Speech by SEC Commissioner:
Remarks before the Center for the Study of International Business Law Breakfast Roundtable Series
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
New York, New York
October 7, 2005
The SEC in a Global Marketplace: Current Issues
Thank you. I appreciate the opportunity to be with you this morning to take part in this Roundtable Series. When Roberta asked me to speak, I was delighted to accept. After all, Roberta and I are both part of the small, but growing group of current and former women SEC Commissioners. There are now seven of us! In addition, I am a member of another select group of Commissioners - those born in Brooklyn. Since 1934, there have been at least seven Commissioners from Brooklyn, including three Chairmen. That's a pretty impressive showing from Brooklyn! Before I go any further, I need to give the Commission's standard disclaimer that the views I express here today are my own and do not necessarily represent the views of the Commission or its staff.
This morning I would like to discuss five initiatives that the Commission is pursuing in the international arena. Some you may be aware of, and some you may not. However, one thing we are all aware of is the global nature of our markets. This is no longer a phrase used to describe the evolution of our markets at some point in the future - it is reality now. As Tom Friedman suggests in his recent book The World is Flat, the world isn't going to be flat, it is flat.1
Technology and communication have developed to the point where cross-border investments can be made quickly and seamlessly, and investors no longer look solely to their home country markets in choosing investments. Companies are moving to their customers, to their suppliers, and to cheaper labor and are building offices and plants around the world. As always, politics plays a role as we see significant new economies, such as China, open their markets to trade and investment. From a regulator's perspective, the global nature of our markets was made crystal clear by the events of the last several years. We quickly learned that the corporate scandals of Enron and WorldCom here in the US were not specific to this country. With the revelation of the scandals at Parmalat, Royal Ahold and others, there was global recognition of the need for regulators worldwide to engage in dialogue not only to address the corporate governance deficiencies apparent from the scandals, but to also work together to identify emerging risks in the financial markets so that potential regulatory problems could be addressed at an early stage.
This brings me to the first issue I would like to cover this morning: the Commission's ongoing dialogues with various financial regulators and governmental entities around the world. One example of this is the US-Japan dialogue. For a number of years, the Commission and the Japanese Financial Services Agency have had ongoing discussions on numerous issues of mutual concern. Earlier this year, the agencies agreed to establish a high-level bilateral dialogue to enhance the quality of regulatory discussions and address key issues for reaching shared objectives. The Commission also participates in the US-Japan Financial Services Working Group, co-chaired by the US Department of Treasury and Japan's Ministry of Finance, which regularly brings together Japanese and US finance and regulatory officials to discuss financial sector developments in each country.
As I mentioned earlier, we are only beginning to see the impact of China's developing markets and industry on the world economy. As you may have heard, in a little over a week from now, SEC Chairman Cox will travel to China with Treasury Secretary John Snow and Federal Reserve Chairman Alan Greenspan to participate in a US-China Joint Economic Committee meeting with their Chinese counterparts. Chairman Cox will also speak at a conference in Beijing organized by the Securities Industry Association on China's capital markets. During this same trip, Commission staff will participate, along with representatives of the Treasury Department, Commodity Futures Trading Commission and Federal Reserve Board, in a Financial Sector Working Group recently formed to review a range of financial regulatory and supervisory concerns. These events are noteworthy as, historically, the Commission's relationship with its Chinese counterparts has generally been restricted to the provision of technical assistance and training. The meetings provide an opportunity to engage the Chinese regulators in an expanded policy dialogue, allowing for the sharing of information and experiences on regulatory matters, particularly in the area of enforcement cooperation.
Probably the most active and developed financial dialogue in which the Commission participates is the US-European Union, or EU, Financial Markets Regulatory Dialogue. Particularly in the wake of the passage of Sarbanes-Oxley in 2002, conflicts between the laws and regulations governing capital markets in the US and EU became apparent, often as a result of unintended consequences. Earlier this year, Charles McCreevy, the EU Commissioner for Internal Markets and Financial Services, went so far as to suggest the US and EU have a "Bart and Homer Simpson" relationship - one side (and neither he, nor I, will say which one!) annoying the other beyond endurance, while the other throttles away in frustration.2 I was able to meet with Commissioner McCreevy during his visit to the US earlier this year, and I hope he would agree that, while this may have been the perception of the US-EU relationship, it is not the reality. The US-EU Dialogue has been very successful in establishing a cooperative forum in which concerns or regulatory conflicts can be raised and addressed early on so as to improve understanding and help smooth implementation of regulation for issuers and intermediaries operating on both sides of the Atlantic.
A good example of this cooperative dialogue in action is related to the EU's Financial Conglomerates Directive, the second issue I would like to discuss this morning. The Directive calls for the application of consolidated supervision to all EU financial holding companies, specifically requiring that non-EU holding companies of EU financial institutions be subject to consolidated supervision "equivalent" to that described in the Directive. Partially in response to the Directive, the Commission promulgated rules creating consolidated supervised entities, or CSEs. These rules allow very large broker-dealers and their affiliates to choose to be subject to consolidated supervision by the SEC.
The EU has determined that, on balance, there is broad equivalence between the supervision of financial groups whose parents are headquartered in the US and those that are headquartered in the EU. The final equivalency determination, however, must be made by the appropriate EU regulator responsible for acting as "coordinator" for each financial group. For US-based CSEs, that supervisor is the United Kingdom's Financial Services Authority, or FSA. In making the final decision with regard to CSE groups, the FSA must determine, among other things, that there is an appropriate level of cooperation from the SEC, and that the holding company holds adequate capital. Late last year, the FSA accepted the SEC's oversight of Merrill Lynch as equivalent to the supervision described in the Directive. The EU Directive imposes a deadline of next month for the FSA to make equivalence findings with regard to SEC supervision of other broker-dealer groups headquartered in the US that operate in the EU. We have no reason to believe this deadline will not be met.
The Financial Conglomerates Directive is an example of a foreign regulation that impacts US-based entities operating overseas. My third issue this morning concerns a US regulation imposed on all public companies required to file reports with the SEC, including foreign issuers: Section 404 of the Sarbanes-Oxley Act of 2002. If anyone in the audience is not familiar with this controversial section of Sarbanes-Oxley, allow me to enlighten you. Section 404 requires management to assess and publicly report on the effectiveness of a company's internal controls. In addition, Section 404, and Audit Standard No. 2 promulgated by the Public Company Accounting Oversight Board, or PCAOB, requires that auditors publicly attest to management's assessment, as well as provide a separate opinion on the effectiveness of the internal controls. The purpose of Section 404 is to help make sure that company financial statements are reliable and materially accurate.
Since the Commission adopted its 404 rules in June 2003, we have twice extended the 404 compliance date for our larger foreign issuers to the current date of fiscal years ending on or after July 15, 2006. In addition, we recently adopted rules to extend the compliance date for both our foreign and domestic smaller issuers - that is, those with less than a $75 million worldwide public float - by an additional year to July 15, 2007.3 There are several reasons why the Commission felt it was necessary to allow additional time for our foreign issuers to comply with our 404 requirements. First, it became apparent that foreign issuers were facing particular challenges in complying with the internal controls requirements, including language, cultural and organizational structures that are far different from what is typical in the US.
Second, beginning January 1st of this year, companies incorporated under the laws of an EU-member country, and whose securities are publicly traded within the EU, were generally required for the first time to prepare their consolidated financial statements under International Financial Reporting Standards, or IFRS.4 We recognized that successful conversion to IFRS, which the Commission fully supports, was the primary focus of foreign issuers this year. We also recognized, due to the increasingly loud and frustrated reactions of our domestic companies, that the implementation of Section 404 requires significant resources, people and time such that it simply was not sensible to impose this new requirement on foreign companies that were simultaneously adjusting to reporting under IFRS.
And finally, with respect to the recent additional delay for our smaller issuers, we realized, based in part upon a recommendation from the Commission's Advisory Committee on Smaller Public Companies,5 that these companies, foreign and domestic, face a greater challenge in implementing the internal control requirements. Smaller companies have fewer employees and resources, less formal and documented controls and procedures and, in many instances, lack a formal internal audit department. Given these additional hurdles facing smaller companies, as well as the pending consideration of a framework for internal controls for small companies and any future potential recommendations from our Advisory Committee, it seemed only fair and logical that we should delay the 404 compliance date for smaller companies. The Commission will continue to monitor these issues and will need to make a determination - I hope sooner rather than later - regarding the application of 404 to these issuers. Until that time, however, while we want them to continue to improve their preparedness, we should not cause them to continue to incur expenses unnecessarily in order to comply with new requirements that may change, and that is why the additional delay made sense.
I have given several speeches addressing Section 404, and if you are interested in my views, you can take a look at my speeches on the SEC's web site. My views have not changed, and unfortunately, from what I hear from those dealing with year two of compliance, apparently neither has the 404 process. The Commission held a roundtable in April of this year to obtain feedback on the first year of 404 implementation from all interested parties, including directors and officers of public companies, both large and small, as well as investors and auditors.6 What I heard loud and clear at the roundtable was that the required assessment of internal controls has to a large extent shifted from management to the auditors in what has become a non-risk-based, check-the-box exercise with an apparent focus on controls for controls sake. This had been my concern since the adoption of PCAOB Audit Standard 2.
As a result of the roundtable, both the Commission and the Board of the PCAOB issued statements in May of this year.7 A general theme of these statements was that both management and auditors must bring reasoned judgment and a top-down, risk-based approach to the 404 compliance process - a one-size fits all, bottom-up, check-the-box approach is not only not required or expected, but it is also not efficient or effective. I was hopeful this message would re-focus both US companies and their auditors in the upcoming second year of compliance on a more appropriate approach to the 404 review. However, with only a few exceptions, I have been hearing stories of 40,000 key controls being identified (which I guess some would argue is an improvement over the 60,000 key controls we heard at the roundtable - I would not make that argument) and cost reductions of anywhere from 4%-20%, versus projected reductions at the time of the roundtable of up to 46%.8
Needless to say, I remain concerned about the unintended, and unnecessary, costs associated with 404. I want to be clear: I do believe that the purpose of Section 404 - to establish and maintain effective internal controls that enable reliable financial statements - is a good one. I also believe that, while the compliance date for our larger foreign issuers was initially delayed, these issuers need to continue preparing for implementation in July 2006. I want to stress, however, that the Commission and its staff will continue to monitor the second year of US implementation of 404. Clearly, we need to be prepared to act quickly and decisively if and when it is determined that additional action, either by the Commission or the PCAOB, is necessary.
This brings me to the fourth issue I would like to mention, and that is deregistration. Some foreign issuers have indicated that they may forgo registering with, or desire to de-register from, the SEC in order to avoid the compliance burdens associated with Sarbanes-Oxley, specifically the internal control burdens. Currently, based in part upon investor protection concerns, Commission rules generally require that issuers continue to meet their reporting requirements as long as they have more than 300 US resident shareholders. That seems to be a very small number in today's markets. As an economist, I believe that once issuers enter a market, they generally should be able to exit as they deem appropriate, based upon efficiency and other business-specific concerns. Our current rules appear to be outdated, creating what some have termed a roach motel scenario - you can get in but you can't get out. Therefore, I fully support the staff's initiative to take a fresh look at our rules in order to ease the deregistration process, so long as any new approach continues to protect US investors.
The final issue I would like to address provides an excellent example of a US standard setter and its foreign counterpart working together to regulate in a global environment, and that is convergence of US and international accounting standards. Since October 2002, the Financial Accounting Standards Board, or FASB, the standard setter for US GAAP, and the International Accounting Standards Board, or IASB, the standard setter for IFRS, have been engaged in a project to converge US GAAP and IFRS. I wholeheartedly support this effort and was pleased to see a first draft of a joint standard on business combinations published earlier this year in June.9
Related to convergence is the issue of reconciliation. Currently, the Commission requires companies that use IFRS to reconcile their financial statements to US GAAP in their filings with us. As you may be aware, Don Nicolaisen, the Commission's Chief Accountant, has proposed a "roadmap" to achieving the acceptance of IFRS in the US without reconciliation. Among the conditions mentioned in the roadmap that must be considered by the Commission and its staff, prior to the elimination of this reconciliation requirement, is the consistent interpretation, application and enforcement of IFRS around the world. Our staff has already begun to analyze these conditions. Because IFRS has only just been implemented in many countries this year, this will need to be a careful and pragmatic process. Despite the recent announcement of Don Nicolaisen's pending departure, I think it is fair to say that the staff will continue to pursue the roadmap and the possible elimination of the reconciliation requirement and the ultimate convergence of IFRS and US GAAP.
Having said that, a potential "speedbump" has arisen as we progress through the roadmap. Pursuant to a request for an analysis of equivalence from the European Commission, the Committee of European Securities Regulators, or CESR, has recommended to the European Commission that, while US GAAP is broadly equivalent to IFRS, issuers should provide some additional disclosures when using US GAAP in the EU. This could effectively require, according to some, a "reverse" reconciliation of US GAAP to IFRS. I understand that the European Commission anticipates making a final determination on the CESR recommendation sometime this fall. I am hopeful that this matter is resolved in a manner agreeable to all parties involved - most importantly, of course, to investors. Continued growth and efficiency of our global markets requires the co-existence of US GAAP and IFRS in our capital markets. Investor trust and understanding of both of these standards is imperative.
In conclusion, it is truly an exciting time to be serving as a regulator in the global marketplace. It is by no means an easy task - as we cross borders, we encounter different cultures, histories, legal regimes, regulatory philosophies and economies. As we strive for conformity and consistency, we must at all times protect against the perceived ease of "lowest common denominator" regulation. In addition, as a US regulator, I believe we must be committed to finding the best way to resolve cross-border issues, not merely endorsing the "US way." And I believe the Commission and its foreign counterparts around the world all realize what we stand to gain from our continued dialogue - efficient markets, increased corporate opportunity and informed, confident investors. Thank you, and I am happy to answer any questions you may have.