Speech by SEC Commissioner:
Remarks at "Beyond the Myth of Anglo-American Corporate Governance"
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
Institute of Chartered Accountants in England & Wales
December 6, 2005
Thank you for the opportunity to speak at this important conference. This occasion has given me the opportunity to bring together several of the themes I have focused on during my four years on the Commission, themes that generally arise from my view of the Commission's regulatory mission from an economist's perspective. It has also caused me to reminisce about the three years I spent in England thirty years ago, when the description of the United States and the United Kingdom as being two countries separated by a common language proved true on a number of occasions. But first, let me give the standard disclaimer that the views I express this morning are my own and do not necessarily reflect those of the Commission, my fellow Commissioners or our staff.
Throughout the day, you will be hearing about the similarities and differences between the U.S. and U.K. approaches to corporate governance. To provide a context for the discussion, I'd like to begin by describing what our ultimate goals regarding corporate governance are - or should be - and then consider the role of the regulator in achieving these goals. You will not be surprised to learn that, as an economist, I generally believe that regulation should not interfere with market forces in the absence of market failure or other externality. This philosophy clearly influences my views on when and how to regulate.
My analysis of corporate governance rules begins with the question of why we care about corporate governance. The simple reason is that once companies evolved from private to public ownership, with ownership and management no longer in the same hands, the interests of owners and managers diverged. Boards of directors were put in place to look out for the interests of shareholders. The role of the board is to make sure that the company's resources are used to build, not destroy, shareholder value. Directors owe a duty of loyalty to the corporation and a duty of care to shareholders.
The directors' role in the corporate governance process includes several important components. First, the board must make sure the company has the right management leadership. The CEO is the board's agent, not vice versa. The board must make sure the CEO is accountable for his or her actions and that the CEO's compensation is appropriate. Next, the board must oversee the company's business strategy - kicking the tires to make sure its assumptions are realistic and that the company is on track to meet its strategic goals. In addition, the board monitors the performance of the company, focusing on both risk and return. The board must understand the drivers of performance and set the tolerance for risk. This covers oversight of operations, financial performance and reporting as well as regulatory compliance and risk management issues. Again, the overall goal of the governance structure and process is to maximize shareholder value through effective use of the firm's capital.
I hope we would all agree that, from a public policy perspective, the efficient allocation of capital is essential to maximizing our economic potential. For this reason too, good corporate governance is an appropriate policy goal. Investors need to be able to trust the companies in which they invest, and that requires that companies practice - and exhibit - good corporate behavior.
The next question is, how do we achieve good corporate governance, and is there a role for regulators in doing so? First and foremost, companies need to have an effective corporate governance process, and corporate boards and senior management must have integrity and promote ethical behavior. I believe that most companies do have good corporate governance processes. They follow the rules not only to avoid the reputational risk of an enforcement action, but also because it is just good business practice and the right thing to do. As regulators, while we cannot impose these values, we can encourage good behavior through well-designed rules and discourage bad behavior through civil and criminal law enforcement. In this way, we can help to bridge any gaps between owners' goals and management's goals.
How do we translate our goal of incenting high standards of corporate behavior into regulatory policy? This brings me to the litany of questions I typically ask myself when the Commission develops proposals for new rules or changes to existing rules.
- What are the objectives we are trying to accomplish with the rule? We need to be able to articulate what we are trying to accomplish. With regard to corporate governance, we want to establish a framework that aligns the interests of management and shareholders. We also want to encourage clear and transparent disclosures so that shareholders have sufficient information to assess whether their interests are being met.
What we do not want to do is to run the company. We do not want to micromanage the board and management structure or impose specific pricing or compensation. Neither do we want to impose a "one-size fits all" approach. A single approach is not appropriate for all companies within a single country or region, let alone across borders. Rules need to be consistent with the history, laws, and culture of the environment in which they will be imposed.
- Will the rule, as enforced, meet our objectives? Given that our overall objectives are to promote good behavior and deter bad behavior, we need a basis for believing that the rule will promote these goals. Cross-border issues frequently come into play in this analysis. An effective solution in one country may not be an effective solution in another country. For example, before they became effective, we learned that some of the new Sarbanes-Oxley rules presented conflicts with the laws and regulations governing capital markets in the EU. As a result of comment from the foreign community, public roundtable discussions at the Commission and the PCAOB, and continuing dialogue among US and EU financial regulators, we made certain accommodations for foreign issuers and their auditors.
My next question is:
- Does the rule go far enough, or does it go too far? Here again, this is an issue that may be analyzed differently in the United States than in other countries. For example, a "comply or explain" regime has developed that seems to work well in the U.K. environment, but may not go far enough in the U.S. context, particularly given the litigious nature of our legal environment. U.S. requirements seem less flexible, and may go too far in the U.K. context.
- Does the rule encourage compliance with the spirit as well as the letter of its provisions? This question arises frequently in the area of financial disclosures. For example, we have taken enforcement action in cases in which a company's MD&A disclosures may have generally complied with the "letter" of financial reporting requirements, but which violated the "spirit" of these requirements by failing to give a complete picture of the company's financial condition.
On the other hand, if our rules are too prescriptive, we may miss the opportunity to encourage compliance with the spirit of the law. This is where discussions of rules-based versus principles-based accounting come into play.
- Does the rule make sense? Are there likely to be unintended consequences? Are the benefits commensurate with the costs? The poster child for this factor is surely Section 404 of Sarbanes-Oxley. Section 404 requires company management to assess and publicly report on the effectiveness of the company's internal controls. The PCAOB's Audit Standard No. 2 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.
While the purpose of Section 404 is laudable -- to help make sure that company financial statements are reliable and materially accurate, there has been widespread criticism of the burdens and costs of implementation. It appears that what was intended as a top-down, risk-based management exercise has become a bottom-up, non-risk-based exercise with an apparent focus on controls for controls' sake.
A follow-on to that question is whether the rule allows entities choice in implementation. Or does the rule have a one-size-fits-all approach to regulation? There is an old saying that "There's more than one way to skin a cat." This is nowhere more true than in business. Rules and regulatory regimes that permit only a single approach to meeting a standard may not adequately reflect important differences in how business is done. Some CEOs have pointed out that the combination of AS2 and the response of the accounting profession has not only limited implementation choices, but has inappropriately taken choice out of the hands of the CEO, who is at risk for running the company and taking the legal risk of certifying the financial statements.
Given that regulation, including mandated disclosure, often imposes fixed costs, regardless of the size or complexity of an entity, it can cause unintentional distortions in the market. This is a point that has been made abundantly clear by industry participants in the post-Sarbanes-Oxley world. The Commission's own public roundtables on various Sarbanes-Oxley implementation issues point to our sensitivity to these issues. The real benefit of a flexible approach to regulation is that it ultimately allows the market to determine what is the best way to meet the rule's objectives. For instance, allowing audit committees in some contexts to determine when and how best to use the audit firm outside the scope of the audit - and disclose it to the public - ensures that companies can obtain the right mix of expert services in the appropriate circumstance.
- Does the rule create unrealistic expectations? As we all know, regulators cannot impose ethics and integrity, and we cannot eliminate fraud. Nor can we - or should we -- prevent companies from pursuing unprofitable business strategies that may end in failure and investor losses. There is a danger, however, that our rules may create expectations among investors that a company's compliance with SEC rules makes an investment safe. In particular, I think that it is important to note that good corporate governance does not guarantee good performance or a high return on investment.
So how do we know if we have reached the right balance? Market reaction to regulation can be instructive on this point, although sometimes in unpredictable ways. When embraced by the market, rules - and the procedures developed to comply with the rules -- can become best practice. And sometimes, what a single firm cannot do on its own for competitive reasons, can be accomplished industry-wide by regulatory fiat.
When the market does not embrace a rule, the market has proven adept at finding a solution that either adapts to the rule in an unintended way or bypasses the rule entirely. For example, the burdens of Section 404 may have created a form of regulatory arbitrage, discouraging some foreign companies from listing in the United States.
Sometimes, our rules can be anti-competitive, entrenching or further entrenching special interests or monopolies. Think, for example, of the Commission's well-meaning attempt to rely on market forces to identify reliable credit ratings. Over time, the "national recognition" requirement necessary for NRSRO status may have become as much of an impediment to competition as an assurance of credibility.
In other instances, markets may develop in such a way that unintended consequences evolve out of public view. Anecdotal reports suggest that, in implementing recent Commission rules on the public disclosure of proxy voting by mutual funds, many advisers are relying on outside entities to determine their votes. Reliance on an outside entity to make proxy voting decisions may separate a fund's proxy voting from potential conflicts of interest, but what we are seeing as a possible unintended consequence is the consolidation of the voting of a large number of shares in the hands of a few third parties. If this is true, I believe that we need to consider whether this development furthers the objectives of the rule, which, among others, was to encourage mutual funds to focus on corporate governance.
In conclusion, we have much to learn from each other on how to regulate wisely and make global markets efficient. As the late Peter Drucker observed,
Because management deals with the integration of people in a common venture, it is deeply embedded in culture. What managers do in Germany, in the United Kingdom, in the United States, in Japan, or in Brazil is exactly the same. How they do it may be quite different.1
Drucker's advice behooves us to approach our regulatory responsibilities with an open mind. Our analysis of regulatory policy needs to be rigorous, yet flexible. We need to be clear about our goals, but recognize that there is more than one way to achieve them. And that, of course, is the topic for today.