Speech by SEC Commissioner:
|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.
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.
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.
|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).|
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