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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks At Rocky Mountain Securities Conference


Commissioner Paul S. Atkins

U.S. Securities and Exchange Commission

Denver, Colorado
May 30, 2003

Thank you, Randy, for that kind introduction. It is a pleasure to have this opportunity to speak here today. What an impressive tradition you have here in the Mile-High City: 35 years of the Rocky Mountain Securities Conference. Congratulations on yet another successful conference.

I am happy to help continue your tradition and to help bring a bit of the SEC's home office from Washington. Before I begin, I must make my own legal and compliance folks back home happy by noting that the views I express here today are my own and do not necessarily reflect those of the SEC as an institution or of my fellow Commissioners.

As Randy mentioned, I have to confess that I am a recidivist SEC employee. My last stint ended about ten years ago. I also must confess that in some ways it seems as if I've been back at the SEC for an eternity with the flurry of activity that the SEC has conducted over the last six months; yet it has only been ten months since I was sworn in as a Commissioner.

It also feels in many ways as if I never left the SEC in that the major issues and topics of discussion when I was at the SEC before - such as improving corporate governance and strengthening management accountability - are still headline news and just as relevant and important today as they were a dozen years ago. Only now, as contrasted to a decade ago, almost everyone in the country seems to know what the SEC is, that it is a government agency in Washington, and that has something to do with law enforcement. I can tell you stories of once upon a time when even people in government were unaware of what we did.

As I am sure everyone in this room knows, the SEC over the last few months has acted upon an unprecedented number of rules. And before I speak briefly on what we've done and what we plan to do, I want to discuss today my approach to addressing these rules and other regulatory matters.

The United States owes its position in the world today to its strong foundation on individual liberty and protection of private property rights - basic free market principles. Government is not, and should never be, a merit regulator, a price setter, or a judge as between competitors. History shows that government - when it tries to substitute its judgment for the market's - can cause more harm than good. I believe the SEC is here to help the market work better and more efficiently, because the market speaks volumes about what investors want and need.

With respect to regulation, I believe that reasonable self-regulation, rather than one-size-fits-all government-imposed mandates, is generally preferable. Unfortunately, self-regulation alone may not always be sufficient. For example, the rules we adopted requiring the independence of accounting firms are essentially professional ethical obligations that should have and could have been adopted by the accounting profession.

Yet because these professionals did not regulate and police themselves - after they had ample warning from regulators and the marketplace - Congress called upon us to act. I believe that the final rules that we adopted regarding auditor independence serve the Congressional mandate for us to take the appropriate steps to lay the groundwork for a restoring of investor confidence in the accounting profession.

I use this word "groundwork" because our rules are not intended to be, and indeed are not, a panacea for the ills of the past few years.

While, sometimes, regulatory action may become necessary when other measures are insufficient, it is imperative that the SEC recognize that - although the well-intended goal may be to serve investors - regulatory burdens may, in fact, harm investors. In certain cases, costs may be imposed upon companies and the marketplace, which are in turn passed on to shareholders, without a commensurate benefit flowing back to those investors. We must seriously and conscientiously compare expected costs to anticipated benefits any time we propose and implement regulations, not only for those rule proposals mandated by Sarbanes-Oxley, but for all of the SEC's regulatory actions. Even more importantly, we must review our mandates periodically to see what the practical effect has been. This goes for Sarbanes-Oxley as well as for the rest of our rulebook.

Before I discuss with you some of the industry-wide aspects of Sarbanes-Oxley, let me address a concern that is rather parochial to most of you in this room: the provision requiring the SEC to adopt final rules regarding "minimum standards of professional conduct" for attorneys.

Some point out that Sarbanes-Oxley is the first significant effort by Congress to mandate federal regulation of lawyers. Others view these rules as a necessary step toward bolstering investor confidence, by forcing attorneys appearing and practicing before the SEC to help ferret out misdeeds. Still others have called the Act's attorney regulation mandate a "wake-up call" to the profession, noting that enforcement of legal ethics rules has typically been directed at suppressing competition, as opposed to protecting the interest of clients.

To say the least, these are critically important issues for attorneys. The bar itself does not necessarily have the best record of disciplining its own. The Public Company Accounting Oversight Board was created because of deep failings in the accounting profession's willingness and ability to regulate itself. I think it is safe to say that the legal profession would not like to see this sort of organization created to regulate it in a similar fashion.

The rule that we proposed in December of 2002 was controversial in many ways. It took an expansive view of who could be found to be "appearing and practicing" before the SEC. It appeared to reach attorneys performing functions outside of legal departments, such as compliance and business personnel. And, it raised issues of jurisdiction and enforceability. Especially abroad.

The final rule is much less controversial. As in all of our Sarbanes-Oxley rules, we received many thoughtful comments and suggestions, and reacted accordingly. Specifically, we narrowed the definition of those deemed to be "appearing and practicing" before the SEC. Otherwise, the rule would have been unworkable. For example, one important exclusion applies to attorneys at public broker-dealers and other issuers who are licensed to practice law and who may transact business with the SEC, but who are not in the legal department and do NOT provide legal services within the context of an attorney-client relationship.

Also very controversial was the "reporting-out" or "noisy withdrawal" provisions of our proposed rule. This is the aspect of the rule that would require corporate attorneys to "rat out" their clients - disclose their clients' material security law violations to the SEC. Not surprisingly, we received many strong objections to this requirement.

Currently, we have asked for comment on whether it makes sense for the issuer itself to disclose when an attorney has resigned, because he believes the company did not respond adequately to a material violation of securities law. This approach would not require the attorney to disclose any information, other than to his client. It would then require the company to report rapidly to the SEC - two business days from receipt of the attorney's notice of withdrawal.

I am happy to say that much of this soon may be rendered moot. This summer, the American Bar Association will take up ethical standards dealing with this issue. I have high hopes that we will see an effective and appropriate set of guidelines established by the appropriate bar groups.

Enough about us lawyers. No one here, or perhaps anywhere in the country needs a recitation of the corporate events of the past couple of years. The tragedy for everyone, corporate managers and investors alike, is that only a handful of corporations caused these recent problems, although they were spectacular in size.

Some people have charged that Sarbanes-Oxley is just a cynical political reaction to a market crisis at the end of a bubble. We Americans certainly have a track record in our history of legislative reactions to a general public demand that government "do something" about a crisis - Dr. Robert Higgs, in his book Crisis and Leviathan, does a great job of tracing this reaction through our history. And, there are certainly parts of Sarbanes-Oxley that some have construed as an overreaction - as our European friends like to remind us.

I think that the better way to look at Sarbanes-Oxley, in the whole and in context, is that it is more than just a political response. Although it certainly represents what formerly would have been an unimaginable incursion of the U.S. federal government into the corporate governance area, it also contains many advances for corporate governance and attempts to provide best practices to prevent the misdeeds that led to investor losses. Many of these ideas are not new, but have been floating around in one form or another for quite a number of years. Many are not outright prescriptive requirements, but rather are items of disclosure, with the burden then on issuers and the market to decide what importance to put on that disclosure.

Fundamentally, the Act acknowledges the importance of stockholder value. Without equity investors and their confidence, our economic growth and continued technological innovations would certainly be slowed. Sarbanes-Oxley strengthens the role of directors as representatives of stockholders and reinforces the role of management as stewards of the stockholders' interest.

A long-standing risk-management principle is the importance of corporate culture and "tone from the top". A CEO's tolerance or lack of tolerance of ethical misdeeds and a CEO's philosophy of business conveys a great deal throughout the organization. The role of directors is to monitor and oversee that situation on behalf of stockholders. Directors are not and should never become full-time employees. There will always be a natural tension between directors as business advisors - a vital role - and their role as monitors of management on behalf of the stockholders' ownership interests.

It is my hope that Sarbanes-Oxley may indirectly help directors in this regard. The law's effect will be to make board members be more inquisitive. By anecdotes I have heard, this process is already happening. I would argue that questions that might have seemed to be "hostile" to management two years ago, now are seen in a different light: to further a director's function. Since some of the recent problems involved corporate managers using the corporation as a personal "piggy bank" or other theft by management of corporate assets, the Act's emphasis on a board's oversight function is certainly a step in the right direction.

While this is certainly my hope, my fear is that Sarbanes-Oxley and our rules intended to strengthen corporate governance will have an unintended consequence: we may dissuade qualified and competent individuals from agreeing to serve on corporate boards. The SEC must also address the growing unease in the boardroom over the crush of new paperwork, fears of increased personal liability, and the increasingly limited availability of director's liability insurance.

Directors serve in a vital, part-time job on which much depends. We cannot afford to have these people wonder if their service is worth it. Anecdotally, I have heard that director candidates are now hiring attorneys and accountants to pour over the books of firms when they receive offers for board seats. Many of these candidates are running from any position that appears to look even slightly problematic. We need to encourage strong candidates to accept challenging positions at companies that need a fresh look from an independent director - not give them more reasons to run away.

Internal Controls

Speaking of "tone from the top," just this week we adopted the final rule regarding the internal control provisions required by the Sarbanes-Oxley Act. The new rule requires management to complete an annual internal control report for the company's annual report and requires the company's auditor to attest to, and report on, management's assessment.

This rule is important for establishing accountability of management for the integrity of financial information. My hope is that investors will be able to gauge the level of risk of a company's reporting system by knowing what sort of oversight framework for financial reporting a company has. I hope that this rule will help to lay the groundwork so that one day we will get to the point that the market will clearly favor companies that develop stringent internal controls and aggressive oversight programs. Cheaper cost of capital and better reception from investors is the marketplace feedback that will encourage good internal controls.

This is not a new concept. In the wake of the Foreign Corrupt Practices Act, the SEC and private sector groups, notably the Committee of Sponsoring Organisations of the Treadway Commission (COSO), focused on this issue. Tone from the top, internal checks and balances, and a robust internal governance and oversight function are important components of a healthy internal culture. This latest rule, of course, is driven by statutory mandate, and our release adopting the rule goes to some pain to try to describe how these internal financial controls - and the certifications and attestations required by them - do not necessarily overlap with the certifications of CEOs and CFOs regarding internal controls over the general disclosure process.

Thus, this internal control rule is a perfect paradigm of how we will need to monitor closely the costs of implementation of our rules versus the results that we hope for. It is fine and good to have internal controls and checks and balances, but if we are not careful, the resulting paperwork and inefficiencies might strangle an organization.

The real question regarding this rule will be: What will it take to have an auditor attest to these reports? You all know the stories of professionals who are circling to make the most of uncertainty in the business community. I would also suggest that the exposure draft of the Accounting Standards Board released on March 18 of this year was unhelpful in that it arguably over-engineered what we are hoping to achieve - the attestation should be of the work that management has done, and not the auditor's starting the documentation process from scratch. That prospect also raises basic independence concerns regarding the auditor's role.

Basically, with respect to how these rules under Section 404 will be implemented in practice, especially in light of all the other rules that we have put into effect recently, we will need to be vigilant and periodically ask two important questions: (1) Are investors better protected as a result of our actions, or are we just fattening the pockets of accounting firms and law firms? and (2) Assuming that investors are receiving some enhanced protection, is this benefit greater than the costs imposed on registrants, and is it possible to be done more efficiently?

Financial Experts

Earlier this year, I also had a similar concern as to the section under Sarbanes-Oxley that directed us to adopt rules requiring the disclosure of whether a company has a "financial expert" on its audit committee, and to define a "financial expert," which we accomplished in January. I think it is beyond debate that it is beneficial for stockholders and companies to have financially literate directors. Indeed, studies show that companies that have board members with significant financial knowledge need to restate the financial statements less than companies with less-experienced board members. Or, as economists would say, there is a negative correlation between restatements and financial literacy.

The good news about our final rule is that we worked hard to make it so that it is not, as I first feared at the proposal stage, what would have amounted to a full-employment act for retired accountants. It is more flexible and inclusive. This flexibility is critical to the 17,000 issuers registered with us. Ultimately, however, this is a disclosure provision. Whether or not financial expertise should be ensconced on the board is something that the market and corporations are best placed to decide, depending on the circumstances. Directors are not full-time employees of companies and the best director is provocative and questioning, not necessarily a financial nerd.

The bad news is that I am still troubled that naming a director an "expert" raises unintended confusion regarding director liability. We live in a litigious society and there is every sign that litigants are going to seize upon this term and attach great significance to it. We tried to do our best to mitigate this concern. For example, we added a specific safe harbor in the rule that provides that the rule is not intended to increase or decrease the level of liability of directors. Also, for the first time that I know of, we added a specific finding of the SEC in the release to the same effect. I hope that these steps will help guide state courts and juries to reach results consistent with our rules.

Hedge Funds

I know that another area that is of great interest to many of you -- and that has received significant attention in the press -- is the SEC's investigation into hedge funds. There has been significant growth recently in the United States, as well as the world, in the number of private unregistered investment funds and the amount of assets under their control. Last year, the SEC commenced a formal fact-finding investigation in this area in order to gain a better understanding of the issues currently affecting these types of investment vehicles. Ultimately our goal is to determine whether the present state of regulation, or lack thereof, is in the public interest.

As part of this fact-finding, the Division of Investment Management recently held a two-day Hedge Fund Roundtable where panelists spoke about the growth of hedge funds, trends in the industry, trading strategies, and basic operational issues. The industry's growth is expected to continue as pension plans and endowments increase their investment in hedge funds. The panelists strongly indicated that these institutional investors hold enough leverage to gain access to information needed to perform due diligence of the hedge fund prior to investment. Institutional investors utilize this market power to perform extensive due diligence and to demand ongoing disclosure.

I would like to focus on two aspects regarding hedge funds and their role in the overall financial services environment. First is the so-called trend toward the "retailization" of hedge funds, and the second is the suggestion that we require some sort of registration of hedge funds. The term "retailization" has arisen because some funds, which are registered with the SEC under the Investment Company Act, are funds of hedge funds and have minimum investments as low as $25,000. The hedge funds in which the registered funds invest are not registered under the Securities Act, but state that they are marketed to accredited investors under private offering exemptions under Regulation D.

These investment sizes raise disclosure and sales practice concerns, all of which are squarely under our own control under current law, without any new regulatory scheme. To whom are these funds being marketed? Do the investors comprehend or appreciate the risk surrounding the investment in a hedge fund product?

Some panelists suggested that the SEC update its regulations to either increase the minimum net worth required for investment or to establish sophistication standards based upon actual investment knowledge and experience. After all, the income and asset thresholds under Regulation D, admittedly a crude measure of investment sophistication at best, are a quarter century old. We all know what 20 years of monetary and asset inflation has done to values. A dollar today ain't worth what it used to be worth.

I would suggest that broker-dealers selling these products to retail investors carefully review their sales practice programs. Appropriately, the NASD has been vocal in this area. It released a Notice to Members in February reminding firms of their obligations when selling direct and indirect interests in hedge funds. The Notice to Members focused on an apparent over-reliance on the accredited investor thresholds in Regulation D. Just because someone has money does not make that person "sophisticated," and does not mean that a product is necessarily suitable for that investor. The ability of the investor to understand the risks is the key consideration. Perhaps a good way for a broker to start each phone call is to warn, "the higher the return, the higher the risk."

The NASD said that broker-dealers must conduct not just due diligence - they must perform substantial due diligence with respect to the hedge funds and funds of hedge funds that they recommend to customers. Brokers must also determine whether the product is suitable for each specific customer - this certainly should not seem to be a revolutionary thought! They must adequately train sales representatives, so that they can properly inform investors about the risks associated with these products. Use of leverage, illiquidity, possible double fee structure, and lack of transparency - just to name a few potential risk factors.

I believe that broker-dealers performing due diligence should focus their attention on the quality of the fund's overall operational structure, including internal controls, governance system, and disclosure system, especially with respect to leverage and asset valuation. Of course, all broker-dealers should ensure that the fund manager or investment adviser is ethical, able, and reputable, but of critical importance when deciding which products to offer to retail customers should weigh in favor of fund structure and overall management.

As to suggestions regarding registration of hedge funds, we must carefully consider what we are talking about. No one knows how many hedge funds are out there, but the best guess seems to be in the range of 6,000. This is about as many as all of the registered investment advisors that we currently oversee today. How would the SEC reasonably carry out an examination program of additional numbers this great? Would our program wind up being nothing more than a mirage to investors, without real added value? Is this the best use of the government's resources? What kind of investors are affected - those with resources and sophistication to ask the right questions or truly unsophisticated investors?

Chairman Donaldson has asked the staff to prepare a report summarizing the results of their fact-finding efforts. The Chairman also asked the public to submit their views on all issues surrounding hedge funds. I urge you to take this opportunity to provide the SEC with your input.

I believe the SEC must always remember the benchmark principles of fiduciary obligations, civil liability, and market power when determining whether a regulatory scheme is just right. The SEC must determine how far it will go to regulate fraud - or the failure of self-regulation - and balance that against whether the proposed regulation will serve investors.

Your presence at this conference indicates that you are striving to gain insight into the issues that face the financial industry. I thank you for your effort and initiative. There are two reasons for my being here today: first, to explain what we are doing at the SEC and why we are doing it; second, I am here to urge your participation in our process by giving us your comments. You are on the ground doing the work. Tell us your war stories. Tell us how the process can work better so that we can help make the markets even more efficient.

Thank you for your time.



Modified: 06/05/2003