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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the ALI-ABA Financial Services Institute 2006


Commissioner Cynthia A. Glassman

U.S. Securities and Exchange Commission

Washington, D.C.
February 3, 2006

Thank you, Marty, for your kind words, and thank you, ALI-ABA, for the opportunity to address the 2006 Financial Services Institute. My theme this morning is the importance of transparency and effective disclosure. Shareholders and investors benefit when disclosure in prospectuses and other investment information is clear and comprehensive. They especially benefit when disclosure meets not only the “letter,” but also the spirit, of our disclosure requirements.

In my remarks this morning, I would like to discuss five initiatives that the Commission has already adopted or is currently considering adopting that are designed to improve the usefulness of information to shareholders, investors and the market. These initiatives include executive compensation, Section 404 of Sarbanes-Oxley, our proposed point of sale document for mutual fund sales by broker-dealers, our investment adviser/broker-dealer rule and the Commission’s new corporate penalty guidelines. Before I begin, let me state that the views I express this morning are my own and not necessarily those of the Commission or our staff.

First on my list is our recent proposal to expand disclosure regarding executive compensation. Over the last quarter century, the gap between executive pay and that of the average worker has widened dramatically. Seemingly high executive compensation is particularly concerning when a company’s performance is poor. Having said that, the Commission should not be setting executive compensation levels. What we should be doing — and I think our proposal succeeds in doing this — is to make sure that disclosure regarding executive compensation is not only clear and comprehensive, but that it is in a form that is useful to investors and the market.

The current regime makes it difficult for investors to figure out what company executives are paid. Working from tables and footnotes in proxy statements, investors must piece together the various components of executive compensation, including deferred compensation, stock options, retirement packages, and executive perks. Under the proposed regime, public companies would instead be required to disclose a single number — and the components that make up that number — representing the total annual compensation of their five highest paid officers — the CEO, the CFO, and the three other highest paid officers — and up to three employees if their pay is higher than the five named officers. These latter employees would not be identified. The proposal would also require a “plain English” narrative to provide a context for the number, which would be called the CD&A or compensation discussion and analysis. In this section, companies would explain their compensation policies and decisions.

Making disclosure regarding executive comp clearer and more comprehensive would make it easier for investors and the markets to take into consideration a firm’s compensation of its senior management and directors when evaluating the company. As I said at the open meeting, if the proposed disclosures make boards or management teams think twice about the nature or level of senior management compensation, so be it. If they are uncomfortable seeing the amount of total executive compensation revealed and disseminated publicly, then perhaps they should not be paying it.

There are some components of the proposal that I suspect will result in a number of comments. One regards perks — where do you draw the line? We have proposed a reduction in certain dollar thresholds, which may increase disclosure of perks, although at these relatively low levels, we need to balance the company’s costs in providing the information with the usefulness of the information to investors. In terms of classifying which perks are executive comp, my own personal rule of thumb is if it walks like a duck and quacks like a duck, it is a perk.

Another issue is valuation of stock options. To calculate the amount of total compensation, the proposed rules would require issuers to value stock options issued to their executive officers and directors. Since it is part of total compensation, the estimate of option awards presented in the tables would be required to be realistic. As proposed, the rules call for issuers to account for forfeitures based on company-specific employee turnover. One question I have is whether we should assume the named executives stay through the vesting period. This would enable “apples to apples” comparisons across companies, but would raise the estimated value of the options. On the other hand, the proposed rules would require that the full and fair value of an option that has been repriced be reported in the tables as if it were a new grant. That raises the question of the potential for double-counting — once when the option is issued and again when it is repriced. Pension benefit valuation is also likely to generate significant discussion.

I fully support the effort to update and improve the disclosure of executive compensation, and I encourage you and your clients to submit comments if these issues are of interest to you. I hope we can be in a position to consider adopting a final rule quickly.

Second on my list are the internal controls disclosures required under Section 404 of Sarbanes-Oxley and the PCAOB’s Auditing Standard No. 2 (“AS No. 2”). With two or so years’ of experience under the new Sarbanes-Oxley rules, we are now in a position to better assess the rules’ overall benefits. Many of the Sarbanes-Oxley rules have achieved positive results, even if they are hard to quantify. CEO and CFO certification requirements appear to have been effective, corporate governance has improved, and directors are devoting more time and effort to their board responsibilities. Moreover, an independent regulatory structure for auditors has the potential to raise audit and auditor standards.

At the same time, our experience under the new rules has pointed up some unintended consequences. Of all the Sarbanes-Oxley provisions, issuers have been most vocal in their criticisms of Section 404. This is the section that requires company management to assess and publicly report on the effectiveness of the company’s internal controls. The PCAOB’s AS No. 2 imposes the additional requirement that auditors not only publicly attest to management’s assessment, but also provide a separate opinion on the effectiveness of the internal controls. The purpose of Section 404 — to help make sure that company financial statements are reliable and materially accurate — is laudable, but there has been widespread criticism of the burdens and costs of implementation, much of which I believe is valid.

The Commission held a roundtable in April 2005 to obtain feedback on the first year of Section 404 implementation. The discussion at the roundtable among investors, officers and directors of public companies, both large and small, and auditors left little doubt that the assessment of internal controls had effectively shifted from a risk-based assessment by management to a non-risk-based exercise by the auditors with an apparent focus on controls for controls’ sake.

After the roundtable, the Commission and the PCAOB issued statements intended to get the 404 compliance process back on track. The statements urged management and auditors to bring reasoned judgment and a top-down, risk-based approach to the process. A prescriptive, one size fits fall, bottom-up approach is not only not required, but it is not effective. I was hopeful that the joint SEC-PCAOB message would re-focus U.S. companies and their auditors on a more appropriate approach to 404 in the second year of compliance, but that remains to be seen. Very significant reductions in auditors’ fees were projected at the time of the roundtable, but recent anecdotal reports suggest that significant declines have not materialized. I do hear that issuers’ internal costs seem to be declining in year two.

I believe in the purpose of Section 404, which is to establish and maintain efficient and effective internal controls that enable reliable financial statements, but I continue to be concerned about the misfocus of the Section 404 process and the associated costs. I remain concerned that the AS No. 2 approach misses the proverbial forest for the trees. As we learn more about year two implementation, I will be looking for a meaningful refocus of 404 efforts towards a more risk-based approach. In my view, to implement the requirements efficiently and effectively, the scope of the audit needs to be related to the level of risk — and the risk I am talking about is in the context of management’s perspective on what is important to the business and to the financial reports. In the absence of such a refocus developing in year two, I believe that the Commission and the PCAOB should continue to consider ways of making the 404 process more effective and efficient. This may require revisiting AS No. 2.

Leaving the world of public companies and turning to investor protection for the retail investor, I am very enthusiastic about our “point of sale” disclosure proposal. This would be a brand new form for investors purchasing mutual funds through broker-dealers. In preparing the form, we have attempted to highlight the information that investors should have and to provide it to them in a simple, clear format. Unlike the confirmation, which comes after the trade is executed, the “point of sale” document would be delivered to investors at the time they are making their investment decision. The proposed form includes information regarding fees, costs and broker conflicts of interest that may affect an investor’s decision to buy mutual fund shares.

Using focus groups, we have actually tested a few versions of the form with real investors to get a sense of the information that would be most helpful to them. We are also considering the best way to make the disclosure appropriate to the method of purchase, whether in person, over the phone, through snail mail or email. And, of course, we are taking into consideration input from broker-dealers and mutual funds about accomplishing our objective in a cost-effective manner. As is often the case, balancing costs and benefits is turning out to be a challenge.

The need for better disclosure was also an important part of the analysis in the fourth item on my list, the so-called IA/BD (Investment Adviser/Broker-Dealer) rule we adopted last year permitting fee-based brokerage accounts. As a condition to offering these accounts, we mandated certain disclosures by brokers intended to draw investors’ attention to the fact that there may be differences in the duties and obligations owed them by different investment professionals.

Drafting a short, succinct paragraph drawing investors’ attention to the fact that the duties and obligations owed them by their investment professionals differed, depending on whether that professional was a broker or an advisor, proved more difficult than you might expect. When our Office of Investor Education and Assistance arranged for our original disclosure language to be tested on actual investors, we got some surprising results. We found that that the proposed disclosure was successful in alerting investors to the need to ask questions about the differences between brokerage and advisory accounts, but it was not successful in answering these questions. For example, focus group participants did not appreciate the distinctions among various financial professionals. Many thought that anyone with a title other than a broker — a “financial adviser” or “financial consultant” — was something more than a broker. Many assumed that investment advisers, financial advisers and financial consultants all provided financial planning. So instead of resolving investors’ issues, we simply raised their anxiety level. In response to this feedback, we revised the language. The rule that we adopted included what we hope is more effective disclosure.

As a result of the negative feedback from the focus group participants, we began to question whether disclosure alone was sufficient to address the broader investor protection concerns raised during the rulemaking. We concluded that issues regarding advertising, the titles investment professionals use, and broker-dealer sales practices were more appropriately considered in another context, and decided to conduct a study. The study would focus on ways to deal with the differences in the regulatory framework applicable to broker-dealers and advisers and on whether these distinctions any longer make sense. I continue to believe such a study is critical, and I would like to see it organized as soon as possible.

The last item for this morning is the Commission’s guidelines on corporate penalties. This is not exactly a disclosure initiative, but it is the Commission’s attempt to provide transparency on an issue that affects corporations and their shareholders. Congress gave the Commission the power to impose civil penalties on corporations in 1990. Congress granted the authority in the belief that increasing the financial consequences of violations would deter unlawful conduct. At the same time, however, it cautioned against imposing corporate penalties on shareholders already victimized by the underlying fraud. In response to Enron, Worldcom and other corporate scandals, the level of corporate penalties in our enforcement actions escalated. As the corporate penalty level rose higher and higher, so did my concern about the consequences of what we were doing. Note, however, that I continue to believe that the imposition of penalties and other sanctions on individuals is a particularly effective deterrent.

When Chairman Cox came on board, he made a meeting of the minds among the Commissioners on corporate penalties a priority. The five of us sat in a room together for many, many hours, reviewing the legislative history, analyzing the policy issues involved, considering several proposed settlements of Commission enforcement cases, and actually drafting the guidelines. Through the process, we identified two principal considerations and a number of additional factors that the Commission will consider in deciding whether a corporate penalty is appropriate in a particular case.

First, recognizing that it is the shareholders who ultimately pay corporate penalties, we will consider whether the shareholders benefited from the fraud or were victimized by it. If they benefited from the fraud, through the corporation’s increased revenues or reduced expenses, for example, a penalty may be appropriate. However, if shareholders were victims of the fraud, then a penalty may not be appropriate. Second, we will consider the degree to which a penalty could be used to recompense innocent victims of the fraud or whether it would simply further harm shareholders.

Additional factors to be weighed include the need to deter the particular type of violation involved, the extent of injury to innocent parties, the pervasiveness of the fraud within the company, the extent of remedial steps taken by the company, and the extent of the company’s cooperation with the Commission. We are constantly asked what “cooperation with the Commission” actually involves and how cooperation affects the outcome of cases. Obviously, the analysis varies from case to case. Based on the guidelines and the guidance offered in the Section 21(a) report on the Seaboard case, I think it’s safe to say that cooperation generally involves one or more of the following: self-reporting, taking prompt and meaningful remedial measures, and cooperating with our staff’s investigation.

Overall, I’m pleased with the guidelines. In my view, they recognize that corporate penalties generally make little sense when imposed on shareholders already victimized by a fraud. But, as in many things, applying the guidelines is easier said than done. To apply them, we will have to figure out whether the shareholders benefited from a fraud or were victimized by it, and this is not necessarily a simple analysis. I hear we are creating a new cottage industry for economists!

You may find it strange that I’ve made it to the end of my remarks at a financial services conference without mentioning Reg B. But all I can say about Reg B at this point is that we are continuing our work with the banking agencies to find a solution that achieves the goal of investor protection without an unnecessarily burdensome compliance framework.

In closing, I hope you will take our plea for clearer and better disclosure to heart. Think about disclosure from the investor’s point of view, and draft your disclosure documents in “plain English.” You may find that it isn’t always that easy — we have certainly learned that — but it’s a very important exercise. For my part, I will continue to do what I can to make sure that the Commission lives up to the “plain English” standard too.

Thank you for your attention, and I would be happy to take your questions.



Modified: 02/03/2006