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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the Darden Distinguished Speaker Series


Commissioner Cynthia A. Glassman

U.S. Securities and Exchange Commission

University of Virginia, Charlottesville
March 26, 2003

I. Introduction

Good afternoon. Thank you Dean Harris for inviting me, and thanks to all of you for welcoming me to your beautiful campus. It is an honor to participate in the Darden Distinguished Speaker series. A special thank you goes to Joel van Arsdale for helping to facilitate this event. When Mark and I recruited Joel to our group a few years back, little did he know that he was working with a future Fed Governor and SEC Commissioner. But come to think of it, Mark and I didn't know it either.

First, I must give the standard disclaimer: the views I express today are my own, and not necessarily those of the Commission or its staff.

This is a particularly appropriate time to be at this venue speaking to this audience about the important issues of corporate governance and ethics. As Dean Harris recently noted, "trust and integrity are essential to free markets." That is a very simple but important statement when you think about it, implying that without trust our markets would not exist as they do. But it is not an overstatement.

It is worth spending a little time talking about the crucial role trust plays in our markets, so I will begin with a brief historical perspective on that topic. I will also discuss why, in the context of that history, the people in this room - the future leaders of the business community and those responsible for preparing them to assume that mantle - are so important to ensuring the continued vitality of our markets. I cannot emphasize too much that how you and your peers view your role in ensuring ethical behavior - and how you act when you are in the business world - will determine to a large extent whether your generation of graduates will revisit the pain of scandal and crisis of confidence we are currently experiencing.

I also want to discuss our recent rulemaking, especially a critical aspect of corporate governance that has figured prominently in our rules - namely, the importance of internal controls and the flow of material information within a company and to the public. Finally, I will try to step back from the current flurry of activity and discuss what I believe our regulatory goals should be going forward.

II. A Brief History on the Importance of Trust

My brief and necessarily oversimplified history starts in our country's early days, when most business was conducted, quite literally, on a personal level. Most businesses were by necessity local in nature, and reputation was everything. People would not do business with you if they were not personally familiar with your reputation or willing to accept the word of someone they trusted to vouch for your character. As an example, those were the days of the neighborhood butcher, whom you knew by name and reputation, and whom you trusted not to sell you inferior meat.

As the corporate form increased in popularity, it gave rise to a less personal form of business. At the same time, a substantial increase in the size, nature and complexity of transactions increased the need for intermediaries - such as bankers and lawyers - to play a much larger part in bringing parties together and facilitating their dealings. Add in the ability to communicate quickly over long distances, and the world just got too big for individuals and businesses to do their own due diligence on everyone with whom they had dealings.

In this new world, the parties to even very substantial transactions could be unfamiliar to each other or even anonymous, with both sides relying instead on bankers and lawyers to vouch for the character and credit-worthiness of the counter-party. As one might suspect, the reputation of these intermediaries for fair dealing became as important as the parties being personally familiar with each other had been in simpler times. Carrying through with the butcher analogy, these are the days of the supermarket, where you do not necessarily know the butcher, but you have to trust the company that brought the meat to his counter, and the independent inspectors who verify its quality. One reason the recent scandals are so disheartening is that our markets rely to a significant extent on bankers, lawyers, analysts and truly independent auditors, and all of these gatekeepers failed to varying degrees.

Although the corporate form is among the most ingenious inventions for promoting private enterprise and the efficient allocation of capital, from the earliest days people have been skeptical of whether a corporation, which after all is a legal construct, could act with the uniquely human quality of virtue in the business world. The skepticism was articulated by Edward, First Baron Thurlow in the 18th century, when he asked, "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?"1 Viewed in this way, the very notion of "corporate ethics" is a paradox.

Nonetheless, we do expect even the modern corporation to have a conscience. Recognizing that the corporate conscience really is just a reflection of the company's directors, officers and employees, over time a series of rules and practices evolved to define how these people are expected to conduct corporate business, and to help prevent and detect misconduct. This complex system of rules - which we refer to as corporate governance - is designed to channel corporate decision making to take account of a company's obligations to the various constituencies it deals with in carrying out its business. Corporate governance is the manifestation of the corporate conscience.

Although we have come a long way from the days of the neighborhood butcher, trust is still an essential element of business. People will take risk in business only with the hope of gain, and the leap of faith involved in taking risk requires confidence that the playing field is level and fair. The required trust is built up with experience over the course of time, which explains why investors once bitten, understandably are twice shy. In dealing with the current issues in our markets, our collective goal, in my view, should be to help restore public confidence that the playing field is level and fair, without putting undue restrictions on private enterprise.

III. The Role of Corporate Governance in Protecting Public Trust

Given the important role corporate governance has assumed as a means for protecting the public trust, nobody should be surprised that recently so much attention has been paid to the subject. The spate of corporate scandals pointed up weaknesses in the way corporations approached governance - weaknesses the recent Sarbanes-Oxley legislation and Commission rules are largely aimed at correcting. We have also sought, through governance reforms, to adjust the perceived imbalance of power between management and shareholders, and enhance the position of the Board as an effective referee.

In Sarbanes-Oxley, Congress directed the Commission to adopt rules to increase the accountability of CEOs and CFOs, improve the quality of financial reporting, and raise professional, legal and ethical standards for the gatekeepers of our financial system - analysts, auditors, audit committees, boards and attorneys.

The Commission and its staff have worked hard to meet the deadlines for passing rules to implement Sarbanes-Oxley. Among other things, the Commission has adopted rules accelerating the filing of quarterly and annual reports for certain issuers, requiring CEOs to certify quarterly and annual reports, and speeding up the disclosure of personal securities trading by corporate insiders. We have also adopted rules requiring heightened standards of auditor independence, disclosure of off-balance sheet arrangements, and the inclusion of a reconciliation to GAAP for earnings releases and other financial information prepared on a pro forma basis. The new rules also require companies to disclose whether they have a code of ethics for executive officers, and whether they have designated an "audit committee financial expert" on their audit committees.

The rules we passed recognize that there are three components to achieving good corporate behavior:

1) a good corporate governance process;
2) punishment of bad behavior - by the company, by civil and criminal law enforcement, and by the market; and
3) an ethical corporate culture.

While no amount of regulation can stop a determined fraudster, our goal was to put additional incentives and penalties in place in some key areas where systemic problems became apparent. The primary reason we wound up with so much federal regulation in the area of governance - an area traditionally left to the States - is the scope and effect of the corporate scandals. Because we cannot legislate the third factor - an ethical corporate culture - our efforts are directed at the first two: rules to incent good procedures and behavior, and enforcement actions to disincent bad-behavior.

Critics point out that no amount of procedures can protect against a truly crooked CEO. True enough. Nonetheless, CEOs do not operate in a vacuum - in a large organization, significant misconduct requires at least implicit, and in most cases explicit, cooperation from others. Good governance procedures can help isolate wrongdoers and significantly hamper their ability to harm the company.

IV. The Importance of Information Flow

One of the most fundamental principles of effective governance is that relevant information must reach those responsible for corporate decision-making, and those responsible for overseeing the decision makers. One of the systemic failures exposed by recent corporate scandals was the absence of adequate procedures to ensure the proper flow of information. In a corporate setting, it is human nature for directors to want to hear good news, and for the CEO to want to deliver it. After all, people naturally do not want to believe that a company under their stewardship failed to live up to expectations.

One way in which the desire to present and receive a rosy picture manifested itself was in "numbers driven" management. We have seen far too many enforcement cases where unreasonable performance goals were set and subsequently met, but nobody stopped to ask, "How?" For example, assume hypothetically that a business unit managed to achieve 20 percent growth in an otherwise contracting industry. One would expect that senior management and the Board, in carrying out their oversight responsibilities, would want to examine how they achieved that result, both to ensure that nothing improper occurred, but also to help manage toward similar positive performance in the future. In some companies where success was measured exclusively by the achievement of numerical goals, however, a culture emerged where as long as the ends were met, nobody questioned the means. At the very least there was willful blindness (a legal term with a very clear meaning).

Among the most important aspects of their jobs, however, is that officers and directors hear - and beyond that seek out - bad news. For highly compensated CEOs to claim that they were too disengaged from their business to be held responsible for fraud that was happening on a grand scale was rightly seen as repugnant by most observers. The notion that companies must have adequate procedures to gather material information, and, further, to make sure that the information percolates up to someone who can take meaningful action to fix the situation, has informed a significant part of our regulatory response.

As an example, as I mentioned earlier, chief executive and financial officers must now certify that they have reviewed the company's internal controls, and that the financial statements are accurate. The new certification requirements address the perceived disconnect between the way some aloof corporate officers viewed their role, and the expectations of shareholders who reasonably believed those officers were vigilantly managing the business.

The new certification requirements have a few lessons to offer to senior executives (and to those of you who aspire to become senior executives). First, you have an obligation to understand your business; willful blindness is a dereliction of duty, and ignorance is not an excuse for not knowing what is going on in your company. Second, you need to use the power and prestige of your office to ensure that investor capital you hold in trust is secure; if you tolerate - or, worse, encourage - a corporate culture that allows for large-scale fraud, you will be accountable. Third, you need to make sure that disclosure controls and systems are in place to enable you to provide full and accurate reports to the Board and investors regarding the company's operations and financial condition. And fourth, public disclosure is one of the most important jobs you have as a corporate officer - don't take it lightly.

In addition to the certification requirements, Sarbanes-Oxley and Commission rules contain a number of specific measures to help ensure the proper flow of material information, and to focus additional attention on a company's internal controls and the quality of its public disclosure. The Commission will soon consider rules requiring the national securities exchanges and associations to require audit committees to have procedures for the receipt and treatment of complaints regarding accounting, internal controls, or auditing matters. Auditors currently are required to report to the audit committee on, among other things, critical accounting policies used by the company, and the effect of alternative accounting treatments that were discussed with management. As the Audit Committee receives this information, it will have the unfettered ability, pursuant to new rules, to hire outside advisers - independent of management or auditors who may have been involved in a transaction - to provide additional guidance and investigate possible wrongdoing. The new rules also will require procedures for anonymous submission to the audit committee of complaints regarding accounting issues, and the statute protects whistleblowers so that employees will be free to provide information about accounting irregularities to the committee without fear of reprisal.

Recognizing the important role of lawyers as protectors of public trust, the Commission's new rules require attorneys to report evidence of a material violation "up the ladder" within the corporation. The rule contemplates that lawyers will act ethically to address wrongdoing by reporting such wrongdoing to lawyers in high positions at the company - and nip fraud in the bud. Reporting up also relies on the ethics of the attorneys who receive the reports - those further up the ladder - to take action appropriate to address the wrongdoing and fulfill their professional obligations. This requirement again is intended to make sure that evidence of corporate wrongdoing gets to the appropriate people who can do something about it.

V. Assessment of Rulemaking

In looking at these important changes, and the Commission's response to the recent corporate scandals, I feel that we have taken a thoughtful and measured approach. Our difficult task has been, and continues to be, to ensure that there is an environment in which the markets can allocate resources efficiently. One way I have come to evaluate our proposals is through what I call the "Goldilocks" approach to regulation: If the media and critics of the Commission say we are too lenient, and the entities we regulate say we are too harsh, chances are we got it just right.

By any measure, we promulgated an ambitious regulatory agenda in the area of corporate governance, and it is becoming clear that some time is necessary for companies to absorb and implement the barrage of new regulations. This not to imply that the Commission will shy away - even in the slightest - from our obligations under Sarbanes-Oxley, or our general investor protection mission. However, we have to acknowledge that regulatory risk is part of running a business, and that the uncertainty caused by perpetual rulemaking can have a chilling effect on legitimate business decisions, including the decision to commit capital. From the Commission's perspective, we should take some time to monitor how the new rules operate in practice; to provide guidance and clarification where necessary; and to get a better measure of the costs and unintended consequences, and an understanding of whether we are accomplishing what we intended.

While I believe that what we have done so far was both necessary and appropriate, I am particularly concerned about the cost of this approach to small business capital formation. Passing a significant amount of additional prescriptive corporate governance regulations at the federal level ultimately will impose costs beyond its benefits, and is not, in my opinion, the model to which we should aspire going forward.

I am encouraged by evidence that the market is driving reform. For example, companies are being more selective in choosing directors - and directors are also being more selective in choosing companies. Anecdotal evidence suggests that some director nominees now hire consultants to review the company and assess the rigor of its governance procedures, the quality of its reporting and the overall risk profile. In the present environment, companies have a strong incentive to adopt rigorous governance procedures because those that fail to do so will be unable to attract top quality directors, and will pay a risk premium in terms of both director compensation and director's and officer's insurance.

The way corporate officers and directors react to our new rules will to a large extent determine whether the rules will be effective, and how much additional regulation will be perceived as necessary. More so than any regulatory body, corporate officers and directors have it within their power to restore public trust. Trust depends not just upon putting new rules on the books, but more importantly on whether there is widespread consensus that those rules are accepted and will be implemented. The contrary perception exists today, and corporate officers and directors hold the ultimate power, and responsibility, for dispelling that perception by conducting themselves in a manner that is worthy of the trust that is placed in them.

In conclusion, I hope all of you keep thinking and talking about these issues throughout your careers. In the current environment, it is easy to say and do the right things because of new rules and pressure from the market to do so. Right now compliance is en vogue. A year or two from now, however, when the scandals hopefully will have faded from the minds of investors, we need to continue this dialogue among investors, Boards, management, lawyers, auditors, bankers, analysts and regulators to help prevent these issues from recurring. As the saying goes, "Those who cannot remember the past are condemned to repeat it."2

Darden has set a good precedent by making an ethics course a mandatory part of the curriculum. But you should not think of ethics as something that can be compartmentalized; it is part of every course you take in school, and should inform every decision you make in the business world. The task of enforcing laws and rules of the market cannot be left to regulators alone. As President Bush recently noted, "Ultimately the ethics of American business depend on the conscience of America's business leaders." You should carry the burden of that knowledge with you throughout your careers. As I said at the outset, it is not an overstatement to say that integrity and trust are essential; nothing less than our free market system as we know it is at stake.

Thank you.



1 Quoted in John C. Coffee, Jr., "'No Soul to Damn: No Body to Kick': An Unscandalized Inquiry into the Problem of Corporate Punishment," 79 Mich. L. Rev. 386, 386 (1981) (quoting M. King, Public Policy and the Corporation 1 (1977)).
2 George Santayana, quoted in The Columbia World of Quotations (Columbia Univ. Press 1996).



Modified: 04/16/2003