Speech by SEC Chairman:
Address to the New York Financial Writers Association
Chairman Christopher Cox
U.S. Securities and Exchange Commission
New York, New York
Thank you, Mike. It's great to see you again. The last time we got together was in early May, in Minneapolis, at the Society of American Business Editors and Writers. Now, barely a month later, here I am again with another 400 journalists. You might wonder ... why? The truth is, I'm happy to show up to any group that prefers plain English to legalese.
June 8, 2006
And of course it's the very nature of your job - that is, the journalists here this evening - to translate complicated events and concepts into easily understandable language that millions of people from thousands of different walks of life can readily grasp.
Your job would be a lot easier if lawmakers and regulators didn't make things so needlessly complicated in the first place.
I'm pretty sure that one of the formative experiences that led me to so strongly dislike legalese was my stint 20 years ago teaching federal income tax to second year MBA students. They were bright young men and women, eager to learn. My job was to get across the important concepts of federal taxation without getting lost in the minutiae and the jargon.
But how does one do that when the Internal Revenue Code itself consists of nothing but minutiae and jargon - 3.4 million words of it? Consider this single sentence from the tax code. It's part of section 3302, which describes a tax time warp that can only make sense in the Twilight Zone. Here goes - see if you can hold your breath for the whole sentence:
"The provisions of the preceding sentence shall not be applicable with respect to the taxable year beginning January 1, 1975, or any succeeding taxable year which begins before January 1, 1980; and, for purposes of such sentence, January 1, 1980, shall be deemed to be the first January 1 occurring after January 1, 1974, and consecutive taxable years in the period commencing January 1, 1980, shall be determined as if the taxable year which begins on January 1, 1980, were the taxable year immediately succeeding the taxable year which began on January 1, 1974."
And that's just the law. There are another 1,800 pages of regulations in fine print that are just as confusingly written.
I'll never forget my experience grading the students' final exams. There were two cases on the final - two business situations nefariously constructed to contain every tax problem known to man. And the exam lasted four hours. Naturally, each of the students filled up multiple blue books.
All, that is, except one. I can't tell you, how excited I was when I picked up this student's single blue book. I was intrigued to find out what this model of concision could possibly look like. And then, when I opened the cover, I discovered that he'd written on just the first page of the one blue book. Here is what he wrote:
"Dear Professor Cox: What I have learned in your course is that federal income tax is extraordinarily complicated. And when I go into business, I'll be sure to hire someone who knows what he's doing in this area."
I'm reasonably certain that this fellow ended up with a career in improv, rather than tax accounting. Either that, or he went to work for Enron. And much as I appreciated the wry humor, I didn't have too much remorse about flunking him.
But you have to admit, that student had a point. The arduous process of unraveling the man-made complexities that are the hallmark of government rules and regulations isn't just hard work. It's entirely unnecessary.
That's why, at the SEC, we're mounting an all out war on needless complexity. Saying what you mean, and saying it clearly, will be every bit as important for the government as it is for companies and mutual funds. There is no room for language that makes things harder to understand in a marketplace where fast moving information drives split-second decisions.
Even more importantly: Our capital markets rely on trust, and investors can't trust legalese and jargon. All of you, as journalists, know better than most that unmasking fraud often consists of exposing the simple truths that lie hidden in the midst of intentional complexity. Back in 2001, when many analysts were praising Enron, it took a journalist - Fortune's Bethany McLean - to make the straightforward observation that the company's financial statements were "nearly impenetrable."
The SEC would undoubtedly have discovered the problems at Enron eventually, but the truth is, your profession beat us there. When all was said and done we learned once again, the hard way, that if a company can't explain its business so you can understand it, maybe it doesn't have a real business.
Nor did the recent guilty verdicts in Houston put an end to this sort of thing. Just as World War I didn't really turn out to be the "war to end all wars," there are undoubtedly more Enrons in our future. And it will require the most talented and dedicated of our next generation of journalists to unmask these future frauds.
That's why I'm so pleased to congratulate this year's scholarship winners. The ten of you will be attending three of best graduate schools in journalism: Columbia, NYU, and Steve Shepard's new program at the City University of New York.
In choosing journalism you're joining a profession that's in the midst of a great transition.
We've come a long way since the days when Evelyn Waugh wrote about the "Daily Beast" in Scoop. Technology will continue to change, and mostly improve, the delivery of information - and hence the ways that it's used by investors.
But despite this trenchant change, the bedrock foundations of your chosen profession remain constant. You still need to be objective and accurate in the gathering and reporting of facts, and society will very much depend on the job you do. It's not understatement to say that our entire free enterprise system would crumble without the work of thousands of journalists competing to discover the truth.
For the graduate students here tonight, there's little difficulty in finding admirable role models. Men and women like Terri Thomson, who was honored tonight with the Elliott V. Bell Award, are setting high standards for financial writers and editors. Terri's Knight-Bagehot Fellowship at Columbia is devoted to the principle that our society benefits immensely from having journalists who are intimately familiar with business and finance, and who don't wince in despair when presented with a balance sheet.
For over a dozen years now, Terri has been shepherding her famous Bagehots all over town, preparing them to become journalists who report business news as it is - whether it's the good news of a growing economy, or the bad news that a company's claims about its own prospects don't quite add up. So, congratulations, Terri, and again, congratulations to all of tonight's scholarship winners for your well-deserved honors.
And may I add my thanks to every financial journalist here this evening. You do your jobs despite complaints, and occasionally even threats, from company officials who charge that your coverage, not their management, is the problem. I know that all too often you're placed in a Catch-22 when you report on what you observe in a company's operations or its financial condition. Too upbeat and optimistic, and you're accused of being a shill. Too negative, and you're accused of attempting to drive down the stock. Damned if you do, damned if you don't.
I'll be specific about what I mean: In his Houston criminal trial, Ken Lay testified that it was the journalists who were, and I quote from his testimony, "absolutely destroying investor confidence in the company and driving down the stock at a time when the company was doing extremely well."
Yes, you're sometimes going to take flack. Someone's always going to try to shoot the messenger. But know that the SEC will not be one of them.
As everyone who reads newspapers knows - and you write them, so you certainly know - the SEC earlier this year subpoenaed some journalists. But lest there be even one person who is still under the impression that we want you to be less aggressive, let me make it very clear once again that the SEC understands and appreciates how much we depend on the work you do.
The formal guidelines the Commission has adopted now make it crystal clear that issuing a subpoena to a journalist will be exceedingly rare, and employed only as a last resort. Whenever there are charges that journalists are violating the securities laws, the SEC will aggressively pursue them. In fact, I don't think you'd want anything less from us. But the overarching aim of our efforts is to strengthen our working relationship with financial journalists.
We will never make compromises when it comes to the 1st Amendment. We will give equal dignity to the public's interest in the freedom of information, and the public's interest in effective law enforcement.
Many, many of you do the work you do - and the students here should hear this - because you have a powerful sense of mission. You want to unearth and publish truths that others try to hide.
You already know that in your gut, and I'm not telling you anything new. But one of the reasons I'm so certain of it is that the professional staff at the SEC shares that same sense of purpose.
Surveys have consistently found that the SEC is one of the most satisfying places to work in Washington. There are many reasons for that, including the fact that the people at the Commission are famously courteous and professional. But another important reason for the high degree of job satisfaction is the intangible, but nonetheless very powerful, sense that the men and women who work as America's investor advocates are the good guys.
Like you, the staff at the Securities & Exchange Commission has a deep sense of mission, as well. It is "to protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation."
If that sounds like we're on the same team wearing the same jerseys, let me be clear. I'm very aware that you don't do the work you do because you're devoted to helping the SEC or any other government agency - any more than a honey bee pollinates flowers out of a sense of duty to the gardener.
It's pretty clear the bee is after its own nectar. And any gardener who doesn't quite understand that is likely to be stung. But the gardener nonetheless benefits greatly from the bee's work.
In my home state of California, half of all the bees in the U.S. are trucked in every year to pollinate almond orchards. Those California farmers are happy to receive the benefit, just like the government official is. And both farmer and government official are happy not to become the target of the honeybee.
In some cases, our roles are reversed - and journalists are the beneficiaries of the work of the SEC. That's true whenever we use the power of the federal government to force disclosure of information that otherwise you couldn't report.
One area where you're avid consumers of the information that the SEC helps make public is executive compensation. This issue is important because it goes to the heart of the relationship between the corporation and its shareholders. In order for our system of public ownership to work, the board of directors must aggressively represent the interests of shareholders and not the personal interests of management, whenever the two diverge.
The way a company shares the compensation pie with management can be a telling barometer of the health of this agency relationship. A company where executive compensation is out of line may well fail in other ways as stewards of the shareholders' money.
The Commission's proposal to significantly improve the way executive compensation is reported to shareholders has received more than 20,000 comments. No issue in the 72 years of the Commission's history has generated such interest. Our basic approach is straightforward: We propose to tell Compensation Committees to release all material information regarding their decisions, and we mean all.
There's not a market on earth that doesn't function better with more quality information. The market for executive talent is no exception.
Our proposal calls for disclosing this information in a way that makes it useful to consumers - that is, more useful to analysts, journalists, shareholders, and even compensation committees themselves. A company would provide one number that includes all compensation to top executives in a given year. And the different elements that make up that number would be presented not in an impenetrable thicket of details, as is the case today, but rather in clearly presented tables, and plain English descriptions.
The principle here is simple: no shareholder should need a machete and a pith helmet to go hunting for what the CEO makes.
And we want shareholders to know how much the executives will get once they retire or leave for any other reason. One of the problems with the current regime for disclosing executive pay is that the shareholder doesn't get to know what the golden parachute looks like until the CEO floats cheerfully away from the mother ship.
The new executive compensation disclosure will deliver more than just clear and understandable numbers. We'll also be getting a plain English narrative that will give investors an insight into the Compensation Committee's thinking when it decides how to pay the CEO.
Today's Compensation Committee Report and Performance Graph - which have become little more than pro-forma and boilerplate - will be replaced with an explanation by management called Compensation Discussion and Analysis. We expect the new CD&A to be clearly written, so every investor can understand it.
Let me tell you about another important part of our pending executive compensation rule that might see further refinements in the days ahead.
Our final rule will very likely address the issue of back-dated options, which is currently so much in the news. As you know, this refers to the practice of selecting a grant date for an option award that's earlier than when the award is actually made.
While I can't comment on the SEC's ongoing investigations of specific companies, I can tell you what the Commission's position is. Back-dating must be fully disclosed. And the granting of back-dated options must be properly accounted for.
Our rulemaking and enforcement interest in back-dating reflects our firm conviction that stock options can be a vital tool for both public and private companies of all sizes. The proper use of options in compensation can make a very positive contribution to our economy by offering significant future rewards to those individuals who create value for a company and its shareholders. Options can be an extremely useful way for a company to establish positive incentives for its executives and employees.
A major purpose of stock options is to give employees the incentive to work harder to increase the value of the company's stock. And in fact, it's entirely reasonable to expect employees with a vested interest in the business to work harder. Another reason that companies issue stock options is to decrease the amount of money they have to spend on salaries. Yet another purpose of options is to create an incentive for executives and employees alike to stay with a company. That's especially true when options vest over time.
In each case, what makes the option work as a powerful motivational tool is that unlike a bonus, it isn't so much a reward for prior performance as it is an incentive for future performance.
That's why the undisclosed back-dating of options is such a serious potential problem.
By giving the recipient of options an undisclosed paper gain right from the start, it cuts the direct connection to future performance. And in the process, what investors might otherwise view as a shareholder-friendly way to align their interests with those of the company's executives becomes instead a more expensive way for the firm to structure its compensation program.
When a company decides to back-date options, it usually does so because the stock price was lower at the earlier date. But if the effect of the back-dating is to hide compensation from the shareholders, by overstating the extent of the risk-based element, there can be serious accounting, tax, and securities law issues.
When a company fails to disclose to shareholders that it paid additional compensation through back-dating in violation of the terms of the company's stock option plan - or when it fraudulently misrepresents that it granted options at an earlier date than they actually were granted - this interferes directly with the shareholders' right to know both the level and the form of executive compensation. And that is clearly wrong.
As one means of dealing with this problem, our proposed executive compensation rule will provide better and more useful disclosure of the backdating of options. It would require that a company clearly identify the portion of compensation that results from "in-the-money" option awards resulting from backdating.
The proposed rule will require the disclosure of the full value of an option based on the date the award was actually made. That means the added value from an option's being in-the-money at the time of grant would be clearly disclosed. It would specifically require a comparison of the exercise price of the option to the grant date market price of the option, whenever the exercise price is lower than market price. That way, investors could see the additional compensation that was immediately conferred on executives when the option was granted.
Just as important as these dates and numbers will be the plain English disclosure of just how the company determined when to make its option awards.
The Commission is even now considering further adjustments to our executive compensation proposal to deal with the issue of backdating options. Our staff in the Division of Corporation Finance are collating all of those thousands of comments and will make a recommendation to the Commission at an open meeting soon.
As part of that review process, we will consider the need not only for any changes to the rule, but also for additional guidance to address further the backdating of stock options. So stay tuned. We want this matter settled in time for next year's proxy season, and I have every reason to expect that it will be.
So what will come of our imminent decision to require more and better disclosure of options and every other aspect of executive pay? How will people use the information? How will it affect overall compensation levels in public companies? What will be the net result?
Well, for starters, disclosure is likely to intensify the debate over CEO compensation. After all, even in the current environment of somewhat confusing disclosure, the moment companies release their pay figures each proxy season, journalists like you tote up the numbers and publish them widely. In the new environment under our proposed rule, the immediate result will be that all of you will find it far easier to tabulate a CEO's total compensation.
You'll also have more details about what that compensation consists of, including the perks, and never-before-disclosed information about what executives might be paid when they leave. We know from experience what happens next, with disclosure of the egregious cases.
The $20,000 oriental carpet, the $8,000 horse, the free company jet in retirement, or the half-million dollar consulting deal that keeps paying your heirs even after you die - those cases will attract a lot of attention, and they'll give shareholder activists new opportunities to call for better discipline.
And the closely watched ratio of average worker-to-boss compensation will be calculated anew, this time with far greater accuracy.
Now you've occasionally heard it said that because aggrieved investors can't automatically convert their distaste for excessive compensation into action - because as shareholders they have no way to directly force change - this new information won't add anything.
But surely, that misses a main point. The SEC requires the disclosure not only of executive compensation, but also hundreds of other significant items that shareholders have a right to know. In every case - and in this respect executive compensation is no different - the fact that the shareholders' interests must be vindicated by their representatives on the board of directors doesn't obviate the need and the value of making the information public.
Improved access to information is in fact a form of public participation in decision-making. It directly enhances the quality of economic decisions. Access to information contributes to public awareness of reform issues. It gives the public the opportunity to express its concerns - and enables not only corporate managers, but also government officials to take into account those concerns.
Which brings us once again to the centrality of your role in all of this.
The truth is, our executive compensation proposal will largely depend upon business and financial journalists for its success. The degree to which you publicize this new information, and the use you make of it, will have a significant influence on corporate governance in general.
The media have long been seen as central to the success of democracy. But it's equally true that a thriving media debate is vital to a healthy economy. Journalists play a critical watchdog role in curbing corruption. More broadly, our entire system of publicly owned and traded enterprises depends on the free flow of information. In a recent book published by the World Bank, "The Right to Tell: The Role of Media in Economic Development," authors Alexander Dyck and Luigi Zingales point out that a critical function of media reporting on business is to pressure corporate managers and directors to behave in ways that are socially acceptable.
But of course, you can only report what you can discover.
Sometimes the force of law is necessary, because companies aren't always willing to disclose information. Or, they might disclose it in ways that aren't readily accessible. So the SEC has drafted the rules we're now proposing with a view to promoting greater freedom of information in order to give you, and the investors we all serve, the tools and opportunity to accomplish genuine change.
I recognize that what I've been talking about is really your daily job.
So I want to thank you and congratulate you for what you do on behalf of America's investors. And especially to those of you who are studying to take up this calling - and to those like Terri and Steve, who are teaching our future journalists - thank you for your selflessness and your idealism. In our common pursuit of full disclosure of the facts that America's investors need to know, we're on the same side. Through your professionalism, your integrity, and your diligence, you help protect America's investors - and you help the SEC do the same.
One final thought, particularly for our scholarship winners.
While idealism has its place in financial journalism, so does cynicism. They really have to go hand in hand. After all, Henry Ford once described an idealist as a person who helps other people to be prosperous - and that's exactly what we expect corporate managers to do. On the other side of the coin, one of journalism's great cynics, H. L. Mencken, defined conscience as the inner voice that warns us: somebody may be looking.
The cynic in each of us knows that every public company can use a little bit of Mencken-style conscience in its pursuit of Henry Ford-style idealism. With the SEC's new executive compensation rule, we can all be more certain that idealistic executives will let conscience be their guide.
And I know that in doing so they'll receive every encouragement from all of you in this room.
Thank you, once again, for inviting me - and thanks for all you do.