Speech by SEC Commissioner:
Remarks Before the Consumer Federation of America Financial Services Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
December 1, 2006
Good morning. I'd like to thank Barbara Roper for her invitation to join you here. I've had a chance to talk frequently with Barbara in my job as an SEC Commissioner, and I know that she is a tireless advocate for investors and consumers throughout the United States. In fact, she is working on a study of the capital markets that has excellent research and insights. I will be borrowing from her draft of that study in today's speech. Barbara, once again, thank you using your materials and research is the greatest form of flattery. Before I begin, I must remind all of you that the comments I make today are my own and do not reflect the opinions of the Commission, its staff, or the other Commissioners.
Let me turn to the topic of my talk today. I'll begin by discussing global competitiveness specifically, I'll talk about U.S. regulation and I'll try to address the arguments that somehow the Sarbanes-Oxley Act of 2002 (SOX) is responsible for the decline in the global competitiveness of U.S. markets. Central to that debate is the role of Section 404 of SOX, so I'll also mention briefly what is happening in that regard. Of course, time permitting, I'd be happy to answer your questions on any topic you see fit.
Before I really begin, let me warm you up with a quick story about accountants and lawyers two professions very much at the heart of the SOX Section 404:
A man invites his lawyer and accountant into his office. "Gentlemen," he says, "I have a simple question. How much is two plus two?" The accountant clears his throat and says that he thinks it's probably three or four, but he can't be sure without a full audit. [Needing a full audit reminds me of the problem of auditors over-auditing internal controls under SOX 404.] The lawyer says to the accountant, "Excuse us, please." The accountant leaves. The lawyer goes to the door, opens it, looks both ways up and down the hall, closes it carefully, and sits back down. Leaning across the desk, he whispers conspiratorially, "How much would you like it to be?"
The Sarbanes-Oxley Act of 2002 and the U.S. Capital Markets
With that said, let me turn to the serious portion of my speech. First, I'd like to spend some time knocking down some myths about the supposed decline in the global competitiveness of the United States capital markets. This is an important issue, and one well worth debating. Technology, innovation, and economic growth around the globe have eliminated the boundaries that once guided the protectionist approach to regulation. Protecting the U.S. marketplace and investors requires coordination and cooperation on a worldwide basis. Regulators such as the SEC must recognize the ever increasing globalization of the capital markets in order to be effective and not hinder the natural tendencies of the marketplace. I have no issue with those in this country who assert that U.S. regulators must been keenly aware of the effects of regulation on the American economy, particularly as it relates to our ability to remain competitive globally. I do have an issue, however, with ideological challenges to regulation based primarily upon anecdotal data and on conclusions not firmly supported by the facts. In particular, I'm referring to the broadside attacks on the Sarbanes-Oxley Act of 2002, and the allegations that SOX particularly Section 404 is somehow responsible for a decline in U.S. global competitiveness.
So, let me start there. In the last year or so, there has been a steady drumbeat of attack on the state of regulation in the United States. Much of this criticism has focused on whether SOX should be scaled back so that the U.S. capital markets can regain their purported lost competitive advantage. Critics assert that the costs of complying with regulation in particular, the cost of complying with Section 404 of SOX outweigh the benefits of using the U.S. markets to obtain capital. A primary justification for this conclusion is that Section 404 has allegedly caused the U.S. share of IPOs to decline significantly since the SOX's passage in 2002. My answer to this argument is simple: I do not believe that the facts support the conclusion that the overall regulatory system in America SOX in particular, or Section 404 by itself is responsible for the alleged decline in American competitiveness. While the implementation of Section 404 has not been without its issues, the underlying principles are sound, and the SEC and the PCAOB have been working to get the standards and the guidance correct.
I'll first turn to the broad attack on U.S. regulation and its alleged effect on global competitiveness. I believe that assigning the blame to the U.S. regulatory system for the decline in IPOs on U.S. exchanges is not justified by the facts or, at a minimum, is a gross oversimplification of what is happening in the real world. Recently, Senator Chris Dodd made a similar point, stating that he is "not quite as convinced as others are that there is as big a problem associated with Sarbanes-Oxley as some have suggested." Moreover, recent studies and events have confirmed that SOX, directly and indirectly, has a significant beneficial effect on our competitiveness in the capital markets in a variety of ways.
In my role as the designated representative of the SEC in the international community and through my study of international matters, I have become convinced that the U.S. regulatory system is, in fact, a "competitive advantage" for our markets. As I will discuss more fully, consider that capital demands protection. Nowhere in the world is capital better protected than in the United States. I am told every day by major foreign investors, such as Hermes and the Norges Bank, that they invest billions of dollars in the U.S. because they love Sarbanes-Oxley and Section 404. By the way, these foreign investors are also advocates for better governance for U.S. companies. It is a truism that, if capital is attracted to the U.S., I can assure you listings and issuers will be close behind.
As to the benefits of SOX, there have been many recent surveys of the costs of U.S. regulation. The available data indicates that savings in the cost of capital for companies cross-listed on the U.S. are several times greater than the costs of complying with U.S. regulations. Why is this?
In a nutshell, capital prefers protection. The U.S. regulatory regime, including SOX, provides a heightened measure of confidence previously lacking in the wake of Enron, Adelphia, WorldCom, and the numerous other scandals of the late 1990s. As time passes, people tend to forget the outrage that such scandals produced, but these scandals involved more than bad conduct. These frauds revealed material weaknesses in the way the companies were operated and regulated, as well as firm cultures that justified and legitimized the conduct. So while it is natural for the public to forget the outrage of the scandals, we should not forget the structural matters that SOX addressed and implemented independent audit committees, better auditor independence, two-day reporting of option and stock grants to executives, enhanced public disclosures. The list goes on.
Indeed, because of the structural protections available to shareholders of U.S. companies, investors have a greater degree of confidence in U.S. companies. Research has shown that non-U.S. companies that cross-list in the U.S. enjoy a significantly lower cost of capital indeed the lowest in the world. Of course, I would be remiss if I failed to mention that a report released this week by the Committee on Capital Markets Regulation comes to a different conclusion that while there is still a significant listing premium, this premium has declined in recent years. One of the primary authors of the report, however, notes that there is still an overall cross-listing premium averaging 30% which is higher than other markets in the world. Given the increased global competition, I think the U.S. premium for cross listing here is a huge competitive advantage. We should not ever be guilty of "throwing out the baby with the bath water" our regulatory system attracts huge amounts of capital and should not be lightly trampled with.
Now, I certainly don't want to dismiss the findings of this report out of hand, and they need to be analyzed closely. I should also point out that the SEC and the PCAOB are endeavoring to modify Section 404 of SOX, which is one of the recommendations of the report. Even Treasury Secretary Paulson has urged against overreacting, noting that there is no "single principle embedded in Sarbanes-Oxley that is ill-founded," and preferring instead that the Commission work to implement Section 404 "in a more efficient and cost effective manner." That's just what we're trying to do.
In any event, I agree that we shouldn't simply ignore the numbers about the IPO market. According to one study, the U.S. accounted for over 35% of worldwide IPOs in 1999, but only about 15% in 2005. So, what's happening here? The answer to that question leads me to my point about oversimplification. While it is undoubtedly true that the U.S. share of global IPOs has declined in recent years, it is a stretch to blame this entirely (or even primarily) on SOX or on Section 404. We are all familiar with the numbers game as Mark Twain said so aptly, there are "lies, damn lies, and statistics."
- For example, the U.S. share of IPOs declined dramatically from 1996 (60%) to 2001 (8%) the year prior to the passage of Sarbanes-Oxley but then it increased to about 15% in 2005. Should SOX be blamed for what happened before it was ever adopted and implemented?
- Further, a percentage of the IPOs listing abroad are secondary listings where the company has already listed in the U.S. As companies expand internationally, it may make more sense for them to offer their stock in foreign markets as well as in the U.S.
- In addition, I don't think we can discount the dramatic drop in the absolute number of IPOs in the United States due to the tech market implosion given the massive decline in real numbers of IPOs here in the U.S., it's inevitable that the percentage would decrease as well.
- Another example of the numbers game: While many have trumpeted the numbers of foreign delistings last year as evidence of a decline in the competitiveness of the U.S. capital markets, 15 of the 26 foreign delistings last year appear to have been from merger and acquisition activity hardly a sign that foreign issuers are fleeing U.S. shores.
- The data for 2006 does not support the argument that foreign company IPOs are not occurring in the U.S. In fact the number of foreign company IPOs in the U.S. is the highest in years. The absolute amount of capital raised through foreign IPOs in the U.S. in 2006 is also at a record pace, reaching $5.8 billion in the first eight months its highest level since 2000, according to the Wall Street Journal. Perhaps foreign companies are not so frightened by SOX after all.
So, the bottom line here is that while the U.S. share of global IPOs has decreased in recent years, I don't think even the numerical data shows that this was due to SOX. If this were a court case, it would be appropriate to state that those who argue that U.S. markets are losing competitiveness because of SOX or overall U.S regulation have "failed to carry their burden of proof."
Thus, I think we must face the fact that there are other factors responsible for the shift in the global environment simply counting the number of IPOs fails to acknowledge a complicated issue. In fact, recent commentators have presented a number of alternative reasons for the change in the IPO environment. For example:
- The cost of underwriting in the U.S. is significantly higher than it is in the UK, Germany, and elsewhere. Here we have the irony that U.S. investment bankers Goldman and others, for example, have offices in all of the major financial centers around the world and are essentially in many cases competing against their New York office. Still the fee for underwriting in New York is higher than in other financial centers, including London.
- A frequently cited factor is the litigious environment in the U.S. Still many lawsuits filed in the U.S. occurred during the dot.com boom, when the U.S. correspondingly had some of the highest numbers of foreign IPOs. So perhaps the perception of how "hot" the U.S. markets are is a more significant factor in IPOs than either litigation or regulation. Of course, this factor is outside of the SEC's bailiwick.
- Further, the success of the single currency Euro has eliminated a former obstacle to trading foreign currency risk exposure helping to concentrate liquidity. So, the need to seek capital abroad is reduced. In addition, as more companies conduct business on a global basis, they aid the maturation and liquidity of the foreign exchanges. This development in turn stimulates investor confidence in foreign markets.
- Further, the privatization of state-owned businesses through IPOs in those countries likely also has been a reason for the U.S. percentage decline, particularly in the Asia Pacific countries, which have seen a spate of home-country listings of noteworthy size. Instead of simply blaming these listings to SOX, I think the more natural conclusion is that these companies were not going to list anywhere but in their home country. Several of the large recent Chinese listings, for example, are issuers in which the Chinese government holds a large stake, both financially and in the control and governance of the company. The Chinese government has publicly stated that they are interested in building up their national stock markets. Nationalism therefore likely plays in the decision of listing locale.
- One must also look at the type of listings that are being counted to support the cry of competitive disadvantage. One segment of so-called "lost listings" has been the small, penny-stock company that would not qualify for listing on the NYSE or Nasdaq stock markets SOX or no SOX. These companies list on London's AIM or Ireland's Irish Enterprise Exchange, among other venues. While I don't have an issue with allowing the listing of companies whose market capitalization is often less than $100 million, it's also important to note that the quality of investor protection afforded these listings is significantly lower than on the larger exchanges, wholly apart from the listing standards imposed by SOX. For example, unlike the U.S. exchanges, AIM does not require for admission minimum shares in public hands, a trading record, prior shareholder approval for most transactions, admission documents pre-vetted by the Exchange or a minimum market capitalization.
Consider also the types of companies that critics are lamenting listed in the AIM in London rather than the U.S. It has been said facetiously that most of the companies not listing in the U.S. these days tend to be or look like "companies from 'Borat.'" (Referring to the recent movie). Take, for example, several companies discussed by Barbara Roper in her excellent study. The business plan for PartyGaming, the online gambling business that conducted its 2005 IPO in London, relies on its having no assets in the United States. This is because the Justice Department and many states maintain that it is breaking the law by providing the opportunity of online gaming in the U.S. This company hardly seems an ideal candidate for meeting NYSE or Nasdaq listing requirements.
Consider also Kazakhmys, another of the large 2005 IPOs conducted in London. The Financial Times reported that Kazakhmys had been challenged over its corporate governance standards. A British financial writer stated, "What is known is that the company recently engaged in share dealings that required it to waive its lock-up rules; nearly half the company is in the hands of one man, who serves as both chairman and chief executive; and one of the company's two independent directors works for the bank advising the company." This is hardly a model of the transparency and independent board that U.S. listings requirements demand.
Or consider Sistema, the Russian telecommunications company that conducted what was at the time the largest IPO of a Russian company. Among the many risk factors listed in the company's offering document is the fact that the company's president and board member will "beneficially own" 65.45 % of the company's outstanding shares, enabling him to "exert significant influence over certain actions requiring shareholder approval." Further, it is stated that the interests of the president could "conflict with the interests of our shareholders and the holders of the GDRs, and he may make decisions that materially adversely affect your investment in GDRs." It also disclosed that "because there is little minority shareholder protection in Russia, your ability to bring, or recover in, an action against us will be limited." So, I think we can reasonably conclude that there are little to none of the minority shareholder protections that investors expect under U.S. regulations and listing requirements. Again, understandably the owners did not want to offer this company to shareholders in the U.S.
So what lesson can we take from this discussion? I think a recent Washington Post editorial summarized the issue succinctly: a declining share of U.S. IPOs is worrying only if it reflects a decline in the efficiency of our markets rather than a rise in the appeal of other options. And, simply put, there are various reasons for foreign companies to list elsewhere than in the U.S. reasons that did not exist just a few years ago. It is therefore not surprising that a foreign issuer may find that the costs and regulatory hurdles do not outweigh the more limited, but growing, access to capital in their own jurisdictions.
This means that things are changing; it does not mean the bottom is falling out of the U.S. capital markets. Our markets remain strong and competitive because of their depth and liquidity. In 2005, the U.S. again achieved the highest amount of capital raised in IPOs by any single country in the world, and the U.S. market continues to attract foreign companies, from North and South America, Asia and elsewhere. While we cannot close our eyes to growing trends, I want to make it clear that, quite simply, the U.S. market remains robust and competitive for those who seek capital here.
A Kinder, Gentler SEC?
The Committee on Capital Markets Regulation also concluded that the SEC should essentially be kinder and gentler to business interests, and be more like the UK FSA. First of all the SEC prides itself in being scrupulously fair in its rulemakings, investigations, and enforcement matters. I can categorically say that all arguments and facts are taken seriously into account in determining whether rulemaking is appropriate, or whether sanctions are advisable when violations have occurred. I should note that many matters that are investigated are ultimately dismissed by the Commission.
Ironically, most letters that the SEC receives are from members of the public that feel that we were not tough enough in particular areas. The investing public has not forgotten Enron and WorldCom, and has no desire for the SEC to be kinder or gentler toward those who violate securities laws.
Essentially what the Committee ignores is that the U.S. markets are fundamentally different from Europe and Asia. No other market has the large retail investor base of the U.S. No other major market has essentially the measured degree of oversight of its non-financial operating public companies. Congress set up the SEC as a civil rulemaking and enforcement agency. Our job is to promulgate reasonable rules and regulations that protect investors, to arrive quickly where there has been a fraud on investors involving the federal securities laws, and through civil suits to recover investor losses and return them to investors where possible.
In short, the SEC is in the business of providing, among other things, deterrence. Our enforcement actions must produce tough but fair sanctions, which will deter others from also being tempted to violate the law and defraud investors. Moreover, our rules are carefully crafted through consultation with all interested parties and a very public notice-and-comment process to ensure that they will effectively, but reasonably, deter misconduct and harm. I should also say that our agency has some of the country's best and most respected lawyers.
In the area of the SEC examinations of the regulated industry e.g., broker-dealers and investment advisers, we can and will do a better job in the future. There has been the perception (I am not sure that it is reality) that our examiners are antagonistic and an extension of our Enforcement division. I think that our examination process should be one which also seeks to teach and encourage best practices, rather than one which is a "gotcha" process. I know that the Director of the SEC's Office of Compliance Inspections and Examinations is committed to creating the correct type of examination and inspection process and environment. However, I realize that no one will ever "love" being inspected.
Sarbanes-Oxley Section 404
Let me conclude by speaking briefly about SOX 404. From the reports I receive, it is working. It has improved internal controls, increased the focus on financial statements (most notably from board members), and inspired greater confidence in U.S. companies. This is not to say that the implementation of Section 404 has been perfect. It hasn't been. But we at the SEC and the PCAOB have been working to improve the relevant regulations. Indeed, in the near future there will be a substantial revision to Auditing Standard #2, the auditing standard implementing Section 404.
It is my hope and expectation that these changes will improve the implementation of Section 404 and reduce the costs of compliance, without compromising the benefits that we have thus far obtained. I urge Congress and the public not to use Sarbanes-Oxley as a scapegoat for declining IPOs in the U.S. We are working to improve Section 404 as quickly as we can. I have every reason to believe that we will be successful. The SEC by the end of 2006 will issue new management guidance and the PCAOB will issue new audit guidance for SOX 404. This package of guidance will do much to bring the benefits into alignments with the costs of the regulation, including dealing with the concerns of the smaller issuers.
There is not much in the way of detail that I can provide today because management guidance and significant revisions to Auditing Standard #2 are imminent, and are being analyzed and revised even as I speak. However, as I've been saying for months now, this is a problem that we are determined to get right not only for the business community that has noted the extensive costs and burdens associated with Section 404 but also for the investors who have most certainly benefited from the increased accuracy in financial reporting.
Our comprehensive research and analysis regarding Section 404 led us to the conclusion earlier this spring that the need for strong internal controls and a strong culture of compliance at all public companies justified the requirements of Section 404 for all public companies. This is consistent with the plain language of the statute which requires that all public companies have both annual management assessments of internal controls as well as audit attestations of those assessments. However, our analysis also led us to the conclusion that these statutory requirements were not being applied in the most cost-efficient manner and risk-focused manner.
Therefore, over the past several months, our own SEC staff and the PCAOB staff have devoted a tremendous amount of their efforts into re-thinking and crafting a 404 framework that will make the management assessment and audit attestation process top-down oriented, risk-based, and focused on those areas of the financial reporting process that are most likely to materially impact company financials.
As you know, two of the key items that we announced in our May 2006 "roadmap" for fixing 404 were SEC management guidance and modifications to AS2. I am optimistic and hopeful that the end results of both processes will lead us to a place that preserves an audit attestation and management assessment requirement for all public companies, yet (1) allows management and auditors to exercise their professional judgment in a scalable and cost-effective manner, including giving them significant ability to utilize the work of others, automated controls, and existing work, and (2) focuses both management and auditors on those areas of greatest risk and vulnerabilities, such as the control and accounting environments.
In conclusion, the real issues facing our capital markets are globalization and technology, and their impact on the way business is conducted in the U.S. not SOX. Some of the issues are at the margins and will self-correct or will be corrected by us after appropriate discussion and study. Other issues, such as convergence of accounting and auditing standards, are front and center on our regulatory agenda. Our challenge is to balance investor protection and global competitiveness in the dynamic world. As stated earlier, SOX and Section 404 (with the planned package of improvements from the SEC and PCAOB) is working and in the near future will work better and more efficiently.
Our overall system of regulation and protection of capital is the envy of the world and has helped create trillions of dollars of wealth for America. Let us not lightly tinker with what has worked so well for our country. I trust Congress and the public will see clearly the value and benefit to America of our overall regulatory system, and in particular the great value that Sarbanes-Oxley is providing.
Thank you very much for your kind attention.