Speech by SEC Commissioner:
Remarks before the Atlanta Chapter of the National Association of Corporate Directors
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
February 23, 2005
Thank you for those kind words, Bob.
It is a privilege to be here today. 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 would first like to share with you my thoughts from my seat on the SEC regarding the Sarbanes-Oxley Act and corporate governance generally. Then, I would like to speak briefly about one trend in securities law enforcement – the imposition of ever-increasing penalties against corporate entities.
In a way, you can call me a child of Sarbanes-Oxley, because the political compromise in Congress that led to the passage of that law broke the logjam that had held up the appointment of 4 of us commissioners. I was appointed to the SEC only a week or so after the President signed Sarbanes-Oxley.
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 hope 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, I am concerned about 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 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 on April 13th. It is important that we have a dialogue between regulators and market participants about this important and expensive rule.
As you all know, the Act directed established 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 primarily from bills sent to approximately 8,500 public companies. Accounting firms also provide a small portion of the PCAOB’s funding. 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 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 a fear of personal liability.
Clear Standards Should be the Goal
What should be a regulator’s goal in this environment? Of paramount importance is trying 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.
I would like to spend a few minutes on another issue of concern: fines against corporations. All too often people in government and outside overlook the fact that corporations are ultimately owned by shareholders. Shareholders are the ones who, at the end of the day, bear most of the costs imposed on the corporation. You might think that in the wake of Enron and World Com, with their large shareholder losses that were broadcast on television, this simple truth would have been driven home.
In the name of deterrence, we have seen heavier and heavier fines against corporations in the securities law context. Shareholders are harmed if prosecutors have one eye on the public relations effect of their actions. Shareholders are also harmed if management is all too willing to offer up the shareholders’ money – after all, it is other people’s money – in order to try to deflect personal responsibility of particular managers. Managers may be hoping that a large sacrifice and public flogging of the corporate entity might just assuage the government prosecutors. But, individuals commit fraud; corporations don’t.
Sometimes, of course, it is too hard – or just not appropriate – to pin blame on individuals, particularly where they did not have the full picture, had no intent to do something underhanded, got wrong legal or other advice, and so on. We also have to guard against criminalizing business decisions by looking at them through the regulator’s lens of 20/20 hindsight. So, in those cases, other steps against a corporate defendant may be in order, including remedial organizational or managerial steps. Fundamentally, we also have to remember that the corporation may already have been punished through reputational and stock-price damage.
Unless the corporation is a criminal enterprise, or the shareholders themselves have somehow benefited from the fraud to the detriment of other corporations or the marketplace as a whole, and the fine serves as a disgorgement of ill-gotten profits, fines against shareholders are often not appropriate. Corporations fined for disclosure-based transgressions use shareholder money to pay for behavior of which the shareholders were the victims. We have to ask ourselves: Who are the victims? Who really is paying the fines? By imposing such fines, are we not punishing the very people who might have already punished through the marketplace when the stock price was clobbered?
I am not saying anything new here – just making the point that the SEC could lose its way in the glare of publicity that it has achieved in the last few years. In fact, Congress gave the SEC its authority to fine public companies only in 1990. Before that time, the SEC could only get an injunction against the company to go forth and sin no more. The legislative history of this law clearly shows that Congress at the time had the same concerns.
In some of our recent cases, we have been fining corporations large sums for accounting and other financial reporting fraud. Some are egregious frauds that reflect wide-spread cultural and ethical problems. In some cases, the companies and their boards found and took corrective action, including firing senior executives, particularly the CEO – without any prompting from the government.
In this context, the SEC is working under new authority from Congress that we got under the Sarbanes-Oxley Act to direct fines to special funds that can be set up to provide a sort of restitution to shareholders harmed by the fraud. This only heightens the conundrum that we face. Basically, we fine the corporation in order to put the fine into a fund to reimburse the shareholders who were just themselves fined.
Of course, in the context of multinational mega-corporations with millions of shareholders, a fine of even hundreds of millions of dollars comes out to relatively minor amounts for each individual shareholder. Another aspect of these settlements is that our fine gets put into the same pot as the settlements from private securities law suits, although we are careful to have none of the SEC fines be paid to the private attorneys. So, I fear that if we are not careful, that we might view ourselves as an extension of the plaintiffs’ bar, with similar philosophies and tactics. I would love to get your feedback and suggestions on this issue.
You all have been a very patient and indulgent audience. Crafting the right balance of private and public input to achieve good corporate governance is a fascinating subject.
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.