Speech by SEC Commissioner:
Remarks Before the Exchequer Club
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
July 16, 2003
Good afternoon, and thank you for inviting me. It's always a pleasure to speak to a group of longtime friends and colleagues. Before beginning, I should note that the views I express are my own and not necessarily those of the Securities and Exchange Commission or its staff.
This month marks the one-year anniversary of Sarbanes-Oxley, a statute that demonstrates how complex and expensive the job of cleaning up Wall Street has become. Consider, in simpler times, that the mayor of New York City was able - quite literally - to clean up the street for 7 pounds, 11 shillings, and one penny. That is how much it cost in 1788 to clean and repair the Wall Street sewer system.1 And, according to Financial History magazine, "[a]s late as the 1840s, thousands of pigs roamed the streets of New York. Their job was garbage consumption."2
Over the course of the past year, our task has required a somewhat more sophisticated approach. I don't want to bore you with a litany of everything we've accomplished under Sarbanes-Oxley - I'm sure you are well aware of all our new rules designed to improve corporate governance, disclosure and professional responsibility. I do want to touch on two current issues related to Sarbanes-Oxley, and then briefly highlight just a few of the many other significant issues we face in carrying out our mission of protecting investors and the integrity of our markets.
What I hope we, as a Commission, have accomplished with our rules and public statements is a heightened consciousness on the part of all market participants that we have had some serious breakdowns, that failures occurred on many different fronts, and that everyone must now be part of the solution if we are to regain trust in our markets for the long term. Companies must improve their governance, disclosure must be clearer, gatekeepers must be more independent and diligent, investors need to be better informed, and regulators need to be more proactive.
Hopefully, through our rules and enforcement actions, we have instilled in company executives and their advisors a reasonable balance between wanting to do the right thing, and fear of doing the wrong thing, that will generate appropriate corporate behavior going forward. My conversations with corporate executives in recent months suggest that, for the most part, they understand what needs to be done. With a lot less complaining than I would have expected, they appear to be taking appropriate steps to meet both the letter and spirit of our new rules and market expectations.
I. Interaction Between Internal Control and Auditor Independence Rules
One area where I am concerned that the message has not quite taken hold relates to the interactions between the new internal controls report required under Section 404 of Sarbanes-Oxley and the auditor independence rules. The Commission's rules require that management report on the effectiveness of the company's internal controls over financial reporting, and that the company's auditors attest to the appropriateness of management's report. When we promulgated the rules under Section 404, I questioned how deeply involved independent auditors could be in the design, implementation and documentation of internal controls - and still maintain their independence.
The simple answer is that while auditors must assess internal controls as part of their audit, and while they can generally assist management, the design and implementation of internal controls must remain management's responsibility. Throughout the attestation process, the auditors must be independent, which means they cannot have usurped management's responsibilities, or be reviewing their own work. It is certainly not appropriate for an auditor to condition the attestation on the use of a proprietary software package or other services offered by the auditor.
Which brings me to a related issue involving audit committee oversight of non-audit services. I can't state strongly enough that anyone who reads our auditor independence rules as giving the green light to all non-audit services that are not specifically prohibited badly misses the point. The new rules make clear that, while it is not per se a violation for the auditor to provide some non-audit services, there are situations in which those services can still impair an auditor's independence. Accordingly, the rules require that the audit committee carefully scrutinize each proposed non-audit service, and make an informed judgment about the impact it might have on the auditor's independence. A process that allowed, for example, pre-approval of a basket of non-audit services would be contrary to the Sarbanes-Oxley requirement that the audit committee pre-approve each service.
Our independence rules struck a balance. In the interest of allowing audit committees to make their own judgment on whether certain non-audit services were in the best interest of the company, we hesitated to impose a "red" light on all non-audit services. However, the intended result was at most a cautious "yellow," and certainly not a "green" light. Auditors should not approach this issue as business as usual, and audit committees should bring a healthy skepticism to the process of approving non-audit services. The Public Company Accounting Oversight Board will be holding a roundtable on July 29 to examine internal control standards and attestation, including these issues. I hope that the outcome will be a better understanding of the meaning and intention of the rules, as well as rigorous standards for auditors providing these attestations.
II. Principles-Based Accounting Standards
Turning to the next topic, the Commission soon will be releasing its report on moving towards a more principles-based approach to setting standards for financial reporting. It is a topic that the international accounting community is dealing with as well. As a general proposition, this is a move I have been in favor of, although, as is often the case, the devil is in the details. The study should help advance the discussion of whether a more principles-based system is beneficial and feasible.
One of the issues we will need to address along that road is that the current reporting framework, with its numerous rules and even more numerous exceptions, can result in the presentation of financial information that does not reflect a company's true financial condition. As an economist, I have a problem with accounting standards that can result in financial reporting that bears little or no resemblance to the economic reality of an underlying transaction.
Furthermore, I believe the drift toward a rules-based system has accelerated. There has been a snowball effect of standard-setters trying to come up with ever-more-specific rules to deal with increasingly complex transactions, and reporting companies coming up with ever-more-complex transactions to avoid the rules. Complying with the complicated maze of rules and interpretations that comprise Generally Accepted Accounting Principles seems to have become an end unto itself, rather than a means of providing useful information to investors and other end-users. Even worse, aggressive interpretation, technical compliance and gamesmanship have in too many instances replaced full disclosure and transparency as the guiding principles for financial reporting.
Should we decide to pursue a more principles-based approach, there are, to be sure, some significant issues that will have to be addressed along the way. For example, we need to make sure that the principles are not so broad that they fail to provide enough guidance to those who prepare and audit financial statements. In addition, the principles must be sufficiently well defined so that they can be applied in a manner that allows for comparability across companies. I don't think anybody envisions that "principles-based" means loose rules that give unfettered discretion, but deciding how much detailed guidance to provide can be more art than science.
In addition, we need to update the overall conceptual framework for financial reporting. The current reporting framework does not capture many of the performance metrics and key measures of opportunities and risks that reflect the complexities of modern business. Changing a framework that has become so engrained in the financial reporting community is a daunting task. To accomplish this, the accounting profession itself will have to be a driving force for positive change. There has been some encouraging evidence that the profession is open to exploring ways to improve the quality and transparency of financial reporting. That's a good sign since, as the old Chinese proverb goes, "A journey of a thousand miles begins with a single step."
To be sure, a more principles-based set of accounting standards is not a cure for all of our financial disclosure problems. A principles-based approach - perhaps even more than a rules-based approach - will be successful only if management, auditors, lawyers and investors act in good faith to foster a culture that values transparency and economic reality in financial reporting. However, given the problems with the current system, it is certainly an appropriate time to explore in a serious way an alternative approach.
III. Looking Forward: Proxy Rules, Hedge Funds, Market Structure and Other Issues
In terms of the Commission's agenda going forward, we have some significant policy decisions to make. I will focus on just a few: proxy votes on shareholder director nominees, hedge funds, market structure issues, and the regulation of credit rating agencies. I'll also give you a brief update on our progress on the bank broker rules under Gramm-Leach-Bliley. I wish I could report to you that we had good resolutions of all of these issues, but there is a lot more work to be done before we reach that point.
A. Shareholder Participation in the Nomination of Directors
Just yesterday, the Commission's Division of Corporation Finance issued a report examining shareholder participation in the proxy process for nominating and electing directors. Chairman Donaldson called for a review of the rules in this area in April, and we received over 650 comments in response. An effective proxy process has never been more important, and increasing corporate directors' responsiveness to shareholder concerns is critical to restoring investor confidence. In response to the comments, the Commission's staff has suggested a number of alternatives for improving shareholder involvement in the nomination and election of directors, including:
- requiring companies to include shareholder nominees in the company's proxy materials under certain circumstances. (This will require us to consider whether there should be events that trigger expanded access, what other eligibility requirements to impose for expanded access, and whether there should be special procedures to ensure that the nominee is qualified.);
- requiring expanded disclosure regarding the nomination process, with possible listing standards requiring nominating committees to consider shareholder nominees; and
- requiring expanded disclosure of shareholder communications with the board, with possible listing standards to provide shareholders increased access and ability to communicate directly with board members.
We anticipate that the report will stimulate a lot of discussion. It also provides a basis for soliciting comments on possible rule proposals.
B. Hedge Funds
On another topic, the Commission recently held a two-day roundtable on hedge funds, and we will be issuing a report of our findings. The roundtable surfaced a number of fundamental issues surrounding the topic of hedge fund regulation. From my perspective, here are some of the key questions:
- Should these complex investments be available to retail investors at all? If so, what restrictions, if any, should be in place? Should the funds or their managers be registered?
- Are investors in these vehicles getting the information they need? This is a question that becomes more important as hedge funds become more available to retail investors, since most institutions can obtain the information they require.
- Should we remove some of the regulatory impediments imposed on mutual funds so that they can offer similar strategies to retail investors?
- What are the high-risk areas in terms of fraud, and how do we best guard against those risks becoming reality?
- And all of these issues are bound up in the overarching question of whether, under the current regulatory framework, the Commission can get the information it needs to carry out its mandate to protect investors and the integrity of the markets.
These are some very important issues the Commission will be wrestling with regarding hedge funds.
C. Market Structure
Market structure is another area where there is no shortage of difficult questions that the Commission needs to answer. During my tenure on the Commission, securities market structure issues are among the most difficult I have encountered. For one thing, market structure issues seem to give rise to more than their fair share of unintended - and unexpected - consequences. Analyzing market structure issues is sort of like sitting on a beanbag chair - as you settle comfortably into one area, it seems to push out in unpredictable ways in all different directions. The securities markets have changed dramatically in the last 25 years, and concepts and rules that were established a quarter-century ago may no longer be relevant, and indeed may stand in the way of progress and even be counter-productive.
Despite the difficulties, the Commission obviously is going to have to deal with some significant market structure issues, including the Nasdaq exchange application, access fees and market data revenue - just to name a few. I believe we need to address these issues in a holistic way, and not take a piecemeal approach. And, while we don't want our rules to impede competition or stifle innovation, we always have to keep paramount our obligation to protect investors and the integrity of the markets.
D. Other Items on the Agenda: Credit Rating Agencies and Gramm-Leach-Bliley
Two other market regulation issues are high on the Commission's agenda. We issued a concept release on the NRSRO (Nationally Recognized Statistical Rating Organization) designation for credit rating agencies in June, and we are still receiving and reviewing the comments. There are two paths we can take - one is to stay in and the other is to get out of the rating agency designation business. If we decide to get out of the business, we will have to consider what other regulatory regime would be substituted or if a regulatory regime is even needed, and how to extricate ourselves in an orderly way. If we stay in the business of designating NRSROs, then we will have to consider whether additional oversight is needed, and, if so, what type. We will also need to improve the transparency of our process.
On the Gramm-Leach-Bliley front, we passed final rules implementing the dealer exemptions, and have moved on to the more difficult implementation issues under the broker exemptions. As we did with the dealer issues, we will be meeting with bank legal and operational personnel and bank regulators to seek input on the issues involved. We want to be sure we understand the operational implications of any proposed rules, and look forward to continuing to receive constructive input.
That's a thumbnail sketch of some of the significant items on the Commission's agenda. So much for the idea that things would be boring after we finished passing the rules required by Sarbanes-Oxley!
And speaking of Sarbanes-Oxley, although we have written essentially all of the rules, I do not view that rulemaking process as complete for two reasons. First, we will continue to look at whether all who have critical responsibilities under our rules for ensuring the integrity of our markets are acting consistently with the letter and spirit of the rules. If not, we will not hesitate to pursue vigorous enforcement actions, and to revisit the rules as necessary. Second, however, it is also important that the Commission hear from companies and the public as to how the rules are operating in practice. I know the people in this room will not be shy about telling me if our new rules are resulting in unintended consequences, and about sharing your views on what we can do better.
Thank you. I am happy to answer your questions.
||Sanford J. Mock, "Cleaning Up on Wall Street," 61 Financial History 32, 32 (Winter 1998).|
||Id. at 33.|