Speech by SEC Commissioner:
Remarks Before the Portland Directors Institute
Lewis & Clark Law School
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
October 27, 2006
Thank you, Roy for your kind introduction. As Roy mentioned, he and I first met nearly a quarter of a century ago at Davis Polk in New York. I do not get many opportunities to come out here to the Pacific Northwest, so I consider it a real honor to be with you today.
There are so many business success stories from this part of the country - perhaps it is because you are just about as far outside the beltway as you can get. Judging from the afternoon session entitled, "What to Do When the Government Knocks on the Door," perhaps you wish that it were still as hard to get from the east coast to the west as it was when Lewis and Clark made their legendary journey two hundred years ago. I can guarantee you that - to quote from Clark -- "[t]he torments of those Missquetors and the want of a Sufficety of Buffalow meat" that they encountered regularly would have kept most government officials from making the trip.1 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.
It is probably fair to say that, in its opening years, the twenty-first century has been a difficult time to be a corporate director. First came the revelations of financial wrongdoings at Enron, Worldcom, Tyco and the others. Then came the Sarbanes-Oxley Act reforms, which Congress hoped would stem the tide of corporate meltdowns. Although the scandals resulted from the misdeeds of a very few corrupt and unscrupulous companies and their top managers, they caused Congress to turn with great fervor to corporate governance reform.
In the interest of full disclosure, I should note that I often refer to myself as a child of Sarbanes-Oxley, because the political compromise in Congress that led to the passage of that law broke the logjam that had held up the appointment of 4 of us commissioners. I was appointed to the SEC only a week or so after the President signed the Sarbanes-Oxley Act.
The Sarbanes-Oxley Act and the SEC's implementation efforts over the past few years have effected many positive changes in corporate governance. Rather than dictating corporate behavior, the Act largely requires corporations to disclose information. Based on this disclosure, the market itself can determine whether and how to react. The Act acknowledges the importance of stockholder value as opposed to stakeholder value.
This makes it easier for you, as directors, to do your jobs, because it reaffirms that you work for stockholders as opposed to any one of the many other groups that may be trying to influence your actions. Indeed, I believe that the Act's most important contribution is that it strengthens and underscores the role of directors as representatives of stockholders and reinforces the role of management as stewards of the stockholders' interest.
Boards of directors have been trying to understand the precise parameters of their responsibilities in the post-Enron regulatory world. They have been working with management, auditors, attorneys, and regulators to implement the Sarbanes-Oxley reforms. Being a director is never easy, but being a director during a period of intense focus on corporate boards is particularly thorny. So, too, is being a director in a period of regulatory change with all of its attendant uncertainty.
Conferences like this are a wonderful opportunity for directors to come together to bolster each other through discussion of shared challenges and to learn from one another and from specialists who can help you to navigate the new terrain. This is important at a time when directors, particularly independent directors, are being asked to do more and are being watched more closely. As a result, your board work might be taking more of your time. You might be thinking that too much of your valuable board time is being taken up with bureaucratic paperwork and not with strategy and tactics for building shareholder value. You might be feeling under greater threat of being named in a class action suit. You might be finding it harder to fill vacant spots on the board. You might be seeing your decisions second-guessed with the benefit of hindsight rather than being accorded business-judgment deference. You might be wondering whether it is worth your while to put your own hard-won personal reputation on the line for the part-time, non-managerial job that you are undertaking.
As hard as it is to be a director now, it is also an exciting and rewarding time to serve on a corporate board. Because regulations and more robust best practices are changing the way that companies oversee and manage their business, the relative roles of management and the board in many companies are undergoing some adjustment. Many directors have become re-energized by events and regulatory changes of the past several years. You might find that the new tools available to you are rather useful. This is a time in which boards that may not have not been assertive enough in the past can assert themselves. Boards that have been assertive all along can exercise their control with the support of a stronger statutory framework.
At the same time, we have seen recent examples of boards that have become rent by personal quarrels, differences over culture and strategy, and individual actions that do not comport with fiduciary duties to the company and its shareholders. That situation is especially destructive to the company and its shareholders. A director, as representative of the shareholders, is an overseer of management, who are hired agents for the owners - the shareholders. But, directors should also serve as valued advisors to management. We expect you to bring your expertise, reputation, and sound judgment to help management build its strategy and adjust it when the inevitable challenges of the marketplace require reassessment.
In today's environment, it is legitimate, and indeed expected, that directors will be inquisitive, sometimes even painfully so. You can and should ask management those difficult questions without being perceived as undermining them. You can probe more deeply if the answers that you are getting raise more questions, are not fully responsive, or simply don't ring true. You can reject a management recommendation when there appears to be a better approach. Management, for its part, ought not take rigorous questioning personally because they should expect no less. Directors can call the shots.
Although the focus was different, we witnessed a similar phenomenon in the years leading up to Y2K. In the 1990s, we saw technology officers asserting themselves, demanding bigger staffs and larger budgets. They had leverage that was derived from fears of what would happen if their demands were ignored. As the Wall Street Journal explained in the waning days of 1999:
[C]ompanies' Y2K fears gave chief technology officers much more clout --and bigger budgets -- than many had ever had and put them in command of armies of technicians who could finally tackle both the big upgrades and the long-neglected to-do list.2
Does this sound eerily like the current role of the CFO in the wake of Sarbanes-Oxley? In the end, the Y2K issue, whether or not it would have been a problem of the magnitude that some had feared that it would be, caused many companies to undertake technology upgrades that were long overdue. It was the ticking clock and the dire warnings of catastrophe that led to the scope and costs of the technology upgrades arguably to be out of proportion to the actual problem at hand.
Likewise, I think that the Sarbanes-Oxley reforms will result in useful long-term corporate governance changes once we have had a chance to make some refinements to the existing rules. At the top of the list of items in need of modification is the regulatory framework under Sarbanes-Oxley Section 404. As you know, Section 404 requires management to complete an annual internal control report and requires the company's auditor to attest to, and report on, management's assessment. Despite its worthy objectives, implementation of that section has produced many unintended consequences - causing companies in the U.S. and abroad to spend great amounts of money and time.
Section 404 costs are high enough that, unlike many less onerous regulatory burdens on public companies, they even have caught the attention of those of you who are private company directors. What the SEC does to reform the Section 404 process could influence your decisions about whether to remain private and, if you decide to go public, where you will do that. Watching companies like Georgia Pacific being taken private might cause you to ask yourselves whether you should shelve any plans of going public that you might have had. The CEO of one of the companies that chose to go private put it this way: "Sarbanes-Oxley was designed to provide additional corporate transparency and safeguards for the investing public. Instead, it is prompting companies like ours to become less transparent [by going private]."3
You might also be watching recent trends that suggest that more of the companies that are deciding to go public are determining to do so outside the United States. Non-U.S. companies are not choosing U.S. exchanges for their IPOs. An investment banker friend of mine, who happens to be a director of a rather good-sized biotech company, told me that his board decided to go public in Europe, where the company also has plants, rather than the U.S. because they figured that they would save at least $3 million by not being a US registrant. In the third quarter of this year, European exchanges had more IPO activity than the U.S. markets, measured by volume and by value.4 Sarbanes-Oxley Section 404 seems to be tipping the balance for at least some portion of the international IPOs.
The specter of having to bear the costs of Sarbanes-Oxley also has made many prospective public companies in the United States willing audiences for marketing pitches by foreign exchanges. The AIM market in London, for example, is actively promoting itself to American companies who are thinking of going public, but want to avoid the regulatory burdens of being listed on an exchange in the United States. In outreach seminars, AIM seeks to woo technology companies in the Silicon Valley and energy companies in Houston.
A study published by the City of London this past summer found the cost of capital to be higher in the U.S.5 The study concluded that, at least so far, Sarbanes-Oxley, by increasing the costs of listing in the United States, had made London markets more competitive:
The recent US corporate governance reforms as part of SOx … may have improved governance standards in the USA, but there is no evidence to date to suggest that the new regime delivers benefits beyond those that apply under the UK regime. The rise in US compliance costs has therefore increased the competitive position of the London markets.6
In response to the escalation in the costs of raising capital in the United States, some foreign companies that are registered here are asking the Commission to ease its deregistration rules to make it easier for them to leave the U.S. capital markets. The Commission is working on a rule change to facilitate their exit. I favor such a liberalization - we should not trap companies into staying in our markets.
It is much more vital, however, that we address the underlying cause of foreign companies' dissatisfaction. After all, if these companies are contemplating leaving the U.S. because of regulatory burdens, those same regulatory burdens are afflicting American companies. We need to address regulatory overload, not only to keep our capital markets attractive, but to keep our domestic companies competitive.
As an important first step, the Commission has pledged to overhaul Section 404 implementation. Many of the problems associated with Section 404 stem from the audit standard adopted by the Public Company Accounting Oversight Board to govern the auditor's role in opining on an issuer's internal controls. The PCAOB, a creation of Sarbanes-Oxley, is the body that is responsible for overseeing audits of U.S. issuers and the auditors that carry out those audits. It is not a governmental entity - although it might look that way from the nature of the powers it possesses and from the levies that public companies are required to pay to finance its operations. It is subject to the oversight of the SEC.
As those of you who are directors of public companies undoubtedly know after having reviewed your auditor's bill, the PCAOB's audit standard has been costly and burdensome. The standard has made it difficult for auditors to employ professional judgment in assessing internal controls and caused them instead to use a time-intensive, deep-in-the-weeds approach. I hear too many stories of excessive documentation, bottom-up audits, and overly conservative material weakness determinations. The resulting process diminishes the risk of auditors' being second-guessed, but does so by foreclosing their use of reasoned judgment.
The PCAOB is working now to revise the relevant audit standard so that it is shorter, simpler, and allows for more efficient, reasoned application. Our newly-appointed Chief Accountant, Conrad Hewitt, and many others of us at the SEC are working to revise this audit standard. The process by which the SEC can oversee and direct the work of the PCAOB is not without its limitations. This might make it difficult for the SEC to shape the PCAOB's final standard with the degree of precision that I would like. Nevertheless, I am committed, if necessary, to employing all of the SEC's oversight tools to ensure that the standard gets fixed. If we do not take sufficient steps to correct the current situation that we have allowed to develop under our watch, Congress surely will.
Importantly, the SEC is simultaneously working on guidelines of our own for company management. Absent such guidance, companies have not had a clear grounding of what they need to do under Section 404. They have incurred great costs in satisfying seemingly unreasonable demands from auditors who are operating under the constraints of the PCAOB's unwieldy audit standard. This problem was exacerbated by the chilling effect that the PCAOB's auditing standard has had on communications between auditors and their clients outside of the audit process. By providing management with guidance of its own, we hope to restore a healthy balance to the process.
The Commission has already undertaken a number of positive regulatory reform initiatives that will benefit the stockowners whose interests you represent. Just last week, the Commission adopted a clarification to its rules governing tender offers. The clarifications are intended to eliminate uncertainty about whether companies participating in a tender offer have to treat compensation paid to a shareholder for services as part of the price paid for his shares. This uncertainty and the attendant legal risk created a disincentive for the use of tender offers as opposed to other forms of business combinations. The clarifications that we adopted will enable companies to choose the method of acquisition that is best for their shareholders.
This past summer, as you know, the Commission adopted reforms of executive compensation disclosure in response to concerns that investors were not getting an accurate picture of the size and nature of executive pay. A company's stockholders, as its owners, ought to know what boards are deciding to pay executives and why. The last big effort in this area took place in 1992. After fourteen years, it was certainly time for us to take a fresh look at our rules governing the disclosure of executive compensation. The updated disclosure framework that we adopted, with features like a revamped tabular approach and total compensation figure, should lead to better, more understandable disclosure. As I commented when we adopted the rule, I still am not convinced that we have gotten everything right. I am concerned about the expense and complexity associated with preparing the new disclosures, but believe that on the whole shareholders will benefit.
More generally, Chairman Cox has given a lot of attention to the ways in which we can use technology to streamline our regulatory regime. The Commission is thinking about, for example, how it can eliminate redundant collection of information through multiple, overlapping forms by instead enabling companies to submit information one time electronically.
I mentioned earlier that it is a good time to be a corporate director. One of the reasons for my sanguine outlook is that American businesses are prospering. Their prosperity is driving the U.S. economy, which, in the last six months, grew at an annual rate of 4.1 percent. No other major industrialized country is growing so quickly. Corporate profits are increasing. Real wages are rising, and unemployment is falling. The current low unemployment rate - 4.6 percent - is the result of more than three years of job creation. The Dow Jones Industrial Average has broken the 12,000 mark.
The strength of our financial markets is due, in large part, to the tremendous entrepreneurial efforts of companies like the ones on whose boards you serve. Your companies build value for the shareholders whom you represent by developing innovative ways to more effectively meet market demand. This is what the economic growth is all about.
The SEC should do its own part in preserving the vitality of the US economy by working to decrease excessive regulatory burdens and improve transparency for investors. Although historically the SEC's most important mission has been policing the securities markets on behalf of investors for fraud, deception, and manipulation, Congress has also charged us since 1996 with facilitating capital formation and maintaining fair, orderly, and efficient markets. Because of this multifaceted mandate, the SEC must balance the costs of regulations with the anticipated benefits - and rigorously examine whether those benefits can be achieved through the method chosen.
Our mission to maintain the integrity of our markets is based on a rather simple premise: if investors have confidence that they will be treated fairly, they will invest their money. The less risky they perceive the markets to be, the lower the risk premium they will demand. This should yield a lower cost of capital, according to the same principle by which the market does not demand junk bond rates from the US Treasury. But, there also must be a balance. We also must not price those very investors out of our markets through burdensome, one-size-fits-all regulations. The actions of government by nature are coercive. Once a government mandate is in place, investors can't opt out of it - it is they who pay for regulation through lower returns, reduced growth, and diminished investment opportunities.
In all of our regulatory initiatives, we need to work hard to get the balance right. This is not always easy, and, as the experience with Section 404 demonstrates, we do not always get things right on the first try. The tone at the top matters at the SEC as at any other entity. For more than a year now, the SEC has been under the leadership of Chris Cox. I am pleased to report that Chairman Cox strives to balance the need for effective regulation with the need for effective regulatory reform. These two goals can be reconciled, and I am committed to working with him toward that end.
My own overriding philosophy when approaching regulatory policy issues is rooted in a belief in our free market system. Government actions are by nature coercive - rather the opposite of the principle of allowing free people to make independent choices with their own money and property. Government should not judge the merit of products or business models, set prices, or select as between competitors. Government should keep barriers to entry low so that new entrants can test their ideas in the marketplace. Pleas for government solutions come all too frequently and from all too many corners. Government's solutions are of necessity cumbersome and imprecise because of their wide application. Therefore, instead of looking instinctively to government when problems arise, we should look first to the marketplace and those who shape it to develop and implement solutions of their own.
On that note, I would be happy to hear your thoughts on these issues or any others. Feel free to give me a call if issues come up in the future and, if you ever make your way out to Washington … D.C. that is … please know that my door is open. Thank you all for your attention.