Speech by SEC Commissioner:
Remarks Before the Council of Institutional Investors
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
March 20, 2007
I am delighted to be here at the Council of Institutional Investors' 2007 Spring Meeting. I have been invited to speak at this conference several times, but unfortunately the schedule has always conflicted with my children's spring break from school. Had I known that CII would provide Al Gore as a warm-up act for my presentation, I gladly would have cancelled the family vacation earlier! Before I begin, 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
Al Gore was an inspired choice as a speaker for this conference. He is a man who has been relentless in his efforts to raise our awareness of environmental issues, and in particular the critical issue of global warming. He stuck to his principles-guided by his passionate belief in the power of the data and by his internal moral compass, even when many ignored his message-and today we can thank him for perhaps the first steps in a long-delayed process of addressing this very important issue. While I would not say that maintaining the competitiveness of the U.S. capital markets is as important as preserving the planet for future generations, I do believe that we could all benefit from the same methodical and thoughtful analysis that Mr. Gore brought to "An Inconvenient Truth."
As you know, there has been a great deal of attention recently to competitiveness issues in the U.S. financial markets. Indeed, in the past few months there have been no less than three blue ribbon efforts focused on examining ways to maintain the preeminence of U.S. capital markets in the face of increased global competition-the Committee on Capital Markets Regulation, chaired by Glenn Hubbard and John Thornton, the McKinsey Report, sponsored by Senator Schumer and Mayor Bloomberg, and most recently, the Commission on the Regulation of U.S. Capital Markets in the 21st Century, established by the U.S. Chamber of Commerce. In addition, Treasury Secretary Paulson held a day-long conference on these issues just last week. I am encouraged that the recent reports uniformly acknowledge the need to maintain high standards. As the Chamber of Commerce report noted, "[h]igher governance standards improve corporate oversight, in turn leading to greater investor confidence and higher shareholder value."2
Our goal, broadly speaking, should be to ensure that our markets continue to be an attractive, cost-effective venue for raising capital, while at the same time maintaining a high level of market integrity and investor protection. In discussions with both industry leaders and government officials over the past few months, I sense that a roadmap for our response to this challenge is beginning to emerge. First, we will need to reflect on our principles and goals. What kind of a marketplace do we want to have? What standards do we believe are appropriate in a highly developed market economy? What are the most cost-effective means of achieving those goals and how can we measure whether the goals are being achieved? The debate will surely cause us to redouble our focus on the costs versus benefits of our regulatory efforts, as well as to strive to eliminate regulatory duplication and inconsistency.
That having been said, the challenge is to identify the key causes of inefficiencies in our capital markets and then recommend effective ways to address them. Not surprisingly, some common issues and concerns emerged in the various reports. High on the list are improving Sarbanes-Oxley Section 404 implementation and streamlining the regulations that apply to foreign issuers. The latter would include allowing easier foreign deregistration, recognition of IFRS without reconciliation to GAAP, and promoting the convergence of accounting and auditing standards. These are not new concerns, and indeed some of the recommendations relating to these issues are already underway at the Commission and elsewhere.
The Section 404 management guidance that we proposed this past December is an example of how the Commission has begun to address unexpected and unintended costs of regulation. Although we all realized that the implementation of Section 404 would entail costs, I do not believe that anyone anticipated that the costs would be so high, or that management's assessment would become driven almost exclusively by the PCAOB's Auditing Standard Number 2, which establishes professional standards for conducting audits of internal controls over financial reporting. Upon realizing the full costs of implementation, the Commission sought comments, hosted two roundtables, and received reports from both the GAO and the SEC Advisory Committee on Smaller Public Companies. The Commission then issued a concept release in July 2006 to raise specific questions about Section 404 implementation and to solicit feedback. The resulting proposed management guidance attempts to maintain the benefits of 404 while emphasizing efficiency and innovation instead of a one-size-fits-all approach. The guidance is intended to liberate management by encouraging them to apply the guidance to their own situations instead of following a prescribed mold. The guidance is designed to be scalable, so that it can be utilized by both large and small companies.
At the same time, the PCAOB has proposed a new Auditing Standard Number 5 to replace AS2. The proposed AS5 is 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.
Additionally, the Commission's oversight of PCAOB inspections will examine whether the inspections have effectively encouraged firms to follow the PCAOB's 2005 guidance on ways to achieve cost-saving efficiencies in their audits. We have heard complaints about auditors over-auditing in part because they fear that PCAOB inspectors would otherwise find their audits insufficient. The PCAOB itself has said that such over-auditing is not desirable.
The periods for public comment on both our proposed management guidance and the PCAOB's proposed AS5 recently closed, and we are actively reviewing the very detailed comments we received. I hope that the SEC and the PCAOB can improve upon and then implement each of these proposals, ideally in time for year-end 2007 reports.
Another current Commission undertaking that I think will make our markets more attractive is our foreign private issuer deregistration proposal. The proposal would change the criteria under which a foreign issuer may exit the SEC's Exchange Act registration and reporting regime. At an open meeting tomorrow, the Commission will consider whether to adopt amendments in this area, which would make it far less burdensome for a foreign private issuer to deregister. As counter-intuitive as it may appear at first blush, I believe that the amendments, if adopted, will make the U.S. a more inviting place in which to do business. Foreign companies will no longer view our markets as a "Hotel California," as our Chairman put it, from which they can never leave,3 thus making the decision to list in our markets an easier calculus.
Another area of focus that I believe will improve our competitive posture is financial accounting. The Financial Accounting Standards Board ("FASB") and the International Accounting Standards Board ("IASB") have been working earnestly since 2002 to achieve convergence between their respective sets of accounting standards-U.S. GAAP and International Financial Reporting Standards ("IFRS"). The SEC has expressly supported and encouraged this development. In 2002, the European Union determined that all listed EU companies would have to prepare their consolidated financial reporting using IFRS beginning in 2005. Other jurisdictions, including Canada, Australia, New Zealand, Israel, and China are adopting IFRS as well.
Right now, foreign private issuers must reconcile their financial statements to U.S. GAAP if their filed financial statements use IFRS. This reconciliation requirement is clearly costly and many argue that it is of limited utility. In 2005, our then-Chief Accountant Don Nicolaisen laid out a "Roadmap" to eliminate that reconciliation requirement by 2009, which is fast approaching. The Roadmap has since then been endorsed by Chairman Cox, and I support it as well. It sets forth a very ambitious work plan with an aggressive timeframe. I am pleased to report that great progress has been made to date. An important step in the Roadmap is the expanded use of IFRS by foreign private issuers and the SEC's review of their filings-a process that already is taking place. Another important step is the continuing convergence efforts of the FASB and the IASB. The ultimate goal of the convergence efforts is to have one set of globally accepted accounting standards. The Roadmap does not require complete convergence; rather, it requires that a process be in place and underway. With so many individuals and entities working diligently toward the elimination of reconciliation, I am optimistic that we will be able to achieve that goal within the proposed timeframe.
Two weeks ago, the SEC held a Roundtable about IFRS and the Roadmap, during which we heard from representatives of many constituencies, including issuers, investors, auditors, and analysts. A number of participants discussed the effects on competition of many of our current efforts. For example, they predicted that eliminating the reconciliation requirement, coupled with adopting the SEC's foreign private issuer deregistration proposal and new Section 404 guidance, would bring more foreign issuers to U.S. markets. Several panelists noted that eliminating the reconciliation requirement could provide significant cost savings and added efficiency in the reporting process for the issuers, and they urged the Commission to eliminate the reconciliation requirement even before 2009. Some participants also suggested that if the reconciliation requirement is eliminated and foreign companies are allowed to report their financial statements using either IFRS or U.S. GAAP, the same choice should be available to domestic issuers. The question is certainly worth asking and exploring.
Other regulatory reforms that will bring costs and benefits into better balance have been market-driven, such as the proposed merger of the regulatory arm of the New York Stock Exchange and the NASD. In addition to more effectively managing conflicts of interest, an NASD/NYSE Regulation combination potentially could achieve greater efficiencies and cost effectiveness than the current model. This consolidation should eliminate costly and overlapping regulation and establish uniform rule sets within a single regulatory organization. Further, a single rule set and enforcement of such rules should reduce complexity and eliminate potential conflicts arising from multiple SROs. It is well worth noting that as market competition becomes even more aggressive as it moves beyond our own borders, we must be even more focused on providing the most effective regulatory oversight in the most cost-effective manner.
Any serious examination of competitiveness issues and unnecessary regulatory cost also will have to focus on our U.S. regulatory structure. This "elephant in the room" has been largely ignored in the recent debate as there has been greater focus on "quick fixes." But our regulatory structure has been virtually unchanged since the 1930s. When one considers the enormous changes that have occurred in the nature of our markets, the market intermediaries, and in the products that they sell, is it any wonder that we have inefficiency, uncertainty and duplication in our regulatory oversight? Indeed, we are witnessing increasing instances of proposed products and services that fall on the jurisdictional seams of the various regulatory agencies. If these activities simply raised questions of "who is in charge," I could understand a lack of broad public interest in the debate. But when the question is "what law applies and what protections do U.S. investors have," then we should all have an interest.
The Chamber report, to its credit, broached the subject of SEC-CFTC consolidation. This topic has traditionally been viewed as virtually unachievable, due largely to the interests of the separate committees in Congress that oversee the two agencies. As you undoubtedly know, we may well be the only jurisdiction in the world that oversees securities and futures activities in two separate agencies. Through financial innovation we now have financial futures and securities options that bear striking resemblances to each other from an economic standpoint. Yet these products are regulated under very different regimes. Among the more important distinctions, securities options and other securities are subject to insider trading prohibitions. Futures subject to exclusive CFTC jurisdiction, on the other hand, are not subject to insider trading prohibitions, even though some of the new products designed to duplicate the OTC credit default swaps market could be used as vehicles for insider trading. These types of issues are arising with increasing frequency as the futures and options exchanges seek to create new exchange-traded products. It is particularly troubling when jurisdictional murkiness provides opportunities to create products that avoid the protections of the securities laws. At some point Congress will need to address these fundamental jurisdictional and policy issues. And dare I note that the issues of potential SEC-CFTC consolidation pale in comparison to the challenges, but also the potential cost savings and efficiencies, that could result from consolidation of even a few of the many federal banking regulators?
I also believe more effort should be made to develop prudential regulatory approaches. There has been much discussion recently about the benefits of principles versus rules-based regulation. Many commentators believe that our rules-based regulation in the U.S. adds unnecessary cost and stifles innovation. I believe that this is a false dichotomy. All regulation should be derived from over-arching principles, but rules can provide guidance and specificity that the marketplace desires. Indeed, Callum McCarthy, the Chairman of the UK's Financial Services Authority ("FSA") has noted that even the FSA, that pillar of principles-based regulation, has hundreds of pages of rules. So in my view the focus should not be on rules versus principles, but rather on a move toward more prudential approaches to regulation. The bank regulators have implemented a prudential regulatory model with success for many years. Although not well known by many in the industry, for two years the SEC also has implemented a highly successful program of consolidated financial supervision. Known as the Consolidated Supervised Entity, the program enables us to work in very close collaboration with our five largest U.S. investment bank holding companies to monitor their risk management capabilities. The program is notable for at least two reasons that distinguish it from the traditional SEC supervision. First, the program emphasizes a prudential approach to supervision. The staff involved in this program meet with the five firms on a regular and periodic basis to review risk management controls and liquidity. Second, the supervision is at the holding company level, and includes not only the regulated but also the unregulated entities. Thus for such firms, the SEC has a wholistic view of the risk management and the business of these firms. Thus enabled, we can effectively carry out our charge of insuring adequate risk controls and liquidity throughout the organization.
Finally, as some of the reports on competitiveness have noted, the need for proactive reflection on the benefits of regulatory reforms is not limited to the Commission. Indeed there are issues outside the immediate purview of the Commission that could have a profound effect on U.S. financial markets now or in the future. I agree, for example, with the McKinsey report's analysis that restrictive immigration and visa laws may be hampering the ability of our financial markets to attract and retain the most talented professionals. We hear accounts of major U.S. brokerage firms that have established innovative operations offshore because of their inability to resolve visa issues for foreign employees. In some cases these employees were even educated in the U.S., yet our immigration policies prevent us from benefiting from the fruits of that educational experience.
In the end, efforts to maintain the preeminence of the U.S. capital markets raise complex issues that require thoughtful analysis. For the most part, these issues are not prone to simple solutions. Some meaningful progress can be made in the short term without legislative changes, such as the SEC's attention to SOX 404 implementation and the continued work on U.S.-GAAP - IFRS convergence. But even greater benefits can be achieved if we focus on the broader opportunities for change. I dare say that if Al Gore can take on the issue of global warming almost single-handedly, then surely we can address the issues of our global competitiveness by continuing to work together creatively and cooperatively.