Do Changes at SEC Signal Retreat on Reforms?
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Do Changes at SEC Signal Retreat on Reforms?

The news that President George W. Bush had nominated Christopher Cox—architect of the legislation that encouraged the corporate malfeasance of the late 90s—to head the Securities & Exchange Commission caused barely a raised eyebrow.

Paul Holmes

If a week is a long time in politics and a quarter in most chief executives’ idea of a long-term horizon, then three-and-a-half years is an eternity and we shouldn’t be particularly surprised if the lessons of the Enron, Tyco and Worldcom scandals are no longer fresh in the nation’s collective memory. So even the news that Bernie Ebbers had been sentenced to 25 years for the kind of heist most career criminals can even fantasize about seemed like an echo of ancient history rather than a timely reminder of that corporate executives do not always have their shareholders’ interests at heart.

Thus, the news that President George W. Bush had nominated Christopher Cox—architect of the legislation that encouraged the corporate malfeasance of the late 90s—to head the Securities & Exchange Commission caused barely a raised eyebrow. There’s no evidence that New York State attorney general Eliot Spitzer is running out of corporate miscreants to prosecute, but from the perspective of most business leaders, apparently, it’s time to start rolling back reforms designed to protect investors and put CEOs back on their honor rather than burdening them with inconvenient regulation.

So it is that Business Week described corporate lobbyists as “almost giddy at the prospect of Cox,” while technology companies began gearing up for a massive push to abandon or at least postpone SEC rules requiring them to level with their investors about the cost of stock options, while the U.S. Chamber of Commerce made it clear its opposition to a Democratic nominee for a vacant commission position who is deemed too enthusiastic about enforcing existing laws.

But most public and investor relations executives believe any giddiness on the part of corporate America is premature. Most of the reforms enacted by the SEC over the past three years, they say, are here to stay. Investor expectations when it comes to transparency have been raised, and will not be lowered just because there’s a changing of the guard at the SEC.

And there’s some precedent for believing they’re right.

When President Bush appointed William Donaldson as chairman of the Securities & Exchange Commission, reformers were dismayed. It was assumed that as a longtime securities industry insider, Donaldson would favor corporate management, which was resisting the tighter regulation in the wake of the Exxon, Worldcom and Tyco scandals.

But Donaldson was a surprise. Replacing Harvey Pitt, whose close ties to the accounting industry were a liability at a time when accounting fraud was a front page story, the Republican Donaldson repeatedly sided with the two Democratic commissioners on the five-person SEC to push through market reforms favored by investor activists.

Donaldson voted to impose requirements that companies count employee stock options as an expense, that mutual funds appoint independent chairmen, that corporations improve their accounting rules, and that auditors operate at arm’s length from their corporate clients. He also pressured the New York Stock Exchange to reform in the wake of the pay scandal involving its former chairman Richard Grasso and advocated greater oversight of the booming hedge fund industry.

“Donaldson oversaw numerous changes which enhanced focus on corporate governance, spurred internal agency management reforms to better anticipate challenges in the securities industry and improve disclosure of financial information,” says Bob Leahy, head of Weber Shandwick investor relations unit The Financial Relations Board. “General consensus is that that public confidence in the capital markets is far higher today than when Donaldson inherited the job. Even Donaldson’s critics have acknowledged that.”

But there are questions about the extent to which the SEC, rather than Congress or state attorneys general, drove the reforms that helped to restore a modicum of confidence in corporate America and the financial markets.

“Donaldson will be most remembered for his role in shaping the way companies implement Sarbanes-Oxley’s provisions and how investors enforce them,” says Richard Torrenzano, founder of The Torrenzano Group and a former communications chief at the New York Stock Exchange. “To the extent Donaldson was perceived to be pro-regulation—particularly in contrast with predecessor Harvey Pitt’s comments about a kinder, gentler SEC—he helped to restore confidence.

“However, much of the framework was already in place when he assumed the chairmanship, not the least of which was the already passed Sarbanes-Oxley legislation and Regulation FD.”

One challenge for business during the Donaldson era was the environment in which the SEC appeared to be competing with Spitzer and others for the title of America’s “toughest corporate regulator,” says Andrew Merrill, general manager of Edelman Financial Communications. “Spitzer’s office got out ahead of the SEC on the conflicts on Wall Street and inappropriate business behavior in the mutual fund and insurance industries. This was an obvious source of frustration and embarrassment for the SEC. Its reaction was, understandably, to get tough.

“Did they go too far?  Perhaps, but the pendulum will inevitably swing back toward the center.”

Even if it does, however, Spitzer and other state attorneys general are likely to step in if they think the SEC is being too easy on corporate wrongdoers.

Others suggest that more aggressive prosecution of white collar criminals—often led by state attorneys general—was a bigger factor in restoring investor confidence.

Says Gordon McCoun, director of investor relations at international communications consultancy Financial Dynamics, “It’s difficult to tell how much the SEC’s initiatives served to restore confidence to the financial markets. I am inclined to think it had as much to do with the attorneys general prosecution of criminal behavior combined with the predictable correction in equity valuations and a healthy economy that brought people back into the stock market.

“The front page photos of Ebbers, Rigas and others doing the ‘perp walk’ were very influential in sending a message to investors that the bad guys were being pursued.”

Unable or unwilling to criticize the prosecutions that have sent several of their peers to jail, most corporate executives have chosen to focus their ire instead on Sarbanes-Oxley, and specifically Section 404, a part of the law that requires companies to shore up internal controls and financial reporting methods. Donaldson’s critics claim his strict interpretation and enforcement of Section 404 has increased accounting costs and made many companies reluctant to list on American exchanges.

“By establishing Sarbanes-Oxley compliance procedures that were either redundant to or in conflict with the security regulations of other major international financial markets, I think the U.S. markets lost a lot of their imprimatur and status as the premier global marketplace,” says McCoun. “The resulting move by companies to delist their securities and cease being SEC filers is not to the benefit of either the companies or American investors.”

At the same time, McCoun questions whether “the benefit to the financial markets from Sarbanes-Oxley 404 certification is anywhere near commensurate with the enormous cost to companies of implementation.”

Others recognize that concern, but believe the costs of Sarbanes-Oxley compliance have been exaggerated, and the benefits neglected.

“The biggest question is whether the improved standards of reporting and governance have been worth the enormous expense,” says Thomas Donaldson, professor of legal studies and ethics at the Wharton business school at the University of Pennsylvania. “But I don’t think there’s any question that companies are more transparent and have better controls now than they did before Sarbanes-Oxley was put into place.”

Unfortunately, the benefits of Sarbanes-Oxley are not as tangible or as measurable as its costs.

Says Torrenzano, “Though most people agree the overall impact of [Sarbanes-Oxley] has been positive with regard to investors’ perceptions of corporate responsibility, businesses have been faced with higher than expected costs—both in time and dollars—to implement Section 404, which Donaldson has defended. I think many small businesses are hoping for some relief under his successor—extensions of the accommodations Donaldson made for small businesses and foreign companies.”

On the whole, Torrenzano believes the move toward increased transparency under Donaldson’s leadership has been beneficial.

“We are certainly moving in the right direction with regard to increased transparency, but I think we still need more,” says Torrenzano. “Ideally, every shareholder would be able to access all company information because they are the owners of the company, but there are obviously practical limitations. The key is to balance between protecting the company’s intellectual property—its competitive advantage—with the desire and necessity of providing shareholders with the relevant and accurate information they need and deserve. This may differ among individual and institutional investors.”

Others believe Donaldson could have gone even further.

Says Leahy, “Donaldson failed to garner adequate support to give shareholders more power to nominate corporate directors, never produced a plan to address late trading, was unable to get through a plan requiring greater disclosure on trading fees at point of sale or new fees for quick trades in and out of mutual funds. To this extent, various vested business interests prevailed.” 

And they are likely to continue to prevail—on some issues, at least—under Cox, a conservative California Congressman and former venture capitalist who was chief sponsor of the 1995 Private Securities Litigation Reform Act, which made shareholder lawsuits more difficult and helped shield accountants and corporate executives from liability for accounting errors.

Cox has “repeatedly expressed the belief—in the face of recent scandals—that financial markets can monitor themselves,” says Robert Kuttner, co-editor of The American Prospent and Business Week columnist. His litigation reform bill “directly invited the abuses that led to Enron and MCI/Worldcom.”

So Cox is expected to side with the commission’s two Republican members when it comes to imposing fines on companies that have committed accounting fraud. Donaldson’s SEC recently fined HealthSouth $100 million, over the objections of the Republicans, who say that shareholders should not be held responsible for the actions of the management teams who act in their name.

Still, Cox has been sending signals—perhaps intended to ease the confirmation process—that he won’t be a pushover.

“The rule of law that the SEC enforces has given America the most dynamic and vibrant capital markets in the world,” he said shortly after his nomination. “The natural enemies of this economic marvel are fraud and unfair dealing.”

Public and investor relations experts say Cox is more likely to side with the two Republican members of the SEC rather than with its two Democrats, but that the Commission as a whole is unlikely to abandon the reforms of the past three years.

“Cox has a history of being ‘laissez-faire’ and a champion of free markets, so I would suspect that the SEC will pursue less of a regulatory agenda,” says McCoun. “But I don’t believe that he will seek to reverse the initiatives put in place under the Donaldson administration. I think he will undertake to reduce the regulatory burden on corporations and seek to limit the SEC’s enforcement to cases where there are unambiguous wrongdoings.

“At the same time I don’t think this means that corporate managers can breathe a collective sigh of relief. With the Democrats looking over his every move to detect bias and state prosecutors also watching his enforcement actions, I don’t think he has latitude to be soft on corporate criminals. So I can see him shifting enforcement onto individuals who commit crimes and looking to them for penalties and restitution rather than place the burden on companies and, by extension, their shareholders.”

Donaldson’s chief ally, Democratic commissioner Harvey Goldschmid, plans to leave this summer to resume teaching at Columbia University Law School, and will likely be replaced by Annette Nazareth, director of market regulation at the SEC, who has been challenged by the U.S. Chamber of Commerce, which says it would like to see someone from outside the regulator who could bring “fresh thinking.” The two Republicans, Paul Atkins and Cynthia Glassman, will remain on the commission.

As a result, “the new tone will not be due solely to Cox’s appointment,” says McCoun. “With the terms of Goldschmid and [Roel] Campos having expired, the entire philosophical tenor of the SEC is likely to shift, giving Cox, Glassman and Atkins the ability to dictate the agenda.”

One big concern for shareholder activists is that several of the rule changes approved by Donaldson—including an initiative that would make it easier for shareholders to elect directors not nominated by the corporate boards themselves—have yet to take effect, and Cox could allow them to languish.

For example, proposed new rules on hedge fund registration, requirements that fund chairmen be independent of management, and options expensing, have all been opposed by Republicans.

Technology companies are clearly hoping that new rules that force them to tell shareholders about the cost of stock options—due to go into effect this month—could be put on hold. Bear Stearns & Co. has estimated that the rule change could result in a 24 percent drop in “profits” for some companies, and one lobbyist recently expressed the hope to Business Week that “you could slow things down pretty easily without an outright reversal.”

But Bear Stearns says 850 companies have already begun subtracting options expenses and “there would be considerable discontent” among analysts and investors over any delays, according to Rebecca McEnally, market policy director at CFA Institute, formerly the Association for Investment Management and Research.

Leahy says he expects to see pressure for review of the trade through measure and recent mutual funds oversight decisions as well as efforts to ease the burden of Sarbanes-Oxley for smaller companies. But major reforms such as the expensing of stock options, he says, “are here to stay.”
But shareholders will be keeping a close eye on any changes.

“Shareholders will continue to lobby the SEC, regardless of the course Cox may set for his chairmanship,” says Torrenzano. “Specifically, I think shareholders—and especially institutional investors—will seek more control over companies, particularly as it relates to board oversight and electing corporate directors.”

The bottom line for most companies is that transparency and integrity will continue to be major issues for their stakeholders, regardless of who is leading the SEC.

“Transparency and integrity are not attributes that can be regulated or enforced,” says McCoun. “So investors should not look to the SEC for relief there. Corporate reputation must be earned, and what that requires far exceeds the regulatory and legal compliance of board structures and disclosure. There is no simple prescription for this. It basically entails a company getting the best people, setting up checks and balances and minimizing conflicts of interest, looking out for the best interests of all one’s constituencies, and optimizing disclosure of positives and negatives to shed sunlight on the business.”

Adds Leahy: “Integrity, transparency as well as full, timely disclosure are not only regulatory and legislative requirements but current public and market mandates as well. Business should expect nothing less.”

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