Speech by SEC Commissioner:
Remarks at the Corporate Directors Forum 2007
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
San Diego, California
January 22, 2007
Thank you for your kind introduction. I appreciate the efforts of Linda Sweeney of the Corporate Directors Forum, program chairman Larry Stambaugh, and meeting co-chairs Richard Koppes and Cynthia Richson to make this event possible. For over fifteen years, the Corporate Directors Forum has operated from a simple premise: that better boards make better companies and that board members should achieve the highest level of corporate governance in the exercise of their fiduciary duties.
Speaking of fiduciary duties, I do have one duty to satisfy before I begin: that is to inform you that that the views I express here are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
The theme of this forum is “Directors, Management, and Shareholders in Dialogue.” In the ideal world, all three of these groups work in perfect harmony to achieve a common goal of maximizing the value of a business.
This topic is a good one, and it is a recurring one, especially for me in a personal sense. Fifteen years ago when I was at the SEC with then-chairman Richard Breeden, we organized a first-ever SEC conference on just this theme: the relationship among shareholders, management, and directors, considering subjects like executive compensation and the overriding theme of American economic competitiveness. I commend that transcript to your reading. That conference helped us to refine a consensus for such innovations as running a short slate of directors, improvements in shareholder communications, and better disclosure of compensation.
The long-recognized challenge, of course, is that the interests of management are not always completely aligned with those of the shareholders. In 1776, Adam Smith wrote about the agency problem of management in the Wealth of Nations: when it comes to money, he said, managers “cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private [partnership] frequently watch over their own.”1 Therefore, “negligence and profusion … must always prevail, more or less, in the management of the affairs of such a company.”2
In the face of such potential for managers’ conflicts of interest, directors must guard the interests of shareholders and ensure that managers do their jobs. They also must perform an extremely important advisory role to management. The widespread dispersion of ownership in a modern corporation makes the role of directors all the more important.
The SEC is very concerned about maintaining our capital markets as an attractive place for investors to invest. In fact, we are charged by Congress to look after not only investor protection, but also competition and efficiency of the financial marketplace and ease of capital formation. We must ensure the integrity of our markets so that investors have confidence that they will be treated fairly. At the same time, our regulations must not price those very investors out of our markets through burdensome regulations or eat up the fruits of their investments through nonsensical mandates.
This evening, I would like to discuss (i) the implementation of Section 404 of Sarbanes-Oxley, (ii) the pending debate on shareholder director nominations, and (iii) some thoughts on the role of a corporate director.
Section 404 of the Sarbanes-Oxley Act
This year marks the fifth anniversary of the Sarbanes-Oxley Act.3 Consider the many provisions of this Act: standards for auditor independence, requirements for companies to disclose codes of ethics, principles to address conflicts of interest among research analysts, and increased criminal sanctions for securities law violations.4 Many of these provisions have raised nary an objection since the law’s enactment.
However, one section of the Act has caused Sarbanes-Oxley to become synonymous with American regulatory over-reach – especially in the international community. That provision, of course, is Section 404. This section requires management to assess annually the effectiveness of internal controls for financial reporting and requires a company’s outside auditor to attest to, and report on, management’s assessment.
At the time Sarbanes-Oxley was passed, few, if any, people expected Section 404 to be the most controversial provision or that it would impose any significant burden. After all, Section 404 itself was copied almost word-for-word from a provision that had applied to banks for more than ten years. Indeed, the Senate committee report on Sarbanes-Oxley observed that high quality audits already “incorporate extensive internal control testing.”5 The Senate report then boldly predicted that the committee did not expect the internal control provision to be the basis for any increased fees or charges by outside auditors.6 We at the SEC ourselves predicted minimal additional costs; we estimated an average of $94,000 per company, for a total of one and a quarter billion dollars. Well, so much for predictions.
The issue is not with the principle that management should have a reasonable control environment that provides assurance as to the integrity of the financial statements, but rather with the flawed implementation of Section 404. Simply put: Benefits should exceed costs. When we embarked on implementing Section 404, the SEC envisioned a top-down, enterprise-focused approach, where a company would focus on entity-level controls that could materially impact the consolidated financial statements. The SEC rule was a principles-based approach aimed at management.
However, the rules that the PCAOB developed for auditors had an entirely different effect. Of course, I am referring to the now-infamous Audit Standard No. 2 (AS 2), a 300-page rule that has been supplemented by a large amount of additional interpretive guidance. Unfortunately, the PCAOB set out on a different path from existing auditing approaches to internal controls. The PCAOB intended to build a better mousetrap, but in hindsight we see that the trap probably caught more fingers than mice! The SEC approved the rule, mainly out of a misplaced sense of deference to the PCAOB.
Basically, the primary flaw of AS 2 was that it lacked a firm grounding in the concept of materiality. AS 2 came into effect just as accountants felt as if they were under the gun from the SEC trying to prove itself, a new regulator in the PCAOB, prosecutors who had just sunk Arthur Andersen, and private lawsuits threatening the solvency of their firms. Was it any surprise, therefore, that the way auditing firms implemented AS 2 led to a very process-intensive, document-oriented, bottom-up approach? We had an atmosphere in which what-if scenarios created mountains out of molehills – a control failure for a $500 error could be just as significant as for a $50 million error. And, we had companies being told to document, analyze, and create process charts for literally tens or hundreds of thousands of supposedly key internal controls – and those numbers are for individual companies, not the market as a whole!
Of course, a company needs controls to ensure that theft or embezzlement does not occur. But as most accountants and corporate executives will tell you – and your common sense will advise you – many of these controls (except perhaps in extremely rare or unusual circumstances) should not rise to the level of being critical to material misstatements of the financial statements in most publicly traded companies. Control processes pertinent to a Sarbanes-Oxley-type discussion, including those designed to detect and correct mistakes, should be focused on picking up the material errors.
I have visited many companies from coast to coast and have heard so many stories of excess that I could regale you all night. Don’t worry; I will not do that. But, take one example. Many companies, especially smaller ones with limited accounting staffs, hired outside 404 consultants to help them produce the requisite reams of control matrices, process charts, and analyses, precisely because auditors felt that AS 2 would not allow them to assist or guide their audit clients in this task. OK. But, did the auditors use these materials even as a reference point? Incredibly, many, many did not. What an absolute waste of shareholder resources, since shareholders in effect pay twice – first for the consultants’ and then for the auditors’ work!
Now, my comments are not intended to downplay the important role of effective internal controls and the role of the audit committee in these matters. But my point is that all of these efforts need to be placed in perspective and that professional judgment and rationality should prevail in balancing costs and benefits.
I think almost all players in this debate have recognized the flawed approach that was initially rolled out. Last month, the SEC proposed additional guidance for management’s assessment of internal control. Around the same time, the PCAOB proposed replacing AS 2 with a new audit standard, AS 5, for an outside auditor’s attestation of internal controls. Far from being a rollback or lessening of standards, I think the new proposals go a long way towards implementing the original vision of Sarbanes-Oxley. I look forward to seeing the comments on these proposals.
Shareholder Access
Four months ago, a federal appellate court in New York issued an opinion in a case involving the insurance company AIG.7 In that case, the AFSCME union sought to include a proposal on AIG’s proxy statement that would amend the company’s bylaws to permit certain shareholders to nominate a competing candidate for director. The SEC staff agreed with AIG that it could exclude the proposal from its proxy statement pursuant our Rule 14a-8 that governs shareholder proposals. The court, however, disagreed with the staff’s position and ruled in favor of the shareholder.
As most of you are aware, the SEC proposed a rule in October 2003 on shareholder director nominations that was subject to extensive discussion and comment.8 There was much criticism of the proposed rule. Some argued that the proposed “trigger” process was too cumbersome and time-consuming. Others argued that the proposal crossed into governing the internal affairs of a corporation, which were a matter of state law. In any event, then-chairman Donaldson decided not to proceed with the proposal.
Since that time, a number of important developments have occurred relating to director elections. First, has been the adoption of some form of majority voting – whether by amendments to the charter or bylaws of a company or adoption of a policy by the board. By the end of the 2006 proxy season, nearly 180 companies had adopted majority voting policies, according to Institutional Shareholder Services (ISS).9 For the 2007 proxy season, ISS notes that there are 104 pending proposals to adopt majority voting policies.10
A second development is that the SEC recently adopted rules to permit the delivery of proxy materials over the Internet.11 Under the optional “notice and access” model, soliciting persons need send out only a brief notice to shareholders and post their proxy statement on the Internet. This approach should reduce the mailing and printing costs associated with third party solicitations, which have been frequently cited as a barrier to mounting proxy contests. E-proxy should further increase the utility of the current rules that allow a shareholder to run a “short slate” proxy solicitation in opposition to management’s candidates. This “short slate” rule, which the SEC adopted in 1992, allows a shareholder to nominate fewer directors than would make up a majority of the board, and then to fill in the remaining slots with the company’s nominees.
I recognize that some proponents of shareholder director nominations would argue that majority voting and e-proxy developments do not go far enough. For instance, some are not satisfied that in most companies with majority voting, if a director fails to receive a majority of votes cast, the nominating committee of the board has the role of proposing a new candidate. And, while e-proxy can significantly reduce distribution costs, there will remain solicitation costs and legal expenses in order to mount a serious challenge.
The question of whether the SEC should mandate shareholder director nominations is one that goes back to the very formative years of the Commission. As early as 1942, the SEC considered the issue. This issue was taken up again in 1977 and again in 1992. In each of these distinct time periods, each marked by different SEC members and staff, no significant changes were made to the SEC’s shareholder nomination rules.12
There are a couple of threshold issues that I take very seriously. First, what authority does the SEC have to mandate the inclusion of shareholder nominated director candidates on the company proxy statement? Second, what are the unintended consequences of doing so?
As to authority, because this would not be merely a disclosure provision, can we impose substantive rules on director selection? The courts have not viewed our authority broadly. Most notable was the 1990 case of The Business Roundtable v. SEC,13 in which the D.C. Circuit struck down the SEC’s one-share-one-vote rule. I should note also that in the past couple of years, SEC rules have been struck down three more times by the D.C. Circuit as overstepping authority or process in rulemaking regarding hedge fund investment advisor registration and mutual fund governance.14 That was despite the confident pronouncements by the proponents of those rules that the SEC had done things properly.
Second, are we indirectly preempting state law, which traditionally governs the selection of directors? Even in the Sarbanes-Oxley Act, Congress was deliberate in how it authorized and directed the SEC to act in this governance area to avoid upsetting the traditional balance.
I appreciate fully the different sides of this debate. On the one hand, I believe that owners of a corporation should decide for themselves how they wish to govern themselves and choose their representatives to oversee management, who are their employees. The best protection is that a majority of shareholders must decide any of this, so let the majority of owners rule. Government should not be telling the owners how to do it. All other things being equal, those corporations that have favorable investor corporate governance structures should enjoy a lower cost of capital and command a premium for their stock price.
On the other hand, I recognize the fears expressed by many that allowing untrammeled shareholder access to the company’s proxy might open the floodgates to special interest groups seeking to hold a company hostage until their pet “stakeholder” issues are addressed. This includes unions, private investment funds, and other parties, as we have seen in some recent incidents. I have also heard complaints that permissive shareholder access rules might facilitate the creation of special-interest directors — meaning directors that are nominated by a certain block of shareholders to represent that block’s interests. Notwithstanding directors’ fiduciary duty to all shareholders, we have seen recently how a fluid concept such as “what-is-best-for-the-shareholders” can divide a board among its members and weaken a company.
A missing element in most of the discussion is what kind of disclosure is needed to protect shareholders: Who is making these nominations and what other interests and conflicts of interest are implicated? Shareholders, of course, generally are not subject to any fiduciary duty to the other shareholders. Thus, as in all activities by any particular shareholder or group of shareholders, who can say for sure that what those shareholders do is in the best interests of all shareholders?
That is one reason that traditionally it has been all or nothing regarding board slates – if you think that you have a better idea of how to run the company, then put your money where your mouth is and take it over with a full slate of directors. No one can then argue as to which direction the company should go.
Although the 1992 rule changes to allow short slates deviated from this traditional approach, procedural and disclosure protections were built into the rule to ensure that investors have full disclosure about the short-slate proponent.
Corporate governance is settled on the notion that boards and management should be responsive to the shareholders. Historically, a fundamental assumption has been that shareholders will vote in accordance with their ownership interests, and that these interests would be consonant with their economic interests. But, what if this assumption is not true? What if a shareholder who participates by voting at a shareholder meeting holds no economic interest, or possibly even, a negative economic interest in the corporation? This can easily happen in today’s financial markets, where through share lending programs and equity derivative instruments, voting rights can be effectively severed, or de-coupled, from the underlying economic interest.
This activity has been dubbed “empty voting” and “vote morphing.” It carries the potential to create much mischief in shareholder voting. Professors Henry Hu and Bernard Black from the University of Texas Law School have discussed this issue in a number of recent articles.15
Financial investors today can relatively easily and cheaply augment their voting power or alter voting results, even when they have no ownership interest in the corporation. In one example, a hedge fund owned a significant stake in a company targeted in a stock-for-stock tender offer. The hedge fund stood to profit greatly if the acquisition went through. However, dissident shareholders of the acquiring company were complaining that the deal was overpriced and should be abandoned.
So what did this hedge fund do? It purchased a 9.9% stake of the acquiring company, but then entered into equity swaps and other transactions to eliminate any of its economic interest in the acquirer. Thus, you had a situation where this hedge fund could vote a significant block of the acquirer’s shares to approve a transaction which would, in turn, benefit the hedge fund but arguably hurt the shareholders of the acquirer.
I look forward to the pending discussion about shareholder director nominations. I recognize that the Second Circuit’s decision in the AIG case has created some confusion as to the proper interpretation of the Commission’s regulations, especially for companies located outside of that court’s jurisdiction. We now have pending before us requests from several companies for clarity in similar situations, and all from other jurisdictions. This number may increase in the days ahead. The Commission has an obligation to the capital markets to remove such uncertainty and articulate a clear policy. We have an obligation to create a learned, organized discussion on this subject. Is there a problem, given all that is occurring in the capital markets, and what solutions should we consider, given our power and authority? Thus, I would be happy to support the introduction of any proposal that Chairman Cox sets forth to get this discussion going and to bring certainty to the marketplace. The commentary and discussion would be highly productive and informative, as it was in 2003.
Role of the Director
Since the corporate scandals at the start of this decade, public company directors have been placed under a magnifying glass and their actions scrutinized intensely at the first whiff of malfeasance at a company. The role as a director has not been made any easier by a regulatory and litigation environment that remains shifting and has not yet settled.
Many of the reforms have been particularly process-oriented – whether an action has been properly documented or a procedure or policy implemented. However, it is worth emphasizing that none of these additional obligations has removed the fundamental obligation of a director to maximize shareholder value or a director’s ability to use business judgment.
Boards of directors must remain focused on the big picture. Board members are not intended to be micromanagers or compliance officers. While divergence of views and experiences on boards is often a good thing, divisiveness, personal vendettas and factional battles within the boardroom can cause paralysis in a business and destroy shareholder value. Recently, we have seen just this problem occur in a highly publicized matter.
Boards and management must not be discouraged from undertaking honest entrepreneurial risk. We live in a global competitive environment in which rapid changes and constant challenges are to be expected. Some efforts will succeed and others will fail; that is the risk and reward trade-off in the marketplace. Government regulators should not be second-guessing legitimate business decisions.
* * *
We should not – and cannot take – our domestic public capital markets for granted. Since the end of World War II, our financial markets have reigned supreme in the world. They have provided an active and liquid market for raising capital. American investors have enjoyed a great investment environment – people from around the world have come here – on our terms – to seek out our investment. Americans generally have benefited from the protections of American laws and our court system. Now that is changing. Perceptions of excessive regulation and a lottery-like litigation environment have created a situation where alternatives to the American public capital markets are being pursued with increased vigor. Once these perceptions take hold, they are extremely difficult to dispel, particularly when other comparable alternatives exist.
I remain a steadfast believer in the public capital markets. Their transparency, liquidity, and depth contribute mightily to this nation’s economy and security. Publicly-held investment should be a competitive source for capital. If we have over-reacted in some respects to corporate scandals, especially where the costs far outweigh any benefits, then I ask for your help in bringing back the right balance.
Thank you for your commitment to upholding the integrity of public reporting companies by improving corporate governance. I look forward to working with many of you on ways to further strengthen and improve our nation’s public capital markets. On these and any other issues before the Commission, my door is always open. Good evening, and I wish you a productive remainder of your conference.
Endnotes
http://www.sec.gov/news/speech/2007/spch012207psa.htm
