Speech by SEC Commissioner:
Remarks Before the Association of Chartered Certified Accountants
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
May 29, 2007
Thank you, Richard [Aitken-Davies], for that kind introduction. It is an honor to be here tonight. I would like to thank the Association of Chartered Certified Accountants and PROMETHEE for hosting this event. I would like to express particular thanks to David Doyle for his efforts in coordinating the evening. Before I proceed any further, I have to tell you 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.
Economic integration is taking place at a rapid rate. In fact, the speed with which the changes are happening is sometimes hard to fathom. Market participants, of course, spend little time trying to understand why the world is integrating so quickly. They are understandably too busy figuring out new ways to harness the integration to improve their business and service to customers. Sometimes it seems as if the only people who ponder the rapid rate of change and the potential side effects of the growing internationalization are academics and policy wonks, the sometimes derogatory term that we use in the United States to describe those who spend most of their waking hours thinking about public policy issues. Regulators need to listen to what these people are saying, but we also need to make haste to figure out whether regulatory adjustments are necessary to enable the markets to take full advantage of that integration in a manner that continues to protect the integrity of the markets.
There is good news about economic integration as well as bad news. First, let us talk about the bad news. The more integrated our financial systems are, the easier it is for fraudsters on one continent to prey on victims on another continent. The international nature of these cases can make them difficult to pursue, because the defendants and their bank accounts are spread across the globe.
Recently, the SEC has been pursuing account intrusion cases in which malefactors break into brokerage accounts, sell the account holder’s existing securities, and purchase for that account securities of a company that is the object of a market manipulation scheme. Thus, their object is not necessarily to steal the money of the account holder, but to further a pump-and-dump scheme to drive up the price of the manipulated stock. Their illicit profit comes from the manipulation. Earlier this spring, for example, the SEC sued three people residing in India and Malaysia who allegedly used computers in India and Thailand to break into American brokerage accounts for this purpose. Similarly, we see cases of people with insider information sending their tips to people outside the country, who then act on those tips from abroad. The money sometimes makes its way out of the country before the SEC can intervene.
Now let us turn to the good aspects of economic integration. Economic integration opens up new possibilities to investors, issuers, and financial service providers. Investors can look beyond their borders to find investments that meet their needs. This helps them diversity their investment risk. Issuers are more easily able to access capital. Financial services firms can serve customers all over the world. Innovation is more likely to happen in an internationally integrated marketplace because the potential market for a new product or service is larger than it would be in a smaller, national market.
Economic integration also tends to bring with it international regulatory co-operation, which allows us to share the regulatory load with our foreign counterparts. We can assist each other in monitoring the markets and enforcing laws and regulations. We can also work together to refine our regulatory approaches. We can endeavor to eliminate unnecessarily duplicative and anti-competitive regulations. We can figure out how to allocate our scarce regulatory resources more wisely. Last month, for example, the SEC signed a memorandum of understanding with Germany’s BaFin to provide a framework for co-operation in overseeing international firms and international markets. Co-operation between the Committee of European Securities Regulators (CESR) and the SEC is also strong. Last month, CESR Chairman Eddy Wymeersch, who is here tonight, and SEC Chairman Cox agreed on a form for bilateral information sharing between the SEC and CESR members regarding dual-listed issuers. Greater sharing of information will lead to greater consistency in financial reporting. The ever-expanding list of exchange consolidations is helping to drive regulatory co-operation.
In an ideal world, regulators would seek to minimize the bad aspects and foster the good aspects of economic integration. This may not be what happens in the real world. Regulators sometimes may find it safer to say no to something new than to say yes and risk taking the blame if something goes wrong. A survey of market participants that was included in a PROMETHEE publication in 2001 found that regulation was perceived to be by far the greatest obstacle to cross-border activities in capital markets.1 Sixty-five percent of survey respondents predicted that there never would be a “global” SEC, a finding consistent with the feeling by eighty percent of respondents that regulators “work actively to ‘protect their turf.’”2 Many survey respondents did predict the imminent establishment of a “Euro-SEC.” Now, while this refers to a Europe-wide securities regulator, there is another twist to this name: What if the SEC comes to Europe? Last week, at an SEC roundtable, four former chairmen of the SEC expressed support for opening a Brussels branch of the US SEC. Needless to say, that may not be exactly what the survey respondents had in mind!
Speaking of roundtables, two weeks from now, the SEC will host a roundtable on the subject of selective mutual recognition. The roundtable will focus primarily upon the issue of substantially comparable regulation. This is an interesting topic for academics and policy wonks, but I am afraid that we are in danger of dissipating our opportunities to make real progress in the near-term on more practical issues that have immediate pay-back. The primary issue, of course, which is also of most interest to you here tonight, is mutual recognition of International Financial Reporting Standards (IFRS) and US GAAP by the SEC and the European Union.
We already are making good progress towards mutual recognition in one important area – accounting standards. I expect that, by summer’s end, the SEC will propose the elimination of the requirement under which companies using IFRS have to reconcile their financial statements to US GAAP. Of course, that may mean less work for many of you in this room. Nevertheless, strong arguments can be made for the rapid elimination of the reconciliation requirement. For one, it is an additional cost for foreign private issuers registered in the U.S. What is more, it appears, from some of the discussion at our IFRS roundtable earlier this spring, as if the reconciliations are of limited use to investors anyway. The SEC likely will consider whether to take the additional step of permitting U.S. companies to select between using U.S. GAAP and IFRS. That would leave the choice between U.S. GAAP and IFRS to the markets. If investors prefer one set of accounting standards over another, they may well reward those issuers who use the preferred set with premium pricing.
As optimistic as I am about the prospects of mutual recognition in the area of accounting standards, I am less certain of the imminence of mutual recognition in the world of oversight of securities firms and exchanges. Two SEC staff members recently published an article discussing an idea of substituted compliance. Although speaking for themselves, they deal with a topic that has been under consideration in one way or another by the SEC for more than twenty years. Their article at least has focused renewed attention on the matter.
In sum, their vision is to make a financial intermediary’s eligibility to participate in U.S. markets contingent on its supervision under a foreign regime that has a regulatory scheme substantially comparable to that in the United States. I have long been a proponent of more flexible treatment of non-U.S. firms in the U.S. markets. U.S. investors will be the ultimate beneficiaries if restrictions are eased.
When we talk about “mutual recognition” and “substitute compliance,” we should be careful about our terminology and how we set out to achieve our goals. It can be all too easy to insist on actual harmonization of regulations between various jurisdictions – as in a rule-by-rule comparison of how each regime puts its principles into effect. If the rules are not in harmony, then must the jurisdictions work to bring them into harmony? That may be a great goal, but to me, this is a bottom-up approach and would result in a completely unworkable and potentially never-ending process. Unfortunately, the process suggested by this article would too easily devolve into this sort of impractical approach.
Basically, the article’s suggested process would begin with each individual foreign firm’s applying for an exemption from SEC registration. The SEC would then engage in discussions with the regulatory regime overseeing the firm, and if necessary seek to eliminate any regulatory gaps. The process would also include an assessment of the firm, with a public notice-and-comment process before approval of the exemption. To top it off, the article suggests that the United States could enter into a series of bilateral treaties with each counterpart nation. To say the least, this does not sound very practical. It certainly is not achievable in the near term.
An alternative framework to that suggested in the article would be a top-down approach. In this regard, the SEC has much to learn from our fellow American regulators, such as the Commodity Futures Trading Commission (CFTC) and Federal Reserve. The CFTC, for example, first identifies the important elements that a compatible regulatory jurisdiction should embody. In the SEC’s case, this would include investor protection standards, such as protection against misappropriation of customer assets, fraudulent sales practices, financial responsibility of registered entities, effective examination, and licensing and qualification of brokers. Then, instead of examining each rule of the foreign jurisdiction, we would assess the adequacy of that jurisdiction’s oversight. Thereafter, a firm could be eligible for exemption.
My main concern with this high-level discussion is that we not be diverted from achievable, near-term goals. We certainly have enough of those, such as the much-needed modernization of Rule 15a-6, which governs the activities of foreign broker-dealers in the U.S. This rule started out in the 1980s as a reform of previous rules, but it has caused consternation and increased costs for brokers and investors alike. A rule that recognizes the reality of the modern markets, including the different needs of institutional investors, is long overdue.
I mentioned earlier the problems that the SEC is facing with account intrusions from overseas. We have also seen instances of overseas boiler rooms reaching into the U.S. How much easier it would be for boiler rooms to defraud U.S. investors if they had direct access to retail investors. Co-operation among international regulators, of course, would be a critical element of any mutual recognition framework. Nevertheless, tricky issues would remain. Would the slightest regulatory change cast doubt upon another country’s regulatory regime? If so, would the SEC effectively have veto power over other countries’ regulations?
Earlier this spring, the SEC made a regulatory change that should promote international economic integration. The SEC adopted rules to allow foreign private issuers to leave American public capital markets by deregistering their equity securities and ceasing to file reports. Non-U.S. companies have long awaited such a rule. The new rule looks to relative U.S. trading volume to determine a company’s eligibility for deregistration. After we have had some experience with the new rule, we may determine that it still needs some refinements. In the meantime, however, I am encouraged by the fact that the door to the U.S. capital markets now opens both ways. It is a pretty daunting prospect to enter a country’s capital markets knowing that it will be nearly impossible to leave.
There are several reasons why foreign companies who are looking to U.S. capital markets might be daunted. One of these is litigation risk. In the U.S., class action lawsuits impose tremendous costs on shareholders. Even if a suit lacks merit, it is often cheaper to settle it than to defend it. Thus, class action lawsuits can end up shifting wealth from innocent current shareholders to a group of equally innocent shareholders who held during some, often arbitrarily defined period with, of course, a hefty chunk reserved for the class action lawyers. Congress took action in the 1990s in an attempt to block baseless suits while allowing meritorious suits to go forward. The lure of the potentially enormous payouts for successfully settled class action lawsuits spawns creativity by the class action bar. Thus, there are always new theories being tried. For example, the U.S. Supreme Court will rule this year on three important cases that will define the reach of securities class actions.
Another potential reason for foreign companies’ avoiding the U.S. capital markets is regulatory uncertainty. Companies might see the regulatory landscape change practically overnight. We saw this, for example, with Sarbanes-Oxley, which made its way through Congress very quickly in response to extreme frustration over a string of high profile corporate scandals. Sarbanes-Oxley already has effected positive change, and I anticipate that it will continue to serve the markets well in the years to come.
Section 404 of the Sarbanes-Oxley Act, however, has gotten off to an embarrassingly bad start. As you all know, Section 404 relates to companies’ internal control over financial reporting. The objective of ensuring greater focus on effective internal controls is not the source of the controversy over the provision. Instead, the crux of the 404 problem has been the manner in which it has been implemented. Implementation has been driven not by attention to risk, nor by the application of reason, but by a commitment to check every box. As a result, the process has been both very costly and less effective than it could have been had attention been properly focused. Up until this point, a dearth of management guidance has meant that the guidance that was intended for auditors also has guided management. As the ACCA explained in a comment letter to the SEC and the Public Company Accounting Oversight Board (PCAOB), this has caused excessive focus on documenting and evidencing key controls “at the expense of a proper evaluation of the control environment” and has made the process more expensive than it needs to be.3 Given that many of you are accountants, the problems with Section 404 are not news to you.
What is news is that the SEC and the PCAOB took steps last week to overhaul the manner in which Section 404 is implemented. On Wednesday, the SEC voted to adopt guidance for management to use in conducting their assessment of internal controls. Because the new management guidance is intended to be flexible, it is short on specific examples. However, it offers guidance in a number of areas that have been particularly problematic, such as information technology controls, entity level controls, and testing in a company made up of multiple locations or business units.
Meanwhile, the SEC has been working with the PCAOB on a standard to replace the ill-reputed Auditing Standard 2 (AS2). On Thursday, the PCAOB voted to replace AS2 with the leaner AS5 that allows for more professional judgment by auditors. Although I have not had a chance to read the new standard, I am hopeful that it is a significant improvement over its predecessor. The PCAOB’s status as a merely quasi-governmental regulator means that AS5 still has to undergo several steps before it becomes final. After an SEC vote, AS5 will go out for another round of comment. Once we have had an opportunity to review the commentary, we will vote again on whether to approve the standard.
The full effect of last week’s reforms remains to be seen. The ultimate goal of these changes is better, more cost-effective service for investors, since investors ultimately pay the bill for the internal review process. If auditing fees do not come down as a result of these changes, then something is terribly wrong with the interpretation of new AS5 and perhaps with the competitive landscape of the auditing profession itself. Many cooks are in the Section 404 kitchen. If one of them adds the wrong ingredient or stirs too vigorously, we might end up with yet another unappetizing round of Section 404. Management needs to resist looking to AS5 as the standard to govern its work. Auditors need to change their approach in response to the new standard. The PCAOB needs to inspect with an eye towards ensuring that auditors are applying the new standard properly. The SEC, which is responsible for inspecting the PCAOB, should keep a close eye on PCAOB and whether the Section 404 reforms are working.
The topics of Sarbanes-Oxley and litigation reform bring me to my final topic, which I will only briefly mention now – the state of the United States capital markets. This has been the subject of much discussion in the United States, where we have been talking a great deal about whether we are losing pace with capital markets outside the U.S. The discussion is an important one. Three reports have been published in the past 6 months. Among the reforms suggested by these reports are better co-operation among U.S. financial services regulators, restructuring the SEC, and reformulating the SEC’s regulatory approach into a more prudential model.
As we engage in this discussion and the attendant comparisons with markets throughout the world, it is important to remember that our objective should never be to pit one capital market against another in a zero-sum battle. Rather our objective should be to cooperate with one another to maximize the opportunities for capital and resources to flow to their highest and best use so that people everywhere will be better off.
Thank you all for your gracious attention. I look forward to hearing your perspectives in the upcoming discussion. So, without further ado, I will hand you over to Allen Blewitt, who will moderate the question and answer session.
1 Annual Survey of Market Participants, Part II of STRATEGIC PERSPECTIVES ON CAPITAL MARKETS OF THE 21ST CENTURY, at 91 (2001) (available at: http://www.promethee.asso.fr/what/what.htm).
2 Id. at 95.
3 Comment Letter of the Association of Chartered Certified Accountants (Feb. 26, 2007) (avail. at: http://www.sec.gov/comments/s7-24-06/s72406-110.pdf).