Speech by SEC Commissioner:
Private and Public Sector Responses to Corporate Governance Issues
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
Conference on Bank Structure and Competition
Federal Reserve Bank of Chicago
May 9, 2003
Good morning. I want to thank Doug Evanoff for inviting me, and thank you, Bill, for your kind introduction. It's a pleasure to be here. I feel right at home. I have been coming to this conference on and off for about 30 years now. And, for those of you who are trying to extrapolate my age from that fact, for the record, my official story is that I was 10 years old the first year I attended.
In the old days, the attendees at this conference were primarily academics as well as economists from the banking agencies. It was held in a small auditorium in the Federal Reserve Bank building. I looked back at the program from the first conference I attended and was struck by how narrowly the topics were focused on bank structure (imagine that at a "bank structure" conference!). Now, it is a highly respected annual forum with hundreds of participants. We're here discussing all sorts of issues affecting a much-changed financial services industry, including the very important topic of this conference corporate governance. However, the preface to the proceedings of the 1972 conference captures the goal of the conference today as well as it did back then: "The common thread that runs through all of the papers and discussions at the conference," the preface stated, "is a concern for acquiring and disseminating the knowledge requisite to the achievement of that mix of competition and regulatory policy which best serves the public interest." That is a worthy objective, and I'm pleased to be part of it.
I should note at this point that the views I express today are my own, and not necessarily those of the Commission or its staff.
It has been a busy time for the SEC since I joined the Commission in January 2002, and it is a good time to be talking about the respective roles of government and the market in regulating the markets, and in responding to crises. For our part, the Commission certainly has contributed our fair share in response to the financial scandals. Our actions have included new rules to: accelerate the filing of quarterly and annual reports for certain issuers; require CEOs and CFOs to certify quarterly and annual reports; speed up the disclosure of personal securities trading by corporate insiders; and 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. We adopted rules requiring heightened standards of auditor independence, disclosure of off-balance sheet arrangements, and a reconciliation to GAAP in earnings releases and other financial information prepared on a pro forma basis. We also adopted rules preventing executives from trading during pension blackouts. And that's not the complete list.
Hopefully, we will now have some time to take a step back to assess what we have done, make sure it is working, look at whether there are unintended consequences, and make necessary adjustments. All market participants need some degree of certainty so that they can order their affairs, and get back to the business of business. Furthermore, as the topic of this panel suggests, we need to look at how the markets have responded in driving positive change, and where they can do better. In keeping with that subject, today I will discuss some issues arising out of both the public and private reaction to the corporate governance scandals. I will also discuss two areas namely, managing conflicts of interest and overseeing executive compensation where market participants need to take meaningful action to prevent the perception that additional government response is needed.
I. Interaction between Public and Private Responses
As a general matter, given a choice between a public and private response, my strong preference is to let markets operate unimpeded. Having said that, however, I realize that regulators play an important role in ensuring integrity in the markets, especially in the context of a market crisis that reveals possible systemic issues. In the face of significant financial scandals it is necessary to do some root-cause analysis to determine whether the markets are in fact functioning properly, and, if not, to try to provide meaningful solutions. The process of determining whether it is appropriate to step in front of the invisible hand of the markets is a delicate one that requires a large dose of humility,but there are times when regulation is necessary to ensure the proper functioning of the markets themselves. That is really where the public and private sectors intersect.
As I view it, the Commission's role is to ensure a level and fair playing field by writing rules that provide incentives to do the right thing, and enforcing them vigorously when the rules are broken. The overriding purpose of SEC rulemaking is to ensure that there is an environment in which investors are protected, and the markets can allocate resources efficiently.
Regarding corporate governance specifically, what we really want is good corporate behavior. But we can't write an enforceable rule that simply says, "Be good." So we write rules to incent good behavior, and we take enforcement actions to punish bad behavior but at the end of the day, it is up to directors and management to put in place the culture to "be good."
II. The Need to Look for Unintended Consequences of Regulation
One reason for my preference for market-based solutions is that, as a general matter, corporate governance reforms driven by regulators give rise to a heightened possibility of unintended consequences. The nature of regulations is that they have general applicability, and it is difficult to consider and craft a response that is appropriate to all situations. One of the great strengths of our capital markets the number and diversity of issuers who participate in them also presents one of the greatest challenges in formulating a response to the recent financial scandals. For example, rules designed for the Fortune 100 are not necessarily appropriate with equal force to a startup company with a small, concentrated investor base. Accordingly, in our rulemaking, we have tried to accommodate some of the unique needs of foreign and small business issuers.
I want to be clear that I believe the rules we passed pursuant to the Sarbanes-Oxley Act were both necessary and appropriate, and are benefiting investors. In the months since we passed the new rules, however, some specific unintended results have surfaced, and we will need to watch them carefully in the coming months. The following are some examples, based on anecdotal evidence:
- We have heard that some companies especially smaller companies (including small banks) are avoiding public offerings or going private, to avoid having to comply with the Sarbanes-Oxley governance requirements.
- There have been reports that some mutual funds are providing less discussion of market trends and other forward-looking information in their reports because that information now must be certified. While a heightened degree of caution is to be expected, if this trend becomes more pronounced it could result in less transparency for investors. That would be troubling, and we have to monitor the impact with respect to investment companies as well as public operating companies.
- A related trend we hear is that senior executives are spending much more time on the content of financial statements, including, by some accounts, a substantial amount of time on details that are not material to the presentation of the company's financial position. This is an unintended, but not wholly unexpected, consequence as executives adjust to the idea of certifying results. To the extent this reflects the fact that executives are taking disclosure more seriously as a result of our certification rules, that is a positive development. As I have said in other venues, if you are a manager of a public company, then accurate disclosure is one of the most important jobs you have, and you should not take it lightly. However, the intent of the rules is to make sure that the disclosures fairly present the company's financial condition in all material respects. As such, managers should spend their time on the critical accounting judgments and corporate events that are most important to ensuring clear and accurate disclosure. Hopefully, to the extent a problem exists, it will work itself out over time as companies have more experience operating under the new rules.
- We have also heard that some public companies are now reluctant to change pension fund administrators because of the new pension-fund blackout rule that prohibits executives from trading when employees are prohibited from doing so. I am not sure of the true extent of this issue, but the decision regarding a provider should be based on sound business, not our trading restrictions.
I should note that, in looking at how the new rules are being implemented, it is important to distinguish between truly unintended consequences, and intended consequences that market participants just don't like. With respect to the former, I encourage people to continue to bring them to our attention so we can evaluate how the rules are affecting the marketplace.
III. Positive Examples of the Market at Work
Turning from government-driven to private-sector responses, it is encouraging to see some significant examples of the market driving reform. For example:
- Some companies have voluntarily included options as an expense in their income statement;
- Some pension funds have decided only to use the services of brokerage firms that agree to adhere to ethical standards embodied in a code of conduct;
- Shareholder proposals regarding governance have received more substantial support;
- More audit committees are carefully scrutinizing whether to allow auditors to provide non-audit services, even if those services are not prohibited by the Commission's stringent new rules regarding auditor independence; and
- Potential director nominees are taking a hard look at the strength of a company's governance program and its overall risk profile before agreeing to be considered for a seat on the board.
IV. Areas Where the Private Sector Can and Should Do Better
These are encouraging signs that the markets are driving reforms, and I hope the trend will continue. I would like to talk about two areas, however, where I would encourage market participants to step up to the plate in a much stronger way. The first is managing conflicts of interest. The second is overseeing executive compensation.
A. Dealing With Conflicts of Interest
When we talk about the market's role in driving reform, directors and officers of public companies obviously have a vital role to play. For example, in the financial services arena, directors and officers should be aware that the advantages of running a financial supermarket also can be the source of wrong incentives and questionable business practices.
Cross-selling is legitimate, but given the conflicts that sometimes arise, the temptation may be to compromise ethics in order to maximize profits. That troubling dynamic is evident in the recent settlements with the largest investment banks relating to conflicts of interest between investment banking and what was supposed to be objective research. It is also present in the allegations that some banks have tied credit decisions to whether the proposed borrower awarded the bank lucrative investment banking business.
Senior management needs to take potential conflicts into account in formulating and managing business strategies. The Board, for its part, must be vigilant in gaining comfort that adequate controls are in place to prevent harm to investors, customers and the markets. The Board should not tolerate management that does not act decisively to stem potential conflicts of interest before they manifest themselves in the type of conduct we saw in the analyst enforcement actions.
If the private sector allows conflicts to operate unchecked, and to develop into systemic issues, the predictable result will be a call for additional government-imposed reforms. While there are degrees of government intervention, the analyst settlements demonstrate that even appropriate remedies can be intrusive. With respect to conflicts of interest, an ounce of market-based prevention can avoid pounds of regulatory cure.
B. Oversight of Executive Compensation
A second area where I would hope for a stronger market response is in the oversight of executive compensation. Similar to the situation with research analysts, there seems to be a disconnect between performance and executive compensation that is a red flag that there is something wrong. Most of the recent governance reforms have focused on the role of the audit committee or the Board as a whole. However, providing the right incentives to management is one of the most important ways for the Board to carry out its oversight role, and compensation is the biggest carrot the Board has in terms of incentives. So if compensation committee members have been jealous of all the recent attention their colleagues on the audit committee have been getting, you can tell them not to despair they seem to be moving rapidly into the spotlight.
There are several principles of good governance that should go into executive compensation decisions. For starters, the compensation committee should be comprised solely of independent directors. In this context, "independence" is especially important, and I mean true independence that goes beyond the technicalities of Commission rules or listing standards. While the rules provide minimum standards, they also leave a lot of room for Board oversight and discretion. Investors should demand, and Boards should ensure, that the compensation committee is truly independent. Collectively, they should look with a jaundiced eye at directors who have personal relationships with the executives whose compensation they have to determine what I would call an "old Board network." Those relationships, while not expressly prohibited in all cases, call into question whether the individuals have the comfortable distance from the decision that gives the market confidence they will be truly objective.
In addition, performance-based compensation should be truly performance based; that is, there should be objective factors that are sufficiently defined and verifiable as to provide a reliable benchmark against which to judge performance.
Finally, performance goals and the overall compensation package should not be a get-rich-quick scheme, but rather should be designed to provide proper long-term incentives. Hopefully companies hire their senior executives for the long-term and, if that is the case, then the pay package should be aimed at compensating them fairly over the full term of their employment.
In sum, it should be clear from the recent scandals that there is a risk that some executives will manage to short-term performance goals to maximize their compensation. For its part, Sarbanes-Oxley provides an incentive against this type of conduct. If a company's public filings are inaccurate due to misconduct, the Act requires the CEO and CFO to reimburse the issuer for certain bonuses and profits from stock sales. But even beyond fraud or illegality, the Board's compensation decisions should remove rather than contribute to any ambiguity about the level of integrity demanded from management.
VI. Creating a Corporate Culture That Respects Ethics
In conclusion, I can't walk away from any discussion of corporate governance without stressing that the most important aspect of reform comes from market participants working proactively to foster an ethical culture in business. This highlights the importance of market-based reforms because ethics is an area where the government frankly cannot legislate or regulate.
The Commission has put significant new rules on the books that I believe will affect behavior positively by providing incentives more consistent with fiduciary responsibilities. However, I hope we have not created unrealistic expectations that the new rules will solve all of our problems. Empty promises will not restore trust. Only if officers and directors follow the spirit as well as the letter of the new rules, will investors again place their full confidence to the markets.
Convincing the public that meaningful changes have occurred will take decisive action, not just words. It brings to mind the story of a businessman who had become known for his sharp and hardnosed business practices. The man once remarked in Mark Twain's presence that, "Before I die I mean to make a pilgrimage to the Holy Land. I will climb to the top of Mount Sinai," he exclaimed, "and read the Ten Commandments aloud at the top."
"I have a better idea," Twain replied. "Why don't you stay right at home in Boston and keep them?"1
1 Bennett Cerf, Shake Well Before Using 110 (Simon & Schuster 1948).