Speech by SEC Commissioner:
Remarks before AmCham Germany
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
May 30, 2007
Thank you, Herr [Ernst] Frings, for that kind introduction. It is an honor and privilege for me to be here tonight. I would like to thank the American Chamber of Commerce in Germany for the important work that you do in building bridges in order to benefit people here in Germany and on the other side of the Atlantic. Speaking of the other side of the Atlantic, my compliance people back home insist that I remind you that the views that I express here are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
AmCham's website makes the sobering statement that: "Overregulation — as well as diverging regulatory standards — in both the EU and the US are some of the largest hindrances to transatlantic commerce today."1 As a regulator, hearing such statements reminds me of the importance of getting the job of regulation right. I also am reminded of how bad the consequences of doing the job wrong can be. Getting it right means employing a "smart regulation" approach to future regulation. Getting regulation right also means being willing to revisit past regulatory decisions that we have gotten wrong.
Regulators sometimes are perceived as not caring about doing the job right. Regulators, after all, set the ground rules and enforce them. Moreover, regulators are not elected politicians, so they are not directly accountable for their mistakes. Further, regulators wield tremendous power over the entities that they regulate. Annoying your regulator is a dangerous business since he will still be your regulator after you annoy him, but his attitude towards you might be worse. In the enforcement context, the regulator can be especially powerful. Given the realities of public relations and the importance of market perception, the subject of the enforcement investigation can be especially helpless.
Perhaps, though, in today's world, regulators are a bit less sheltered and more responsive to constructive criticism than they have been in the past. This might not be the case for all regulators across the board, so I will limit my discussion to my regulatory agency, the SEC. In today's world, the SEC has to care about doing its job right. It has to look for ways to regulate effectively with an eye towards avoiding unnecessary direct and indirect costs. Although perhaps less comfortable for the SEC, the new paradigm can help us to move forward towards greater transatlantic integration.
The SEC today regulates a world that looks very different from the world that it faced when the SEC was created more than seventy years ago. Indeed, the SEC's world is dramatically different than it was just ten years ago, or even five years ago when the President appointed me commissioner. The United States markets are huge and continue to grow, but international markets are also huge and growing. Europe now considers itself one market, not just a loose union of national markets. The United States public markets still offer deep liquidity, but there also are other sources of liquidity in the private markets. The United States is still an excellent place to be listed and offers access to a tremendous amount of capital, but it is easy to access capital in other places too. Exchanges are merging with one another without much regard for the national borders that have separated them in the past.
Aside from the growth in magnitude and breadth of the markets, there is also increasing diversity. New financial products multiply and take hold at remarkable speed. Rapid changes in technology have spawned a whole new array of financial products, services, and modes of delivery. Financial products that were once illiquid are being standardized so that they can trade more easily. Private capital markets are flourishing and new venues are being developed to trade non-public securities. The entrepreneurial spirit is still alive and well in the United States, but many other countries are enjoying a surge in entrepreneurial behavior as they restructure their legal frameworks to reward entrepreneurs.
As markets grow in size and complexity, the opportunities for those who would defraud others also increase. Fraudsters are learning to harness technology for their own benefit. They can target victims thousands of miles away with little more than the push of a few buttons on a computer keyboard. The ill-gotten gains of a fraudulent scheme across borders can be moved in an instant. Fraudsters can target victims en masse with an email or a fax.
What do all these changes mean for the SEC? The short answer is that the SEC is changing with the times. First, the SEC is coming to understand the need to consider thoroughly its actions and their potential costs before undertaking them. Second, the SEC is learning that investors are harmed by unnecessary costs imposed on the companies that they own. Third, the SEC is also learning the need to be responsive to the concerns of those whom it regulates. Fourth, the SEC, having acknowledged that it is not a regulatory monopoly, appreciates more than ever the need for closer co-operation with other regulators. Finally, the SEC is learning to learn from others. It just goes to show that you are never too old to change.
Admittedly, this is not an exhaustive list. Admittedly too, some of these changes have been embraced with greater eagerness than others. I will discuss each one of these changes in SEC attitude in turn.
First, then, is the notion that careful thought should precede regulatory action. Because the capital markets are so large, a slight misstep by the SEC can be quite costly. In several recent instances, the SEC has taken regulatory action only to have the action invalidated in court. I dissented from the regulatory actions taken in three of the four instances. Two of the court defeats related to governance of mutual funds. The SEC, over my objection, attempted twice to adopt a rule without first considering, as the SEC is required to do, the potential effects of the rule on efficiency, competition, and capital formation. A third court defeat was the rejection of the SEC rule that required hedge fund advisors to register, a rule from which I also dissented. The rule was rejected by the court as not being consistent with the authority granted to us. Not only did the SEC fail to think through the legal issues behind that rule, but the SEC also did not tie the rationale of that rule to any real problem in the marketplace. The real issues with respect to hedge funds are concerns about whether the SEC's eligibility rules for hedge fund investors are outdated and concerns about systemic risk.
With respect to hedge fund regulation, I agree fully with the points that Federal Reserve Chairman Ben Bernanke made recently:
Direct regulation [of financial services firms] may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risk-taking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds' ability to provide market liquidity.2
As for systemic risk concerns, we cannot regulate them away. Instead, the President's Working Group on Financial Markets, or PWG, is properly taking the lead role in addressing that issue in a principles-based manner. The PWG is made up of representatives of the Treasury, Federal Reserve, Commodity Futures Trading Commission (CFTC) and the SEC. Recently, for example, the PWG issued a statement with respect to hedge funds and other private pools of capital.3 The statement generally supported the existing regulatory approach, and the views expressed by Chairman Bernanke. It laid out some principles to guide investors, advisors, creditors, counterparties, and government regulators in their dealings with hedge funds. The principles recognized both the beneficial role played by hedge funds and the importance of harnessing market discipline to guard against systemic risk.
It is important to note the increased co-operation and co-ordination by government authorities in both the United States and abroad. The SEC has stepped up its risk oversight of the large prime brokers to hedge funds, and bank supervisors actively monitor and conduct targeted reviews of banks' dealings with hedge funds.
I should add that the SEC recently proposed raising the minimum requirements for investors in hedge funds. These numbers have not been updated since 1982. Inflation and relative asset values in the marketplace have certainly affected the relevance of these numbers. We have received much comment on this proposal, including from those who object to the government's telling them what they may or may not invest in. I look forward to considering these comments in the months ahead.
The second attitude shift at the SEC is a growing understanding that when companies bear costs, the shareholders ultimately pay the price. One example that is particularly relevant in the U.S. is the tremendous costs that shareholders bear as a result of class action lawsuits against corporations. 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.
Because shareholders bear the costs, the SEC ought to monitor closely regulatory costs on companies. One example that is of current relevance is Sarbanes-Oxley 404. The Sarbanes-Oxley Act has benefited shareholders overall. 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. Shareholders benefit from strong internal controls. The manner in which Section 404 has been implemented, however, has subjected companies — and hence their shareholders — to enormous costs and reduced the Section's effectiveness.
Implementation is within the purview of the SEC and the Public Company Accounting Oversight Board (PCAOB), a non-governmental entity with a government-type mandate and that is subject to SEC oversight. The PCAOB's Audit Standard 2 drove auditors to act not necessarily based on attention to risk, nor necessarily by the application of reason, but instead by a bottom-up approach. This approach ensured that every box got checked, but precluded the exercise of professional judgment. Up until this point, a dearth of management guidance has meant that the guidance that was intended for auditors also has guided management. As a result, costs mounted well above our predictions. Investors were paying a high price and seeing resources diverted from other important uses.
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 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 hope 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 AS5 and perhaps with the competitive landscape of the auditing profession itself. Management needs to resist the temptation to look to AS5, which is still longer than the guidance that the SEC prepared for them, as the standard to govern their 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, in turn, should keep a close eye on PCAOB and whether the Section 404 reforms are working.
The third change in attitude at the SEC is the new understanding that it makes good regulatory sense to be responsive to those it regulates. One demonstration of this attitude shift is the SEC's decision earlier in the year to modify the deregistration process for foreign private issuers. 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. Although not a perfect measure of how we are doing, opening up the exit doors will help to increase our responsiveness. If our regulations are too burdensome without counterbalancing benefits, companies will exit for other regimes with more rational regulatory frameworks.
A fourth new attitude at the SEC is a greater willingness than ever before to work with other regulators. 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.
Among other issues, we are working with CESR and International Organization of Securities Commissions (IOSCO) on achieving consistent application and interpretation of International Financial Reporting Standards (IFRS). The SEC staff, which receives IFRS filings from all over the world, is in an excellent position to spot potential issues, but it does not intend to become the arbiter of IFRS. Importantly, the SEC is making real progress towards eliminating the reconciliation requirement for companies that use IFRS.
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. 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 those who look at financial statements anyway.
What is even more remarkable evidence of an attitude shift is that 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 fact, 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.
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 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 also would 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.
Another possible framework would be a top-down approach. In this regard, the SEC has much to learn from our fellow American regulators, such as the CFTC and the 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?
The final attitude shift at the SEC is a new appreciation for the need to learn from others. The state of the United States capital markets has been the subject of three reports published in the past six months. As a consequence, we have been talking a great deal about whether we are losing pace with capital markets outside the U.S. 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. The SEC is paying attention to the discussions and considering the reforms. We will also listen to and learn from regulators, participants, and investors in the capital markets outside the U.S. Undoubtedly, the SEC can learn some lessons from them.
I believe that the SEC, armed with its new attitudes, will be a better partner in moving forward towards greater trans-Atlantic financial co-operation. The SEC understands that it is one player in a tremendously large, rapidly changing marketplace. The SEC knows that if it is to be successful, it must work with and learn from the investors whom it protects, the entities that it regulates, and the regulators with whom it shares responsibility.
I look forward to hearing your thoughts now and in the future when you find the time to stop by and visit my office in Washington. Thank you all for your attention.