Speech by SEC Staff:
Remarks at the 58th National Conference of the American Society of Corporate Secretaries
Alan L. Beller
Director, Division of Corporation Finance
U.S. Securities and Exchange Commission
July 10, 2004
Thank you, Peggy, for that kind introduction. It is a privilege to be addressing the ASCS National Conference this morning. Your organization has long been in the forefront of a number of important governance and disclosure issues. You have also had a long history of dialogue with the Commission and the staff, and we have found that extremely useful.
My assigned topic this morning is to provide an SEC Update. When I began to prepare my remarks, it seemed to me that a key item should be the current thinking of the Commission and staff regarding the Sarbanes-Oxley Act. This month the second anniversary of the passage of the Act seems a particularly appropriate time to reflect on its effect. In addition, while the Act obviously is still a critical item, I would like to spend time on some other topics that you and I both consider important.
Before I continue my remarks, I should note that, as a matter of policy, the SEC disclaims responsibility for remarks by members of the staff. My remarks this morning therefore represent my own views and not necessarily those of the Commission or other members of the staff.
Sarbanes-Oxley Two Years Later
To recap the Commission's rulemaking and related activities under Sarbanes-Oxley, the Commission completed its own Sarbanes-Oxley rulemaking some months ago. Last month it approved one of the last major elements of Sarbanes-Oxley the Public Company Accounting Oversight Board's Audit Standard No. 2, regarding audits of companies' internal controls over financial reporting. This year also marks the opening season for filing reports with the Commission that reflect major aspects of the new requirements of the Act and the Commission's implementing rules. Of course, the requirement to provide management's assessment of the effectiveness of internal control over financial reporting and the accompanying audit under Standard No. 2 is required for the first time for fiscal years ended after November 15, 2004 for accelerated filers and for fiscal years ended after July 15, 2005 for smaller issuers and foreign private issuers.
I know that you are all familiar with the principal Sarbanes-Oxley requirements, so I don't intend to detail them here. I generally think of them in five categories of reforms intended to improve financial and other reporting, improve corporate governance and restore investor confidence.
First, the Act provided for important reforms aimed at improving the performance of and restoring confidence in the accounting profession. The Act ended self-regulation of the accounting profession where the audit of public companies was concerned. In its place the Act created the Public Company Accounting Oversight Board. The Act provided for the Commission to reaffirm the role of the Financial Accounting Standards Board and established an independent funding source for the FASB.
Under the leadership of Chairman William McDonough, the PCAOB has progressed from its start-up phase to become a real operating entity. Its most visible achievement to date has been the adoption of Auditing Standard No. 2. Less noticed, but at least as important over the long run, the PCAOB has commenced inspections of registered auditing firms, even while it continues to recruit and hire additional staff necessary for its full inspection program. I believe the inspection program should be the cornerstone of the PCAOB's efforts to ensure audit quality and over time will be the key test of the regulatory model for the accounting profession established by Sarbanes-Oxley. Chairman McDonough noted in testimony before Congress on June 24 that the limited inspections to date had uncovered audit and accounting issues that the Board was pursuing.
I should also note that while the PCAOB is responsible for inspecting registered auditing firms, it is issuers that are responsible for the correctness of their accounting, financial reporting and disclosure. Very importantly, therefore, the Office of the Chief Accountant and the Division of Corporation Finance expect issuers to make it clear to their auditors that any issues raised by the PCAOB with an auditor relating to an issuer's accounting, financial reporting or disclosure are to be communicated to the issuer. Further, OCA and the Division will continue to be the ultimate arbiters regarding an issuer's accounting, financial reporting or disclosure, however the issues in question arise. This would be true for example in cases where they are identified by the issuer or the auditor, identified through the comment process, or identified in a PCAOB inspection.
Second, the Act gave the Commission new tools to enforce the securities laws. And the Commission has been using those tools to good effect. Last year the Commission brought 679 cases, of which 199 involved financial fraud or reporting deficiencies. The Commission has obtained orders for penalties and disgorgements totaling $2.2 billion as of late June 2004. And between October 2003 and June 2004 the Commission sought 110 officer and director bars.
Third, the Act mandated new requirements designed to improve financial reporting and other disclosure. These include the rules requiring CEO and CFO certifications. They also include rules regarding the disclosure of material off-balance sheet transactions and the use of non-GAAP financial measures, as well as rules strengthening the independence and responsibilities of audit committees. I also place in this category the provision that I have already mentioned and that is currently receiving the most attention from companies and auditors the requirement of an annual management report on, and audit of, companies' internal control over financial reporting.
In the longer term the internal control provisions may have the largest effect on companies, both in terms of time and expense and in terms of the impact on their systems, their financial reporting and their audits. To date, however, I believe that the CEO and CFO certification provisions have had the biggest impact on financial reporting and disclosure. One of a company's top management's most important responsibilities is to assure that the company communicates honestly and effectively with investors.
CEOs and CFOs already had responsibility for company disclosures in the filings in question. But the certification requirements have focused their attention on the completeness and accuracy of disclosure in very salutary ways. The Commission also went beyond the requirements of Sarbanes-Oxley in complementing the certification provisions with a requirement that companies maintain disclosure controls and procedures. This requirement is intended to ensure that information is captured, evaluated as to materiality and disclosed (or not disclosed) as required in a timely manner. The "check-the-box" wing of the bar predictably and nearly immediately came up with elaborately worded "sub-certifications" to be signed by employees at levels below the CEO and CFO. While sub-certifications can be a sensible part of a program of controls and procedures in connection with periodic reporting, they would not appear to be the whole package. Moreover, I would expect that companies have just about finished refining their controls and procedures in light of the new expanded and accelerated Form 8-K reporting requirements that go into effect next month. I also should note that on June 29th the Commission brought its first action charging inadequate disclosure controls and procedures in a case that also involves a charge of a violation of Regulation FD.
To return to Sarbanes-Oxley, as my fourth category, the Act addressed the performance of certain "gatekeepers." The Commission has adopted rules requiring attorneys with evidence of material violations of the securities laws or breaches of fiduciary duty to report that information "up the ladder." The Commission has also adopted rules enhancing the independence and accountability of analysts. And, of course, the Act specifically addressed the role of the audit committee as an important gatekeeper in overseeing accounting, auditing and financial reporting.
Finally, the Act included provisions designed to improve the "tone at the top" of public companies. These rules include:
- the CEO and CFO certification requirements;
- prohibitions on loans to company insiders;
- mandated accelerated electronic filing of disclosures of insider transactions; and
- disclosure about whether company have codes of ethics for CEOs, CFOs and other senior financial personnel.
We are often asked for updates about how companies are doing with the new Sarbanes-Oxley requirements. As I mentioned, March was the first major Form 10-K season for which many of the requirements are in effect, so it is difficult to generalize about companies' performance. I think that it is fair to say, however, that responses have been varied. Some companies have embraced the requirements, and others still need work. We continue to answer issuers' questions, review companies' disclosure, and issue comment letters. We will also be preparing and delivering to Congress later this year a report regarding disclosure of off-balance sheet transactions, the last item the Commission is required to complete under Sarbanes-Oxley.
The Companion to Sarbanes-Oxley Continued Focus on Corporate Governance
One of the things we have learned in the last two or three years is that the malaise affecting our corporations and their stewards went well beyond the Enrons, the WorldComs, the Tycos, the Adelphias and the other poster children for corporate scandal. Sadly, the erosion of corporate standards during the boom years of the 1990s and the dot.com era affected a far larger number of companies and corporate leaders.
The restoration of proper standards has required a reexamination of the principles of governance of our corporations. A key element has been to grant to boards of directors their rightful place in corporate governance and to give them the responsibility and tools to provide real oversight of corporations and their managers. Part of the change derived from Sarbanes-Oxley, for example the new independence requirements and responsibilities of audit committees. However, for many of the other structural enhancements designed to improve corporate governance, the Commission looked to the listing standards of the nation's principal markets.
As early as February 2002 we called on the New York Stock Exchange and the Nasdaq to examine issues of corporate governance, corporate accountability and listing standards in light of Enron. Both markets came forward with proposals for listing standards, and they and we then worked together for more than a year improving those proposals and harmonizing them, except where the differences in listed companies justified differences in the standards.
In the summer of 2003 the Commission approved listing standards of the New York Stock Exchange and the Nasdaq requiring shareholder approval for equity-linked compensation plans. In November 2003 the Commission approved those markets' final corporate governance listing standards. I know that people in this audience have worked intimately with these new standards since they were put in place for the proxy and annual meeting seasons that are just now winding down.
In terms of impact to date, we know that many companies have restructured at least part of their board to satisfy the new stricter independence standards for directors, the majority independent director requirement and the requirement that only independent directors be involved in processes relating to auditing, director nominations, governance and compensation. We also know that there were a number of questions regarding the transition provisions for the "look-back" in the New York Stock Exchange standards. The one-year transition provision was not an oversight or anomaly. It was the solution devised by the Exchange and approved by us to deal with both the desire, which we strongly advocated, to have a look-back in place at the beginning, instead of one that phased in as prior proposals had provided, and the concern that for at least the 2004 season there had to be some transition flexibility.
The new listing standards also contain new disclosure requirements regarding independence standards and determinations. We expect that the markets will be looking at the performance of companies under these new requirements. In a related area, in November 2003 the Commission also adopted new disclosure requirements regarding the processes of nominating committees and shareholder communications with directors. We will be considering how to evaluate disclosure both in response to our new requirements and those imposed by the recent listing standards.
The Backlash against Sarbanes-Oxley Is There a Basis?
Even as we're assessing companies' early responses to the new requirements, and before the last provisions are even effective, we are beginning to hear complaints about Sarbanes-Oxley and other reforms.
Perhaps it is inevitable that as memories fade of how appalling the bad conduct was, how widespread it was, and how outraged were America's investors (who now number in the tens of millions and not just the wealthy few of prior decades) some companies and pundits see the costs and burdens and ignore the benefits. In my view the provisions of Sarbanes-Oxley and other requirements that impose the greatest burdens in terms of time, attention and money and here I am thinking for example about assessments and audits of internal control, stricter and increased independence standards for boards and committees, and CEO and CFO certifications are the most central to necessary reform.
Having said that, I can assure you that the Commission and staff are very sensitive to imposing unnecessary costs and burdens on registered companies and other participants in our capital markets. Everyone knew when the Act was passed that there would be expense involved. That is one reason why we have been encouraging companies to plan ahead, especially for the rules relating to the assessment and audit of internal control over financial reporting.
We also understand the possibility of disproportionate burdens on smaller companies, and we were sensitive to these concerns where possible when we adopted our Sarbanes-Oxley rules. Again, we believe it is likely that the internal control provisions will place the greatest relative burdens on smaller companies. We also believe that the right way to get at the issues of internal control for smaller companies is through an appropriate framework for evaluating internal control that takes into account differences in size, geographic and other scope and complexity of business that may be relevant for smaller businesses. In fact, the Commission's adopting release for the internal control requirement suggested that there was flexibility in the method of evaluation that smaller businesses could use. Further, the staff's recent Frequently Asked Questions on the requirement states that we would support efforts by bodies such as COSO to develop an internal control framework specifically for smaller companies. We welcome progress from COSO or other interested parties in these areas.
Beyond these specific points, increasingly I've seen reports about the actual or potential costs of the Sarbanes-Oxley Act used to support calls for modification or repeal of certain of its provisions. It may be that some who were hesitant to voice legitimate concerns about costs when the Act was passed now feel more comfortable doing so, but I think that others may be using people's short memories opportunistically in order to try to roll back reforms.
Whatever the motive, the specific data now available seems too incomplete to support specific conclusions about how the Act has affected issuers and investors. There is no doubt costs are increasing. The Commission's Office of Economic Analysis has reviewed several of the available studies and will continue to do so. In addition to noting that the studies generally confirm that costs to corporations are increasing, OEA has raised several concerns about the quality of the reported evidence to date.
First, the studies tend to rely on small samples and on the results of surveys without documentation. This raises serious questions about how valid the survey methods are and how representative the responses are. For example, one of the studies most prominently cited in the press, probably because it concludes that 21% of respondents were considering going private, is a study where 9000 surveys were sent out and 115 public companies, or 1.3%, returned responses.1
Second, the data on costs, while growing, are still limited. Until next year there will not be available cost information that covers all of the Act's requirements. And it will take longer than that to get a good idea of ongoing costs since I believe most agree that costs in the first year or two of compliance are likely to be greater than those in later years.
Finally, and most importantly, a balanced evaluation of the effects of the Act will require study of the benefits as well as the costs. To date, researchers have produced few if any reports on the benefits. As available evidence of such benefits increases and such reports emerge, only then will it be possible to evaluate both the benefits and the costs. Studies that show significant percentage cost increases for example a recent FEI study that found a 38% increase in fees to auditors and a more recent update that suggests that number is higher, principally as the internal control requirements kick in suggest increases in dollar terms that may be justified when compared to the countervailing benefits. This last conclusion may be more open to question for smaller companies, but as I suggested above, we are trying to address the biggest potential costs for those companies.
Many of the benefits of the Act are difficult to measure using the survey methods that have been the basis of the reported cost estimates. At least one recent poll, however, suggests a link between the Act and improved investor confidence. The Wall Street Journal recently cited a Harris poll where 59% of investors polled believed Sarbanes-Oxley will help safeguard their stock investments.2 We regard improved investor confidence as a significant benefit of the Act. We also have anecdotal evidence of improved financial reporting and corporate governance.
What I think is needed is to let run one or two cycles of the fully implemented Act and to revisit the evidence from economic research, which should have grown significantly by that time. We may choose to supplement that research with separate rigorous economic studies of the costs and benefits of the Act done with proper sampling and measurement. Then we should see what we can learn from those studies. Until then we are dealing with little more than speculation.
In the meantime, the people in this audience are more intimately familiar than almost any other group with the burdens, including costs, that Sarbanes-Oxley and companion reforms have placed on their companies. You are also able to evaluate from your companies' perspectives the benefits that the reforms have engendered including more focus on the quality of financial reporting and good audits, top management that is in many cases more aware of and more engaged in disclosure matters, more genuinely independent boards carrying out genuine oversight functions. Should we really forego these benefits? And does anyone really believe that corporate America would have obtained and provided these benefits without the legislative and regulatory reaction of 2002 and 2003? I for one do not.
Current Items on the Commission Agenda
While Sarbanes-Oxley and its impact continue to be important, the Commission has also moved on to other matters. Some of them are subjects of daily reports, such as mutual fund reform, including the new rules regarding independent chairs and other governance matters, and hedge fund adviser registration. I want to spend a few minutes on some of the matters of particular interest to this audience.
Improvements to the Proxy Process
On July 15 of last year, the Division of Corporation Finance provided the Commission with its report on the proxy rules related to the nomination and election of directors. As I mentioned earlier, in November the Commission adopted new disclosure standards addressing the report's first recommendation, requiring enhanced disclosure of nominating committee processes and the processes by which security holders may communicate with directors.
In October, the Commission proposed new Exchange Act Rule 14a-11 and other rule amendments intended to implement the second of the Division's recommendations, requiring companies under limited circumstances to include in their proxy materials nominees for director of large long-term shareholders or groups of shareholders where those shareholders or groups have a state law right to nominate.
The proposal would give substantial shareholders a way to address their dissatisfaction with a company's management in a way other than by selling their stock or waging an expensive proxy fight that is currently required under our proxy process. The expense of a proxy fight may be justified in the context of a contest for control but is not justified when an investor or groups not seeking to influence control is trying to exercise its right to nominate what it believes is a better director.
The issues and views on all sides of this issue are all too well known, and I will not outline them or discuss them here. The views on all sides are strongly held and strongly expressed. Indeed, the rhetoric has at times not been conducive to any sensible rule-making process. It is unfair to companies to suggest that the board nominating process is to replace Tweedledum with Tweedledee, as one commenter has suggested. It is inflated and unjustified to suggest that the Commission's proposal will put the economic recovery at risk or seriously damage the competitiveness of American business, as corporate opponents have stated.
I will leave you with two thoughts on this subject. First, notwithstanding some press reports, the proposal is not dead. It remains alive and before the Commission. There are ongoing discussions about how to proceed. If a final rule can be crafted that the Chairman supports and that has the requisite Commission support, it will be adopted. And the Chairman will not impose an artificial deadline on this process.
Second, I must say, and this really is just my own view, I don't understand the expressed position of much of corporate America that no version of this proposal is acceptable. I believe there are companies where our current proxy process is impeding desirable shareholder choices in director nominations and elections for which state law provides, and I believe every company, or virtually every company, represented in this room agrees with me. The Commission, in making its original proposal in October, started from the general proposition that improving our proxy process for candidates for director properly nominated under state law, in limited circumstances and outside the control context, had merit. Virtually every investor with a computer, typewriter, pen or pencil has expressed support for some version of this proposal, and in many cases support for a proposal that would go further than what is before the Commission. In my view, this issue is not going to go away.
Securities Act Reform
Since the mid-1990s, and indeed in some sense since the mid-1980s, following the adoption of shelf registration, the staff of the Division of Corporation Finance and the Commission have sought to address Securities Act reform. We are at it again. We are trying to devise a set of proposals to recommend to the Commission that will address four principal areas of regulation, as well as a larger number of incidental and ancillary issues. The principal areas are the following:
- We are looking at the liberalization of communications, especially written communications beyond the statutory prospectus, in registered offerings. We are considering liberalization in the context of both routine communications and communications that are offers. We are also looking at these questions as they relate to filing requirements and liability issues.
- We are looking at whether at least a limited category of large seasoned issuers should have fewer regulatory obstacles to immediate access to the capital markets. Our work in improving Exchange Act reporting should make this more feasible.
- We are considering how to provide clearer rules that investors should have adequate and accurate information at the time they make their investment decisions, without slowing down the offering process as a result. Better Exchange Act reporting and liberalized communications methods may help resolve some of the issues of giving investors access to adequate information.
- We are considering the restrictions placed on unregistered private offerings, at least in the context of offerings to large institutional investors.
These issues and possible approaches are all at a somewhat preliminary stage, and of course any proposal will depend on what the Commission decides on each of these questions.
One area of governance that has received a fair amount of attention lately is the amount of compensation earned by company executives. I certainly do not believe that the Commission should be involved in setting executive compensation. I do believe our legitimate interest in governance requires us to monitor companies' performance under the listing standards that we approved that establish independence requirements for compensation committees. And our disclosure rules mandate disclosure of all compensation earned by the CEO and other top executives, as well as compensation policies.
The NYSE and Nasdaq focused on the governance issue in adopting a requirement that CEOs' compensation be determined by an independent compensation committee or by independent directors. To fulfill their responsibilities, in addition to requiring independence under the rules, directors who set executive pay should be independent in spirit. Their responsibility is to set appropriate compensation for each individual, not to fit within a prescribed range based on industry or company size. And their responsibility is certainly not to follow the Lake Wobegone theory of compensation, where all executives of all companies are above average. To this end, companies and their boards should consider carefully whether compensation is focused on the long-term performance of the company and its executives in all respects (and not just short-term results or narrow measures, such as those limited to earnings). Directors should take advantage of their independence to make their own decisions. If compensation consultants are used, they should be those of the compensation committee. From a personal point of view, I don't understand the advantages of dueling consultants in setting CEO compensation, one for the CEO and one for the committee.
Companies also should be concerned about whether their executive compensation disclosure is accurate and complete. This is an area where, based on questions we receive, there sometimes seems to be a desire to limit disclosure to the minimum rather than to create disclosure that fully informs investors. Why is this the case? Are executives seeking to minimize comp disclosure? Are too many lawyers who participate in drafting these sections putting the expressed interests of executives ahead of those of their client, the company? How is the company well served by disclosure that is minimal and seeks to obfuscate rather than disclosure that is informative and seeks to clarify?
I would also ask companies, and especially the independent members of compensation committees, to take a fresh look at their compensation committee reports. There has not been guidance in this area since a 1993 Commission release, one year after the report requirement was adopted. But the guidance remains sound today. Too much of what is written is boilerplate, and is not as specific or informative as it could be.
On our side, both the executive compensation rules, including the compensation committee report requirement, and the director compensation and relationship rules are more than a decade old. We are in the process of taking a look at them. They are very detailed and specific, the opposite of principles-based rules. So far as I can tell, the Commission went in that direction because of a concern that another approach would not capture all compensation and because the detailed tables fostered comparability over time periods and between companies. We will review the rules and the disclosure we are getting and make some judgments about whether there need to be changes and whether there needs to be more up-to-date guidance. We may not recommend anything to the Commission, but then again we may.
I will stop at this point. Thank you again for inviting me to be with you this morning. I would be pleased to take questions if we have time.
1 See Thomas E. Hartman, Foley & Lardner LLP, The Cost of Being Public in the Era of Sarbanes-Oxley, 2004 National Directors Institute (May 19, 2004).
2 Judith Burns, Is Sarbanes-Oxley Working? Wall Street Journal, R8 (June 21, 2004).