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U.S. Securities and Exchange Commission

Speech by SEC Acting Chairman:
This Year's Proxy Season: Sunlight Shines on Auditor Independence and Executive Compensation

Remarks by

Acting Chairman Laura S. Unger

U.S. Securities & Exchange Commission

Center for Professional Education, Inc.
Washington, D.C.

June 25, 2001

Good morning. For those in the crowd who are securities lawyers, you've no doubt heard the phrase "sunlight is the best disinfectant." In other words, full disclosure makes our securities markets fairer and more efficient. I'd like to use my time this morning to prove that this old adage continues to ring true today - not just as it relates to the purchase or sale of securities, but to corporate governance matters as well. If there was ever any doubt that sunlight is the best disinfectant, the results from this year's recently-ended proxy season prove it. Our eyes were opened wide in two particular areas: auditor independence and executive compensation.

For the first time, as a result of our new auditor independence rules, public companies were required to disclose in their proxy statements their expenditures for both audit and non-audit consulting services. The numbers disclosed leave no doubt that the Commission's concern about the potential for auditors' conflicts of interest to affect the integrity of financial statements was justified. In fact, the numbers appear to demonstrate that the problem may be larger than we originally thought, but I'll get to that in a minute.

Some disclosures about executive compensation were also startling. Along with many investors, we were taken aback at some of the compensation packages awarded to executives. Executive compensation disclosure is not new. What is new is looking at this information against the backdrop of current economic conditions. It's no secret that the pay of top executives has skyrocketed in the last decade. But you have to scratch your head at seeing these salaries continue to go sky-high during the recent leaner times in the market, when companies don't appear to be doing as well and shareholders are suffering losses. Obviously it's not the Commission's role to judge these packages. Rather, it is our role to ensure that the packages are put on full display for shareholders. A related area benefiting from more sunlight that I'll touch upon is options repricing - what companies are doing about "underwater" stock options.

Let's Start with the Auditor Independence Rules.

As you are all well aware, the Commission adopted new auditor independence rules last year after months of heated debate. The rules were designed to limit the scope of consulting services offered by audit firms to SEC audit clients, and to direct sunlight on the types and magnitude of other services being provided by audit firms to SEC audit clients.

At the time of the rulemaking and during the public hearings, the Commission was very interested in learning the extent to which accounting firms were providing non-audit services to SEC audit clients, but no one offered any concrete data. Many in the accounting industry argued that the Commission should not go forward with the rulemaking because of a lack of evidence demonstrating that providing non-audit services to an audit client could impair the integrity of the financial statements.

The Commission had good reason, however, for forging ahead. As early as 1988, large public accounting firms were looking to enter into joint ventures, limited partnership agreements, and other similar arrangements with audit clients. According to the Commission's estimates, consulting was contributing to half of the Big Five's revenue - and was growing three times as fast as their basic auditing business. Public companies such as Waste Management, Cendant, Sunbeam and Microstrategy were announcing accounting irregularities all too often, and raising concerns at the Commission about the integrity of financial statements.

The Commission was also seeing many companies restate their financial statements: 104 in 1997, 116 in 1998, and 142 in 1999. The growing trend in the number of restatements did not abate in 2000. According to a recent study, there were 156 restatements last year. The study further reports that the restatements resulted in total market losses of $31.2 billion in 2000, $24.2 billion in 1999 and $17.7 billion in 1998.

The final auditor independence rules meet to a large degree the Commission's original goals. We could have engaged in substantive regulation and banned non-audit services. We didn't. Rather, we put faith in the fact again that sunlight would serve as the best disinfectant and adopted a disclosure-based approach. The new rules charge public companies with disclosing in their annual proxy statements the fees for audit, IT consulting and all other services provided by their auditors during the last fiscal year. In addition, they require the audit committee to state that it has considered whether providing non-audit services is compatible with maintaining the auditor's independence.

The Commission's Office of Chief Accountant recently released data based on the latest proxy filings from more than half of the Fortune 1000 companies regarding fees paid for audit and non-audit services. The data is illuminating.

It shows that, on average, for every dollar of audit fee audit clients paid to their independent accountants, they paid $2.69 for non-audit services. On average, non-audit fees comprised 73% of total fees companies paid to their accounting firms. The ten companies that paid the most in IT fees paid their independent accountants between $3.57 and $32.33 for non-audit services for each dollar of the audit fee paid.

What is the significance of this information? Although the numbers we're seeing as a result of the new disclosure obviously don't prove that the audits for these companies have been impaired, I think we were all quite surprised by the disparity between the auditing and consulting fees.

Disclosure in this context serves a number of purposes. First, and most apparent, investors will now receive information on the amount of non-audit services provided by their companies' auditors. This will enable investors to decide for themselves whether the auditor of the company they've invested in - who, after all, is supposed to be their watchdog - is really in a situation to bark should the company attempt to steal some biscuits. I think that if we've learned anything from this first proxy season under the new rules, it is that these disclosures will receive plenty of attention.

Second, disclosure requirements have the capacity to shape the behavior of the company required to make the disclosure. Companies may perceive disclosing the ratio of fees for non-audit to audit services will decrease investor confidence in the validity of their financial statements. In that case, we can expect companies to take steps to improve that ratio - if doing so costs less than finding another service provider to perform those non-audit services. Disclosure will create market discipline regarding the size of the fees for non-audit services in a flexible and efficient way.

Third, the disclosures required by the final rules promote effective corporate governance. As I mentioned before, under the Commission's final rules, audit committees must state that they have considered whether the provision of non-audit services is compatible with maintaining the auditor's independence.

The financial reporting process is often analogized to a three-legged stool - with the public company's management, outside auditors and audit committee comprising the three legs. In the last few years, a number of steps have been taken to make sure that audit committees are holding up their end of the stool; including the recommendations of Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, new SRO audit committees rules, new Commission rules, Standard No.1 of the Independence Standards Board, and the recommendations of the O'Malley Panel. The audit committee disclosure required by the Commission's final rules complements these other initiatives. It encourages audit committees to focus particular attention on the effect of non-audit services on the auditor's independence.

Fourth, and finally, the new disclosures lay the groundwork for future study of the effect of non-audit services on auditor independence. Even casual observers of the Commission's recent rulemaking probably know that certain accounting firms argued that there was no empirical evidence to show that providing non-audit services affect audit quality. What accounting firms didn't talk about was that such "evidence" would be hard to come by. Among other things, accounting firms and their audit clients did not have to disclose the audit and non-audit fees charged to individual clients. Indeed, some of the most useful recent studies of the relationship of non-audit services to audit failures are based on U.K. companies, where disclosures similar to those in the Commission's final rules have been required for the last several years. I hope that the Commission's new disclosure rules will enable improved study and better empirical information on the effect of various non-audit services in the future.

One last word on auditor independence. During our rulemaking, many argued the problem was only in our minds, as we couldn't cite examples of audit failures where the auditors had also provided significant consulting or other non-audit services. We put this notion to rest last week when we sued Arthur Andersen for having issued false and misleading audit reports in the Waste Management debacle. Although the Commission did not charge Andersen with a violation of the auditor independence rules, the Commission's order did summarize some of the factors that may have played into Andersen's failure to make the hard decisions, including:

  1. Andersen regarded Waste Management as a "crown jewel" client;

  2. Until 1997, every CFO and CAO had previously worked for Andersen; and

  3. Between 1991-97, Andersen billed Waste Management approximately $7.5 million in audit fees and $11.8 million in non-audit fees.

In my mind, this is the sort of information that should be disclosed to investors. The case should silence many of the critics of our new rules.

Executive Compensation

This past proxy season has also shed quite a bit of sunlight on executive compensation. As a result of Commission initiatives over the last decade, we have seen improved disclosure of executive compensation. Few investors seemed to take issue with executive compensation during the bull market. So long as shareholders profited from the rising value of their stock, it seemed acceptable that corporate executives be rewarded - in many cases, amply so - for their companies' performance.

But times have changed. This past year has generally brought about leaner times in the market. Yet while stocks have gone down in value, many officers' salaries continue to trend upwards. Now seems the time to realize the true value of our disclosure rules. How will shareholders react to lavish executive salaries when their share value no longer appreciates?

The current edition of Fortune magazine adds grist to the mill. The cover story contains the glaring headline: "Inside the Great CEO Pay Heist." According to the article, the number one earners in each of the past five years received compensation packages valued cumulatively at nearly $1.4 billion. Despite paying their executives a staggering average of $274 million a year, four of the five companies have under-performed. Last year, the CEO with the largest pay package received $381 million, if you include the $90 million Gulfstream jet. Now that is pay that I'd like SEC staffers to have parity with!

If you are offended by this data, then all I can say is that our execution compensation disclosure rules have succeeded. Such is the beauty of disclosure. The Commission need not make a judgment about the appropriate level of compensation for any given CEO - the marketplace will make that judgment. But it is our place to ensure that the marketplace has the relevant data to make a well-informed judgment. If I were a shareholder of a company that was lagging, I would want to know that my CEO was being paid $381 million. And thanks to SEC rules, as a shareholder of that company, I have a right to know.

On a related but separate note, I worry that some directors do not always fully discharge their duties. In the same issue of Fortune, several directors who sit on executive compensation committees anonymously admitted that the executive compensation committees were essentially "in the pocket of the CEOs." The article tells the story of an executive who ran his division into the ground. He was, according to the article, "the architect of some terrible deals" and "never seemed to have a handle on what was going on." He nonetheless received a large bonus. The chairman of the compensation committee admitted "this stuff is wrong" but said "we've got to do it." As elaborated on in the article, the committee believed it had to go along with management or else risk losing favor. Another compensation committee member tells the story that he wouldn't give the CEO the pay that the CEO wanted. Later, all the people on the board were rotated to new committees.

These admissions trouble me. Directors have an obligation to the company and its shareholders, not the CEO. Kow-towing to management and blindly signing off on large compensation packages is not a proper discharge of a director's duties. An individual too scared or shy to ask the tough questions and take tough - but justified - action, should not serve on the compensation committee and perhaps the board itself.

I remain curious to see how investors react to this year's proxy disclosures about executive compensation.

Option Repricings

The market decline has forced many companies, primarily high tech companies, to address the problem of "underwater" stock options. As a result, we have seen many companies reprice their employees' stock options. Some of the repricings we've all read about in the press have been done unilaterally. However, many issuers have structured the repricings as option "exchanges," that may come within the issuer tender offer rules under the Securities Exchange Act of 1934. These covered exchange offers generally involve options issued under "broad-based" plans that are open to rank-and-file employees as well as executive or senior officers of the issuer.

Unlike the situation where an issuer reprices its options unilaterally, option holders in an exchange offer have to make difficult and individual decisions. For example, the exchange offer may invite options holders to relinquish a fully or partially vested option in exchange for a new option to be granted, and priced, in six months time. Clearly this decision is an investment decision, not just a compensation decision, and the option holder is entitled to full and satisfactory disclosure.

Issuers conducting broad-based exchanges as tender offers have run into problems with some tender offer requirements. Their need to treat option holders differently in order to accomplish their compensation objectives makes it difficult for them to comply with the "all holders" and "best price" conditions under the issuer tender rules. To alleviate this situation, the Commission's Division of Corporation Finance issued an order this spring that exempts issuers from compliance with these two requirements under certain circumstances.

The treatment of broad-based option exchanges as tender offers has brought sunlight to the repricings, improving both the extent and the timing of public disclosure about these transactions.


While the long-term impact of recent rules and guidance calling for increased disclosure cannot be predicted, the Commission's goal is to help establish the foundation for a reliable accounting and financial reporting system. The new information coming to light empowers audit committees and investors by providing them with additional tools with which to engage in active and vigilant corporate governance - activity that is essential to promoting the quality and integrity of financial reporting. Ultimately, greater sunlight on corporate actions and decisions will brighten all of corporate America.


Modified: 06/27/2001