Speech by SEC Commissioner:
Remarks Before PLI's 38th Annual Institute on Securities Regulation
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
New York, New York
November 9, 2006
Thank you so much for inviting me to speak today at PLI's 38th Annual Institute on Securities Regulation. I would especially like to thank Mary Jo White, Curtis Mo, and David Harms for their work in putting together this important conference. I could not help noticing that the first day of this conference highlights some of the Commission's more recent rulemakings. I thought I'd take this opportunity to explore the Commission's recent and upcoming rulemakings and how they fit into the broader mission of the Commission. However, before I get started, let me remind you that my remarks represent my own views and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.1
A number of the Commission's recently adopted or proposed rules illustrate how enhanced issuer disclosure fulfills the Commission's mission to protect investors. The Commission is arming investors with more relevant, digestible information because clear and accurate disclosure of material information is essential to effective market functioning and investor protection. And I believe these rulemakings are based on clearly articulated principles. Simply put, principles provide the foundation for useful guidance and disclosure rules that can withstand the test of time as an issuer's conditions and circumstances change.
A case in point is the Commission's new rule regarding disclosure of executive compensation. I assume many of you are likely preparing to comply with that new rule for the first time. While the tabular format prescribes specific disclosure requirements, the new Compensation Discussion and Analysis narrative will put that information into context by explaining objectives, policies, and decisions that were made. The new rule also requires disclosure of related-party transactions, director compensation, security ownership by management and directors, and information about the compensation committee and other corporate governance matters.
The rule exemplifies the Commission's regulatory focus on clear and targeted investor disclosure. The principles at work are clearly enunciated in the text of the rule's adopting release, which states that "[t]he amendments are intended to make proxy and information statements, reports and registration statements easier to understand. They are also intended to provide investors with a clearer and more complete picture of the compensation earned by a company's principal executive officer, principal financial officer, and highest paid executive officers and members of its board of directors." This statement demonstrates the significance of the principle underlying the release.
The executive compensation rule aims to provide a clear and complete picture of compensation through enhanced, meaningful disclosure. The rule does not seek to set or change compensation - it only requires disclosure of compensation. While examples of disclosure scenarios are available, the rule recognizes the limitations of those examples because they cannot anticipate changes in facts and circumstances. Since rules can take us only so far by giving particular examples of the exact information that must be disclosed, those rules by necessity rely on the underlying principles.
The Commission has regulated the disclosure of executive compensation in some form since 1938. Tabular disclosures were first introduced in 1942, and then refined or expanded in 1952 and 1978, to keep pace with shifts in compensation and try to present compensation information in the manner most useful to investors. Our 1992 approach to tabular disclosure was the most inclusive, but did not adequately provide a plain-English narrative. As a result, our recent rulemaking required supplementary narrative disclosure about objectives, policies, specific types of compensation, independence, and related-party transactions. The additional disclosure also reflects a shift in investor focus. Namely, investors are increasingly focused on the issue of director independence, including possible conflicts of interest that could be indicated by related-party transactions, and the corporate governance policies designed to address such conflicts. We believe that this information is material to investors and commenters supported its inclusion in the release.
I'd like to believe that this rule will withstand the test of time. While it calls for more specific types of disclosure, it is also intended to be flexible enough to pick up new forms of compensation as they develop. The rule recognizes the futility of trying to predict every kind of compensation or incentive likely to emerge in the next fifteen years. Therefore, it clearly requires disclosure of all forms of compensation, even those that do not yet exist in 2006.
I acknowledge the hard work that is required to implement these new rules, especially in the first year. As with many of our rulemakings, it is incumbent on us to understand the burdens of compliance and to assess whether we have achieved our regulatory goals in the most cost-effective manner. Anecdotally, several general counsels of issuers have complained to me about the burdens of implementing these new rules, with particular emphasis on the conflict of interest assessments and, of course, on the information gathering required to create the new tables. I have no doubt this is posing new challenges in an already highly regulatory environment. It is my hope that once these processes are put in place this year, compliance in future years will be substantially easier. As always, we value your ongoing input during and after the implementation period.
I'd like to turn next to Section 404 of the Sarbanes-Oxley Act and the Commission's efforts to address the very significant problems experienced with the implementation of that Section. I may be one of the few commentators willing to state that there was great value in the Sarbanes-Oxley Act. But I am totally in agreement with those who have very few positive things to say about the implementation of Section 404. I emphasize that I am speaking of the implementation and not Section 404 itself. But somewhere along the line - whether it was in AS 2, overzealous auditors, or a combination of those and other issues - the early years of 404 compliance were a significant problem. I believe help is on the way, and not a moment too soon.
In recognition of the need for additional guidance on management's Section 404 assessment of internal controls over financial reporting, the Commission issued a concept release in July, asking for comment on assessing risks, identifying controls, evaluating effectiveness of internal controls, and documenting the basis for the assessment. The comment period ended in September, and the Commission is now closely considering the comments from over a hundred and fifty individuals and entities and is scheduled to consider the proposed guidance in December. I expect that the resulting proposal will be principles-based and flexible. We recognize that many issuers already have invested substantial resources into compliance with Section 404, so the guidance should recognize past efforts. This new proposed guidance will not suggest the dismantling of established procedures for documentation and evaluation, nor will it dictate how to perform the assessment of internal controls. Instead, I expect the guidance will outline general principles to be followed in completing the assessment and should aid issuers which are trying to determine how to comply with Section 404 in the most cost-effective manner. I urge all of you to send us your comments after the proposed guidance is released. Receiving feedback is an important part of the Commission's consideration of proposed guidance or rules.
The need for more guidance on how to cost-effectively implement Section 404 is especially acute in the case of certain issuers, including smaller public companies. Therefore, the Commission has taken the initiative to extend deadlines for certain issuers. For foreign private issuers that are accelerated filers, we extended the deadline to provide an auditor's attestation report (but not management's assessment) until fiscal years ending on or after July 15, 2007. For non-accelerated filers, both foreign and domestic, we proposed in August to extend deadlines for their provision of management's assessment and the auditor attestation under Section 404. The extensions contemplate future guidance from the Commission, and demonstrate the Commission's response to comments from smaller issuers concerning their potentially disproportionate difficulties and burdens in complying with Section 404.
The upcoming proposed guidance to management will be accompanied by the PCAOB's anticipated amendments to its Auditing Standard No. 2. These amendments are intended to reduce or eliminate the prescriptive nature of the existing standard and instead focus auditors on areas that pose a higher risk of fraud or material error, allowing them to make their audits of internal controls more efficient and cost-effective. Providing more clarity of purpose to the audits instead of giving auditors a checklist should underscore the principles of requiring an auditor attestation under Section 404. That purpose is to disclose to investors whether internal controls are in fact designed to ensure reliable financial reporting.
In addition to these rulemakings which focus on disclosure, there is also an ongoing focus at the Commission on the manner and method in which the disclosure is provided. Within the last year, the Commission proposed the electronic delivery of proxies, which the Commission will consider adopting as final rule amendments to its proxy rules in December. The amendments would permit a "notice and access" method of delivery, in which a company could mail a paper notice to shareholders directing them to an electronic Web site on which the company had posted its proxy materials. The mailing also would provide the shareholder with a toll-free telephone number and an e-mail address to contact if the shareholder wishes to receive the proxy materials in paper form. If the shareholder requested a paper copy, the company would be obligated to mail it promptly. Otherwise, the company's provision of proxy materials on a Web site would be sufficient. In essence, the rule amendments would allow companies to shift their default delivery method from paper to the internet, potentially saving the company, and by extension shareholders, significant printing and mailing costs. In addition to the cost-savings, I am hopeful that the use of the internet will enhance the disclosure provided by making it more user-friendly. For example, companies can use hyperlinks to provide quick access to related documents and materials. Shareholders also would benefit because electronic information is more easily searched, allowing shareholders to locate the information that is of the greatest interest to them and possibly track and compare components of the proxy information across companies. The rule amendments may even lead more shareholders to vote online after reviewing the electronic proxy materials. More online voting could generate greater shareholder participation in corporate governance at the companies they own.
The Commission also has made progress in its XBRL initiative, or eXtensible Business Reporting Language. Reports in XBRL will allow investors to easily use software to make apple to apple comparisons of companies. For example, the value of the disclosure required by the executive compensation rule will be magnified through the use of XBRL because specific compensation information can be placed in a larger context by shareholders. Already, some of the largest issuers are submitting reports in XBRL, such as 3M, ADP, Bristol-Myers Squibb, Ford, GE, Microsoft, PepsiCo, and Xerox, just to name a few. If you have not seen a demonstration of XBRL, I recommend that you stay for Director John White's panel on technology this afternoon. But if you miss it, you can visit the SEC's Web site to view the webcast of the recent presentation at the interactive data roundtable last month.
With enhanced disclosure and accessibility to information, shareholders likewise have increased their expectations regarding corporate governance policy and procedures. Shareholders not only expect more disclosure, but also expect to be more involved in board elections, and demand more board accountability. In response to shareholders' requests for more information, a number of companies have begun to voluntarily disclose corporate governance policies in proxy statements.
Shareholder involvement may be heightened soon, too. Two weeks ago, the New York Stock Exchange filed a proposal with the SEC to amend its Rule 452 and eliminate broker discretionary voting in uncontested elections of directors. This means that instead of brokers casting votes on behalf of shareholders in uncontested board elections where the beneficial owner of the stock has not provided specific voting instructions, those votes could be cast by the shareholders themselves. The Commission will be interested in comments on the proposal, particularly from smaller issuers and closed-end mutual funds which may have concerns about meeting quorum requirements. If the proposal is approved, it would apply to shareholder meetings held on or after January 1, 2008.
In addition, as you know, shareholders have campaigned for the adoption of majority voting in which a director in an uncontested election would only be elected if he received more "for" votes than "withhold" votes. Over one hundred corporations have adopted some form of majority voting in the past year, including companies such as General Motors, WalMart, Intel, and BestBuy.
Corporations also are trending toward increased board independence and accountability. Some companies are requiring that their Chairman of the Board and Chief Executive Officer positions be held by two different individuals, and some also require that the Chairman be an independent director. Some companies have eliminated staggered boards, allowing the entire slate of board members to come up for election annually. If anything, this past proxy season showed the high interest that shareholders have in the quality of companies' boards of directors. Among the proposals from shareholders were requests to limit the number of boards on which a director may sit and impose mandatory retirement ages for directors.
The Commission will have its own opportunity to address the movement toward increased shareholder involvement and board accountability when it considers a proposal at an open meeting of the Commission in December. For the fifth time since 1942, we will consider allowing shareholders to have access to corporate proxy ballots. The proposed proxy access rule would set out principles under which shareholders' nominees could be placed on those proxies.
As the Commission begins to consider the proposal next month, it is noteworthy that we will not be addressing the proposed rule in an ad hoc manner. Rather, one of the advantages of our ambitious schedule in December is that it will allow us to view all of the various rules and proposals as part of a holistic approach. How do each of the proposals and final rules fit into the Commission's overall mission? Each of the issues - Section 404 guidance, amendments to AS 2, e-proxy, and proxy access - are guided by the Commission's cornerstone. It is the Commission's mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
Consideration of the proxy access issue will permit us to carefully balance the protection of investors with the need to foster the competition and entrepreneurial spirit for which American business is known. Emotions are intense on both sides of the issue - both for and against proxy access. And both sides have valid and well-researched arguments. I hope that we can address the issue in a way that balances the competing views and interests.
The Commission is carefully considering whether and how to provide an avenue for investors to more easily effect change in board composition through proxy access. We will need to consider whether that access can be granted without harming investors more than it helps them. While I cannot do justice to the complexity of the issues surrounding proxy access during this twenty minute speech, I would like to highlight some of those issues. The Commission's previous consideration of the proxy access issue in 2003 prompted the submission of about 13,000 comment letters. The proponents of the rule seemed to focus on the principle that allowing proxy access would promote accountability in a way that the current avenue for nominating directors did not. The proponents of the rule believed that increased accountability would have a positive effect on corporate governance by promoting better communication between company boards and shareholders, encouraging adoption of best practice corporate governance structures, and making boards more likely to respond to shareholder suggestions of the type expressed through current Rule 14a-8 proposals. Proponents also felt that the accountability could limit conflicts of interest and enhance the quality of the nominating process.
The opponents of the rule cited stability, the ability to attract qualified candidates, and use of resources as the principles that would be sacrificed if proxy access were accommodated. I recognize these valid concerns and believe that they should be addressed. We might be able to address fears of instability, losing qualified candidates, and spending valuable company resources through proper controls and safeguards on shareholder access. It is incumbent upon all of us to think about proxy access in terms of the principles at issue - the need to balance board accountability and sound corporate governance with the interests that all shareholders have in a healthy, profitable corporation.
A number of opponents to the 2003 proposal requested that the Commission hold off on finalizing proxy rules to permit issuers the time to adjust to the then-recent rules put in place under the Sarbanes-Oxley Act. My own view is that corporations have now lived with Sarbanes-Oxley for four years. As I previously noted, many corporations already have begun responding to the trend toward increased board accountability. Perhaps now is the time to address proxy access, while keeping in mind Congress's original intent when it enacted Section 14(a) of the Exchange Act. Congress intended Section 14(a) to address the important right of fair corporate suffrage. By controlling the conditions under which proxies may be solicited, Congress intended to prevent abuses that frustrated the voting rights of shareholders. Proper proxy access could further the intent of Congress by facilitating shareholders' ability to vote in the most fully informed and meaningful manner.
I believe that both proponents and opponents of the 2003 proposal for proxy access realized that avenues toward sound corporate governance are in everyone's best interest. It is my hope that we can build on the suggestions and comments from the 2003 proposal, raising the level of dialogue to one of practicality and purpose, designed to address the issue in a principled way.
For the next three days, you'll hear from some of the foremost experts on the SEC's disclosure requirements and their underlying principles. I hope that you'll also keep those principles in mind when you consider the issues coming up in December. I encourage you to stay tuned over the next month and submit comments to the Commission after we consider management guidance under Section 404, amendments to AS 2, e-proxy, and the proxy access rule proposal.