Speech by SEC Commissioner:
Remarks Before the Society of Corporate Secretaries and Governance Professionals
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 30, 2006
Thank you, David. I am delighted to be with you here today at your national conference in celebration of the Society's 60th year. To remind ourselves of how much the world has changed since 1946, let us look back at some other things that happened in the Society's birth year. It is amazing how much the world has changed in those 60 years.
It was in 1946 that Winston Churchill coined the term "iron curtain," which he described as stretching from Stettin on the Baltic to Trieste on the Adriatic. Fifteen years later that Iron Curtain crystallized as the Berlin Wall, and it took until the bloodless revolution in November 1989 that Ronald Reagan launched for that horrible scar across the face of Europe to fall. It was in 1946 that the United Nations General Assembly met for the first time and the League of Nations held its last meeting. 1946 was the year in which the Nuremburg trials took place. Two classics made their appearance in 1946: the movie, It's a Wonderful Life, and Dr. Spock's Commonsense Book of Baby and Child Care. Coincidentally, all this happened in the same year that marked the start of the baby boom. Just a few blocks away from here, on February 14, 1946, the University of Pennsylvania's Moore School of Electrical Engineering introduced the world to the electronic numerical integrator and computer, or ENIAC, which plunged the world into the computer age.
Needless to say, the world has changed quite a bit in the intervening 60 years. But, how has the regulatory landscape changed to keep pace with the world around it? Although I am partly responsible for only a small corner of that regulatory landscape, it is incumbent upon us regulators to do our business with an appreciation for the change that has transformed and will continue to transform the financial services industry and the investors whom it serves. Before I begin, I must remind you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
Organizations like the Society of Corporate Secretaries and Governance Professionals are essential to our work as regulators. The Society, whose members include many of the nation's public corporations, has weighed in on many of the important issues on the Commission's agenda this year. I would like to discuss some of those issues this morning.
One proposal that has attracted comment from many different corners is the Commission's proposed overhaul of executive compensation disclosure. The proposal would refine the currently required tabular disclosure and combine it with improved narrative disclosure, including a new Compensation Discussion and Analysis section. Most notable is the total compensation figure for each of the named executives.
I was working for Chairman Richard Breeden in 1992 when the last major overhaul of executive compensation disclosure took place. There is widespread agreement that in the ensuing years some critical holes in compensation disclosure have developed and become apparent. Through this new proposal, we hope to address those problems in a manner that will give shareholders better information for their investment decisions without imposing unnecessary burdens on issuers. The proposal should help to ensure that shareholders have access to both salary and non-salary compensation. This is important in the aftermath of the so-called Million Dollar Rule of Section 162(m) of the Internal Revenue Code, which limits the deductibility of non-performance-related executive compensation to $1 million. This 13-year-old tax provision has resulted in the widespread use of non-salary compensation.
Of course, it is also important for the Commission to tread carefully in this area. Our goal should be to design regulations that provide a framework for shareholders to receive clear, comprehensive, and non-boilerplate compensation information that is comparable from year to year as well as from company to company. We must avoid double-counting, which can distort investors' understanding of compensation. We also must avoid imposing disclosure requirements that will skew business decisions.
The very disclosure of executive compensation, some argue, has contributed to compensation inflation, as all packages are now public and any company can see what its competitors pay. If a board sees that a CEO at another company is making more than the CEO of its own company, the board might want to pay its CEO a little more to ensure that he is not lured away. You can easily see how a ratcheting effect could result - in order to improve its business prospects, Company A tries to reach for an executive that arguably would be out of its league. Company B, which thinks itself superior to Company A, for whatever reason, then feels that it must pay its executives more to keep up and stay ahead. You get the idea.
Nevertheless, disclosure of executive compensation is necessary given shareholders' legitimate interest in knowing how boards are compensating executives and given that word-of-mouth, compensation consultants, and overlapping board members all would likely combine to create formal or informal databases for comparison, even if no information were publicly available.
The same cannot be said of disclosure of the compensation to employees who are not executive officers, which is also an element of the proposal. As many commenters, including the Society, have pointed out, the competitive ramifications of this provision are potentially severe. This disclosure is not offset by the need for sunlight since non-executive compensation decisions are not subject to the same conflicts of interest as executive compensation decisions. We have received virtually universally negative comments on this aspect of the proposal. I have to say that I have extremely deep reservations about this aspect of our proposal.
As the Society pointed out in its comment letter, the overall rule proposal raises a number of other concerns. As proposed, for example, the determination of named executive officers, for whom disclosure is necessary, would be made by looking at total compensation. The total compensation figure turns in part on components that are the product of assumption-laden calculations. This could lead to a somewhat arbitrary group of named executive officers that changes from year to year. An additional concern is that some information may cause investor confusion, such as requiring companies to disclose stock and option awards both at grant date fair value and subsequently upon vesting or exercise or modification of the award. As we move toward adoption, we are taking a close look at these and the other concerns that you and other commenters have raised.
Another important rulemaking under consideration at the Commission is the proposal to allow for the Internet delivery of proxy materials. This proposal would allow issuers to take advantage of the Internet, a cost-effective medium with which increasing numbers of shareholders are increasingly familiar. Shareholders who prefer paper would be able to continue to receive proxy materials in paper form. Because of the convenience and interactive potential of the Internet, the proposal could enhance shareholders' familiarity with the companies in which they invest.
In another attempt to take advantage of the opportunities afforded to us by the Internet, Chairman Cox has spearheaded an initiative on the use of interactive data. Earlier this month, the SEC conducted an Interactive Data Roundtable. Interactive data offers the promise of faster, more accurate and cost effective financial reporting that enables professional and retail investors and analysts to collect, compare and analyze information better. Twenty companies have volunteered to take part in a test group. In exchange for benefits such as expedited reviews of their SEC registration statements and annual reports, these companies will agree to furnish for one year the financial data in their periodic reports to the SEC using the XBRL data-tagging format. I will be interested to hear their experiences.
I cannot address a group like this one without touching briefly on Sarbanes-Oxley. As you all know, the implementation of Section 404 of the Sarbanes-Oxley Act has been the cause of particular concern. Companies and auditors have been far too conservative in exercising their judgment with respect to identifying and testing internal controls. As a consequence, external consulting and audit costs have ballooned.
I have had the opportunity to speak with a number of issuers on this subject. The stories that I hear are, frankly, frightening. For large companies, the expenses far outpace everyone's estimates. For small companies, the money and time diverted to Section 404 implementation are having a tangible effect. In the real world, of course, resources are limited. The more that companies spend on things like internal controls, the less they can invest in developing and marketing products, hiring and retaining talent, and embracing new technologies. That does not mean that internal controls and other organizational costs are not important. They are; but, there must be a balance.
The burden of these rules also can affect business opportunities. Some companies have avoided new acquisitions, delayed or cancelled upgrading their computer systems, or not added a new product line lest they set off a new flurry of internal control documentation. As the Society mentioned in a comment letter, "As currently structured, the regulatory burden falls disproportionately on the smaller companies and makes them less able to compete with either their US-based competitors or their ex-US competition of any size. The impact is clearly demonstrated by the rush of new offerings to London to avoid this burden."1
I am optimistic, however, that real changes will be made for small and large companies. In the aftermath of last month's Section 404 Roundtable at the SEC, both the Commission and the PCAOB have pledged to take steps to streamline Section 404 implementation. Not only do we have a new chairman at the SEC, but now we have new leadership at the Public Company Accounting Oversight Board. Changes are long overdue. I am confident that, if such steps are taken, Section 404 can achieve its intended and laudable purpose of improving the integrity of financial information and providing shareholders with additional insight into the credibility of financial statements.
Next, I am going to shift gears and mention a corporate governance rulemaking that arose in the mutual fund context, but which reflects a regulatory mindset that should concern those of you at operating companies. According to the Society's website, you are "skeptical of one-size-fits-all governance prescriptions
, believ[e] that ethics, integrity and independence cannot be legislated and that many governance practice prescriptions tend to elevate form and appearance over substance."2 It is exactly this sentiment that has driven me to take the part of the skeptic with respect to the Commission's 3-year-old rulemaking foray in the area of fund governance.
In 2004, over Commissioner Glassman's and my dissent, the Commission voted effectively to mandate a uniform corporate governance structure for all mutual funds. Fund boards would have to be 75% independent and have independent chairmen. The U.S. Chamber of Commerce sued the Commission over the rulemaking. In an opinion issued last June, the U.S. Court of Appeals for the DC Circuit held that the Commission's rulemaking ran afoul of the Administrative Procedure Act by failing to assess the economic implications of its proposed action and failing to consider a disclosure-based alternative to the independent chairman requirement. With respect to the first of these failures, the Court explained that
uncertainty may limit what the Commission can do, but it does not excuse the Commission from its statutory obligation to do what it can to apprise itself - and hence the public and the Congress - of the economic consequences of a proposed regulation before it decides whether to adopt the measure.3
On June 29 of last year, eight days after the Court announced its decision and one day before Chairman Donaldson left the Commission, the Commission, again in a split vote, readopted the two disputed requirements without change. The Chamber of Commerce filed another lawsuit. In April, the Court once again found that the Commission had violated the Administrative Procedure Act. This time, the Court vacated the provisions in the rule that would have required funds to have a board with 75% independent directors and an independent chairman. My friend and former colleague Commissioner Goldschmid, who voted in favor of the rule, thus proved to be correct in his prediction that "[i]f we are wrong about being fully responsive, the Court will certainly tell us so."4
The Court, although it vacated the rule, gave us ninety days -- if we wished -- to reopen the record for comment on the rule, which we have done. We are in the midst of a new rulemaking process, so please get your comments in. This rulemaking process has an effect greater than just for the mutual fund industry - it is the first time that the United States government has mandated a one-size-fits-all corporate governance structure for an entire industry. Many commenters have already weighed in and many more are likely to submit letters before the August deadline. I look forward to hearing what the commenters think about the full range of fund governance options. Whatever we do in this area should be done with an understanding not only of the direct costs, but also the indirect costs that can result from government mandates and other measures that limit investor choice.
Of course, the fund governance rulemaking is not the only recent instance in which the SEC has been the subject of judicial criticism. Indeed, just a week ago, the Court of Appeals for the District of Columbia issued a ruling with respect to another of our rules from which I dissented- the hedge fund registration requirement that went into effect in February. The Court vacated and remanded the rule in response to a challenge to the statutory interpretation that the Commission employed in order to require hedge funds to register. The Court, taking issue with the SEC's awkward definitional machinations, characterized the rule as "arbitrary" and gave the Commission the following stern warning: "That the Commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable. But the Commission may not accomplish its objective by a manipulation of meaning."5
This decision was a stinging rebuke. Of course, as with any court loss, the Commission could seek review of this decision. Or, we could try to find another way, within the confines of our statutory authority, to require hedge funds to register. Given the current circumstances, I cannot imagine a scenario under which we would pursue either course of action. Indeed, it is hard for me to imagine that I could support taking either of those actions. It is high time that we finally work with our fellow regulators - the Treasury, the Federal Reserve, and the CFTC - to co-ordinate our efforts with respect to the oversight of these market participants. There are other possibilities that were not adequately explored prior to the Commission's adoption of the rule. In the meantime, under this vacated rule, hedge fund advisors that wish to do so may deregister via Form ADV-W.
That is not to say that hedge funds are completely unregulated, running amok, subject to no rule of law or accountability. Completely to the contrary. Hedge funds, like any investors in the market, are subject to surveillance by the NYSE, NASDAQ, and other regulators regarding their trades against manipulation. The SEC has broad inspection authority under the securities laws that we can use if we have cause to suspect wrongdoing from tips and other alerts. That is source of the vast majority of our enforcement actions, anyway. The anti-fraud laws apply to hedge funds as well as to any other participant in our financial markets.
Chairman Cox's response to the hedge fund decision was noteworthy. He "instructed the SEC's professional staff to promptly evaluate the court's decision, and to provide to the Commission a set of alternatives for our consideration." He also stated that "we will continue to work with the other members of the President's Working Group on Financial Markets, including the Treasury, the CFTC, and the Federal Reserve, to evaluate both the systemic market risks and retail investment issues associated with the growing presence of hedge funds in the world's capital markets."6
Although this string of judicial rebukes is disheartening, I do not expect it to continue. Chairman Cox has shown himself to be committed to adopting new rules only after a thorough and deliberate rulemaking process carried out within our statutory limitations and with genuine consideration of the economic implications and alternatives. This commitment was evident when, in response to last week's decision in the hedge fund case, the Chairman promised that "the SEC will use the court's decision as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors, maintain fair and orderly markets, and promote capital formation."7 Chairman Cox, after the Court overturned the fund governance provisions, directed the General Counsel to ensure that rulemakings are grounded firmly in real cost-benefit analysis.
In addition to working with the Chairman to improve the way in which the Commission makes rules, I am looking forward to continuing to tackle issues related to the enforcement of those rules. Last January, the Commission took an important step on this front when it issued its statement concerning the imposition of financial penalties against corporations in enforcement actions. The statement recognized that, "If the victims are shareholders of the corporation being penalized, they will still bear the cost of issuer penalty payments (which is the case with any penalty against a corporate entity)."8 That critical acknowledgement has been all too often lost in recent years. In financial fraud cases, shareholders, who are the ultimate owners of the corporations on which we impose these penalties, may already have been punished through reputational and stock-price damage. Admittedly, the exact outlines of the penalty statement will only become clear after they are applied to the facts and circumstances of actual cases. That is why I am waiting to see if this policy will actually change behavior. It would be unfortunate after all our efforts to the contrary if the Commission reverts back to its prior practice of inappropriately imposing penalties on shareholders with a boiler-plate nod to the penalty statement.
As you embark on your seventh decade as an organization, I wish you success. I appreciate your attention and hope that you will give me a chance to hear some of your thoughts and concerns on these issues. Please also remember that my door is always open.