulk of the Sarbanes-Oxley initiatives, we still have certain matters that we must address, and, of course, we will have to fine-tune the Sarbanes-Oxley rules that we have completed. As part of Sarbanes-Oxley, Congress mandated that the SEC establish the Public Company Accounting Oversight Board to oversee the audits of public companies that are subject to the securities laws.
The mandate to establish the Oversight Board - and for the SEC to amend its auditor independence rules - arose because the accounting profession itself fell down on the job largely failing to adopt what are essentially professional ethical obligations that should have and could have been adopted by the accounting profession. Further, I believe that the problems in that profession - and certainly a significant cause of the recent scandals - can be attributed to a culture that has fostered audit relationships that are too cozy with clients. As Sarah Teslik once noted, "If fifth graders picked their teachers, fifth graders would get A's."
Chairman Donaldson stated in his confirmation hearings that the selection of a Chairperson for the Oversight Board is his number one priority. In response, the SEC has adopted a process for conducting its search for the Chairperson, including soliciting input from a variety of sources, and establishing vetting and interviewing procedures. Further, we issued a statement, summarizing the mandatory and desirable criteria that we believe a Chairperson should possess and that we will evaluate during the selection process. The Oversight Board has a difficult and important job to do, and we at the SEC must ensure that all of the Oversight Board's members are working to achieve its mission. Accordingly, we are currently in the process of following the adopted appointment procedures, and I look forward to the appointment of a Chairperson for the Oversight Board in the near future.
So, those are some of the current matters that are before us. I've only touched on a few, and certainly I look forward to working with Chairman Donaldson and my other colleagues on the many other issues facing us in our role of the investors' advocate, including -
- analyst independence issues;
- continued scrutiny of how our corporate governance rules under Sarbanes-Oxley are faring, including our rule proposal regarding audit committee listing requirements;
- continued reforms to our market structure;
- the convergence of global accounting principles;
- the need to forge a new era of co-ordination with our fellow federal and state regulators; and
- a long-neglected need to bring our basic rules regarding disclosure and investor interests from a 1930s-based mentality into the 21st century.
With the forthcoming panel, I hope to elaborate on these matters and some of the additional issues before us, and to respond to the many questions that you no doubt have.
Thank you for your time.