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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Address to the Stanford Law School Directors' College


Chairman Christopher Cox

U.S. Securities and Exchange Commission

Palo Alto, California
June 26, 2006

Thank you, Sy, for that kind introduction. Sy Lorne, as you know, was himself an extraordinary leader of the Securities and Exchange Commission during the 1990s. The fact that such an exceptionally talented individual as Sy would be willing to serve the nation in this way at the SEC speaks volumes about both his commitment to public service, and the Commission's high standing among federal agencies in Washington.

The very same point can be made about Joe Grundfest, who is the driving force behind this three-day event, and who served so ably as a Democratic Commissioner of the SEC appointed by President Reagan.

For years, under Joe's leadership, Stanford has produced research and data about the most important issues in securities regulation. And that body of work has been of enormous benefit not only to scholars, but to policy makers, business leaders, investors, and directors of publicly owned enterprises. Joe, thank you for all that you do.

The East Coast may have its attractions, but the place we're gathered tonight is truly special. So I'm not surprised that Professor Grundfest hasn't succumbed to the many entreaties for him to return to Washington. And for my part, I can tell you that ever since my new responsibilities have required me to give up my routine visits to California, I've really missed it here myself.

California has been a state of mind and a promised land since even before it was created. The alluring name comes from a romantic novel written more than four centuries before the Beach Boys, in 1510. In the novel, which was a best-seller in Spain for many decades, California was described as a rich island close to the "Terrestrial Paradise." It abounded in precious stones, and it was inhabited only by women.

Despite what you may have heard, this wasn't the only reason I moved to California from my native Minnesota. The weather also had a lot to do with it.

Palo Alto is a much less romantic name: It just means Tall Stick. That, of course, refers to a particular thousand-year-old Redwood tree that stands not far from here. But it's also an appropriate metaphor for what we're discussing here at the Director's College — because when it comes to boards of directors of public companies, the focus is now on you. Increasingly, shareholders are demanding that the directors who work for them go out and fight for their interests — if not with the Palo Alto, then with the Palo Grande — the Big Stick.

Activist shareholders increasingly are demanding activist directors.

As you all know far better than even the Chairman of the SEC, today's directors are expected to be a sensitive instrument, responding to the concerns of the investors whom they are elected to serve.

In fact, we may be witnessing another important step in the gradual evolution of the publicly owned corporation. With each step in this development, we're coming closer to solving the agency problem that implies a potential divergence of interests between a company's shareholders and its management.

Of course, the phenomenon of shareholders directly challenging management is nothing new. Ninety years ago, activist minority shareholders in the Ford Motor Co. brought a lawsuit against Ford to prevent the cancellation of their dividend, which management had intended to use instead on the expansion of a new plant. Those minority shareholders were the Dodge brothers — and they were counting on the dividend to finance their own expansion at Dodge.

The court ultimately sided with the dissident shareholders, and reinstated the dividend. That struck a blow for shareholder activism; and shareholder democracy has continued to grow in power ever since.

A more recent milestone came in the 1970s, when the SEC finally abolished fixed commission rates. The ensuing competition significantly reduced brokerage fees; and that contributed directly to higher levels of equity participation and ownership by millions of Americans. The proliferation of large mutual funds followed closely behind.

The result is that today, more than 50% of Americans own stocks, directly or through mutual funds and retirement plans. And now, as defined benefit pension plans give way to defined contribution plans, even more Americans will be taking charge of their investment decisions.

And that means that even more Americans will be asking hard questions, and making demands.

Not too long ago, I read about a couple with a large family whose youngest son had never spoken. The boy was five years old, and seemed perfectly happy; he was otherwise outgoing, loving, healthy, and apparently very bright. There was nothing to explain his silence. He just never spoke. Then, one day, at breakfast, from out of the blue, the boy pushed his plate toward his mother and announced in perfect diction: "The eggs are cold."

The parents were flabbergasted. "What!?"

"I said…the eggs are cold."

The family hugged each other, and cried tears of joy. The father raised his arms to heaven and repeated over and over, "He can talk! My son can talk!" The boy gave him a funny look and said, "Of course I can talk." And his father, who couldn't believe any of this, said, "Well then why, after five years, have you just now said something?"

And the boy said, "Because I'm a very patient sort. But finally, after all those years of cold eggs, I just couldn't take it any longer."

That investors are now speaking up may come as the same kind of a shock to directors as it did to those parents. If it ever were true that the corporation meant only management, and the shareholders were just silent partners along for the ride, that day is past.

Times are changing. We're in a new age of information and disclosure. If the eggs are cold, you're gonna hear about it.

Signs of increasing shareholder involvement are everywhere. According to recent news accounts, during the current proxy season alone, shareholders at 70 companies have approved proposals making it easier to fire directors. At 38 companies, resolutions were approved demanding an end to staggered elections for the board, so that all directors would be voted on every year. Now, more than half the nation's 500 largest companies will have annual elections for the full board.

And shareholders at 32 companies during the current proxy season have voted for directors to be elected with a majority of shares voted. Over 100 other companies this year decided to adopt this standard on their own. These 130-odd companies join 145 others in the S&P 500 that already elect directors by a majority of votes cast, or require directors to withdraw if they don't receive majority support.

Shareholders are also wading deeper into the question of executive compensation. This season, four companies — including Novellus Systems not far from here — have adopted shareholder proposals tying executive compensation to company performance. And seven other companies, including Morgan Stanley and McDonald's, passed shareholder resolutions limiting the severance pay of executives.

Now, there's been a fair amount of commentary on the subject of whether this kind of shareholder activism is good. Some have criticized it on the grounds that shareholders lack the sophistication to make these choices, or that they might hijack the business to the service of political or social agendas unrelated to return on investment.

But the evidence is increasingly showing that shareholders tend not to vote for agendas that are detached from economic reality. There is also an impressive and growing body of empirical data suggesting that companies with a habit of meeting shareholder needs tend to be more profitable.

The starting point in all of this is the principle that good governance is tied to profitability.

Very recently, we've gotten some evidence that connects a company's profitability to the investor friendliness of its shareholder communications. A new University of Michigan study suggests that companies whose annual reports are easy to read and understand also tend to be companies that perform better. Conversely, underperforming companies more frequently try to blow smoke in investors' eyes, to obscure the fact that they're not meeting their goals.

The study's author, Prof. Feng Li, tested annual reports for complexity using linguistic measurement tools with plain English names like the "Fog Index." Then he compared the complexity indices with both current and future earnings performance.


The correlation was very strong and very obvious.

Professor Li concluded, in the sort of plain English that's as rare in academic treatises as it is in annual reports: "I find that the annual reports of firms with lower earnings are harder to read."

Prof. Li added some useful advice for companies that believe in their future performance: You may want to disclose information more clearly, to distinguish yourselves from the "lemons."

I couldn't agree more.

Both at the SEC and in the boardroom, one of the best ways to satisfy the legitimate demands of shareholders for better information that they can actually use to make decisions is to use plain English.

Nowhere is this more true than in the area of executive compensation. That's why the SEC has proposed significant improvements in the quality of executive compensation disclosure.

It is a testament to the level of shareholder and corporate interest in this issue that this proposal has received a greater response than any other in the entire 72-year history of SEC: over 20,000 formal comments.

The proposal is designed to make disclosure of executive compensation useful to the shareholder, and also to the director who sits on the compensation committee and needs to rely on solid market data for his or her judgments. Both shareholders and directors need to understand clearly what executives are actually being paid.

And so the proposal provides, in addition to useful detail, one number that captures all compensation promised to top executives in a given year.

Under the proposal, the clearer answers to the question "how much" will be accompanied by better explanations of the "why." To those of you who sit on compensation committees, I hope you will take the opportunity to give shareholders a clear indication of why you acted as you did. You undoubtedly have good reasons. Share them with your investors.

The forum for this frank discussion with the shareholders will be a new Compensation Discussion and Analysis section. Rather than the boilerplate and legalese that has come to typify today's compensation committee report, the new CD&A should be prepared with the investor in mind as the intended audience.

Despite the fact that America has 75% of the world's lawyers, lawyers represent less than one half of 1% of the U.S. population. It's time we put an end to lawyers writing for other lawyers, and put all of these important investor discussions into plain English.

That's exactly what the new rule will require.

There's one more shareholder-friendly initiative I'd like to urge you to consider. That's making your company's financial statements interactive, so that not only investors, but you as directors can make better use of them.

Interactive data can make a company's financial information, such as that concerning executive compensation, far more useful. That's why an increasing number of companies are participating in the Commission's program to use interactive data in their SEC filings. Just last week, four more companies joined: Automatic Data Processing, Ford Motor Company, Ford Motor Credit Company, and Radyne Corporation.

And here's a secret almost nobody knows: the power of interactive data can be applied beyond financial statement disclosure to virtually any text, footnotes, or other information in your shareholder communications.

What could this mean to you as directors? Well, as just one example, you could compare a particular CEO's compensation to that of his or her peer group over the past three years, automatically. You could instantly rank an executive's compensation in every category against every other public company — with the click of a button.

And that's just the basics. If you wanted, you could subscribe to an RSS feed of executive compensation for 10 companies, and be notified automatically any time a company disclosed compensation that was, say, 10% greater than the three-year moving average in any category you chose.

In this context, and so many others, interactive data has the potential to completely transform the way the world shares and uses financial information.

The purpose of so many of these SEC initiatives — including our e-proxy proposal, our push for interactive data, our updating of the executive compensation rules, and our emphasis on plain English — is to empower investors. The SEC is, after all, the investor's advocate. We view the investor as our customer. And so in every action we take — every rulemaking, every inspection and enforcement proceeding, every change to our disclosure rules — our aim must be to improve things from the investor's standpoint.

And of course, as directors, that's your job, too. So we're very much partners in this business of customer service.

Here in Silicon Valley, where technology is everyone's business, there's been a long-running debate about the state of customer service. Many people complain that the advent of touch tone caller menus, long hold times, outsourced tech support, and mechanized consumer relations have all but eliminated customer service.

Others point to the amazing consumer empowerment that comes with worldwide comparison shopping on the Internet, easy-to-access research about products and services, and build-to-order customization of virtually anything one wishes — all delivered to your doorstep — as evidence that in the 21st century, the customer is truly king.

The truth is, both camps may be right. Consider, by way of analogy, the way customers are flocking these days to premium coffee houses that offer a world of choices and flavors.

Obviously, many consumers appreciate the variety at these places. But at the same time, as the venerable comedian Jackie Mason has observed, if you order coffee in a coffee shop, it's 60 cents. But at the coffee boutique, Cafe Latte is $3.50. Cafe Cremier is $4.50. And if it's Cafe Suisse: $9.50. For each French word, another $4. Why, he asks, does a little cream in coffee make it worth $3.50?

Go into any coffee shop, he says, they'll give you all the cream you want, until you're blue in the face. Forty million people are walking around in coffee shops with cruets of cream: "Here's all the cream you want!" And it's still 60 cents. You know why? Because it's called "coffee." But if it's Cafe Latte — $4.50.

Then there's a sign that says, "please clean it up when you're finished." They don't give you a waiter or a busboy. Now you've become the janitor. Now you have to start cleaning up the place. And then, the guy at the cash register has a glass in front of him that says "Tips." You're waiting on yourself for 20 minutes, and you owe him money?

If I said to you, "I have a great idea for a business. I'll open a whole new type of coffee shop. A whole new type. Instead of 60 cents for coffee, I'll charge $2.50, $3.50, $4.50, and $5.50. Not only that, I'll have no tables, no chairs, no waiter, no busboy, and you'll clean it up for 20 minutes after you're finished." Would you say to me, "That's the greatest idea for a business I ever heard! We can open a chain of these all over the world!"

Maybe not. But the fact is, business is booming at today's prestige-priced luxury coffee houses, because customers like the choices. For consumers who like variety, it's the best of times. But you might say, when it comes to customer service, it's the worst of times.

And the same might be said for today's investors when it comes to customer service: it's the best of times, and in many ways the worst of times.

Investors are getting access to a wider range of investment products and services than ever before, and their transaction costs are lower than they've ever been. But when it comes to being able to find their way through the prospectus and the proxy statement and all the other investor communications the SEC requires, the customers have to do all the work.

If it's really the investor who's in charge, then it's high time the quality of shareholder communications reflected that fact.

We at the SEC have the responsibility to insure that just as today's investors are gaining access to more product choices and lower transaction costs, the legally mandated disclosure that goes with it is also high quality, affordable, and addressed to the customer's real needs.

There's no reason that we can't rely upon technology to empower investors with opportunities for easy comparison shopping on the Internet; easy-to-access research about investment products and services; and even build-to-order customization of their own investment research, online.

If customers want their coffee with frothy cream, and their eggs piping hot — or, in this case, their nest egg safe and growing — then by God, that's what they should get.

As the SEC continues to survey investors about their concerns, and works to focus every legally mandated disclosure on empowering investors, we'll turn increasingly to all of you, whose vocation and sworn duty it is to vindicate the shareholders' interests.

At the SEC, we know we share this important responsibility for investor protection with America's directors — and we are proud to be your partners. Thank you for inviting me, and thank you for all you do to make our nation more prosperous, and our world a better place.


Modified: 06/27/2006