Speech by SEC Chairman:
Remarks from Directors College at Stanford University Law School
William H. Donaldson
U.S. Securities and Exchange Commission
June 20, 2004
Thanks Joe, and thanks for inviting me to join you to help you kick off this year's Directors College. This is my second appearance before this esteemed group. I had the pleasure of attending over a year ago, a few months after becoming SEC Chairman.
You have assembled a distinguished group of speakers, and have organized the program to allow for targeted discussions of some of the most pressing issues facing directors at publicly-traded corporations. As directors, you are well positioned to initiate and implement the corporate governance reforms necessary to restore investor confidence and prevent a repeat of the corporate failures we've seen in recent years. As all of you know, a collective reassessment of the role of corporate boards is underway, with a shift away from the Imperial CEO model of the 1990s and toward great responsibility and authority for directors. I will have more to say about this later in my remarks. Before I go any further, let me issue the standard disclaimer that the views I express here are my own and do not necessarily represent those of the Commission or its staff.
When I became SEC Chairman, I put forth five goals: restore investor confidence, hold accountable those who have violated the public trust, make the securities markets more efficient and transparent, implement structural changes to the Commission that would help it become more anticipatory, and promote responsible corporate governance. These objectives are fundamental to the foundation of our securities markets. It was clear that the work to advance them would be challenging, not to mention urgent. The corporate landscape was littered with high-profile failures, scandals had come to dominate the business news, and equity markets had plunged. Beyond that, there were compelling signs that shortcomings in the performance of corporate leaders were more pervasive - making the numbers, managing earnings in "good" ways, and other troublesome practices seemed too common and, even worse, there were signs that this sort of unacceptable behavior was on the verge of becoming accepted practice.
The cumulative effect of all this produced a crisis of investor confidence, which in turn led to a demand for corrective action. The enactment of Sarbanes-Oxley marked the beginning of a new era for American business. The SEC staff has skillfully implemented the many different provisions of the landmark law. The process has been marked by the Commission's focused rulemaking in a number of areas, augmented by efforts aimed at cleaning up after corporate scandals, and tackling the wrongdoing in the mutual fund industry. At the same time, we are seeking to adopt regulations for governing the functioning of our securities markets, which are becoming more technical, active, and global. While the job is not complete, I believe we have made real and lasting progress toward reform and in so doing, toward restoration of investor confidence.
Let me begin by talking about some of these initiatives and accomplishments since I was here a year ago, and then move on to a few comments on the vital issues of corporate governance that have brought you all together for this conference.
Internal Reforms at the Commission
Upon becoming Chairman, internal reform of the structure at the Commission has been one of my top priorities. It was clear to me that we needed to devote more time and energy to anticipating potential problems across the corporate and financial industries before they occur. While I have referred to this effort as "looking over the hill and around the corner" for the next emerging problem, what we're really referring to is a systematic and philosophical approach to risk assessment embraced by the Commission. It is an effort to anticipate "red flags" and address upcoming problems before they happen - instead of arriving at the scene of the accident after it has occurred.
To do this has required a complete reevaluation of how the SEC should function - to foster an unprecedented level of communication, coordination and cooperation between staff in the divisions and offices. Thanks to significant budgetary help from Congress and the President, we have been able to hire over 840 professionals for the Commission's staff.
We have initiated a new program of risk assessment, with multi-discipline teams drawn from inside the agency, designed to be integrated with our new Office of Risk Assessment and Strategic Planning, the first of its kind at the Commission. The goal is twofold: to become better equipped to anticipate potential problems, and then to seek to prevent these problems from infecting our markets.
Our first priority has been to infuse the agency's various divisions and offices with a commitment to risk assessment in their own spheres of responsibility. We have organized internal risk teams for each major program area. This framework allows for a bottom-up approach to assessing risk in each of our divisions. A good example of this approach can be found in our Office of Compliance Inspections and Examinations, where our front-line examiners across the country produced a complete "risk map" of potential problems -- new or resurgent forms of fraud and illegal or questionable activities -- in the mutual fund and broker-delar industries.
I believe the risk assessment initiative will influence all of our work in the agency - from enforcement, to examinations, to rulemakings, to our review of required filings. It will arm senior managers at the Commission with the information they need to make better decisions and to proactively adjust operations, resources, and methods of oversight to address new challenges and prevent new problems. The initiative will also help foster better communication, coordination, and even cross-fertilization between the divisions and offices within the Commission.
A different illustration of our effort to encourage this communication, coordination, and cross-fertilization is the creation of policy task forces. These task forces bring together staff from various divisions and offices to brainstorm, evaluate, and create policy options that will help us undertake issues of emerging concern in protecting our securities markets. Currently, there are six such task forces tackling a number of important issues: soft dollar arrangements, bond market transparency, college savings plans, or the so-called 529 plans, self-reporting regime for mutual funds and self-regulatory organizations (SROs or markets), and, over the longer haul, our entire disclosure regime. The task forces are meeting with relevant, interested parties such as individual investors, industry representatives, and fellow regulators to gather critical intelligence and data, and then they will produce policy options designed to address problems over the long haul.
Enforcing America's Securities Laws
Critical to the Commission's work, of course, is the enforcement of America's securities laws. In the past year alone, the Enforcement Division has brought charges of misconduct against 12 of the 25 largest mutual fund complexes. The division also filed more enforcement actions in the previous fiscal year than in any other year on record (679), and this year has already obtained orders for more than $2.2 billion in penalties and disgorgements.
I cite all of these numbers only as measures of just how pervasive malfeasance has been in recent years, and of the impact of the expanded enforcement powers vested with the SEC thanks to Sarbanes-Oxley. Those expanded powers are not only helping us to pursue wrongdoers, but also to return to investors a portion of the penalties we impose against firms, through the Fair Fund provisions.
While aggressively pursuing wrongdoing, the Division's core code is to execute its mission in a manner that is both forceful and fair. I believe we are delivering on this imperative.
Market Structure Reform
The Division of Market Regulation is tackling a number of critical issues - none more important than addressing changes in the structure of America's equity markets. As our financial markets continue evolving due to new technologies, new market entrants, and changing investment patterns, the Commission must monitor these changes and ensure that the regulation of the market structure remains up to date.
In February, the Commission proposed Regulation NMS - National Market System - which is a comprehensive package of rule proposals aimed at modernizing the national market system that Congress mandated in 1975. In brief, the proposed regulation would modernize trading rules, establish greater consistency in access fees, ban the display of sub-penny quotes in most stocks, and alter the rules concerning how market data is disseminated and priced.
Reform the Mutual Fund Industry
A particularly urgent priority for the Commission has been our efforts to reform the mutual fund industry. Over the years we have all seen isolated cases of wrongdoing here and there. But I think everyone was shocked to discover the complicity of certain elements of the industry in condoning widespread unethical and illegal practices.
The Commission has moved swiftly and forcefully in this area, considering 12 new mutual fund rulemaking proposals - all of which, taken together, seek to strengthen the governance structure of mutual funds, address conflicts of interests, enhance disclosure to mutual fund shareholders, and foster an atmosphere of high ethical standards and compliance within the industry.
On Wednesday, the Commission will consider for final approval a rule to bolster the effectiveness of independent directors and to solidify the role of the fund board as the primary advocate for fund shareholders. The rule includes a requirement for an independent board chairman and a board on which at least 75 percent of the directors are independent. The proposal also solidifies the role of the fund board as the primary advocate for fund shareholders.
Conflicts of interest are inherent in the mutual fund context, where the interests of fund shareholders are not always aligned with the interests of the adviser or the adviser's shareholders. The Commission recognizes that there are interested fund chairmen who strive to represent the interests of fund investors in the boardroom while also serving as executives of the fund's adviser. But no matter how hard they try, they cannot eliminate the inherent conflicts of interest. When the Chairman or CEO of a mutual fund's adviser is simultaneously serving as the Chairman of the mutual fund itself, this individual is put in the untenable position of having to serve two masters. On the one hand, he or she owes a state-law-imposed duty of loyalty and care to the mutual fund, augmented by the Investment Company Act requirement that the fund must be operated solely for the benefit of the fund's shareholders. On the other hand, he or she owes a separate duty of loyalty and care to the shareholders of the fund's investment adviser. It is easy to see that these two duties are often in conflict; for example, consider the conflict that necessarily arises when it comes to setting the level of fees the fund will pay the adviser.
Registration of Hedge Fund Advisers
It has been hard to miss the media coverage concerning the SEC's attention to hedge funds, and the role several prominent hedge funds played in recent mutual fund scandals. Given the rapid rate of growth in hedge funds, the size of their assets - about $800 billion and rapidly approach $1 trillion - and the involvement of some hedge fund managers in illegal behavior, the Commission staff is evaluating a form of registration and an oversight regime for hedge fund managers.
The goal is simple: to enable the Commission to collect more accurate information about this important industry, and better target our inquiries to those hedge fund managers where there is some reasonable concern that they may be violating the federal securities laws. There is no desire to regulate how hedge funds make their investments, to require disclosure of their methods, or to choke off their expansion, as hedge funds have an important role to play in our equity markets.
Improving Governance Generally
I want to turn to the Commission's rulemaking on governance issues, but first I'd like to say a few words about how we should all think about SEC rules versus our own responsibilities.
It is important to remember that the Commission's rules have never been enough, are not enough today, and will never be enough in the future to ensure that our markets and our corporations are clean and ethical. What's really needed is a change in mindset - a company-wide culture that fosters ethical behavior and decision-making. Creating that culture means doing more than developing good policies and procedures, doing more than installing competent legal and accounting staff, and doing more than giving them resources and up-to-date technology. It means instilling an ethic - a company-wide commitment to do the right thing, this time and every time - so much so that it becomes the core of what I call the essential "DNA" of the company.
Companies, management, their gatekeepers, and above, all, their directors, must look beyond just conforming to the letter of the new laws and regulations. They must redefine corporate governance with practices that go beyond mere adherence to new rules and demonstrate ethics, integrity, honesty, and transparency. The recent shifting of primary corporate governance responsibilities to corporate boards demands that directors be the true stewards of corporate governance, and their actions must demonstrate their dedication to this stewardship without undue interference from the CEO and other members of management.
One litmus test for this new board stewardship of corporate governance involves executive compensation. In making compensation decisions, boards and compensation committees must focus above all on long-term performance. And directors should examine their dependence on management and compensation consultants when making decisions about compensation for the chief executive and other senior management. The conventional wisdom of many corporate boards these days has become that in order to remain competitive, executive compensation must be in the top quarter of companies in their industry. But we don't live in Lake Woebegon, where as Garrison Keillor says, "All the women are strong, all the men are good looking and all the children are above average." Rather, it is the job of the board to set appropriate compensation that is related to the goals and performance of top management, not the pressure to meet an artificial standard informed by outside consultants who do not share the responsibility of being board members.
Some have said government should rein in the high pay of CEOs. I don't believe that the government should intervene to set compensation levels, but I do believe that company boards must show greater discipline and judgment in awarding pay packages that are linked to long-term performance. I would like to see a much broader definition of performance - performing an evaluation that goes well beyond EPS and other financial measures, to identify what management excellence, and hence reward, is all about.
Of course, we can in fact support your stewardship efforts through focused and fair rulemaking by the Commission. We have labored hard to meet this standard at the SEC - all against the backdrop of a decade in which corporate governance was often grossly inadequate, and sometimes failed completely. Sarbanes-Oxley and all the rules we have adopted to implement Sarbanes Oxley have helped to correct these failures, and have forced a reassessment of the role of the board of directors in particular. At bottom, all these legislative and rule changes have reinforced the notion that the responsibilities of directors must be partially redefined, with the objective that directors should finally emerge from the long shadow of the Imperial CEO and should assert their oversight authority in corporate decision-making.
And when we looked at how directors should be elected to these refocused and reenergized corporate boards, we realized that the proxy process needed some critical attention. In the pre-Sarbanes-Oxley world, overly compliant boards of directors often allowed management almost unfettered control over many critical governance issues, including over the proxy process related to nominating and electing directors. As a result, some company boards and management would completely ignore dissatisfied shareholders in the proxy process. Immediately after the annual meeting, shareholder resolutions passed by a large plurality or a majority of votes cast were just disregarded and never implemented. And when significant numbers of company shareholders expressed their disapproval of management's director nominees by withholding their votes, management and the incumbent board ignored the withheld votes too. Management and boards refused to respond in any demonstrable way to a clear expression of dissatisfaction of large numbers of shareholders.
The Commission took the first step to address this issue head-on last fall, when we adopted new standards to address the breakdown in shareholder communications by improving corporate disclosure in two areas. First, improved disclosure regarding the process by which nominating committees consider director candidates, including those recommended by shareholders. And second, improved disclosure about the processes by which security holders could communicate directly with members of the board. We hope that the transparency created by these standards will help produce more communication among management, directors, and shareholders generally, but especially with respect to the nomination of candidates for boards of directors.
A second step the Commission took to address the issue is a proposed rule that would require the inclusion of shareholder nominees in the company's proxy materials, under limited circumstances and only upon the occurrence of certain triggering events.
Consider the situation faced by a sizeable group of shareholders who are committed to the long-term prospects for a certain company, but who confront a company management that refuses to respond to, or even communicate about, the shareholder group's concerns. The dilemma is that the shareholders have only two practical choices. First, they can choose to cease being committed to the long-term health of the company; in other words, they can sell their stock. Under this choice, they would be forced to give up their belief that with some modest changes in company direction, the company could be more successful in its markets and could therefore be an extremely productive investment over the longer term.
Their second - and only other - choice is to wage an extremely expensive proxy fight. This contest could be for the entire board of directors or for only some seats on the board - a so-called "short slate." In either case, the proxy fight takes on the trappings of a contest for control. Under this choice too, therefore, the shareholders would be forced to give up their belief that modest changes in company direction could produce the long-term benefits they seek. Instead, they are forced to divert the company's resources away from the business they're building, to the proxy fight they're waging - the last thing the shareholders really want for the company's future.
The proxy access proposal under consideration by the SEC is an attempt to find a middle ground between the extreme choices of forcing shareholders to give up their long-term interest in the company and sell their stock, on the one hand, and forcing them to wage a wasteful proxy fight on the other. It is an attempt to find a middle ground that would, under certain restrictions and limitations, provide shareholders having a true interest in the long-term health of the company, with a more effective proxy process that gives them a better voice in this nomination and election of the board of directors. In essence, it is an attempt to encourage management and long-term shareholders to communicate more effectively with each other about the company's future.
The current proposal is important, but complex and controversial. Unfortunately, the controversial aspect threatens to overshadow the importance of what the Commission is trying to accomplish. There are strongly held views on all sides of this issue. While we welcome the expression of all views - that is the essence of our notice and comment rule-making process - the escalating, shrill, and fearful rhetoric on all sides of this issue has drowned out thoughtful discourse and comment. Those who believe that our proposal is a serious and unwarranted threat to the operation of boards and those who believe that our proposal does not go far enough in giving shareholders a more effective proxy process have gone well beyond the bounds of thoughtful and sensible comment.
For example, some proposed offering the company a chance to "cure" the shareholder communication problem on its own - that is, if a majority of shareholders withheld their vote for an incumbent director, the board nominating committee would be empowered to replace the "withheld" director with a new director more acceptable to the shareholders. In response, a prominent publication quoted someone summarizing the proposal like this: "If Bozo A gets voted down, the nominating committee can substitute him for Bozo B." Similarly, a corporate governance activist has derided this idea as doing no more than replacing "Tweedledum with Tweedledee."
On the other side, the Business Roundtable has said this one modest change in the proxy rule would, and I quote, "put companies, shareholders, and the economic recovery at risk." The U.S. Chamber of Commerce has said that the proposal "could seriously impair the competitiveness of America's best companies [and] put proprietary business information at risk."
That this is an election year doesn't help. Reports that this is a partisan political issue miss the point entirely. Republicans and Democrats alike are on all sides of this issue. Politics must not be allowed to drive the public debate or the Commission's deliberations on this matter, or any other. The imperative here is to approach this issue - like all others - in a thoughtful, measured way and to try to do the right thing for the corporations and shareholders who own them.
I remain committed to responsible and constructive change in this area, and will proceed thoughtfully and carefully. Our goal is the right course, rather than a hasty, less thoughtful course. We will not be forced to act in the face of an artificial deadline. However, after 60 years of repeated Commission consideration of this topic, the time has come for sensible, balanced, and constructive debate leading to action designed to improve our proxy process for the nomination of directors.
So I would encourage you - and the companies you serve - to avoid unproductive rhetoric and focus rather on the central problem the proposed rule addresses - how to find a middle ground between the extreme choices of forcing shareholders to give up their long-term interest in the company and sell their stock, on the one hand, and forcing them to wage a wasteful proxy fight on the other. Let's not mock those who struggle to find this middle ground. And let's not proclaim the end of American economic competitiveness if any such middle ground were found. Instead, I would ask you and your companies to provide thoughtful, meaningful input that will help the Commission arrive at an effective, workable solution that will benefit investors, our companies, and our markets. Frankly, they deserve nothing less.
I am encouraged by the work the Commission staff has set in motion, on a range of issues, as well as the work it has completed. And I know this has been a difficult period for everyone working in or around American business. The past five years or so have had more peaks and valleys, and general tumult, than any other equivalent time period in recent memory. Extraordinary wealth has been created, and destroyed, during this period. Regaining the confidence of all investors will still take time, but I believe the pendulum is swinging in the right direction, and by working together we will win back this confidence.
I want to thank Joe Grundfest and the Directors College again for giving me this opportunity to speak today. This forum is helping to foster the important discussion on what should be done to strengthen the mores of corporate America and how to help our markets resume their primary role as an engine of prosperity -- for people in the United States, and throughout the world.