Speech by SEC Commissioner:
Remarks before the Tenth Annual Corporate Counsel Institute
Priorities and Concerns at the SEC
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
March 9, 2006
Thank you, Larry. Although our Chairman, Chris Cox, was originally scheduled to deliver the keynote address today, as many of you know, he recently had surgery and was "out of commission" for a few weeks. I am happy to report that the Chairman is now back "in Commission," both literally and figuratively, and is transitioning back to a full-time schedule. So for those of you who may have missed the program change - I am not Chris Cox. The Chairman asked me to stand in for him today to address priorities and concerns at the SEC. But before I do that, I have to give our standard disclaimer: The views I express today are my own and do not necessarily reflect the views of the Commission or its staff.
Obviously, with numerous offices and divisions within the agency, our priorities are clustered around different issues. They relate to public companies, investment funds and self-regulatory organizations. Given the audience today, I want to focus on those issues that are most relevant for counsel to SEC reporting companies. In particular, I want to emphasize the importance of complying not just with the letter - but also with the spirit - of our rules and highlight the role that you as corporate counsel can play in this process. But I don't want this to be a "do as I say, not as I do" speech. We at the SEC have a responsibility to make our rules and expectations clear and appropriate. I will start with YOU first.
As corporate counsel, you play a critical role in helping public companies provide full and fair disclosure. Ideally, you help your corporate clients focus on disclosing information to the market that is important for shareholders or potential shareholders to know. I have said in the past that management needs to tell a story - a strictly non-fiction story, of course! Ideally, the story should be compelling and understandable. Management should strive to convey to shareholders all of the essential information that is important to them. To help tell the story, counsel should do more than just resolve technical disclosure issues, such as determining how many years of financial statements are required in a filing. Where the disclosure issues are more subjective and the rules are more principles-based, counsel should help management comply with the spirit as well as the letter of the law. This can help make the story more specific and complete, and ultimately more informative.
Under our current rules, management can tell its story most effectively in the Management's Discussion and Analysis section, the MD&A. Of all of our disclosure rules, MD&A may be the most principles-based. When I became a Commissioner four years ago, I observed that in many instances, MD&A had become confusing and uninformative. Management's story was obscured and had devolved in many instances into lengthy boilerplate. Many management teams were merely reciting the numbers from the financial statements and disclosing percentage changes in financial statement line items from period to period. When I was at the Federal Reserve, we called this "elevator analysis" - i.e., x went up and y went down - descriptive, but not very informative. As such, while Generally Accepted Accounting Principles (GAAP) were and still are important, management was not using MD&A to bridge the gaps between GAAP and the economic reality of the company's operations. Therefore, in 2003, we issued an interpretative release that provided principles-based guidance to help get MD&A back on point.
So, three years and thousands of filings later, what is the state of MD&A disclosure? Are management teams doing a better job telling their stories? Well, the hardworking staff members in the Commission's Division of Corporation Finance reviewed over 6,000 public companies' filings last year. They tell me that generally, MD&A has improved. In many instances, companies are better explaining their financial statements, providing and clarifying context, and using MD&A to fill in some of those gaps in GAAP.
In particular, the staff has observed that many companies are making their executive summaries and results of operations more informative. The better executive summaries furnish investors with information and guidance that provide context and make the details that follow easier to understand. Regarding the results of operations, I am encouraged that, consistent with our guidance, many companies are explaining why the results of operations are what they are - rather than merely repeating what GAAP says they are.
Despite this progress, there is still room for improvement, and you can help. Some companies are still merely doing an "elevator analysis" without ample explanation. Also, some companies' MD&A is still unnecessarily lengthy and not focused on telling the story clearly.
Management's story would be more complete if it contained more forward looking information, better explained trends and uncertainties that affect the business, and discussed in more detail the business' key drivers. While forward looking statements are generally not required, they help investors understand where the company is going, and they complement the historical financial statements, which tell where the business has been.
Overall, though, I am encouraged by the progress I have seen since we issued our interpretive release in 2003, and commend you and your clients.
Another area where your role is critical is the disclosure of executive compensation. For some time now, executive compensation has been in the headlines. Chief executive compensation as a multiple of the pay of the average worker has surged in the last 20 or so years. This is particularly concerning when a company's performance is poor. Having said that, let me reiterate what I have said often: the Commission should not be setting executive compensation levels. Our role is to make sure that our disclosure rules regarding executive compensation elicit clear and comprehensive information in a form that is useful to investors and the market.
Under our current disclosure rules, it is often difficult for investors to figure out exactly how much 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. Even after they go through this sometimes laborious process, they still may not know how much executives and directors are getting paid, because under the current disclosure rules, a complete compensation picture is not always discernable. In contrast, under our proposed rules, investors would be able to look to one place in the disclosure to learn the total annual compensation of each of their directors, five highest paid executive 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 executives. These latter employees would not be identified. The other tabular and footnote disclosure would provide more detailed information about the different elements comprising total compensation.
I want to draw your attention particularly to the proposed new plain English Compensation Discussion and Analysis, or CD&A. The CD&A would require management to provide more descriptive, principles-based disclosure. In the CD&A, a company would identify the principles underlying its executive compensation policies and decisions. As I understand the proposal, boilerplate language would be non-compliant and contrary to the spirit of the rule. Rather, the disclosure would have to be specific and comprehensive. Companies would be expected to provide perspective for, and explain the how and why behind, the numbers in the tables and footnotes. This disclosure would be more detailed than that currently required in the Compensation Committee Report, which the new rules would eliminate. Companies would be required to explain why they are paying various types and amounts of compensation to the executive officers and directors. This would be an opportunity for you to help your corporate clients explain why members of top management make what they make.
Likewise, the related party disclosure rules would be more principles-based. These rules would still mandate disclosure of transactions and relationships between the company and its management and directors. However, the instructions for delineating between reportable and excludable transactions would be modified in favor of a more principles-based approach focused on materiality. Companies following the letter and spirit of these proposed rules would provide more useful and specific material information to investors. This would be another opportunity for you to help management tell a more complete story.
Of the several provisions of the exec comp rule on which I am betting we will receive many comments, one regards perks. 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. I know we will get questions as to where to draw the line between perks and items related to the performance of the executive's duties or types of amenities that are not perks. In terms of classifying which perks are executive comp, my own principle is that if it looks like a perk and quacks like a perk, it's a perk, and you shouldn't duck disclosing it.
So, I hope you get the gist of my remarks. I see your role as encouraging your clients to tell a complete story. You should encourage them to meet the spirit - not just the letter - of our requirements. And I also encourage your comments on our rules - proposed or existing - to help us get them right, which brings me to OUR role.
As I said, it is incumbent upon the Commission to make its rules and expectations clear and appropriate. Where warranted, we need to update our rules to comport with the realities of today's capital markets. Most of the securities statutes have been on the books for decades. Many of the rules that have been promulgated thereunder are old. In the interim, much has changed. We should be mindful of trends and advances that have developed in the financial markets, the way people communicate and other dynamics that technological innovation has spawned. This is exactly what we did last year with our Securities Act Reform rules which I know Marty Dunn will talk about in some detail later today. Those rules modernized our public offering rules to account for the numerous financial and technological changes that have occurred over the last half century.
We should also try, where possible, to eliminate complexity. To the extent we can streamline and simplify our rules, we communicate more understandable expectations. This in turn induces more informative disclosure. Where appropriate, our rules should not be overly focused on bright-line, prescriptive standards. That approach can induce a "check-the-box" and "fill-in-blank" mentality, and often obscures the message.
As an example of an existing requirement that I believe needs improvement, I will start with Section 404 of the Sarbanes-Oxley Act of 2002. In case there is a Rip Van Winkle in this audience, who missed the discussions of the past few years, Section 404 requires company management to assess and publicly report on the effectiveness of the company's internal controls. The PCAOB's Audit Standard No. 2 (AS2) 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. Section 404 and AS2 are, of course, measures whose purpose is to ensure that financial statements are accurate. Laudable as these intentions are, there has been widespread criticism of the unnecessary burdens and costs of implementation.
In April of last year, a roundtable that the Commission sponsored of public company officers, directors, investors and auditors made abundantly clear that the implementation of Section 404 had often inappropriately shifted the focus from a top-down, risk-based management perspective to a bottom-up, "check the box" auditor perspective. After the roundtable, the Commission and the PCAOB issued new guidance reminding management and auditors to use reasoned judgment and a risk-based approach in the process. Nevertheless, I continue to hear more about potential misfocus of the Section 404 process and the associated costs. To better understand and evaluate these concerns, the Commission and the PCAOB have scheduled another roundtable in May. As I have stated repeatedly, I remain receptive to recommendations to improve the 404 process, including possible changes to AS2.
One final thought on 404: there has been much discussion about exempting smaller public companies from complying with 404. I have always believed in the concept behind 404 - that management should establish and maintain effective internal controls over financial reporting. This is necessary to manage risk, and it is just plain good business. I believe that at a minimum, small public companies should be held to that standard. What is harder to determine in the case of both small and large public companies is the appropriate role for auditors in that process. My current thinking is that it would be better to ensure that 404 is applied appropriately for all companies, and tailored if necessary, based on company size and complexity, than to exempt certain companies from 404 completely.
Another area that needs to be modernized is the technology that supports our filings. An exciting new initiative is the submission of SEC filings using Extensible Business Reporting Language, more commonly known as XBRL. XBRL is an interactive data format that makes financial information easier to locate and analyze. XBRL enables filers to "tag" electronically various items in their reports. I analogize the tagged data to Lego building blocks - investors can use the data to construct for themselves financial, operating ratio or other meaningful information about companies just as Lego blocks can be used to build a variety of different structures, be they buildings or bridges. Users can retrieve the tagged data through computer searches and analyze it quickly and easily with other computer software tools to construct a variety of analyses, such as trends over time at one company and comparisons across companies. Doing this electronically saves time and money and ensures better accuracy - ultimately resulting in more robust and efficient analyses. I am hopeful that this powerful technology could make the information that registrants file with us more useful to investors and other market constituents.
The Commission is currently engaged in XBRL experimental programs. Last year, we launched a voluntary XBRL pilot program. That presents registrants the opportunity to explore the costs and benefits of this new approach. In January, the SEC solicited interest in a new test group under the voluntary program. Participants in the test group will undertake to furnish data in their periodic and investment company reports in XBRL format for at least one year and provide feedback on the costs and benefits of using the interactive data format. In return for participating, the staff will screen and review these participants' filings on an expedited basis.
Our rules concerning registration and deregistration, and the mechanisms for proxy voting are other areas that may need to be reexamined because of changes in the way people hold their securities. Forty years ago, when the current rules regarding registration and deregistration were promulgated, less than 25% of public company shares were held in street name. Now, 85% of public company shares are held in street name. For shares held in street name, the record holder is the broker, not the beneficial shareholder. Why is this important? It is important because the number of record holders is the main criterion that determines whether or not a company is public. Thus, a company with many total shareholders but few holders of record may not have to report, whereas another company with fewer total shareholders but more record holders may have to report. This anomaly suggests to me that we need to consider whether the requirement to report should be premised on different criteria.
This change in the form of ownership also affects our proxy voting mechanisms to facilitate shareholder voting. Numerous intermediaries have to interact with issuers and the beneficial owners of their securities who hold in street name. Recognizing the opportunities the Internet provides, we proposed changes to our proxy rules last year that would enable companies to make greater use of the Internet to deliver proxy materials to investors. In formulating any new rules in this area, we should be mindful that this change in ownership form has introduced many intermediaries into the proxy delivery and voting process. We have to be careful, therefore, to understand fully the consequences of any changes we consider.
Finally, we need to be clear about our expectations of you and your clients. Our recently released guidelines on when corporate penalties are appropriate in enforcement cases is an example of our trying to make a sometimes opaque process more transparent. As we said in the release, "The Commission believes it important to provide the maximum possible degree of clarity, consistency, and predictability in explaining the way that its corporate penalty authority will be exercised."
To sum up, we both play important roles as to compliance and disclosure. You and your management teams have more material information about the companies you work for than regulators could ever hope to elicit with bright-line tests and highly technical standards. If you and management strive to ensure that companies comply with both the letter and spirit of our rules, regulations and disclosure requirements, the result will be more informed investors and happier regulators. Likewise, we regulators should formulate rules that make sense and accomplish our objectives in an efficient and effective way. So, I have one last request - and that is, for you to feel free to let me know which rules you would put at the top of your list for a fresh look. I'm sure there are more than a few that could use an update. Thank you.