Speech by SEC Chairman:
Closing Remarks to the Second Annual Corporate Governance Summit
Chairman Christopher Cox
U.S. Securities and Exchange Commission
USC Marshall School of Business
Los Angeles, California
March 23, 2007
Thank you, Tom [Marshall School of Business Dean Thomas Gilligan], for that kind introduction. It's great to be back at USC just as the Trojans are getting ready to play tonight in pursuit of another national championship. [Applause] It's good to know there are so many college basketball fans this far east of Westwood. And since I know in an audience this size there are many Bruin fans as well - this is a bipartisan group, as we say in Washington - I want to point out how splendid it is that Los Angeles teams represent over 12% of the Sweet 16. [Applause]
I want to tip my hat to President Sample and to Dean Gilligan for the outstanding job they are doing in elevating USC to the championship ranks not only in athletics but in every field of academics as well. It's true in both the undergraduate and the graduate programs that SC is attracting exceptional talent, and producing outstanding research. The global preeminence that the university has achieved is nowhere more in evidence than here at the Marshall School, where so much cutting-edge work is being done that is benefiting almost every aspect of business, finance, and accounting.
And because your faculty are so well established as leaders in their fields, the Securities and Exchange Commission knew to come here when we needed one of the nation's foremost experts in auditing. To help fix the problems with Sarbanes-Oxley and the 404 audit, I tapped Dr. Zoe-Vonna Palmrose, who was the PriceWaterhouseCoopers Professor of Auditing here at the Marshall School. She is now the Deputy Chief Accountant for the SEC. And she is working closely with the members of the Public Company Accounting Oversight Board to replace the existing auditing standard under section 404 with a more workable approach that is top-down, risk-based, and scalable for companies of all sizes. Of course the agency is delighted that she was also one of the presenters at this Summit.
As you know, getting Sarbanes-Oxley implementation right is of critical importance for America's investors, who pay the bills for 404 audits - and who depend on good internal controls to produce reliable financial statements. When that task is accomplished, and America's leadership in the world's increasingly competitive capital markets is reinforced, our nation will have Dr. Palmrose to thank - and also USC, because the university is making a financial contribution to her service in Washington.
This is the Second Annual USC Corporate Governance Summit. Since it is my opportunity to provide the closing remarks, I can say with conviction that this year's program has been every bit as good as the first. And that's saying quite a lot, with all of the distinguished guests you attracted last year, including Don Nicolaisen, Denny Beresford, and Pat Haden. Don, of course, was the SEC's Chief Accountant when I began as Chairman, and he is responsible for the Roadmap to U.S. convergence with International Financial Reporting Standards that I endorsed in February of 2006. His successor as Chief Accountant, Conrad Hewitt, is our former top banking regulator in California, and a protégé of Denny Beresford. And Pat Haden, of course, is in a league of his own. He is USC's Renaissance man, equally accomplished in academics, sports, law, broadcasting, and business. His contributions to the university and to our community have been extraordinary.
For me, it really is a privilege to be back on campus in my current role. In fact, however, this isn't the first time that's happened: Two years ago, when I had just recently become SEC Chairman, I was here on campus for the USC-UCLA game. As you all remember, that was a classic all-day event that began in the morning with elaborate tailgate parties all around the campus and the Coliseum. And like all of these gatherings, it was a great opportunity to see old friends and meet new ones.
Well, during the pregame festivities a woman came up to me with her son, and rather sheepishly asked, "Are you the new Chairman of the SEC?" I told her I was, but she still seemed unsure, and said, "Really?" And I assured her that really, I was. And so she said, "will you sign this for my son?" And she handed me a football. I signed it for her, and she was very excited, and I watched her go back to her group of friends and say - "You'll never believe it! I just got the autograph of the new Chairman of the Southeastern Conference!"
So it's a special privilege to be here before an audience that may be almost as excited about securities regulation as that woman was about football.
By your attendance today at this Corporate Governance Summit, you've identified yourselves as leaders in the effort to reshape the relationship between companies and their shareholders. Every one of you is destined to play a vital role in the implementation of the SEC's new disclosure initiatives in this area. As you know, we at the SEC (that's the Securities and Exchange Commission) have been making some dramatic changes in the way that companies disclose information and interact with their shareholders. These changes are remaking the very nature of communications between companies and investors. Whether in periodic reports, or proxy solicitations, or any other investor communication, our overarching goal is to make disclosure more accessible and more useful to investors.
From the forms issuers file to the accounting standards they use, the SEC is waging an all-out war on complexity. And in this effort we're tapping the power of technology to bring higher-quality information to investors more quickly and more easily than ever before. Our new e-proxy rules will soon make it possible for investors to realize the full potential of interactive data. And in a related area, our ongoing conceptual work to update the proxy rules could pave the way for an Electronic Shareholder Forum in which investors could securely and anonymously share information about their company. That cutting-edge thinking is already spurring private firms to invest in creative new ways for shareholders to use the Internet to communicate with one another.
Nothing is more important to investors' understanding of the governance climate at their company than the description of the philosophy and the practice of compensating management. With that principle in mind, the SEC recently put into place a comprehensive rewrite of the rules governing executive compensation disclosure. As you know, and as Karen Ferguson's panel discussed yesterday, those rules have just gone into effect this year. And in the last several weeks, the first proxy statements containing the new disclosures have been filed with the Commission.
In a moment, I'll show you a brief demonstration of what investors can do with some of these new compensation numbers when we leverage the information with the power of interactive data. But just as important as the new numbers - including the one number that summarizes all forms of an executive's compensation last year - is the new narrative disclosure in the Compensation Disclosure and Analysis. This is intended to be very different than the boilerplate we've had in the past. It's an opportunity for a candid conversation between a company and its shareholders about the reasons it structures executive compensation the way it does, and the policies that the company will apply on a going-forward basis. And it's all required to be written in plain English.
Now, I realize that since this is a gathering of corporate governance experts, it's likely that many of you are lawyers. And in that case, you're multilingual. Your second language is Legalese. But even for the lawyers among us, I'd be willing to bet you'd appreciate a good John Grisham novel far more than a big fat 10-K, any day of the week.
So let me ask you a question. Take off your lawyer hat, and put on your investor hat - the one you wear when you figure out what to do with your 401(k), your IRA, your 527 plan, or your lifetime savings. When you get that prospectus or that proxy statement in the mail - do you immediately plunk down in a comfortable chair and read it? How many people here actually read all of the stuff that comes in the mail courtesy of the SEC? [Laughter] And tell the truth now - how many of you throw it away? [Almost all hands raised]
Just as I thought.
Well, it goes without saying, that's a sad irony. Because the SEC is the investor's advocate, and if you're an investor, you're our customer. Any enterprise has to be concerned if the customers are throwing away the product. So it's our aim to break down all the legalese and the jargon, and the dense cover-your-assets boilerplate that reads more like the insurance policy it is than the helpful guide to investors that it's meant to be.
Nowhere is this more important than with the new executive compensation disclosure, because of its close connection to good corporate governance. In the past, the disclosure about executives' pay has been among the most complicated for investors to decipher. That's why the SEC is so adamant that the new Compensation Discussion and Analysis be written in plain English. But now that the proxy season is well under way, and we've reviewed the first of this year's crop, alarm bells are ringing. Already we're seeing examples of over-lawyering that are leading to 30- and 40-page long executive compensation sections in proxy statements.
I have to report that we are disappointed with the lack of clarity in much of the narrative disclosure that's been filed with the SEC so far. Based on the early returns, the average Compensation Disclosure and Analysis section isn't anywhere close to plain English. In fact, according to objective third-party testing, most of it's as tough to read as a Ph.D. dissertation.
A private sector investor relations firm, Clarity Communications, has analyzed 40 companies' CD&As for their level of compliance with the plain English requirement. They determined that all 40 of them fall far short of accepted standards of readability. In fact, they found that most of the disclosure documents failed even to meet the readability standards that states require for insurance forms.
For starters, the executive pay disclosures in the study were verbose. We had it in mind that they'd be just a few pages long, but the median length for the CD&As was 5,472 words - over 1,000 words more than the U.S. Constitution.
And the longest was more than 13,500 words - a far sight longer than a full-length feature in the New Yorker.
But we have tools to help us fight back. Just as the Black-Scholes model is a commonplace when it comes to compliance with the stock option compensation rules, we may soon be looking to the Gunning-Fog and Flesch-Kincaid models to judge the level of compliance with the plain English rules.
Those are the readability metrics that were used in this study. Specifically, the study used three models: the Gunning-Fog Index, the Flesch Reading Ease test, and the Flesch-Kincaid readability algorithm.
It's worth taking a moment to consider how these tools work. Let's start with the Gunning Fog Index, named for its creator, Robert Gunning. (You've got to love a readability algorithm called the Fog Index.)
Actually, the Gunning Fog Index is a venerable linguistic tool that's been around for over half a century. It was developed in 1952 to measure the readability of English prose, based on sentence length and the number of complex words. Writing that's aimed at a general audience should have a Fog Index number of less than 12. So let's take the Wall Street Journal as an example of writing aimed at a highly educated general audience. Not surprisingly, the articles in the Wall Street Journal score just under 12, with a typical Fog Index of between 11 and 12.
Over at Readers Digest, which targets a broader slice of the general public, they usually score around 8.
So where do you think our new Compensation Disclosure and Analysis sections come in, seeing as how they're newly minted in "plain English" for the average investor? In these tests, the average Fog Index for the CD&As in the sample was 16.45. That's about the same as an academic paper, such as a Ph.D. dissertation here at USC.
And things may be even worse than that, because the test they used could only calculate the Fog Index accurately up to a maximum of 17. Believe it or not, 15 of the 40 companies maxed out at 17, or even blew straight through the limit and scored higher.
Since scores over 17 didn't count in the average, the 16.45 average score that was reported actually sugarcoats the full extent of the problem.
The most readable CD&A in the group came in at 14.02. That means the Wall Street Journal editors would have flunked it if it had been submitted to them for publication.
And if all that weren't bad news enough, there's more. The results from the Flesch Reading Ease test were just as bad. This test was developed at Columbia University. In fact, its creator was also a lawyer and a writer, and he earned his Ph.D. for inventing it. The algorithm computes readability based on the complexity of the words used - specifically, the average number of syllables per word - and the average number of words per sentence.
Scores on this test range from 0 to 100. Just as in English class, getting 100 is good.
The higher the score, the more readable the writing. To provide a little context, what the test administrators consider "standard writing" - the kind, for example, that appears in Readers Digest - averages about 60 to 70 on this scale. Most states that have plain English standards in force for insurance forms require a score between 40 and 50 on this test.
So, do you think the average CD&A is as readable as your standard insurance contract?
In the sample of 40 proxy statements that were reviewed in these tests, the average Flesch Reading Ease score was just 34.86. If that were your grade in English class on a 100-point scale, you'd not only flunk - you'd be sent back a grade.
The good news is, Sen. Barack Obama and the SEC's General Counsel, Brian Cartwright, could read and understand these disclosures. That's because they were both President of the Harvard Law Review. And a 34.86 is just about the same score that's earned by the not-so-readable essays in that publication.
Fully two-thirds of American adults simply can't read at a level of 34.86, according to the Accessibility Institute at the University of Texas.
Of course, readability tests such as these are only a rough guide to whether disclosures are made in plain English. Like the grammar check in Microsoft Word, they wouldn't recognize poetry if they saw it. They certainly can't tell if the CD&As are accurate and complete, which is what the whole enterprise is ultimately about.
But the SEC's own qualitative review of this year's proxy statements indicates that we have far to go before we can say that legalese and jargon have truly been replaced by plain English. It's clear that many companies are letting lawyers have the final say on the CD&A. As the firm that undertook this study points out, many of the problems could easily have been fixed in just a few hours by a qualified copy editor. Retail investors deserve better.
It's important to understand how we got to this unhappy juncture, lest we address only the symptoms, and wind up right back where we started. So let's return to the state of nature, as it were, in the early 20th century, before today's patterns and practices had developed.
You will not be surprised to hear that prospectuses and proxy statements used to be shorter, and less cumbersome. The accretion of detail that comprises today's much longer investor disclosures took time. Whereas in 1934 securities lawyers were writing on an essentially blank slate when it came to compliance, today we have the benefit of seven decades of judicial common law, regulatory interpretations, congressional enactments, and industry standards. Increasingly in recent years, the omnipresent threat of litigation, which can instill a healthy fear into managers of other people's money when conscience is insufficient, has had a decidedly unhealthy influence on the writing style in disclosure documents. That's because slowly but surely, the main purpose of the drafting exercise has shifted from informing investors to insuring the issuer and the underwriter against potential claims. In the process, the jargon of lawyers has taken over.
The lawyers' understandable concern, of course, extends not only to the full disclosure of all material facts - in that the SEC wholly concurs - but equally if not more strongly, to the recital of magic words from court opinions, rules, and regulations that have definitively addressed some topic or other. I think we've all observed that there is a near-religious scrupulousness in this adherence to "legally correct" language. If a competitor in the same industry has faced a disclosure issue that has survived a court test, by all means someone in the company's legal department will want to mimic the very phrases. Choosing words to describe the company's business that no other company has used in exactly the same way is thought to be indefensibly risky.
And so the overarching purpose seems no longer to be informing the investor, but above all else erecting a sturdy defense against potential claims that something was left out or improperly expressed. Rather obviously, the result of all this is not plain English.
If I leave you with no other message from today's talk, I hope it will be this: The SEC is dead serious about shedding 70 years of accumulated bad habits in writing. We are well aware that our retail disclosure system has devolved into a self-serving exercise for issuers, underwriters, and their lawyers. No company that serves retail customers would seek to draw their attention to important subjects with an 80- page doorstop. Nor should we, if we are to continue to deserve our title as "the investor's advocate."
Ordinary Americans are busy people. They're neither idle nor rich. And they haven't got the time on their hands to discover that what they really need to know is in the footnotes on page 63 of their proxy statement. They are working mothers and fathers, and young people trying to gain skills and build careers, and seniors fighting illness and disability who are trying to make ends meet. Their savings mean the world to them, so it is not for lack of interest that they throw away the SEC's mandated disclosure documents. It is rather because those documents are too long, too dense, and too hopelessly unintelligible for retail investors to decipher in the necessarily limited time they have between other chores.
It doesn't have to be this way. The Compensation Discussion and Analysis section is a brand new creation. Obviously, no one has drafted these before. There's no boilerplate out there. No precedents to mark up and reuse. So there's no reason for a company to "match up" its disclosure to that of its peers or competitors. Every company has a chance to start with a clean slate.
For those of you who are still getting ready to file this year's proxy statement, I hope you take the opportunity to make a difference, and plainly tell the company's compensation story to your investors.
Of course, the narrative side of the new compensation disclosures is just half the picture. At the SEC, we're planning to give investors even more tools to make the most of the new quantitative information that's being disclosed. I promised you a demonstration, and you won't be disappointed.
As you know, whether or not the CD&A is in plain English, the new executive compensation disclosure has vastly simplified things for investors. It used to be that an investor would have to hunt throughout the proxy statement, the financials, and the footnotes to track down all the various forms of CEO pay. Now, there is one number that totals all of this information, and a clear summary table that shows all the components of the total.
This data-rich disclosure is tailor made for interactive data, which lets users slice and dice the information any way they like.
If the executive compensation data were tagged in XBRL, the computer language of interactive data, then any investor could quickly do industry comparisons, or even analyses of particular forms of compensation, such as stock options.
Of course, right now only a handful of early adopters are reporting their financial information to the SEC using interactive data. We aim to change that very soon. But even before interactive data becomes the norm for all reporting companies, we're going to tag the executive compensation data for you using XBRL. We're going to do this with at least several hundred of the largest public companies in America. And we expect to have it available in June.
You won't see the XBRL coding, of course. That's because just like the HTML code that operates in the background when you surf the web, it's invisible to the user. But what you will see is its power. And to make it easy for you to take advantage of this new power, we're going to put an interactive data web tool on the SEC's site.
[Chairman Cox begins live computer demonstration]
Before I show you what you'll be able to do in the very near future with interactive data, let me show you some of the brand new features of executive compensation disclosure that are already available to you on the Internet. As a result of the new information that's being provided in the current proxy season, there's a great deal more at your fingertips than ever before. And today, you don't even need to use the SEC's EDGAR website to tap into it. You might prefer to use your favorite search engine instead.
[Chairman Cox opens Google search page]
Let's say you're interested in the way the top executives are paid at General Electric. You can just Google the phrase "GE executive compensation 2006". Next we'll click "Search", and then scroll down a bit - and here we see a direct link to the GE proxy statement.
Now we're on the GE website. And here we can see a link to the PDF version of the 2006 proxy statement.
[Chairman Cox opens PDF version of proxy statement]
Now let's go to the Table of Contents. As you can see, the Summary Compensation Table is listed here. It's on page 21. So let's jump to page 21 - and right away we see the new single figure for the total compensation of each of the top executives.
But let's say we want to get fancy, and calculate total compensation a different way. For example, we might want to figure total pay using the grant date fair value of all of the options that were granted last year, instead of the annual 123R expense that ties to the income statements.
Let's do that for GE's chief executive officer.
Here on the Summary Compensation Table we find the 123R figures for the option and stock awards. So let's do some simple math. We'll subtract the 123R values from total pay, because we don't want to use them.
Now we need to find the grant date fair value of all the stock awards and options granted to the CEO last year, because that's what we want to use instead. So let's scroll two pages down to the Plan-Based Awards table in the proxy statement.
[Chairman Cox displays Plan-Based Awards table]
And here are the grant date fair value figures we're looking for. The last bit of math we'll need to do is add this to the CEO's total compensation.
Now we can see the CEO's compensation measured a different way. Instead of the 123R measurement for the value of stock options, we've used the grant date fair value for all the options he was granted last year. As you can see, if we figure it this way, GE's CEO actually made about $1.7 million less in 2006 than was reported using the 123R number.
Now remember, we discovered all of this on a Google search. But it took a little work.
Today, there's not a good free website that links to this kind of information for many different companies, and that lets investors do this sort of math automatically. But that's about to change. In just a few weeks, the SEC plans to take executive compensation disclosure to a new level. And the way we plan to do it is with interactive data.
Let me show you some of the big advantages of interactive data.
[Chairman Cox displays prototype SEC executive compensation Search page]
This is a mock-up of one of the SEC's planned executive compensation web pages. The SEC will tag the executive compensation data with hidden computer codes, written in XBRL. And we'll give you some exciting new tools that will unlock the power of that XBRL code.
We're doing this all in open source - so it will be available to any programmer or software developer who wants to build even fancier tools to analyze SEC data.
One thing an investor might want to do is create a comparison of pay data from several public companies. As an example, let's type in a few company names on the SEC's prototype search page.
[Chairman Cox types in names of seven companies on Search page]
I'm simply using the names of the most recent proxy filers with the SEC, as listed by the Wall Street Journal as of last week. And I'm including GE as well, since we started with it.
Now, we just check the box for whichever officer interests us. Let's pick the CEO.
And since we're interested in "Total Compensation," we'll check that box. Finally, we check "Table" to display the results in tabular format.
Now, by clicking "Build Report," we instantly create a display of the total compensation for each CEO in this sample of seven companies. As you can see, this report makes it exceptionally easy to compare CEO pay among these companies.
Let's go back to the Search page now. Just as a final flourish before I wrap up, let's say we want to compare the total CEO compensation at all seven of these companies using the 123R figure for stock options, on the one hand, and using grant date fair value of all grants last year, on the other hand.
As you'll see, this is going to be a lot easier and faster using interactive data than it was when we had to cut and paste the data into our calculator.
We start by adding "Grant Date Fair Value" as a category we want to report. Now, just for variety, let's check "Graph" instead of "Table." All that's left is to click "Build Report."
As you can see, this time the hidden XBRL code has done all the work for us. We've created a graphic display comparing the total compensation for each CEO as calculated using each of the two different methods.
With no more effort than that, we can now see which firms show higher compensation using the 123R method, and which companies show higher compensation using the grant date fair value for all of last year's grants. In this case, five of the seven firms show higher compensation using 123R. Two show higher compensation using all of last year's grants.
That's just a few examples of what interactive data can do for you - and what you'll be able to do yourself in a very short while.
And that's why interactive data is one of the SEC's top priorities. This exciting new way for investors to get more and better information about the companies they own is part of our commitment to renewing the SEC's focus on the retail investor.
Without question, getting investors the information they need, in a form they can use, is the most basic ingredient of insuring good corporate governance. But the truth is, as the SEC moves to strengthen the hand of investors in their knowledge and understanding of the companies they own, the choices each of you makes will determine how successful these reforms will be. From the quality of disclosure, to the structure of boards of directors, to the way firms address investor concerns and solicit proxies, the implementation of our regulations is the fulcrum upon which the entire effort rests.
It is only through your efforts that we'll be successful in protecting the interests of investors. With your help, we can we raise the standards for the protection of market participants, and at the same time be confident that we are truly making our markets more efficient.
So thank you for what you do each day. And in particular, thank you for your devotion of time and energy these last two day at this Corporate Governance Summit. America's investors can be grateful for your devotion to the cause of sound corporate governance. And in that endeavor, we at the Securities and Exchange Commission are proud to be your partners.