When a young Fortune magazine reporter broke the Enron story, the SEC — and just about everyone else — was caught off guard. Unlike most of us, however, the SEC's raison d'etre is to make sure that capital markets run smoothly and that Enrons, Worldcoms, and Tycos do not happen. Now, years after the recent corporate scandals, the SEC is still reeling from one misstep after another: It was again caught off guard by the mutual fund timing scandal, which was uncovered by New York Attorney General Eliot Spitzer; the Government Accountability Office has noted that the SEC failed to correct weaknesses in its own internal controls over computer security, tracking of fines and penalties, and preparation of financial results; and, most recently, the Chamber of Commerce has recommended a dramatic reorganization of the SEC so that it mirrors the market it regulates.
The SEC is under scrutiny, its trajectory and effectiveness are under question — and it is no longer receiving high marks from its various constituencies. If anything, the SEC is on academic probation. Let's examine 10 major matters that came before the Commission in 2006 and grade its handling of these issues.
1. Executive compensation: B-
The SEC unveiled its new principles-based executive compensation disclosure rules in January 2006. The rules, which apply to the company's directors, CEO, CFO, and the three other highest-paid executives, require disclosure of a total compensation figure, perks worth $10,000 (lowering the threshold from the previous $50,000 requirement), a detailed analysis of how pay is determined, and new tables requiring better disclosure of retirement plans and director pay, including a dollar-value listing for stock-based awards such as options. The proposed rule also required that companies use the same formula for valuing stock options that it used when expensing them. A last minute reversal by the SEC permits disclosure of stock options when they vest rather than when granted.
Although the SEC describes this initiative as “wage clarity” and not “wage control,” historically, the SEC has used disclosure requirements that have tended to set normative standards of conduct for public companies and their stewards. Some indications are that it is not working: Recent disclosures by some executives reflect negative income — resulting from the SEC's last minute reversal on accounting for stock options — and some important figures (such as company contribution to the executive's 401K plan) have been left outside the disclosure requirements altogether. For all of the work and effort the SEC has poured into this initiative, it is still a far cry from the “one-stop shopping” goal of executive compensation transparency, meriting no more than a “B-.”
2. Options Timing: B
Increasingly, the Commission appears more concerned with unanimity that with getting things done. As a result, the sweeping 100-plus investigations into options backdating in 2006 resulted in few enforcement actions, and even fewer resolutions. Mercury Interactive Corp. was one of the first companies caught up in the options backdating scandal. In July 2006, in a surprising reach into the boardroom, three directors of Mercury Interactive received Wells notices, an indicator that the SEC was inclined to pursue civil securities charges against the individuals. After this initial announcement, there has been no further word — at least not publicly — on any potential action against the directors.
In another prominent case, Brocade settled its options backdating action for $7 million in July 2006; 8 months later, the Commission has yet to decide on the settlement — leaving the company in limbo, with settlement reached but no resolution achieved. Although the Commission denies any disagreement among its members on penalties for backdating, there is little else to explain the long delay in approving — or rejecting — the settlement.
The SEC has tried to clamp down on options backdating through the executive compensation disclosure rules and increased accounting guidance. The SEC chief accountant issued guidance on the proper accounting for options grants in light of the SEC's investigation into options backdating. Although the guidance makes clear that the SEC will distinguish between honest mistakes, such as paperwork errors, and those suggesting that the company was trying to game the accounting rules, it does not shed any light on what criteria will determine which of the 100-plus cases under investigation will result in enforcement proceedings. This incomplete, glacial approach deserves no more than a “B.”
3. Penalty guidelines: C
Since 2000, the SEC has pursued monetary penalties against companies with seemingly little regard for the unnecessary financial pain it would inflict on shareholders who had already been harmed by the conduct of executives. These penalties were assessed with little rhyme or reason — there being no obvious patterns to the penalty, nor any relationship to the underlying financial damage or benefit gained. The one consistent element was that the SEC seemed to demand as much as the target company was willing to pay. In addition to being patently unfair, this haphazard approach to assessing monetary penalties made costs-benefits analysis of voluntary disclosure near impossible.
In 2006, the SEC issued the Statement on Penalties, which it said it would use in deciding whether and how much to fine a company. Despite the fanfare, the new penalties guidelines have little that is new. Not surprisingly, they emphasize cooperation and criticize intentional wrongdoing, much along the lines of the 2001 Seaboard Release. The SEC has done nothing to explain why some companies are fined under $10 million, others over $100 million. It is this critical information — how the SEC decides the magnitude of fines and penalties — that the business community has been anticipating. The new penalties guidance does no such thing. We are left with the same statutory penalties — and no indication of how the SEC interprets and applies them — that we had before.
Exacerbating an already confusing landscape, the SEC has done little else by way of penalties since it issued its guidelines — including approving them. Few penalty-related cases have been brought to the Commission and many of the ones that have been finalized have been unanimous 5-0 votes — leading to speculation that Chairman Cox's emphasis on unanimity has lead to an impasse. Part of the delay results from the need to document and prove the principles outlined in the framework, adding another layer of analysis and documentation. The new guidelines have failed to clarify the assessment of penalty amounts, while resulting in long delays in obtaining final approval of settlements, such as the eight-months-and-counting wait for approval of the Brocade settlement. A “C.”
4. Sarbanes-Oxley section 404 and small businesses: C+
The SEC promised to revisit the application of Section 404 to small businesses in response to concerns that the new certification and auditing requirements would prove exorbitantly costly to small companies. However, the SEC rejected its advisory group's proposal that small companies be exempted altogether from Section 404. Instead, in December of 2006, the SEC issued additional guidance on how small companies should assess the adequacy of their internal controls and extended the time frame for companies to comply. The SEC proposed that companies with a market value of less than $75 million would not have to file 404 certifications until after Dec. 15, 2007, and auditors only have to start signing off on these controls for fiscal years ending after Dec. 15, 2008. The new guidance allows corporate managers to use their discretion to focus on controls and processes that they feel pose the greatest risk and could result in major misstatements.
The pendulum appears to be swinging back. In recent weeks, the White House met with business and Wall Street representatives to consider the unintended consequences of Sarbanes-Oxley, with administration officials urging a “balanced” approach to regulation. However, although the administration is pursuing the critical examination of Sarbanes-Oxley, the SEC fails to offer real relief. The new guidance on 404 compliance for small companies does not alleviate the burdens of 404 implementation; it allows them to be more flexible in deciding how to fulfill their obligations — a flexibility that introduces ambiguity and, without the guidance of specific examples, does little to limit potential exposure to liability. This is not so much relief as it is adding to the costs and burden of compliance, those of determining what constitutes compliance. This earns the agency a “C+.”
5. Mutual fund rule: F
Under former Chairman William Donaldson's leadership, the Commission passed a controversial mutual fund governance rule by a 3-2 vote. The new rule increased the mandatory number of independent directors sitting on the board of a mutual fund from 40 percent to 75 percent, and required that the chairman also be independent. A federal appellate court sent the rule back to the SEC to conduct a cost-benefits analysis of the new requirement. Eight days later, the SEC announced that it had determined the rule was cost-effective. The rule was successfully challenged a second time and sent back to the SEC for further review of costs and alternatives.
Many expected Chairman Cox to abandon his predecessor's controversial initiative. Surprisingly, Cox instead announced his intention to seek approval of the rule, and reopened it for public comment in June 2006. In December, the SEC voted to reissue the rule and pledged to make public two reports on the rule's costs and benefits available as part of the public comment process. However, those reports revealed that there was no demonstrable evidence linking director independence and fund performance. The SEC continued to defend the rule, arguing that failure to detect a link might result from limitations in the standard statistical methods used and did not necessarily evidence that director independence was unrelated to fund performance. The mutual fund rule remains unresolved, as the SEC continues to float revisions.
This initiative is bewildering. First, the SEC's efforts were twice rebuffed by a federal appellate court. Second, the SEC's own economic analysis reveals no recognizable benefit conferred by the rule's objective of creating an independent board. Third, such regulation may be moot, as it would seek to make mandatory what the majority of mutual funds already do voluntarily, as approximately 80 percent of mutual funds report meeting the 75 percent standard. Why continue to promote an insupportable rule that minimally impacts the status quo because the vast majority of the industry complies with it anyway? The SEC's inexplicable pursuit of this initiative earns it a failing grade of “F.”
6. Shareholder access: C
In 2003, the SEC proposed a rule increasing shareholder access to the proxy statements to nominate candidates for director; the proposed rule was soundly opposed and consequently never finalized. The SEC then reversed course, routinely approving company requests to exclude shareholder efforts to establish procedures for greater shareholder access to company proxy materials.
As the events of the last year have shown, there are many battles in this war. Institutional investors took their challenge to federal court and, in 2006, the Second Circuit ruled that companies could not exclude from proxy materials shareholder proposals to amend the corporate bylaws to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot. The Second Circuit decision opened the door for shareholder amendment to company bylaws — something the SEC was unable to do through its traditional rule-making powers. Along a parallel front, shareholders sought amendments to companies' organic documents to provide that directors be elected by a majority of shareholder votes rather than a plurality. The potential shift from a plurality to a majority standard arose as a significant corporate governance issue in 2006.
The business and investor communities poised to see what the SEC would do next. The Commission could have chosen to close — or at least reorganize — this discourse by formally adopting a position to exclude proposals for shareholder nomination of directors in management's proxy statement. Instead, the SEC did nothing. Through inaction, the SEC aligned itself with shareholders, using market forces to help shape policies on shareholder access. The “market” here is in corporate governance, with corporate boards as producers and shareholder consumers. Instead of ending the debate, the Commission left the constituencies to continue their dialogue of ideas. This move demonstrates the agency's declining effectiveness, as it allows market participants, rather than government institutions, to pursue policy objectives properly considered by market regulators. A “C.”
7. Hedge fund advisor registration rule: C
The rapid growth and increased allegations of fraud involving hedge funds prompted the SEC to adopt rules requiring fund advisors to register with the agency. Under the new rules — again promulgated under Chairman Donaldson — larger hedge fund advisors with 15 or more clients were required to register with the SEC, submit to periodic audits, adopt a compliance officer, and provide more information to the agency about their trading. The registration also required general details about pay structure and strategy, as well as any pending or resolved criminal felony charges and regulatory actions. The new rule was again of questionable effect, as hedge funds wishing to avoid registration took advantage of two loopholes in the rule by simply locking up their clients' investments for two years and closing their funds to new investors. A federal appellate court rejected the rule in June 2006. Despite repeated assurances that it would revisit the rule, the SEC has taken no further action; by deed — if not by word — the SEC appears to have abandoned hedge fund advisor registration.
While it is no surprise that the SEC would try to protect investors by regulating an unfamiliar industry, the proposed rule demonstrates how little the SEC understands hedge fund operations. The rule was easily avoided by those wishing no part of it. Further, its boilerplate disclosure requirements revealed little (if any) new information to sophisticated hedge fund investors who conducted thorough investigations — often including interviews, questionnaires, and private consultants — before investing assets. Finally, the reporting and compliance requirements would be unproductive because hedge fund investments often change quickly; any report would only be a snapshot showing the fund at that particular time, and could quickly become obsolete.
The SEC quickly recognized the limited utility of hedge fund advisor registration and let it die quietly. The agency would have done better to have applied transparency principles to its own actions, and admitted that it was indeed abandoning the rule. The SEC's foray into hedge fund registration earns it a “C.”
8. Approaching hedge funds from a different angle: Regulating investors: B-
After a failed attempt at regulating hedge funds, the SEC sought to address its concerns regarding potential exploitation of unwary investors by restricting who can invest in hedge funds. Under current rules, which are also applicable to private equity funds and venture capital funds, individuals can invest if they have a net worth of $1 million or an annual income of $200,000 in the previous two years. The new rule would require hedge fund and private equity fund investors to have $2.5 million in investment assets, excluding primary residences, potentially reducing the number of qualified investors by 88 percent. When the original rule was passed in 1982, only 1.87 percent of all U.S. households were qualified to invest in hedge funds; today, 8.5 percent are. The proposed rule would reduce that percentage to 1.29 percent. The new proposed rule would not apply to venture capital funds. SEC staff members who drafted the rule said they wanted to avoid reducing the amount of capital available to start ups, but this rationale seems weak, as venture capital funds can prove as risky as hedge funds.
The SEC has proved itself dexterous in seeking to address its concerns regarding hedge funds by restricting the investors it seeks to protect, rather than regulating the hedge funds themselves. This approach seems inherently unfair to those investors lacking sufficient wealth to participate in what are often highly lucrative investment vehicles; however, it is a more subtle approach than seeking to impose costly reforms on or to otherwise restrict the entire industry. This earns it a “B-.”
9. Securities lending: A
The SEC has also indicated an interest in curbing abuses increasingly associated with securities lending and its implications for shareholder voting. Because the vote follows the holder of the shares — not the owner — the practice has raised concerns that investors are borrowing shares to affect the vote. This practice, known as “empty voting,” became particularly controversial when it was discovered that some mutual fund firms were not following proper procedures when lending securities.
Although it has yet to take concrete action, the SEC is targeting a practice that undermines the basic principle of public companies — that shareholders wield influence in the company that is roughly commensurate with their financial interest. The SEC's newly tuned interest seeks to curb a particular practice rather than increasing industry-wide regulation. The SEC's use of precision instruments rather than blunt tools earns it an “A.”
10. Delisting for foreign private issuers: C
The unanticipated fallout of Sarbanes-Oxley's onerous requirements has been its dampening effect on the U.S. position in world capital markets. The legislation's hasty drafting and enactment made no allowance or exceptions for the concerns of foreign private issuers. Consequently, some of the Sarbanes-Oxley imposed requirements conflicted with obligations under the laws of foreign issuers' home jurisdictions — making entry into the U.S. market less desirable for some potential foreign issuers.
On the theory that companies would be more likely to take the initial step into U.S. markets if given some comfort that they could easily exit when the government drastically “changes the rules of the game,” should they choose to do so, the SEC has sought to make it easier for foreign private issuers to delist their securities, terminate their reporting requirements, and exit the U.S. market. Under the old rules, issuers could only delist if they had fewer than 300 U.S. investors — irrespective of what proportion of the company's securities that number represented. Under the new proposed rule, issuers could delist if the average trading volume in the U.S. was no greater than 5 percent of its average daily trading volume in its primary trading market over a recent 12-month period. The new rule also makes its easier to terminate — rather than merely suspend — issuers' reporting requirements.
The option to delist does not provide any real relief from the heavy regulatory burden imposed in the U.S. securities markets, as it does not alleviate the burden so much as avoid it. We can easily anticipate that not all foreign private issuers wishing to delist will meet the 5 percent volume threshold; for those that do not, and for whom Sarbanes-Oxley imposes obligations conflicting with those of its home jurisdiction, the delisting remedy is no remedy at all. A “C.”
Refresh and regroup
On April 17, 2007, regulators from nearly 70 nations convened in Washington to attend the annual two-week program the SEC organizes and presents for regulators of emerging markets. The program brings together leaders from emerging or recently emerged markets for training on developing, maintaining, and regulating securities markets. The SEC should be taking opportunities like this to refresh their own familiarity with the basic lessons they will be teaching others, and hopefully improve their performance in the year to come. â–
The authors can be contacted at [email protected], [email protected], and [email protected].