Speech by SEC Commissioner:
Remarks Before the Twentieth Annual Tulane Corporate Law Institute
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New Orleans, Louisiana
April 3, 2008
Thank you, Vic [Lewkow], for your kind introduction. Before I begin, I must say that the views that I express here are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.
I am honored to be speaking with you today at the Twentieth Annual Tulane Corporate Law Institute, taking place in the Crescent City, the Big Easy, Birthplace of Jazz, and, of course, the center of Mardi Gras, where hundreds of thousands congregate each year to celebrate. Unfortunately, with recent events on Wall Street, there are fewer people on Wall Street in a festive mood these days. We must remember, however, that we have experienced turbulent periods such as this before and have emerged from them with our economy intact and indeed stronger than when we went in. As Federal Reserve Chairman Ben Bernanke said yesterday, "Clearly, the U.S. economy is going through a very difficult period. But among the great strengths of our economy is its ability to adapt and to respond to diverse challenges."1
The Current Economic Situation
Having timely information is critical during a turbulent time. The famous Battle of New Orleans during the War of 1812 illustrates this point. Major General Andrew Jackson was heralded as a national hero for leading 4,000 militiamen to a victory over 10,000 or more British soldiers in the Battle of New Orleans. But the battle itself should never have happened. The War of 1812 had ended two weeks earlier with the signing of the Treaty of Ghent. It took over a month for the news to reach British and American forces in Louisiana.2
Information is as critical to regulators as it is to military commanders, as the current economic situation illustrates. Some have criticized the SEC and regulators for not anticipating the current market conditions on Wall Street, including the sudden demise of Bear Stearns, one of Wall Street's largest investment banks, in less than a week. But regulators cannot always predict what market participants will do.
Bear Stearns represents a situation analogous to a run on the bank. It failed as a result of a lack of confidence by participants in the marketplace. Bear Stearns at all times had a sufficient capital cushion exceeding what is required to meet supervisory standards under the Basel II standard. What caused Bear Stearns's demise was a sudden and unexpected loss of liquidity prompted by counterparty withdrawals and credit denials. It was not caused by a lack of capital.
And, we have to remember that a high capital ratio is not the same as being liquid, particularly if the assets cannot be sold quickly for cash or if the firm cannot obtain alternate, even secured, sources of liquidity.
It is fair to ask, as many are doing, whether our regulatory structure needs some updating to enable our government agencies to react not from a narrow-minded viewpoint that focuses only on their particular segment of the financial services industry, but rather as part of a larger, more systemic solution. In answering that question, we cannot forget that we were asking that question long before the recent problems began. Treasury's Blueprint released on Monday is one more important step in this process. We should not forget that four well-researched studies have been published since November 2006 regarding the competitiveness of the U.S. capital markets and suggesting recommendations to improve our regulatory structure.
In a free market economy driven by innovation, our regulatory structure cannot remain static. We are in need of constant adjustments so that our markets remain the most attractive and competitive. The progress that people had made in thinking about those issues should not be cast aside in favor of a new regulatory framework hastily designed solely with only the current challenges in mind. In making changes, the problems that we face today instead should be taken into account along with the problems that had us considering regulatory modernization long before the current period of market uncertainty.
These themes were reflected in the Treasury's report on financial regulation that Secretary Paulson unveiled on Monday. The report was the product of many months of work and benefited from the input of many contributors. I commend the Treasury on its efforts to spark further dialogue to improve our regulatory scheme, and I look forward to hearing comments on the Blueprint. As Secretary Paulson acknowledged when he announced the Treasury's Blueprint, any efforts ultimately adopted should be driven by the long-term health of the economy rather than a hasty reaction to current market situations.
Sovereign Wealth Funds
As we consider regulations, we also must be mindful that the composition of market participants has changed greatly since many of our regulatory agencies were created. The number of institutional investors and their influence has increased significantly in the second half of the last century. In 1950, only seven percent of the total outstanding corporate stock was owned by institutional investors.3 Today, institutional investors compose roughly half of all stock ownership in the more than $15 trillion United States equity markets.4
In recent years, sovereign wealth funds have grown in visibility. Five years ago, you would have been hard pressed to find someone outside of the investment banking community who gave any thought to these funds. Today, virtually every American has heard of sovereign wealth funds, and opinions are forming quickly, often without the benefit of deliberation and careful study.
Sovereign wealth funds are estimated at $2.5 trillion and expected to grow to $12.5 trillion over the next five years.5 One fund, Abu Dhabi's, which recently invested in Citigroup, is estimated to be close to $1 trillion of assets under management.6 The size of the funds, the fact that they are controlled by foreign governments, and their recent investments in troubled sectors of the U.S. economy have caused some to call for additional regulations and oversight. We in the government must ensure that the pursuit of reasonable regulatory measures does not give way to protectionist pressures.
Foreign investment of large amounts of sovereign capital affects not only the United States, but also the world. As a result, the issues should be addressed with, and among, the nations. The U.S. Treasury Department, along with the President's Working Group on Financial Markets, of which the SEC chairman is a member, is discussing the implications of the growth of these funds.
Treasury officials have been meeting with other G-20 countries to discuss a comprehensive approach, and the IMF is working to develop best practices for sovereign wealth funds. The Organization for Economic Cooperation and Development (OECD) also has been working on formal guidance for countries receiving investments from sovereign wealth funds.
In the United States, there is already a mechanism in place to evaluate concerns with respect to national security. The Committee on Foreign Investment in the United States (CFIUS), chaired by the Treasury Department, reviews foreign direct investment that would result in foreign control of U.S. business and that may raise national security considerations. Congress only last year strengthened the CFIUS review process to address concerns. If a transaction poses a risk to national security, CFIUS can respond in a fair and proportional way to that risk.
There are, of course, issues relating to sovereign wealth funds that ultimately may be unique to the SEC. The SEC is responsible for overseeing U.S. federal securities laws, which include anti-fraud provisions. It is important that we not treat sovereign wealth funds any differently than we do other investors merely because the principals are governmental entities. The U.S. should welcome the vote of confidence that foreign capital investment represents, particularly during the current time.
A notable trend counter to the calls for increased protectionism is the discussion about mutual recognition of foreign securities regulatory regimes. Mutual recognition is a process by which the SEC would allow foreign exchanges or broker-dealers to participate more freely in U.S. markets, provided that they are subject to a satisfactory foreign regulatory regime.
I have long been a proponent of more flexible treatment of foreign firms in the U.S. markets. Increased access by foreign and U.S. securities exchanges to each others' markets should produce great benefits. Investors will be the ultimate beneficiaries through lower costs and more choice, if restrictions are eased.
Last year, the SEC hosted a public meeting on this subject, focused primarily on the issue of whether to allow mutual recognition of foreign regulatory regimes that are substantially equivalent to the U.S. rules. However, we need to be very careful about proceeding in this manner.
Mutual recognition does not mean consolidation or reconciliation of the regulations of two jurisdictions. The process should not be analogous to the process of reconciling conflicting bills from the U.S. House of Representatives, on the one hand, and the U.S. Senate, on the other hand. In other words, mutual recognition must not be an attempt at harmonizing regulations from the U.S. and a foreign jurisdiction through a side-by-side, rule-by-rule comparison.
Such a bottom-up approach would result in a completely unworkable and potentially never-ending process. Would the slightest statutory, judicial, or regulatory change cast doubt upon another country's regime? How would those changes be monitored and addressed? Imagine the effort and personnel that would be needed to monitor and respond to regulatory changes in a dozen or more jurisdictions. Would the SEC find itself with effective veto power over other countries' regulations? It might be good material for a law review article, but it would not work in the dynamic, resource-constricted real world.
A better framework would be a top-down approach, similar to one employed by other U.S. regulators, such as the Commodity Futures Trading Commission and the Federal Reserve. Under this approach, the SEC would first identify the important elements that a compatible regulatory jurisdiction should embody. This might include investor protection standards, such as protection against misappropriation of customer assets, fraudulent sales practices, financial responsibility of registered entities, and effective examination, licensing and qualification of brokers.
Instead of examining each rule of the foreign jurisdiction, we would generally assess the adequacy of that jurisdiction's oversight. If the foreign jurisdiction's regulatory regime is deemed adequate, a firm could be eligible for exemption.
In evaluating a foreign jurisdiction's regulatory oversight, we also must resist calls for the country to have the same agencies that we have in the U.S. After all, as we saw on Monday with the publication of the Treasury's Blueprint, our own system of regulatory oversight may see changes in the coming years. Therefore, a foreign jurisdiction need not mirror our own system. For example, a foreign jurisdiction does not necessarily need a replica of the Public Company Accounting Oversight Board — the foreign jurisdiction may have some governmental or private sector alternative that suits its system better.
A workable mutual recognition regime would go far within the context of the transatlantic framework towards fostering cooperation and reducing regulatory burdens. We should work diligently to craft a practicable top-down approach, and recognize that the alternative bottom-up approach will never work.
Last week, the SEC announced upcoming plans for progress in the area of mutual recognition. Importantly, these plans include long-overdue amendments to Rule 15a-6. These amendments would make it easier for U.S. investors to deal directly with foreign broker-dealers and thereby trade foreign securities.
Issues Relating to Foreign Private Issuers
Another topic that is — or should be — on the minds of corporations, investors, accountants, and analysts is International Financial Reporting Standards (IFRS). Last year, the Commission adopted a rule that permits foreign private issuers who report under IFRS, as adopted by the International Accounting Standards Board (IASB), to file their financial statements with the SEC without reconciliation to U.S. generally accepted accounting principles (US GAAP).
Now that we have taken that step, the natural question is whether U.S. issuers likewise should be able to choose to report in IFRS or US GAAP. In August 2007, the Commission issued a concept release that posed this question. The comment period closed on November 13, 2007, and the SEC is in the process of reviewing the comments submitted. In the meantime, efforts continue to achieve greater convergence between IFRS and US GAAP.
In March 2007, we adopted new rules that significantly changed the requirements for exiting the Exchange Act reporting system by foreign private issuers. Unlike the older rules that required a foreign private issuer to have less than 300 holders resident in the United States, new Exchange Act Rule 12h-6 permits the de-registration of a class of equity securities if U.S. average daily trading volume is less than five percent of the average worldwide daily trading volume for a recent 12-month period.
I suppose it is fitting that I am speaking in the state with the largest population of Cajuns. Cajuns, as you may know, are descendants of the Acadians, who were driven out of Canada in the 1700s because they would not pledge allegiance to the King of England.7 Now, that tragic British intolerance unintentionally led to our country's gaining the richness of Cajun culture and enterprise. Our markets are similarly the richer because of foreign presence.
American investors benefit from diversity of investment options and convenience that flows from having foreign issuers registered here under our laws and conforming to our standards. That is the goal of the new deregistration approach: by making it easier and cleaner for foreign issuers to leave if it turns out that there is not sufficient American investor interest, we ultimately will have more foreign firms listing here in the first place. Registering in the U.S. need not be a permanent decision.
A number of eligible foreign private issuers filed to withdraw immediately after effectiveness of the new rule. After years of pent-up demand, which was aggravated by the turmoil wrought by the ill-fated and ill-conceived Audit Standard 2 of the PCAOB, we expected a large number of deregistrations.
According to the Division of Corporation Finance, as of the end of last year, approximately one hundred foreign private issuers had filed the deregistration form (Form 15F) under the new criteria set forth in Rule 12h-6. This equates to just under 9% of all foreign registrants filing for deregistration, with the largest group coming from the European Union.
One of the intended effects of the new rule was that it might encourage foreign private issuers to register with the Commission in the first place — because if you know you can leave, then you just might want to come to the United States in the first place to try it out. So I am happy to report that, during 2007, more than 75 new foreign private issuers registered securities with the SEC.
Having utilized relative U.S. average daily trading volume as a measure to exit the SEC registration system, we now are looking to use a similar measurement to determine when U.S. registration would be appropriate. Last month, we proposed revisions to our current exemption under Rule 12g3-2(b).
Under the new proposal, a foreign private issuer would be exempt from registration so long as its relative U.S. average daily trading volume was less than 20% and the issuer electronically publishes its disclosure documents in English. I look forward to seeing the comments on this proposed rule.
A related proposal that the SEC issued in February would change the annual report filing deadline for foreign private issuers. Under our current rules, foreign private issuers may file their Form 20-F up to six months after the end of their fiscal year. This deadline is the same as it was when first adopted in the 1970s. That is when it took about two weeks just to send a package to London — longer elsewhere. In today's investment world, six months is an eternity. The six-month filing deadline makes even less sense for IFRS filers, because they now can avoid the GAAP reconciliation requirement entirely.
I look forward to hearing the comments about the appropriate time for annual reports on Form 20-F to be filed as well as the other proposed changes to disclosure by foreign private issuers.
One area that affects virtually every participant in the securities industry, including those in the M&A arena, is the concept of materiality. The crux of our federal disclosure system is that all material information must be disclosed — with an emphasis on material. Yet the age-old question is: What does it mean to be "material"?
Issuers, investors, and regulators have struggled with applying the materiality test since the enactment of the securities laws. Materiality is an objective test: the Supreme Court has said that something is material if "there is a substantial likelihood that a reasonable shareholder would consider it … as having significantly altered the 'total mix' of information made available."8
It is not enough that some investors may view a fact as important; rather, it must be important to the reasonable investor. In arriving at this standard, the Supreme Court in 1976 in TSC Industries v. Northway, specifically overturned a test applied by the Second Circuit — that material facts include all facts that a reasonable shareholder might consider important. Can you imagine what prospectuses and proxy statements would look like if that standard had prevailed? TSC Industries is an example of the Supreme Court showing judicial restraint by not expanding the securities laws. Does this sound familiar? We have seen similar restraint in recent Supreme Court decisions in the area of securities law, including the Stoneridge decision.
In TSC Industries, the Supreme Court clearly understood the problem of materiality. In the unanimous opinion written by Justice Thurgood Marshall, the Court observed that "[s]ome information is of such dubious significance that insistence on its disclosure may accomplish more harm than good." The potential liability for a fraud violation can be great and, so Justice Marshall explained, "If the standard of materiality is unnecessarily low, not only may the corporation and its management be subjected to liability for insignificant omissions or misstatements, but also management's fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decision-making."9
The waters were muddied on the issue of materiality in 1999 with Staff Accounting Bulletin 99. Anyone who has tried to apply SAB 99 is left with little certainty. Regardless of how quantitatively tiny a disclosure might be, the answer to any materiality question seems to be "it depends." (Of course, too often it is said to be clear later in 20/20 hindsight.) And yet that bulletin has been cited by courts, SEC staff, and lawyers as authority for materiality. As a result of SAB 99, issuers feel compelled to inundate shareholders with "an avalanche of trivial information," which was precisely the fear of the Supreme Court almost 32 years ago.
Would it surprise you to learn that SAB 99 is not a Commission-approved document, so it does not necessarily represent the views of the Commission? As the title implies, it is a Staff Accounting Bulletin. The process of issuing Staff Accounting Bulletins is organized to avoid "complications" with the Administrative Procedure Act. Is that how a full-disclosure agency should operate?
The Commission never voted on the views espoused within any SAB, so it does not and cannot represent the views of the SEC. It lacks the Commission's imprimatur to make it legally binding under the Administrative Procedure Act. Worse yet, SEC staff developed SAB 99 without public input. Substantive policy ought not to be made by the staff in private meetings, and ought not to be made based solely on the wisdom and experiences of SEC staff.
Moreover, since SAB 99 was released, a lot has changed. We now have Sarbanes-Oxley and new case law and regulations. Some are calling for new disclosure requirements on topics such as state sponsors of terrorism, climate change, and global warming. As with any other potential items, these should be governed by materiality.
The Advisory Committee on Improvements to Financial Reporting, which the SEC established, has been considering the issue of materiality. Draft proposal 4.1 of the Committee contemplates recommending that the Commission issue guidance reinforcing, among other things, that "Just as qualitative factors can lead to a conclusion that a quantitatively small error is material, qualitative factors also can lead to a conclusion that a quantitatively significant error may not be material."10
I support the work of that committee and appreciate Bob Pozen's leadership. When the SEC takes up the issue of materiality, we must approach it by returning to "first principles" — that materiality is determined based upon the objective "reasonable investor" standard. The Commission itself — after proceeding with public notice and comment — should clear up this issue with the full input of the investor, legal, accounting, academic, and business communities. I hope that many of you in this room will participate in the process.
Thank you for allowing me to speak with you today. This conference is an excellent opportunity for the exchange of ideas among the best and brightest minds in corporate and securities law. I hope that you will share your ideas with me if you are ever in Washington, D.C. Thank you all for your attention.