Speech by SEC Commissioner:
Remarks Before the 4th Annual Financial Services Conference
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
January 31, 2006
It is an honor to be here with you today at the 4th Annual Financial Services Conference. Let me start by saying, as I am required to do, that the views I express here are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
It is a pleasure to be back in Europe, and in particular to be here in Brussels. I was here exactly a year ago for another conference and visited Brussels four times in all last year. This is a good way to start off another year.
I am very happy to say that you soon will be greeting a new ambassador to the European Union, whom the President appointed just a couple of weeks ago: Boyden Gray. Boyden steps into the shoes of Rockwell Schnabel, who did a splendid job as a representative of the United States on this continent. I have every confidence that you will enjoy having Boyden in Brussels - he is an outstanding lawyer, a distinguished public servant, an engaging raconteur, and -- best of all for you who are justly proud of the cuisine here in Brussels - a first-rate connoisseur. The President could not have chosen a finer person for this position. Boyden really stands out in a crowd, whether by his physical height (around 198 centimeters), because of his intellect, or by his walking his daughter's pet pot-bellied pig through Washington. Boyden should feel at home here in no time, and I encourage you all to get to know him as he settles in during the coming weeks.
Today, I am particularly pleased to be with you to discuss trends in transatlantic capital markets. As some of you may recall - and I recognize a number of you from my previous visits - when I was in Brussels and Strasbourg just last October, I had the privilege of discussing my thoughts on the importance of Europeans and Americans working together to encourage global competition in the financial markets. Having lived and worked in Paris for a time during my early legal career, the topic of European and American cooperation is one that remains close to my heart.
The SEC was established by act of Congress in 1934 and is charged with the mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. Our mission to facilitate capital formation extends not just to companies headquartered in the United States, but to those from outside the country as well. I was therefore troubled to read - just last Thursday - in The Wall Street Journal an article about a Bombay-listed company, Indiabulls Financial Services, which decided to list its shares on an overseas stock market but elected not to register in the United States. Their decision reportedly turned on the excessive time and cost required for a registration in the U.S. compared with listing in jurisdictions in Europe. They made this decision despite the fact that many of the company's largest investors are U.S. money managers.
If this story actually reflects a rising trend, it is not a welcome one from my perspective. The Wall Street Journal reports that up until the year 2000, nine out of every 10 dollars raised by foreign companies through new stock listings were done in New York. By 2005, the numbers had fallen and, in fact, the ratio reversed such that now nine of every 10 dollars are raised outside of America.1
Of course, since this article suggests that many new listings are going to European exchanges - Indiabulls, for example, chose to list on the London exchange -- I realize that many in this audience might applaud these new listings here in Europe. I would, however, be concerned about any such trend if it reflects actual or perceived inefficiencies in the American regulatory system. As we all know, perceptions can be every bit as important as reality, especially in the financial markets. Because of our mandate from Congress to protect investors and encourage capital formation, it is important that the SEC balance the costs of regulations with the anticipated benefits - and rigorously examine whether those benefits can be achieved through the method chosen.
Certainly, though, the reasons why companies may choose not to list in the United States are multifaceted. Some reasons may reflect conditions that the SEC has the means to address. For example, increased costs and risks associated with the implementation of the Sarbanes-Oxley legislation passed in 2002 may be partly responsible. This is something the Securities and Exchange Commission has some ability to address.
Our litigation system might be an additional reason, because of the unexpected costs and management distraction that frivolous law suits may impose. President Bush, Congress, and the courts themselves are making advances in helping to end some of the conditions that led to examples of game playing and unethical behavior by lawyers. Although the SEC does not have any direct authority in this area, we can do much to make sure that the enforcement actions that we pursue are based on clear violations of unambiguous rules, and that we do not turn the enforcement process into rulemaking after the fact.
Another factor - pointed to in the Wall Street Journal article - may be the relative underperformance of the U.S. markets when compared with returns in foreign markets over the last several years. This is something we as regulators have, unfortunately, little control over.
As I commented when I was in Europe in the autumn, in an ideal world neither the Sarbanes-Oxley Act nor the implementing rules should dissuade a foreign company from considering a U.S. listing. Foreign listings not only benefit U.S. investors in the form of greater investment choices and diversification, but also provide foreign issuers with access to the U.S. capital markets and greater potential for making acquisitions in the U.S. However, in the real world, the decisions of foreign issuers are clearly influenced by either the real or perceived costs of Sarbanes-Oxley compliance.
There is much discussion within and outside the SEC regarding ways in which individual provisions of the Sarbanes-Oxley Act may be imposing a greater cost than was anticipated, or than may be justified by the benefits imparted to investors. One example is the implementation of Section 404 of the Act, which requires management to complete an annual internal control report and requires the company's auditor to attest to, and report on, management's assessment. This is perhaps the most controversial provision of the Sarbanes-Oxley Act. The controversy concerns mostly definition and cost. If we can find a cost-effective way for Section 404 to achieve its objectives, it could be one of the most valuable parts of the Act.
The emphasis on good controls over financial reporting is laudable. Section 404 focuses on the integrity of financial information and seeks to give shareholders some insight into the credibility of the financial statements. The principle is that investors might step up their scrutiny of financial statements of a company that has been found to have "material weaknesses" in the internal controls around the processes that produce its financial statements.
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 would be about $1.24 billion or $94,000 per public company. Actual costs incurred during year one for 404 compliance, according to surveys, were some TWENTY times higher than estimated costs. In the SEC's defense, we made this estimate before the Public Company Accounting Oversight Board released its 300-page Auditing Standard No. 2 to govern the 404 process.
It is widely acknowledged that under AS2, corporate management and auditing firms have been much too conservative in exercising their judgment. We hear too many stories of how people seem to be driven by the impulse to document virtually every process in an effort to appear to be thorough and to avoid being second-guessed by regulators and litigators. The PCAOB itself acknowledged this in a report it issued in November 2005 on the implementation of AS2. The PCAOB found that there were problems with its implementation, including a tendency to employ a bottom-up approach, which resulted in the expenditure of "more time and effort than was necessary to complete the audit."
The good news for foreign private issuers is that the SEC has recognized the difficulties that Section 404 may pose, particularly in combination with migration to the new International Financial Reporting Standards. Last March we extended the Section 404 compliance date for foreign private issuers for another year such that foreign issuers now need to comply with Section 404 for their first fiscal year ending on or after July 15, 2006. We also extended the compliance deadline for smaller public companies, including smaller foreign private issuers. These companies will have to comply with the Section 404 requirements for their first fiscal year ending on or after July 15, 2007. This is consistent with other accommodations that we have made for non-U.S. issuers since we first started to implement Sarbanes-Oxley.
We will continue to work on a more rational approach to implementing Section 404. I have made no secret of what I view as the need to re-examine the PCAOB's Audit Standard 2. As we did a year ago, the SEC and PCAOB are planning another joint public roundtable this spring to determine how the second year of Audit Standard 2 has gone. I anticipate that we will hear similar stories of excessive documentation and improper scope and focus in the planning and execution of these reviews.
If we are able to address the Section 404 problems and evaluate whether there are other areas where the cost of complying with Sarbanes-Oxley can be reduced without diminishing investor protection, we will begin to ameliorate the concerns expressed by international - as well as domestic - issuers.
Deregistration is another area where foreign issuers have expressed concern, and the SEC has reacted to the concerns of the marketplace. Currently, the process for a foreign issuer to deregister in the United States can be uncertain, complicated, and costly. I mentioned when I was here in October that the SEC staff was looking at ways to modify the process. In December we published for comment a proposed rule concerning a foreign private issuer's termination of its reporting requirements.
The idea is to make the process for deregistration clearer and less cumbersome. While the immediate prospect of losing registrants may be unattractive, a longer-term view suggests that non-U.S. companies are more likely to register with us if they know that they are not making an eternal commitment. We must recognize that conditions change for individual registrants. We should allow for as much flexibility as possible, without sacrificing the expectations of and fairness to American equity investors.
Under current rules, a foreign issuer may exit the registration and reporting regime only if fewer than 300 record holders of the issuer's securities are U.S. residents. Under this rule, a foreign issuer may find it difficult to terminate its Exchange Act registration and reporting obligations even if there is relatively little investor interest in the United States.
The proposed rule would let foreign issuers terminate, and not merely suspend, their reporting requirements as long as they meet certain conditions that depend on the type of securities - equity or debt. Forgive me if the particulars are a bit tedious at lunch, but I think that it is worthwhile going through the details for a couple of minutes:
For equity securities, a foreign issuer first would have to establish its eligibility to terminate registration. It will have to have (i) filed all required reports in the US for the preceding two years, including at least two annual reports; (ii) not sold its securities in the United States through either a registered or unregistered offering during the preceding 12 months; and (iii) maintained during the preceding two years a listing of the securities on an exchange in its home country, which constitutes the primary trading market for the securities.
An eligible foreign private issuer would then have to meet one of a set of alternative benchmarks, depending on whether it is a "well-known seasoned issuer".
If it is a "well-known seasoned issuer", which is generally a large multi-national company, then it can deregister if either: (i) U.S. average daily trading volume has been 5% or less of the average daily trading volume in its primary trading market and U.S. residents held no more than 10% of the issuer's worldwide public float or (ii) regardless of U.S. trading volume, U.S. residents held no more than 5 percent of the issuer's worldwide public float. If the issuer is not a "well-known seasoned issuer", then, regardless of U.S. trading volume, U.S. residents must have held no more than 5% of the issuer's worldwide public float.
The proposed rule would also provide that a foreign issuer that is unable to meet one of the proposed benchmarks, but that satisfies the rule's other conditions, could still terminate its registration obligations as long as the class of securities is held of record by less than 300 persons on a worldwide basis or less than 300 persons resident in the United States. This is essentially the current rule, which companies can still use if it suits them better.
The proposal also provides that a deregistering foreign issuer would have to publish in English the home country materials - required by Rule 12g3-2(b) - on its Internet web site or through an electronic information delivery system that is generally available to the public in its primary trading market. It is intended that a foreign private issuer that regularly posts corporate information on its web site would be able to maintain this exemption.
For debt securities, a foreign issuer would be eligible to terminate its reporting obligations if it has filed all required reports, including at least one annual report; and the class of debt securities is either held of record by less than 300 persons on a worldwide basis or less than 300 persons resident in the United States.
I understand that there may be some debate over the actual number of foreign issuers that would be eligible to deregister under the proposed rules. I have heard numbers ranging anywhere from 5% to 26% of issuers. Some have said that these numbers may not be high enough. But, please bear in mind that our underlying premise is to allow companies to shed their registration obligations if there is relatively little interest by US investors in the domestic market.
I would encourage you, if you have information or an opinion, to file comments with the Securities and Exchange Commission during the notice and comment period for the proposed rule. Your comments are critical for us to gauge the potential effect of these rules. By law, we must take your comments into account, so please take part in this process. If there is a better way to approach this question, I should very much like to hear it.
Another topic I would like to address is the effort to achieve convergence between U.S. GAAP and International Financial Reporting Standards. Done correctly, convergence holds out the promise of allowing investors to compare more reliably the results of competing firms based in different regions and thereby facilitates the global flow of capital. This, in turn, will ease the task of raising funds for all companies regardless of where they are situated.
I am optimistic that the United States and the European Union are on track to realize significant improvements in both GAAP and IFRS as a result of the convergence effort. The Financial Accounting Standards Board and the International Accounting Standards Board have been working attentively in the effort to eliminate differences between U.S. GAAP and IFRS consistent with the Norwalk Agreement. As you know, that agreement, issued in October 2002, commits both the FASB and the IASB to work toward convergence where the result will be an improvement to either GAAP or IFRS, or to both. I have heard several comments that the level of cooperation between the two accounting boards is excellent, and some hold it up as a model for European and American cooperation more generally. Certainly, the process is progressing at a rate far faster than I would have anticipated when the process began.
That being said, I do not believe it is necessary to impose a single set of accounting rules on all participants in the global marketplace in order to allow competition across borders. In fact, due to differences in culture, legal systems, and liability regimes, true equivalence in accounting standards may be an impractical objective. What is critical, however, is that accounting standards be clearly stated and evenly applied by all nations and companies adopting those standards. Moreover, financial reporting standards must be implemented in such a way that they succeed in serving their intended purpose of protecting investors. Achieving evenness in the application of the new standards may be as important as narrowing the differences between the formal accounting systems.
Last April, our Chairman and chief accountant set out a so-called "roadmap" by which they anticipated a 2007-2009 timeframe of mutual recognition of accounting standards. I was happy to support this plan and personally remain confident that the SEC will meet this timetable. Certainly, none of the changes in personnel at the SEC during the past year has caused any rethinking of this timetable or how important we perceive its successful completion. I am confident that the need for reconciliation will disappear as all of us gain experience with IFRS in practice, which can be done within this timeframe.
As I noted last October, there is great interest in the United States in how European companies manage the transition to International Financial Reporting Standards. We recognize, of course, that this is a difficult process. I applaud the effort towards greater transparency and understand that European companies are concerned about continuing to bear the costs of reconciliation to U.S. GAAP in addition to switching to IFRS. I expect that, consistent with the roadmap and the ongoing encouraging progress on convergence, the day will come soon when companies conforming to IFRS will be able to raise capital in the United States without reconciling their results to GAAP. Certainly, the level of comfort with IFRS that such a development would reflect will be a great boon to investors.
However, I am concerned and disappointed at suggestions by some that Europeans should begin to require U.S. companies to reconcile their U.S. GAAP financial statements to IFRS. This runs against the direction that we are taking in the United States and undermines our efforts towards mutual recognition. Some may assert that this is a useful bargaining chip to ensure that we Americans will recognize IFRS. But, I believe that it is counter-productive, ignores historical precedent and market practice, and diverts attention and energy from solving the real challenges before us. Because of the size of the US markets historically, US GAAP was the benchmark against which others compared their financials, not just because of SEC rules, but also because of investor demand. Our process recognizes the growth of the international marketplace and that IFRS has the potential as it is implemented to be a coherent, consistent standard. IFRS will stand or fall on its own merits. Our collective efforts on both sides of the Atlantic should be focused on making sure that it succeeds.
Finally, I want to mention an initiative of our energetic and insightful Chairman, Christopher Cox. The Chairman is committed to fostering the widespread use of Extensible Business Reporting Language, more easily stated as "XBRL." XBRL is a new platform for delivering the numbers in financial statements. Chairman Cox has recognized that we must maintain parity with our foreign counterparts, who are leading the way toward implementing this technology.
By making the data interactive, XBRL makes 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 key performance indicators. I look forward to working with the Chairman as well as with issuers and users of financial statements on furthering the XBRL initiative.
I would like to leave you with the final thought that further government regulation will often not be the best solution for what ails our capital markets at any particular time. As we have seen in the past, politicians are mightily influenced by well publicized events. The Sarbanes-Oxley Act was a political response to the financial and accounting scandals of the late 1990s and early 2000's - including Enron, Global Crossing, Qwest, and WorldCom - that captured the imagination of the American public. Congress was under pressure to act - and it did. Some argue that, in certain respects, it overreacted. Others view all aspects of it as a long-overdue set of reforms. Only time will tell.
A far better result could be realized if private industry more effectively policed its own affairs. The private sector could - and should - be proactive in its efforts to fix problems before government regulators are required to step in. I would therefore encourage those of you in private industry to work with your colleagues to design efficient, effective solutions and preventive measures of your own, without government intervention and before the government steps in. As a person who prefers seeing the marketplace itself fashion reforms, it distresses me when business people do not react to perceived problems using a principle-based approach to guide the conduct of their organization and the industry. Too often, however, it seems that market participants look instead to regulatory solutions. Not only can such solutions be manipulated to the benefit of a few - and to the detriment of the many - but regulatory solutions can quickly take on a life of their own, particularly where events in the media drive elected officials toward a populist political solution.
It is also important, once a regulatory solution is in the works, to actively participate in that process to the extent permitted under the regulatory regime's rules. Lawmakers and regulators cannot be faulted for missing important issues if they were not brought to their attention when the laws and regulations were being considered. The SEC, for example, is legally bound to take comments into account and explain why we accept or reject them. We take this obligation seriously and look to investors, regulators, and corporations outside the U.S. for information and insights about unique challenges that our rules may pose for them. By representing your own interests effectively, you help us to protect investors in U.S. markets - be they US citizens or others - and maximize the efficiency of the global economy.
With your assistance, we can work to address some of your concerns about recent regulatory reforms in the U.S. We can also work to shape future regulatory initiatives so that they fulfill their intended function of protecting investors without imposing unnecessary burdens in the U.S. and abroad. I am confident that international cooperation in these regulatory matters will benefit all of us in the long run.
Thank you for your attention. I look forward to discussing these matters with you further.