Speech by SEC Commissioner:
Remarks before the European Institute of the University of Gent
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 23, 2005
It is a privilege to be back in Brussels among friends and colleagues to discuss the changing landscape in which increasingly multinational corporations operate. Just as corporations can no longer afford isolationist thinking, so regulators are finding that they need to broaden their outlooks. Before the discussion begins, I must remind you that the views that I express here today are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
The issues that we are here to discuss are difficult. Securities regulators on both sides of the Atlantic must fulfill their responsibilities to the investors whom they are charged to protect. This mission is more complicated now that investors are routinely looking beyond their own borders for investment opportunities. Domestic regulators cannot blindly impose their regulatory regimes on foreign market participants. But, I am confident that if regulators and market participants work together, we can make the necessary adjustments to our regulatory systems so that there can be free flow of capital across borders.
In the United States, many children learn a poem that talks about the start of the American Revolution that talks about "the shot heard round the world."1 The Revolution had ramifications far beyond our shores. The Sarbanes-Oxley Act is a sort of corporate governance equivalent of the "shot heard round the world". With the implementation of Sarbanes-Oxley largely accomplished in January 2003 under Chairman Harvey Pitt, the U.S. government has completed the largest financial services regulatory initiative since the regulatory initiative from which the SEC was born. The changes that Congress mandated have had broad ramifications for companies across the globe. The pace of this new wave of regulation has been daunting for U.S. and non-U.S. companies alike, but I understand the unique concern of non-U.S. issuers that, under Sarbanes-Oxley, the SEC is unnecessarily treading on regulatory territory already within the sights of local regulators.
My concerns with respect to Sarbanes-Oxley are somewhat attenuated by the fact that the Act, to a large extent, requires corporations to disclose aspects of their governance models and then lets the market decide what value to give to different models. Although perhaps imperfect, Congress intended the Sarbanes-Oxley reforms to address the ways in which the system has failed to protect the individual investor and to eliminate the systemic weaknesses that created misrepresentations and skewed the transparency in the market. Broadly speaking, Sarbanes-Oxley reflects goals shared by Europeans and Americans with respect to strengthening corporate governance. Sarbanes-Oxley's promotion of independent audit committees, for example, confirmed a global trend toward setting up such audit committees.
In implementing Sarbanes-Oxley, the SEC sought and received comments from a wide variety of commenters, including the corporate community, as part of the process of adopting the rules. The SEC has hosted interactive roundtables on the application of the Act to non-U.S. issuers. We have met with foreign delegations and European securities regulators and non-U.S. issuers. Input from these meetings and from non-U.S. commenters led us to make a number of accommodations. For example, we have made changes to allow certain individuals, who might not qualify as independent under our definition, to serve as members of a company's audit or supervisory board. This accommodation recognizes, among other things, the German Mitbestimmung requirement pursuant to which leitende Angesellten - non-management employees - serve as members of a company's audit or supervisory board. We also allowed shareholders to select, or ratify the selection of, auditors and allowed the development of alternative structures such as boards of auditors to perform auditor oversight functions where such structures are provided for under local law. I look forward to continued European and worldwide input.
One aspect of Sarbanes-Oxley that I want to focus on for a few minutes is Section 404, which requires management to complete an annual internal control report and requires the company's auditor to attest to, and report on, management's assessment. The goals of Section 404 are laudable; good controls over financial reporting are critically important. But, the manner in which companies and auditors have implemented Section 404 has not necessarily furthered these goals.
Because these rules can require significant internal changes, the SEC has been flexible with respect to its implementation. Among other accommodations, we have extended compliance deadlines for non-U.S. issuers and did not preclude management from looking outside the U.S. for a suitable, recognized control framework upon which to base its evaluation of the effectiveness of their company's internal controls.
Now that many companies have made it through the trying first year of the 404 process, we need to look for lessons from the experience. This is an evolving process, one that I believe will take years to get right. Everyone greatly underestimated the costs involved in the 404 process. I do not think that shareholders should -- or could -- accept the prospect of years of costs like the one we just went through. Some of these costs might be one-time initial start-up costs, but others will recur from year-to-year. The important goals underlying Section 404 do not justify the expenditure of unlimited resources. Nor is it clear, as some have argued, that documentation of internal controls would have been able to prevent the type of collusive fraud by management that we have seen in recent corporate failures in both the US and Europe. Internal controls, which have been required in the U.S. since the 1970s, are a tool to assist financial reporting -- they are not a stand-alone goal and they are not an insurance policy against fraud.
I support good internal controls, but I am also very sympathetic to the concerns that I have heard about 404. Complaints seem to stem not from the statute or our SEC rule, but rather from the implementation of the PCAOB's Auditing Standard 2. There are differing views as to whether the PCAOB's AS2 is a workable standard. In any case, it is widely acknowledged that under AS2, corporate management and auditing firms have been much too conservative in exercising their judgment. People are driven by the impulse to document virtually every process in an effort to appear to be thorough and to avoid being second-guessed.
Having conducted internal control reviews in my days at an accounting firm, I have seen how easily this process, if not guided and managed properly, can spin out of control. Particularly in troubled situations, a control review can take on a life of its own and balloon into a massive project, with volumes of documents and process-charts that seem obsolete as soon as they are printed and distributed simply because a corporation is a dynamic, ever-changing entity. This paperwork sometimes provides little practical benefit, except to the accounting firm's bottom line.
Our recent day-long Section 404 roundtable provided some insight into the granularity that has characterized 404 reviews. We heard about a company determining that it has 60,000 key internal controls. Recently, the CFO of a large European company told me that the company determined that it had 500 key internal controls, but its outside auditor found 20,000 key internal controls. Regardless of whether the company was right in its assessment, I am confident in saying that the auditor was way off the mark. It is also troubling when accounting firms suggest that they were making materiality determinations at the segment, interim financials level. This is much too deep in the details; materiality assessments need to be made on an enterprise basis at the annual period level. In the current environment, it is no surprise that conservatism has ruled the day, but we need to make some changes if Section 404 is to achieve its goals.
People will not dare to rationalize their approach to the internal control process until both the SEC and the PCAOB have given them comfort that we will not continually second-guess their professional judgment. The SEC and the PCAOB, which both recently issued guidance, generally agree that there was overkill by auditors (and management) in the first year. Both sets of guidance acknowledge that more needs to be done in this area to encourage companies and their auditors to move away from the excessively granular current approach and towards a risk-based, top-down strategy.
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.
My hope is that eventually 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. The rules can 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 type of marketplace feedback that will encourage good internal controls. If my hopes are realized, Section 404 of Sarbanes-Oxley, which has easily proven to be the most expensive and most burdensome piece of Sarbanes-Oxley, it could be one of the most valuable parts of the Act.
The implementation of Section 404 turns a great deal on choices made by the Public Company Accounting Oversight Board. The Commission needs, as the statute requires, to keep a close eye on the PCAOB's activities. The PCAOB was created because of deep failings in the U.S. accounting profession's ability to regulate itself. The accounting profession fell down on the job and got what it deserved in the Act. The fact that the accounting profession "earned" this new oversight does not mean that the public should not closely monitor the PCAOB's actions. The PCAOB is a unique creature in Washington - it is a non-governmental, nonprofit corporation that, as you know, derives its substantial subsistence primarily from bills sent to approximately 8,500 public companies. Accounting firms also provide a small portion of the PCAOB's funding. In essence, this non-governmental organization has taxing authority. As such, it must be transparent and accountable to the taxpayers. We would be derelict in our responsibility to the investing public if we simply rubber-stamped the PCAOB's actions. I promise to take the SEC's oversight responsibility of the PCAOB seriously and hope that you will continue to monitor its progress.
Listing and Delisting in the U.S.
Neither the Sarbanes-Oxley Act nor implementing rules should dissuade a foreign company from considering a U.S. listing. Recently, a number of corporations in deciding not to list in the U.S. have suggested that Sarbanes-Oxley regulations were a deciding factor. The press is also full of stories that Sarbanes-Oxley encourages some non-U.S. listed companies to contemplate shedding their American listings. Our latest statistics as of the end of 2004, however, show a slight increase - eight - in the number of foreign companies registered and reporting with us as compared with the prior year.
Suggestions that the costs of compliance outweigh the benefits of being listed in the U.S. cause me great concern. Foreign listings not only benefit U.S. investors in the form of greater investment choices and diversification, but also provide foreign issuers with access to the U.S. capital markets and greater potential for making acquisitions in the U.S. If there are additional accommodations the SEC can make for non-U.S. issuers without undermining the objectives of Sarbanes-Oxley, we should do so.
That said, in order to make our markets attractive to foreign capital, we must enable foreign companies to leave if they wish to do so. Of course, the ease of a company's ability to leave the U.S. market has to be balanced against the protection of U.S. investors that committed capital to the company while it was here. Currently, deregistration is not available to a company that has more than 300 U.S. resident shareholders. Practically speaking, it is often difficult to determine whether a company meets this deregistration threshold because counting U.S. resident holders is difficult - most securities are held in street name with several tiers of intermediaries.
The deregistration issue has been discussed at length this year. Several European organizations wrote to the SEC asking the SEC to relax the deregistration rules. The organizations pushing for a change to our registration rules have acted in a constructive manner; they have submitted two specific alternatives for our consideration. The first focuses on ensuring post-deregistration protection by requiring that the companies continue to publish financials in accordance with IFRS and continue to report on corporate governance, accounting standards, and tax treatment of U.S. investors during a transition period. The second, instead of focusing on post-deregistration protection, focuses on the level of U.S. interest in the particular company. Deregistration would be available if U.S. interest in the company had decreased to certain levels.
This is an issue that SEC Chairman Donaldson has asked the SEC staff to study. The staff will not limit its consideration to the two alternatives described above, so you should feel free to give us other ideas. The SEC staff expects to have a recommendation for the commissioners before the end of the year.
As I am sure you know, for many many years, accountants, standard setters, and academics have dreamed of setting uniform, world-wide accounting standards. That dream is becoming more of a reality. Global markets certainly do exist - now more than ever before because of the forward march of technology and global trade. This globalization is driving the change.
The European Parliament and the Council of the European Union recently decided that all listed EU companies must prepare their financial statements, beginning in 2005, in accordance with International Financial Reporting Standards or IFRS. This decision by the EU to establish a widely-used set of accounting standards provides a critical step to make Trans-Atlantic convergence possible. It is much easier to converge two standards than twenty-five from each separate European country!
Before we talk about the necessary steps to bring about true convergence of U.S. GAAP and IFRS, it makes sense to step back and discuss the benefits of convergence. At the outset, it is important to note that this is largely a market-driven policy. Most issuers and investors alike recognize the benefits of having one cross-border financial reporting system. Of course, there might be some pressure to stay with the status quo. Some might view reporting under the new converged standard, with its inevitable changes and adjustments, as an unnecessary regulatory burden. It is a pain to get up to speed with new rules and practices. However, market forces will likely demand convergence because the benefits of it should outweigh the burdens. Similar concerns regarding costs of conversion greeted the birth of the Euro, but the benefits in terms of transparency, comparability, and simplification of trade have been dramatic.
The regulator's role in this convergence process is not to serve as the sole decision-maker. A regulator can help determine whether or not a standard is of high quality. A regulator can inform the public if a standard has derived from a process that gave market participants due process. Aside from these two primary roles, it is for market participants to decide if the standard is valuable to investors. In the area of convergence, market participants should decide what parts of each standard are the most useful and demand that those aspects of the standard remain in the converged standard. Thriving capital markets demand investor understanding and transparency.
Financial statements prepared using a common set of accounting standards can help promote better investor understanding. Comparability can assist an investor in making an investment decision. Comparable or uniform standards can also lower costs on participants. When non-U.S. companies seek to raise capital in the U.S., they have to spend large amounts of money to reconcile the company's home financials to U.S. GAAP. Money spent for auditors and personnel to perform this reconciliation process would be better used for the company's business.
As I am sure you can appreciate, it will take a lot of work before convergence of U.S. GAAP and IFRS will be a reality.
Currently, in order to raise capital in the U.S., a company's financials must use U.S. GAAP or reconcile to U.S. GAAP. This SEC approach to reconciliation is grounded in the Securities Act of 1933: regardless of the company's home country, investors should have the same type of information to make an investment decision about that company.
In 2002, proponents of convergence had a breakthrough. The IASB and the FASB signed the so-called Norwalk Agreement. I guess that we will have to leave it to history to decide whether or not to list Norwalk, Connecticut, up there with Vienna, Paris, Münster, and Versailles as sites of the signing of major international treaties. Only, instead of ending a war, this agreement bound both standard setters to employ "best efforts" to achieve convergence. They pledged to make their existing financial reporting standards fully compatible as soon as practicable and to coordinate future projects to ensure that once compatibility is achieved, it will be maintained.
So, that is the goal, and here is where things stand. As I mentioned before, this is the first year that EU participants registered in the U.S. will be using IFRS. We expect there to be over 300 filers using IFRS in the U.S. market.
At the SEC, we plan to study these filings and the reconciliations of IFRS reports to U.S. GAAP. We hope that our review of these filings will give us the comfort to eliminate the reconciliation requirement, without sacrificing investor protection. This review should take place in the second half of 2006. The SEC's Office of Chief Accountant has designated a senior official, who is charged specifically with international issues, to lead this project.
As this review is proceeding, the SEC will be meeting and speaking with investors, auditors, standard setters, and other regulators to learn and share experiences associated with the IFRS reconciliation. During the next few years, the SEC will continue to monitor future filings and continue to discuss how things are working with market participants. We seem to be on track for the SEC staff to be able to recommend to the Commissioners by 2009 or sooner that the reconciliation requirement can be eliminated.
On the other side of the Atlantic, things have progressed a bit differently. Historically, especially in the corporate bond markets, U.S. companies using U.S. GAAP have been able to raise capital abroad. No reconciliation to another accounting standard was necessary.
However, in the process that the EU has set forth for itself, the European Commission must determine whether U.S., Canadian, and Japanese GAAP is "equivalent" to IFRS. In April 2005, the technical committee in charge of this determination, the Committee of European Securities Regulators (CESR), came to an interesting conclusion in its draft recommendation on this issue. Its draft conclusion states that companies using U.S. GAAP need to add significant disclosure, in both narrative and numeric form, that compares U.S. GAAP to IFRS. In determining whether this disclosure is needed for a particular item, the company must determine whether the disclosure "would be significant to investors".
This could create problems for U.S. companies. Audit firms and market participants have been interpreting this "significant to investors" standard as requiring a full reconciliation of U.S. GAAP to IFRS, even though the proposal itself says that such a reconciliation is not needed. I hope that - and understand from my European counterparts that - this is a misunderstanding. Members of the SEC's staff are working with CESR to address this issue.
I am optimistic about the future in this area. You can easily see what is critical to this process - public input. While encouraging you to participate in this process, I want to emphasize that the goal is compatibility, not wholesale uniformity. The goal is not identical results, but rather close alignment and comparable results. This means more mutual recognition and equivalence, rather than absolute uniformity. Given differing cultures, business practices, and - most importantly - legal and tort systems, it is difficult for me to imagine a truly uniform regime, even if we start out with identical principles.
It is crucial that the SEC obtain information from foreign issuers and practitioners about this process. Speak now, or forever hold your peace! This is a pivotal moment for those in the accounting world.
Later today you will be talking about the trans-border reach of the courts. American litigation is certainly an unwelcome prospect. I have talked with representatives of non-U.S. issuers who have raised concerns about the tremendous cost of litigation in the U.S. This is a legitimate concern, and one shared by your U.S. counterparts. The SEC can do its part by, for example, not taking steps that turn disclosure documents into litigation documents. We should also undertake a fundamental review of our rules that help to shape disclosure documents in that direction.
Finally, some of you might have heard that SEC Chairman Donaldson is planning on leaving the Commission at the end of the month. You may be wondering how the change in leadership will affect the Commission's agenda and its approach to issues, including those of particular interest to you. I cannot speculate about how or whether the SEC's agenda will change, but the President has named Representative Chris Cox as Chairman Donaldson's successor, subject to Senate confirmation. I look forward to working with him if he is confirmed.
Thank you for your attention. I look forward to discussing these issues with you and my co-panelists. I hope that the dialogue continues beyond the confines of this panel. I have a plane to catch in a few hours, so I will not be able to stay around for the rest of your meeting, but I look forward to working with you in the months to come to address your concerns and to get your input on current regulatory initiatives. International cooperation in these regulatory matters will benefit all of us in the long run.