Speech by SEC Commissioner:
Remarks before the Securities Regulation Institute
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
San Diego, California
January 19, 2006
Thank you, David, for that gracious introduction. Needless to say, I am not your promised luncheon speaker. And, unlike Chairman Cox, I do not hail from these parts. I am nevertheless honored to have the chance to speak to you, and hope that you will not be inundating David Ruder with refund requests after my speech. Chairman Cox asked me to convey his regrets that he cannot be with you today. You can rest assured that he would not have missed a trip home to California without a really important reason for doing so. My filling in for the Chairman does not change the need for me to give the standard disclaimer: the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
I also would like to take the opportunity to congratulate Ed Greene, David Ruder, and Dave Van Zandt for working together to produce such a good conference this year. It has been a decade or so since I last was here, so it is good to again be back among so many familiar faces.
As I look ahead to 2006, I am optimistic about the direction in which the Commission is heading. Unfortunately, you will not have the chance to witness this for yourselves today, but Chairman Cox is an insightful, engaged, and enthusiastic leader. He brings a new spirit of leadership, collegiality, and a sense of cooperation and mutual goal-setting that he honed through years of working in the House of Representatives. Under his leadership, the Commission has already achieved a number of significant milestones. Just last week, for example, five years after it filed its application, Nasdaq achieved registration as a national securities exchange.
And, at the beginning of the month, the Commission unanimously issued a statement that set forth certain principles for the imposition of penalties against corporations. The statement acknowledged the importance of looking at:
whether the issuer's violation has provided an improper benefit to the shareholders, or conversely whether the violation has resulted in harm to the shareholders. Where shareholders have been victimized by the violative conduct, or by the resulting negative effect on the entity following its discovery, the Commission is expected to seek penalties from culpable individual offenders acting for a corporation.1
We have basically recognized that, "If the victims are shareholders of the corporation being penalized, they will still bear the cost of issuer penalty payments (which is the case with any penalty against a corporate entity)."2 That is a critical acknowledgement that has been all too often lost in recent years. In financial fraud cases, shareholders, who are the ultimate owners of the corporations on which we impose these penalties, may already have been punished through reputational and stock-price damage. I am pleased that the Commission, true to congressional intent behind the Remedies Act, has now publicly committed itself to a more rational and systematic approach to deciding whether to impose penalties on shareholders.
Fortunately, Chairman Cox is not only addressing the issues that he inherited when he took over as chairman, but is looking ahead. If he had been here today, Chairman Cox likely would have spoken to you about an ongoing initiative: his commitment to fostering the widespread use of Extensible Business Reporting Language, which more readily rolls off the tongue as "XBRL." XBRL is a new platform for delivering the numbers in financial statements. Chairman Cox has recognized that we cannot afford to be left behind our foreign counterparts, who are already hard at work implementing this technology.
By making the data interactive, XBRL will make financial reporting faster, more accurate and cost effective for issuers. It will also benefit users of the data -- analysts, professional and retail investors - who will be able to collect, compare and analyze an ever-growing amount of relevant information. This, in turn, will benefit financial markets. XBRL tags numbers in the financial statements so they can be searchable by computer. This allows analysts to search the data electronically, and reach down to the level of granularity they desire. They do not have to physically input numbers, which translates into a huge savings in terms of cost, labor, and avoided inputting errors. Any user of financial information can then create his own ratios to compare, for example, return on equity across all companies in an industry. Some companies are working on tagging and disclosing non-financial information too, such as the company's strategy key performance indicators.
Last week, the Chairman announced that the companies that volunteer for a test group as part of the Commission's interactive data initiative will be eligible for, among other incentives, expedited reviews of securities registrations. Your companies or the companies that you represent should consider taking part in this voluntary program. I look forward to working with the Chairman as well as with issuers and users of financial statements on furthering the XBRL initiative.
Despite my optimism for 2006, the Commission will face some hardships in the upcoming months. Among other things, we will be saying goodbye to Alan Beller, who after four very busy years as head of the Division of Corporation Finance, is leaving the Commission. His tenure has been marked by a number of important rulemaking initiatives. It is probably safe to say that Alan holds the production record of any SEC division director in that he published more releases - about 70 in all - in the Federal Register during such a relatively short time. Although counting Federal Register releases is certainly not my personal idea of gauging a successful period in government, in Alan's case I have to make an exception. In Sarbanes-Oxley, Congress, of course, imposed a large number of very specific mandates on the SEC, complete with tight time frames by which we had to promulgate rules. Thanks to Alan's great working relationship with Chairman Harvey Pitt, a good staff, and the superb leadership and brains that they put to the task, the SEC was able to accomplish all of its assignments on time. I wonder if that is a record matched by any other agency in Washington, where it is not unusual at all for the rulemaking process to drag on for years after a relevant legislative deadline has passed.
Thanks to Alan, our rulemakings were also balanced and responsive to comment. When allowed by Congress, we looked critically at the legislative provisions and made modifications where necessary. One example is the rule regarding a financial expert on an audit committee. Alan also deserves a Nobel Peace Prize for listening to foreign concerns, particularly with respect to our rules regarding independent directors. He played a key role in diffusing trans-Atlantic tensions in the business sector at a critical time for the US. I am sure that his years posted abroad in Tokyo and Paris gave him a special sensitivity to foreign systems and practices.
Normally, I am not in the habit of talking about directors when they are not present, but I thought that I'd make an exception in Alan's case. Unfortunately, Alan could not be here with you today, either. He is under doctor's orders not to fly. I suppose that he could have taken the overland route, but we needed him in Washington on Tuesday. Speaking of which, I would like to discuss several recent rulemakings that came out of the Division of Corporation Finance.
On Tuesday, the Commission voted to propose rules that would revamp disclosure of executive compensation. The proposals would refine the currently required tabular disclosure and combine it with improved narrative disclosure, including a new Compensation Discussion and Analysis section. Companies would provide a total compensation figure for each of the named executives. Executive compensation disclosure would be organized into three broad categories: compensation over the last three years, holdings of outstanding equity-related interests received as compensation that are the source of future gains, and retirement plans and other post-employment payments and benefits. There would also be enhanced disclosure about related person transactions, director independence and other corporate governance matters.
I was working for Chairman Breeden in 1992 when the last major overhaul of executive compensation disclosure took place. In the ensuing years, some critical holes in compensation disclosure have developed and become apparent. This week's proposal, I hope, will address those problems in a manner that will give shareholders better information for their investment decisions without imposing unnecessary burdens on issuers.
Of course, it is important for the Commission to tread carefully in this area. It has become apparent to me in reading various critiques of executive compensation, both on an individual-company basis and generally, that methodologies of calculating pay differ greatly. Some people count, for example, in the same year, exercise of previously granted options together with the estimated value of currently granted options. To others, this seems like double-counting. Our regulations should guard against double-counting, while also ensuring that shareholders get a comprehensive picture of compensation packages.
We also must be careful about unintended consequences. Some suggest that the very disclosure of executive compensation has contributed to compensation inflation, as all packages are now public and any company can see what its competitors pay. There may be a ratcheting effect as each tries to outdo its competitors. Although it is certainly true that these compensation packages are now in the open, I suspect that compensation consultants would have found a way to build databases of comparison even if no information were publicly available. All the same, it is to be expected that if a board sees that a CEO at another company is making more than the CEO of its company, the board might want to pay the CEO a little more to ensure that he is not lured away. Thus begins the inevitable ratcheting spiral.
One action that has had far-reaching, unintended effects in this area is the so-called Million Dollar Rule of section 162(m) of the Internal Revenue Code. This 1993 law limits the deductibility of non-performance-related executive compensation to $1 million. Thus, in effect, it costs companies 35% more to pay their top executives more than $1 million per year because of the corporate tax rate. In 1993, the Clinton Administration's Treasury Department did not listen to the late Linda Quinn's advice regarding the problems with this provision. We should be grateful that they did heed some of her points regarding mechanics, which at least made that provision workable.
Linda, as usual, was correct in her predictions of the ill effects of this law. Economic studies have shown, not surprisingly, that companies as a result changed their pay packages away from salary and toward "performance-based pay." That led to the increase in the grant of stock options, which had been seen as too risky in the past as compared to cash. With a stock market increasing in value, options, while still risky, became more attractive. Our proposal should help to ensure that shareholders have access to both salary and non-salary compensation.
Before turning to updating executive compensation disclosure, Alan Beller shepherded through the Commission the Securities Act reform amendments. The Commission adopted these important amendments last summer.
I expect that we will see the benefits of these Securities Act reforms for years to come. The amendments are designed to liberalize and modernize the registration, communications, and offering processes under the Securities Act of 1933, which should ease the capital formation process. The rules eliminate unnecessary and outmoded restrictions on offerings and allow for the provision of more timely investment information to investors. The new rules went into effect in December, and preliminary reports suggest that they are streamlining the process.3 In short, these changes should enhance the efficiency of our marketplace without compromising its integrity for the benefit of issuers and investors.
A month ago, the Commission proposed another corporation finance rulemaking -- new deregistration rules, a response to our friends outside the United States, who have long been asking us to remove nearly insurmountable obstacles to deregistration from the U.S. Some might argue that by easing exit for foreign companies we are laying the groundwork for a mass exodus. Certainly, there will be those who leave if we adopt the proposal, but there are others who will enter because of it. Non-U.S. companies will be more willing to register with us if they understand that they are not making an everlasting commitment.
One of the factors that is driving foreign companies to take a second look at exiting the American market is section 404 of the Sarbanes-Oxley Act. I believe that we need to take a second look at section 404, or, more precisely, at the manner in which it has been implemented. The goals of Section 404 are laudable: management should be accountable for the integrity of financial information, and shareholders should have a gauge to help them assess to what degree they should rely upon a company's financial statements.
But it is indisputable that everyone greatly underestimated the costs involved in the 404 process. When the SEC first released its implementation rules for 404, we estimated that the aggregate costs of the rule would be about $1.24 billion or $94,000 per public company. In the SEC's defense, we made this estimate before the PCAOB released its 300 page Auditing Standard No. 2. Unfortunately, surveys indicate that actual costs incurred for 404 compliance were TWENTY times higher than what we estimated. Many had predicted last year that almost half of the costs incurred to comply with Section 404 were first-time start up costs that would not be repeated in year 2. A recent study that was sponsored by the Big 4 Accounting Firms predicted that total 404 implementation costs would decline in year two, but the biggest cause of the decline was expected to be reduced documentation costs for the companies.4 But. I would be surprised if companies' out-of-pocket costs or auditors' 404 revenues will fall. I am especially interested to see whether these predictions will prove correct or not.
At last Spring's Section 404 roundtable, we heard about a company determining that it has 60,000 key internal controls. On another occasion, the CFO of a large European company told me that the company determined that it had 500 key internal controls, but its outside auditor found 20,000 key internal controls. Regardless of whether the company was right in its assessment, I am confident in saying that the auditor was way off the mark.
Hearing of companies like these with tens or hundreds of thousands of key internal controls, all of which must be documented and audited, I can't help but conclude that the cost/benefit analysis has fallen by the wayside in this process. Our rule adopting the internal control provision provides that the control process must give "reasonable assurance" regarding its control structures. It also states that records should be maintained in "reasonable detail" and that a company's policies and procedures provide "reasonable assurance" that transactions are recorded accurately in accordance with GAAP. Despite our attempt to emphasize reasonableness, people in the trenches are taking an excessively granular approach. The biggest problem seems to be the fact that accountants and companies fear being second-guessed.
The SEC and the PCAOB need to give people more comfort that they will allow people to use their professional judgment and that second-guessing will not happen. A survey at the end of last year found that "82% of CFOs think it's important for the SEC and PCAOB to provide further guidance about Sarbanes-Oxley for more effectiveness and cost-efficiency."5
The Public Company Accounting Oversight Board will be essential in any second look at section 404. Both the SEC and PCOAB issued statements in March that were geared towards moving companies and auditors off their granular approach and more towards a risk-based model as we originally contemplated. I look forward to working to further address section 404 concerns with the PCAOB under newly designated Acting Chairman Gradison.
This is just one area in which I am committed to fostering a close relationship between the SEC and PCAOB. Congress established the SEC as the overseer of the PCAOB, a quasi-governmental organization with de facto taxing authority but without direct accountability to the public. It is important that we establish solid procedures for carrying out this oversight in these early years of the PCAOB's life. Our doing so should not be viewed as an indictment of the work of the PCAOB, but rather as a commitment to carrying out our own Sarbanes-Oxley responsibilities.
As I said, I am optimistic about our agenda at the Commission during the upcoming year. I look forward to rulemaking that is shaped by a concern for both costs and benefits. I look forward to enforcement actions that are imbued with due process and focused on punishing wrongdoers, rather than making rules through the back door. I look forward to a renewed focus on the mechanics of what in the business world is called "client-service" - improving our responsiveness in the no-action and application process.
Since we have many alumni and old SEC-hands in this room, I do not have to tell you how important your input into our rulemaking processes is. Please continue to read our releases critically, as you already do. Don't be afraid to visit us commissioners to register your thoughts - my door is certainly always open. You are a vital component to helping us carry out our objectives and reminding us where we need to do more work or thinking about an issue. Thank you for all that you do - your loyalty to the agency, camaraderie, support, and -- yes at times -- indulgence for delays or other shortcomings.
Benjamin Franklin, whose 300th birthday was Tuesday, said that "He that speaks much, is much mistaken." So, heeding that warning, I thank you for your attention and would be happy to listen to any comments or concerns that you might have.