Speech by SEC Commissioner:
Remarks at the Royal Society of Arts
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
March 27, 2007
Thank you for that kind introduction. It is an honor to be back in London. I thank all of you for taking the time to be here this morning. Before I begin, I must tell you that the views that I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or of my fellow Commissioners.
A movie now playing at theaters in the United States commemorates the two hundredth anniversary of the culmination of William Wilberforce's long struggle to end the slavery trade in the British Empire. Henry Thornton is a minor character in the movie, featured for introducing Wilberforce to the woman who was to become his wife. In addition to being a successful matchmaker, Henry Thornton was a brilliant economist whose seminal work was An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. The Cass Business School at the City University of London hosts a lecture series in Thornton's honor. In 1998, that lecture was given by the then-head of the Financial Services Authority (FSA), Howard Davies.1 The lecture was entitled, "Why Regulate?" and suggested a starting point for answering that question:
[R]egulatory intervention is only likely to be justified if we have the right answers to the following questions:
- what is the nature of the market imperfection (if any) causing a problem?
- are there ways in which that imperfection can be tackled, with outcomes that deliver a net improvement in welfare, or does any possible cure cause worse problems elsewhere?
If we can jump those two fences, then we must still ask whether the FSA is the appropriate organisation to organise intervention.2
The approach that Mr. Davies outlined in his speech was not only appropriate for the FSA, which at the time had just become the UK's single financial regulator, but is also applicable to US regulators nearly a decade later.
Along those lines, as of the beginning of the year, the President has required each agency to:
identify in writing the specific market failure (such as externalities, market power, lack of information) or other specific problem that it intends to address (including, where applicable, the failures of public institutions) that warrant new agency action, as well as assess the significance of that problem, to enable assessment of whether any new regulation is warranted.3
Looking at the economics underlying regulation enables regulatory agencies to direct their resources to areas in which they will be most beneficial to the capital markets and the investors who invest in them.
Recently, there has been much talk in the United States about the health of our capital markets. Just two weeks ago, Treasury Secretary Paulson hosted a Capital Markets Competitiveness Conference.4 In this discussion and others, we have been asking ourselves whether we can make changes to make the U.S. more attractive to businesses all around the globe that are in need of capital without compromising investor protection. At the core of much of this discussion has been the need for economic analysis as a prerequisite for regulatory action.
Earlier this month, the Commission on the Regulation of U.S. Capital Markets in the 21st Century, a group organized by the U.S. Chamber of Commerce, issued its report with recommendations, including a recommendation that the SEC do thorough cost-benefit analyses before and a year or two after taking regulatory action.5 Last November, the Committee on Capital Markets Regulation, which is chaired by Glenn Hubbard and John Thornton and directed by Hal Scott, issued an interim report that similarly recommended that the SEC "systematically implement … a carefully applied cost-benefit analysis of its proposed rules and regulations" both prior to adoption and periodically thereafter.6
In January, Senator Charles Schumer and New York City Mayor Michael Bloomberg issued a report, prepared by McKinsey Consulting, on the state of the financial services industry in New York and the U.S.7 The report, citing the FSA's six principles of good regulation,8 recommended cooperation among the federal financial regulators in the United States to develop a set of principles for good regulation and guidance for financial institutions. The report suggested, for example, that the President's Working Group on Financial Markets — a group made up of the Secretary of the Treasury and the chairmen of the Board of Governors of the Federal Reserve System, the SEC, and the Commodity Futures Trading Commission — could undertake the task. As the report explained:
if regulators agreed to principles requiring a rigorous cost/benefit analysis or materiality tests guided by sound economic analysis conducted by a proficient and dedicated staff, then all future regulations would be subject to such thorough assessments before being adopted. Similarly, enforcement action would be taken only if there was material impact on either the specific institution or the financial system in general.9
The SEC would be well-served by such an approach, as would the investors whom it protects and the financial services industry that it regulates. In the past, we have shied away from looking seriously at whether there is a problem, whether a regulatory solution is the best way to solve it, and what the costs of that regulatory solution will be.
Unfortunately, a coalition of contrarians — we can call it the "What-me-worry?" Crowd — has recently begun a campaign to mute the calls for action in the three reports. They apparently believe that the U.S. capital markets are perfectly fine — indeed the market is doing very well with the Dow near its all-time high, strong macro-economic fundamentals, and healthy investor interest. They also seem to believe that it is unnecessary to examine the calibration and implementation of our regulations.
To support this position, they have been citing, among other things, a summary study that purportedly contradicts the findings of the three policy groups. The report states that "foreign issuers of IPOs are flocking to US exchanges at unprecedented levels."10 The study's own statistics, which show the high-water mark was in the late 1990s, seem inconsistent with that statement. Moreover, this study is merely a tabulation of the number, size, and proportion of foreign IPOs in the US market during the past 20 years, apparently without adjustment for inflation. Further, it looks at the US market in isolation, something that the three policy groups have stressed that we no longer have the luxury to do. As E.U. Commissioner Charlie McCreevy recently pointed out in an excellent opinion piece in the Wall Street Journal, the US share of global IPOs has fallen from 57% in 2001 to 16% in 2006, while Europe's has increased from 33% to 63%.11 Statistics, rather than empty rhetoric, are extremely useful in this debate and must be carefully analyzed.
Listing in the US markets offers foreign firms many benefits including deep liquidity, visibility to US investors, transparency, and corporate finance and business strategy opportunities. At the same time, however, other markets have grown and liberalized during the past couple of decades, narrowing the advantages of our markets. This is ultimately for the good of all. In the end, companies are rational — they expect benefits to exceed costs and will seek a market where that is so. If the costs of raising money in the public markets is too high, many of these companies will end up in the deep and flexible US private markets.
The all-too-frequent lack of interest in the economic justification for and consequences of regulatory actions at the SEC has manifested itself in unfortunate ways. I am pleased to report that this is changing under the leadership of Christopher Cox, who took over as Chairman of the SEC in 2005. He has called for a top-to-bottom review of the SEC's compliance with its obligations to analyze the economic effects of the SEC's rules.12 In addition to this comprehensive look at how well the SEC is using its economic resources in policymaking, the Chairman has been instrumental in ensuring that the SEC considers the economic ramifications of specific regulatory actions.
One recent example of the Chairman's commitment to changing the SEC's attitude towards economic analysis was his decision at the end of last year to publish for public comment two studies by our Office of Economic Analysis. The studies look at whether there is economic support for a far-reaching SEC rule that sought to impose a one-size-fits-all governance structure of every mutual fund. The rule as adopted twice by the Commission, both times over my dissent, would have required each fund to have a board made up of at least 75% independent directors, one of whom is chairman. The economists' studies would seem to support the conclusion that there is not a universally optimal governance structure for mutual funds; independent chairmen are better for some funds and interested chairman are better for other funds. Publication of the economic studies was particularly important because the rule was struck down twice in court for the Commission's having failed to consider properly the costs of and alternatives to the measure.
Another recent example of how the SEC has sought to use economic analysis in making rules was the pilot test that our economists conducted in connection with short sales. For many years, academics had been questioning whether the SEC's short sale price test, or "tick test," was needed. The tick test, which has been on the books for seventy years, restricts the prices at which short sales may be executed. Our economists conducted a pilot test on approximately 1,000 securities. They did not find evidence to suggest that pilot stocks are more likely to be manipulated downward than other stocks. Based on the results of the pilot, the Commission proposed last December to eliminate the tick test across the board.
The consequences of failing to consider the costs of a rule before it is implemented were illustrated starkly by Section 404 of the Sarbanes-Oxley Act, which requires each public company to include in its annual report an assessment by management on the state of the company's internal control over financial reporting. Section 404 also requires a company's auditor to attest to and report on management's assessment of internal controls. The SEC implements Section 404 as it applies to management, and the Public Company Accounting Oversight Board (PCAOB) implements the Section for auditors.
Section 404's implementation difficulties surprised a lot of people. 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.13 Estimates have put actual average costs at more than 20 times that amount. The unanticipated costs seem largely attributable to the fact that the SEC's rule was principles-based, but the PCAOB's Audit Standard No. 2 (AS 2) was not.14 AS 2 has made it difficult for auditors to employ professional judgment in assessing internal controls and encouraged them instead to use a time-intensive, materiality-insensitive, bottom-up approach. In a world of limited resources, the more that companies spend on things like internal controls assessments, the less they can invest in developing and marketing products, hiring and retaining talent, and embracing new technologies.
In an attempt to restore the cost-benefit balance, the SEC and the PCAOB set out to craft a new approach that recognizes the tremendous importance of internal controls, but also appreciates the need for balance. In December 2006, the SEC proposed additional guidance for management's assessment of internal control.15 To complement these changes, the PCAOB has proposed a new auditing standard to replace AS2 in toto.16 The proposed standard affords auditors greater room for judgment and employs a risk-based framework to direct their efforts.
I am encouraged by the commentary that we have received — not only by the positive comments, but by the comments that provide insight as to what we can improve. The PCAOB and we are working to align the new audit standard with our management guidance. Additional changes that commenters have called for include the elimination of the many "shoulds" and "musts" that are prescriptive vestiges of AS2, the elimination of the unnecessary focus on significant deficiencies, a more workable approach to scalability, refinements to the definition of "material weakness," and further facilitation of auditors' reliance on the work of others. Many commenters have pointed out, however, that implementation will be the true determinant of success.
As we work on developing the new approach, the SEC has given smaller companies and foreign issuers additional time before they have to comply with the Section 404 requirements. If we are unable to make the necessary changes quickly, we may find that further extensions are necessary.
Just last week, the SEC approved final rules that should greatly ease the burden for U.S.-registered foreign issuers looking to exit the U.S. markets. This change will serve as an incentive for us to get the cost-benefit balance of our regulations right. The rule change itself will eliminate the "Hotel Califonia" disincentive; a decision to list in the U.S. will no longer be irreversible.
Under the SEC's former rules, a non-U.S. issuer could only terminate its U.S. registration if fewer than 300 record holders of the issuer's equity securities were U.S. residents.17 Foreign issuers found it difficult to meet this standard even if there was relatively little investor interest in the United States. In late 2005, we published for comment a proposed rule that would have examined the percentage of U.S. ownership of the foreign issuer's worldwide public float.18
Many comment letters that we received19 raised issues similar to my own belief that 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. U.S. residents who execute their trades abroad should not have the expectation that U.S. securities laws will apply to those overseas transactions. So I was very pleased that we reproposed and last week adopted a much more philosophically sound deregistration rule that is consistent with the Commission's long-standing "territorial approach" to international securities regulation.20 A good test of the rule's flexibility in the face of changing world market structures will be the post-MiFID European markets.
The Commission is poised to explore other initiatives that will test the bounds of the "territorial approach." In a recent article, a member of the SEC's staff proposed a dramatic system of mutual recognition for non-U.S. broker-dealers and securities exchanges. Having long called for the Commission to revisit the rules governing the U.S. activities of non-U.S. firms, I was pleased to see that this proposal triggered a debate on the propriety of the SEC's current rules for non-U.S brokerage and trading activities. That said, it will be difficult to mesh the proposal with our investor-protection mandate as well as our duty to promote competitiveness in the US marketplace. Boiler rooms in Berlin or Bucharest or a pump-and-dump scheme run out of Parma or the Dordogne with direct access to US retail investors are a concern. Increased international cooperation is absolutely necessary to combat fraud because we all are short of resources. At the same time, the SEC can work to reduce the barriers to entry that unduly restrict both foreign firms and exchanges and U.S. investor choice. To that end, I was encouraged to see recent comments by our new director of the Division of Market Regulation, Erik Sirri, on this topic.
Speaking of mutual recognition, let me turn briefly to a subject that is much discussed both here and in the U.S — the reconciliation requirement for foreign private issuers that use International Financial Reporting Standards (IFRS). The reality that the costs of reconciliation may indeed outweigh any benefits to investors has helped fuel the efforts to end the reconciliation requirement.21 The European Commission bolstered the move towards equivalence by extending an exemption to make reconciliation of U.S. GAAP to IFRS unnecessary. Just imagine how counter-productive it would be to our mutual recognition efforts if the E.U. were to impose a new reconciliation requirement, essentially saying that the two are not equivalent just as we are hoping to find that they are equivalent.
Meanwhile, the SEC has been gaining its first insights into how IFRS is working in practice from staff reviews of IFRS filings, on which it is cooperating with the Committee of European Securities Regulators.22 The objective of the SEC staff's reviews is not to attempt to dictate how IFRS ought to be applied, nor is it to turn IFRS from principles-based accounting standards into rule-based standards. Rather our staff is looking at whether IFRS filings are complete and adhere to IFRS standards. The SEC staff is also looking at whether IFRS filers are using a single, uniform set of standards rather than a dizzying array of nationally-tailored versions of IFRS.
We must remember that an important measure of success of all of these efforts is whether they deliver to users of financial statements a clear and accurate picture upon which sound investment decisions can be based. If we recognize IFRS as an acceptable set of standards for foreign companies to use in their US filings, we should also ask whether it is equally acceptable for US companies to use IFRS as well. If nothing else, this could add some long-absent accountability for the standard setters themselves.
All of the regulatory issues that we face call for a commitment not only to weigh the economic implications, but also to work with our transatlantic counterparts. German Chancellor Angela Merkel's initiative for a transatlantic economic partnership highlighted the importance of such cooperation. I appreciate the hard work of many others in Europe, including Commissioner McCreevy, with whom I had the honor of sharing a podium yesterday, and those of you here today.
Thank you for your attention this morning. I look forward to joining you in the audience to hear the debate.