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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks before the Council of Institutional Investors 2005 Spring Conference


Harvey J. Goldschmid

U.S. Securities and Exchange Commission

Washington, D.C.
April 11, 2005

Critical SEC Issues for 2005 - 2006

The title for my remarks this morning is "Critical SEC Issues for 2005-2006." The Introduction to the Council's SEC Briefing Book for this meeting perceptively states: "The Council is concerned that regulators and legislators are under pressure to ease up on corporate wrongdoers and reforms." My remarks will focus you on what I believe are three major areas for special concern. The reference to 2005-2006 in my title indicates that I am already thinking in terms of the academic year. As many of you know, I will be returning to Columbia Law School sometime this summer.

The first area of special concern that I will discuss relates to the Commission's critically important - and controversial - current rigorous approach to enforcement. The second area relates to threats to the effectiveness of the SEC itself. My third area of special concern relates to the SEC's stalled - but not dead - shareholder proxy access proposal. In my view, final approval of a proxy access proposal is the single most significant way to improve dramatically corporate governance in the United States today.

Let me start with what I hope represents common ground in this room. The corporate and mutual fund scandals of the 1990s and early 2000s have been the most serious that have occurred in the United States since the Great Depression. In my view, we have witnessed a systemic failure. The checks and balances that we thought would be provided by independent directors, independent accountants, lawyers, securities analysts, commercial and investment bankers, and compliance personnel (particularly for mutual funds) too often have failed. That is why, during the past two and a half years, serious SEC rulemakings and enforcement efforts have come in each of these areas.

But before I tell you more, I'd better do something I should have done at the beginning of my remarks. The comments I make today are my own and do not necessarily represent the views of the Commission, my fellow Commissioners or the Commission staff.


Sarbanes-Oxley provided the SEC and the Department of Justice with new, potent sanctioning and remedial powers. Now available to the SEC or Department of Justice are: new civil penalty and disgorgement powers; easier to obtain officer and director bars (including the possibility of administrative imposition); broad equitable remedial powers; and, for the Department of Justice, enhanced criminal sanctions (for venal and willful conduct).

What Congress recognized in Sarbanes-Oxley is that mutual funds, corporations, other entities, the individuals who comprise them, and the various "gatekeepers" must know that they are likely to be held accountable for wrongdoing if our securities regulatory system is to work. Effective deterrence requires a strong, credible threat. It is that "threat" that creates powerful incentives to avoid wrongful acts and to bring about the cultural, procedural, and process changes necessary to protect investors.

For me, "accountability" and "deterrence" are the key words in the Commission's enforcement approach today. Good people often act properly for reasons entirely unrelated to legal sanctions and enforcement. Pride, decency, peer pressure, professionalism, etc., all motivate real people. But, for some, at least, legal sanctions and enforcement provide a critical incremental incentive for proper conduct. This incremental incentive, combined with accountability and deterrence values, are fundamentally important in making our economic system work.

Some commentators have drawn what, for me, is a false dichotomy between individual actors and entities, by arguing that only "real people" can be deterred. Their conclusion is that entity sanctions, particularly monetary sanctions, are - or are often - counterproductive. I fully agree that legal sanctions against wrongdoing individuals are essential if we are to create accountability and deterrence. But the basic need is to go after both individuals and entities. Potential entity liability creates powerful incentives for preventative programs and procedures and for corporations to reform and clean house when wrongdoing has occurred. Moreover, Section 308 of Sarbanes-Oxley, the "fair funds" provision, now permits the Commission to give the money it collects, from both ill-gotten gains (disgorgement) and civil money penalties, to the most innocent and appropriate victims of financial fraud.

There are complex issues as to when individuals or entities should be charged. At times, in evidentiary and fairness terms, it may be difficult to hold any given individual liable for a company's failures. In general, an entity should not be held liable for an isolated, unanticipated wrongdoing by, for example, a single run-of-the-mill partner at a large accounting firm. Other complex issues relate to financially weak public companies, particularly when they have innocent public shareholders (who may have already suffered from a fraud). But collective good sense and prosecutorial discretion provide the Commission with plenty of leeway to deal with these complex situations. . . .

Threats to the Effectiveness of the SEC Itself

The SEC is an independent regulatory agency with about 3,900 employees and a budget of roughly $900 million. In Washington, D.C. terms, the agency is a minnow when measured by personnel and dollars. Traditionally, the SEC has had a first-rate staff. As to the overall quality of the SEC, Senator Paul Sarbanes recently correctly concluded, "[T]he SEC is . . . the crown jewel among [independent] regulatory agencies."

SEC Chairman Bill Donaldson has described the proposed fiscal year 2006 budget for the Commission - of $888 million - as "lean" but "adequate." I agree that the proposed budget is lean. But I am truly worried that flat budgets in fiscal year 2007 and beyond -- a pattern that occurred in the 1990s -- could well lead to tragic regulatory and economic failures. Keep your eyes on the adequacy of the resources available to the Commission.

Of more immediate concern are challenges to the Commission's non-partisan nature and independence. Suggestions, for example, that "Republican Commissioners should stick together or vote together" are inconsistent with the agency's history and best traditions. I fully agree that it would be ideal if all five Commissioners could vote together - on the right public policies - all of the time. But independent, honest voting - to protect investors and the public interest - is critical. As Bill Donaldson put it in recent Congressional testimony:

The Commission was specifically designed by Congress to be independent and must remain fully so if we are to continue restoring the public's faith in the fairness of our markets.

The term "independent agency" embodies a complex concept. I believe that my late Columbia colleague, and former Chairman of the SEC, William L. Cary, had the correct analysis. He concluded that "[independent] agencies are stepchildren whose custody is contested by both Congress and the Executive, but without much affection from either one." That is reality.

It is important to understand, however, that there are real advantages to being an institutional stepchild. While the Commission must obviously try to work well with both the executive and legislative branches, its separation from each of them affords it a meaningful measure of autonomy. Its autonomy and independent status have undoubtedly insulated the Commission significantly from business and political pressures over the years, and this has worked very much in the public's interest. It is of critical importance, I believe, that the Commission's autonomy and independence be scrupulously maintained.

One final point, at least in this area. The Commission, as most of you know, is very delicately balanced right now. The choice of my successor is a matter of great consequence. My only recommendation to the Council is to demand a new Commissioner of the highest quality who will work well with Chairman Donaldson.

Shareholder Access to the Proxy Process

In my view, the Commission's October 2003 shareholder proxy access proposal - or, more accurately, an effective variant on that proposal - is stalled, but not dead. I remain hopeful that the Commission will act on an access proposal before I leave town this summer. I have said often that the blockage so far represents a triumph of the worst instincts of the CEO community. But I feel absolutely certain that whether or not the Commission acts by this summer, proxy access will be a fact of life in the United States in the not-too-distant future. There is simply too much merit in the shareholder access approach for it to be rejected over the long term.

Let me draw an imperfect analogy from my old academic life. I was a Reporter for the American Law Institute's Corporate Governance Project in the 1980s and early 1990s. Two volumes of the ALI's Principles of Corporate Governance were published in 1994. Various of those "Principles" were highly controversial for a time. The Business Roundtable fought, with immense tenacity (that is an understatement, not hyperbole), against recommendations that the boards of large public corporations have a majority of independent directors and that audit committees be wholly independent. These recommendations are non-controversial, fully implemented (through Sarbanes-Oxley and listing requirements), plain vanilla requirements today.

Let me briefly explain why I believe shareholder proxy access will undoubtedly happen, at least if the merits continue to have anything to do with what happens in the United States.

First, I am a great believer in shareholders. Shareholders, under our free-market system, not only supply capital (which is no small matter), but have the right economic instincts. After everyone else gets paid, shareholders get what is left - the residual. It stands to reason, then, that of critical concern to shareholders are corporate efficiency, honesty, productivity, and profitability. In a macroeconomic sense, these shareholder interests are entirely consistent with the nation's economic needs.

Second, I recognize that if all goes well, active, independent directors, acting in accordance with the "monitoring model," will represent effectively these basic shareholder interests. But what happens when corporate senior managers are unimaginative, ineffective, or wrongheaded, and a compliant board of directors allows them to remain on a painful or disastrous course? What can dissatisfied shareholders do?

The old so-called "Wall Street Rule" or "Wall Street Walk" would be one option for shareholders. If shareholders don't like what is going on, they can simply sell their shares in a public market. If, however, because of a management's disastrous course, my shares have fallen from $40 to $20, selling them before they fall to $10 will be beneficial (though painful) for me, but will not improve the corporation's governance or performance. Wouldn't a rational economic system permit shareholders to bring about mid-course corrections? Is waiting for bankruptcy the ideal way to deal with wrongheaded, economically destructive boards and senior managers?

A proxy contest to remove corporate deadwood is a much better alternative. But how realistic an option is it for shareholders? Under state law, right now, incumbents can spend lavishly across the board for all the modern paraphernalia of a proxy fight. They can use company employees, newspaper ads, letters, millions of dollars worth of work by lawyers and proxy solicitors, and they are reimbursed automatically out of company assets. Insurgents are free to mount such a fight as well, but they get not a penny back unless they win and the shareholders vote to approve their expenditures. The bottom line is that absent special circumstances (e.g., involving small cap companies or the need to disarm a "poison pill"), there are virtually no contested director elections in the United States today. The costs are too large and the risks too high. This situation is not economically rational.

Business community critics have consistently complained that the SEC's October 2003 access proposal was too complex. Ironically, the proposal's complexity lies in those provisions designed to ensure that obstructionists or non-efficiency types could not abuse the opportunity for access. Nevertheless, the Commission has been persistently accused of potentially opening corporate boards to capture by wild-eyed radicals. This accusation -- to put it as gently as possible -- is absurd.

I would support the following simplified proxy access approach today. If a majority of shareholders (not counting broker votes) withhold their votes from a director in year one, the corporation's shareholders would get access in year two, under a Rule 14a-8-like process. As was true in the Commission's October 2003 proposal, the year two board nominees - which could be one, two, or three directors and a roughly 10-20% minority - would be nominated by the largest group of shareholders (holding at least five percent of the outstanding shares for two years). The idea that two majority votes, at two annual meetings, would result in shareholders electing obstructionists or wild-eyed types is entirely unreal.

But when you have an underperforming company and a dead board, two majority votes against the incumbent CEO and board are likely to be an important stimulant for change. That would be all to the good. My proposal would make vulnerable only those companies that ought to be vulnerable. It would also make vulnerable excessive CEO compensation. My purpose is to foster corporate efficiency, honesty, productivity, and profitability. Of course, effective variations on my proxy access proposal are possible, including a balanced cure provision. One thing is certain, however: a shareholder access process of the type I have outlined would go far toward restoring the public's confidence in the fairness and economic rationality of our corporate governance system.

Let me close on an optimistic note. Over the past two and a half years, serious SEC rulemakings and enforcement efforts have occurred in area after area. Disclosure, officers and directors, accountants, lawyers, mutual funds, and others in the financial community have been dealt with sensibly and with balance. In general, the scandals of the 1990s and early 2000s have forced us to face serious systemic imperfections. But they have also made it possible for us to bring about reform. In the end, I believe, the SEC's post-Enron efforts will permit us to maintain and strengthen the status of the United States as the world's leader in both corporate accountability and financial disclosure.


Modified: 05/04/2005