Speech by SEC Commissioner
Remarks before the Economic Club of Memphis
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
February 16, 2005
Thank you for those kind words, David.
It is a privilege to be here today back in the great state of Tennessee. Let me start by saying that 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 need to clarify that, although I am thrilled to be involved in an event honoring leadership in corporate governance, I was not involved in selecting tonight’s winner. I salute the Economic Club and Armstrong Allen for establishing this award.
Tonight, I would like to share with you my thoughts from my seat on the SEC regarding the Sarbanes-Oxley Act and corporate governance generally. In fact, you can call me a child of Sarbanes-Oxley, because I was appointed to the SEC only a week or so after the President signed it. During the past few years, politicians and pundits have pointed to revelations of corporate wrongdoings serious enough to shake the foundations of seemingly unshakable corporations as raising the level of anxiety of investors all over the country and, indeed, all over the world. But, just as the problems reverberate across the marketplace, so too the solutions or attempted solutions, whether regulatory or self-imposed, have global outworkings.
It is no surprise to anyone here that Sarbanes-Oxley has caused the SEC to craft and implement an unprecedented amount of rules in a short amount of time. As you all know, the SEC has been busy. Despite the fact that the Sarbanes-Oxley implementation is just about finished, the regulatory pace hasn’t ceased. Recent scandals in the mutual fund area have led to an SEC reaction and a series of initiatives, some of which I support, some of which I do not. Although there is still much on our regulatory plate, we at the SEC should take a moment to reflect on what we have done and on what we are proposing or contemplating so that we take care not to jeopardize the position of the U.S. as the best and most dynamic market in the world.
I cannot deny the frenetic pace or the significance of the SEC’s regulatory initiatives since the passage of Sarbanes-Oxley. This is largely a problem born out of the misdeeds of some. Simply put, some businesses lost their ethical compass, and the shadow of those few has fallen across the rest.
Corporations, however, must themselves do some soul-searching. Private firms lay the groundwork for regulatory solutions when they fail to uphold their own end of simple business ethics through voluntarily-implemented, effective compliance programs. A corporation that focuses on ensuring the long-term success of its business is more likely to implement strict internal controls than one that is primarily concerned with achieving short-term targets.
The culture of a firm is determined by the tone set by its executives, the firm’s organizational structure, compensation incentives, and the degree of oversight activity by gatekeepers such as directors, auditors, and attorneys. A CEO’s tolerance or lack of tolerance of ethical misdeeds and a CEO’s philosophy of business conveys a great deal throughout the organization. An informed, inquisitive, and well-rounded board of directors serves an important role in monitoring the corporation and management on behalf of stockholders for whose benefit the corporation ultimately exists.
Of course, as regulators, we need to conduct the same type of soul-searching that we expect of market participants.
Regulatory reaction is typical in periods of financial turmoil and usually leads politicians and regulators to conclude that, by ratcheting up the level of regulation, future problems can be averted. In fact, the SEC was born out of just such a rush to regulation following the 1929 market crash, which came after an economic boom period, complete with a stock market bubble. In the 1930s, the government attempted to pull the country out of the depression by continued intervention, which included everything from price controls to an anti-free market domestic regulatory policy. These policies, most economists today would agree, were failures. We are still living with many of those market distortions two generations later.
History teaches us time and again that rarely do regulators seriously question, much less analyze, whether the prior regulatory framework was at least partly to blame for any or all of the problems. The regulatory response to the corporate scandals of the last several years has not been any different in this regard. We regulators do not ask whether we have done anything wrong, but instead what more we need to do. Market forces are painted as villains against whom only regulators stand a chance.
I am hopeful that we will take this opportunity and take a hard look at what we have done. We must determine whether the measures that we have implemented serve their intended purpose of protecting investors and at what cost. We must be particularly vigilant because the SEC, in implementing Sarbanes-Oxley and in other recent regulatory actions, has in some ways stepped outside its traditional sphere of regulatory activity, and, as a result, has come into conflict with other established regulatory frameworks.
There are many positive attributes to the Sarbanes Oxley Act. It attempts to set forth best practices to prevent the misdeeds that led to investor losses. For the most part, it does not dictate corporate behavior, but it requires corporations to disclose information and then let the market decide what importance to put on that disclosure.
The Act acknowledges the importance of stockholder value as opposed to stakeholder value. The Board is clearly there to represent the stockholders’ interest. Most importantly, the Act strengthens the role of directors as representatives of stockholders and reinforces the role of management as stewards of the stockholders’ interest.
It is my hope that Sarbanes-Oxley will help directors perform their function as fiduciaries of the shareholder’s interest. From what I am hearing, one positive effect of the law has been to make board members be more inquisitive. Therefore, questions that might have seemed to be “hostile” to management before Sarbanes-Oxley will now be seen to be in furtherance of a director’s function.
Since some of the recent problems involved corporate managers using the corporation as a personal “piggy bank” or other theft by management of corporate assets, the Act’s emphasis on a board’s oversight function is certainly a step in the right direction.
But, I do have concerns about the Act and what we have done to implement it. Underlying all my other concerns is a basic philosophical one, namely that we must not allow the American economy to be unduly encumbered by a web of regulations that stifles investment, innovation, and entrepreneurship. Recently, the Wall Street Journal and the Heritage Foundation released their annual “Index of Economic Freedom.” For the first time in the decade-long history of the index, the U.S. is no longer among the top ten “most free” countries. Although it is wonderful to see other countries becoming more free, I do not like to see the U.S. losing its reputation for being a great place to do business. President Bush said it very well recently when he reminded us that “it’s very important not to get [the system] out of balance when it comes to [ ] government reach.”
When we talk about balance, one aspect of the new law that concerns me is the implementation of the new internal controls provision, called Section 404 of Sarbanes-Oxley. It has easily proven to be the most expensive and most burdensome piece of Sarbanes-Oxley. Importantly, if it achieves its objectives, it could be one of the most valuable parts of the Act.
I have a relatively unique view of this issue. From my days at an accounting firm, I am probably the only one of the SEC commissioners who has ever actually done a control review for a company. I have seen how, especially in troubled situations, a control review can take on a life of its own and balloon into a massive project, with volumes of documents and flow-charts that seem obsolete as soon as they are printed and distributed, simply because a corporation is a dynamic, ever-changing entity. This paperwork sometimes provides little practical benefit, except perhaps to the accounting firm’s bottom line. I hope that Section 404 doesn’t lead us in this direction.
Although public companies have been required to maintain internal controls since the seventies, we are entering new territory with these new rules. For example, how many companies do you think disclosed material weaknesses or significant deficiencies in internal controls last year? Almost 600 -- 582 to be exact.1 Should these disclosures trigger a significant market impact? Are these problems already priced into the stock? What are investors supposed to make of these disclosures? What criteria are used to constitute a material weakness and are those criteria applied consistently across all companies? Should investors even care, particularly if the auditors have given a clean report on the financial statements? Only time will tell.
For these reasons, I am pleased that the SEC will be having a roundtable on internal control reporting requirements this April. It is important that we have a dialogue between regulators and market participants about this important and expensive rule.
As you all know, the Sarbanes-Oxley Act created a new Public Company Accounting Oversight Board to oversee the accounting profession and public company audits. It was created because of deep failings in the U.S. accounting profession's ability to regulate itself. The accounting profession fell down on the job and got what it deserved in the Act. But, simply because the accounting profession “earned” this new oversight, it does not mean that the public should not closely monitor the PCAOB’s actions.
The PCAOB is a unique creature in Washington – it is a non-governmental, nonprofit corporation that derives its subsistence from bills sent not only to accounting firms, but also to approximately 8,500 public companies. Thus, it is not a self-regulatory organization. In essence, this non-government organization has taxing authority. Therefore, it must be accountable to the taxpayers in a transparent way. We have seen this organization begin in 2003 and it is already a hundred-million-plus-dollar entity. I promise to take the SEC’s oversight responsibility of the PCAOB seriously and hope that you will continue to monitor its progress.
Regulation of Corporate Governance
As we move into the post-Sarbanes-Oxley era, we must continue to ensure that issuers are not constrained to adhere to a single, predetermined corporate governance model. The SEC’s recent decision, taken on a 3-2 vote, to require that all mutual funds have independent chairmen and boards made up of at least 75% independent directors, sends an unfortunate signal that a one-size-fits-all mandate is appropriate in the corporate governance context. Let me be clear that I believe that a non-executive chairman of the board can be appropriate under certain circumstances. Those circumstances, however, must be determined by that corporation’s shareholders and their representatives, who are much closer to the facts of a particular company than regulators in Washington, D.C.
Historically, the States have had responsibility for corporate governance matters, and the stock exchanges have included certain corporate governance standards among their listing requirements. Although Sarbanes-Oxley has federalized corporate governance issues to some extent, we must continue to acknowledge that a variety of approaches to corporate governance is acceptable and indeed desirable. Flexibility encourages innovation.
Regulation of Corporate Gatekeepers
Now that Sarbanes-Oxley has strengthened the hand of federal regulators in overseeing corporate gatekeepers such as directors, attorneys, accountants, and audit personnel, I worry about the form that oversight will take. The SEC understandably is interested in ensuring that these gatekeepers play an active role in shaping business decisions. My concern is that, frustrated by a few instances of incompetence or venality, we might devise our own overly-technical prescriptions for them. For example, the SEC narrowly averted an unfortunate result with what began as an arguably overly restrictive definition of “financial expert” of an audit committee. These sorts of technical prescriptions and other concerns could prevent or dissuade talented professionals from serving in a gatekeeper capacity for public corporations. In this regard, especially for directors, is the concern of a growing paperwork burden in the boardroom and fear of personal liability.
Clear Standards Should be the Goal
So, those are a few of my concerns. What should be a regulator’s goal in this environment? Of paramount importance is to craft clear standards for market participants to follow. Not everything is black and white, but we need not keep the public under the cloud of perpetual gray. Effective regulation and oversight is achieved by establishing clear standards and rules, by examining for compliance with them, and then by bringing enforcement actions for violations of these rules.
It is counterproductive in the long term to use enforcement actions to supplement rules. With the benefit of hindsight, it might become abundantly clear that the rules were not clearly articulated in the first place. Basic questions of fairness arise for those subject to arguably new standards of conduct imposed after the fact through an enforcement proceeding. Unfortunately, we have to acknowledge that organizational inertia and the pain of tackling complex, controversial issues tend to keep regulators from being more proactive up front – before problems have manifested themselves.
Even worse from a long-term, good-governance perspective, the regulator’s failure to provide clear standards compromises private-sector compliance efforts, because compliance officers cannot speak to their business colleagues with authority as to what is improper conduct.
Crafting the right balance of private and public input to achieve good corporate governance is a fascinating subject. As we celebrate demonstrated leadership in corporate governance tonight, let us continue the debate as to how we can do better.
Please do not hesitate to contact me to discuss these issues. My door is always open, and I encourage you to tackle these issues head-on, before something else down the road tackles you. As I remind my Cub Scout sons, the motto to live by is “Be prepared.” Thank you.
1 Compliance Week, February 2005, at 16.