Speech by SEC Staff:
Remarks at the 58th National Conference of the
American Society of Corporate Secretaries
by
Alan L. Beller
Director, Division of Corporation Finance
U.S. Securities
and Exchange Commission
Boston, Massachusetts
July 10, 2004
Thank you, Peggy, for that kind introduction. It is a privilege to be
addressing the ASCS National Conference this morning. Your organization
has long been in the forefront of a number of important governance and
disclosure issues. You have also had a long history of dialogue with the
Commission and the staff, and we have found that extremely useful.
My assigned topic this morning is to provide an SEC Update. When I
began to prepare my remarks, it seemed to me that a key item should be the
current thinking of the Commission and staff regarding the Sarbanes-Oxley
Act. This month — the second anniversary of the passage of the Act — seems
a particularly appropriate time to reflect on its effect. In addition,
while the Act obviously is still a critical item, I would like to spend
time on some other topics that you and I both consider important.
Before I continue my remarks, I should note that, as a matter of
policy, the SEC disclaims responsibility for remarks by members of the
staff. My remarks this morning therefore represent my own views and not
necessarily those of the Commission or other members of the staff.
Sarbanes-Oxley Two Years Later
To recap the Commission's rulemaking and related activities under
Sarbanes-Oxley, the Commission completed its own Sarbanes-Oxley rulemaking
some months ago. Last month it approved one of the last major elements of
Sarbanes-Oxley — the Public Company Accounting Oversight Board's Audit
Standard No. 2, regarding audits of companies' internal controls over
financial reporting. This year also marks the opening season for filing
reports with the Commission that reflect major aspects of the new
requirements of the Act and the Commission's implementing rules. Of
course, the requirement to provide management's assessment of the
effectiveness of internal control over financial reporting and the
accompanying audit under Standard No. 2 is required for the first time for
fiscal years ended after November 15, 2004 for accelerated filers and for
fiscal years ended after July 15, 2005 for smaller issuers and foreign
private issuers.
I know that you are all familiar with the principal Sarbanes-Oxley
requirements, so I don't intend to detail them here. I generally think of
them in five categories of reforms intended to improve financial and other
reporting, improve corporate governance and restore investor confidence.
First, the Act provided for important reforms aimed at improving the
performance of and restoring confidence in the accounting profession. The
Act ended self-regulation of the accounting profession where the audit of
public companies was concerned. In its place the Act created the Public
Company Accounting Oversight Board. The Act provided for the Commission to
reaffirm the role of the Financial Accounting Standards Board and
established an independent funding source for the FASB.
Under the leadership of Chairman William McDonough, the PCAOB has
progressed from its start-up phase to become a real operating entity. Its
most visible achievement to date has been the adoption of Auditing
Standard No. 2. Less noticed, but at least as important over the long run,
the PCAOB has commenced inspections of registered auditing firms, even
while it continues to recruit and hire additional staff necessary for its
full inspection program. I believe the inspection program should be the
cornerstone of the PCAOB's efforts to ensure audit quality and over time
will be the key test of the regulatory model for the accounting profession
established by Sarbanes-Oxley. Chairman McDonough noted in testimony
before Congress on June 24 that the limited inspections to date had
uncovered audit and accounting issues that the Board was pursuing.
I should also note that while the PCAOB is responsible for inspecting
registered auditing firms, it is issuers that are responsible for the
correctness of their accounting, financial reporting and disclosure. Very
importantly, therefore, the Office of the Chief Accountant and the
Division of Corporation Finance expect issuers to make it clear to their
auditors that any issues raised by the PCAOB with an auditor relating to
an issuer's accounting, financial reporting or disclosure are to be
communicated to the issuer. Further, OCA and the Division will continue to
be the ultimate arbiters regarding an issuer's accounting, financial
reporting or disclosure, however the issues in question arise. This would
be true for example in cases where they are identified by the issuer or
the auditor, identified through the comment process, or identified in a
PCAOB inspection.
Second, the Act gave the Commission new tools to enforce the securities
laws. And the Commission has been using those tools to good effect. Last
year the Commission brought 679 cases, of which 199 involved financial
fraud or reporting deficiencies. The Commission has obtained orders for
penalties and disgorgements totaling $2.2 billion as of late June 2004.
And between October 2003 and June 2004 the Commission sought 110 officer
and director bars.
Third, the Act mandated new requirements designed to improve financial
reporting and other disclosure. These include the rules requiring CEO and
CFO certifications. They also include rules regarding the disclosure of
material off-balance sheet transactions and the use of non-GAAP financial
measures, as well as rules strengthening the independence and
responsibilities of audit committees. I also place in this category the
provision that I have already mentioned and that is currently receiving
the most attention from companies and auditors — the requirement of an
annual management report on, and audit of, companies' internal control
over financial reporting.
In the longer term the internal control provisions may have the largest
effect on companies, both in terms of time and expense and in terms of the
impact on their systems, their financial reporting and their audits. To
date, however, I believe that the CEO and CFO certification provisions
have had the biggest impact on financial reporting and disclosure. One of
a company's top management's most important responsibilities is to assure
that the company communicates honestly and effectively with investors.
CEOs and CFOs already had responsibility for company disclosures in the
filings in question. But the certification requirements have focused their
attention on the completeness and accuracy of disclosure in very salutary
ways. The Commission also went beyond the requirements of Sarbanes-Oxley
in complementing the certification provisions with a requirement that
companies maintain disclosure controls and procedures. This requirement is
intended to ensure that information is captured, evaluated as to
materiality and disclosed (or not disclosed) as required in a timely
manner. The "check-the-box" wing of the bar predictably and nearly
immediately came up with elaborately worded "sub-certifications" to be
signed by employees at levels below the CEO and CFO. While
sub-certifications can be a sensible part of a program of controls and
procedures in connection with periodic reporting, they would not appear to
be the whole package. Moreover, I would expect that companies have just
about finished refining their controls and procedures in light of the new
expanded and accelerated Form 8-K reporting requirements that go into
effect next month. I also should note that on June 29th the Commission
brought its first action charging inadequate disclosure controls and
procedures in a case that also involves a charge of a violation of
Regulation FD.
To return to Sarbanes-Oxley, as my fourth category, the Act addressed
the performance of certain "gatekeepers." The Commission has adopted rules
requiring attorneys with evidence of material violations of the securities
laws or breaches of fiduciary duty to report that information "up the
ladder." The Commission has also adopted rules enhancing the independence
and accountability of analysts. And, of course, the Act specifically
addressed the role of the audit committee as an important gatekeeper in
overseeing accounting, auditing and financial reporting.
Finally, the Act included provisions designed to improve the "tone at
the top" of public companies. These rules include:
- the CEO and CFO certification requirements;
- prohibitions on loans to company insiders;
- mandated accelerated electronic filing of disclosures of insider
transactions; and
- disclosure about whether company have codes of ethics for CEOs, CFOs
and other senior financial personnel.
We are often asked for updates about how companies are doing with the
new Sarbanes-Oxley requirements. As I mentioned, March was the first major
Form 10-K season for which many of the requirements are in effect, so it
is difficult to generalize about companies' performance. I think that it
is fair to say, however, that responses have been varied. Some companies
have embraced the requirements, and others still need work. We continue to
answer issuers' questions, review companies' disclosure, and issue comment
letters. We will also be preparing and delivering to Congress later this
year a report regarding disclosure of off-balance sheet transactions, the
last item the Commission is required to complete under Sarbanes-Oxley.
The Companion to Sarbanes-Oxley — Continued Focus on Corporate
Governance
One of the things we have learned in the last two or three years is
that the malaise affecting our corporations and their stewards went well
beyond the Enrons, the WorldComs, the Tycos, the Adelphias and the other
poster children for corporate scandal. Sadly, the erosion of corporate
standards during the boom years of the 1990s and the dot.com era affected
a far larger number of companies and corporate leaders.
The restoration of proper standards has required a reexamination of the
principles of governance of our corporations. A key element has been to
grant to boards of directors their rightful place in corporate governance
and to give them the responsibility and tools to provide real oversight of
corporations and their managers. Part of the change derived from
Sarbanes-Oxley, for example the new independence requirements and
responsibilities of audit committees. However, for many of the other
structural enhancements designed to improve corporate governance, the
Commission looked to the listing standards of the nation's principal
markets.
As early as February 2002 we called on the New York Stock Exchange and
the Nasdaq to examine issues of corporate governance, corporate
accountability and listing standards in light of Enron. Both markets came
forward with proposals for listing standards, and they and we then worked
together for more than a year improving those proposals and harmonizing
them, except where the differences in listed companies justified
differences in the standards.
In the summer of 2003 the Commission approved listing standards of the
New York Stock Exchange and the Nasdaq requiring shareholder approval for
equity-linked compensation plans. In November 2003 the Commission approved
those markets' final corporate governance listing standards. I know that
people in this audience have worked intimately with these new standards
since they were put in place for the proxy and annual meeting seasons that
are just now winding down.
In terms of impact to date, we know that many companies have
restructured at least part of their board to satisfy the new stricter
independence standards for directors, the majority independent director
requirement and the requirement that only independent directors be
involved in processes relating to auditing, director nominations,
governance and compensation. We also know that there were a number of
questions regarding the transition provisions for the "look-back" in the
New York Stock Exchange standards. The one-year transition provision was
not an oversight or anomaly. It was the solution devised by the Exchange
and approved by us to deal with both the desire, which we strongly
advocated, to have a look-back in place at the beginning, instead of one
that phased in as prior proposals had provided, and the concern that for
at least the 2004 season there had to be some transition flexibility.
The new listing standards also contain new disclosure requirements
regarding independence standards and determinations. We expect that the
markets will be looking at the performance of companies under these new
requirements. In a related area, in November 2003 the Commission also
adopted new disclosure requirements regarding the processes of nominating
committees and shareholder communications with directors. We will be
considering how to evaluate disclosure both in response to our new
requirements and those imposed by the recent listing standards.
The Backlash against Sarbanes-Oxley — Is There a Basis?
Even as we're assessing companies' early responses to the new
requirements, and before the last provisions are even effective, we are
beginning to hear complaints about Sarbanes-Oxley and other reforms.
Perhaps it is inevitable that as memories fade of how appalling the bad
conduct was, how widespread it was, and how outraged were America's
investors (who now number in the tens of millions and not just the wealthy
few of prior decades) some companies and pundits see the costs and burdens
and ignore the benefits. In my view the provisions of Sarbanes-Oxley and
other requirements that impose the greatest burdens in terms of time,
attention and money — and here I am thinking for example about assessments
and audits of internal control, stricter and increased independence
standards for boards and committees, and CEO and CFO certifications — are
the most central to necessary reform.
Having said that, I can assure you that the Commission and staff are
very sensitive to imposing unnecessary costs and burdens on registered
companies and other participants in our capital markets. Everyone knew
when the Act was passed that there would be expense involved. That is one
reason why we have been encouraging companies to plan ahead, especially
for the rules relating to the assessment and audit of internal control
over financial reporting.
We also understand the possibility of disproportionate burdens on
smaller companies, and we were sensitive to these concerns where possible
when we adopted our Sarbanes-Oxley rules. Again, we believe it is likely
that the internal control provisions will place the greatest relative
burdens on smaller companies. We also believe that the right way to get at
the issues of internal control for smaller companies is through an
appropriate framework for evaluating internal control that takes into
account differences in size, geographic and other scope and complexity of
business that may be relevant for smaller businesses. In fact, the
Commission's adopting release for the internal control requirement
suggested that there was flexibility in the method of evaluation that
smaller businesses could use. Further, the staff's recent Frequently Asked
Questions on the requirement states that we would support efforts by
bodies such as COSO to develop an internal control framework specifically
for smaller companies. We welcome progress from COSO or other interested
parties in these areas.
Beyond these specific points, increasingly I've seen reports about the
actual or potential costs of the Sarbanes-Oxley Act used to support calls
for modification or repeal of certain of its provisions. It may be that
some who were hesitant to voice legitimate concerns about costs when the
Act was passed now feel more comfortable doing so, but I think that others
may be using people's short memories opportunistically in order to try to
roll back reforms.
Whatever the motive, the specific data now available seems too
incomplete to support specific conclusions about how the Act has affected
issuers and investors. There is no doubt costs are increasing. The
Commission's Office of Economic Analysis has reviewed several of the
available studies and will continue to do so. In addition to noting that
the studies generally confirm that costs to corporations are increasing,
OEA has raised several concerns about the quality of the reported evidence
to date.
First, the studies tend to rely on small samples and on the results of
surveys without documentation. This raises serious questions about how
valid the survey methods are and how representative the responses are. For
example, one of the studies most prominently cited in the press, probably
because it concludes that 21% of respondents were considering going
private, is a study where 9000 surveys were sent out and 115 public
companies, or 1.3%, returned responses.1
Second, the data on costs, while growing, are still limited. Until next
year there will not be available cost information that covers all of the
Act's requirements. And it will take longer than that to get a good idea
of ongoing costs since I believe most agree that costs in the first year
or two of compliance are likely to be greater than those in later years.
Finally, and most importantly, a balanced evaluation of the effects of
the Act will require study of the benefits as well as the costs. To date,
researchers have produced few if any reports on the benefits. As available
evidence of such benefits increases and such reports emerge, only then
will it be possible to evaluate both the benefits and the costs. Studies
that show significant percentage cost increases — for example a recent FEI
study that found a 38% increase in fees to auditors and a more recent
update that suggests that number is higher, principally as the internal
control requirements kick in — suggest increases in dollar terms that may
be justified when compared to the countervailing benefits. This last
conclusion may be more open to question for smaller companies, but as I
suggested above, we are trying to address the biggest potential costs for
those companies.
Many of the benefits of the Act are difficult to measure using the
survey methods that have been the basis of the reported cost estimates. At
least one recent poll, however, suggests a link between the Act and
improved investor confidence. The Wall Street Journal recently cited a
Harris poll where 59% of investors polled believed Sarbanes-Oxley will
help safeguard their stock investments.2 We regard improved investor confidence as a
significant benefit of the Act. We also have anecdotal evidence of
improved financial reporting and corporate governance.
What I think is needed is to let run one or two cycles of the fully
implemented Act and to revisit the evidence from economic research, which
should have grown significantly by that time. We may choose to supplement
that research with separate rigorous economic studies of the costs and
benefits of the Act done with proper sampling and measurement. Then we
should see what we can learn from those studies. Until then we are dealing
with little more than speculation.
In the meantime, the people in this audience are more intimately
familiar than almost any other group with the burdens, including costs,
that Sarbanes-Oxley and companion reforms have placed on their companies.
You are also able to evaluate from your companies' perspectives the
benefits that the reforms have engendered — including more focus on the
quality of financial reporting and good audits, top management that is in
many cases more aware of and more engaged in disclosure matters, more
genuinely independent boards carrying out genuine oversight functions.
Should we really forego these benefits? And does anyone really believe
that corporate America would have obtained and provided these benefits
without the legislative and regulatory reaction of 2002 and 2003? I for
one do not.
Current Items on the Commission Agenda
While Sarbanes-Oxley and its impact continue to be important, the
Commission has also moved on to other matters. Some of them are subjects
of daily reports, such as mutual fund reform, including the new rules
regarding independent chairs and other governance matters, and hedge fund
adviser registration. I want to spend a few minutes on some of the matters
of particular interest to this audience.
Improvements to the Proxy Process
On July 15 of last year, the Division of Corporation Finance provided
the Commission with its report on the proxy rules related to the
nomination and election of directors. As I mentioned earlier, in November
the Commission adopted new disclosure standards addressing the report's
first recommendation, requiring enhanced disclosure of nominating
committee processes and the processes by which security holders may
communicate with directors.
In October, the Commission proposed new Exchange Act Rule 14a-11 and
other rule amendments intended to implement the second of the Division's
recommendations, requiring companies under limited circumstances to
include in their proxy materials nominees for director of large long-term
shareholders or groups of shareholders where those shareholders or groups
have a state law right to nominate.
The proposal would give substantial shareholders a way to address their
dissatisfaction with a company's management in a way other than by selling
their stock or waging an expensive proxy fight that is currently required
under our proxy process. The expense of a proxy fight may be justified in
the context of a contest for control but is not justified when an investor
or groups not seeking to influence control is trying to exercise its right
to nominate what it believes is a better director.
The issues and views on all sides of this issue are all too well known,
and I will not outline them or discuss them here. The views on all sides
are strongly held and strongly expressed. Indeed, the rhetoric has at
times not been conducive to any sensible rule-making process. It is unfair
to companies to suggest that the board nominating process is to replace
Tweedledum with Tweedledee, as one commenter has suggested. It is inflated
and unjustified to suggest that the Commission's proposal will put the
economic recovery at risk or seriously damage the competitiveness of
American business, as corporate opponents have stated.
I will leave you with two thoughts on this subject. First,
notwithstanding some press reports, the proposal is not dead. It remains
alive and before the Commission. There are ongoing discussions about how
to proceed. If a final rule can be crafted that the Chairman supports and
that has the requisite Commission support, it will be adopted. And the
Chairman will not impose an artificial deadline on this process.
Second, I must say, and this really is just my own view, I don't
understand the expressed position of much of corporate America that no
version of this proposal is acceptable. I believe there are companies
where our current proxy process is impeding desirable shareholder choices
in director nominations and elections for which state law provides, and I
believe every company, or virtually every company, represented in this
room agrees with me. The Commission, in making its original proposal in
October, started from the general proposition that improving our proxy
process for candidates for director properly nominated under state law, in
limited circumstances and outside the control context, had merit.
Virtually every investor with a computer, typewriter, pen or pencil has
expressed support for some version of this proposal, and in many cases
support for a proposal that would go further than what is before the
Commission. In my view, this issue is not going to go away.
Since the mid-1990s, and indeed in some sense since the mid-1980s,
following the adoption of shelf registration, the staff of the Division of
Corporation Finance and the Commission have sought to address Securities
Act reform. We are at it again. We are trying to devise a set of proposals
to recommend to the Commission that will address four principal areas of
regulation, as well as a larger number of incidental and ancillary issues.
The principal areas are the following:
- We are looking at the liberalization of communications, especially
written communications beyond the statutory prospectus, in registered
offerings. We are considering liberalization in the context of both
routine communications and communications that are offers. We are also
looking at these questions as they relate to filing requirements and
liability issues.
- We are looking at whether at least a limited category of large
seasoned issuers should have fewer regulatory obstacles to immediate
access to the capital markets. Our work in improving Exchange Act
reporting should make this more feasible.
- We are considering how to provide clearer rules that investors
should have adequate and accurate information at the time they make
their investment decisions, without slowing down the offering process as
a result. Better Exchange Act reporting and liberalized communications
methods may help resolve some of the issues of giving investors access
to adequate information.
- We are considering the restrictions placed on unregistered private
offerings, at least in the context of offerings to large institutional
investors.
These issues and possible approaches are all at a somewhat preliminary
stage, and of course any proposal will depend on what the Commission
decides on each of these questions.
Executive Compensation
One area of governance that has received a fair amount of attention
lately is the amount of compensation earned by company executives. I
certainly do not believe that the Commission should be involved in setting
executive compensation. I do believe our legitimate interest in governance
requires us to monitor companies' performance under the listing standards
that we approved that establish independence requirements for compensation
committees. And our disclosure rules mandate disclosure of all
compensation earned by the CEO and other top executives, as well as
compensation policies.
The NYSE and Nasdaq focused on the governance issue in adopting a
requirement that CEOs' compensation be determined by an independent
compensation committee or by independent directors. To fulfill their
responsibilities, in addition to requiring independence under the rules,
directors who set executive pay should be independent in spirit. Their
responsibility is to set appropriate compensation for each individual, not
to fit within a prescribed range based on industry or company size. And
their responsibility is certainly not to follow the Lake Wobegone theory
of compensation, where all executives of all companies are above average.
To this end, companies and their boards should consider carefully whether
compensation is focused on the long-term performance of the company and
its executives in all respects (and not just short-term results or narrow
measures, such as those limited to earnings). Directors should take
advantage of their independence to make their own decisions. If
compensation consultants are used, they should be those of the
compensation committee. From a personal point of view, I don't understand
the advantages of dueling consultants in setting CEO compensation, one for
the CEO and one for the committee.
Companies also should be concerned about whether their executive
compensation disclosure is accurate and complete. This is an area where,
based on questions we receive, there sometimes seems to be a desire to
limit disclosure to the minimum rather than to create disclosure that
fully informs investors. Why is this the case? Are executives seeking to
minimize comp disclosure? Are too many lawyers who participate in drafting
these sections putting the expressed interests of executives ahead of
those of their client, the company? How is the company well served by
disclosure that is minimal and seeks to obfuscate rather than disclosure
that is informative and seeks to clarify?
I would also ask companies, and especially the independent members of
compensation committees, to take a fresh look at their compensation
committee reports. There has not been guidance in this area since a 1993
Commission release, one year after the report requirement was adopted. But
the guidance remains sound today. Too much of what is written is
boilerplate, and is not as specific or informative as it could be.
On our side, both the executive compensation rules, including the
compensation committee report requirement, and the director compensation
and relationship rules are more than a decade old. We are in the process
of taking a look at them. They are very detailed and specific, the
opposite of principles-based rules. So far as I can tell, the Commission
went in that direction because of a concern that another approach would
not capture all compensation and because the detailed tables fostered
comparability over time periods and between companies. We will review the
rules and the disclosure we are getting and make some judgments about
whether there need to be changes and whether there needs to be more
up-to-date guidance. We may not recommend anything to the Commission, but
then again we may.
I will stop at this point. Thank you again for inviting me to be with
you this morning. I would be pleased to take questions if we have
time.
1 See Thomas E. Hartman, Foley &
Lardner LLP, The Cost of Being Public in the Era of Sarbanes-Oxley, 2004
National Directors Institute (May 19, 2004).
2 Judith Burns, Is Sarbanes-Oxley Working? Wall
Street Journal, R8 (June 21, 2004).
http://www.sec.gov/news/speech/spch071004alb.htm
