U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
New Rules, Old Principles

Remarks by

David M. Becker

General Counsel
U.S. Securities & Exchange Commission

2000 Securities Law Developments Conference
Washington, D.C.

December 4, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Becker and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Thank you for that kind introduction. It's my pleasure to be here at this conference. In truth, it's been a pleasure to be at most conferences these past two years. After a quarter-century of private practice, I'm able to go to conferences without a stack of business cards. And I'm free to say what I think, though of course, I'm required to remind you that what you will hear are my views alone and not necessarily the views of the Commission or others on the staff.

I've been at the Commission for two years and General Counsel for a year. I'd like to share with you some of what I've learned. First, I'll give you a brief update of what's happened with two of our recent rulemakings, on selective disclosure and auditor independence, and then I'll report on how life looks from the other side of the table.

Regulation FD

First, I'd like to discuss Reg FD - the Commission's Fair Disclosure rule. Given the attention the rule has received, it's easy to forget that the rule has been effective only for little over a month. I do have late-breaking news that I'd like to share with those of you who have been indoors all day. Mike and I walked over, and changed our habits of looking at shoes. This time we looked up, and very carefully. After thorough inspection. I'm pleased to report that the sky has not yet fallen. The dire predictions appear to have been unfounded.

This isn't to say that the rule hasn't caused people to think about, and in some cases change, how they are doing business. It was supposed to. The rule's ultimate effectiveness will depend on how it is put into practice. Your organizations - as consumers of material information and, for those of you who represent public companies, as distributors of material information - will play a key role in that process. To that end, I'd like to address the rule's effect on issuers and analysts and, I hope, respond to the two main concerns the ICI articulated in its comment letter on FD: that the rule would lead to a "chilling effect" on issuers' communications and that the rule could impinge on the viability of the "mosaic" theory.

While people will continue to dispute whether the rule has had or will have a "chilling effect" on issuer's communications, it certainly hasn't chilled anyone from predicting a chill on the order of a nuclear winter. I've written many a law firm newsletter in my day. They are good marketing materials; the best are informative and insightful. But they do share a common message. It goes like this: The SEC has just done something dreadful. You may not have thought it was dreadful, but let me point out to you the 17 ways that it is dreadful that you might not have noticed. You, dear potential client, have been living in a fool's paradise, unaware of the pending catastrophe. You need a guardian, who watches over these things; you need an interpreter to explain what seductively simple prose really portends; you need procedures; you need reviews to make sure you're following the procedures. Of course, you'll need to update your procedures. Most of all, you need me, at a mere $400 an hour.

Lots of this is often true. And the private bar helps the public by helping clients, in discerning risks and traps that the regulators may not have seen. But sometimes it can get a bit overblown. And sometimes, particularly when the concern is a potential "chilling effect," some of the prose sounds less like a warning than like a self-fulfilling prophesy.

I believe that we, in addition to you and the private bar, have an obligation to see that the rule is put into practice in a manner that - while ending what even the rule's strongest opponents conceded was the gross unfairness of selective disclosure - does not dampen the flow of information to the market. I know that in the rulemaking process, the ICI was one of a number of commenters that expressed particular concern with Reg FD's use of the materiality standard. In the words of its comment letter, "the uncertainty of this analysis and the constant risk of after-the-fact assessments could chill valuable marketplace contacts."

We've tried to do our part by responding in the final rule to concerns about a potential chilling effect. First, to provide more guidance about what information is more likely to be considered material, the adopting release contains a non-exclusive list of types of information -- such as earnings, new products, and new contracts -- that should be reviewed carefully to determine whether they are material. Second, the final rule makes clear that the rule's requirement for "intentional" (that is, knowing or reckless) conduct also extends to the judgment of whether the information disclosed was material. Most importantly, however, the Commission, in its adopting release and in subsequent staff statements, has signaled that it does not intend to second-guess mistaken judgments about materiality in cases that are arguably close.

As our Enforcement Director said in a speech to the SIA last month, "We are not looking to frustrate the purpose of the rule - which is to promote broader and fairer disclosure of information to investors - by second-guessing reasonable disclosure decisions made in good faith, even if we don't agree with them." Rather, the Enforcement Division will be looking for "egregious violations involving the intentional or reckless disclosure of information that is unquestionably material . . . . [such as] information regarding mergers or acquisitions [or] earnings . . . ."

Commenters, again including the ICI, also raised legitimate concerns about the effect of Reg FD on the valuable work that analysts (sell-side and buy-side) provide. The ICI, in particular, urged the Commission to reaffirm the core principles of the mosaic theory - under which an analyst can assemble pieces of non-public and immaterial information into a mosaic that reveals a material conclusion. I hope that the Commission's adopting release couldn't be clearer on this point. We did, of course, make clear that we wanted to keep a clear path for analysis while blocking the path to the practice of distributing material nonpublic information to a favored few.

How is it working? After a month, it's too early to tell in anything but the most anecdotal way. Here are a few observations.

First, corporate America, and in that I include the investment company industry, is working hard to understand, to comply, and to institutionalize its compliance so it can be accomplished effectively at low cost. As usual, compliance with our rules comes principally from the good faith and hard work of people who obey the rules, even if they wouldn't have chosen them in the first place.

Second, people are thinking about matters they haven't thought about before. The new rules have raised all sorts of questions. What's the difference between building relationships with management so that it gives you good information, on the one hand, and putting together a mosaic, on the other? What does it mean to say that you're "comfortable with" an earlier forecast? When can you talk to the press? When you do talk to the press, does that make a disclosure public? As we've all asked these questions, we've encountered some things about which we've needed to give additional guidance, and we have. And the distributors and users of nonpublic information, I think, have learned some things about what can harm the markets.

Third, and not surprisingly, issuers are being more conservative now than they will be in the future. Everyone is proceeding cautiously over new ground. That's to be expected. As the ground becomes more familiar, we will all tread more confidently and worry less about unintended consequences of thoughtless selective disclosure. It's also to be expected that some issuers are using the new rules as a convenient wall to crouch behind to avoid any disclosure. I believe the market won't let them get away with it, and I'm counting on the help of many of the investment companies represented in this room. Markets demand information; Regulation FD requires only that the information be available to the markets rather than a favored few. Issuers can - and will - make full disclosures to the markets if the markets demand it.

Fourth, analyst conference calls have been largely opened to the public. Not all of the public is used to getting all this information. There have been a few isolated circumstances in which newcomers forgot that even though they were new, the so-called "news" was old news. This has produced a few short-term hiccups in the market, but they went away quickly. Here again, I'm optimistic about our markets. FD will, I believe, cause greater competition for the investors' ears, and investors will soon learn who is reliable and who is not.

Fifth, life has probably gotten tougher for some analysts. I don't doubt that some issuers are saying less, a phenomenon, as I mentioned, that I believe will be temporary. We've all seen newspaper stories about the analysts who are finding it hard to handle the stresses of actually having to go to company meetings. I am less sympathetic to that one. And many of you probably saw an article in the New York Times yesterday blasting analysts for having been caught flat-footed by Gateway's recent announcement of disappointing results. I know nothing about the matter, and I have no view as to whether the criticism is justified. But I don't doubt that Regulation FD will put pressure on analysts to analyze, and that, I think, is very good for the public.

The bottom line for today on Regulation FD is that it is too soon to tell very much. But I am pleased with the efforts to comply and the questions they have engendered, and I'm very optimistic that the rule will prove to be extremely useful for our markets and for investors.

Auditor Independence

Next, a brief word on auditor independence. As I'm sure you all are aware, on November 15, 2000, the Commission adopted amendments to its auditor independence rule. These amendments, which will be effective in early February, amount to the most comprehensive overhaul of the Commission's auditor independence requirements since the 1930s. These rule amendments have important implications - including some that have been largely overlooked -- for investment advisers, investment companies and all who represent them.

During the rulemaking, the proposed limitations on the types of non-audit services that auditors can provide their audit clients attracted the most attention and controversy. The rules the Commission adopted identify nine non-audit services that, when provided to an audit client, are deemed inconsistent with maintaining the auditor's independence. Seven of the nine services are already restricted under pre-existing rules of the Commission or the profession. The Commission modified its proposed rules to ensure that the final rules on these seven services closely track the existing proscriptions. The final rules also contain new restrictions on internal audit and information technology services, though these rules are substantially modified from the rule as proposed.

One aspect of our proposed rules on non-audit services that was of particular concern to the investment advisory community was our proposed rule on designing an audit client's system for complying with investment adviser regulations. Our concern was that, if in conducting an audit, the auditor relies on the controls that are part of the compliance system designed by that same auditor, the auditor could be in the position of auditing his or her own work. We sought comment in particular on the extent to which an auditor relies on these controls in conducting an audit. Commenters, most notably the ICI, argued that "an auditor performing an audit of a fund's financial statements will not focus primarily on the fund's compliance system and will not be placed in a position of auditing its own work." I'm sure that many of you will be pleased to hear that, after considering these comments and others, the Commission chose not to include any restriction on designing compliance systems in the final rules.

The final rules also imposed new disclosure requirements on registrants that are required to file proxy statements in connection with their annual shareholders' meeting. These companies, including investment companies, must disclose the aggregate amounts, if any, of fees billed for three categories of services rendered by the registrant's auditor during the most recent fiscal year: audit and review services, information technology services, and all other non-audit services. Because of the unique interrelationships between investment companies and their advisers and other service providers, the Commission decided that, in disclosing the amount of fees, investment company registrants must disclose fees for information technology and other non-audit services provided to the registrant itself, its adviser, and entities in a control relationship with the adviser that provide services to the registrant.

Registrants are also required to disclose whether their audit committee, or the board of directors if there is no audit committee, has considered whether the provision of the non-audit services by their auditor is compatible with maintaining the auditor's independence. This disclosure relates to all non-audit services rendered by the auditor, including, for example, the compliance system design services the Commission decided not to restrict in its final rules.

You will note that the Commission adopted a dual approach to a conflict of interest issue. It relied on disclosure whenever possible, under the theory that investors should be given an opportunity to evaluate these matters. But disclosures don't eliminate conflicts, and so the rule prohibits certain relationships between auditors and their audit clients.

Some Lessons Learned From Commission Rulemakings

Finally, having completed my first year of service as the Commission's General Counsel, I'd like to share with you some thoughts on how the world looks from the vantage point of the Commission staff. For years before I got here, I represented clients who found themselves misunderstood by the Division of Enforcement. I'd ask myself rhetorically, "how could the SEC be so foolish as to do that"? Well, I know now. Here are some observations:

First, we're the "real world," though so are you. Things really do look different from this side of the table. We are all in the business, in part, of managing risks. We share overlapping concerns, but the risks we focus on most are those of harm to investors. I know you care about that too, but you have additional concerns that are quite rightly priorities in running your businesses. You share those concerns, but investor protection has been, and will remain, this agency's number 1 concern. Of course we have different perspectives.

Second, we're under pressure to be as good as we can, and should, be. We need to be able to keep our dedicated staff longer. To do that, we need to pay them more, as much as they can make at other financial regulators. I'm tempted to ask you to keep away from our staff; but I don't believe in futile gestures. I will ask you, and anyone else who is willing to listen, to make sure that our staff can get the same pay and other benefits as the other financial regulators. My experience here confirms what you know in the private sector, that the public and the markets are best served when the SEC can keep its top quality employees.

Third, we listen. In both the Regulation FD rulemaking and in the auditor independence rulemaking, we made substantial changes in light of the thoughtful comments we received from the public. The key word here is "thoughtful." You are the most effective advocate for your views when you don't "play to the cheap seats." We respond best to credible, nuanced ideas. You can predict the end of the world only so many times and keep your credibility. Someone is going to be right once, but until then everyone else will be wrong. We also don't respond well to arguments as to the public good where they are transparently self-interested. We don't respond well to arguments that information that isn't confusing to you would be confusing to investors. On the other hand, we do respond to illustrations of unintended consequences, and we do respond to constructive suggestions, those that point out a better way of promoting the public interest.

You don't do us or the public a service by being thoughtlessly compliant either, not that this is much of a risk. We need you to "keep us honest." Let me explain what I mean. The Commission, like many organs of government, has the power to do things for people, and to people, that can have a profound impact on their lives. When we do these things - from promulgating rules to bringing enforcement cases - we need to get it right. You help us, you help yourselves, and you help the public when you put us to the test. Like any organization, we at the Commission spend much of our time talking to each other. We find each other pretty convincing, compelling even. But, like any organization, we can always benefit from another view, particularly one we can trust. We may not always like it, just as you might not like it when the tables are turned, but we need to hold each other to the highest possible standards.

You can help also by keeping us relevant. We are an agency of limited resources. We believe that we keep to an agenda that targets these resources to places where they are most urgently needed. But you may not agree. We function best when industries tell us about their businesses, and the challenges they face, and where the public needs the most help. At times, that means reminding the agency that it must focus its limited resources on issues of lasting significance to investors, rather than just the issues of the moment. If the agency is pursuing something that seems wrong or trivial, tell us. We may not agree, but we're better hearing it sooner rather than later.

I'm pleased to be able to say that the ICI's relationship with the SEC exemplifies these rules in action. While the ICI has at times been a critic, and we don't always agree - ask me about private rights of action - the ICI's criticism has always been constructive and helpful. I am confident that this tradition continues.

Thank you very much.