Speech by SEC Commissioner:
Remarks Before the Annual Washington Conference of the Institute of International Bankers
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
March 5, 2007
Thank you for your kind introduction and for the privilege of addressing this annual conference of the Institute of International Bankers. Today, I thought that I would focus on several regulatory topics under consideration at the SEC: Regulation NMS, the implementation of international financial reporting standards, the revised proposal for de-registration of foreign private issuers, and finally, adjustments to the internal control requirements of the Sarbanes-Oxley Act. But before I go further, I have to note 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.
My term as commissioner represents my second tour of duty with the SEC. Just call me a recidivist. The first tour started in 1990, when I served under then-SEC Chairmen Richard Breeden and Arthur Levitt before leaving in 1994. During that period, the paths of the international banking community and the SEC did not cross too often. The U.S. activities of internationally headquartered banks were overseen mainly by the banking regulators and the role of the SEC was quite limited.
It is amazing how much has changed since then. The passage of the Gramm-Leach-Bliley Act eliminated most of the antiquated, artificial barriers between commercial banking and other financial services within the United States that the Glass-Steagall Act had imposed. Those barriers had raised operating costs and hurt the competitiveness of the American financial services industry with little clear investor-protection benefit.
We have also seen that the rapid changes in technology and other factors have led to an ever-increasing convergence in the global capital markets. This convergence brings forth many potential opportunities and risks for business and investors alike.
More companies are raising debt and equity capital beyond their home boundaries. Investors are increasingly allocating their capital outside their home countries to seek better returns and diversification. Competition and technology are driving speedier innovation, resulting in a breathtaking diversity of new financial instruments and services to businesses, consumers, and investors. Events such as the combination of the New York Stock Exchange and Euronext mark the continuation, not the end, of this convergence. As a result, the shadow of SEC regulation today looms much larger over the international banking community than ever before.
The SEC has equally important – and statutorily imposed – goals of protecting investors, maintaining fair, orderly, and efficient markets, and promoting capital formation.1 The SEC has a responsibility to regulate in a manner that both protects investors and fosters innovation, competition and growth in the financial sector. Because SEC regulatory actions often affect individuals and entities in other countries, it is critical that we seek the insights of all parties who may be affected by our rules. We need to constantly rethink our approach to cross-border financial services, including carefully reassessing the outworkings of our regulations on market mechanisms.
SEC chairman Chris Cox recently observed that national regulations which create outsized burdens do not work well in this new environment of global capital markets; they actually harm investors – by limiting investor choice, by raising trading costs, and by undercutting the effectiveness of securities law enforcement "through a bunker mentality that ignores what's going on around us."2 I agree with his sentiment and am glad that he has used it to inform his decision-making since coming to the SEC.
Well, it is now about 9:40 a.m. and the U.S. equity markets opened just a few minutes ago. Since I was speaking of burdensome national regulations, I cannot resist noting that today marks the beginning of the long-delayed implementation of the new market structure rules that the SEC adopted in the spring of 2005, before Chris Cox was named chairman. These rules are the notorious and hotly debated Regulation NMS – for National Market System.3 The rules basically arise from a wish to centralize our dynamic markets – the major means is via a market-wide rule against trade-throughs, even though there is little evidence that there is or was a problem regarding trading through better priced quotations.
I was staunchly opposed to the adoption of this burdensome and costly set of rules, which spring from a utopian philosophy that we know what is best for the marketplace, regardless of what market participants want, and that we will force our will on the marketplace, regardless of the costs and consequences. Some give NMS credit for pushing technological innovation in the marketplace. This credit is misplaced, because competition and customer pressure were and continue to be the real drivers of change. Besides trampling on investor choice, the major, intractable problems that this rule faces are the lack of connectivity between the various competing markets and the need for determining who might be said to have the best price at any one micro-second of time.
Already the implementation of Regulation NMS has been delayed time and again because of a clearly unrealistic timetable that ignored the numerous interpretive questions and thorny technological issues raised by the rules. The SEC staff, through an amazingly broad set of powers delegated to it through the rule, has granted exemption after exemption that has exposed the rules' many flaws.4 They realize that there is a serious problem. I will be watching carefully the implementation of Regulation NMS and hope that its consequences turn out to be a non-event – other than the thousands of hours and millions of dollars spent in an effort by market participants to implement it. The trouble is that the real consequences for our markets will not be known for years, after the damage has been done and after trading patterns have shifted in unpredictable ways and perhaps to other venues.
International Financial Reporting Standards
I would like to turn briefly to the world of financial reporting and developments related to International Financial Reporting Standards (IFRS). Having a robust set of accounting standards in addition to US GAAP is a positive development. A single set of accounting rules is not a necessary prerequisite to a well-functioning global market place. That said, I support the extensive collaboration between the Financial Accounting Standards Board and its counterpart, the International Accounting Standards Board (IASB). Differences in culture, legal systems, and liability regimes make true equivalence in accounting standards a difficult goal, if it be even possible to achieve. What is critical, however, is that accounting standards be clearly stated and evenly applied by all nations and companies adopting those standards. Financial reporting standards must be implemented in such a way that they succeed in presenting a clear and accurate picture to users of financial statements, especially for investors so that they can judge their investment and hold their management accountable for results.
As you may know, the SEC is far down the road towards the elimination of the reconciliation requirement set forth in the so-called IFRS-GAAP roadmap.5 This roadmap was articulated in 2005 by the SEC accounting staff with Commission support. It sets 2009 as a target for ending the requirement that financial statements prepared under IFRS be reconciled to US GAAP. Chairman Cox has endorsed the target of 2009, noting that "achieving that goal depends on various factors
including the effective implementation of IFRS in practice."6
Since the middle of 2006, the SEC has gained its first insights into just what is happening in practice. Last summer, our staff began reviewing the filings that we received from foreign private issuers that adopted IFRS in 2005. They have coordinated this project with the Committee of European Securities Regulators, as the chairmen of CESR and the SEC announced last summer. The objective of these reviews is to see how closely IFRS filers in fact are adhering to IFRS standards. In the course of the reviews, our staff has found a number of interesting things. For example, they have found that some filings did not include certain disclosures that appear to be required by IFRS. Needless to say, it will be easier for us to eliminate the reconciliation requirement if IFRS filings are complete and adhere to IFRS standards. I suspect, however, that many of these types of problems are a natural by-product of the first year of IFRS implementation and will disappear as companies and their auditors become more accustomed to the requirements of IFRS.
Another interesting phenomenon was that in only 40 or so cases were foreign registrants' financial statements represented as being in accordance with IFRS as promulgated by the IASB. This number was significantly lower than expected. One reason for the low number is that many foreign registrants stated that their financial statements were prepared in accordance with IFRS as promulgated by their home countries, instead of IFRS as promulgated by the IASB. This practice raises the specter of multiple national versions of IFRS, with varying degrees of disparity from the IASB version. This could well imperil our goal of ending the reconciliation requirement, since we could be back to a world of multifarious GAAPs, each with its own idiosyncrasies.
A poem by Robert Frost, "The Road Not Taken,"7 comes to mind. Faced with the choice of two roads in a forest, the poet chooses the "one less traveled" and, reflecting on that choice, found that "that has made all the difference." With respect to IFRS, by contrast, it will make all the difference if companies choose the road more traveled – a single, consistently applied set of IFRS standards. National regulators, for their part, need to resist the impulse to develop a nationally-specific version of IFRS. This is the time during which the groundwork must be laid to ensure high-quality standards and consistent application of IFRS across all of the nations in which it is used.
I am keenly aware that during this assessment period shareholders will continue to bear the costs of reconciliation, which can be considerable. I remain optimistic that we will complete our assessment and be able to determine that the reconciliation requirement is unnecessary well within the 2009 goal for reconciliation. It is encouraging that the European Commission has responded to our efforts at eliminating reconciliation by deferring for two years its decision with respect to the equivalence of GAAP and IFRS and, in the meantime, has extended an exemption to make reconciliation of U.S. GAAP to IFRS unnecessary.
Requiring U.S. companies to reconcile their U.S. GAAP financial statements to IFRS would undermine our own efforts towards mutual recognition by raising doubts about equivalence just when the SEC is hoping for sufficient equivalence to justify ending the reconciliation requirement. U.S. GAAP is already an established standard that has proven itself to investors over time. The need for reconciliation disappears when IFRS shows itself to be, like U.S. GAAP, a consistently applied, high quality set of accounting standards. Everyone on both sides of the Atlantic has a commonality of interest to make sure that IFRS succeeds as a coherent, internationally sound set of standards. It is in everyone's best interest to achieve the elimination of the reconciliation requirement as quickly as possible.
Tomorrow, the Commission's Division of Corporation Finance and Office of Chief Accountant will be hosting a roundtable to discuss the IFRS roadmap and its effect on participants in the U.S. capital markets and the capital raising process.8 This discussion likely will be of interest to many of you. I feel uneasy doing any more advertising for an event that conflicts with this conference, so I will simply remind you that we will be interested in hearing your thoughts even after the roundtable is over.
The increasing globalization of the capital markets raises the question of whether it remains advantageous for a foreign private issuer to list its securities on a U.S. exchange. In earlier times, limited home-market trading liquidity or the need to raise a large amount of capital made it desirable to be listed in the United States. Once listed, of course, the foreign issuer is subject to the reporting requirements under the Securities Exchange Act.
Circumstances, however, may change and a foreign issuer may find it no longer desirable to maintain its U.S. listing. For example, a foreign issuer may find that its trading market in the United States is relatively small compared to its home jurisdiction and that the costs – and potential liabilities – associated with listing far outweigh any benefit to the company. Under current rules, however, a foreign issuer may terminate its Exchange Act registration only if fewer than 300 record holders of the issuer's equity securities are U.S. residents.9 Foreign issuers may find it difficult to meet this standard even if there is relatively little investor interest in the United States. For one, how do you count shareholders? Thus, there is a widespread perception that a decision to list in the U. S. can never be reversed. This perception, in turn, serves as a disincentive to list securities in the U. S. in the first place.
In late 2005, we published for comment a proposed rule that would expand the criteria for a foreign private issuer's termination of its reporting requirements beyond the 300-holder test.10 As originally proposed, one of the key tests would have examined the percentage of U.S. ownership of the foreign issuer's worldwide public float.
We received many comment letters in response to our proposal.11 Because I did not believe that our original proposal addressed the situation as well as it should, I was sympathetic to many of the comments raised. So I was very pleased that, in December 2006, we voted to issue a revised proposal to permit a foreign company to de-register its shares in the United States.12
The Commission's revised proposal would allow a foreign private issuer to de-register its equity securities based solely on comparative trading volumes. I believe that the revised proposal is much more philosophically sound than the original one. In my mind, the proper approach should allow issuers to de-register unless their shareholder base includes a large number of U.S. residents who bought the securities in the U.S. and who therefore have a reasonable expectation of being able to trade in the U.S. markets. U.S. residents who execute their trades abroad should not have the expectation that U.S. securities laws will apply to those overseas transactions. The revised approach is consistent with the "territorial approach" to international securities regulation that the Commission has embraced for twenty years. I believe that the territorial approach should continue to be the Commission's guiding principle as we deal with what appears to be an unprecedented series of major international developments in the markets.
We are now considering whether the revised de-registration proposal satisfies the concerns with the shortcomings of the original rule. The need for flexibility for issuers must be balanced, of course, against the expectations of American equity investors. I look forward to reviewing the additional comments that we have received. In particular, I note that we have received many comments regarding the measurement and definition of trading volumes and comparing the level of trading in the US to home market trading. I agree with many of the comments that I have read and look forward to discussing them with my colleagues. Ideally, a final rule for de-registration will be adopted prior to the mandatory date for full compliance with Section 404 of Sarbanes-Oxley, thereby giving those companies who qualify for de-registration the option of remaining subject to the U.S. securities laws.
Section 404 of the Sarbanes-Oxley Act
Speaking of the devil: calls for a liberalization of our deregistration rules intensified in the aftermath of the Sarbanes-Oxley Act, which this year marks its fifth anniversary.13 However, the real concern of foreign entities is Section 404 of the Act. Section 404 requires management to complete an annual internal control assessment and requires the company's outside auditor to attest to, and report on, management's assessment. Despite its worthy objectives, implementation of that section has produced many unintended consequences, at great cost for companies in the U.S. and abroad.
At the time Sarbanes-Oxley was passed, few, if any, people expected Section 404 to be the most controversial provision or that it would impose any significant burden. After all, Section 404 was copied almost word-for-word from a provision that had applied to U.S. banks for more than ten years. Indeed, the Senate committee report on Sarbanes-Oxley observed that high quality audits already "incorporate extensive internal control testing" and that the committee did not expect the internal control provision to be the basis for any increased fees or charges by outside auditors.14 Similarly, the SEC estimated that implementation of Section 404 would cost an average of $91,000 per company, for a total of one and a quarter billion dollars.15 Estimates have put actual average costs at more than 20 times that amount.
The issue is not with the principle that management should have a reasonable control environment that provides assurance as to the integrity of the financial statements, but rather with the flawed implementation of Section 404. Simply put, benefits should exceed costs. When we embarked on implementing Section 404, the SEC envisioned a top-down, enterprise-focused approach, where a company would focus on entity-level controls that could materially impact the consolidated financial statements. The SEC rule was intended to be a principles-based approach aimed at management.
However, Audit Standard No. 2 (AS 2), as developed by the Public Company Accounting Oversight Board (PCAOB), had an entirely different effect.16 The primary flaw of AS 2 was that it lacked a firm grounding in the concept of materiality. The standard has made it difficult for auditors to employ professional judgment in assessing internal controls and encouraged them instead to use a time-intensive bottom-up approach. I have heard too many stories of excessive documentation, bottom-up audits, and overly conservative material weakness determinations.
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. 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. This does not mean that internal controls and other organizational costs are not important. They are, but there must be a balance.
I think nearly all players in this debate have recognized the flawed approach that was initially rolled out. The SEC is committed to addressing those implementation problems. As evidence of this commitment, the SEC has given smaller companies and foreign issuers more time to comply with the Section 404 requirements.
In December 2006, the SEC proposed additional guidance for management's assessment of internal control.17 Whether intended or not, management's assessment of internal controls has largely been driven by AS 2, a standard that was directed at the conduct of outside auditors. We have received many comments on this proposed guidance, and I hope that, when we finalize it, the guidance will restore the appropriate balance.
Around the same time that the SEC was issuing its proposed guidance to management on internal controls, the PCAOB proposed replacing AS 2 with a new audit standard, AS 5, for an outside auditor's attestation of internal controls.18 The SEC, through its Office of Chief Accountant, is working closely with the PCAOB on AS 5. The process for overseeing the work of the PCAOB is not without its limitations, which may 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.
Far from being a rollback or lessening of standards, I think the new SEC and PCAOB proposals on internal controls go a long way towards implementing the original vision of Sarbanes-Oxley.
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I know there are other issues at the Commission that may be of interest to the international banking community, such as our recently proposed Regulation R as well as our proposed rules on nationally recognized statistical rating organizations. So I am happy that you will have the opportunity to interact later at this conference with Dr. Erik Sirri, the Commission's director of the Division of Market Regulation.
I welcome your continued involvement in our issues, including your questions and comments. I would be happy to address your comments and questions.