Speech by SEC Commissioner:
Remarks Before the U.S. Chamber of Commerce Mid-Market Elite Series
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
July 8, 2008
Thank you, David (Hirschmann), for that kind introduction. I appreciate the opportunity to be with you here in Cleveland today. I hope that you all had an enjoyable Fourth of July weekend. I know that you take your baseball seriously here in Cleveland, so I am sure that you are disappointed about the Indians’ weekend losses to the Minnesota Twins. If it makes you feel any better, the Washington Nationals also had a rough weekend against the Cincinnati Reds. But, it’s still a long time until September, so there is always hope.
The fireworks of the 4th of July are still ringing in our ears. The freedom that we enjoy in this country is certainly something to celebrate. It is incumbent upon those of us in government to guard that freedom. My term as a Commissioner at the Securities and Exchange Commission has ended and my successor, Troy Paredes, has been nominated by the President and confirmed by the Senate. I will step down at the end of this month, when Troy is ready to take office. I have enjoyed an exciting and definitely memorable six-year tenure at the SEC, but I look forward to taking on new challenges. My six years as a commissioner have presented me many opportunities to consider how government’s actions can bolster or undermine the principles of freedom and individual liberty on which this country is based. Before I begin, I must state that the views expressed here today are my own and do not necessarily reflect the official views of the SEC or the other commissioners.
My tenure at the SEC has spanned a period in which there have been many changes and many challenges. I started just after the Sarbanes-Oxley Act was signed into law in July 2002. SOX, of course, was a response to the collapse of Enron and a few other large public companies under the weight of financial fraud in the wake of the bursting of the dot-com bubble in 2000. I am now finishing my tenure after the burst of the housing bubble. Even with these problems, we must not forget that this period also has been marked by considerable economic prosperity.
The question that we have now is what sort of legislative or regulatory response will follow the bursting of the housing bubble and the collapse of Bear Stearns? Will we have Son-of-SOX? The natural tendency is to conclude that today’s crisis is worse than yesterday’s and that, while market solutions might have worked in the past, today’s challenges call for something more dramatic. We can learn new lessons from new crises, but we must not forget the old lessons in the process. Financial crises have always created an impetus to “do something.”
Although Sarbanes-Oxley had positive aspects, its implementation created considerable problems of its own that had not existed before. Sorry for the pun, but it is the law of unintended consequences. The prime posterchild is, of course, Section 404, which requires management to assess annually the effectiveness of internal controls for financial reporting and requires a company’s outside auditor to attest to, and report on, management’s assessment.
At the time the Sarbanes-Oxley Act was passed, few, if any, people expected Section 404 to be the most controversial provision or that it would impose any significant burden. Section 404 was copied almost word-for-word from a provision that had already applied to U.S. banks for more than ten years. The Senate committee report on Sarbanes-Oxley observed that high quality audits already “incorporate extensive internal control testing” and that the requirements could be imposed with little additional costs on companies.
The SEC envisioned Section 404 as a top-down, enterprise-focused approach, where a company would focus on entity-level controls that could materially affect the consolidated financial statements. But instead of a principles-based approach aimed at management, we ended up with a very process-intensive, document-oriented, bottom-up approach. We created an atmosphere in which what-if scenarios created mountains out of molehills with the result that a control failure for a $500 error could be just as significant as for a $50 million error. Companies were documenting, analyzing, and creating process charts for literally tens or hundreds of thousands of supposedly key internal controls.
The principle underlying Section 404 — that a company’s internal controls should provide reasonable assurance as to the integrity of the financial statements — is a sound one. The implementation of Section 404, however, was highly flawed and extremely burdensome for public companies. Shareholders ultimately paid the price as valuable resources and managerial effort was devoted not to pursuing business opportunities, but rather to complying with internal control requirements.
The SEC and Sarbanes-Oxley’s newly created regulatory entity, the Public Company Accounting Oversight Board, were responsible for implementation of this internal control provision. As many of you know, some have used for “PCAOB” the nickname “Peekaboo.” So, if in implementing this internal control provision of Sarbanes-Oxley, Peekaboo set up an internal control unit, or ICU, one could call it the Peekaboo ICU.
Implementing 404 was certainly a learning experience. The SEC took an essentially principles-based approach to Section 404 and emphasized a company's taking a reasonable approach, with reasonable detail, with the goal of reasonable assurance. Unfortunately, the PCAOB’s standard for auditors, the notorious Audit Standard Number 2, was far from principles-based. The prescriptions (and proscriptions) that it placed on auditors flowed down to their public company audit clients, and this Audit Standard 2 colored the Section 404 implementation for the next 2 years.
AS 2 had a chilling effect on communications between public companies and their auditors. The Chamber of Commerce explained this phenomenon in a 2005 letter to the SEC:
Section 404 has also had a significant effect on the relationship between companies and their independent auditors. All stakeholders benefit when companies and auditors are able to productively work together to identify and solve real problems. In the current environment, however, independent auditors feel compelled to focus more on noting flaws and weaknesses than in assisting with the investigation or resolution of those issues.1
Section 404 provided auditing firms, in the wake of accounting frauds that implicated auditors, with a lucrative new source of revenue. Last year, one of the Big Four accounting firms took out a full-page advertisement in an international financial daily newspaper. This advertisement congratulated the firm’s retiring CEO for five years of 20-percent annual revenue growth. He became CEO in 2002, when SOX became law. How many other industries can boast that sort of revenue growth? This irony was not lost on public companies that saw auditor bills climb along with their frustrations in their relationships with their auditors.
It took the SEC and PCAOB nearly five years, but we have attempted to fix the implementation of Section 404. Last year, the SEC issued interpretive guidance on Section 404, which filled a gaping hole because the only available public guidance was addressed to auditors, which in effect put them in the driver’s seat for 404 projects. The law, after all, calls for management’s assessment with independent attestation — the auditors should not call the shots. With personnel change at the PCAOB in 2006, the PCAOB finally repealed its much criticized initial rule and replaced it entirely with a new rule that better reflected the original intent of Section 404.
While we still do not know the full effects of these new revisions, I have received far fewer complaints about the new regulatory requirements than I received about the old requirements. Perhaps issuers have gotten used to 404, have already spent the money necessary to implement it, or are just worn out. So, I hope that we may have found a proper balance between benefits and costs for those companies subject to Section 404. For smaller companies, the auditor prong of Section 404 has been postponed and is scheduled to apply to fiscal years ending after December 15, 2009.
In the meantime, the SEC’s Office of Economic Analysis is undertaking a study of the costs and benefits to companies after the issuance of the SEC’s new interpretive guidance and the PCAOB’s new audit standard. This study should yield some useful insights into whether our efforts last year have been effective at achieving the intended objective of Section 404 without imposing unacceptable costs. I welcome your insights on this issue.
As painful as the initial years of Section 404 implementation have been, the experience can serve as a useful warning to us in the midst of the current subprime crisis. If regulatory responses are not carefully crafted, their unintended consequences can overwhelm the benefits that those regulations were designed to achieve. Fears that there has been under-regulation can obscure the reality that regulations impose costs. As with 404’s implementation under Audit Standard 2, these costs can misdirect resources from more productive uses that build shareholder value.
So, what will come next following the burst of the housing bubble? It is extremely likely that Congress and the next Administration will take up the issue next year. Much will depend on the continuing developments in the credit markets and, of course, in the overall economy. The Department of Treasury issued a Blueprint for Financial Services Regulatory Reform in March to propose an approach that wisely focuses on more than simply solving the current subprime crisis. The Blueprint recommends short-, medium-, and long-term steps to address regulatory issues in the financial markets, including a long-term reordering of the regulatory structure in the United States, which is based more on accident of history rather than any grand plan. Treasury basically suggests changing the financial regulatory structure to rely less on industry and focus instead on objectives. Changes like these will not happen overnight, but the recommendations in Treasury’s Blueprint provide an excellent starting point for the debate.
The costs of regulation are fresh in the minds of many, because the subprime crisis follows on the heels of a period of heightened attention to the health of our capital markets. I commend the Chamber of Commerce for having done a great deal of work in this area, particularly through its Center for Capital Markets Competitiveness. In March of this year, the Chamber released a report on the capital markets and held its second annual summit on the issue. The Chamber of Commerce is by no means alone in its focus on the capital markets. The diversity of other groups that have undertaken similar studies of the capital markets makes me hopeful that reforms will be undertaken with an appreciation for their effect on the long-term health of our capital markets.
Even as the debate over long-term changes to the regulatory structure proceeds, regulators will be taking steps to improve their cooperation with one another. The SEC and the CFTC recently entered into a Memorandum of Understanding, our second with that agency. The run-on-the-bank at Bear Stearns has spurred enhanced cooperation between the SEC and the Federal Reserve, and today we sign a Memorandum of Understanding with them to facilitate information sharing. The SEC has MOUs with almost 40 foreign jurisdictions regarding information sharing and mutual assistance. You taxpayers should be forgiven for wondering why different organs of the same government, all supposedly serving the American taxpayer and certainly funded by the American taxpayer, find it necessary to sign formal documents to work together. Only in Washington would this be necessary.
In the end, those who participate in the markets are essential to developing effective solutions to our current problems. As recent events have demonstrated all too clearly, the market sometimes produces painful results for investors and consumers. If fraud and deception have taken place, we should and will pursue it. However, we must be careful not to skew the incentives that motivate entrepreneurs to provide new products to consumers and new opportunities to investors. Regulatory solutions that displace decision-making by the marketplace with bureaucratic decision-making dull the ability of the markets to respond to problems.
One area in which there is a temptation to look to bureaucrats to substitute their judgment for that of the marketplace is credit ratings. The subprime crisis has pointed up weaknesses in the processes by which credit rating agencies issued credit ratings and decided whether to update them.
Some of the problems in the credit rating area can be traced back to SEC actions. Before Congress passed the Credit Rating Agency Reform Act of 2006, the SEC’s staff designated so-called “Nationally Recognized Statistical Rating Organizations” or “NRSROs” through a frustratingly slow process that had the effect of limiting competition in issuing credit ratings. The 2006 legislation made the application process speedier and more transparent. We now have ten NRSROs, up from about half that number in 2005.
The subprime problems made it clear that many investors relied on credit ratings without performing their own due diligence. The SEC voted last month to propose two packages of reforms that are designed to help people better understand how ratings are developed, to address the conflicts of interest that NRSROs face, and, perhaps most significantly, to remove references to NRSROs from the SEC’s rules. Over the past 30 years or so, these references became embedded in many of our rules and have created a perception that we endorse the process by which NRSROs produce their ratings, if not the ratings themselves. This is an incorrect perception; the SEC is not equipped to assess the quality of NRSRO ratings or the procedures by which they are devised. Congress did not give us the authority to do so. Removing the ratings from our rulebook should encourage people to rethink how they use credit ratings.
Just as difficult times bring calls for stricter rules, they also bring calls for more aggressive enforcement of existing rules. Upon discovery of a problem, regulators face great pressure to show that they are doing something by bringing enforcement actions. As with regulatory changes, it is important for regulators to act carefully in undertaking enforcement actions. The SEC has brought and will continue to bring enforcement actions against those who have violated our rules in connection with the subprime crisis. However, the SEC must take care to avoid “pushing the envelope” by devising new legal theories to reach behavior that does not clearly violate an existing rule.
Enforcement actions must not become the way in which the SEC clarifies grey areas of the law. Rather, if clarification is needed, we should change the rules or issue formal interpretations with future effect. We should not be playing “gotcha” with our enforcement powers. When we go through formal rulemaking, the law requires us to give affected parties an opportunity to comment on our proposed rules and requires us to address those comments.
A recent example of this sort of restraint involves the option backdating cases brought against a number of corporations. These cases have generally involved management’s granting of options to employees as a form of compensation. Rather than pricing the options on the date of the actual grant, management instead looked at the historical stock price and selected the date on which the stock price was lowest. This allowed employees to have an instant gain on the value of their stock options. In many cases, accounting rules required the companies to disclose a compensation expense for these awards, but the companies failed to do so. This resulted in a violation of our laws.
Some called on the SEC to pursue so-called “springloading,” the practice by which a company purposefully schedules an option grant ahead of good news, or purposefully postpones an option grant until after bad news. Some argued that the definition of insider trading should be stretched to cover instances of springloading. However, this extension of insider trading liability would represent a fundamental change in the interpretation of the federal securities laws. Insider trading liability always had been based on the notion that one party in a transaction possessed material, nonpublic information that the other party did not have.
In a spring-loading situation, management (corporate officers) essentially negotiates with the corporation itself (represented by the board of non-executive directors) in a private transaction. Presumably, the corporation knows, or has access to, any inside information possessed by the corporation itself. In this type of private transaction, the two parties — the officers and the board — do not have unequal information, which is the central principle of insider trading. Instead, spring-loading situations are more appropriately considered as how to handle the potential conflict of interest between management and the corporation. For these situations, the resolution of these conflicts is best handled by state fiduciary and corporate governance laws.
State corporate governance laws might allow the adoption of procedures designed to minimize the impact of any conflict of interest. In particular, there are situations in which a board might want to spring-load option grants. For example, in approving the grant, the board may determine that they can grant fewer options to get the same economic effect because they anticipate that the share price will rise. Well-timed grants may be a cheaper way for shareholders to compensate employees than compensating them with precious cash.
Anyway, the SEC specifically rejected the application of any theory of insider trading liability based on spring-loading in a recent enforcement action. In the final order of settlement in that case, the Commission specifically stated:
The SEC’s complaint also describes [the company’s and CEO’s] undisclosed practice of granting executive and employee stock options in advance of the announcement of favorable nonpublic financial information about the company. As stated in the complaint, this practice was not a basis for the charges alleged in the complaint.2
Whether the circumstances surrounding a particular spring-loaded option grant violate state corporate governance law is a question that will likely be heard in state courts in the future. But it is not — and should not be — a question of insider trading under the federal securities laws.
Maintaining proper lines between state and federal issues is important. Some are urging, for example, greater involvement by the SEC in corporate governance issues. In 2004, under former Chairman Donaldson and over my dissent, the SEC attempted to micro-manage the structure of mutual fund boards by mandating an independent chairman and that at least seventy-five percent of the board be independent. The Chamber of Commerce, recognizing the danger of the SEC’s dictating board structure, sued and prevailed twice, thus succeeding in getting the rule thrown out. Sadly, the SEC wasted a lot of time and energy in developing and defending a mandate that would have imposed a one-size-fits-all corporate governance framework on fund shareholders.
The capital markets ought to be the ultimate arbiter of the value-added by a particular corporate governance framework. Our system promotes competition among the states for the most favorable corporate governance structure to investors. To the extent that other states provide a better corporate governance framework than, for example, Delaware, the markets should place a premium on the valuation of companies incorporated in such other jurisdiction.
One good example is the enactment last year of the North Dakota Publicly Traded Corporations Act. Among other corporate governance provisions required by the law are provisions requiring majority votes in the election of directors, advisory shareholder votes on executive compensation, proxy access for five percent shareholders, and the separation of the roles of chairman and chief executive officer. Only time will tell how the markets will react to this law. If these corporate governance provisions are perceived to be valuable, then either more companies will incorporate in North Dakota or other states will adopt provisions similar to North Dakota’s.
The federal securities laws are intended to complement, not replace, state laws on corporate governance. The drafters of the federal securities laws — most notably the Securities Act of 1933 and the Securities Exchange Act of 1934 — specifically designed the statutes to be disclosure-based. These laws did not allow the SEC to intervene in the internal corporate governance of corporations; rather, the statutes provided limited authority to the SEC to require companies to provide disclosure about various aspects of their corporate governance. Sarbanes-Oxley gave the SEC limited authority regarding certain corporate governance issues, but did not generally upset the SEC’s focus on disclosure.
The question of shareholder proposals on company proxy statements must be analyzed with this federal-state allocation of responsibility in mind. One critical right that is associated with corporate stock is the right to vote those shares of stock at a meeting of the shareholders. The federal proxy rules are designed to allow a shareholder, who satisfies a number of procedural and substantive requirements, to request that the company include his proposal on the company’s proxy statement that is distributed to shareholders. In recent years, shareholders have submitted so-called “advisory” proposals to companies on a multitude of issues, including executive compensation, employment policies, the environment, healthcare, and operations in certain countries where human rights abuses have been reported. The SEC recognizes that dealing with such proposals consumes a significant amount of management time and attention. Although the SEC permits companies to exclude such proposals under certain circumstances, in many other instances it does not.
Last year, the SEC issued two separate releases that addressed shareholder proposals. Although the primary focus of those two releases was on whether shareholders should be permitted to nominate their own candidates to the board of directors on the company’s proxy statement — rather than through their own proxy solicitation — the SEC issued some thoughtful guidance on the interaction of state corporate governance laws and the federal proxy rules. In one release, the SEC acknowledged the ultimate role of the state corporate governance laws in deciding whether a matter was proper to be brought before a shareholder meeting. Thus, to the extent a company adopts a proper bylaw under state law that limits or prohibits the consideration of advisory proposals at a shareholder meeting, SEC rules provide that the proposal may be excluded from the company’s proxy statement.
Just as the SEC should avoid regulating in areas that are better left to the states, attempts by states to impose disclosure obligations that “supplement” federal obligations are likewise troubling. Congress, in adopting the National Securities Markets Improvement Act in 1996, recognized the importance of uniform disclosure standards. State attorneys general should not be free to impose their own requirements.
As I prepare to leave the SEC, I anticipate that there will be many interesting and difficult issues on the SEC’s agenda in the upcoming months and years. I urge you to be involved in the debates over those issues. Your experience is invaluable in helping us to understand the ramifications of our proposed actions and bringing problems with existing rules to our attention. You are more likely to spot issues early than are we regulators, and you have much better information about costs of particular rules than we have. Another experience like the Section 404 implementation would be very damaging to our capital markets and to the investors that rely on those markets. We need to work together to prevent that from happening. We also need to work together to make sure that our markets remain the freest and most accommodating to innovation of any in the world.
Thank you for being such an attentive audience. I look forward to hearing your thoughts and concerns. If they cannot be addressed before I leave the SEC, I will be glad to pass them on to my colleagues.
1 Comment Letter of U.S. Chamber of Commerce (Apr. 13, 2005) (available at: http://www.sec.gov/news/press/4-497/dchavern3638.pdf).
2 SEC v. Analog Devices, Inc. and Jerald Fishman, Litigation Release No. 20604 (May 30, 2008).