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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the American Electronics Association Classic Financial Conference


Commissioner Paul S. Atkins

U.S. Securities and Exchange Commission

Monterey, California
November 7, 2006

Thank you, Tim, for your kind introduction, and thank you for the opportunity to be part of AeA's Classic Financial Conference. I always enjoy speaking at AeA gatherings. These events consistently prove to be more of an opportunity for me to learn than a time for me to try to impart information to all of you. Since AeA member companies are on the cutting edge of the nation's — and indeed the world's — economy, my being here is truly a refreshing break from being in Washington, where we perhaps have more than our share of people who seem to have an innate, deeply ingrained fear of entrepreneurs and their new ideas and approaches. Besides, being here also gets me out of Washington during the madness of election time!

The size and topics of your conference also are a reminder of what lies beneath the recent economic growth statistics. Economic figures released just last week showed unemployment at a five-year low of 4.4 percent, real wages up by 2.4 percent as compared to a year ago, and the economy growing at a rate of 2.9%. Those statistics are a product of the hard work of companies like yours and, in the case of those of you who are investors, your willingness to commit capital. Before I begin on the substance of my talk, my ethics folks want me to remind you that the views I express here are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.

Since it is election day at the end of a rough-and-tumble midterm election campaign season, I would like to discuss a subject about which there is bipartisan agreement. Regardless of party affiliation, people have pretty similar things to say about this subject. Vice President Dick Cheney thinks that a case can be made that it "went too far."1 Bipartisan bills have been introduced in Congress to make changes. Representative Nancy Pelosi complained of its "unintended consequences" and calls for revisiting it.2 And, in a jointly authored opinion piece in last week's Wall Street Journal, Senator Chuck Schumer and New York City Mayor Michael Bloomberg called for a "re-examin[ation]" of it.3 So what is it? Well, Sarbanes-Oxley, of course.

The widespread sentiment in favor of taking another look at Sarbanes-Oxley centers around Section 404 of the Act. As you all know, that section requires management to complete an annual internal control report and requires the company's auditor to attest to, and report on, management's assessment. The statutory language, which is a mere twenty lines long, is not the problem. The problem is the way in which that statutory mandate is being implemented.

The SEC and the Public Company Accounting Oversight Board, or PCAOB, share the responsibility for creating the regulatory framework to implement Section 404. The SEC adopted implementing rules in June 2003. The auditor's attestation is governed by the PCAOB's implementing standard, Audit Standard Number 2, or AS 2, which the SEC approved a year after we adopted our management guidance.

Armed with this regulatory guidance, companies and auditors set to work on implementing it. When we at the SEC adopted our rule on section 404, we optimistically estimated that companies would spend an average of $91,000 a year on compliance with the new mandate.4 As you know all too well, actual costs quickly surpassed our estimates; they continued to balloon to perhaps twenty times what we had anticipated they would be. They reached a level that is frankly not justifiable when weighed against the benefits.

Mind you, the SEC's rule was about 17 pages in the Federal Register and was basically principles-based: the process that we envisioned a company to undertake was top-down, enterprise-focused. We talked about a company's taking a reasonable approach, with reasonable detail, with the goal of reasonable assurance. We recognized that internal controls are an integral part of a good audit of the financial statements. So, what happened?

In short, AS 2. This 300-page rule, excluding the hundreds of pages of interpretative add-ons, turned out to be a flawed approach — the wrong medicine at the wrong time. AS 2 was much more detailed and prescriptive than the guidance that the SEC provided to management. In tone and substance it lacked a sense of materiality as an operating concept, did not sufficiently integrate the 404 process with the financial statement audit, minimized the accountants' exercise of professional judgment, restricted their ability to rely on work that management had done on internal controls, drove them to detailed levels of testing, and limited their communication with management on technical matters. Basically, it drove accountants, who are famously risk-averse anyway, to attempt to ward off liability with unprecedented levels of mechanistic processes and testing. It is hard to blame them in light of Arthur Anderson, PCAOB investigations, and class-action lawsuits. An added bonus for the auditor: he bills for the extra work.

AS 2 has also inflicted severe collateral consequences on issuers. Although it was intended as auditor guidance, it has dominated the internal control work of both management and their auditors. As a result, auditors — and 404 consultants who are trying to anticipate what auditors want to see — have used it to prescribe management's internal control efforts.

Last year, many had predicted that almost half of the costs incurred to comply with Section 404 were first-time start-up costs that would not be repeated in year two. A study that was sponsored by the Big 4 Accounting Firms in spring 2006 found that total 404 costs did decline in year two, by approximately thirty percent for small companies, and more than forty percent for large companies.5 But, is it a coincidence that at the same time total audit fees (including 404 fees) declined by only four percent for small companies and increased slightly from year one fees for large companies?6 Of course, it also seems likely that the benefits would be substantially smaller in year two, since the first year's one-time benefits of a long-overdue, in-depth review of internal controls by definition cannot be repeated in year two. At a minimum, we must still ask the question whether the benefits are worth the costs.

One problem with the implementation of Section 404 has been auditors' inability under the current framework to rely on work done by the company. The experience of one frustrated AeA member company is probably typical. That company, a small company, compiled 23 testing binders in connection with its 2005 internal testing. Nevertheless, its auditors did not rely on the company's internal testing and re-performed internal control testing for all of our processes regardless of associated risk.

When we approved the PCAOB's AS 2, the Commission noted that one commenter suggested that the PCAOB "closely monitor the impact of the proposed standard on small and medium-sized companies."7 As this commenter anticipated, Section 404 has imposed disproportionate costs on small companies. In a report issued last year, the AeA found that Section 404 costs can eat up nearly three percent of revenue for small companies, in contrast to .about 05 percent for the largest companies.8

Perhaps some of the most damaging costs associated with Section 404 are the intangible costs. I have heard stories of Section 404 costs elbowing out other expenditures in revenue-producing areas such as research, testing of new products, new employees, or equipment. Documentation requirements under Section 404 serve as a disincentive for companies to update systems. Small internal accounting and finance staffs are feeling the strain of a tremendously increased workload. Internal accounting departments, driven by concerns about compliance with Section 404, are less able to accommodate the inevitable and constant changes that characterize growing companies. Any change in the way things are done becomes cumbersome.

Recently, I visited a small biotechnology company that has the unfortunate distinction of paying more to its outside auditors and consultants to audit its financial statements and internal controls and help it implement 404 than it pays its CFO and all the people reporting to the CFO. That is, it is paying more to audit its financials than it does to put them together! This for a company that has no operating revenues and is busy trying to do more research and development while it waits for FDA approval for its drugs in the pipeline. Every dollar spent on excessive regulatory costs is a dollar less that the company could spend on building future value for the stockholders. The dollars there are literally coming out of the investors' pockets.

That does not mean that internal controls and other organizational costs are not important. They are; but, there must be a balance. Almost everyone with whom I have talked appreciates the benefit of strengthening internal controls, but people are frustrated by the wasted time and money that characterize implementation under the current regulatory framework.

The costs incurred by companies under Section 404 seem to be significant enough to have macro-economic effects. Companies are thinking about Section 404 as they make major decisions, such as whether and where to conduct an IPO. The Alternate Investment Market (or "AIM") in London is actively promoting itself to American companies that are thinking of going public, but want to avoid the regulatory burdens of being listed on an exchange in the United States. 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 both number of IPOs and their value.9

Is Sarbanes-Oxley Section 404 tipping the balance for at least some portion of international IPOs? A study published by the City of London this past summer found that the cost of capital is higher in the U.S.10 The study concluded that, at least so far, Sarbanes-Oxley, by increasing the costs of listing in the United States, has 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.11

Some companies that are public are rethinking their status. An AeA member company, for example, explained to me that its "shareholders have expressed concern about the future profitability of the company and the reasonableness of it being a standalone enterprise with this SOX 404 cost structure being imposed." The CEO of a company that chose to go private explained the irony of this unintended consequence of Section 404: "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]."12

Other companies that are not yet public might delay that step in their development. I have heard that a well-known venture capital firm recently shut down its newest fund and returned the money to investors because, among other things, the managers did not think that the IPO market could provide an attractive exit strategy for the fund's investments. Since the investment horizons of venture capitalists tend to be long, that is a troubling sign.

AeA has been an active participant in this debate, and I give AeA credit for not always sugar-coating its views. At our Section 404 Roundtable last May, Alex Davern, chairman of the AeA's Committee on Reform of Sarbanes-Oxley 404, gave his unvarnished perspective "that the Commission deserves a failing grade, frankly, for the implementation of Section 404."13 My objective over the next six months or so is to turn that failing grade into a passing grade — perhaps even an "A". I believe that my fellow commissioners and the Board members at the PCAOB share this objective. If we do not take sufficient steps to correct the current situation that we have allowed to develop under our watch, Congress surely will.

Just as the SEC and PCAOB shared responsibility for the initial implementation of Section 404, we share the responsibility for fixing the problems. True change, however, cannot be achieved absent a total overhaul of, or more accurately replacement of, the existing regulatory framework for Section 404. As Stanford Professor Joe Grundfest explained, "The various policy statements and exhortations by the Commission and PCAOB … are insufficient as long as the rules themselves are so hard wired with definitions that can easily be used to rationalize processes that test the fringe of remoteness and inconsequentiality."14

To that end, the SEC issued a concept release in July to solicit ideas about how to reshape management's evaluation and assessment of internal control over financial reporting. We are determined to address the situation that allowed AS 2 to be, in effect, the operable standard for management. We heard from more than 150 commenters in response to our concept release. We are reviewing those comments now.

The PCAOB meanwhile is working on new guidance for auditors. We have appointed a new chairman at the PCAOB, and of course we have a new chairman, chief accountant, general counsel, and head of our corporation finance division at the SEC. The atmosphere is completely different from that of two years ago. I am very hopeful that this change of attitude will allow us to work more closely with the PCAOB to shape its final standard. I am committed, if necessary, to employing all of the SEC's somewhat awkward oversight tools to ensure that the standard gets fixed.

I am optimistic that we will be successful. If we are, then I believe that Section 404 will prove itself to be one of the most important Sarbanes-Oxley reforms. Once its implementation is more rational, we will be able wholeheartedly to applaud Section 404 for improving the integrity of financial information and providing shareholders with additional insight into the credibility of financial statements.

Of course, the success of our attempts to improve the implementation of Sarbanes-Oxley Section 404 is not entirely within the control of the SEC and PCAOB. The litigiousness of our nation drives the behavior of auditors and companies. Litigation costs are particularly problematic because of their arbitrariness and difficulty of predictability. A recent study found that tort costs in the United States totaled $260 billion, or 2.2 percent of the country's gross domestic product in 2004.15 2006 may be a remarkably slow year for securities class action suits; only 61 cases had been filed by the end of July, which is lower than any six month period since 1996.16 Even if this rate continues throughout the rest of the year, 1.8 percent of listed companies will be defendants in securities class actions filed in 2006.17 The costs of settlement are high. In 2005, the average cost of a private securities class action was $71.1 million, not including the Enron and WorldCom settlements, which would have pushed this number even higher.18 One of the factors underlying that increase was the inclusion of auditors and other third parties among the defendants.19

Speaking of litigation, I am sure you will not let me leave without a word on the current situation regarding stock options.

In the United States, broad-based stock options have been the catalyst for corporate success since they were pioneered by venture capitalists over four decades ago. Their theory was that stock option grants to employees, not just to executives, would result in a new owner class of employees who would be given an incentive to maximize the value of the company's stock. This theory proved correct, and employee stock options have been one of the main reasons that innovative corporations have flourished.

In the wake of the FASB's decision to adopt FAS 123R, which requires expensing of stock options, we are working actively on market-based alternatives to a uniform application of the Black-Scholes pricing model. The overwhelming view of economists these days is against Black-Scholes — current thinking seems to prefer the lattice or Monte-Carlo type of modeling. Of course, all of these economic models have flaws — they are theoretical valuations as compared to what these instruments would be valued by market participants in arm's length deals.

I would be remiss in not mentioning the recent slew of stories, and actions by the SEC and Department of Justice, regarding alleged transgressions in the granting of stock options. Indeed, some of the reported facts are grim — stories of executives and directors conspiring to manipulate stock option prices for their own gain, or purposefully "backdating" options grants, in contravention of the company's public disclosure, to avoid recognizing compensation expenses. Falsifying documents to backdate option grants is illegal. The SEC will vigorously pursue cases in which there has been clear-cut, intentional doctoring of documents. Attempts to evade legal obligations through intentional alteration of documents or deliberate flouting of internal controls cannot be tolerated, because they can constitute fraud; they violate tax laws; and they strike at the core of our system of corporate governance and disclosure.

But it is worth taking a step back before we plunge headlong into wholesale condemnation of all options practices. We need to distinguish scenarios that are black-and-white fraud from legitimate practices that are being attacked with attenuated theories of liability. The SEC enforcement staff has stated that they are taking all measures to differentiate between these types of illegal activities and dating issues arising from ministerial, logistical delays. Likewise, our Office of Chief Accountant has released guidance to help avoid the "lumping together" of the innocuous with the nefarious, and is working with accounting firms to ensure that this does not occur.20 I hope that this can avoid a mass stampede of restatements because of misplaced, excessive zeal.

Unfortunately, some commentators, some of whom are even economists and should know better, have failed to appreciate the nuances of this issue. They throw perspective out the window in a dubious attempt to politicize the issue. I am happy to say, even on this election day that, to date, this has not worked. The SEC and its staff will continue its efforts to provide perspective and rationality. Moreover, the recent focus on options should not obscure the fundamental principle that companies' disclosure should not drive the business decisions that boards make, but should provide stockholders with an accurate picture of why and how those decisions are made.

Thank you all for your attention. As I mentioned when I started, I learn a great deal from hearing your experiences, questions, and concerns. Please know that my door is always open and I look forward to your input.



Modified: 11/22/2006