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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks before ASIC Summer School (by recorded DVD)


Commissioner Roel C. Campos

U.S. Securities and Exchange Commission

Washington, DC
February 13, 2006

Good afternoon or good morning, in the event this video is shown at a different time than originally planned. I hope you can hear me loud and clear. One thing about a recording, you can always turn up the volume. However, you are not allowed to fast forward this video, even if I get a little boring during this presentation. I must say I am very envious of all of you who have managed your business life to be able to attend in person the ASIC summer school. My schedule, unfortunately for me, prevented me from being there with you in person. I must say that this summer school has become one of the best securities regulation training conferences in the world. It used to be that the ASIC summer program would steal ideas from our own U.S. SEC's training programs, but I think it is now reversed - we are taking ideas from the ASIC program.

My congratulations and thanks to my good friend ASIC Chairman Jeff Lucy for supporting and maintaining this terrific program. Chairman Lucy has become quite a respected and well known regulator in international circles. Thank you for inviting me to speak today. Also I know that Greg Tanzer has been for many years the nurturing and driving force behind ASIC's Summer Program and I congratulate him for helping build it to its current prominence. In fact I owe Greg a great debt of gratitude because he was the first to explain to me the rules of cricket in a way that I could understand, obviously very pedagogically gifted. I also know that Liz Roberts deserves much credit for long hours in preparations for the program this year.

Well, on to business. As you have gathered, my comments today represent my personal views and not those of my agency, the U.S. SEC. I thought that I would focus on two topics that have been on the SEC's current agenda as a means to discuss the US approach to regulation. These topics are executive compensation and internal controls under Section 404 of Sarbanes-Oxley. If there is time for questions perhaps we can also discuss items such as our hedge fund registration rules or our new foreign issuer delisting rules or other topics that you may be interested in.


It seems that executive compensation is to the financial press and journals like sex is to tabloids. Everyone is interested in it and everyone wants to know how much they are getting. It is fair to say, that many of the decisions surrounding executive pay in the public companies in America have been made in very dark corners, difficult to discern and understand fully. Retirement benefits that have included New York city apartments and free use of corporate jets are one example. The automatic pay to certain executives upon the completion of a merger astounded many investors.

Well, last month, the Commission did something about this and issued a comprehensive set of proposals, which set forth a new disclosure regime for the compensation of the five top executive officers and directors of public companies. Essentially, this requirement will provide a "one stop shopping," in the proxy statement where investors and the public can discover all of the aspects of executive compensation. Through a set of very clever tables and narratives, the proposed rules will require that the various elements of executive compensation be revealed: cash, incentive pay, equity - including all manner of options and restricted stock, retirement benefits and change in control compensation - and the amount the executive would receive in cash and equity if the company were sold. The new rules will require that the options be priced, presumably using the method (Black Scholes or others) that is used in expensing the options. Most importantly, these tables provide for the computation of a final amount in the summary table of the executive's compensation. Imagine that - one figure that puts all of these compensation elements together. Of course, there will be some elements such as retirement that will principally be in narrative form, but the rules will require that examples be given as to what the executive will earn if normal conditions occur.

The levels of executive compensation in the US and the disparity in pay globally also argue in favor of improved disclosure. In 1982, the ratio between chief executives and the average employee was 42:1. In 2004, the ratio of the average CEO pay to that of the average non-management worker in the US was 431:1. There is certainly no evidence that today's executives in the U.S. are 10 times better than twenty years ago. The US ratio far exceeds any international comparison, which remain closer to the historical average. Although internationally there has been a trend towards increased "US-style" pay, according to a 2001 report by management consultants Towers Perrin the same ratio in other heavily developed nations was 25:1 in the case of the UK, 16:1 in France, 11:1 in Germany and as low as 10:1 in Japan (as compared to 531:1 in the US in that same year).

Of course, one must recognize that some of the disparity has been due to governmental constraints such as the restriction on granting of stock options. In Japan and Korea, for example, it was not until 1997 that such restrictions were lifted. Even so, the 10:1 ratio in Japan versus the 531:1 ratio in the US in 2001 is stunning.

Of course investors do not begrudge high compensation if they have created high value for shareholders. I remember speaking to the lawyer of Disney's Michael Eisner in December of 1997. The worry was how would investors react to Eisner cashing in on the amazing sum of $565 million of options. I remember asking the lawyer, "well, how much value has Eisner created for shareholders during his tenure?" The answer was, "in the billions." Then, I said, "there will be no justified resentment from investors." I turned out to be right. Shareholders did not complain in that instance. The problem today, however, is that high pay seems to be totally unrelated to performance. Indeed, many pay experts claim that "pay for performance" has become "pay for pulse."

Now, as I said on the day that the Commission voted to issue the proposals, we will not set a level of compensation. It is not the role of the SEC or any part of government for that matter to determine what executives' pay should be. That judgment must continue to be made by directors and shareholders. In America, unlike the UK and other jurisdictions around the world, shareholders in most public companies use a plurality voting system and under such a system, it is difficult for shareholders to remove directors from the board. Still, I believe that public pressure, withhold vote campaigns, and behind the scene discussions with management can be used by investors to bring about change in compensation. I believe our proposals provide investors a tool that will enable them to assess whether executives through their compensation are essentially raiding the company's till. Ultimately, I believe that shareholders will have no one to blame but themselves if executive pay continues to shoot upward in an unacceptable way. It will be their responsibility to expect their directors to impose limits and restraints and seek to replace directors who do not. Shareholders will have to hold directors accountable for their decisions and directors will have to hold executives accountable for their performance.

It appears that other jurisdictions may be taking a similar tact to executive compensation, at least at the higher levels. Currently, there is no uniform approach across the EU; differences exist with respect to both pay-setting and the disclosure of executive pay. That being said, in 2004, the EU adopted two non-binding recommendations on executive compensation which seem to suggest that disclosure is emerging as a key mechanism for managing pay across the EU, although the degree of disclosure may vary.

As always, the devil is in the details. The recommendation does not require individualized disclosure. Germany, for example, seems to be an opponent of such disclosure. The recommendation also does not require discussion of the company's share price performance as against a benchmark which is required in the UK. My point in mentioning these examples is only to note that approaches vary even within the common construct of disclosure.

The second EU recommendation relates to effective board governance in setting pay. Here, the premise is that independent board oversight can protect the interests of shareholders. Again, I am intrigued to see that our regulatory theories are not so far apart. Noticeably, neither of the EU recommendations, nor for that matter the regulatory regimes in Germany or the UK, for example, attempt to regulate the amount of compensation. Although I believe disclosure (with its potential influence on accountability) is the right approach to this regulatory dilemma, I look forward to following the developments in the EU as well as receiving the public comments on our own proposals.


It is safe to say that the internal controls provision of Sarbanes Oxley ("SOx")- Section 404 - has been the most controversial and the provision subject to the most complaints from the business community. It is also safe to say that while most of the principles of Sarbanes Oxley will eventually converge with those of Europe and Asia, SOx 404 will probably not. While European directives have imposed rules regarding internal controls, this will be left to management disclosure and will not require outside auditor certification. Section 404 and the Commission's related rules require management of an issuer to assess the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent financial year. Once management concludes and asserts that the internal control system is effective or ineffective, the auditor attests to the integrity of management's conclusion (pursuant to rules established by the PCAOB). The Act also requires management to include in the company's annual report to shareholders management's conclusion, as a result of that assessment, as to whether the company's internal controls are effective.

A major issue of contention surrounding Section 404 has been the cost associated with complying with the applicable rules. I should say that recent reports by major audit firms, such as Ernst and Young, have predicted that SOx 404 costs should come down 40% this year. Most of the savings will be from companies not needing to document anew the existing internal controls and procedures. As many of you know, many small businesses have complained that the cost of compliance with Section 404 is exceedingly onerous and costly. The SEC's advisory committee on smaller public companies also recently recommended that micro-cap and smaller public companies be partially or wholly exempted from the main requirements of 404. This proposal recommended that public companies with market cap of less than $100 million and revenue of no more than $125 million be exempt completely from 404 requirements, while companies with a market cap of less than $700 million and revenues of no more than $250 million be exempt from the requirement that an independent, outside auditor test the internal controls.

This suggestion presents a difficult regulatory dilemma. While 404 regulatory costs will naturally be disproportionately heavier for smaller companies, smaller companies often present the greatest risks to investors, in that many incidents of fraud have occurred in the small company sector. To date, evidence is being presented that in establishing internal control systems that meet these requirements, companies have discovered inefficiencies that have existed for lengthy periods of time that, when corrected or improved, actually result in operational cost-savings. More rigorous emphasis on internal controls already has prevented the much too frequent scenario of "bad" financial statements that are the result of inadequate internal controls. From my perspective the most important result of the 404 work is that management, investors and others have focused so intently on what's important to investors - reliable financial reporting and the need for good internal controls to accomplish that. Indeed, I believe that there is an added benefit of lower cost of capital when there is sufficient trust in the integrity of financial statements. A more rigorous internal control framework helps provide that trust.

Exempting smaller public companies - which represent 80% of all public companies today - from the requirements of 404 could severely undermine this trust. Already, smaller companies suffer from reduced global investment because of the perceived risks and lack of transparency associated with them. According to one major source, in the five years before 2004, nearly of all financial restatements were reported by companies with annual revenues of less than $500 million. Moreover, many of the internal control problems that I have seen as a Commissioner have taken place in smaller companies that have less robust compliance and surveillance infrastructures and that remain generally shaded from the disinfecting "sunlight" of probing institutional investors or the media. Thus, I believe that "lowering the bar" for these smaller companies with respect to their internal controls, instead of being helpful, could further inhibit investment in these companies. This would have the perverse effect of escalating, rather than reducing, the costs to them of attracting and raising capital. Nevertheless, we are actively considering how to ease the pain for small businesses. Recently, former Chairman Arthur Levitt in an op/ed piece in the Wall Street Journal suggested that small companies should not be exempted and that regulators could make a difference by not requiring auditors to recheck every year internal controls that were working. We have already granted them some relief in the way giving them more time to complete this first round of 404 audits, and we are considering additional steps.

Independent of the cost-issue on the domestic front, we recognize that many foreign private issuers are facing regulatory and reporting challenges in addition to internal control reporting. Some have also questioned the willingness of foreign issuers to come or to stay in the U.S. capital market if they must subject themselves to these potential costs, despite the benefits I've just outlined. Accordingly, the Commission extended the deadline for compliance with the internal control over financial reporting requirements for foreign issuers to their first fiscal year ending on or after July 15, 2006. This additional time will afford foreign private issuers an opportunity to benefit from additional guidance gleaned from the experience of US issuers as well as an opportunity to evaluate and work through their own domestic issues.

This is a very delicate balance because relaxing standards for foreign issuers and not their American counterparts may not go over well on the home-front. Fore example, what justifications are there for imposing disclosure costs on U.S. issuers that are not borne by foreign issuers when they are accessing the U.S. capital markets? Consider further that a fundamental objective of the Commission's basic information package is comparability among issuers. Is this objective seriously compromised when an important segment of issuers, foreign issuers, is not subject to the same disclosure standards as apply to domestic issuers? This is especially acute with Section 404, given the need for U.S. investors to have confidence in the internal controls of companies in which they invest and to see that an independent auditor has attested to those internal controls. This was a fundamental piece of Sarbanes-Oxley and to give the foreign issuers an out may not be in the best interest of investors.

Today, there are no EU-wide requirements for company management to report on internal controls and the effectiveness of internal controls, or for auditors to provide public reports on company internal controls, that are similar to what we have instituted in the US since the passage of the Sarbanes Oxley. However, there are a wide variety of national requirements and/or voluntary corporate governance codes in place throughout the 25 individual EU member states that do touch on one or more aspects of issuer company responsibilities for having internal controls, including some that require management and/or boards of directors to report on these responsibilities. Such issuer reports, where they occur, do not generally have to include a statement regarding the effectiveness of internal controls or be accompanied by auditor's reports. Some of the EU countries have added to their requirements in recent years, or are considering possible changes in requirements. France, in particular, instituted new requirements on corporate governance and internal control reporting for publicly listed companies in 2003. In January 2005, the AMF published a report regarding first-year implementation of the new requirements and analyzing the reports that had been submitted.

On a global scale, interest in internal controls is growing too. IOSCO has undertaken a study on issuer internal control requirements, to be completed later in 2006. The International Standards on Auditing developed by the International Auditing and Assurance Standards Board (IAASB) have raised the issue of auditor discussions of control weaknesses with management and those charged with governance in a standard currently under development. In addition, the IAASB, in October 2005, approved a project proposal to develop additional guidance for auditors on material weaknesses in internal control in relation to financial reporting.

Comparing the US and the EU, I am aware that there are both philosophical differences and varying practices in regard to what is done today on the subject of responsibilities for internal controls in a public company and whether or how management should report to shareholders on those responsibilities. Clearly the debate on internal controls is not unique to the US as evidenced by differences in views and practices within the various member states in the EU. But in all of this, in the US and elsewhere, I am greatly encouraged by the level of attention that is being paid to corporate governance and internal control matters. More people than ever are focusing on the importance of internal controls and on how best to put in place responsibilities and accountabilities for management and directors on internal controls.

The discussions and debates and the actions that are occurring will benefit investors and will ultimately be a force for enhancing confidence in public company financial reporting. I believe that, over time, capital market forces will encourage the institution of greater accountabilities for management and directors, and requirements for issuer internal control reporting and disclosure are part of creating greater accountability. I also believe that a requirement for auditors to make separate evaluations of internal controls enhances accountability.

Executive compensation and SOx 404 are just two examples of the importance we place on disclosure and accountability within the US regulatory approach. We at the SEC must carefully analyze which regulatory alternative, if any, provides the best structure to reach the goals of investor protection and confidence with the least interference in the marketplace. Our experience has led us to believe that these two hallmarks - disclosure and accountability - help to ensure that we maintain that balance.

Thank you for your kind attention.


Modified: 2/15/2006