Our capital markets are the deepest, most efficient, and most transparent in the world. We are the world's leader and innovator in mergers and acquisitions advice, venture capital, private equity, hedge funds, derivatives, securitization skills, and Exchange Traded Funds. This expertise has made our leading financial institutions, many of them headquartered right here in New York, leaders in Asia, Europe, and Latin America. U.S. commercial and investment banks contribute greatly to economic success all around the globe.The problem:
A checklist of what could be at work:
Despite our strong economy and stock market, IPO dollar volume in the U.S. is well below the historical trend and below the trend and activity level in a number of foreign markets.
Moreover, existing public companies in the U.S. are deciding to forgo their public status – with its attendant regulatory requirements – and go private. This is occurring in record numbers, at record volumes, and, as a percentage of overall public company M&A activity, is approaching levels we have not seen in almost 20 years. This development is being facilitated by ever-growing private pools of capital.
- The development of markets outside the U.S., particularly in London and Hong Kong – and the ability of U.S. investors to participate in these offerings;
- A legal system in the U.S. that exposes market participants to significant litigation risk;
- A complex and confusing regulatory structure and enforcement environment;
- And new accounting and governance rules which, while necessary, are being implemented in a way that may be creating unnecessary costs and introducing new risks to our economy.
The usual conservative, sensible call for reforms of the tort system:
A number of foreign markets have developed excellent standards and protocols. In some parts of the world, particularly Europe, public companies adhere to the International Financial Reporting Standards – an accounting system that differs from ours.
One important feature of the IFRS accounting system is that it is principles-based, rather than rules-based. By "principles-based," I mean that the system is organized around a relatively small number of ideas or concepts that provide a framework for thinking about specific issues. The advantage of a principles-based system is that it is flexible and sensible in dealing with new or special situations. A rules-based system typically gives more specific guidance than a principles-based system, but it can be too rigid and may lead to a "tick-the-box" approach. I will be talking about the difference between principles-based and rules-based systems in a number of contexts today.
International companies that list in the United States must reconcile their IFRS statements with U.S. Generally Accepted Accounting Principles, or GAAP. We should recognize that the time and cost that go into reconciling and restating IFRS statements may not be a worthwhile expense for a foreign company considering the U.S. market. Because of progress being made in converging accounting standards, the U.S. and EU have developed a "roadmap," with the goal of allowing listings in the U.S. market on the basis of statements prepared using IFRS, and likewise continuing to permit listings in the EU on the basis of statements prepared according to GAAP. These efforts are encouraging.
A sophisticated legal structure – with property rights, contract law, mechanisms to resolve disputes, and a system for compensating injured parties – is necessary to protect investors, businesses, and consumers. But our legal system has gone beyond protection. In 2004, U.S. tort costs reached a record quarter-trillion dollars, which is approximately 2.2 percent of our GDP. This is twice the relative cost in Germany and Japan, and three times the level in the UK. The consulting firm Towers-Perrin found that the tort system is highly inefficient, with only 42 cents of every tort dollar going to compensate injured plaintiffs. The balance goes to administration, attorney's fees, and defense costs. Inefficient tort costs are effectively a tax paid by shareholders, employees, and consumers. Simply put, the broken tort system is an Achilles heel for our economy. This is not a political issue, it is a competitiveness issue and it must be addressed in a bipartisan fashion.
From an Indian perspective, a very interesting rumination on a messy financial architecture:
Another issue to consider in assessing the competitiveness of our financial markets is regulation. Over the course of our nation's history, we have added multiple regulators to respond to the issues of the day. Our regulatory system has adapted to the changing market by expanding, but perhaps not always by focusing on the broader objective of regulatory efficiency.
For example, while the business of banking has converged over time, we still have four separate banking regulators. We have a similar dynamic with the securities and commodities markets, and their related self-regulatory structures. Each of these organizations has different statutory responsibilities and a number have different regulatory philosophies. We also have a dual federal-state regulatory system in the banking and securities markets – and the degree of federal preemption over state law in these areas varies greatly. Another large and important part of our financial sector, insurance, is regulated solely at the state level.
A consequence of our regulatory structure is an ever-expanding rulebook in which multiple regulators impose rule upon rule upon rule. Unless we carefully consider the cost/benefit tradeoff implicit in these rules, there is a danger of creating a thicket of regulation that impedes competitiveness.
A very UK-style advocacy of principles-based regulation instead of rules based regulation:
Our rules-based regulatory system is prescriptive, and leads to a greater focus on compliance with specific rules. We should move toward a structure that gives regulators more flexibility to work with entities on compliance within the spirit of regulatory principles.
Rules by themselves cannot eliminate fraud. Wrongdoers will seek out loopholes or ways to circumvent the rules. For instance, in the recent business scandals, management at some companies remained technically within the rules while offering deceptive financial statements.
Some rules developed in the past have proved to be deficient in today's dynamic marketplace and some that are developed today are likely to be sub-optimal in a few years unless they are rooted in principles which will stand the test of time.
The problems of multiple inspectors from multiple regulators going after the industry:
At times, our legal system and regulatory structure produce unintended consequences. Consider the area of enforcement. Over the last several years different regulators at the state and federal level have been focused on finding and prosecuting wrongdoing – a worthy, necessary, and successful effort. But when multiple jurisdictions and entities are involved, each with their own objectives and approaches, the enforcement environment can become inefficient and, to the regulated, can appear confusing and threatening.
On SOX, the Republicans don't seem to have an appetite for legislative solutions; they want to only improve the administration of the Act:
At this time, I do not believe we need new legislation to amend Sarbanes-Oxley. Instead, we need to implement the law in ways that better balance the benefits of the legislation with the very significant costs that it imposes, especially on small businesses.
By far the single biggest challenge with Sarbanes-Oxley is section 404, which requires management to assess the effectiveness of a company's internal controls and requires an auditor's attestation of that assessment. Companies should invest in strong internal controls and shareholders welcome this development because it is in their best interest. However, section 404 should be implemented in a more efficient and cost effective manner. It seems clear that a significant portion of the time, energy, and expense associated with implementing section 404 might have been better focused on direct business matters that create jobs and reward shareholders.
Businesses around the world are eager to see how we address this issue. The Chairman of the SEC, Chris Cox, recognizes the severity of this problem and is providing strong leadership to address it. He understands that it will take an aggressive forward-leaning approach to change the implementation of Section 404 and make it more efficient.
Mark Olson, the Chairman of the Public Company Accounting Oversight Board, shares Chris Cox's viewpoint. Collectively, they have responsibility for providing guidance on implementing Section 404. The SEC will soon seek comments on a new and much improved auditing standard aimed at ensuring that the internal control audit is top down, risk based, and focused on what truly matters to the integrity of a company's financial statements. This new guidance for both companies and their auditors should encourage common sense reliance on past work, and on the work of others. Moreover, the SEC and the PCAOB are going to provide tailored guidance for small companies that recognizes their specific characteristics and needs.
A paean on principles as opposed to rules; adhering to principles is harder than checkboxes on rules done by a clever compliance person!
We should remember that we cannot legislate or rule-make our way to ethical behavior, whether it be in the business world or any other endeavor. Proper corporate governance processes increase the likelihood that well-intentioned people will do the right thing. But they do not guarantee such an outcome – and they certainly do not guarantee that unethical people will do the right thing. In my judgment, we must rise above a rules-based mindset that asks, "Is this legal?" and adopt a more principles-based approach that asks, "Is this right?"
Several weeks ago, Warren Buffett offered a warning to his leadership team at Berkshire Hathaway when he wrote, "The five most dangerous words in business may be `Everybody else is doing it.'" As usual, Warren Buffett was right. The ability to avoid these pitfalls takes moral leadership, starting right at the top.
Concerns about accounting:
Given the importance of accounting to our financial system, is there enough competition?
- Will our reformed accounting system produce the high-quality audits and attract the talented auditors we need?
- Do auditors seek detailed rules in order to focus on technical compliance rather than using professional judgment that could be second-guessed by the PCAOB or private litigants?
Importance of principles-based system for accounting:
A common theme in my remarks today is the desirability, where practical, of moving toward a principles-based system. Nowhere is this issue more relevant than in the accounting system. Added complexity and more rules are not the answer for a system that needs to provide accurate and timely information to investors in a world where best of class companies are continually readjusting their business models to remain competitive.
Last year, approximately 1,200 publicly listed companies in the United States restated their financials. As of September 30 of this year, the number is more than 1,000. Some of these companies were involved in the business scandals. Many others were well-intentioned companies struggling to cope with a redefinition of rules in a complex system. These restatements draw time and attention away from other value-enhancing activities – and they represent an added cost to shareholders. Businesses and auditors are searching for something that doesn't exist in today's constantly changing world – a rules-based safe haven that still provides investors with an accurate portrayal of a company's financial performance.
Auditors should be able to focus on one fundamental objective – ensuring the integrity and economic substance of management's financial statements. To get there, we must recognize that accounting is not a science. It is a profession, requiring judgments that cannot be prescribed in a one-size-fits-all manner that undermines the usefulness of financial statements to investors.
They seem to have an interesting "President's Working Group on Financial Markets". One feels so much safer when the head of Goldman Sachs has to make decisions about hedge funds:
And the President's Working Group on Financial Markets – comprised of the Treasury Secretary and the Chairmen of the Federal Reserve Board, the SEC, and the CFTC – continues to review and monitor markets, assess issues related to the performance of derivatives, and study the activities of hedge funds in three broad areas: investor protection, operational risk, and potential for systemic risk. We have begun a series of educational meetings with a broad array of participants in the hedge fund community to gain insight as we move forward with our deliberations.
- First, it is necessary to take a global view. We don't operate in isolation, so it is very important to consider how changes we make affect the ability of our companies to compete globally and how these changes affect our interaction with markets and regulators around the world.
- Second, our regulatory structure should be more agile and responsive to changes in today's marketplace.
- Third, to stand the test of time, rules should be embedded in sound principles.
- Fourth, regulators should take a risk-based approach to regulation, weighing the cost to shareholders against the benefits.
- Fifth, our enforcement regime should punish and deter wrongdoing and encourage good behavior without hindering responsible risk-taking and innovation.
- And, lastly, the best way our business leaders can protect the integrity and competitiveness of our markets is to exert moral leadership, where the threshold question is, "Is this right?" not "Do the rules allow us to do this?"
- Our capital markets remain strong and competitive, but they face some significant challenges that do not lend themselves to easy answers or quick fixes. The Treasury Department plans to host a Conference on Capital Markets and Economic Competitiveness early next year. We will invite participants with a wide range of perspectives, particularly the investor perspective. The Conference will cover the three primary areas I have discussed today – our regulatory structure, our accounting system, and our legal system – all of which impact our capital markets and are critical to the overall economic competitiveness of our nation. Our objective will be to stimulate bipartisan discussion and to lay the groundwork for a long-term strategic examination of these issues.