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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks Before the Directors Education Institute


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Duke University
Durham, North Carolina
March 16, 2005

Let me begin by extending my congratulations to Duke University for the recent performance of its basketball teams – the men and the women – and by thanking Duke’s Global Capital Markets Center and the New York Stock Exchange for cosponsoring this important forum. You have assembled a distinguished group of speakers, and have organized the program to allow for targeted discussions of some of the most pressing issues facing directors at publicly-traded corporations.

I am glad to have the opportunity to join all of you here tonight, since you are well-positioned to continue implementing the corporate governance reforms necessary to strengthen investor confidence – and reduce the incidence of corporate failure we’ve seen in recent years. I want to acknowledge the progress that’s been achieved over the past few years, as sweeping reforms have transformed the corporate landscape.

One especially healthy consequence of these reforms is a trend well-known to all of you, and that is a collective reassessment of the role of corporate boards, with a shift away from the Imperial CEO model of the 1990s and toward greater responsibility and authority for directors. I will have more to say about this later in my remarks, but before I go any further let me issue the standard disclaimer that the views I express here are my own and do not necessarily represent those of the Commission or its staff.

Sarbanes-Oxley Implementation

Two years ago, when I came to the Commission, the country was still reeling from its disappointment with cooked books, indefensible lapses in audit and corporate governance responsibilities, and intentional manipulation of accounting rules. The resulting Sarbanes-Oxley Act laid the foundation necessary to improve financial reporting and the behavior of companies and gatekeepers. We have now completed the rulemaking to implement these critically important reforms. Key requirements have taken hold, including:

  • CEO and CFO certifications of the material completeness and accuracy of SEC periodic filings;

  • Creation of listing standards for audit committees;

  • Electronic reporting within two business days of insider transactions;

  • Increased disclosure of material current events affecting companies;

  • Establishment and launch of the PCAOB;

  • For the first time, public reporting by management and auditors on internal controls and their effectiveness.

As you know, we have also approved more rigorous standards for companies listed on the New York Stock Exchange and the Nasdaq. The rules establish a more detailed definition of independence for directors and require the majority of members on listed companies’ boards to satisfy that standard. The rule changes also include provisions that require and facilitate independent director oversight of processes relating to corporate governance, auditing, director nominations, and compensation.

I would like to focus for a moment on the Section 404 requirement for management and a company’s auditor to report on the effectiveness of internal controls over financial reporting. This section of Sarbanes-Oxley may have the greatest long-term potential to improve financial reporting. It may also be the most urgent financial reporting challenge facing a large share of corporate America and the audit profession in 2005. I expect that in the coming months a number of companies will announce that they or their auditors have been unable to complete their assessments or audits of controls, and additional companies will announce that they have material weaknesses in their controls. In those cases, we are looking for clear disclosure by companies of the nature of the material weaknesses, their impact on financial reporting, and how companies plan to address them. Outside directors, particularly members of audit committees, have important oversight roles regarding the assessments and audits of internal controls, the resulting disclosures, and management’s decisions regarding remediation.

But the disclosure of internal-control weaknesses should not, by itself, provoke immediate or severe market reactions. Section 404 is a disclosure provision, and investors will benefit from receiving full disclosure regarding any material weaknesses that are found. Section 404 will work as intended if it brings this information into public view, in which case the disclosure of material weaknesses in internal controls should be the beginning and not the end of the analysis for investors and markets. The goal should be continual improvement in controls over financial reporting and increased investor information and confidence. This should lead to better input for management decisions and higher-quality information being provided to investors.

While these benefits are clear, it is also important that the Commission continue to evaluate the implementation of our rules and the auditing standard issued by the PCAOB to ensure that these benefits are achieved in the most sensible way. We have been very sensitive to the implementation of all aspects of the Sarbanes-Oxley Act, and especially to this very significant aspect. This has included several measured extensions over this past year to accommodate the first wave of reporting.

In order to assess SEC and PCAOB rules for Section 404, the Commission will hold roundtable discussions next month and is currently soliciting written feedback from the public regarding registrants’ and accounting firms’ implementation of these new reporting requirements. Through the roundtable and this feedback, we will be closely listening to and assessing the experiences with the management and auditor internal control requirements, including seeking to identify best practices for the preparation of these reports and evaluating whether there are ways to make the process more efficient and effective, while fully preserving the benefits of the requirements. Throughout this process the Commission and its staff will closely coordinate with the PCAOB and its staff, and we will seriously consider additional guidance, interpretive statements or modifications to our rules or the PCAOB standard as necessary and appropriate.

We are actively engaged in other activities to evaluate and assess the effects of the recent reforms, including the internal control reporting rules. For example, we have established an Advisory Committee on Smaller Public Companies. This committee will conduct its work with a view to protecting investors, considering whether the costs imposed by the current regulatory system for smaller public companies are proportionate to the benefits, and identifying methods of minimizing costs and maximizing benefits.

Rules vs. Responsibilities

I want to turn to the Commission’s rulemaking on governance issues, but first I’d like to say a few words about how we should all think about SEC rules versus your own responsibilities.

It is important to remember that the Commission’s rules cannot ensure that our markets and our corporations are clean and ethical. What’s really needed is the proper mindset – a company-wide culture that fosters ethical behavior and decision-making. Creating, preserving, and strengthening that culture means doing more than developing good policies and procedures, doing more than installing competent legal and accounting staff, and doing more than giving them resources and up-to-date technology. It means instilling and maintaining an ethic – a company-wide commitment to do the right thing, this time and every time – so much so that it becomes entwined in what I call the essential “DNA” of the company.

Companies, management, their gatekeepers, and above all, their directors, must look beyond simple compliance with the letter of the new laws and regulations in a check-the-box manner. They must redefine corporate governance with practices that go beyond mere adherence to new rules and demonstrate ethics, integrity, honesty, and transparency.

As you all know, spelling out the importance of these practices is infinitely easier than implementing them. Drawing up a corporate code of ethics is a useful exercise, but it is no guarantee of ethical behavior. Indeed, a number of CEOs who have been the most outspoken about their corporate codes of ethics, and standards of performance, have faced serious allegations of misconduct. Their statements are a reminder that a rhetorical commitment to codes of conduct and effective corporate governance is meaningless if not backed up with action.

Corporate governance has always been – and will continue to be – the primary responsibility of corporate boards, and this has been reaffirmed with the reforms of recent years. Directors must ensure that they remain the true stewards of corporate accountability, and their actions must demonstrate their dedication to this stewardship without undue interference from the CEO or other members of management.

One litmus test for this new board stewardship of corporate governance involves executive compensation. In making compensation decisions, boards and compensation committees must focus above all on long-term performance. And directors should examine their dependence on management and compensation consultants when making decisions about compensation for the chief executive and other senior management. The conventional wisdom of many corporate boards these days has become that in order to remain competitive, executive compensation must be in the top quarter of companies in their industry. But as I have said before, we don't live in Lake Woebegon, where as Garrison Keillor says, "All the women are strong, all the men are good looking and all the children are above average." Rather, it is the job of the board to set appropriate compensation that is related to the goals and performance of top management, not the pressure to meet an artificial standard informed by outside consultants who do not owe a duty to your shareholders and who do not, therefore, share the responsibility of being board members.

Some have said government should rein in the high pay of CEOs. I disagree emphatically, but I do believe that company boards must show greater discipline and judgment in carrying out their fiduciary duties to shareholders to award pay packages that are linked to long-term performance. I would like to see a much broader definition of performance – necessitating an evaluation that goes well beyond EPS and other financial measures, to identify what management excellence, and hence reward, is all about.

I would also like to see greater disclosure of pay packages – with not only the total amount of compensation provided, but for each element of this compensation to be clearly explained, including benefits that may not be easily assessed but which carry a clear value and which the CEO clearly cares about. The Commission is continuing to evaluate such disclosure under our existing rules, while the Division of Corporation Finance is looking at ways to modernize these rules.

Responsibilities of Directors

Turning to the responsibilities of directors, we are, as I said at the outset of my remarks, seeing a healthy shift away from the Imperial CEO and toward more responsibility for directors. This is partly a function of new laws and regulations, such as Sarbanes Oxley, which a recent McKinsey study said is holding boards “more responsible for meeting high standards in reporting and controlling the financial affairs of their companies.” But I also believe that more and more directors are taking it upon themselves to show renewed vigilance in monitoring the activities of the companies they’re serving. This is, of course, partly borne of fears over liability, though there is also a recognition that some of the excesses of the late 1990s were a function of poor corporate governance, and that the mistakes of that period can be avoided through stronger board oversight.

While the McKinsey study shows progress, it also shows there is still room for improvement. Of the 1,000 public-company directors surveyed, 27 percent said they had a limited understanding of their company’s current strategy, and only 11 percent said they had a complete understanding.

Viewed in light of the developments of recent years, this data should provide extra incentive for directors to roll up their sleeves and inject new candor into boardroom discussions. Boards should begin with serious discussions about their vision for the companies they are serving. They should seek to set a tone that the company executives and other employees can embrace. A precursor to this effort must be an intense and continuing examination of the dynamics of the Board meetings – a “getting down to basics” focused on the openness that is needed if the tough questions are to be asked and the answers are to be clear and forthright.

Directors also must be prepared to devote sufficient time to their duties, as we have seen too many cases where inattentive boards have enabled management to plunder the corporation. A more engaged board of directors can help to identify pressure points, prevent small problems from spreading, and send a powerful message to a company’s stakeholders that the Board is focused on its responsibilities. To this end, board members need to make an honest assessment of the number of boards and committees they and future candidates can serve on in order to meet the legitimate and heightened expectations of shareholders.

Directors must also find out what’s really happening at the companies they are serving. And if management doesn’t answer the questions adequately, directors need to look elsewhere for answers.

To this end, an important element of strengthened corporate governance is not only a stronger, more active board of directors, but also a board that is independent of management, in both appearance and in reality. The combination of Sarbanes-Oxley, the Commission’s rulemaking efforts, and SRO standards has helped assure the independence of directors and encouraged them to be more assertive about exercising their oversight authority in corporate decision-making.

But by the same token, directors need to be able to look themselves in the mirror and say they’re independent. I recognize this might be easier said than done, and a March 3rd article in the Wall Street Journal highlighted the difficulty in determining just what qualifies directors to call themselves independent. While some room for judgment is both necessary and desirable, I hope that directors will make their determinations about independence based not simply on the letter of the rules, but also the spirit. Don’t just engage in that check-the-box approach as to whether you, or your colleagues, are truly independent. Understand the reasoning and intent behind the rules, and if you have gnawing doubts about your real independence from the CEO, whatever the rules say, then you probably are not really independent.

The Commission recognizes that there are many new expectations facing directors, and we appreciate the new challenges. We also understand the complexity of business decisions – and a decision that might look foolish today may have seemed perfectly sensible two years ago.

This is important for everyone – but particularly regulators – to keep in mind. While we want a corporate culture in which directors exercise their oversight responsibilities, we don’t want to create a culture in which fear of litigation and retribution snuffs out the risk-taking that is at the heart of business.

Before closing, I want to emphasize two points that sometimes get overlooked in the discussions of reforming corporate governance. First, the corporate board’s role – to provide strategic guidance and effective oversight – must not be compromised or misinterpreted. Allowing boards to devolve into operating committees, and to dilute their effectiveness and that of operating management, will not benefit shareholders, employees, or other stakeholders.

Second, there are no one-size-fits-all solutions to the corporate governance challenge. The key is for companies and their boards to understand the need for greater transparency and greater accountability.


So while there is still much that can be done to strengthen corporate governance, and there is still much each of you can do, I want to reiterate what I said at the opening: we have seen real progress over the past few years, and our challenge now is to continue building on that progress. An important step in charting that progress is bringing together directors to discuss the issues of the day, and so I reiterate my thanks to the Duke Global Capital Markets Center and the New York Stock Exchange for co-sponsoring this forum and building momentum for the reforms that can help to ensure America’s markets will continue to be a model for markets throughout the world.

Thank you.



Modified: 03/17/2005