Speech by SEC Commissioner:
Remarks Before the ALI-ABA Conference on "Corporate Governance: The Changing Environment"
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
February 21, 2008
Thank you and good morning. I am honored to be a participant in this important conference focusing on recent developments and the future of corporate governance.
You have a busy agenda that focuses on many of the issues of the day, such as 404 internal controls, shareholder activism, and the state of U.S. competitiveness.
Given the ample opportunity to create controversy in any of those areas, let me first state for the record that the views I express here today are my own and do not necessarily reflect the views of the U.S. Securities and Exchange Commission or my fellow Commissioners.
Notwithstanding my disclaimer, there is much to say about the changing environment in corporate governance from the SEC's perspective, but let me start by recognizing that the role of the SEC — while an important one — is also a limited one.
Although Congress vested the SEC with important authorities under the Securities laws, the SEC's complementary role to State law historically has been largely disclosure-based and intended to protect investors by ensuring full, fair, accurate, and timely reporting of material information about public companies.
Corporate governance is, first and foremost, a matter of State law that flows from a well-developed common law tradition.
This tradition is a distinctive trait found in the English-speaking countries throughout the world: a habit of mind to discover laws and not make them; and a conviction that these discoveries are made by ordinary citizens by trial and error, applied by courts to experiences as they are actually lived.
The common law creates a continuity of inquiry despite separation by hundreds of miles and hundreds of years. And perhaps, it is no coincidence that eight of the ten countries with the greatest degree of economic freedom (as measured in the 2007 Index of Economic Freedom)1 have benefited from this common law tradition.
This common law tradition that has helped create some of the freest and most prosperous nations on Earth is also what has made the American corporate model such an important part of our economic success.
With a majority of U.S. public companies incorporated in Delaware, Delaware corporate law and adjudications by Delaware courts effectively establish corporate governance standards throughout the United States.
Delaware courts are recognized as the most expert in the country, and capable of rendering high-quality judgments effectively using what is, in effect, national case law on corporations.
Predictability in the law is also ensured by the requirement of a two-thirds vote of the legislature to amend Delaware corporate law.2
Appreciating this important foundation is fundamental to informing and guiding the SEC's role in the U.S. corporate governance scheme.
Over the past 75 years, deviations from that system have largely been triggered by corporate scandals or perceived insufficiencies found in existing legal regimes. Indeed, the most recent example being the passage of the Sarbanes-Oxley Act of 2002 — propelled by the high profile scandals of Enron and Worldcom, among others.
But, a heightened focus on corporate governance issues was also inevitable — reflecting a confluence of market developments including a shift in U.S. shareholder ownership in favor of large institutional investors, the rise of activist investors, and the increasing globalization of financial markets attracting large foreign stakeholders from different governance cultures.
These trends all contribute to pressures on our corporate governance traditions and culture and test the continued effectiveness and competitiveness of our system.
These trends may also lead to greater calls to harmonize standards that will likely only grow as markets continue to expand and converge. This, despite, the fact that governance systems vary greatly among countries and, like our common law experience, they are the product of different, often particular, cultural and legal traditions. Governance issues may therefore not always lend themselves so handily to such harmonization.
Similarly, these pressures may also foster an increasing tendency to seek Federal solutions to perceived deficiencies in the market that also test our traditional approach to U.S. corporate governance.
Here too, any response to such pressures requires a careful deference to the well-developed and carefully crafted State corporate law that has served our markets for so many years.
At bottom, these pressures necessarily query the efficacy and existence of an "ideal" corporate governance system.
And any such query must start with challenging the value proposition of seeking such uniformity where the power of an open and transparent market to drive competition between differing governance systems is likely to promote greater wealth and opportunity for investors.
Today, I would like to focus the remainder of my remarks on three key areas that remain in the forefront of the SEC's engagement on corporate governance: 404 internal controls, proxy rules, and executive compensation.
Recall market circumstances six years ago. At that time, the Sarbanes-Oxley Act played an important role in restoring investor confidence and market integrity to a market shaken by high-profile corporate scandals. But, it also highlighted the interconnectedness of our markets and brought to bear the challenges we face in seeking effective and efficient solutions to complex governance issues.
Indeed, no other issue in recent years has come to symbolize regulation gone awry than the relatively modest-looking Section 404 of the Sarbanes-Oxley Act.
While the spirit and letter of the law never contemplated the costly and burdensome result that this provision has generated, the law's implementation undoubtedly facilitated such a result.
To address some of these effects, the Commission repeatedly delayed the compliance date of Section 404 for smaller issuers and certain foreign issuers.
And, the Commission has most recently worked with the PCAOB to align its revised audit standard with the Commission's management guidance to encourage greater use of a top-down, risk-based, principles approach that would promote greater flexibility and exercise of judgment in both assessing and auditing company internal controls.
Such alignment is critical if the 404 process is to become scalable, less prescriptive and more focused on those areas that pose the greatest risk that material misstatements in a company's financial statements would not be detected or prevented on a timely basis.
Ultimately, the Commission's success in making the internal control provisions more efficient and effective for all issuers will be measured by our ability to alter behavior, and this will depend, just as importantly, on how the SEC and PCAOB examine and enforce the law for compliance and how issuers and auditors view the risk of exercising greater judgment under new guidance and a revised auditing standard.
What we put on paper must be borne out in the market, and this will require the Commission to continue to monitor and consider the effectiveness of the changes and implementation the Commission and the PCAOB seek in the months and years ahead.
I believe that our efforts on 404 further offer the Commission and the PCAOB an opportunity to demonstrate how such requirements can be implemented in a way that avoids a "one size fits all" construct and embraces a more principles-based approach more easily translated to companies of differing size, complexity and governance structure.
We hope that, as a result of our actions, accelerated filers will see a reduction in the costs and burdens of the internal control requirements. We recognize that these filers are already subject to Section 404 and have already created their compliance infrastructure, but we continue to hope to see a reduction in costs, and therefore fees, associated with this audit function.
Late last month, the Commission voted unanimously to a one-year extension of the Section 404(b) auditor attestation requirement for smaller companies, which would allow time for completion of a cost-benefit study by the SEC's Office of Economic Analysis.
The study will give us the opportunity to ensure that the investor protections of Section 404 are implemented in accordance with Congressional intent, and do not impose disproportionate or unintended burdens on smaller companies. The study by the Office of Economic Analysis, which it hopes to complete by this Fall, will consist of two main parts: 1) a Web-based survey of companies that are subject to Section 404; and 2) in-depth interviews including companies that are just now becoming compliant.
The dual approach will enable the Commission to gather data from a large cross-section of companies and analyze more detailed information about what drives costs and where companies and investors derive the benefits.
But, only time, and continued diligence, will tell whether these efforts succeed in better aligning the costs and benefits of Section 404. Thus while significant progress has been made — there still remains work to be done.
The aftermath of the corporate scandals and technology bubble also sharply drew into focus the issue of executive compensation.
A highly sensitive issue which often touches fundamental notions of equality and fairness — executive compensation remains a hot button issue for many shareholders and the public at large.
Previous legislative efforts to reign in executive pay (through the tax laws, for example) have met with — shall we say — "mixed" results.
Indeed, like a rock on jello — compensation simply shifted to other areas and has only continued to rise.
Without even attempting to analyze some of the reasons for this — indeed this remains a rich area for academic and economic research and analysis — I believe the SEC's efforts to improve the quality and usefulness of compensation disclosure has been an important effort to empower shareholders with better and clearer information to make more informed judgments.
Without imposing arbitrary and subjective regulatory value-judgments in place of shareholder views, exposing compensation to full public scrutiny is the best check in my view to ensuring that boards and executives remain accountable to shareholders for their compensation policies and decisions.
Despite the 2006 rule amendments or perhaps as a result of the greater disclosure required, executive compensation continues to be an issue of intense public focus and a lightning rod for corporate governance criticism.
So, perhaps the rule is working as intended. Let sunshine brighten the dark corners of compensation and, ultimately, shareholders will make the ultimate value judgment on a company's compensation practices and overall performance.
The Commission remains committed to ensuring the effectiveness of the new rule and continues to monitor the new disclosures' sufficiency of effectively informing investors. Most recently, the Commission staff has highlighted some of its findings from the first-year filings, which while largely positive, also identify areas for future improvement.
Vital to shareholders being able to hold corporate boards accountable pursuant to their State law rights, is the proper interpretation and application of the SEC's proxy rules.
From the Commission's earliest days, proxy issues have been an area of intense controversy and debate. And the issue of shareholder access to the company ballot has resurfaced time and again, calling into focus fundamental issues regarding the appropriate balance between State and Federal law in the area of corporate governance.
Each time the Commission has reviewed the proxy area, in 1942, 1977, 1992, and 2003 the Commission has made improvements to its proxy rules to facilitate greater shareholder voice and communication, but failed to reach consensus on the need, advisability, and appropriateness of what would be viewed as more fundamental changes.
Like all of our rules, proxy rules should be clear and certain. It is in their clarity and certainty that they gain and maintain their legitimacy — this is so much the case that the "no action" process has developed, providing protection to an issuer who, in good faith, seeks to rely upon those of our rules that exclude certain proxy proposals.
While I have supported and continue to support the Commission's efforts to evaluate the operation and effectiveness of our proxy rules with an eye to considering whether changes to our rules are advisable or warranted, I have also firmly believed, since the Second Circuit decision in the AFSCME v. AIG decision, that the Commission must provide this needed clarity and certainty by first reaffirming its long-standing interpretation that Rule 14a-8 is not the proper means to wage a contested election and that bylaw proposals such as the AFSCME proposal are excludable under 14a-8(i)8.
I continue to believe that this long-standing policy is sound and preserves a carefully crafted disclosure regime for the protection of all shareholders.
Recognizing the long history, sensitivity and significant import of these issues for shareholders and companies, I also continue to believe that an open and deliberative process is necessary to inform the Commission's consideration of any fundamental changes to the current operation of our rules and whether such changes would effectively serve the interests of all shareholders.
Further, as a touchstone, the Commission should remain guided by the limits of our statutory authority and be sensitive to encroaching into State substantive law.
While I was pleased that the Commission's efforts last year were intended to give due deference to such concerns, they remained deeply flawed and failed, in my view, to adequately address this primary concern.
What did become clear through the Commission's consideration of this issue last year is that the basic debate remains largely the same despite important changes in the market and various reforms adopted over the years at both the State and Federal level.
While concern about costs of soliciting proxies has been one of the most compelling arguments for why our proxy rules may act as an undue impediment to shareholders seeking to exercise their rights, the Commission has made great steps in recent years to drive down the costs of solicitations to make them more affordable.
Last summer we mandated e-proxy rules, making it possible to notify shareholders of proxy matters through inexpensive electronic means.
And late last year, we adopted a rule that should facilitate the use of the internet for communications among shareholders and between shareholders and companies, so that shareholders can gauge others' interest in proposals before incurring substantial costs; as well as potentially alert companies to matters of import to shareholders.
These are incremental but important steps that could significantly remedy the cost concerns that have been raised, but that still allow for full disclosure.
Other proponents of change have focused more upon providing access to remedy a perceived imbalance between the power of management and the power of shareholders to influence corporate activities.
To the extent that an imbalance is created by the costs associated by mounting a proxy contest, the Commission is acting to drive down these costs through some of the efforts that I detailed a moment ago.
But to the extent an imbalance is created by State law and proxy access is really about achieving a more fundamental power shift of rights and responsibilities among shareholders and corporate boards and management, then I question the authority of the Commission to seek to craft such a remedy.
Still others have argued for access as a means to achieve more corporate reform and greater accountability in the wake of the scandals we experienced earlier in the decade. Whether directors are sufficiently accountable to shareholders is a question whose answer is also largely grounded in State law.
However, the Commission has acted where it can — such as assuring greater disclosure of conflicts of interest, executive compensation, stock options granting practices, or through our enforcement and examination programs. But again, the Commission's role is a statutorily limited one.
And indeed, over the last several years, many positive changes and reforms have occurred without the involvement of the Commission. We have seen a rise of institutional investors that have an increasing ability to interact with Boards and management to influence change even before mounting a proxy challenge.
In addition, majority voting is now the norm, further empowering shareholders by requiring that management's nominees garner broad support before they can assume their fiduciary responsibilities.
Listing standards have also forced governance reforms, with companies increasingly requiring independent chairs for their boards. And audit committees are now independent as a result of Sarbanes-Oxley.
These changes in the way companies are governed and shareholders interact with management and boards are significant.
Many of the comments we received focused upon these changes and urged that they be permitted time to develop and mature so that their effects can be known before seeking more changes to our governmental scheme.
These and other comments made it clear to me that we should be treading very carefully when we seek to disturb both our longstanding rules and interpretations, but also the rights of all shareholders.
For if we work to create subsidies for certain shareholders and not others, and if we make arbitrary thresholds that limit some but enable others, we are necessarily upsetting a balance set by State corporate law.
This is a tortured road the Commission has been down many times before. It remains highly controversial and does not lend itself easily to consensus.
Recognizing this challenge, the Chairman has signaled his intent to reinitiate consideration of these issues once the Commission has a full complement of Commissioners. I believe that is a wise course. So, stay tuned.
While discreet, all of these issues have implications for our competitiveness.
While we often regulate on the margins — even marginal changes make a difference in a highly competitive market.
It is also important that we recognize the natural limitations of regulation in affecting desired market behavior, and that not every problem should look like a nail just because we have a hammer.
If we regulate without looking first for market-based alternatives, or if we use the regulatory tools too zealously, we will increase the likelihood of pushing financial markets overseas.
In the last year, three major studies have called into question U.S. competitiveness. Each concludes that America is losing ground to foreign markets. They suggest that these trends may be caused by foreign markets developing and evolving — no more than a natural growth and maturation in markets abroad.
But they also question whether America's regulatory climate dissuades investment in our markets. For example, one of the reports concludes that our competitiveness concerns derive from needed reform in our legal system and regulatory approach.
In response to these reports, some argue that we must act now, or we will forever lose our competitive edge. Others warn that the concern is overblown and that any reforms would be a 'rollback' of investor protections and could be catastrophic for investors' interests.
For my part, I do not believe this is necessarily a binary choice. On the one hand, the sky is not falling — America's capital markets remain rich, deep, vibrant and attractive; and while we may be losing global market share, there are likely many reasons for this trend, not all of our own making.
On the other hand, doing nothing to analyze and consider these very noteworthy trends would be perhaps the worst thing we could do, and would almost certainly further erode our ability to compete internationally.
So this is a debate we should be having, and that we should be taking seriously. And although the emergence of other significant foreign capital markets could be seen as a threat to the central role U.S. markets have historically played in global commerce, it can also be seen as an opportunity for growth and productive change. We can all benefit from competition, whether at home or abroad.
It has been nearly two decades since Michael Jensen wrote his seminal article on the "Eclipse of the Public Corporation" in the Harvard Business Review to explain the growth of a newly widespread competition for corporate control through leveraged buyouts. Jensen wrote that "the idea that outside directors with little or no equity stake in the company could effectively monitor and discipline the managers who selected them has proven hollow at best. In practice, only the capital markets have played much of a control function." The circumstances in the late 1980's saw a rebirth of what Jensen called "active investors, who hold large equity or debt positions, sit on boards of directors, monitor and sometimes dismiss management, are involved with the long-term strategic direction of the companies they invest in, and sometimes manage the companies themselves." The political response in Washington and in State capitals to this upheaval in the board room was a push to support board incumbent protection mechanisms, but a legislated response was averted by a series of Delaware court cases that upheld the legality of preferred share purchase plans known as "poison pills." The poison pills may have been rough medicine to stop the use of some legislated blunt instruments, but the market responded over time as some corporate boards reconsidered the authorization of some poison pill defenses as a drag on share prices.
Making the right changes at the right time is very difficult. A slow response wins little praise at the time, but a rapid response is often not the best one in hindsight.
The quick response by Congress to address the corporate governance disasters of Enron and WorldCom yielded Sarbanes-Oxley, which while an important response at a critical time, also has had unanticipated costs associated with it that we are only now starting to understand — 404 being the most visible offender.
Like the competitiveness reports I just cited, the post-Enron, post-Sarbanes-Oxley environment has fostered a wealth of fascinating and provocative academic literature, research and analysis, including the studies on the impact of certain governance structures on innovation, the growth of the 144A market; trends in listing decisions of new IPO's; and analysis of market data showing whether more companies are going or staying private to avoid the more burdensome regulatory and legal risk environment of the public market.
A market response to a well-intended regulatory solution that encourages the opting out of most regulation altogether is certainly not the optimal goal, and investors may not all be the richer for it.
With humility comes wisdom.
We cannot deter all corporate wrongdoing, expose all fraudulent conduct, or prevent every corporate scandal by regulation alone; more importantly, we must recognize and promote the power of competitive market forces in achieving effective and transparent corporate governance standards.
As corporate and securities lawyers, you play a critical role in this fast-changing and competitive marketplace to help identify and solve difficult market problems. Your voice and expertise is highly valuable to our consideration of many of these issues. Thank you again for allowing me to join you today and please accept my best wishes for a successful and productive conference.