Speech by SEC Commissioner:
Remarks at the Federalist Society
20th Annual Convention
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
November 14, 2002
Thank you, Ms. O'Connor for your kind introduction. It is truly a privilege to be here speaking with you today. The Federalist Society is an organization that I respect and admire. It is a pleasure to be here today to talk with you about the current environment of the SEC.
As you know, I am today standing in for our chairman, Harvey Pitt. I would first like to say a few words about him. He accomplished much in his tenure as chairman and I have learned very much in our short time together. He always demanded the most efficient and effective use of the SEC's limited resources during a time of unprecedented strain. He is committed to sensible regulation. Despite what you may have read in the papers, he is a collegial man, and he has a wonderful sense of humor. Harvey's commitment to this agency and its mission will be difficult, if not impossible, to match.
I'd like to share some statistics that I recently read. These are troubling:
- According to a recent Gallup poll, 70% of U.S. investors stated that business accounting issues were hurting the investment climate "a lot."
- Only 51% of polled employees told Gallup that they agree with the statement that the people that run most companies are "honest and ethical."
- Corporate executives are now at the same "trust" level as accountants, lawyers and, believe it or not, politicians.
In the past year, investors have been confronted with spectacular failures of several large corporations because of bad accounting practices. Corporate managers have engaged in what some argue amounts to theft of the private property of the owners of their corporation. These scandal-ridden companies have earned their infamy. The largest failures fed the disappearance of approximately $5 trillion in market capitalization from the U.S. capital markets since its high in March 2000. That translates to almost $60,000 per U.S. household. Investors, confronted with rapidly dwindling retirement savings accounts were disgusted and clamored for action. Politicians of all stripes began to focus on the SEC, especially in the context of what some saw as a referendum on the current Administration. "Corporate Responsibility" became a national political issue, for the first time in perhaps 70 years. In late July of 2002, Congress passed the Sarbanes-Oxley Act, with only 3 members voting "no."
When the President nominated me as a commissioner last December, I could not in my wildest imagination have foreseen all that has transpired at the agency since then. As Ms. O'Connor said, I used to work in the SEC chairman's office under Chairmen Breeden and Levitt. In those misty days of yore, I remember calling over to the White House or Capitol Hill and introducing myself as calling from the SEC. Invariably, I would be asked if I meant the FCC or FTC. No, I replied, the Securities and Exchange Commission. "Is that a government agency?" I would be asked.
Those days have certainly changed. I have not seen a poll on this subject, but I would bet that a very high percentage of Americans today know about the Securities and Exchange Commission. I was stunned recently when an airport security man in Atlanta saw "SEC" on my laptop and asked me if I worked at the Securities and Exchange Commission or with the South Eastern Conference. A year or so ago, I'm certain he would have assumed I worked for the football conference. In truth, I'll bet that he was hoping that I could have revealed some inside information about the Georgia Bulldogs' next game instead of inside information about recent rule promulgations under the Sarbanes-Oxley Act. But, alas, his knowledge about my employer did reaffirm my belief that these are unique times and that the SEC has gone mainstream. Whether or not this is a good thing is a debate for another time.
It is certainly true that the relative anonymity with which we were able to operate and seek to discharge our responsibilities is gone. People outside of Washington DC have heard of us - and they now expect a lot from us. And believe me, as we tackle the long list of what we call "homework" that Congress has given us to do in Sarbanes-Oxley, we will never forget our primary mission: protect investors and maintain the integrity of the securities markets.
Crises - especially of the financial variety - have yielded a legislative reaction many times in our past. Professor Robert Higgs wrote a book a few years ago that I am sure many of you in this room have read, called Crisis and Leviathan. His primary thesis is that government's command-and-control system of resource allocation expands at the expense of the private-sector cost-revealing market system when government responds to an insistent but ill-defined public demand that it "do something" about a crisis. He traces a number of crises in our history - some financial, some military - and reveals how the market sector has given way in those cases.
We are now at such a crossroads. In response to investor outrage and political pressure, Congress enacted the Sarbanes-Oxley Act. It is sweeping legislation intended to hold corporate executives and auditors more accountable to the shareholders of public companies. It calls for a re-examination of our corporate governance structure and seeks to fill in the holes that have left investors out in the cold.
We are, of course, charged with implementing this new law. As we move forward to accomplish this task, I believe we must constantly remind ourselves that that investors need to believe that auditors of public companies are unconflicted, ethical, and acting in the best interests of shareholders. Investors also need to believe that corporate officers are honest and have the best interests of their companies and stockholders in mind, not just what is good for their own wallets. They need to know that their representatives on corporate boards are actively guarding their interests. And, most of all, investors should be able to rely on the financial reports issued by public companies to present a clear and accurate picture of the financial health of those companies.
With those bedrock principles in mind, the challenge that we face at the SEC is to avoid simply reacting in an effort to "do something", instead of trying to address and remedy the underlying problem. Frederic Bastiat in his book, Loi, famously warned of the dangers of legal plunder - the power of government to override private property rights for its benefit or for the benefit of selected groups. We need to be sure that our laws allow for the proper oversight by shareholders over their managers through directors who are their representatives. We -- and this will be a recurring theme in my remarks today -- depend on your active involvement through our proposal process to give us comments, and I have no doubt that you will do so forcefully. I cannot stress enough the importance of receiving thoughtful comments about our proposed rules. For your information, this jacket of mine is lined with Kevlar - standard issue at the SEC these days.
In the Act, Congress has required that companies provide more information to investors. Public companies will now have to disclose material changes in their financial condition rapidly. We will now require a public company to disclose and explain how it uses pro-forma financial information and whether it has significant "off-balance sheet" arrangements. The purpose of these rules is clear - give the investing public information so that they can truly evaluate a company's financial condition. Put another way, and to quote the President - we want to prevent a company from using "fuzzy math" in its public filings.
Under the Act, accountants and auditors are now more accountable to their real employer - the corporation and its shareholders. Audit committee members are now required to be independent, and audit committee members must have the ability to retain independent advisers. These are important strides because they stand clearly for the principle that the auditing function must be independent of the management function. The accounting profession has rightfully lost the confidence of the investing public. Hopefully, these requirements are the first steps toward restoring the investing public's confidence, respect, and faith.
I see from your schedule that you will be focusing this afternoon on "The Ethics of Corporate Lawyering." With that theme in mind, let me touch on a topic that is rather controversial within the bar: the SEC's mandate under Sarbanes-Oxley to establish parameters for the way lawyers representing public companies appear and practice before the SEC. Clearly, in the mind of the ordinary investor, lawyers are also part of the problem and need to be "encouraged" to be part of the solution.
I realize that the discussion of federal standards to regulate attorney conduct might be the proverbial "third rail" with this audience. But remember - as I mentioned before, this suit is lined with Kevlar.
Let me remind you at the outset that we are required by Sarbanes-Oxley to adopt final rules within a very short time frame -- 180 days after enactment, to be exact. Therefore, although I know this is a hot-button issue for many, I would like to make the same request that Chairman Pitt made at a recent SEC meeting - please be as constructive as possible with your comments. I encourage you, for example, to suggest alternatives to our proposals, rather than offer blanket objections to them.
We are in unchartered waters with these new rules. They have been referred to as the "first significant effort by Congress to mandate the federal regulation of lawyers." Like accountants, lawyers have historically been a self-regulated profession. We certainly expect that there will be comments from bar associations as to how traditional standards of professional conduct and these new conduct regulations can "live together." It is incumbent upon the bar to help us deal with these issues, keeping in mind, of course, that we are directed by the Act to "do something."
Some will view these rules as unnecessary federal governmental encroachment into the necessarily private relationship between an attorney and his client. Others will view them as a necessary step toward bolstering investor confidence by forcing professionals serving public companies 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. These are critically important issues for attorneys. The Public Company Accounting Oversight Board was created because of deep failings in the accounting profession's ability to regulate itself. I think it is safe to say that the legal profession would not like to see a similar organization created to regulate it in a similar fashion.
I believe that these rules should be viewed primarily as a codification of a principle that is easily stated but often difficult to carry out: in the corporate context, an attorney's client is the corporation and its shareholders, not the management that hired and, in fact, can fire the attorney. I believe in this principle, recognizing that it forces attorneys to make difficult choices. But as professionals, attorneys must continuously ask themselves, "who is my client?" and "is this action in the best interest of my client?" What an attorney does while answering these questions is the more difficult issue before us as we try to fill in the gaps left by the Act.
Here is a snapshot of the proposed rules, the text of which we plan to release shortly. Congress's mandate is misleadingly simple. To paraphrase it, we must set forth "minimum standards of professional conduct" for attorneys appearing and practicing before the Commission. These attorneys must "report evidence of a material violation of securities law" to the company's chief legal counsel or CEO. If the chief legal counsel or CEO does not "appropriately respond" the attorney has to make a report to the company's audit committee or full board of directors.
In implementing this apparently simple concept, the staff had to make some choices as to how to fill in the gaps and create an effective reporting regime. The proposal will appropriately note that attorneys appear and practice before the Commission in a variety of ways, and so it will be rather expansive on which attorneys will be subject to the rule. The proposal will state that all attorneys licensed or otherwise qualified to practice law -- whether employed in-house by a company or retained as an outside legal advisor by the Company -- are considered to be appearing and practicing before the SEC. As proposed, the rule would also cover non-US lawyers - although we will be looking for specific guidance as to how and whether this rule should apply to non-US lawyers.
The rule will affirmatively state that the attorney's client is the company and not the officers or other individuals with whom the attorney interacts. An attorney is charged with reporting any material violation of the securities laws that he "reasonably believes" has occurred, is occurring, or is about to occur. This, of course, is a lower standard of reporting than that requiring attorneys to report known material violations. The rule then describes what an attorney should do if a reportable event occurs. The attorney must take reasonable steps to preserve documentary evidence and must report this information to the company's chief legal officer (or CEO). Depending on the response received from the chief legal officer, the attorney's duties are either discharged (in the event that the attorney receives an "appropriate response") or will require the attorney to go "up the ladder" to the company's audit committee, another committee of independent directors, or the full board.
If an attorney has not received an appropriate response from the company, the rule permits -- and sometimes requires -- a "noisy withdrawal." In this context, there is a significant distinction between in-house attorneys and outside legal advisors. If an outside legal advisor who has reported a material violation that is likely to result in substantial injury to the financial interest or property of the company has not received an appropriate response, that attorney is, in some circumstances, required to withdraw from representation, notify the Commission of his withdrawal, and disaffirm any submission to the Commission that is tainted by the violation. This issue is likely to generate the most forceful opposition, as it is the first time that a lawyer might be compelled to report information outside the organizational structure of his client. Internal attorneys who have not received an appropriate response to a material violation that they have reported that is likely to result in substantial injury to the financial interest or property of the company are required to disaffirm any tainted submission, but are not required to resign.
The rule will also provide for the confidential release of client information. The proposal would allow an attorney to use client information to defend against attorney misconduct or to the extent necessary to prevent an illegal act that may result in a fraud or in substantial injury to the financial or property interests of the company. The rule will also make clear that the company does not waive any attorney/client privilege by sharing confidential information with the Commission pursuant to the terms of the rule.
As an alternative process for considering material violations of law, a company may establish a qualified legal compliance committee, comprised of at least one member of the audit committee and two independent members of the company's board, for the purpose of investigating these reports about material violations of law. This committee would be authorized to require a company to take remedial action in response to the material violation.
The rule will also describe how violations of the rule will be prosecuted. Importantly, a violation of these rules will be treated as a violation of the Exchange Act and subject to all of the remedies and sanctions under the Exchange Act, including injunctions, O&D bars, etc.
It is appropriate to consider Professor Higgs's thesis again in light of this new rule proposal. I welcome debate as to whether the current state-based regulatory framework on attorney conduct is insufficient, thus requiring a new, federal regulatory scheme of professional conduct. My colleague Commissioner Glassman appropriately inquired at our public meeting on these rules whether there is any data on what type of impact this rule will have on preventing future violations of the securities laws. This is precisely the type of inquiry we should be making as we continue to respond to Sarbanes-Oxley's mandate. Of course, in a perfect world, this rule will result in potential violations of the securities laws being reported "up the ladder" and remedied before SEC action is required. Any rule that produced that kind of outcome would certainly be considered a success story. But we all know that the world is a notoriously imperfect place. Since we can rarely prove with statistics whether or not a rule successfully achieves its stated objective, it is important to continue asking why are we enacting a rule. We should not simply "do something" merely for appearance's sake.
In an op-ed piece in The Wall Street Journal last week, Charles Schwab said that in his forty years of working with individual investors, he had never seen such a crisis of public trust. The constant revelations of corporate malfeasance have undermined our capital markets in a profound way. We at the SEC have heard the calls from the investing public, and we are working hard to be more vigilant, more aggressive, more faithful defenders of the public trust. We have, I believe, made significant steps over the last year to restore confidence in our financial system. But there is a lot more to be done and we need your help. The investing public wants, and indeed deserves, more from us.
Thank you very much.