Speech by SEC Commissioner:
Sarbanes-Oxley and the Idea of "Good" Governance
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
American Society of Corporate Secretaries
September 27, 2002
These remarks reflect solely the personal views of Commissioner Glassman, and do not necessarily reflect the views of the Commission, the individual members of the Commission, or its Staff.
Good afternoon. I would like to thank the American Society of Corporate Secretaries for inviting me to participate in this timely and important program.
From the outset of my tenure as a Commissioner, I have valued your forthright and pragmatic comments on our rule proposals - and there certainly has been no shortage of opportunities to provide comments lately. Whether on accelerated reporting, disclosure of management transactions, the treatment of critical accounting policies in MD&A, or CEO certification, your input has helped improve many of the rules we have proposed and adopted. I appreciate your continued attention to these and the other important matters we will be dealing with as we continue to implement the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley").
Having said that - and maybe right after complimenting you is not the best time to say this - but the views expressed today are my own and not necessarily those of the Commission or its staff.
It has been an eventful nine months since I joined the Commission, to say the least, and this is a particularly appropriate time to be addressing this audience. The already fundamental role of corporate secretaries in ensuring high standards of good governance at America's public companies has become even more critical in light of recent events, and especially with the enactment of Sarbanes-Oxley and the Commission's governance reforms. The corporate secretary will a be key player in implementing the corporate governance reforms, and in providing guidance to management and the board of directors on how best to meet their responsibilities. You also will play an important role in ensuring that an appropriate governance infrastructure is put in place to meet the overarching goals of those reforms.
I would like to talk a little bit this afternoon about those goals, and also the assumptions I believe underlie Sarbanes-Oxley - the themes that bind the legislation's various provisions together. In addition, I will also discuss some concrete ways in which I believe companies can put the idea of "good governance" into action.
I. The Impetus for Corporate Reform
A. Some History on Corporate Scandals
In thinking about themes underlying recent legislation and rules, it is useful to begin by examining some of the examples history provides with respect to corporate scandals -- to look both at the common threads that run throughout and also at what distinguishes the recent spate of scandals from those that preceded them. As economist John Kenneth Galbraith commented, "[t]he man who is admired for the ingenuity of his larceny is almost always rediscovering some earlier form of fraud. The basic forms . . . have all been practicised."1 Some examples from history show this to be all too true:
- For starters, it is part of securities industry folklore that organized trading in America was borne out of scandal. What is presently the New York Stock Exchange arose out of a financial crisis caused largely by a real estate speculator named William Duer, who leveraged his speculative investments to such a degree that he was unable to repay his loans. Duer's personal failure was followed by the failure of several banks that lent him money, and then by the organization of traders who, underneath a Buttonwood tree in lower Manhattan, formed the exchange in the hope that the events would not be repeated.
- In the late 1800s, the promise that rail transportation would boost productivity and completely change the business paradigm led to rampant speculation in companies involved in railroad production. Analyzing the situation after the railroad bubble burst, financier Henry Clews noted in 1891 that the resulting crises "were chiefly due to an excessive diversion of capital into the building of railroads, and also the fact that the new companies were organized upon a grossly speculative and inflated basis." Sound familiar? He also expressed dismay at "[t]he extent to which not only large promoting companies, but even banking-houses of high repute, have been involved in floating these new issues . . . ."2
- In the early 1900s, the failure of United Copper Company and the inability of one of its affiliated banks to satisfy customer withdrawal demands caused another run on banks and forced investors to re-evaluate United Copper's business model.3 Shareholders in United Copper saw the share price plummet from $84 to $10 per share in a single day.4
- In 1929, of course, we had the Great Crash. An interesting parallel to today's issues was the way some companies assisted their officers after the market crashed in 1929. National City Bank, for example, created a "morale loan fund" for officers who had over-leveraged themselves in the securities markets. The company made about $2 million in interest-free, uncollateralized loans to National City officers. Three years later only five percent of the loans were repaid.5
- Skipping ahead to more modern history, I would like to share a description I recently came across which I found particularly insightful. It provided the following summary of events:
[T]he distribution of securities by companies that had not made a previous public offering reached the highest level in history. This activity in new issues took place in a climate of general optimism and speculative interest. The public eagerly sought stocks of companies in certain "glamour" industries, especially the electronics industry, in the expectation that they would rise to a substantial premium - an expectation that was often fulfilled. Within a few days or even hours after the initial distribution, these so-called hot issues would be traded at premiums of as much as 300 percent above the original offering price. In many cases the price of a "hot" issue later fell to a fraction of its original offering price.
This passage, of course, is not describing the Internet bubble of the 1990s, but rather speculation in electronics stocks in the late 1950s and early 1960s, which was documented in the Commission's "Special Study of the Securities Markets" - published in 1963.
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Although many political, economic, social and psychological factors can lead to a market crisis, there seem to be enough common threads to these stories to suggest that the issues confronting us today are far from new. Much of the behavior we have witnessed recently - greed, sacrificing strategic interests for instant gratification, promoting self-interest over fiduciary responsibility, suspension of rational investment decision-making, and loose lending practices coupled with rampant speculation - have plagued business and the markets throughout recorded history.
B. Market Reaction to Scandal and the Need for Regulatory Reform
The question, then, is what distinguishing characteristics of recent corporate scandals pointed up the need for the most sweeping securities reform legislation since the New Deal? In the long history of financial scandals, the most frequent and often well-advised response to market failures has been to let the machinery of the markets themselves work out excesses over time. History has shown that markets have a way of disciplining those who violate the public trust, and to a significant extent we can see evidence of this taking place in the present as well. Some examples include: (a) rating agencies that have changed revenue analysis to include stock options as expenses; (b) pension funds choosing to hire only those brokerage firms that adhere to a code of ethical standards regarding providing independent advice; (c) increased success of shareholder activists in passing resolutions and electing directors; and (d) overall increased vigilance by previously passive institutional money managers. There is also evidence that boards of directors and audit committees are taking more seriously their obligation to be fully informed of all material facts before making business judgments.
However, market solutions are not sufficient in the current environment. What distinguishes recent corporate scandals is that nearly all of the market institutions that provide protection against large-scale fraud - including investment bankers, buy- and sell-side analysts, lawyers, rating agencies, auditors, officers and directors - failed to varying degrees. These failures have largely been attributed to perverse incentives and conflicts of interest that should have been avoided - and should not have been tolerated - in the first place.
Perhaps more important is the breadth of effect these scandals have had on innocent investors. One statistic is that over 88 million shareholders, representing 51 percent of U.S. households, invest in the markets today, which is substantially higher than even 20 years ago. To compound the situation, the increasing popularity of 401(k)s, stock purchase programs, stock ownership guidelines and other plans have actively encouraged employees not only to be owners, but to concentrate a significant amount of their net worth in a single company. These fairly recent developments raised the stakes substantially in terms of the consequences of fraud for employee-owners - they not only lost their jobs but also their retirement savings.
These circumstances put a heightened premium on accountability and prevention as regulatory goals. While one can quarrel with the specifics of the regulatory responses, there can be no doubt that the circumstances cried out for a response in ways unlike prior business scandals.
II. The Idea of "Good" Governance
Given that a regulatory response was called for, the question then is what the overriding principle of that response should be. With respect to Sarbanes-Oxley and the Commission's reforms, the common thread seems to be that governance matters. That is, "good" governance tends to channel corporate decisions in the right direction, and conversely "bad" governance leads to - or at least enables - "bad" decisions. In judging which decisions are "good" or "bad" in this context, it is important to note that corporate representatives are fiduciaries, and as such are not free to act in unabashed self-interest; they must often subjugate their own interests to the duties and obligations they owe to act in the best interest of their stakeholders. In this sense, "good" corporate governance is intended to cause corporate decisions to take appropriate account of the various (and sometimes conflicting) constituencies whose interests the corporation must take into account Sarbanes-Oxley codifies certain standards of "good" governance into specific requirements, the idea being that some responsibilities are too important to be left to loose concepts of fiduciary responsibility, and also that more severe treatment in the breach can provide a strong incentive to avoid such failures.
The notion of the corporate conscience as embodied in its governance procedures is therefore central to an understanding of recent corporate reforms. But how are managers supposed to create an ethical identity for a corporate entity that itself is a legal construct created to serve economic ends? The answer, to borrow from Henry David Thoreau, is that "a corporation of conscientious men is a corporation with a conscience."6 Put bluntly, those who act on behalf of a corporation - its officers, directors and employees - must be its conscience. Sarbanes-Oxley and the Commission's rules impose specific requirements - coupled with substantial penalties - aimed at ensuring that those who act on behalf of a company give life to the corporate conscience.
A. The Tone at the Top
First and foremost, Sarbanes-Oxley makes clear that a company's senior officers are responsible for the culture they create, and must be faithful to the same rules they set out for other employees. One goal of the Commission's recent rules requiring that the CEO ultimately be responsible for the quality of a company's disclosure controls and financial reporting is to ensure that "tone at the top" has real meaning.
Anyone who reads the newspapers these days will witness the effects of a failure to set the right tone at the highest levels of an organization. The cavalier attitude toward accounting and disclosure that has surfaced in some of our investigations was so pervasive that it can only have resulted from a total lapse of corporate ethics. Even if senior managers did not knowingly participate, their failure to be aware of and prevent the environment in which far-reaching scandal was possible was at minimum a serious moral failure.
Recognizing that awareness must precede action, Sarbanes-Oxley and the Commission's rules require the CEO and Board to make certain that procedures are in place to ensure that they hear bad news. Under the Commission's recently adopted rules, these procedures must ensure that all material information - both financial and non-financial - gets to those responsible for reporting it to the investing public. Even beyond the required system of controls, however, the Chief Executive must be careful not to create an environment in which senior officials are afraid to discuss or act on potentially serious misconduct that comes to their attention. Employees who are told that ethical conduct is important, but who in practice face inaction - or, worse, retaliation - when they report corporate misconduct, rightfully question whether the corporate ethical code is merely a hollow promise. Accordingly, Sarbanes-Oxley also appropriately provides protection for employees who attempt to bring fraud to the attention of those with the responsibility for dealing with it.
B. Ownership of Corporate Responsibility
In terms of trying to personify the corporate conscience, there is something not specifically required, but which I feel is essential nonetheless. While the CEO cannot delegate his or her ultimate responsibility, to fully carry out the mandate of Sarbanes-Oxley and the Commission's rules, a company should have an officer with ownership of corporate compliance and ethics issues, and of what Title III of Sarbanes-Oxley broadly refers to as "Corporate Responsibility." While every company must assess its particular needs based on the size and nature of its business, there are several characteristics that I would want the corporate responsibility officer to have if I were relying on this person:
- He or she should have sufficient seniority and authority to take the actions necessary under the circumstances. To assess whether your corporate responsibility officer meets this requirement, ask yourself if the person would be able to address the worst-case scenario.
- The position should have the full support of the CEO and senior management, both in theory and in practice. The corporate responsibility officer should have access and provide regular reports to senior management. In this regard, he or she can play an important role in helping a company meet the information gathering and reporting requirements contained in the Commission's new internal control and certification rules.
- Although regular board reports on compliance and controls seem advisable, even if they do not occur regularly, the corporate responsibility officer should have the ability to report directly to the board (for example, to the audit committee chairman) on matters of significant import to the company or matters involving misconduct by senior management.
- In addition, the responsible officer should have sufficient time and adequate resources to implement the company's corporate responsibility program in an effective manner. The best written code of ethics will be worthless if the company starves the budget of the officer who has to implement it.
C. Robust Audit Committees
Audit committees also have significant responsibility for safeguarding the corporate conscience, and Sarbanes-Oxley deals with the audit committee in several ways.
The first is to look at the job description for audit committee members and say that if you are going to accept the earnest responsibility of serving on the audit committee of a public company, you must have the minimum requisite credentials to do the job in a competent manner. Given the importance of the audit committee to corporate governance, Sarbanes-Oxley suggests appropriately high standards for financial literacy and expertise, a topic the NYSE and NASDAQ have been dealing with, and the exact requirements of which the Commission will be taking up in the very near future.
Beyond the strict regulatory requirements, the clear thrust of the rules is that audit committee members need to be inquisitive - that is, they should put their financial literacy to good use. This does not mean that audit committee members have to re-audit the financial statements or re-design internal controls; however, it does mean that they should have a healthy skepticism and pursue issues until they are satisfied they have received adequate information to make an informed judgment. This is especially true with respect to instances that involve real or potential conflicts of interest for management or auditors.
Consistent with the necessity for inquisitiveness, Section 301 of Sarbanes-Oxley gives the committee the right to hire at company expense its own counsel or other advisors, including forensic accountants, as it sees fit to fulfill its mission. The committee's ability to look to advisors who are independent of the company and free from involvement in transactions that may have been approved by its management or auditors is essential to having a truly independent committee that can pursue its role with appropriate vigor.
The audit committee also has a role to play in ensuring that the company has robust internal and reporting controls. The new regime helps the committee in this regard by requiring that officers assess the company's controls, and certify that they have disclosed any significant deficiencies to the audit committee. To foster additional support for internal auditors and to help meet the requirements of Section 301 of the Act for handling complaints relating to internal controls, it is advisable for the head of internal audit to have a direct and effective line of communication to the audit committee.
There is encouraging evidence that audit committees already are getting more involved in approving fees for audit and non-audit services, hiring and supervising internal auditors, and inquiring into the relationship between management and the outside auditors. In light of audit committees' new powers and responsibilities, boards should review the audit committee charter to ensure that it adequately details the company's expectations regarding the audit committee's role. Audit committees have evolved both as a result of new regulations, but also because of the increasing complexity of many public companies, and it is important that the charter reflects the reasoned judgment of the board regarding the role the company expects the audit committee to play.
III. Corporate Governance as Part of Strategic Planning
Finally, let me briefly address those who legitimately have asked whether the costs of recent governance reforms are too high. More specifically, a number of recent articles have asked how much investors are willing to pay for enhanced governance procedures that undoubtedly will impose additional costs on companies.
My background is as an economist who has focused on risk management. As the only non-lawyer serving on the Commission, I am keenly aware that corporate governance involves a strong dose of risk management, especially in today's environment. Looked at in this light, I respectfully suggest that if it is the responsibility of management and the board to maximize long-term shareholder value, companies that cut corners on compliance fail in this regard by jeopardizing the long-term profitability - and ultimately viability - of the company. A company's reputation is a valuable asset, and one that can be squandered just as plainly as its tangible plant and equipment. It follows that controls to safeguard reputational assets are necessary just as surely as a company locks its warehouse to prevent thieves from walking off with its inventory. While recent reforms leave companies discretion in many areas to determine what level of controls are adequate, the Commission's goal is to ensure that minimum controls - controls so apparently lacking in several recent cases - are in place.
The failure to implement good governance can have a heavy cost beyond regulatory problems. Evidence suggests that companies that do not employ meaningful governance procedures can pay a significant risk premium when competing for scarce capital in the public markets. In a recent study, for example, three-quarters of the institutional investors surveyed were willing to pay a substantial premium for shares of companies that adopted good governance practices, and conversely more than 60 percent might avoid investing in individual companies based on governance concerns.7 Analysts also have acquired an increased appreciation for the correlation between governance and returns, as an increasing number of reports not only discuss governance in general terms, but also have explicitly altered investment recommendations based on the strength or weakness of a company's corporate governance infrastructure.
Beyond that, if you need another justification to sell the idea of good corporate governance, I would point out that the Commission takes seriously the pronouncements made in our Section 21(a) report on the "Relationship of Cooperation to Agency Enforcement Decisions."8 In the report, the Commission noted that one factor we will look at is whether the company took seriously its obligation to detect fraud. Obviously, no system of controls can prevent all misconduct; however, if a company can demonstrate that it has satisfied its obligation to implement good procedures, then in my eyes it has a significantly better chance of receiving leniency (assuming the other criteria set out in the report are met). In short, if you are looking for leniency you had better be able to show that you cared about preventing corporate misconduct before you discover that it occurred.
Despite the importance of corporate governance from a risk management perspective, I wonder how many board meetings or high-level strategic plans actually deal with governance issues in a meaningful way. Ask yourself if your company is providing the proper incentives to make its governance program work. For example, is adherence to the code of conduct one of the criteria used in employee performance evaluations and the calculation of bonuses?
As the corporate secretary, you should make sure that the topic is on the agenda for both management and the board. If not, you risk a rude awaking similar to the one confronted by the corporate chieftain in the popular Dilbert cartoon, who in a recent strip found a five-year old copy of his company's five-year plan. Reading aloud to the assembled employees, he noted that the last page of the plan had forecast that: "At the end of the fifth year the entire management team will be investigated for accounting irregularities." To which Dilbert's colleague Wally replied, simply, "Spooky."9
In conclusion, let me say that I agree with the old adage that that there is no way to legislate morality. However, I do believe that we can control conflicts of interest that provide temptation to do the wrong thing, and institute the incentives and penalties that encourage people to live up to their public duties. As officers of public companies, you are keepers of the public trust, not only for your own company, but also ultimately for the entire market. My hope is that the extensive governance reforms we are in the process of implementing will provide an opportunity for companies to engage in real self-examination and learning regarding what it takes to be a good corporate citizen.
While one could easily become disheartened by the regularity with which market participants seem able to forget the past and to replicate the behaviors that lead to market crises, I remain optimistic at the resilience of the markets which each and every time reaffirm the fundamental strengths of capitalism. While there is still a long way to go, I think we are heading in the right direction in terms of restoring public confidence and putting recent events behind us. Whether we continue down that path will depend to a large extent on whether corporate officers and directors prove worthy of the trust that has been placed in them.
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Thank you for this opportunity. I look forward to continuing what I view as a productive relationship with the American Society of Corporate Secretaries, and also to your continued input as we make further rule proposals and implement the rules we have passed.
1 John Kenneth Galbraith, The Age of Uncertainty, Ch. 2 (1977).
2 Henry Clews, "The Late Financial Crisis," 152 The North American Review 410 (Jan. 1891).
3 Rudiger K. Weng, "The Stock That Set Off the 1907 Crash," Friends of Financial History, p. 29 (Fall 1994).
4 T. Patrick Harris, "The Stock Market Panic of 1907 - And the Death of the Copper King," Friends of Financial History, p. 30 (Fall 1994).
5 Joel Seligman, The Transformation of Wall Street 26 (Northeastern University Press 1995 ed.).
6 Henry David Thoreau, "Civil Disobedience," in The Writings of Henry David Thoreau, vol. 4, p. 358 (Houghton Mifflin 1906).
7 McKinsey & Company, Global Investor Opinion Survey: Key Findings (July 2002).
8 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 on the Relationship of Cooperation to Agency Enforcement Decisions, Exchange Act Rel. No. 44969 (Oct. 23, 2001).
9 Scott Adams, Dilbert, August 27, 2002 (© 2002 United Feature Syndicate, Inc.)