Speech by SEC Commissioner:
Remarks Before the SIA Industry Leadership Luncheon
Paul S. Atkins
U.S. Securities and Exchange Commission
San Francisco, CA
June 8, 2005
Thank you for that kind introduction, George, and for the opportunity to talk with you today. I am thrilled to be back on the West Coast. At the outset of my remarks, I must note that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
Back in Washington, we have settled into our normal summer patterns. Humidity is up; Congress is winding down; the Cherry Blossoms have come and gone; sports fans are talking about baseball, only it's the Nationals, not the Orioles that we talk about now. In fact, the only thing in Washington that does not appear to be slowing down for summer is the SEC! Of course, the most recent news at the SEC is the resignation of Chairman Donaldson.
I would like to say a few words about Bill Donaldson. I thank him for his service and appreciate sincerely his responding to the President's call to lead the SEC in a time when the agency was faced with a highly politicized environment after the election year 2002. Chairman Donaldson helped to get the PCAOB up and running and shaped its internal management structure. He also set up a new risk assessment group at the SEC that could prove to be invaluable in years to come. I appreciate his recognition that some aspects of the implementation of our rules, particularly regarding internal control attestations and their effect on small public companies, might be unduly burdensome. Bill and I had our philosophical and policy differences, but I learned much from working with him. I wish him well.
I am encouraged that the President acted swiftly in naming Representative Chris Cox of California to succeed Chairman Donaldson. By all accounts, Representative Cox is an intelligent and eminently qualified person to succeed Chairman Donaldson. I look forward to working with Representative Cox if he is confirmed.
Today, I would like to talk generally about some of the items that are on the Commission's agenda. Then I would like to talk a little more specifically about some enforcement concerns, Sarbanes-Oxley section 404, and a little about stock options, an issue that is near and dear to many hearts here in the center of the high-tech world.
The Commission is wrestling with a number of difficult policy issues. You should know, and I think be comforted by the fact, that even within the Commission, there are different philosophical approaches to regulation. Lively and spirited debate about the appropriate use of the Commission's considerable powers is healthy and, in times like these, necessary in order to achieve the right balance. I do not think we are there yet, but I am an eternal optimist. I am not, however, an optimist about the government's ability to solve all problems.
My overriding philosophy is based on a belief in our free market system. Government is not, and should never be, a merit regulator, a price setter, or a judge as between competitors. I like to think that I add a dose of "healthy skepticism" about the ability of the government to solve each and every problem that we are confronted with in our financial markets. Back when the markets were first learning of the large-scale corporate scandals, Alan Greenspan wisely stated that we cannot look to "significant expansion of regulation as the solution to current problems" and that "regulation has, over the years, only been partially successful in dissuading individuals from playing with the rules of accounting." I could not agree more. History shows that government, when it tries to substitute its judgment for that of the markets, can cause more harm than good.
As I am sure you are all aware, a divided Commission has recently acted on rules that will have a broad impact on our financial markets. Of course, I am referring to the hedge fund rule, the mutual fund governance rules (otherwise known as the independent chair rules) and Regulation NMS. These actions reflect a puzzling willingness to undertake sweeping regulatory actions without adequate justification. Perhaps more troubling is that these actions occurred before we determined that other approaches were less costly and less disruptive.
The Regulation NMS release, together with Commissioner Glassman's and my dissent, should be out shortly. To give you a sense of what to expect, think of the dictionary. It's almost as long as the Oxford unabridged dictionary. As the recent merger announcements demonstrate - New York and Archipelago, NASDAQ and Instinet - the marketplace moves on despite our regulatory action. Business combinations of this sort have long been expected - certainly since fierce competition between electronic markets slashed transaction costs and decimalization upended business models. Rationalization of the marketplace was inevitable - only the identity of the eventual pairings was the subject of fervent speculation. If anything, the uncertainly caused by the Commission's zigs and zags regarding market structure over the past year or two may have postponed these transactions. Who wants to commit billions of dollars of capital without an idea of what the SEC might come up with next? A government that acts unpredictably inevitably increases costs for businesses and investors. If these business transactions were grounded on the arbitrary rules that we approved, as some at the Commission have claimed, without something more fundamental driving them, then I would really be worried about the soundness of the United States' capital markets.
Very recently, Chairman Donaldson appointed a new enforcement director, Linda Thomsen. I look forward to working with Linda to help to keep the securities markets safe for investors. In doing so, we must take a closer look at some of the practices that have become routine in the enforcement division. Large corporate penalties, for example, generally make good headlines, but do they make economic sense in cases of financial fraud, where management basically has lied to shareholders? Shareholders, who have already lost money as a result of a financial fraud when their stock's value declined in the marketplace, are again penalized when the corporation is slapped with a penalty. Our goal is to return this money defrauded shareholders. But would it not make more sense to leave it with the shareholders in the first place and go after individual wrongdoers instead? Supporters of large corporate penalties justify them as necessary for deterrence. But whom are we deterring? Corporations don't act, people do. Wouldn't stiff penalties against individuals have a larger deterrent effect?
Especially in a crowd of business professionals, I try to avoid citing statutory sections for fear that the quickest way to lose an audience is to start a sentence with "Section X, paragraph Y, of the Securities Act requires…" But, for this topic, I will break my own rule - everyone seems to know exactly what "404" means. Of course, I am referring to Section 404 of the Sarbanes-Oxley Act which requires management to complete an annual internal control report and require the company's auditor to attest to, and report on, management's assessment. The goals of Section 404 are laudable. Emphasizing the need and importance of good controls over financial reporting is critically important. Company management and its outside auditor should be working hand-in-hand to get this right. I fear that in the current environment, many executives feel as if they aren't working hand-in-hand but are actually in hand-TO-hand combat with their auditors as they go through the 404 process!
For many companies, we are through the first year of the 404 process. Now that we have made it through that period of strain, we need to learn from what we experienced. Everyone greatly underestimated the costs involved in the 404 process. Some of these costs might be one-time initial start-up costs, but some of them will be recurring. This is an evolving process, one that I believe will take years to get right. Is that a reasonable assumption - do we have years to get this right? I do not think that shareholders should - or could - accept the prospect of years of costs like the one we just went through. Some justify any cost in this area as the price to pay to prevent another Enron-type collapse. Well, I certainly think that good internal controls, which have been required since the 1970s, are important and valuable for a company and its shareholders. But it is certainly not clear to me that documentation of internal controls would have been able to prevent the type of collusive fraud by management that we saw in the recent corporate failures.
I am very sympathetic to the concerns that I have heard about 404. I think there is enough blame to go around - corporate management and the auditing firms have been much too conservative in exercising their judgment. I understand why conservatism in this current environment has ruled the day, but we need to make some changes. I have not heard much complaint about the statute or our SEC rule, but more about the implementation of the PCAOB's Auditing Standard Number 2. There appears to be general agreement between the SEC and the PCAOB that there was overkill by the auditors (and by management) in the first year. There are differing views, however, as to whether the PCAOB's AS 2 is a workable standard.
Before people will rationalize their approach to the internal control process, both the SEC and the PCAOB will have to give people comfort that we will actually allow people to use their professional judgment and that they will not be second-guessed. Both the SEC and the PCAOB recently issued guidance on these issues. Both sets of guidance acknowledged that more needs to be done in this area and that the current approach was too granular, was not risk-based and did not employ a top-down strategy.
I can safely say that I am the only one of the SEC commissioners or PCAOB members that has actually done an internal control review. I have seen how this process can easily spin out of control if not guided and managed properly. Many are driven by the impulse to document virtually every process in an effort to appear to be thorough and to avoid being second-guessed.
One point must be emphasized - our rule adopting the internal control provision provides that the control process must provide "reasonable assurance" regarding its control structures. It also states that records should be maintained in "reasonable detail" and that a company's policies and procedures provide "reasonable assurance" that transactions are recorded accurately in accordance with GAAP. Let me be clear - reasonable means reasonable - it does not mean absolute or certain or perfect.
We need to make it clear that the process was much too granular and needs significant improvement. Internal controls are a tool to assist financial reporting - they are not a stand-alone goal. Internal controls are not an insurance policy against fraud.
I am very concerned when we hear, as we did at our recent 404 roundtable, of a company determining that it has 60,000 key internal controls. Or, of a large European company whose CFO told me that the company determined that it had 500 key controls, but its outside auditor found 20,000 controls. I do not know if the company is right, but I am confident in saying that the auditor is way off the mark.
I am also very concerned when accounting firms suggest that they were making materiality determinations at the segment, interim financials level. This is much too deep in the weeds. Materiality assessments need to be made on an enterprise basis at the annual period level.
When all the smoke clears, 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 also hope the rules 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 sound 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.
The implementation of section 404 turns a great deal on choices made by the PCAOB. As the PCAOB continues to mature and to set the ground rules by which it will operate, the Commission needs, as the statute requires, to keep a close eye on its activities. We would be derelict in our responsibility to the investing public if we simply rubber stamped the PCAOB's actions.
I would be remiss if, at a speech in the heart of Silicon Valley, I did not mention the complex issue of stock option accounting. I am not necessarily suggesting here that we reopen the debate about whether or not stock options should be expensed. The FASB has been dealing with this issue for a number of years.
I appreciate the independence of the FASB. The FASB is in the standards setting business. The SEC's and the FASB's relationship has been changed somewhat under Sarbanes-Oxley. The SEC now has more responsibility over the FASB, especially how the FASB funds itself. I have focused on increasing the transparency of FASB's budget and processes and its overall accountability.
With regard to stock option accounting, my primary concern has always been valuation and the integrity of the financial statements. Of course, financial statements are littered with estimates, some more accurate than others. This is a necessary byproduct of GAAP, and the process of trying to summarize, as of a particular point in time, the value of a company, with its attendant complexities of assets and liabilities. However, I have not met many people, either inside or outside the Commission, who are truly confident the FASB Standard 123-R models, Lattice or Black-Scholes, provide good estimates of employee stock option value, especially for options distributed in a broad-based plan. That has been and continues to be a concern for me, particularly if these estimations are material and can be subject to management of the assumptions and outcome.
I am encouraged that market participants and the SEC are working together to develop a market-based options pricing model. Without getting into too much detail, the idea is to try to establish a security that mimics the characteristics of the option and tries to find a willing buyer and a willing seller for this security. There is no better way to determine what something is worth than to get people to negotiate to buy it. I am following this closely and encouraged to see that we are using the power of the marketplace to guide us to make reasonable, informed regulatory choices.
I would like to make one more point about this market-based valuation model. Some recent press reports have characterized this idea as a scaling back or a "discount" to Black-Scholes or Lattice. These characterizations are flawed. The FASB standard specifically allows market-based models to determine value of options. If a functioning market determines a value, then we need not compare that value to a number that is derived from any other existing model. Market value is real; a model is just an estimate. If you have any thoughts about this approach, I would welcome the opportunity to discuss it with you.
Lastly, I think that investors benefit from the heightened attention of the SEC and its actions especially if it this attention inspires them to focus more on investing and savings. Regardless of how the debate about social security reform turns out, it will have the salutary effect of encouraging Americans to think seriously about their retirement savings. We at the Commission need to be particularly diligent in ensuring that investors have many investment options, have ready access to understandable and reliable information about those options, and know where to turn for help if they have problems. I look forward to striving to fulfill these objectives.
It is safe to say that the upcoming year will be an exciting and important one for investors and the Commission. I would welcome your questions and comments. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thank you for your time and attention.