[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
H.R. 3763--THE CORPORATE AND AUDITING
ACCOUNTABILITY, RESPONSIBILITY AND
TRANSPARENCY ACT OF 2002
=======================================================================
HEARINGS
BEFORE THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
MARCH 13, 20; APRIL 9, 2002
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-60
U. S. GOVERNMENT PRINTING OFFICE
78-501 WASHINGTON : 2002
___________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
C O N T E N T S
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Page
Hearing held on:
March 13, 2002............................................... 1
March 20, 2002............................................... 66
April 9, 2002................................................ 125
Appendix:
March 13, 2002............................................... 175
March 20, 2002............................................... 295
April 9, 2002................................................ 417
WITNESSES
Wednesday, March 13, 2002
Glassman, James K., Resident Fellow, American Enterprise
Institute...................................................... 12
Hills, Hon. Roderick M., Former Chairman, Securities and Exchange
Commission..................................................... 47
Lackritz, Marc E., President, Securities Industry Association.... 8
Melancon, Barry, President and CEO, American Institute of
Certified Public Accountants................................... 10
Roper, Barbara, Director of Investor Protection, Comsumer
Federation of America.......................................... 49
Turner, Lynn, Director, Center for Quality Financial Reporting... 50
White, Ted, Director, Corporate Governance, California Public
Employees' Retirement System................................... 14
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 176
Gillmor, Hon. Paul E......................................... 182
Carson, Hon. Julia........................................... 178
Jones, Hon. Stephanie........................................ 180
Royce, Hon. Ed............................................... 183
Glassman, James K............................................ 210
Hills, Hon. Roderick M....................................... 254
Lackritz, Marc E............................................. 184
Melancon, Barry.............................................. 199
Roper, Barbara............................................... 266
Turner, Lynn................................................. 274
White, Ted (with attachment)................................. 226
WITNESSES
Wednesday, March 20, 2002
Clapman, Peter C., Senior Vice President and Chief Counsel,
Corporate
Governance, TIAA-CREF.......................................... 107
DelRaso, Joseph V., Esq., Partner, Pepper Hamilton, LLP.......... 101
Jasinowski, Jerry J., President, National Association of
Manufacturers.................................................. 106
Livingston, Philip B., President and CEO, Financial Executives
International.................................................. 104
McCall, Hon. H. Carl, Comptroller, State of New York, Office of
the State
Comptroller.................................................... 96
Pitt, Hon. Harvey L., Chairman, U.S. Securities and Exchange
Commission..................................................... 69
Raines, Franklin D., Chairman and CEO, Fannie Mae; Chairman,
Corporate Governance Task Force of the Business Roundtable..... 98
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 296
Gillmor, Hon. Paul E......................................... 298
Jones, Hon. Stephanie T...................................... 299
Royce, Hon. Ed............................................... 301
Clapman, Peter C............................................. 397
DelRaso, Joseph V............................................ 360
Jasinowski, Jerry J.......................................... 388
Livingston, Philip B. (with attachment)...................... 365
McCall, Hon. H. Carl......................................... 316
Pitt, Hon. Harvey L.......................................... 302
Raines, Franklin D. (with attachments)....................... 320
Additional Material Submitted for the Record
Maloney, Hon. Carolyn:
Hon. Eugene A. Ludwig, former Comptroller of the Currency,
speech, February 15, 2002.................................. 413
Raines, Franklin D.:
The Business Roundtable statement on the Corporate and
Auditing Accountability, Responsibility and Transparency
Act of 2002................................................ 351
Department of the Treasury's Peter R. Fisher, Under Secretary for
Domestic Finance, prepared statement........................... 409
WITNESSES
Wednesday, April 9, 2002
Breeden, Hon. Richard C., former Chairman, Securities and
Exchange Commission, Richard C. Breeden & Company.............. 137
Langevoort, Prof. Donald C., Georgetown University Law Center.... 140
Silvers, Damon A., Associate General Counsel, AFL-CIO............ 141
Walker, Hon. David M., Comptroller General of the United States,
U.S. General Accounting Office................................. 135
APPENDIX
Prepared statements:
Gillmor, Hon. Paul E......................................... 418
Jones, Hon. Stephanie T...................................... 419
Breeden, Hon. Richard C...................................... 454
Langevoort, Prof. Donald C................................... 482
Silvers, Damon A............................................. 492
Walker, Hon. David M......................................... 422
H.R. 3763--THE CORPORATE AND AUDITING
ACCOUNTABILITY, RESPONSIBILITY AND
TRANSPARENCY ACT OF 2002
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WEDNESDAY, MARCH 13, 2002
U.S. House of Representatives,
Committee on Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:00 a.m. in room
2128, Rayburn House Office Building, Hon. Michael G. Oxley,
[chairman of the committee], presiding.
Present: Chairman Oxley; Representatives Roukema, Bereuter,
Baker, Lucas, Ney, Kelly, Weldon, Biggert, Shays, Cantor,
Grucci, Hart, Capito, Rogers, Tiberi, Royce, Gillmor, Ose,
Green, LaFalce, Waters, Sanders, C. Maloney of New York, Watt,
Sherman, Lee, Inslee, Jones of Ohio, Kanjorski, Moloney of
Connecticut, Lucas of Kentucky, Clay, Israel, and Roso.
Chairman Oxley. Good morning and welcome to the committee's
first legislative hearing on the Corporate and Auditing
Accountability, Responsibility and Transparency Act of 2002 or
CARTA. This legislation makes important changes in the
accounting profession, in the way public companies report their
financial results, and the manner in which investors access
their information. These issues are among the most serious in
our jurisdiction. They have percolated for some time. Now, the
bankruptcies of Enron, Global Crossing, and others have pushed
them to the forefront.
Hearings held in this committee over the past few months
have demonstrated yet again the need for modernizing our
financial reporting and disclosure system. Also, it is clear
that we must have strong oversight of the accounting
profession. There should be no question that the Federal
securities laws need to be updated to ensure that investors
have access to transparent, and meaningful information
concerning public companies. Enhancing the public's faith in
financial statements is absolutely critical. They serve as the
bedrock of our capital markets.
Our legislation, CARTA, addresses these fundamental issues
by strengthening our markets in a very careful way. We avoided
the temptation some apparently feel to blanket market
participants in a sea of red tape. This legislation creates an
entirely new oversight regime for public accountants, requiring
accountants to be rigorously reviewed to ensure that they meet
the highest standards of competence, independence, and ethical
conduct.
CARTA also recognizes the need for corporate leaders to act
responsibly and holds them accountable if they fail to do so.
The legislation makes important improvements in the area of
corporate transparency, requiring that company's disclose to
investors important company news on a real time basis. It also
directs the SEC to require companies to disclose the use of
off-balance sheet transactions.
CARTA's provisions are designed to increase public
confidence in the U.S. capital markets. It is important that
they remain the world's most efficient means of promoting
economic growth and providing retirement security.
President Bush recently announced the 10 Point Plan to
improve corporate responsibility and protect America's
shareholders. I am pleased that the plan's core principles,
providing better information to investors, making corporate
officers more accountable, and developing a stronger more
independent audit system are embodied in our legislation.
I look forward to continuing our close collaboration with
the Administration on this vital capital markets issue.
I also would like to mention Fed Chairman Alan Greenspan's
recent testimony before this committee. Discussing the
implications of the Enron collapse, Chairman Greenspan noted
that it has already sparked a very significant shift toward
more corporate transparency and more responsible corporate
governance practices. While it does not in my view obviate the
need for Government action, the market's self-correcting
mechanism certainly does underscore the danger of overreacting
to the Enron matter.
I am pleased that CARTA reflects Chairman Greenspan's
support for more transparent financial reporting and for
strengthening the independence of the audit.
I want to thank all the Members of this committee for
working so diligently on this important legislation. Let me
also thank all of our witnesses in advance for their important
participation here this morning.
I turn now to Ranking Member LaFalce for his opening
statement.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 176 in the appendix.]
Mr. LaFalce. Thank you very much, Mr. Chairman. I ask
unanimous consent that the entirety of my opening statement be
included in the record.
Chairman Oxley. Without objection, all the Members opening
statements will be made part of the record.
Mr. LaFalce. I thank you. Our committee assumed
jurisdiction over securities and insurance for the first time
in January of 2001. And the Chairman has indicated that he is
concerned that we not overreact to the problem. Well, I think
that that is a reasonable concern. But I think that it is also
true that we under reacted to the problem historically and that
was a much greater concern. At the beginning of 2001, I began
talking about the problem of earnings manipulation. That is
when we assumed jurisdiction. The SEC, as you know, was
tripling the number of mandated restatements, which was at
least some indication that something might well be wrong.
And there was too much of an incentive it seemed to me
within corporate America, particularly because of the
compensation mechanisms that have evolved over the years, for
earnings manipulation, for revenue recognition when it should
not be recognized, for channel stuffing, cookie jar reserves,
and so forth, and so forth. Very often, unchecked by the board
of directors for one reason or another, because of a policy
passivity that may have existed at too many boards, because of
the same stock options to a lesser extent to be sure that
corporate officers, their chief desire is not a better product
or a better service, but market capitalization, to drive
capitalization.
And then enter the accounting profession that was
responsible to the public as a public fiduciary for auditing
these companies and making sure that the books by the CFO and
the CEO, and so forth, and the audit committees were done
right. And there was a difficulty there. They too had evolved
over the years so that in a good many respects they would make
more money through consulting than through auditing. But also
independent of that they just had obviously a vested interest
in being retained and then staying retained by the firm because
it was an employer/employee relationship and you want to make
the client happy so you have this tension.
And then enter Wall Street. Wall Street got into an
attitude of stock hype, there is actually no question about it.
Certainly the number of recommendations went down precipitously
from what it previously had been. And then too we witnesses a
number of blatant conflicts that existed.
Now nobody was paying attention in this committee when we
were considering the SEC fee reduction bill, I said what we
should be considering in the first instance is not a 2 or 3
percent increase in the SEC budget, but a 200 or 300 percent
increase in the SEC budget, because of what is going on. And I
made the same argument before the Rules Committee, and I made
the same argument on the floor of the House. But nobody was
paying attention until Enron. And then when Enron happened,
people started paying attention.
Now, the Chairman is correct, we ought not to overreact,
but we ought to act. And we have to find that balance, what is
the right way. We ought to keep that pendulum. But we want good
action, strong action.
To restore confidence in the integrity of our markets, I
think we have to do at least the following. Enact legislation
that will address the serious deficiencies in our current
system. Now, I have recently introduced a bill, the Chairman
had called a hearing on his bill, but there is at least one
other bill. There are many other bills actually. And there are
good ideas in all of them. We have to sort through them and try
to come to some consensus. I hope we can do that. If we don't,
we will just vote them up or vote them down, not bill by bill,
but issue by issue.
We should at least consider these particular proposals. The
appropriate separate of audit and consulting functions; the
concept of auditor rotation; and other proposals that address
the relationship of the auditor to its audit client. We must
also provide for meaningful oversight of the audit profession.
And that means a strong and credible regulator. And you have to
have individuals who are on this board, whatever it is going to
be, that will instill some confidence in the investing public
and restore the concept of integrity to the accounting
profession that is so richly deserved over the years. We must
reform the functioning of audit committees and the boards of
directors of public companies to ensure that independent
directors are truly independent and that auditors are working
for the shareholders, not for the management. And I think we
need to reconsider liability issues. Did we go a bit too far in
1995 and 1998? I think we need to reopen that issue, not in
toto, but at least in part.
I said early last year, and Lynn Turner, the Chief
Accountant of the SEC at that time, said that what we have
witnessed so far was just the tip of the iceberg. I am afraid
that what we witnessed so far too is still the tip of the
iceberg, that there is a lot more out there. Now I know that
corporate officers and board of directors and accountants are
much more zealous today than they were in October and November
and earlier, but I think that having good legislation will
enhance that.
Second, and this is something that I think we can now agree
on, and I will finish up, I called for the 200 to 300 percent
increase in the SEC budget. I certainly called for pay parity,
and the Chairman and I are going to team up I am sure with Mr.
Baker and Mr. Kanjorski and push the Administration and the
Congress to give the SEC the resources that it so desperately
needs to do the job that all America wants it to do.
I thank the Chairman.
Chairman Oxley. The gentleman's time has expired. The Chair
now recognizes the Chairman of the Capital Market Subcommittee,
the gentleman from Louisiana, Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman. I want to commend you
for the hearing and start by putting what I believe is our
mutual perspective about this problem on the record. By and
large, day to day, most professionals engaged in the business
of running corporations, auditing corporations, analyzing
corporations, and reporting on corporations are doing the best
job in the most professional capacity they know how to achieve
those ends for the benefit of all stockholders, including
shareholders.
And the problems we are addressing today, I do not believe
are systemic or a condemnation of the business free-enterprise
system in the United States. I do believe that the rules now
written some 60-70 years ago, are inadequate in light of the
technological change and the speed with which business is
conducted, but it is apparent to me that most individuals who
are here today to testify are coming with helpful suggestions
in how they believe we can improve the legislation before us.
But generally, everyone agrees we are on track. We have not
missed it. It is time to act. Every stakeholder wants these
issues resolved. We want to ensure investor and public
confidence in the credibility of our markets. And it is in our
mutual economic interest to see that occurs as quickly as
possible.
To that end, I want to point out, Mr. Chairman, that you
took decisive action with regard to suggestions for treatment
of analyst conduct, together with the regulators and members of
the profession, and announced mandatory, not voluntary, changes
that should be implemented which is now subject to public
comment. And they were sweeping in their effects. Research
departments may not be subject to supervision or control of the
investment banking department. The subject company may not
approve prior reports prior to distribution. The firm may not
tie compensation to specific investment banking practices. A
firm must disclose if the analysts receive compensation based
upon the firm's investment banking revenues and establish
certain quiet periods. No analyst may purchase or receive an
issuer's securities prior to an initial public offering. No
analyst may trade securities issued by the company the analyst
follows for a period beginning 30 calendar days. And it goes
on. A firm must disclose in research reports and an analyst
must disclose in public appearances if they have a financial
interest in the securities of the company. A firm must disclose
in research reports and in public appearances whether or not
the firm or its affiliates beneficially own 1 percent of any
class of common equity securities of the subject company. And
it goes on.
The point being that these are mandatory changes in analyst
conduct subject to penalties up to and including disbarment
from practice, which will, I believe, significantly alter the
method and manner in which analyst reports are issued and the
public can view the information contained therein.
The legislation before us here today is similar in its
effect. I had suggested that we analyze the consequences of
having exchange-based engagement of audits. There has been any
number of suggestions to radically alter the relationships
between audits and their corporations. And on reflection and
consultation with the SEC and many others who have expert
opinion, I believe the bill before us, with perhaps slight
modification here or there, is an excellent vehicle for
appropriate reform in light of the circumstance we face.
Just examine the GAO's own report. I think they make two
excellent statements that are worth repeating this morning. One
is go carefully. We are engaged in discussions that affect the
entire capital markets of this Nation and consequently
internationally have some significant potential for
repercussions if we get it wrong.
And, second, that we need to make it clear that the
financial statement belongs to the shareholder. I was somewhat
taken aback when the CEO of Andersen Consulting said in
response to a question before our hearing, ``To whom does the
financial statement belong?'' He said, ``To management and the
shareholder.'' Management 101, the financial statement should
reflect accurate financial condition of the corporation based
upon management's performance for the shareholder. Once we
return to that, and we ensure that there is independence in the
preparation of that audit statement, and that we enable a good
auditor to do good work despite what management might choose
for them to report, the consequences for our capital markets,
the auditor, the shareholder, and everyone will be greatly
enhanced.
I think you have got it right, Mr. Chairman. I think this
is an excellent start. Perhaps there is a change to be made
here or there, but in the overall picture and the risk we would
take by going further faster, I think it is not warranted in
light of the circumstances we face, and I commend you for
calling this hearing.
Chairman Oxley. The gentleman's time has expired. We now
turn to our distinguished panel. And let me introduce them. Mr.
Marc E. Lackritz.
Mr. Sanders. Mr. Chairman, will others be allowed to make
opening statements?
Chairman Oxley. Just the Ranking Member and the
subcommittee.
Mr. Sanders. We were told otherwise.
Mr. Sherman. That is not what we were told by staff by the
way.
Chairman Oxley. Staff informs me that you are correct. The
gentleman from Vermont, Mr. Sanders.
Mr. Sanders. Thank you very much, Mr. Chairman. And thank
you and Mr. LaFalce for holding this important hearing. I find
myself in agreement with the Chairman and Mr. LaFalce and Mr.
Baker, but I would go further than they, because I think we
have a very, very serious problem, which the United States
Congress has got to address.
Let me just for a moment do a Dave Letterman Top 10, if I
might, in terms of failed audits. This suggests that while
Enron has gotten all of the publicity, the problem is a lot
deeper than Enron.
One: Arthur Andersen and Enron. We all know that.
Number two: KPMG failed in its audit of Rite-Aid causing a
$800 million loss in stock value after recalculation of
profits.
Number three: Arthur Andersen failed in its audit of
Sunbeam, causing a $1.2 billion loss in stock value after the
recalculation of profits.
Four: PriceWaterhouseCoopers failed in its audit of Micro
Strategy, resulting in a $10.4 billion loss in stock value
after their recalculation of profits.
Five: Arthur Andersen failed in its audit of Waste
Management, resulting in a loss of $900 million in stock value
after their recalculation of profits.
Six: Arthur Andersen failed in its audit of McKessen HBOC,
resulting in a $7.9 billion loss in stock value.
Seven: Ernst & Young failed in its audit of Cendant,
resulting in a loss of $11.3 billion in stock value.
Eight: KPMG failed in its audit of Greentree, resulting in
a loss of $1.1 billion in stock value.
Nine: while Global Crossing executives cashed in on some
$1.3 billion in Global Crossing stock, Arthur Andersen's failed
audit of this company has caused many of their employees to
lose their entire life savings.
Ten: Arthur Andersen failed in its audit of the Baptist
Foundation of Arizona.
The point is, Mr. Chairman, we have a serious problem. And
I think, Mr. Chairman, we need a serious solution. Mr. LaFalce
touched on the inherent conflict of interest between those who
consult for the company, and that is kind of obvious and I
would hope that most of us would want to end that practice
immediately. Mr. LaFalce also touched upon the employer-
employee relationship. If you are working for a company and you
are getting paid well by that company, are you going to go up
to that company and say: ``By the way, you are cooking the
books and you are ripping off the stockowners of your
company.'' Apparently, many of the large auditing firms are not
prepared to do that.
So it seems to me that at the very least we need to
significantly beef up the SEC, but, in fact, we may want to go
a lot further than that. When people invest in the stock
market, when people who represent pension funds, who are
representing the retirement savings of millions of American
workers are investing in a company, they have the right to know
that the books are being honestly kept. And, unfortunately,
that has not been in many cases the record up to today.
So I think we are going to need some very bold solutions to
this very serious problem.
Thank you, Mr. Chairman.
Chairman Oxley. The gentleman's time has expired. There are
other opening statements. The gentleman from California, Mr.
Sherman, is recognized for 3 minutes.
Mr. Sherman. Thank you, Mr. Chairman. We need not only to
be concerned with the culture of the business world, which I
don't think we can change, but rather design strong rules and
clear rules rather than simply rely on adding more ethics
courses to business school curricula.
We ought to look at the scope of service that auditing
firms provide. But keep in mind, if Arthur Andersen had just
been an auditing firm, they would have collected only $25
million from Enron, not $50 or $52. But they would have been a
firm of half the size. And if our concern is the size of the
fee having an effect on the auditor and the auditor's judgment,
we ought to perhaps limit the total fee for all services
provided to 150 percent of the audit fee so that some
incidental services could be provided.
We ought to look at the structure of accounting firms to
ensure that the technical review department always makes the
final decision. That is not what happened with Arthur Andersen,
which unlike the other Big Five firms, decided to have the
decisions made in Houston in effect by the sales partner.
We need to have minimum capitalization requirements so that
if you sue an accounting firm, you don't collect absolutely
nothing. You can't drive in most States without liability
insurance, but you can practice accounting and be responsible
for trillions of dollars in market reliance without adequate
malpractice insurance or adequate capitalization.
If we are going to rotate auditors, perhaps we also ought
to give them tenure as well. Because if you are in the first
year of what is a maximum of 5 or 10 years of auditing a firm,
you are subject to pressure from the client, loosen your
accounting interpretations or you may lose your last 9 years of
a contract. If instead these were 6 or 10-year contracts,
auditors would be free without financial pressure to be able to
make the judgment decisions.
The SEC should have been here asking us to quadruple their
budget or double their budget. Instead the SEC was not even
reading Enron's financial statements. If tiny companies, going
public for the first time, get a review of their filings by the
SEC and have to answer questions and make their documents clear
and complete, certainly we should require the same kind of
scrutiny of the thousand largest firms in America.
We ought to have the FASB come before us, Mr. Chairman, to
talk about how the accounting standards were so loose that
people at Arthur Andersen and Enron could convince themselves
that they were even close to compliance. And we ought to hear
more from institutional investors, who frankly I think have
under investigated in their Washington presence. When it comes
to reducing capital gains, we have thousands of lobbyists. When
it comes to other things that would help investors, we tend not
to hear from them nearly as loudly.
I yield back.
Chairman Oxley. The gentleman's time has expired. Are there
further opening statements?
Now, I turn to our distinguished panel. The gentleman, Mr.
Marc Lackritz, president of the Securities Industry
Association; Mr. Barry C. Melancon, president and CEO, American
Institute of Certified Public Accountants; Mr. James Glassman,
resident fellow of the American Enterprise Institute; and Mr.
Ted White, director of Corporate Governance, California Public
Employees' Retirement System.
Gentlemen, welcome to all of you. And Mr. Lackritz, we will
begin with you.
STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES INDUSTRY
ASSOCIATION;
Mr. Lackritz. Thank you, Mr. Chairman.
Mr. Chairman, Congressman LaFalce, and Members of the
committee, I am pleased to testify before you today on H.R.
3763. We commend you, Mr. Chairman, and Members of the
committee for your ongoing efforts to ensure that investors
will continue to be well served and well protected.
SIA is deeply concerned about the implosion of Enron and
the corrosive effect this event is having on the public's trust
and confidence in our country's corporations and financial
markets. Public trust and confidence is the bedrock of our
financial system, the core asset underlying why our financial
markets are the envy of the world.
Although Enron's collapse appears to be a massive failure
in the accuracy of information that flowed into the
marketplace, the securities industry's regulatory structure
remains fundamentally strong. Although we are still learning
the full story behind Enron's collapse, we strongly support
responsible reforms that will ensure that financial
information, the lifeblood of our markets, is honest, accurate,
and easily accessible.
SIA welcomes the reforms in pension laws announced by the
Administration in February. We support, for example,
prohibiting insiders from selling their securities during a
blackout period, requiring prior notice of blackout periods,
and the concept of permitting participants to sell company
stock in their 401K plan after a reasonable period.
We also encourage the Senate to follow the House's lead in
passing legislation to allow retirement plan administrators to
provide individual financial advice to employee participants.
Giving investors greater access to information will help them
make more informed decisions about their retirement accounts.
SIA also supports full funding of pay parity for the
Securities and Exchange Commission's professional staff. The
SEC has been a tough, effective cop on the beat. We have been
profoundly troubled by the huge turnover in experienced staff
that the SEC has suffered in recent years. Congress should fund
pay parity and increase the agency's funding to ensure that the
SEC has the staff and resources it needs to be an effective
regulator.
SIA believes that H.R. 3763 includes a number of important
improvements to the current regulatory system. The bill sets up
a strong statutory framework for public oversight of the
independent audit function. It is a sensible, appropriate
reaction to the shadow the Enron debacle has cast on the
current performance of outside auditors.
We also support giving the SEC authority to prosecute
senior executives of a public company that willfully mislead an
independent auditor. Although the SEC already has strong
authority in this area, the committee should consider President
Bush's proposal to grant the SEC the statutory authority to
require senior executives to disgorge bonuses and other
incentive-based forms of compensation in cases of accounting
restatements resulting from misconduct.
Although SIA generally supports H.R. 3763's provisions for
more timely and better disclosure of corporate information, we
note that the SEC has already announced its intention to act in
this area, we believe that the best action here is to provide
the SEC with the flexibility to make the necessary judgments
about the timing and content of required disclosures.
Similarly, the bill's provisions to improve transparency in
financial statements generally overlap with the recent SEC
statement to issuers regarding certain disclosures. Since those
disclosures have just been mandated, we believe it is premature
to legislate at this time in this area.
Our written statement includes additional recommendations,
Mr. Chairman, for improving corporate disclosures. Further,
special purpose entities play a critical role in a number of
important financial markets, especially in the case of
securitization programs. Regulatory or legislative actions
should be considered carefully in light of the significant
adverse impact upon financial markets that might result from
inappropriate restrictions on SPEs.
Finally, SIA supports the provisions directing the SEC to
conduct a study of any final SRO rules regarding conflicts of
interest by equity analysts. SIA developed a set of best
practices for research a year ago that we believe have been
very useful and constructive. The NASD and the New York Stock
Exchange have recently proposed regulations in this area. And
while we have some serious issues with some aspects of these
proposals, we support their overall goal.
SIA believes our system of securities regulation and
corporate disclosure is second to none. Our financial markets
are envied worldwide for their efficiency and integrity, and we
now have the opportunity to develop sensible, responsible
reforms that will improve the markets for everyone.
Certainly Enron has brought us a new set of challenges to
address. We look forward, Mr. Chairman, to working with you,
the SEC, and the Administration to develop a reasonable
measured response to those challenges.
Thank you very much.
[The prepared statement of Marc E. Lackritz can be found on
page 184 in the appendix.]
Chairman Oxley. Thank you, Mr. Lackritz.
Mr. Melancon.
STATEMENT OF BARRY C. MELANCON, PRESIDENT AND CEO, AMERICAN
INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Mr. Melancon. Thank you, Mr. Chairman. Chairman Oxley,
Ranking Member LaFalce, and Members of the committee, I am
Barry Melancon, a CPA and president and CEO of the American
Institute of Certified Public Accountants. I am here today on
behalf of the 350,000 members of the AICPA and for the almost
1,000 firms that perform audits for public registrants and
45,000 firms that service small business throughout America.
CPAs across this country and the Members of this committee
share a common goal, to restore faith in the financial
reporting system and reassure investors that they have access
to the most up-to-date, relevant, and accurate financial
information.
Our profession has a long history of dedication of
maintaining and improving the quality of financial disclosures.
We require it, investors demand it, and the strength of our
financial markets depends upon it. We take that responsibility
very serious, and we have zero tolerance for those who break
the rules.
I would like to be clear: We support meaningful change,
because thoughtful improvements are needed. But we all should
be wary of proposals that can lead to unintended consequences.
We ask that this committee and Congress evaluate legislative
proposals with an eye to a straightforward public interest
test, a test that asks four important questions:
Will it help investors make informed investment decisions?
Will it enhance audit quality and the quality of financial
reporting?
Will it increase confidence in the capital markets, our
financial reporting system, and the accounting profession?
Will it be good for America's financial markets and
economic growth?
We support a robust private-sector regulatory body for
auditors of public companies dominated by members who are not
accountants, with SEC oversight, and a clear charter to
undertake professional discipline and quality review. A highly
effective disciplinary and quality review body will alleviate
the need for individual prescriptive proposals.
Audit quality is another issue that I would like to discuss
today. New and more complicated financial instruments and the
speed and complex nature of business transactions has
significantly increased the challenges facing auditors. The
competency and experience needed to conduct today's audit are
vastly broader than they were just even a few years ago. And
those requirements will be ever more far-reaching in years to
come.
I would like to take a moment here to discuss the very real
risk that broad proposals that restrict services provided to
audit clients, whether intended or not, could lead to a
profession comprised of firms that provide narrowly defined
audit services and little else. This will have unfortunate,
unintended consequences. The ripple effect of such action could
hurt businesses of all sizes and all communities. Such
statutory restrictions will substitute informed and reasoned
decisionmaking by companies in their audit committees with
Government fiat.
Next, the issue of corporate governance. We should all
recognize that the financial reporting process is a complex
system of checks and balances that begins with the creation of
the financial statement by the company. To enhance this first
step in the process, the audit committee should also have the
sole authority to approve the company's financial statements
and require business disclosures in the annual report and other
public documents. And the audit committee should be responsible
for the hiring and firing of the company's auditor. Equally
important, it should be composed of outside directors with
auditing, accounting, or financial experience.
We hope that policymakers recognize that it would be
harmful to cast a dark cloud over all services outside the
statutory audit by establishing a negative presumption that an
auditor cannot be independent if any such services are provided
to an audit client even if that presumption could be overridden
by an audit committee's affirmative action.
Mandatory rotation of audit firms has been proven to
increase the potential for fraud. The COSA study of financial
statement fraud shows that client fraud is three times more
likely in the first 2 years of a client-auditor relationship.
Safeguards are already in place. All firms that conduct audits
for publicly traded companies are currently required to take
the lead engagement partner off engagements after 7 years for a
period of at least 2 years. Finally, I must mention that at one
time Canada, Greece, Spain, and Italy all required mandatory
audit firm rotation in one form or another. Three of those four
countries subsequently dropped the requirement. In short, given
the known risk, why follow these failed experiments.
On another note, it is ludicrous to suggest that
accountants are off the liability hook. One simply has to read
the newspaper today to see that the opposite is true. The past
few years have seen record numbers of lawsuits and record
settlements from accounting firms.
And now to the reforms that the AICPA has advocated for
many years.
Chairman Oxley. Can you sum up, Mr. Melancon.
Mr. Melancon. Yes, sir. Reforms in our 70 year old
financial system. The current system is no longer adequate in
the information age. Efforts to modernize business reporting
must be accelerated.
On behalf of the CPAs around the country, I thank you for
the opportunity to present our views today and commend the
committee for what we trust will be a thoughtful approach to
these important and complex issues.
[The prepared statement of Barry C. Melancon can be found
on page 199 in the appendix.]
STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Glassman. you, Mr. Chairman. Mr. Chairman and Members
of the committee, thank you for inviting me to testify today.
My name is James K. Glassman. I am a Resident Fellow with the
American Enterprise Institute and host of
techcentralstation.com. Since 1993, I have been writing
regularly on investing for a broad audience. I am a financial
columnist for The Washington Post. My second book, ``The Secret
Code of the Superior Investor,'' was published in January.
I believe that my usefulness to this committee lies in my
understanding of what makes small investors tick and of the
consequences of financial policies on the economy and markets.
In the current over-heated atmosphere, H.R. 3763 is admirably
level-headed, especially in comparison with the Comprehensive
Investor Protection Act. Still, some of the bill's provisions
are troubling. Rather than protecting investors, these
provisions may harm them.
First, understand that investors do a remarkable job
protecting themselves. Investors reward good corporate citizens
with higher stock prices and they punish miscreants with lower.
Recent academic research confirms this fact, as I show in my
written statement. Investors have their own unwritten set of
rules and when companies violate them, the retribution is
swift. Investors do not tolerate lying. In Enron's case, as
soon as it became clear that the firm had deceived them,
investors entered a verdict of guilty and applied ``capital''
punishment. They didn't wait for a trial. They didn't wait for
an SEC investigation. Similarly, clients of Arthur Andersen,
Enron's accounting firm, did not wait for an indictment or a
Government report. Delta Airlines, Merck & Company, Freddie
Mac, among others, fired Andersen as their auditor. In
addition, of course, Enron and Andersen executives face
possible criminal penalties.
In the face of such a ferocious reaction, why is Congress
considering at least 30 pieces of legislation in the Enron
matter? Congress has played an important role in exposing the
details of the scandal to the public and in calling the
participants to account publicly. This committee deserves
particular praise. But much of the legislation itself is
unproductive at best.
Let me comment briefly. Auditor independence: H.R. 3763
would bar accounting firms from providing clients with both
external audit services and financial information services or
internal audit services. The CIPA goes further. Both approaches
are harmful to investors.
First, Zoe Palmrose and Ralph Saul show in an extensive
article in the winter issue of Regulation, which I would like
to enter into the record, the issue of auditor independence has
been extensively studied with almost no empirical evidence of
abuse. The theory put forth by advocates of independence rules
is that companies use the high fees involved in contracts for
non-audit services in order to bribe accounting firms to
produce deceptive audits that favor the company. But Enron
actually paid low non-audit fees relative to its audit fees.
And why should forbidding non-audit work solve the problem?
After all it is just as easy to bribe accountants, if you
believe this theory, directly. Just pump up the fees for audit
work.
While evildoers lurk in the corporate world as well as
outside it, the main reason that respected companies use the
same firms for audit and non-audit is not that this combination
provides some kind of nefarious leverage, but that it makes
sense economically in an age of high technology. Forcing this
highly artificial separation will add expenses, lower profits,
and inevitably lower stock prices, and that hurts investors. It
does not help them.
Increasing the complexity of accounting rules: You should
understand that the complex nature of American corporations
means that every loophole cannot be plugged, every possible
deception and distortion cannot be remedied with a new rule.
The answer is not more numbers and legalese, but more leeway
for auditors and corporate executives to explain the truth
health of a company, along with strict accountability from
companies and auditors.
So what should be done? Well, I strongly agree with Section
4 of H.R. 3763, which requires officers and directors to
disclose sales of company stock to the SEC within two days
after the transaction. I would go further and say that this
information should be contemporaneous. I also concur with
blackout provisions and with stricter laws against companies
interfering with audits.
Another remedy, which is beyond the scope of this
committee, is this: Cash dividends are the clearest, most
transparent evidence of corporate profits. An investor who sees
dividends increasing every year can properly have confidence in
a company. But dividends are taxed twice and mainly as a result
fewer public companies now pay dividends ever in history.
Ending double taxation of dividends would increase pay-outs and
vastly increase investor confidence.
Repealing litigation reform: Congress, in 1995, overrode
President Clinton's veto of the Private Securities Litigation
Reform Act, a bill that scaled back the excesses involved in
often frivolous securities fraud cases brought by a small group
of politically generous plaintiffs' lawyers. Now some in
Congress have decided that these moderate reforms were
responsible for the Enron excesses. In fact, the law does not
prevent such lawsuits. Cendant, for example, settled the class
action lawsuit after the new law for $2.8 billion. And its
former auditor, Ernst & Young, settled another suit for $335
million. Attorneys could have sued Enron earlier and they are
certainly suing Enron and its auditor, Arthur Andersen, today.
Repealing this reform would not protect shareholders. It
would hurt them by forcing their companies to make payments of
tribute and distracting executives who should be focusing on
managing their firm. Indeed, in my opinion, the bar should be
raised higher to deter more frivolous suits.
After the Enron scandal entered full public consciousness
in December, the media carried stories claiming that as a
result investors were losing faith in the stock market in
general. Instead, while investors have certainly become much
more vigilant, to their credit they have not responded by
dumping shares across the board. In fact, in January 2002,
according to the Investment Company Institute, investors added
$20 billion more to equity mutual funds than they took out, the
largest such net gain in many months.
Chairman Oxley. If you could sum up.
Mr. Glassman. Yes, sir. I do have to mention something. I
was not aware that CalPERS was going to be testifying today,
but let me say this. For this discipline that I have talked
about, the discipline involved with investors enacting
retribution against Enron and other firms, for it to work,
investors must act responsibly. Unfortunately, that is not
always the case. The New York Times reported on February 5th
that while the large California Public Pension Fund, CalPERS,
was alerted to the abuses at Enron, in December 2000, 9 months
before the company started to announce to write-offs, was
alerted to these abuses, executives ``did not confront Enron's
board,'' or ``publicize its concerns.'' Instead it continued to
profit from dubious partnerships like Jedi.
Instead of concocting new laws, this committee should use
its bully pulpit to exhort accountants, corporations, and
pension funds to act responsibly. Finally, in times of scandal,
emotions run high. And the urge to rush in with legislative
remedies is understandable, but it should be resisted. Parts of
H.R. 3763 are admirable, but market discipline and current
criminal and civil laws provide powerful remedies and
protections against another Enron already.
Thank you, Mr. Chairman and Members of the committee.
[The prepared statement of James K. Glassman can be found
on page 183 in the appendix.]
Chairman Oxley. Thank you, Mr. Glassman.
Mr. White.
STATEMENT OF TED WHITE, DIRECTOR OF CORPORATE GOVERNANCE,
CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM
Mr. White. Thank you. Chairman Oxley, Ranking Member
LaFalce, and distinguished Members of the committee, I am Ted
White. I am the Director of Corporate Governance for the
California Public Employees' Retirement System or CalPERS. On
behalf of the CalPERS' board and myself, I would like to thank
you for the opportunity to testify today regarding issues that
are of such importance to our capital markets.
CalPERS is the largest public pension system in the world,
with approximately $155 billion in assets. We represent over
1.2 million members. Over $67 billion of our assets are
invested in the U.S. stock market alone.
CalPERS has long been a vocal, leading advocate for
effective corporate governance. We strongly believe that as
owners of the companies we invest in, shareholders have a right
and a duty to attempt to hold management and boards of
directors accountable for their performance. The concepts of
accountability and transparency have long been recognized as
the cornerstones of a successful corporate governance model.
Unfortunately, the events of the last few months have
demonstrated all too clearly that basic ethics, something that
we may have all taken for granted, must also be a concern for
today's investors.
With this background, I would like to focus on two key
legislative issues, auditor independence and audit industry
oversight and several regulatory matters.
CalPERS was pleased to see both Chairman Oxley's bill and
Ranking Member LaFalce's bill include provisions on these
important topics. Thank you both for recognizing the need for
Congress to address these issues.
On the issue of auditor independence, CalPERS believes
there is currently a crisis of confidence with the accounting
industry. The independence of the auditor must be beyond
reproach. Investors must be able to trust when an auditor says
the books are accurate, then they are accurate. The Enron/
Andersen situation, as well as many others, have prompted this
erosion in investor confidence due in large part to the very
obvious conflicts that exist when an auditor is simultaneously
receiving fees for non-audit work. How can investors trust the
discretion that is inherent in audit work while the auditor may
be influenced by the desire to keep a well-paying client happy.
We understand that there is much debate over when to draw
the line between audit and non-audit services. As one investor,
CalPERS believes that there should be a bright line ban on
external auditors providing consulting work or internal audit
services to audit clients. A firm should be an auditor or a
consultant, but never the same for the same client.
CalPERS is also advocating a system of mandatory auditor
rotation of company external auditors. We have suggested a 5 to
7-year limit. Although we recognize there is a cost inherent in
this proposal, we believe the cost is far outweighed by the
benefits, benefits that can bring a fresh perspective and
renewed investor confidence in the industry.
I would note for your reference that CalPERS is mandatorily
required to rotate its auditor every 5 years. And while this is
not easy for a financial institution of our size and
complexity, we do it nonetheless.
Turning to the oversight of the accounting industry, we
again applaud the efforts of this committee, SEC Chairman Pitt,
and President Bush for identifying the need to strengthen the
oversight of auditors and accountants. We believe it is time to
update the oversight of this industry.
To achieve a goal of rebuilding the market's confidence, we
must create an effective oversight body. To be effective, we
believe that the oversight body should be created with the
following principles in mind. It must represent the interests
of end-users. The governing body should be dominated by
independent public members. It should have a stable and
independent funding source. It should have the power to
effectively oversee the industry, which means conduct
investigations and discipline. And it must have standard
setting capability. We also believe that while the SEC should
oversee this new entity, the creation, its charter, and its
scope of authority at a minimum must be established by
Congress.
We recognize that the current forms of the Oxley bill, as
well as the LaFalce bill, contains several elements that are
consistent with CalPERS existing reform package and we
appreciate that you are addressing these issues. For example,
requirements on auditor independence, mandatory auditor
rotation, revolving door provisions, requirements that the
auditor be hired by the auditor committee, provisions related
to director independence, and the creation of the oversight
body with a secure funding service, investigative and
disciplinary power, and the ability to set standards.
Finally, CalPERS would like to express our strong desire
that pay parity for the SEC staff be fully funded by Congress
this year.
In conclusion, CalPERS is pleased that the Members of this
committee are taking such a thoughtful and constructive
approach to addressing the financial reporting issues stemming
from the Enron collapse. We believe Congress must play an
important role in helping restore investor confidence by
improving auditor independence, enhancing accounting industry
oversight, providing regulators with the power and resources to
effectively regulate the industries, and encourage interested
market participants to assist them when practical.
Thank you. And I would be pleased to answer any questions.
[The prepared statement of Ted White can be found on page
226 in the appendix.]
Chairman Oxley. Thank you, Mr. White and thanks to all of
our panel.
Let me begin by asking Mr. Lackritz, and this was also
mentioned by Mr. Glassman, there have been media reports and
sources from the trial bar that the Securities Litigation
Reform Act of 1995 has reduced the number of shareholders'
suits or the average settlement amount. Would you care to
comment on the numbers as they are reflected today after
passage of that Act?
Mr. Lackritz. Yes, I would be happy to, Mr. Chairman. In
fact, the number of lawsuits that have been filed in the 4
years since the Act became effective have actually gone up, and
gone up proportionately, to the number of suits that were filed
actually before the Act was passed. And in addition the average
settlement amount has actually gone up, so that indicates that
the quality of the lawsuits that have been filed have probably
improved significantly. And the purpose of the Act, which is to
deter abusive practices by lawyers that didn't have any
clients, is being served quite well. And I think that the
examples that Jim Glassman cited are further evidence that the
law is actually working very much as it was intended to work.
Chairman Oxley. Thank you. Mr. Glassman, you had indicated
even that you would have perhaps gone further in the pursuit of
limiting those frivolous lawsuits. Is that correct?
Mr. Glassman. Yes, sir. I think that when you talk to
people in Silicon Valley today, these lawsuits, the threat of
these lawsuits is hanging over their heads. The notion that
just because the stock price has declined, somebody did
something wrong, which by the way is the wrong signal always to
send to investors, they have to understand that stock prices do
decline and they need to protect themselves against that, I
think in part has put a chill on that industry and distracted
many of its executives. And it is not a good thing. But
certainly when companies like Cendant do the things that
Cendant has done, they ought to be punished for it in the
courts and perhaps in criminal activities.
Chairman Oxley. I thought your comments were most
appropriate. And I am speaking now to Mr. Glassman,
particularly in view of Chairman Greenspan's comments that the
markets have a remarkable way of making corrections, punishing
wrongdoers and the like. One of the biggest fears that I have
frankly, and it was expressed by you and Mr. Melancon, at least
obliquely, is what would be worst, doing nothing, that is the
Congress, or overreacting and passing overly restrictive
legislation? I obviously know your answer, Mr. Glassman. Let me
ask Mr. Melancon what his perception of that is?
Mr. Melancon. Mr. Chairman, I would certainly agree with
you that in effect Congress has done something through its
bully pulpit, through these hearings, and a whole host of
others that have caused changes to occur, due diligence to
occur, a greater awareness by everybody involved in the
process. And that is a positive thing and that is an
indication, as Mr. Glassman has said, of the marketplace's
unique capabilities in our economy to be responsive.
With that as a basis, if you are asking me specifically on
would it be better to have far-reaching unintended consequences
through legislation or no legislation, I think our economy
would be better served because it has responded to your
activities and others with the more restrained approach because
the unintended consequences could be extraordinarily negative.
Chairman Oxley. One of the things you learn after being
around here awhile is that sometimes laws are forever, or at
least seemingly so. It took us 70 years to repeal Glass-Steagle
and some of us have the wounds to prove it. That is, when the
Congress enacts even bad legislation, it tends to take us a
long time for it to correct. And clearly the intent of our
legislation was to provide a broad framework for corrective
action, but essentially to allow the regulators and to allow
the market to work this out.
Mr. Greenspan even indicated that he thought, even at this
early going, that 50 percent of the problems inherent with the
Enron debacle have already been dealt with. And in my
discussions with CEOs from various industries, it also leads me
to think that that is happening. Clearly, the actions taken by
a number of boards recently regarding Andersen, by Andersen
hiring Paul Volcker, by Volcker's announcement just recently,
all would indicate that there is a heightened awareness of
corporate responsibility. There is heightened awareness of
auditor independence and their need to provide an accurate and
fair audit.
And there is indeed, obviously, the need with the changes
taking place in technology for virtually instantaneous
information to be placed before the investing public. Mr.
Glassman, for example, thought 2 days was perhaps too slow,
that it ought to be instantaneous, maybe we ought to look at
that. Maybe there are some other issues that can be brought up.
But, I have to say the more I discuss these issues with people
in the private sector, the more I am convinced that we have to
tread very carefully in this arena.
I thank you, and my time is just about up. Let me recognize
my good friend from New York, Mr. LaFalce.
Mr. LaFalce. Thank you, Mr. Chairman. And of course we must
always act deliberately and carefully, but we must act. And we
must not act with timidity. And we must act in the public
interest as opposed to listening primarily to the voices of the
private special interests. Discerning the difference between
the two is often difficult.
I am struck by a number of comments that have been made.
Mr. Lackritz praised the 1995, 1998 legislation, saying that
number one, lawsuits have gone up. Number two, settlement
dollar amounts have gone up. Number three, the quality of the
lawsuit has gone up. And that the intention of the Congress has
worked. I didn't know that the intention of the Congress was to
increase the number of lawsuits, increase the settlements. Some
people said it was indeed to the contrary. Some people who
authored the legislation of 1995, 1998 may actually have wanted
to see the number of lawsuits gone down, may have actually
wanted to see the settlement figures go down. But that is I
supposed historical perspective.
There has also been quite a bit of talk too about the
markets will punish the wrongdoers. The markets will make
corrections. Well, there is a certain amount of truth in that.
But to what extent will the markets, number one, obtain redress
for the victims of wrongdoing. And, number two, to what extent
will the working of the marketplace in and of itself prevent
future difficulties, future earnings manipulations?
That is where I think that you do need--in order to make
the market work, you do need a good system of laws and a good
system of regulation. That is the whole concept of law and
regulation, to make the market work. We have a good public
capital market, the public can invest on it. But I don't think
we can rely on the concept of buyer beware, which is if I were
to summarize Mr. Glassman's testimony in two words, which would
be very unfair, Mr. Glassman, because you were thousands of
times more nuanced than that, but basically it sounds to me as
if you are saying, ``Let the buyer beware.'' And we have to go
beyond that. Now how far beyond that, we need to discuss and
debate.
Clearly, the accounting industry has come in with its own
proposals. Clearly, there have been countless recommendations
from corporate America for corporate governance changes.
Clearly, the securities industry, the regulator, the NASD, has
come in with some changes. They are good as far as they go.
Other major securities firms have gone even further, and maybe
that is the best practice and maybe we should codify the best
practice. This is what we certainly need to debate.
But I don't think it is good to just put our head in the
sand and say the marketplace is going to take care of it and to
warn us all about overreacting. I have not seen too many
individuals so far who have been overreacting. And I don't
think when the comptroller for the State of New York, for
example, calls for mandatory rotation, when the former
controller of the city of New York calls for mandatory
rotation, when one of the former chairmen, at least one, of the
SEC calls for that concept, that is something that should be
considered seriously. When the Chairman of the Capital Markets
Subcommittee does not call for mandatory rotation, but calls
for at least a consideration of the concept of the exchanges
being responsible for the determination of the auditors, that
is something that merits very, very serious consideration.
And I look forward to working with the Chairman, maybe his
idea is better. It ought to be on the table. When CalPERS can
rotate its auditors every 5 years, that shows it can be done.
When companies fire one auditor and hire another, as they have
been doing the past several weeks, it shows it can be done. And
it is done hopefully to improve things. It is done for a whole
slew of reasons even though they may have been satisfied with
the auditing, they think it is necessary to restore investor
confidence, which is a good value in and of itself too that
should be weighed along with whatever learning difficulties
there might be. So if we have problems, learning difficulties,
whether it is a new Congressman, whether it is a new chief of
staff, and so forth, that goes with the territory, but it
should not create a paralysis on our part.
I thank the Chair.
Chairman Oxley. The gentleman's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman.
Mr. White, in reviewing your testimony, I found it very
helpful in this sense, that you obviously manage a system that
is financially significant, with a significant responsibility
for a large number of people's retirement futures. In your
remarks you talk about the adequacy of the audit committee
construction and point out that having only one member possess
financial literacy skills is not sufficient. I agree with you
and think that the provision in the underlying legislation that
allows for public members to be part of the regulatory body is
an advisable thing, but only if we can assure that the
appointment of these individuals to this incredibly important
responsibility have financial literacy as an asset. I think it
goes beyond the ability just to read the financial statement
itself. I think it creates an environment where there is much
more likely to be independence in making judgments because you
then understand what the facts are saying.
And that really gets to one of the principal concerns I
have about whatever system we adopt, to what extent is there
assurance that when the auditor is within the structure, doing
the work that is required at the direction of the audit
committee, the audit team has to engage with management to
understand what is going on almost always. Based on Mr.
Melancon's comment that fraud is most likely to occur when an
auditor is new to the business structure.
At the same time, I don't know on how many occasions that
the audit team is asked by the audit committee has management
asked you to modify, alter, change, in any way indicate that
the financial report you are presenting to us was inaccurate
and have a responsibility for that auditor to disclose what
relationships may have occurred with management beyond the
normal due diligence required to prepare the financials?
Is that a customary practice in your view?
Mr. White. That is a good question. First, your opening
comments about the applicability of how we feel about the role
of the audit committee and the expertise there and the
expertise needed on the oversight body I think are excellent
points. What we would stress on the oversight body is that the
independence of those members is of extreme importance, along
side with their expertise and that they will obviously hire
audit staff that would carry out the reviews and you would need
a greater level of expertise at that level.
Your question about the role of the audit committee, it
would be our strong desire that chairmen of audit committees
and audit committee members would hold the audit firm's feet to
the fire on exactly those issues. I have no statistics to
represent to you how often that happens. In my conversations
with audit committees and audit committee chairmen, I think it
is a mixed bag of how well they fill that role. One of the
things that we have learned out of this is we are going to put
additional pressure on audit committees to do exactly the types
of things that you mentioned right there. It is one of the
reasons that we want the audit committee to have the absolute
responsibility to hire and fire the auditors and to approve any
non-audit services, whether there be a ban or come from another
angle.
Mr. Baker. Thank you. Mr. Glassman, I always respect your
defense of free enterprise and generally are right there with
you on most of these observations. One point that I think needs
to be made in the current environment though is that short-term
earnings pressures on corporate management are enormous. And if
you don't beat the street numbers by a little, something is
wrong. And if you invest for the long-term profitability of a
corporation's life at the expense of the short-term quarterly
report, you enter that category called fired.
I think we need to incentivize in some method a way for
management to look to the long term, not to the short-term
quarterly report. One of the ideas was to indicate where a no-
cost option is exercised by an executive and through
manipulations of reports helps to bump the stock price up,
either by whisper numbers or whatever is out there that can be
done accordingly. And subsequent, in some time period, 3, 4, 5,
6 months, there is a restatement of earnings. Today, the
individual profits greatly while the shareholders take the hit
for that write-down of value.
Is there any kind of scenario, if it is a no-cost option,
give back of profits in that environment, is there anything we
can do to lock down and incentivize executives to return to the
old fashioned way of making product?
Mr. Glassman. I agree that that is a big problem. And I
know that Chairman Greenspan said the same thing. I believe,
and I say this in my written testimony, that one step that can
be taken is, in fact, to expense options immediately, the
majority of options. I know that is a controversial issue. I
know that there are especially technology companies that say
this would be terrible for them. I don't believe that. I
understand their concerns. But I think that would go a long way
toward addressing exactly what you are talking about. In other
words, there is no reason why there should not be a level
playing field between options and cash compensation so that
companies are making economic decisions about how compensation
should be awarded to executives. And I think that that is a
step that I would take.
Chairman Oxley. The gentleman's time has expired.
The gentleman from Vermont, Mr. Sanders.
Mr. Sanders. Thank you, Mr. Chairman. The issue that we are
discussing is really not very complicated. And the issue is if
somebody invests in the stock market or Mr. White helps invest
billions and billions of dollars representing workers in the
stock market, do they have a right to know that the financial
reports that they are reading, talking about the conditions of
the company are accurate and who is going to help us determine
that. That is the issue.
I think the evidence is pretty clear that we cannot simply
trust the industry or the accountants under the present
scenario to provide us with that information.
I would like to ask Mr. Melancon a question. Mr. Melancon,
while the AICPA has the power to discipline auditing firms and
their employees for ethical and legal infractions, my
understanding or my observation is that it does not seem to be
doing that job. Now I read a little while ago 10 instances of
where the top five auditing firms screwed up. Can you tell me
the kind of punishment that your organization levied on any of
them? You said in your report, as I understand it, we have zero
tolerance for those who break the rules. Now tell the American
people exactly how you have sanctioned Arthur Andersen and the
other companies for repeated violations of the rules, and, in
fact, in situations where they were sued for huge sums of money
and, in fact, even fined by the SEC. Now tell us what the self-
governing regulatory body did in terms of sanctions to those
companies?
Mr. Melancon. Congressman, we discipline hundreds of CPAs
each year. In addition to that, I think as you talk about
moving to different types of bodies, there are obviously issues
of individual due process rights that come into play. And
clearly we have supported an enhancement to the disciplinary
process that has been talked about because there are some
weaknesses in private sector bodies being able to discipline
primarily concerns in the liability areas, and so forth.
However----
Mr. Sanders. Excuse me, Mr. Melancon, may I ask you this.
In the last 25 years, has your public oversight board once
sanctioned a major accounting firm, one time in the last 25
years?
Mr. Melancon. The public oversight board oversees peer
reviews. There have been firms in the top 20 firms in this
country that have gotten modified reports, yes.
Mr. Sanders. In the top five?
Mr. Melancon. The firms in the top five have had----
Mr. Sanders. Who account for a huge amount of the volume.
Mr. Melancon. There have been individuals that have been
sanctioned in the Big Five, yes, sir.
Mr. Sanders. In the last 25 years?
Mr. Melancon. Yes, sir.
Mr. Sanders. Can you tell me who they are?
Mr. Melancon. I cannot tell you who they are right now. We
will be glad to provide you that information.
Mr. Sanders. My understanding, and I stand to be corrected,
is that, in fact, in the last 25 years of existence your
supposed regulatory board has never once sanctioned a major
accounting firm.
Mr. Melancon. There has been disciplinary action against
members of the Big Five absolutely in that 25-year period. And
in addition to that, Congressman, we have a system that----
Mr. Sanders. Can you describe what--my understanding of
that may mean retraining of auditors. Fines? How much have they
been fined?
Mr. Melancon. We do not have the power to fine,
Congressman.
Mr. Sanders. You don't have the power. What do you do, do
you re-train? Do you slap them on the wrist? Do you give them a
talking to? What do you do?
Mr. Melancon. We publicly, in an egregious situation, they
are publicly dismissed from the AICPA, which would----
Mr. Sanders. Any of the Big Five publicly dismissed from
the AICPA?
Mr. Melancon. Individual members have been, yes, sir.
Mr. Sanders. Top members? Mr. Chairman, I would say----
Mr. Melancon. Partners have, yes.
Mr. Sanders. Mr. Chairman, I would say that here is a
situation, some people talk let the industry regulate itself.
You don't need Government to play a role to protect investors
or pension funds. I would give an example, I would just simply
say that the record is fairly clear that the self-established
regulatory group, the AICPA, has not done the job that is
necessary. And in fact, whether we like it or not, the
Government is going to have to play a much stronger role to
protect American investors.
I yield back, Mr. Chairman.
Chairman Oxley. The gentleman yields back.
The gentlelady from New Jersey, Mrs. Roukema.
Mrs. Roukema. Thank you, Mr. Chairman. I, unfortunately,
did not hear all your testimony, but I have reviewed some of
it. And I do have a question for Mr. Lackritz. If I understand
his testimony, I believe he said, ``We believe that as part of
the effort to improve disclosure, it would be beneficial to
look at the earnings estimates that firms release.''
Could you elaborate a little bit more and with more
specificity with respect to how this proposed legislation would
deal with that issue?
Mr. Lackritz. Sure, I would be happy to. The issue here is
how to improve the quality of the information in the
marketplace. And while the legislation for example would
accelerate reporting requirements that are necessary under SEC
regulation, the really relevant and important reporting comes
with the earnings releases that happen about 21 days after the
end of the quarter, not statements to regulators. What we were
suggesting was that there might be a means of suggesting a best
practices for releasing earnings estimates into the marketplace
that would provide a common set of practices for firms to
follow in addition to the regulatory requirements.
Mrs. Roukema. Well, does this legislation adequately deal
with that subject or how would you suggest that we would refine
it and close any potential loophole there?
Mr. Lackritz. We were suggesting that it might go further
than it did and that is why the suggestion was in there.
Mrs. Roukema. Well, if you have anything more that you
would contribute with a specific proposal as to how we would do
that, I would be more than happy to accommodate you and work
with you.
Mr. Lackritz. Great.
Mrs. Roukema. In defining that. And I must say that I do
look to the SEC for leadership here.
I thank the Chairman.
Chairman Oxley. The gentlelady's time has expired.
The gentleman from Washington, Mr. Inslee.
Mr. Inslee. Thank you, Mr. Chair. From my neck of the
woods, the CPAs are people of integrity and the people I know
have acted very professional. And yet since the Enron collapse,
when I have been thinking about how the accounting industry is
structured, where you essentially have one team paying the
referee and the referee being able to go to work for one of the
teams afterwards at a good salary, and the referee being sort
of working in tandem with just one team like the Harlem
Globetrotters for 30 years, it is really amazing to me that we
have done as well as we can. So this has been a real eye-opener
for me in the Enron situation.
And one thing I think that many of us are considering are
how to gain the independence that we need from auditors while
not having unnecessary dysfunctions in their services, and that
is what I think all of us are looking for.
Mr. Melancon, I was really struck by your testimony. I read
your testimony. I don't know if you said this verbally, but you
had something that really caught my eye. You said that, ``Lower
paid, less skilled accountants may staff audit-only firms,
harming the ability of lead audit partners to go toe to toe
with the modern corporate financial executive.''
And the reason it struck me is that what I think you
posited there is that we need auditors who can go toe to toe
with their clients, if you will, which is a difficult thing to
do when the client is paying you to go toe to toe with the
client. But we need, because we are unwilling to have the
market pay for the auditing services, we are all sort of agreed
that we are going to continue the situation where the client
pays the service, and that has obvious huge problems for an
auditor to go toe to toe with the guy who is paying him. And it
seems to me we need to look for ways to reduce the
disinclination to go toe to toe like that.
Now in your testimony you told us that some auditing firms
now have rules about rotation of lead auditors internally, that
that is a rule. And I assume if you rotate a lead auditor, you
would have the same difficulty of getting up the knowledge bank
as you would if we imposed this rotational requirement. I just
wondered should we look at those differently somehow, if
internally companies impose the rotational requirement for
their lead auditors, it is a much greater problem to have a
rotational requirement for the firm itself. And don't exactly
the same reasons to impose a rotational requirement for lead
auditor, shouldn't those same reasons exist for a firm in
itself?
Mr. Melancon. Congressman, the requirement for rotating a
lead auditor is a profession-wide requirement. It is not a
company requirement. It is, in fact, a requirement that we have
put on the profession.
And on your sort of dilemma issue that you raised, that is
why the audit committee is particularly important in the
process, because the audit committee is the buffer if you will
in that environment that you described in the pay.
When you look at an audit engagement, there is a team of
people, these are multi-national companies in large part today,
there are literally hundreds and hundreds of people involved in
learning curves and understanding the business complexities. To
rotate that whole team of people actually creates a greater
risk from an audit quality perspective. The fact of the matter
is is that by changing the lead partner, which is a requirement
again as I said of the firm, of the profession, we are trying
to have, and through standard setting in the past, have tried
to set up a system that approaches the appropriate balance. And
that is really--and you sort of described it and captured that
very well, it is the appropriate balance in all of these
issues. And so the system that we have in place is we try to
extract the best of knowledge of the enterprise, knowledge of
the details, so that the quality of auditing is good, with
requirements to take some different look from a lead audit
perspective.
We also have a series of requirements if, in fact, someone
goes to work for an engagement that requires the audit--for a
client that the auditor take certain steps.
So it really is all about balance, Congressman.
Mr. Inslee. So what do you think of this analogy of the
referee situation. I think it would be unhealthy if NBA
referees had the possibility of going to work for management of
one of the teams they are refereeing in, it seems to me that
that is an unhealthy situation. But that is the situation we
have now for auditors.
And I understand part of your testimony that that decreases
the attraction of the profession a little bit, to think that
you now are less able if you do the auditing function to go to
work with management. But how can we tell our constituents that
we have got this increased level of trust in the profession if
we continue to allow the referees to go to work for the people
they are refereeing the next Monday morning after they finish
the audit? Isn't that a major issue here in trust?
Mr. Melancon. Congressman, there are series of issues
associated with that. There are requirements to discuss that
issue with the audit committee. There are requirements where a
person would go to work for an audit client, if it is during
the audit engagement, that the work that that person did to be
re-done by someone else. There is a requirement that if, in
fact, a person goes to work in an important position in the
client, that someone not associated previously with that audit
team review the work of that person and review that work to
make sure that there is a completely different look and so that
there is no, the concerns that you are articulating or the
closeness issues that are taken care of from that perspective.
And in addition to that, if a person is a member of an
audit team and is even offered employment from--not even if he
takes it, but if he is offered employment from a client, he is
required to be removed from that audit team.
Chairman Oxley. The gentleman's time has expired.
Mr. Inslee. Just one more comment, if I may. I want to
thank a lot of your members for helping us. I have been talking
to a lot of your members and they have been very good in
helping us understand these issues. I just want to pass that on
to you.
Thank you.
Mr. Melancon. Thank you, Congressman.
Chairman Oxley. The gentle lady from New York, Ms. Kelly.
Mrs. Kelly. Thank you, Mr. Chairman.
Mr. Melancon, could you please tell me--and give me the
correct pronunciation of your name?
Mr. Melancon. It is Melancon. Congressman Baker had it
right because we both have those Louisiana ties.
Mrs. Kelly. Thank you very much, Mr. Melancon. I would like
to ask you a question. In your testimony, you talk about your
opposition to a cooling off period. We in Congress have one
here as do a lot of the Hill staffers. I am curious about why
you don't see any conflict of interest for businesses wrongly
influencing audits by offering better jobs with the company.
You seem to be opposed to that cooling off period. I wonder if
you would talk about that a bit.
Mr. Melancon. Interestingly, Congressman, in the past we
have articulated concerns in that particular area as a
profession. The Independent Standards Board, which was made up
of people, 50 percent who were not associated with the
profession at all, spent a lot of time just in the last couple
of years focusing on this particular issue. And the conclusion
that was reached was that a series of safeguards was the best
way to balance that particular environment, some of the
safeguards that I just articulated that require discussions
with audit committees, that require work that that person was
involved with being reviewed by someone else in the firm that
didn't have anything to do with that particular person and the
audit team to ensure that the work is being done correctly. And
the conclusion was reached through a very deliberative process,
with public exposure and a tremendous amount of non-profession
involvement in the issue that the right answer was, in fact, a
series of safeguards to produce the appropriate balance.
The other thing that I just might mention on this
particular issue is that the movement of individuals into
corporate America, if we look at that history over the last 40
or 50 years, has had a tremendous positive influence on the
quality of financial reporting. If we compare corporate
America's internal capabilities today versus decades ago, we
have a much better situation in this country because of
movement that is supported in that area.
But the safeguards are very, very important. And
Congressman Baker's questions about audit committees, I think
there is an audit committee role when that particular situation
does occur to ensure the protection from the shareholder
perspective.
Mrs. Kelly. Thank you. I still find it curious that we are
held to such strong restrictions here on Capital Hill and the
business community doesn't feel any compunction--well, even
though you are talking about your safeguards, you feel that you
can get around that. I hope it works better than the Chinese
Walls that are written into some areas.
I would like to talk to Mr. Glassman a minute. You talked
about the fact that you agreed with parts of H.R. 3763, but you
think it is too regulatory and it sends the wrong message to
the investors. What do you see as the wrong message here? Do
you think it is going to hurt the investment for small
investors?
Mr. Glassman. First of all, I think there are two points
where small investors are concerned. Number one, as I said
earlier, I think it adds unnecessary costs when you essentially
tell really some of the best corporations in America--there are
8,000, I think that is the most recent number, listed companies
on the three major exchanges, certainly there have been abuses
by some of them. But the vast majority of excellent companies,
companies like IBM, McDonald's, Exxon-Mobil use the same
company for audit work and non-audit work, and there is a
reason for that. It is the most efficient way to do it. These
companies are very well run. They are looking toward
efficiency. So you add in cost.
The second thing, and I think this is maybe more important,
the signal that Congress has frequently sent to investors, not
just in this area, but in some hearings about analysts is that
look, if stock prices go down, somebody is at fault. Somebody,
some crook is taking your money away. That is not the way the
stock market works. In 22 years out of the last 76, the stock
market has declined. It goes up. It goes down. What investors
need to be told is the market is extremely risky in the short
term. You need to hold diversified portfolios. You need to hold
them for the long term. And to have them feel that Congress is
going to take care of everything, that there is going to be a
law that is going to be passed so that this stock is not going
to go down anymore, that is just the wrong signal. While, as
you said, I do agree that there are some steps that ought to be
taken, and I think there are parts of this bill that I admire.
Chairman Oxley. The gentlelady's time has expired.
The gentleman from North Carolina, Mr. Watt.
Mr. Watt. Thank you, Mr. Chairman. I appreciate your
calling this hearing. It has been enlightening and informative.
I just had a couple of comments and maybe one or two questions.
I guess we are all kind of seeking a framework to evaluate
what has happened, and we all do that from our individual
backgrounds and experiences. In my experience of 22 years of
practicing law before I came here and working in the trenches
beside accountants, representing small businesses, and seeing
them do consulting and/or auditing and accounting more than
perhaps auditing for those businesses is that there has been a
very strong sense of professionalism among both lawyers and
accountants. So I have been kind of wrestling on where I come
down on this, whether we should be heavy-handed and
overreacting or whether we should be letting the market take
some of this into account.
It seemed to me that auditors over the years and
accountants over the years have had an even greater
responsibility to be independent of the people, the companies
for which they are doing work even than lawyers. Yet there has
always been a very, very strict conflicts of interest set of
standards that apply to lawyers in their relationships with
clients and others.
I am wondering, Mr. Melancon, I blow it even worse--I think
it is spelled wrong on our sheets is the problem.
[Laughter.]
Mr. Melancon. It is just pronounced wrong.
Mr. Watt. Well, maybe it is pronounced wrong. Well, I
certainly just pronounced it wrong.
Do you think that the existing conflicts of interest and/or
other rules in place in your profession are strong enough, the
existing set that are out there, strong enough to allow
consulting and accounting and auditing to peacefully co-exist
without any kind of further regulation or do you think there is
something that needs to be done to adjust that?
Mr. Melancon. First off, Congressman, thank you for the
kind comments about the members of our profession that you have
worked with over the years, and I would agree with your
assessment from that standpoint. There are 350,000 members of
our profession, men and women doing the right thing in small
businesses and large businesses every day.
Mr. Watt. Don't take too much of my time to brag about
them. I gave them as much of my time to do that----
Mr. Melancon. Thank you, Congressman.
Mr. Watt. As I wanted to.
Mr. Melancon. I will move to the answer to your question.
The fact of the matter is that there are significant rules
in place to protect that environment. We only need to look at
the existing situation to understand that if, in fact, a CPA
treads on their reputation, that the horrendous results that
can occur. And the thing that they have to protect is their
reputation. And so there is a more----
Mr. Watt. You know I kind of expected you to say that. I
think the thing that I am having trouble reconciling, and I
think Mr. Glassman probably pointed it out more than anything
else, it is hard for me to be saying that we should let the
market control accounting practices at the same time we seem to
be ratcheting up our oversight and rules and laws related to
the legal profession. And so this whole--I mean, it seems to me
that what Mr. Glassman is saying is--and I mean this in the
kindest way, not in a negative way--almost duplicitous. That we
should be ratcheting up the standards that are at play in the
legal profession, but we should be letting the market kind of
control what is happening in the accounting profession.
And so if he could just respond to that.
Mr. Glassman. Well, in the first place, I am not aware of
any PRO that governs the legal profession. I do think however
that conflict of interest is a serious problem. There is no
doubt about that. The set-up with CPAs and corporations
presents a conflict of interest. The question is how do you
constrain it? I think it is very well constrained by the
marketplace where investors say if you guys are fooling around,
we are not going to invest in this company.
And let me just give you an analogy, because it is a
business that I know about and that is journalism. In 1992,
according to a survey by The Freedom Foundation, 89 percent of
journalists who were the chiefs of their bureaus in Washington
voted for Bill Clinton for president, 9 percent voted for
George Bush. But I can tell you that 100 percent of those
journalists will tell you that they are unbiased, that they put
that particular interest aside in their professional lives. And
I would say for the majority of them that is true. And they are
constrained by the public. That if their bias shows, people are
not going to read their newspapers. People are not going to
believe them.
Mr. Watt. In drawing a parallel between voting for some
Member of Congress or the President and the responsibilities,
the professional responsibilities that accountants have to
shareholders and businesses, I think that is----
Mr. Glassman. I am saying that professionals in all walks
of life are torn by conflicts, as are you. I am sure you have
personal interests, but you have also obligations to your
constituents. And you are constrained by what your constituents
see of your behavior here. Same thing with investors. I don't
think we necessarily need rules on rotation. For example,
CalPERS can tell companies, ``We are not going to invest in you
unless you rotate your auditors.'' So those are the kinds of--I
think those are much more effective constraints.
Chairman Oxley. The gentleman's time has expired.
The gentlelady from Illinois, Ms. Biggert.
Ms. Biggert. Thank you, Mr. Chairman. I am sorry to have
missed the testimony, but I still have a couple of questions
that I would like to ask.
One of the issues that came up in one of the hearings
recently was the fact--there was a discussion of whether audits
now always have to be unqualified or whether an auditing firm
can give a qualified opinion. I know that in the past they
could. But it was stated, I think on the other side of the
aisle. I don't know whoever can answer that, I would appreciate
it.
Mr. Melancon. Certainly there can be qualifications to an
audit report today. I think that comment was probably related
to where there is a qualified opinion, there is any gradation
of a qualified opinion. And so I think that was where it is.
But there are qualifications available.
Mr. Glassman. Could I just comment on that briefly?
Ms. Biggert. Yes.
Mr. Glassman. This is what I was trying to drive at in part
of my testimony. I really think that audit firms should be
freer to tell people, tell investors in clear English what is
going on with a company. For example, I think Andersen could
have said, if it believed that these books were sound, that
everything here is on the up and up. However, investors should
be aware that there are hundreds of special purpose entities
out there, that here are the liabilities. That is the
obligation of accountants. And I think frankly that they have
failed in that obligation. But part of the reason they fail is
the structure, the incredibly complicated structure of the GAAP
system. In fact, if it were loosened and more judgment were
involved, but also more accountability, the system would work
better.
Ms. Biggert. And I think that that is what I was driving at
in asking that question. And it seems that there is--they want
to make it appear the best and even if it is qualified, there
still isn't any statements on that. So I would agree with you.
The other question I have is talking about real time
disclosures. And it is my understanding that when officers now
sell stock or purchase--particularly selling their stock, but
purchasing, that the newspapers do carry that. And I guess I
would ask this of Mr. Glassman.
Mr. Glassman. Yes, the way that the current system works is
that smart CEOs who want to conceal their sales can time it in
such a way that it doesn't appear for 40 days. And I think
there is no reason on earth for that. I think that sales and
purchases of stock by insiders are an important market signal
that investors should know about. And they should know about it
the instant that it occurs. And I think the technology is there
for that happen. And it should happen.
Ms. Biggert. In the paper, but certainly there has never
been any education to the public or to anyone that this is an
important item that maybe as an investor they should be
watching for.
Mr. Glassman. Well, there are services that provide this
information. It can be overrated as an item. There are hundreds
or thousands of little items that go into making decisions
about investments. And I think that is one of them. It is not
dispositive. It doesn't mean that because someone has sold
stock as an insider that there is something terrible going on
with the company. But that is a piece of information that
people should be able to take into account. Right now, frankly,
they can't.
Ms. Biggert. So you would agree with the bill then, that it
should be immediate disclosure?
Mr. Glassman. Right, what I say in my testimony is actually
that the disclosure should be faster. The bill allows
essentially 2 days for the information to get to the public, I
think it should be 2 minutes.
Ms. Biggert. And then as far as the restrictions on selling
stock, the selling in the blackout period for officers should
be the same as the employees, the restrictions?
Mr. Glassman. I agree with the blackout period in the
interest of fairness, even though I understand that there is a
difference between assets held in the 401K plan and assets held
outside the plan by executives. But I think this is a hardship,
if you want to call it that, that executives of corporations
should endure in the interest of fairness. So, yes, I think
there should be a blackout period for them too.
Ms. Biggert. OK, thank you. Thank you, Madam Chairwoman.
Mrs. Roukema. I thank you. Now, Mr. Kanjorski.
Mr. Kanjorski. We seem to be talking around the issue in
terms of what transparency and accountability will do.
First and foremost, I will tell you what I am disturbed
about. If you look at the Enron situation, it seems that
because of the accounting system that was established, there
was not a clear disclosure of all of these risky transactions
that were happening. Then, we see that the pension fund was
heavily invested in its own stock. 401Ks particularly were
heavily invested by the employees. But also, when you look
across the country, we have the pension funds, throughout the
States, the public pension funds and the private pension funds,
that were heavily directed to one stock. So the loss factors,
it seemed as a result of the Enron collapse, fell upon people
who were not in control of their investments. Their investments
were basically being made by investment companies on Wall
Street. These companies were deriving profits from the
transactions on commission basis as opposed to having anything
at risk. They had nothing to lose, and they could only gain by
the transactions.
As we move toward democratic capitalism, and that is what
we are talking about, we have to recognize, I think, a couple
of factors. One, a lot of these people do not directly control
their investments. They are controlled by ``specialists'' who
reside on Wall Street. Second, they are not the best informed
investors in the world. Now, unless we develop a system that
guarantees that we are either going to educate our investors,
and that is a large mass of new investors, and we are going to
give them some capacity to directly control their investments,
they are at risk of these people that did not exercise
diligence. These people were the 14 out of 15 analysts that
were calling for purchasing Enron's stock up to a week before
the collapse. It is ridiculous. All of us are shocked.
Now, it seems to me that the accounting profession and the
accounting firm clearly did not follow principles and rules of
accounting to account for all these risky transactions on the
book. If they did, they wrote it in such a way, in such
language, that not even the best Wall Street analyst could
penetrate the language to understand the risk. So clearly, if
we do not do something there, this is going to continue in the
future.
On the other hand, we run the risk of passing legislation
very quickly, and then getting the unintended response. I
understand we are hell-bent on getting this legislation passed
by Memorial Day, which is shocking to me, because I do not
think we know the extent of the problem here.
So maybe any one of the four of you can tell us what you
think, or tell me what you think this problem really is at this
point and whether or not the Congress of the United States is
so able, that it should be able to act in 2 or 3 weeks to solve
the problem?
Mr. Glassman. Let me respond quickly. I agree with you that
this Congress should not be hellbent on finding a solution,
because we really do not even know all the facts in this case.
They are just not out yet.
But I just want to comment very quickly on one of the
things you said that I completely agree with, and I am glad
that you brought it up, Congressman, and that is this issue of
investor education, which I have devoted a good deal of my
professional life to. The fact is that 50 percent of Americans
now own stock. It is going to be 60, 70, 80 percent within a
few years. And that is good. That is good. However, many of
them really do not understand the basics of investing. And I
really think that if there is a role, a major role for Congress
here is in making sure that investors do have that base in
education. Now in most cases they are going to have to trust
professionals to make these decisions, these investing
decisions for them. And most of the time professionals do a
good job, but they do need that base of education.
And that to me is one of the most important factors that
has come out of this Enron case, how little people still
understand about the basics, such as diversification. That is
the way to protect yourself against an Enron.
Mr. Kanjorski. Yes?
Mr. Lackritz. Mr. Kanjorski, I would like to respond to
your question too. I think that it is very important to get
this right rather than necessarily getting it fast. That being
said, I think there are a number of provisions in this
legislation that obviously are going to help to improve the
quality of information in the marketplace, and the real issue
here is how to improve that quality of information, because
that is what everything else stems from.
And then to go on with the other point that Jim Glassman
raised with respect to investor education, I think that is
something that both the private sector and our association is
engaged in in a big way. We are launching an investor education
website next month that will draw together the best of class
investment advice, objective investment advice, because there
is nothing that is being sold on this site. It is going to be
made available throughout the country.
And so I think that along those lines, I think some of the
responses we are making go to that question that you have
raised as well.
Mr. White. From our organization, I would be the first to
say that we do not want to see overreaction either. We are one
of the groups with significant assets at risk in the financial
markets. We care more about how they work than any other group.
But what I would submit to you is that the issues that are on
the table and all the current forms of legislation and SEC
Chairman Pitt's proposal and President Bush are not at all
overreaction. These issues are not brand new. They have been on
the table for years. The issue of auditor oversight and the
issue of auditor independence are things that have been fully
debated in the public.
We are an end-user of this, and we are completely convinced
that the measures that are being debated are absolutely
essential to the capital markets and to our protection as an
investor.
Mr. Kanjorski. I am not sure I understand. You think we
should adopt immediately, before Memorial Day, the Bush
solutions and then go home?
Mr. White. No, I am not saying that that should be a
deadline. But what I am saying is that the issue of
overreaction is one that we just simply do not agree with.
These issues are all real. And, yes, let's take the time to
debate them and discuss them, but I think the comments toward
overreaction are more geared toward slowing down the process so
real reform does not take place.
Mr. Kanjorski. Do you really think that the Congress----
Mrs. Roukema. Excuse me, excuse me. The 5 minutes are up,
but will you let the last panelist respond to your first
question. I do not think you have time for another question.
Mr. Melancon. Thank you, ma'am. Just a couple of quick
points. I think, Congressman, the overreaction or the
unintended consequences is something you should be concerned
about, because it has a dire concern to us in the financial
market system. As to the education of people, this Congress
enacted a tax-free benefit to educating employees on investment
advice, which was a good first step in this education activity.
And if you had to focus on one thing that was important to
changing this whole environment, that is a financial reporting
model that is not rooted in the 1930s, but is commensurate with
the world that exists today.
Mrs. Roukema. I thank you.
Congressman Shays.
Mr. Shays. Thank you, Madam Chairwoman. I would like to ask
Mr. White some questions and preface my statement by the fact
that in our previous hearings and going over the Powers Report,
Enron clearly is a story of a tremendous amount of greed. And
no profession looks good. The accountants do not look good. The
lawyers do not look good. The analysts do not look good. The
bankers do not look good. And the investors do not look good
either, particularly even your organization frankly.
And I want to ask you about the special purpose entities
and why you invested in them?
Mr. White. First off, I am not the best person at CalPERS
to answer those questions. I will gladly answer what I can and
if you want further detail, I will be more than happy to
respond in writing at a later date.
The two private equity deals that CalPERS did with Enron
were fundamentally different in their nature than the
partnerships that got Enron ultimately into trouble. And I
would note to you that CalPERS declined to invest in those
relationships after the fundamentals of the investment proposal
changed. Why there is criticism----
Mr. Shays. Well, you invested in Jedi One and you invested
in Jedi Two. And Jedi Two was basically determined to be
somewhat illegal, wasn't it?
Mr. White. I do not believe that is accurate, no.
Mr. Shays. Do you have any expertise to be able to respond
to us on these issues? What expertise are you bringing here?
Mr. White. My role is--I am the Director of Corporate
Governance. The private equity unit in CalPERS is an asset
class that is headed by a senior investment officer. And those
questions----
Mr. Shays. The reason why I thought you were here was that
basically you were a major player with Enron. Isn't that true?
Didn't you invest almost $300 million in the first one. And
almost $500 million in the second?
Mr. White. Correct.
Mr. Shays. And what brought Enron down was the fact that
these special purpose entities were basically hiding their
liabilities and over-inflating their income. Isn't that true?
Mr. White. Well, the two partnerships that CalPERS invested
in, number one, did not have the conflicts of interest that the
later partnerships, which CalPERS did not invest in had. There
is a fundamental difference in that. Our organization was not
interested in participating in those, because we did not like--
--
Mr. Shays. Were you an investor in the company besides
having these special purpose entities?
Mr. White. Correct. We hold common stock in Enron as well
as----
Mr. Shays. So you had common stock and yet you were part of
an operation, all these special purpose entities basically
enabled the company to get into the fix they were in. And when
they had to disclose Jedi Two, they basically were disclosing a
tremendous amount of liabilities that nobody knew. That is what
basically brought the company down. And that was your
investment.
Mr. Glassman, do you have any comment on this?
Mr. Glassman. Yes, because I think actually the worst thing
that CalPERS did, which the New York Times revealed on February
5th, and I mentioned in my oral statement, is that when it was
alerted about the nature of another one of these special
purpose entities by its advisors in December 2000, it declined
to invest in it. As Mr. White said, it did decline. But then it
did not live up to what I think is its moral and public
responsibility to bring the matter before the board of Enron.
And more important I think what I would have done at CalPERS, I
would have brought it to the attention of the American
investing public.
Mr. Shays. Let me ask why----
Mr. Glassman. And if that had been done, we may have
learned about this whole Enron situation at least 9 months
before we ended up learning about it.
Mr. Shays. Why wasn't that done, Mr. White?
Mr. White. Again, personally I was not even on staff at the
time that that happened. But while it is true CalPERS is a
leading governance organization, and we pride ourselves on
being an active, involved owner, we cannot read the tea leaves.
We do not have a crystal ball. While there may have been a
conflict at Enron, it was impossible for anybody to forecast
that those conflicts would mushroom into the types of
relationships and become what is apparently fraud at Enron.
Mr. Shays. See, I have a different theory and
unfortunately, you are not--you are saying you are not capable
of answering. My theory is that basically you were making such
a great return on the first 22 percent and then you were making
62 percent on an annualized basis, that you all basically were
part of the problem like everyone else. You were part of the
whole thing on greed. It would seem to me that anyone who is
making 62 percent says, ``Hey, why is this happening?'' And
when they start to ask the questions, they learn. In your case,
you learned and then your organization remained silent.
Mr. White. No, sir, our organization did not invest. The
types of returns that we made on the partnerships----
Mr. Shays. Did you invest in Jedi two?
Mr. White. Correct.
Mr. Shays. Isn't it true that you had an annualized gain
through June of 2001 of 62 percent?
Mr. White. I believe that is accurate.
Mr. Shays. OK. I mean, when you are getting that kind of
return, it should tell you a lot of things. And one of the
things it tells you is maybe this is not happening in a way
that is credible.
Mr. White. Well, if I may respond? If your theory about our
decisions were driven only by greed were correct, then those
returns would have led us to invest in the next partnerships,
yet we did not.
Mr. Shays. No, I think by then people were aware of what
was going on. I think by then people knew that this was a house
of cards that was about to collapse.
Mr. White. I think to the contrary, Enron was only
beginning to form all of the partnerships that had the terrible
conflicts of interest that led to the problems, at that point
in time. You remember this 1996, 1997 era. So at that point in
time, Enron was not even forming those partnerships.
Mr. Shays. My time is up.
Mrs. Roukema. All right, thank you.
Mr. Sherman.
Mr. Sherman. Thank you, Madam Chairwoman. I am glad we are
doing something, hopefully not by Easter, but by the Fourth of
July. And what we should do is not mere window dressing. We
cannot just use the bully pulpit of this committee to urge Wall
Street to all join hands and sing Kumbayah or community values
are better than greed. Nor can we scream, ``Caveat Emptor'' at
the investing public.
I hope very much that we do not introduce ``judgment'' into
Generally Accepted Accounting Principles to the point where two
identical companies will be issuing wildly different financial
statements based on the different styles of the auditors that
they select, nor can we analogize the conflicts of interest
faced by an auditor, by that faced by a journalist who might
happen to vote for Al Gore. The difference between the local
journalist on the one hand and David Duncan of Arthur Andersen
on the other is $52 million. Now if there was any journalist
getting $52 million for himself or his publication, then
perhaps that would be an equivalent conflict of interest.
I hope that if we rotate, we will also look at providing
tenure to auditors. Otherwise if you have a chance of being the
auditor for 8 years, but you can get fired after 1, then
perhaps Ken Lay will be able to convince you to go a little
easy on which special purpose entities you consolidate.
Mr. Melancon.
Mr. Melancon. Melancon.
Mr. Sherman. Melancon. On the wall of my office is the
AICPA certificate. I hope our colleagues recognize that you are
a voluntary organization like the ABA. Many CPAs choose not to
pay you dues. The worst you could do to a CPA is throw him out
and then he saves the dues. Really the worst you can do though
is publish rules that if we violate, some lawyer can sue us.
And it is your rulemaking, not your ability to discipline
members who after all do not really want to pay your dues
anyway that is key.
I think you are wise to bring up the fact that we need not
only untainted judgment, which is the focus of these hearings,
but smart investigators. And those two are in conflict. A smart
investigator would love to be involved in the internal auditing
because he would learn more about the company or the
accountants would learn more about the company. But then they
would get a fee which might taint their judgment. Likewise,
rotation may reduce the tainted judgment, but might prevent the
audit from being as effective as it would be because you are in
a learning curve the first year of an audit. So I would hope
that we would make sure that auditors remain good investigators
as well as do everything we can to prevent them from having
tainted judgment.
I would like to focus on one area where I think the AICPA--
--
Mrs. Roukema. Excuse me, Mr. Sherman. I do not know that
you realize that a vote has been called. So do you want to
continue this or do you want to recess--do the two votes on the
floor and then return because your time is almost out?
Mr. Sherman. Why don't I continue and then we can go vote.
Mrs. Roukema. Go ahead.
Mr. Sherman. The one area where I think the AICPA screwed
up is in allowing Arthur Andersen to adopt a structure where
the technical review department did not have final authority
over whether Arthur Andersen signed the financial statements.
And that is like having a situation where the life insurance
agent decides whether to insure me for $10 million despite a
little heart flutter rather than the underwriter back at the
home office. What we I would hope, and I would like to know if
you are planning to do this soon, adopt an ethics rule that
every member of the AICPA must vote within their firm to demand
that it is the technical review department that makes the
decision as to whether to sign the audited financial statement.
Otherwise we are going to be in a situation where the guy whose
chief job is to go golfing with Ken Lay is the guy that makes
all the decisions as to whether Arthur Andersen's name appears
at the bottom of the audit report.
I would like you to respond.
Mr. Melancon. Congressman, first off, I appreciate the fact
that you have the AICPA certificate. And I understand your
point on that control issue. And I think it is one that is very
important for us to take a look at. It would be in the issue of
quality control. It would be in the standards in the SEC PS
just from a technical standpoint. And I am sure that we will,
in fact, take a look at that.
Mr. Sherman. Well, I am sure you are going to look at it. I
hope that you will call me a month from today and tell me that
you have decided to change what is a glaring hole in the ethics
rules that you have control over.
Mr. Melancon. Thank you, Congressman. I would also say, I
would agree with you on the issue of discipline and that is why
we have supported, as I think you have, the notion of an
enhanced capability of discipline that actually is beyond the
way you described it from that standpoint.
Mrs. Roukema. I think we are going to have to recess now
because the bells have rung. I would just ask the Members to
please return promptly so that we can continue and conclude
with this panel.
Pardon me?
Mrs. Maloney. Can you tell me who the next questioner is,
please?
Mrs. Roukema. Dr. Weldon on our side and you will follow
that.
Mrs. Maloney. Very good, I will rush.
Mrs. Roukema. You are the second one after the recess. All
right, we will be back shortly.
[Recess.]
Chairman Oxley. [Presiding] Come to order. And the Chair
would recognize the gentleman from New York, Mr. Grucci.
Mr. Grucci. Thank you, Mr. Chairman. At the risk of
destroying your name once more, would it be OK if I called you
Barry?
Mr. Melancon. That would be great, Congressman.
Mr. Grucci. Thank you for that. You had in your testimony
earlier talked about the ability of industry to self-police
itself. And I concur that industry can do a good job of doing
that. And you talked about some of the issues that took place,
some notices in files and people being expelled, and so forth.
If I was a business and I wanted to know about an accounting
firm that I was thinking about putting on to give me the types
of information and look over my books, and contacted your
operation, if indeed there was a sanction against them, would I
be able to access that information?
Mr. Melancon. You would be able to access the results of
their peer review report and discipline is typically on an
individual basis, however, Congressman.
But it is important to make one point on this that I didn't
get to make on the other, and it is along the lines of your
questioning. One of the advantages that we have--and we support
enhanced discipline and an enhanced regulatory body for
discipline. So we are not opposed to that. But one of the
advantages that we have is that if a auditor, a partner, a
public company auditor is alleged to have done something wrong,
we do not have to--by rule we do not wait until the culmination
of the investigation. We can require the firm, and we do today,
require the firm to take that person off of audits. They have a
choice. They can take the person off audits. They can fire the
person. Or they can build an infrastructure around the person
to protect the public in effect without going through the whole
due process system that would be in a normal Government
environment. That is a public protection point. It is an
advantage that we have. Now we have some disadvantages as well.
Mr. Grucci. But, I guess what I am trying to get to is that
I would be able to determine as a business owner that a firm
that I was thinking about hiring indeed had some issues that
were being addressed by a peer review board of some sort. What
kind of an effect do you think that that would have?
Mr. Melancon. You could get their peer review report and
something called their letter of comments, which is sort of
like management suggestions and you could have dialogue with
the firm as to what are they doing to fix those letter of
comments, if they have any, and you could reach a conclusion
from that standpoint. All 45,000 firms in the country go
through a peer review.
Mr. Grucci. And I would suspect that they don't look
forward to those types of peer reviews because it could have a
chilling effect on their business?
Mr. Melancon. Congressman, firms, first off, invest
millions and millions and millions of dollars in their systems
of quality control to avoid failing that process, which is a
part of the constant improving process that is in place in our
profession, because failing that process is like putting a gun
to your head.
Mr. Grucci. Thank you. I would like to move to Mr. White if
I may. You represented a pension fund that has $150 billion,
and I don't know how much of it was invested in any single
company. I do not wish to drag up the Enron issue. But what I
do wish to ask you is when you are about to invest parts of
your pension fund in either a company or in a construction
project or whatever you may be investing in for the purposes of
getting a return back for the retirees. What process do you go
through to make that determination? When I make an investment,
basically because it is such a small investment on my part, it
is a gut hunch. Do I think that investment is going to do well
or not? I would think that you would do more than just a gut
hunch when you put millions upon millions of dollars of
retirees' pensions at risk. Could you bring me through the
process that leads you to your investment decisions?
Mr. White. Certainly. The bulk of our assets, approximately
two-thirds, are invested through what we call an index
strategy, it is a passive strategy. You will find that many
large institutions use that because it is a cost-effective way
for us to get equity exposure to the market. We also invest
through active strategies through both internal programs and
through external programs. We also have private equity
partnerships. We also have a real estate program. You will see
a huge distinction between how institutional investors put
money out on an index strategy versus an active strategy. For
the index, if companies are included in the index, by and large
we are going to hold them.
Mr. Grucci. Let me try asking this another way, because I
am not sure I made myself clear to you. When you invest the
money, is there a criteria that you go through? Is there a
checklist that you go down? Is there some kind of thought
process other than, yes, I know that project, it sounds like a
good one. I think I will put some money in building a shopping
center or building offices or investing into a corporation.
What do you do to ensure in your own minds that you have made
the right decision in investing in that product?
Mr. White. OK, let me just get to the distinction quicker
then. Through our active strategies, we do a high level of due
diligence, that includes the real estate program. It includes
the private equity program. And it includes the active
investments on the public market side. Our external managers
that operate on our behalf, as well as our internal managers,
do due diligence on company specific. This is fundamental
research on the things that you are asking about, whether or
not we feel that a company is under valued or overvalued.
On the index strategy, again which is the bulk of our
assets, we are buying the market index. It is an efficient way
to get exposure to the markets. But what it does is it gives us
companies in our portfolios that you may not pick through an
active strategy, companies that are weak. It is one of the
reasons that CalPERS has such an active corporate governance
program, is because our size necessitates that we have broad
equity exposure. We simply could not in a cost-effective way
make active decisions for a portfolio of our size.
Mr. Grucci. Thank you and I assume my time has expired.
Thank you, Mr. Chairman.
Chairman Oxley. Thank you, Mr. Grucci.
Mrs. Jones.
Mrs. Jones. Thank you, Mr. Chairman. When you are doing,
Mr. White, your active strategy, what do you use--let me be
just real straight. You rely on an audit to make your decision
about a company, whether you are going to invest in them, don't
you, sir?
Mr. White. Yes, ma'am, we do.
Mrs. Jones. Thank you. Let me turn to Mr. Glassman. Mr.
Glassman, tell me what is the American Enterprise Institute,
sir?
Mr. Glassman. The American Enterprise Institute is a think-
tank started about 50 or 60 years ago. They have 150 people who
work there. A think-tank is----
Mrs. Jones. I know what a think-tank is.
Mr. Glassman. OK.
Mrs. Jones. Thanks. Mr. Glassman, what is your area of
specialty at the Enterprise Institute?
Mr. Glassman. Economics, finance, markets, although I have
wide-ranging interests, including education and health care as
well.
Mrs. Jones. OK, but you are here based on your economics
and finance background today, is that correct?
Mr. Glassman. I think I am mainly here because I have for
many years written a column about investing that is syndicated,
it is in The Washington Post.
Mrs. Jones. Simple answer, Mr. Glassman, you are here
because of your background or experience in this area. I only
have 5 minutes. I can't give you a chance to do all you would
like to do.
Mr. Glassman. Yes, yes.
Mrs. Jones. OK, now, would you say that as a result of the
regulations of the SEC that accountants have a place in the
process of investment that few other professionals have?
Mr. Glassman. Yes.
Mrs. Jones. And as result of that, that puts a greater
burden upon auditors to be highly ethical in their conduct and
forthcoming in the work that they do on behalf of companies. Is
that a fair statement?
Mr. Glassman. I think it puts a great burden on them,
greater than corporate executives.
Mrs. Jones. Well, let me finish. Greater than any other
profession that is not required by the SEC?
Mr. Glassman. Quite frankly, I think corporate executive
boards of directors have enormous responsibility.
Mrs. Jones. I was not talking--listen to my question.
Mr. Glassman. Probably greater than accountants.
Mrs. Jones. Mr. Glassman, listen, my question was with
regard to accountant----
Mr. Glassman. Right.
Mrs. Jones. Professionals dealing with companies, they have
an unusual placement by the SEC, greater than any other
professional, I mean a lawyer, I am not talking about the
people in the business. I am talking about professionals that
are hired by the company. You don't have to have----
Mr. Glassman. I don't necessarily agree with that, but
there certainly is a great burden.
Mrs. Jones. Well, let me ask you this question. You don't
have to have a lawyer to allow people to invest in your
company, do you, sir?
Mr. Glassman. I think it would be a good--I can't imagine--
--
Mrs. Jones. I didn't say whether it is a good idea, but you
are not required by the SEC to have a lawyer?
Mr. Glassman. I guess not.
Mrs. Jones. And you are not required to have a doctor?
Mr. Glassman. No.
Mrs. Jones. And you are not required to have a
psychologist?
Mr. Glassman. Right.
Mrs. Jones. But you are required to have an accountant who
is to do the audit. Is that a fair statement?
Mr. Glassman. Correct.
Mrs. Jones. I say that to get to the point that you are
saying that we ought to allow the industry to regulate--the
market regulation to require--to do compliance in this area, is
that a fair statement?
Mr. Glassman. No, it is not a fair statement. I think that
investors apply--you can call it the market if you want to
think about it as----
Mrs. Jones. I got that word from you. I wrote a quote, but
if you----
Mr. Glassman. The investors and the market apply a
tremendous discipline to corporations to behave correctly.
Mrs. Jones. Who applies the discipline to the auditors?
Mr. Glassman. To the auditors? Well, let's put it this way.
Arthur Andersen has just been accused of doing some terrible
things regarding Enron. It has been fired by some of the
biggest corporations in America.
Mrs. Jones. But what does that do for--since you all are
beating up on CalPERS, claiming they made so much money, what
does that do for the other smaller public employment retirement
systems that lost money as a result of the reports or audits
done by Arthur Andersen that were not factual?
Mr. Glassman. There is no doubt that among the 8,000 listed
companies in America some of them misbehave. Now actually Mr.
White just said something important about indexing. Enron----
Mrs. Jones. My question is, what does that do for the poor
people who lost their money as a result of the
misrepresentation of Arthur Andersen?
Mr. Glassman. Well, I have to say that the nature of the
stock market is that you sometimes lose money. And you
sometimes make money. Dell Computer was up by 7,800 percent.
Mrs. Jones. OK, that is enough.
Mr. Glassman. You don't have to turn that money back.
Mrs. Jones. Let me go back to this. That maybe the nature
of the stock market that you sometimes lose money and sometimes
make money.
Mr. Glassman. Correct.
Mrs. Jones. But when you invest in the stock market, you
invest knowing the financial situation of the company, whether
you win or lose, and you chose to win or lose based on that
knowledge.
And I will be done, Mr. Chairman.
Mr. Glassman. Oh, can I respond? Absolutely.
Mrs. Jones. Oh, I want you to respond, sir.
Mr. Glassman. Absolutely, Congresswoman. I think that that
is true. You either make money or lose money. In the case of
Enron----
Mrs. Jones. You said you make money or lose money. My
statement is you make money or lose money and you invest based
on the knowledge you have on the financial condition of the
company. Is that fair?
Mr. Glassman. There is no doubt about that and that is why
we are here today. Enron misrepresented its financial
statements. It is dead as a company. Capital punishment has
been inflicted on it before it was ever indicted, before
Congress did anything, before anybody did anything. And that is
probably true as well----
Mrs. Jones. But what we are trying to do here today----
Mr. Glassman. Because of Arthur Andersen.
Mrs. Jones. Is figure out how we never find ourselves in
that situation again.
Mr. Glassman. I realize that.
Mrs. Jones. And the position that I am trying to get is
that you have auditors who have a position better than anybody
else in the investment world and therefore there has to be a
greater obligation on them to represent the truth.
And I yield the balance of my time. Thank you.
Chairman Oxley. Thank you, Ms. Jones.
Mr. Cantor.
Mr. Cantor. Thank you, Mr. Chairman. I would like to ask
Mr. Glassman, in your testimony I think it is fair to say, and
if not, please correct me, that while you agree with parts of
the bill, H.R. 3763, you contend it might be too regulatory in
its approach and sends the wrong message to investors. Can you
respond to that assertion and perhaps offer some suggestions if
that is your position?
Mr. Glassman. Well, it is my position. I think there are
certain things that should be done that I outlined in my oral
testimony and my written testimony. I think there should be a
blackout period. I think there should be stricter
accountability. I think there should be contemporaneous
reporting by executives when they buy or sell stocks. But I
worry about for example the notion that Congress should decide
the functions that auditors perform within a company. There is
a good reason why corporations, the biggest and best
corporations in America, corporations completely beyond
reproach, and I mentioned some of them earlier, companies like
Exxon-Mobil and IBM and McDonald's, and I don't want to leave
anybody out, there is a reason that they pay more in
proportional sense for non-audit services than audit services
because they think they are getting good value. And when you
come in and decide that this not the way that they should be
doing business, it causes them to incur extra costs, reduces
their efficiency, and diminishes their profits and therefore
their value to shareholders. So I think that is a big problem.
And the second problem is something I alluded to earlier,
which is that we are telling--in hearings like this sometimes
people get the wrong message, investors get the wrong message.
And the message is that the reason that stock prices go down is
there are all these crooks around who are out to make money and
do things in nefarious ways and that is why you, the poor
shareholder, is losing money. That is not why people lose money
in the stock market in most cases. The reason they lose money
is because stocks do not go straight up. They never have. About
one out of every 3 or 4 years, the market as a whole goes down.
And I think it is very important that investors, that Americans
understand that and structure their portfolios accordingly. So
that is basically my point.
Mr. Cantor. Can you talk about and address the issue of
repealing litigation reform and say that it would not help
shareholders. Can you try and address that as well?
Mr. Glassman. Well, I just, you know, despite litigation
reform, there have been many, many cases filed, actions taken,
I cited in my testimony the Cendant case in which Cendant paid
$2.8 billion to settle a shareholder's suit. The accounting
firm that was involved paid $330 million. Lots of money has
been spent to settle suits since this law was passed. And some
in Congress are pointing to this law as a reason for the Enron
scandal itself, and I am just saying that it is not and I don't
think that law needs to be revised. And I think if anything,
the bar ought to be raised, because the law still makes it so
easy to sue companies that really are not doing anything wrong
in many cases. In some cases they are, and I think it is good
that they are sued and they ought to pay for it. However, it
does distract executives and causes money that shareholders--
shareholder assets get paid out in these lawsuits. It hurts
shareholders.
Mr. Cantor. Thank you, Mr. Chairman. I yield back.
Chairman Oxley. Ms. Waters.
Ms. Waters. Thank you very much.
Mr. White from CalPERS, how much did we lose with our Enron
investments in California?
Mr. White. At CalPERS, I can speak for CalPERS, we still
have assets at risk. As it stands right now, we have total
losses based on the book value of approximately $9 million. But
we still have private equity assets that are what I would say
at risk. We do not know how much of that we will be able to
recover.
Ms. Waters. Thank you very much. I have a million questions
I could ask, but I chose to use this time to distinguish
between the thinking of American Enterprise Institute as
represented here by Mr. Glassman and the more conservative
thought in America politically. I am a Democrat. I am a liberal
Democrat. I believe in the body of law that we have developed
in this Nation to protect consumers. I do not take the position
that they ought to know better. They ought to be smart enough.
We have consumer law that is developed in so many ways. For
example, maybe people should know the difference between bad
meat and good meat. But we do not leave it to them. We have
meat inspections. Maybe people should know how to protect
themselves against dirty water. But we have laws to ensure that
we have clean water. Maybe people should know the difference
between big banks and financial institutions that do predatory
lending and all of that and insurance companies, but we do not
just leave it to them. We believe that Government has a role in
helping to protect the least of these or the average consumer.
And perhaps we should not have any building and safety laws,
because people ought to know when they contract with someone to
build a building, that they are just going to do the right
thing.
That is where you and I differ. That is the difference
between your conservative thought and my more liberal thought.
We believe that Government must play an important role in
protecting consumers. And when we find that Government is
intruding unnecessarily, we should stand up for that also.
To assume that somehow because Enron has been caught and it
is going to have to pay a price that the market is working fine
and we should not worry about having to come up with new law by
which to deal with the problems that have surfaced. However,
how many people have to be hurt? You talk about the biggest and
the best corporations in America. Enron was considered the
biggest and the best. It even got an award for being the best.
Enron enjoyed close relationships with the President of the
United States and Members of Congress and they gave out lots of
money. They were all at the best parties. They said the right
things. It was considered one of the biggest and the best.
If you are saying do not get involved in creating new law
or getting overly involved in this because it is all right now,
they are going to be punished, what do you say to the
pensioners who had their life savings in that 401K that was
managed by Enron that helped to make them feel comfortable in
putting their funds into the company stock? What do you say to
the person who had no more than $300,000 or $400,000 to live
with for the rest of their lives once they retired? Don't
worry. Don't worry. If another company does something bad, we
will catch them. The marketplace will work.
No, the political difference and the philosophy that is so
different here is that some of us no matter what you say about
the fact that they will have to pay a price, we come at this
differently and we say we should not allow people to get harmed
time and time again, because eventually the thieves will get
caught and the big corporations may come down. Just do not
bother with trying to create a body of law that will prevent
it.
Well, I want you to know we disagree with you, Mr.
Glassman. And we do not think for one minute that the fact that
Enron is going to have to pay a price that that is enough. We
think that we should use the power that the people have given
us to legislate, to prevent this kind of catastrophe from ever
happening again.
And so instead of asking you a question, I just want to
help people to understand the difference in your thinking and
someone like me, my thinking. And probably conservatives versus
so-called liberals. We are people who believe that Government
must play a role in protecting folks. If you say don't they
know they should diversify, don't they know that the stock
market is cyclical and that it changes and they should be aware
of that, no, we do not take it for granted that they know. And
that is why we are going to protect social security from being
privatized and leaving retirees out there at the mercy of the
suede shoe boys who would take their money and do whatever at
the time they can do with it and leave them penniless.
So without having any questions to you, I hope that the
students around the country are listening to this so that we
can help them to understand the difference between the
conservative thought that comes out of the American Enterprise
Institute and the thought of us liberals about consumerism and
how we use our role in Congress to protect folks who some
people think ought to know better, but maybe they don't.
Thank you very much.
Chairman Oxley. The gentlelady's time has expired. And I
would like to start a short second round, and say to a great
extent there are elements of Ms. Waters' comments with which I
agree. Just because a corporation is large, just because it has
been successful, just because it is well regarded does not
necessarily mean that it is not subject to failure nor
criticism nor that regulatory changes are in order. I would
welcome her participation with regard to the GSEs in that
regard.
I would also say that----
Ms. Waters. You got it.
Chairman Oxley. I would also say that despite the fact we
suffered great loss on 9-11 and that we have suffered another
great loss with the demise of a Fortune 50 corporation, that
the markets have remained extraordinarily responsive and
appropriately balanced to these difficult times. Investors,
although guardedly, are still investing their money in the
greatest capitalist system in the world and our profiting from
it.
Now should we prohibit the blue suede shoe guys from
getting involved in the pension funds of social security is
another issue. Should we relegate the American taxpayer to a
2.3 percent rate of return simply because we do not want to
allow them inside the corporate boardroom? I don't think so.
There is balance here to be obtained. I think the balance is
appropriate oversight to catch the wrongdoers and create an
environment in which there are penalties for inappropriate,
unprofessional, irresponsible behavior. And I also agree that
the rules of 1930 do not fit 2002 and they need to be
revisited, rewritten, and made appropriately responsive for the
environment in which we find ourselves.
I do not however think it is advisable to have the Unite
States postal system making corporate decisions for the rest of
the world. And that the role for Government, from a
conservative perspective, is to get out of the way and let free
markets make appropriate decisions to provide for a competitive
environment where you have the most number of products provided
at the cheapest price so that consumers can make the best
choice for their families and not be told by the Government
they are too stupid to make their own investments.
Somewhere between the chasm that has been created by Ms.
Waters and myself there is an appropriate balance that I hope
this committee will reach. And for all those students who are
listening here today, I hope they take a well-advised approach
in looking at both the alternatives presented in the committee
today.
Thank you very much.
Mr. LaFalce.
Mr. LaFalce. Mr. Chairman, may I just point out between the
extreme that you pose and the extreme that Ms. Waters pose is
my middle ground bill.
[Laughter.]
And I am glad in trying to reach common ground you have now
endorsed it. At least that is one spin that I could put at it.
Just a few comments, because I do want to get on to the
second panel and when I am Chairman we will only have one panel
per day for a hearing so they don't have to stick around
forever and lose all the members. I don't know when that day is
going to come, but if it does.
Let me just make a few points. Mr. Lackritz, and we go back
a long time, and I have the highest regard for you and your
profession. But if I were to single out anybody where we need
to focus, it is the securities analysts. And I do not mean that
in a punitive sense at all. But we have got to improve the
quality of analysis. And you have got to work on some
mechanisms to compensate analysts based upon the quality of
their research. And there has got to be much better peer review
and we have got to withstand the pressure to get on a bandwagon
and hype stocks. And you and your organization and the NASD are
better equipped to do that than the Congress, but that is a
heavy, heavy responsibility and you have to be really zealous
in going after it. And we will try to watch over your shoulder
and assist you in that effort, OK. Sure.
Mr. Lackritz. Mr. LaFalce, I think we agree with what you
said and I think given the hearings that Congressman Baker
initiated last year and the process that he initiated----
Mr. LaFalce. Yes, his hearings were terrific.
Mr. Lackritz. We have made a lot of strides.
Mr. LaFalce. And you have made strides. You have made
strides. We cannot undo the damage, but we can try to prevent
future damage.
And speaking of undoing the damage, Mr. Glassman, you point
out the settlements. The difficulty is most of those
settlements have been for pennies on the dollars that have been
lost because of the wrongdoing. And I am not talking about
honest--I am talking about the wrongdoing. And so the
individuals who have aggrieved have not been made whole even
when there has been a successful lawsuit and a so-called
settlement. And we want to prevent that, especially given the
evolution of people's financial habits and corporate habits.
What do I mean? Well, 20 or 30 years or so ago, if you were
fortunate enough to have a pension plan, you had two-thirds
probability of having a defined benefit plan. Today, a smaller
percentage of Americans have pension plans and of those who do,
two-thirds are in defined contributions. And a corollary of
that and an outgrowth of that in part has been the fact that
only a small handful of Americans invested in their publicly
traded securities decades ago, today a good preponderance do.
So an awful lot more people have an awful lot more of their
wealth in the markets, and we need to be more zealous and our
laws have to be better, our regulation and our oversight needs
to be better.
It is going to be difficult to make the people whole. They
have been injured. I don't know that we can, but we have to try
to prevent other people from being injured in the future.
And Mr. Melancon.
Mr. Melancon. Melancon.
Mr. LaFalce. Melancon. I am very concerned about a number
of things. I do not want the accounting profession to take an
unfair wrap, but clearly there have been some inappropriate
actions, negligence, recklessness, and you have to see this in
perspective. There are an awful lot of accounting firms. There
is a Big Five right now and then thousands of others that are
much smaller and they range from $1 billion dollar to $100,000
accounting firms in revenues. And I know you are responsible
for them all. I don't want to see an Arthur Andersen go under.
They have got 85,000 employees. I spent money with the chairman
of the board of Eastman Kodak, which has so many employees in
my district, well, Eastman Kodak is far smaller than Arthur
Andersen. That is how big Arthur Andersen is. And I don't want
to see a Big Five go to a big four because I don't think the
country would be well-served. I like when we had a big eight. I
don't think we are going to be able to revisit those days. But
I am very worried, if you only have four or five that could do
the major corporations in any event, those that are global in
nature, and increasingly even small companies are global in
nature, you have some real problems in the marketplace because
you don't have the type of competition that you do need.
And so we need to do something, with all due deference to
the 99 percent of accountants who are always doing the very,
very best they can, that small percentage can wreak havoc with
the marketplace. And while the marketplace may correct, the
damage done by that 1 percent is not self-corrective and it
does not prevent future abuses. So we need to work together.
And I just don't think will ever be able to rely on accountants
watching accountants again. I just don't think that is going to
sell to either Democrats or Republicans. I could be mistaken.
I think we need a stronger oversight board. We can argue
about who should be on that oversight board. My preference is
to have representatives of investors and institutional
investors such as private employees pension funds, public
employee pension funds, Council of Institutional Investors
because I think they are more likely to be zealous in
overseeing it. And that is probably the most, single most
important provision within my bill or maybe anybody's bill I
think to restore confidence and integrity in the markets.
With respect to each of the other provisions, we will
dialogue on them. I thank you.
Chairman Oxley. Thank you, Mr. LaFalce. I would like to
express appreciation to the panelists for their participation
and helpful remarks today, particularly you, Mr. Melancon, for
the many names that you were called during the course of the
day. But as I have explained your good humor to other Members,
guys from Louisiana are accustomed to being called a lot of
things.
To all of the panelists, our appreciation. I would like to
have the second panel.
I am sorry, I did not know you had an interest.
Mrs. Tubbs Jones.
Mrs. Jones. Thank you, Mr. Chairman. I have a couple of
questions. Well, I am going to ask a question and then make a
quick statement.
Mr. Lackritz, what is your position with regard to the
provision that would limit--put a 4-year limitation on the use
of an auditor for purposes of preparing an audit?
Mr. Lackritz. You mean the term limits?
Mrs. Jones. Yes.
Mr. Lackritz. On auditors?
Mrs. Jones. Yes, like the people running for public office,
yes.
Mr. Lackritz. We have not taken a specific position on that
provision. What we are concerned about primarily is improving
the quality of the information and so we don't have a specific
position on that.
Mrs. Jones. Mr. Glassman, what is your position?
Mr. Glassman. I am against term limits in all their forms,
including for Members of Congress.
Mrs. Jones. What do you that think term limits will do in
terms of the support or the ability of an auditor to do his or
her job?
Mr. Glassman. I think it will add to confusion if there is
a term limit. I just do not see the necessity for it. I think
companies can do a very good job on their own deciding how long
the tenure of their accounting firm ought to be.
Mrs. Jones. Knowing the public's discomfort with auditors
right now, let me put this question to Mr. Melancon, even if
you do not support the term limits, sir, what do you do to
increase the public's confidence in your profession?
Mr. Melancon. Well, first off, public confidence is
critically important and I would agree with your focus in that
area. We have supported a board that has greater capabilities
in enforcement and in quality control areas so we would support
that. We think that that would be a very positive step.
The problem with rotation, ma'am, is that as Mr. LaFalce
just pointed out, there are huge capacity issues and there are
going to be disruption issues. And if you are looking at 17,000
public companies on an annual basis, 3,400 or so would be
changing auditors, there would be a tremendous inefficiency to
mandate that.
CalPERS has a situation where they voluntarily do that.
They want to do that. That is part of their corporate
governance. That is part of the free market system. And we
think that audit committees ought to review that relationship.
And the other thing that I would say is that we have supported
is that the audit committee, representing the shareholders,
ought to be the one that hires and fires the auditor.
Mrs. Jones. Let me close with this, Mr. Chairman. I had an
opportunity about 2 weeks ago to speak to a class at the
Wutherhead School of Management at Case Western Reserve
University. These were first year students working on their
Master's degrees and they were just full of questioning about
what is Congress going to do about Enron and so forth and so
on. I went through some of the things that were being
presented. But what I tried to weigh upon each and every one of
those students, and I call upon each of you when you give
testimony, is to help young people in every profession to
understand the importance of character and good worth and
loyalty and all the things that I don't care how much
regulation we do in any of our professions we are not going to
take care of.
I feel obligated as Member of Congress sent here by the
people of the City of Cleveland and the surrounding communities
to put forth some legislation that will deal with some of the
issues that Enron brought forward. But I am constantly trying
to say, and I come from having been a judge, an elected
prosecutor, I serve on the Ethics Committee, I have done a lot
of things like that, to say we have got to teach young people
what it means to have character and honor. And if you don't do
it, I don't know who else will. Those of you sitting in the
profession.
I yield the balance of my time, Mr. Chairman. And I thank
each of you for coming here this afternoon.
Chairman Oxley. Again, I thank you gentlemen and appreciate
your participation. The record will remain open if other
Members have additional questions as a follow-up.
Thank you very much.
And we do appreciate your patience in participating in this
important hearing. We have the Honorable Roderick M. Hills,
former Chairman of the Securities and Exchange Commission; Ms.
Barbara Roper, Director of Investor Protection, Consumer
Federation of America; and Mr. Lynn Turner, Director, Center
for Quality for Financial Reporting.
Welcome. Please proceed. Your statements will be
incorporated as part of the record. Feel free to summarize.
And, Mr. Hills, we are glad to have you with us today, sir.
STATEMENT OF HON. RODERICK M. HILLS, FORMER CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION
Mr. Hills. Thank you, Mr. Chairman and Mr. LaFalce.
It should be clear that the accounting embarrassments of
Waste Management, Enron, Global Crossing, to name a few, means
that we have serious weaknesses in our accounting profession
and in our regulatory system. We have had them before. In the
middle 1970s, the Securities and Exchange Commission compelled
400-plus companies to disclose that they had bribed foreign
officials or made questionable payments to them. At that time,
the SEC stimulated the New York Stock Exchange to require
outside audit committees as a condition of listing. We
strengthened the responsibilities of auditors and we required
internal controls for the first time. As we deal with the
weaknesses in the system, I would hope that we could build upon
the foundation laid back then.
What are the weaknesses?
First, the overall system, as many have said, is very old,
it is almost 70 years old. Almost anything 70 years old gets a
little creaky. It needs a major overhaul.
Second, it has become increasingly clear that some audit
partners are not going to be able to consistently resist the
management pressures to allow questionable accounting policies
or incomplete financial statements.
And, finally, the audit committees of far too many boards
are just not exercising the authority that has been given them.
H.R. 3763 has the prospect of making significant
improvements in all three areas.
Criticism of the regulatory system really has two aspects.
The audit has become a commodity. The CEO sees no value added.
The accountants compete on the basis of price, not on quality.
Auditors are not chosen for their judgment. They have become
rule checkers and we have too many rules. They have allowed the
implication that if something is not prohibited, it is
therefore permitted.
The traditional auditor statement says: ``In our opinion,
the financial statements prepared by management fairly present
in all material respects the financial position of the
company.'' That suggests judgment. That is not what they mean.
What they mean is we have found no material violation of the
laws.
Section 6 of the bill would cause both management and
auditors to use considerable judgment in deciding what the key
accounting principles are that affect the financial position of
the company, whether for good or for bad.
Let me turn briefly to FASB, the Financial Accounting
Standards Board.
Paul Brown of the accounting department of NYU summed up
the role of FASB pretty well. He said, ``It is an old adage of
a FASB rule. It takes 4 years to write it. It takes 4 minutes
for an astute investment banker to get around it.'' The
proposed bill does not deal specifically with FASB, and I would
suggest the committee may wish to put in Section 9 that
somebody review it.
Turning to the profession. In addition to its other
problems, the accounting profession is not able to get the
talent that it needs. Twenty years ago, some 25 percent more
people were entering the profession. Twenty years ago the
leading business schools, Stanford, Wharton, Michigan, sent a
substantial percentage of their graduates to the accounting
profession. They do not go there anymore. And yet today, the
Big Five are hiring far more people than they hired before.
This difficulty of finding top-notch personnel, the
difficulty of finding a precise rule to deal with an ingenious
corporate structure designed by Wall Street, and perhaps above
all, the pressing financial need to keep a client. Too often,
as I said before, it allows a questionable accounting policy to
slip by.
Section 3 of the bill will provide some deterrent to
zealous management people to try to influence the auditors. But
auditors will not have the freedom unless the freedom is given
to them, the independence is given to them by the audit
committees.
Section 2 of the bill restricts the ability of auditors to
provide some services to their audit clients. To the extent
that it deals with financial system design, I think it is
constructive. I do believe however that an absolute prohibition
against the internal audit is both unwise and unpractical. I
have set forth in my written statement some reasons for that.
The SEC rules now permit an external auditor to do 40
percent of the internal audit. As long as there is a strong
independent audit function, it seems to me that the SEC rule is
better than an absolute ban.
The audit committee. The primary responsibility of the
audit committee is to protect the auditor. Unfortunately, CEOs
too often appoint the members to the board and therefore decide
who is going to be on the audit committee and selects the chair
of the audit committee. The audit committee members seldom ask
the auditors if there is a better way to make the financial
presentation that has been designed by the company. In other
words, is there a better way to do it?
The audit committee seldom plays any role of significance
in the selection either of the auditors or the selection of the
audit partner. In short, they seldom establish themselves as
the party in charge of the audit, and they do not establish
themselves as the party in charge of retaining the auditor.
Section 9 of the bill asked the President's working group
to decide whether or not the Commission should establish the
duties of the audit committee. I think that is appropriate. But
I suggest that the committee may wish to be a bit more specific
about what the responsibilities of the audit committee should
be.
After 25 years, I think the audit committee deserves a
legal status. It has been ambiguous. I suggest first of all
that the SEC by a simple speech could say that the failure to
have a competent, independent audit committee constitutes a
material weakness in the internal controls of the company. That
status would be obtained if the SEC would say it.
The SEC could also make clear, as could this committee,
that the failure to have an independent nominating committee is
absolutely necessary to having an independent audit committee.
Who is going to put the members on the committee? Who is going
to select the chair? Who is going to evaluate their
performance?
And, finally, the SEC can make it clear and this committee
can make it clear that the audit committee's single most
important task is to make the auditor believe that its
retention depends solely upon the discretion of the audit
committee.
In conclusion, Mr. Chairman, the Enron debacle is
emblematic of weaknesses in the regulatory system. Andersen is
in the headlines, but they all have the same problem. Andersen
and the other firms are not blameless, but they are not
entirely to blame. The profession has real problems because of
a system that they cannot change by themselves.
Thank you very much.
[The prepared statement of Hon. Roderick M. Hills can be
found on page 210 in the appendix.]
Mr. Baker. [Presiding] Thank you, Mr. Hills.
At this time I would like to recognize Ms. Barbara Roper,
Director of Investor Protection, Consumer Federation of
America. Welcome.
STATEMENT OF BARBARA ROPER, DIRECTOR OF INVESTOR PROTECTION,
CONSUMER FEDERATION OF AMERICA
Ms. Roper. Thank you. I would like to thank the committee
for inviting me to testify today. I am testifying on behalf of
both Consumer Federation of America and Consumer's Union.
Because of the central importance of the outside audit in
keeping company managers honest, our organizations believe the
two most important things Congress can and must do to restore
investor confidence in the reliability of corporate disclosures
is to first and foremost restore real independence to the
independent audit and second to provide effective oversight of
auditors.
This legislation tackles both of those issues and for that
reason we congratulate you. However, because it fails to deal
adequately with the central issue of auditor independence and
because it does not do enough to guarantee the effectiveness
and independence of the regulatory body it creates, H.R. 3763
does not provide the comprehensive strong reforms that we
believe the current crisis demands.
Because of time limits I am going to focus exclusively on
these two aspects of the bill in my oral testimony. My written
testimony discusses the broader provisions of the legislation.
Unless the auditor is independent, unless he or she is free
of bias, brings an appropriate level of professional skepticism
to the task and feels free to challenge management decisions,
the audit has no more value than if the company were allowed to
certify its own books. Unfortunately, in recent years auditors
have been unwilling to adopt the total independence that this
essential watchdog function demands.
To increase auditor independence, this legislation directs
the SEC to adopt a rule prohibiting auditors from providing
internal audit and financial information system design and
implementation to their audit clients. In doing so, it simply
codifies steps that the major accounting firms have said they
plan to adopt voluntarily. While there is certainly a benefit
to having these restrictions written into the rule book to
prevent backsliding once attention has turned elsewhere, we
believe more is needed. Specifically, we support a broad ban on
the provision of non-audit services to audit clients. Certain
services could be exempt on a case by case basis, but only if
they benefit investors and only if they are directly and
separately approved by the audit committee of the board.
Furthermore, we believe Congress must look beyond the issue
of consulting services in dealing with auditor independence.
After all the lack of independence starts with the fact that
auditors are hired, paid, and fired by the audit client. This
gives them considerable potential influence over the audit. We
believe one way to limit that influence is to require mandatory
periodic rotation of auditors. The basic reasoning behind this
approach is that it is far easier for an auditor to challenge
management and risk losing an audit client if they know the
audit engagement is only temporary.
Another problem that in our view clearly needs to be
addressed is the revolving door that all too often exists
between auditors and their audit clients. And that is why we
also support a cooling off period for auditors before they
could seek or accept employment at an audit client.
While Congressman LaFalce's bill, H.R. 3818, does not ban
all non-audit services, it contains most of what we believe is
necessary to restore a reasonable level of independence to the
independent audit.
H.R. 3763 is, in our view, stronger on the issue of auditor
oversight than it is on auditor independence. At its heart is a
requirement that all accountants who audit publicly traded
companies belong to a newly created professional regulatory
body with oversight and investigatory powers. We believe that
an independent regulator subject to SEC oversight could
significantly improve the regulation of the accounting
industry. To do so however it must be completely independent of
the accounting industry, be adequately funded, have extensive
rulemaking and standard setting authority and be endowed with
strong investigative and enforcement powers.
The bill takes important steps in this direction.
Unfortunately, much of the language in H.R. 3763 is simply too
vague to ensure that these essential standards for effective
oversight will be met.
The Enron collapse has understandably shaken investor
confidence in the safeguards our financial system provides to
keep company management honest. Only a comprehensive package of
reforms with strong auditor independence and oversight at its
heart will restore that confidence. If it were strengthened in
these key areas, H.R. 3763 could provide the framework for
meaningful reform. Without these changes, many of which can be
found in H.R. 3818, fundamental problems will persist and
investor distrust of corporate disclosures will remain.
Once again, I want to thank you for inviting me to appear
today.
[The prepared statement of Barbara Roper can be found on
page 266 in the appendix.]
Mr. Baker. Thank you.
The Chair now recognizes Mr. Lynn Turner, Director of the
Center for Quality Financial Reporting. Welcome.
STATEMENT OF LYNN TURNER, DIRECTOR, CENTER FOR QUALITY
FINANCIAL REPORTING
Mr. Turner. I would like to thank Chairman Oxley and
Congressman LaFalce and Members of the committee, including the
one remaining Member of the committee, for inviting me here to
speak today. My comments today do draw upon my past experience
as an auditor, a business executive, a regulator and an
educator.
I commend Chairman Oxley, Ranking Member LaFalce, and
Congressmen Baker and Kanjorski for their respective efforts in
raising red flags with respect to leaks in our system before
Enron struck the iceberg. But now that we have a sunken ship,
we need to ensure adequate reforms are made in a timely fashion
to protect investors. After tens if not hundreds of billions in
losses, we must stop the damage to capital markets and
investors.
As described in further detail in my written statement,
reforms set forth in the proposed legislation and the following
testimony will be even more critical if the Big Five turn into
the Final Four. It is in the best interest of both the business
community and the profession if Andersen continues as a
separate firm. If we end up with just four firms and there is
another disaster, our current system of public audits will
quite frankly no longer be a viable system. American investors
will then rightly ask Congress why was it not fixed after
Enron?
The independent and oversight committee of Andersen chaired
by former Federal Reserve Chairman Paul Volcker has said the
problems facing accountants today are profession wide and not
just an Andersen issue. I agree with their conclusion. Those
changes made by Andersen and/or the oversight board should
receive serious consideration by the committee.
H.R. 3763 does encompass some of the changes that will
enhance the current financial disclosure system. But as I will
describe later, there are additional reforms required that are
addressed in Congressman LaFalce's bill, H.R. 3818, that need
to be enacted. While I may quibble with certain sections or
have minor quibbles with certain sections, I think it--that
bill has my wholehearted support and I think it will move
things along a long way.
Key elements of H.R. 3763 include:
The establishment of a public regulatory oversight board
for the accounting profession under the oversight of the SEC,
making it unlawful for company executives or directors to
willfully and improperly influence, coerce, manipulate or
mislead the auditor; requiring more timely disclosure of
financial information provided all investors receive such
information consistent with the current requirements of
Regulation FD; and real time electronic disclosure of insider
transactions.
Certain improvements to H.R. 3763, many of which are set
forth in Congressman LaFalce's bill, would provide greater
protection for the investing public. These improvements
include:
Providing the PRO with greater authority and powers along
the lines of what are outlined in my written testimony,
including a public board, as Congressman LaFalce earlier
described, made up of members from the public; enhancing
auditors' independence by including all the original provisions
of the SEC's rule proposal rather than just those the
accounting firms have already quite frankly agreed to. There
should be both mandatory retention and mandatory rotation of
auditors.
Modifying the bill to require the SEC--or modifying the
bill to require the SEC to modify its rules in the event that
FASB does not complete the task in a timely manner. I strongly
oppose congressional influence over and legislation of
accounting standards. It has directly contributed to less
transparency in accounting for stock options and some of the
problems we have today.
Adding a statutory requirement that CEOs and CFOs provide a
statement to their shareholders vouching for the full and fair
disclosure of a company's public disclosures and consistent
with legislation previously enacted by this committee, Section
36 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 include a report on management's responsibility for
internal controls and laws and regulations and the
effectiveness of those controls accompanied by an independent
accountant's report provide the necessary appropriations for
the SEC, including a provision for adequate staffing and
technology resources to undertake the mandated review
requirements. In that regard, I strongly support the funding
and risk rating system proposed in H.R. 3818, enhancing the
independence and oversight of corporate boards.
In general, I believe the PRO proposed in H.R. 3763, while
a step in the right direction, does not advance the ball
sufficiently down the court to score. As my dad always taught
me, if something is worth doing, it is worth doing right the
first time.
Let me close by noting that many of the issues being
debated today are not new. They were raised again and again
during congressional hearings in the 1970s and in the 1980s.
[The prepared statement of Lynn Turner can be found on page
274 in the appendix.]
Mr. Baker. Thank you, Mr. Turner.
Mr. Hills, I would like to address the first question to
you. In view of your extensive experience not only as Chairman
of the SEC, but your extensive board experience, can you tell
the committee a little bit about what you view the role of the
audit committee should be in specificity? What makes a good
audit committee and what should they be doing?
Mr. Hills. They should initially take charge of the audit
and that is a simple thing to do. If the auditors know that you
are in charge, they will know it. The audit committee should be
in charge of the fee negotiations. In my experience of seeing
any audit committee for the first time and hearing of other
audit committees, they often think their highest role is to
reduce the audit fee by 5 percent. They seldom ask what could
you do if we gave you $100,000 more?
Let me just speak quickly about the subject of
independence. We all talk about objective independence. That is
one dimension. But the auditor independence has three
dimensions. Objective independence means how many times do you
play golf with the CEO? And that is easy to determine. The
second dimension is the audit committee has to understand for
itself what it needs to know about the company. You cannot just
sit there passively and hear what is told you. You need to go
out. Whether you call it financial expertise or commonsense,
you need to figure out what you need to understand that
company. And that takes a second dimension.
And, third, you have got to confer that independence upon
the auditor. They have to know that you are in charge of their
fee. They have to know that you will be there to mediate the
disputes. They need to know that they have to come to you
first.
Let me give you an example. At Waste Management we wrote
off $3.5 billion in 6 months. The audit committee had not seen
a management letter in 5 years, and yet the auditors had given
the management a treaty of 12 items, 12 significant items, you
have got to change those things. Nobody told the audit
committee. Well, who do you blame? I think you cannot
understand fully the fragility of the auditor, who is about 55
years of age. If he loses that account, he is out of there. And
so the most important thing for the audit committee is to
confer that independence upon the auditor.
Mr. Baker. Ms. Roper, I would like to ask you to turn again
to this issue of auditor independence, and I think that we are
in agreement that Congress should not politicize and legislate
accounting standards. But when you get to talking about
standards of independence, I believe that you have suggested
that Congress get involved in that area beyond what even the
SEC has recommended. And so can you explain to the committee,
this difference in your opinion on these two issues?
Ms. Roper. The only reason to have an audit and to impose
that expense on companies is if it is independent. If it is not
independent, it does not serve its mandated function to provide
outside expertise. And we believe that people respond to
financial incentives. And in the area of audits right now we
have the worst possible combination. We have financial
incentives that at least up to a point favor doing the wrong
thing. The money is in consulting. The glamor is in consultant.
If you are too tough on the audit, you could lose the
consulting contract. If you are too tough on the audit, you
could lose the audit fee and not this year's audit fee but,
because of the low turnover, an endless stream of future audit
fees.
And so we have, as I say, financial incentives that benefit
the firm if they do the wrong thing, and we have no real
regulatory oversight to punish them in those instances. We
think regulation only works effectively when the financial
incentives are not stacked too strongly against it. But if you
have a system of regulation that is imposed on a system where
the financial incentives work the other way, that regulators
are always swimming upstream, always cleaning up messes after
they have been made.
And our view on auditor independence derives from the
Supreme Court's statement that the public watchdog function
that auditors perform demands total independence. And so if we
are going to have a law that mandates that the audit be
conducted, and if its only value is independence, then I think
it is absolutely appropriate for the laws to specify what it
takes to be independent. And I think it is necessary because
the necessary has not accepted that responsibility that goes
with performing that function.
In the area of writing accounting rules, we have decided,
rightly or wrongly, to delegate that to a provide standard-
setting body. And we believe that more needs to be done to
enhance the independence of that body as well, because our
experience has taught us in following some of the rules that
they put forward that if they contemplate a rule that will be
opposed by big business and will also be opposed by the
accounting firms, they know they have years of opposition in
front of them and that those constituents will go to Members of
Congress and that they will in turn face threats to their role
as a private standard-setting body.
And so we do believe that that process should be
politicized, not that Members of Congress don't have an
absolutely appropriate way to play in commenting on rules if
they have a direct interest in them, but that a group cannot
maintain its independence if it feels that its very existence
as a standards-setting body will be threatened if it does
anything controversial. And I think you have to look at one of
the reasons we do not have comprehensive rules on special
purpose entities is that FASB knew that if they tackled that
issue, that they would be running into even more opposition
than they have run into on their rules on hedging practices or
stock options disclosures.
So if we are concerned that we do not have adequate rules
in this area, I think we have to look at some of the reasons
why we don't have those adequate rules. And I think the lack of
a guaranteed independence for FASB is one of the reasons.
Mr. Baker. Thank you, Ms. Roper.
Now, Ranking Member LaFalce.
Mr. LaFalce. Thank you, Mr. Chairman.
Mr. Baker. It is nice to be a Chairman after just a year.
Mr. LaFalce. Again, let me apologize to the three of you.
Mr. Turner, you came from Colorado. Ms. Roper, Colorado also?
Ms. Roper. Also Colorado.
Mr. LaFalce. And, Mr. Hills, where are you?
Mr. Hills. Just up the street.
Mr. LaFalce. Just up the street, OK. You came a long
distance and spent a lot of time to testify. It is regrettable
that we have almost no Members here, and so they won't hear the
benefit of your comments, because each of the three of you, I
think, had some really terrific comments to make about the
issues. That is why, again, I would exhort at our future
hearings we have one panel. What happened here today was not
only predictable, but virtually certain, that is you would have
an empty House. And we won't correct that. We need some
structural changes too in the way we do business and one of
them is just one panel per day.
Having said that, I hope the Chair will give me a little
latitude since we have so few Members here.
Mr. Baker. Latitude granted.
Mr. LaFalce. OK, thanks. Let's try to take the issues one
at a time. Let's first go to the corporate officers themselves.
And then from the corporate officers, let's go to the board of
directors and the audit committee in particular and then let's
go to the auditing firm. And if you want to, we can go to the
credit rating agencies. But I am just not sure what we should
or shouldn't do there. I certainly want to focus on the
securities analysts and see what we should do.
How do we get to the corporate officers to make sure that
they do not engage in earnings manipulation in order to
increase market capitalization in order to make big bucks on
their stock options?
Mr. Hills. I will be a broken record, Mr. LaFalce. The only
way you deal with that, first of all, you have to have the
capacity to punish them, and I certainly support the notion
that the SEC should have an effective way to ``disbar'' them. I
thought the existing law was sufficient, but Chairman Pitt
thinks he would like some more help, and I think he should get
it.
If you don't have somebody speaking up for the auditors and
speaking up for the financial statements, the chairman will run
the company, the chairman of the company.
Mr. LaFalce. My experience, which is extremely limited, has
been the chairman or the CEO runs everything. They pick members
for the board who are already friendly to them or who will be
friendly to them. They pick auditors who are or will be. And
then they nurture that relationship so that it almost becomes
like a familial relationship where you can't tell on a family
member.
Mr. Hills. Well, it is not quite as bad as it used to be or
I wouldn't have been on the last eight boards. It is better. It
really is better. But, again, it is to me an oxymoron, you
cannot have an independent audit committee unless you have an
independent nominating committee. And that happens more and
more. Now it happens that Enron did have an independent
nominating committee.
Mr. LaFalce. We don't have to legislate that. That is
something that is within the power of the SEC to promulgate by
rule, correct?
Mr. Hills. You bet. You bet.
Mr. LaFalce. OK, good. Is this something you have discussed
with Harvey?
Mr. Hills. You bet.
Mr. LaFalce. Please continue.
Mr. Hills. Well, it is that function, it is that capacity
to have--it is the capacity of an independent board. Are there
seven to nine people coming to hear the chairman as a panel or
have they coalesced into a body that has the capacity to make
decisions.
Mr. LaFalce. They almost need a staff of their own then
too, because in my experience on boards, you come and you do
not even know what the agenda is before until the night before
maybe you get something in the mail and then you probably don't
have time to read it by the time you get it. And then the CEO
or the chairman, whoever it is, goes over the agenda and sort
of tells you. You pretty much rely on the chairman of each of
the committees within the board to tell you what is going on
within their committee. And then you find out that their
committee didn't even meet, that they did everything by phone.
And so the members of that particular committee who are
supposed to be responsive to the full board usually don't even
know what went on within their own committee.
Mr. Hills. There is a staff available. The chairman of the
audit committee, all he has to do is have one lunch a year with
the CEO of the audit firm, the audit partner and spend a day or
an afternoon. I have been chairman of nine audit committees,
and that is how you start out. You sit down and go away to
their place, spend the day with them and make sure he
understands you are in charge. There is your staff.
Mr. Turner. Congressman LaFalce, I think it takes a number
of things to drive at the question that you are asking about.
For starters, I think President Bush's and Secretary O'Neill's
notion of dealing with the executives, forcing them to write a
statement to their shareholders acknowledging their
responsibility for those financial statements and ensuring that
they are thoroughly presented I think is an excellent idea. I
certainly support that notion along with----
Mr. LaFalce. But, I don't think that Mr. Lay or Schilling
would have had any qualms about writing such a letter or
statement. So I don't know whether that is adequate.
Mr. Turner. In and of itself, no, I think you not only have
to deal with the executives, you have to deal with the board
and audit committee so I come at it from a number of angles. I
think that is a very good thing, and I strongly support what
they have done there. I strongly support that some of the
things that former Chairman Hills has stated. I would
definitely make it a requirement that the audit committee hire,
fire, and really oversee directly the audit. Right now in
practice the bottom line is the auditors are dealing directly
with management. I have been there myself as an audit partner
in one of these firms.
Mr. LaFalce. What about banning auditors from working for
the corporate employer for a certain period of time, a year or
two, because it seems to me that very frequently an auditor
will be encouraged by his firm, maybe take an early retirement,
go to work for the company and that will just deepen the
relationship between the auditing firm and the company. And of
course if an auditor is contemplating future employment as an
individual with the firm, the less zealous that auditor is
likely to be about the public fiduciary responsibilities. So I
have got a 2-year ban on employment if you have audited a firm.
What do you think about that?
Mr. Turner. I will actually speak from personal experience.
I was a partner at Coopers, certainly one of the big six at the
time and actually went to work for my audit client. Obviously,
it was permitted, but it was not a good situation. And I think
some of the things that you highlight, if I go back and look at
it. First of all, the company had other very fine qualified
CFOs that were in the search that they could have picked from.
You have always got in the back of you mind the point you just
made about would you cut them a deal or not if you had a
difficult issue, because you know if you are getting into a
fight with them, they are not likely to hire you.
But at the same time when you get across on the other side
and you get down to the audit time and here are all these
people that you have known for many, many years and now you are
in charge, if you will, as the CFO, it just leaves you with a
queasy thing. It would be like when I was at the Commission, if
I had been involved with an investigation of a situation like
Enron and then walked out the door and then right the next day
I was back in trying to influence the SEC about the outcome.
The Government has put in prohibitions against that. And having
gone through that process, and had some of those concerns in
the back of my mind, I strongly think the 2-year cooling off
period is very good.
And a number of years ago, it was either the chairman of
the Big Five firms, the Big Six at that time, or the board of
directors of the AICPA recommended a 2-year cooling-off period
too. So I think it is an excellent idea.
Mr. LaFalce. They recommended it?
Mr. Turner. Yes, they recommended----
Mr. LaFalce. What happened to the recommendation?
Mr. Turner. It never went anyplace.
Mr. LaFalce. That is the difficulty when something is
volitional.
Mr. Turner. It is still a recommendation.
Mr. LaFalce. It was a recommendation to themselves,
correct?
Mr. Turner. Yes.
Mr. LaFalce. Yes, OK.
Chairman Oxley. The gentleman's time has expired. The
gentleman from Louisiana, Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman. I wanted to compliment
you, Ms. Roper, on the content of the Federation's analysis of
the legislation. Obviously, there are points where you feel
that modification is warranted, but on balance the approach
seems to be one which has merit. And I think that is very
helpful in the discussion we are having. At the request of the
Chairman, we are going to have a number of hearings in the
subcommittee over the coming weeks to receive suggestive
criticisms and potential modifications to the bill before we
would go to a full committee mark up. But I think it is
appropriate to say based on all we have heard today, that we
have got it pretty close and we are on the right track. And
there are elements that need to be addressed, but we are
certainly acting appropriately given the circumstances we face.
And to any who choose to respond, I think to a great extent
many are looking at the problem as if we only have bad audit
and bad audit individuals within a company where we have
perhaps questionable management or maybe OK management. What
troubles me, and I don't have a good sense of how we resolve
this, is if you have a good auditor who is in a company where
you have clearly badly motivated management. And where does
that auditor go short of resigning from service to get
assistance in balancing the act within the influence of
management. If you have an independent audit team, that goes
away. If you don't have good management, you are not likely to
have an independent audit team.
If there were disputes as to the construction, oh let's say
of an SPE, and whether it would be beneficial to shareholders
or not. And the audit team said we think this ought to be
disclosed, because it is not in the shareholder interest. And
there was a dispute. How does that resolve today? Mr. Hills, is
there a SEC phone number you call and say ``I've got a problem,
come help me''?
Mr. Hills. Well, if you believe as I do that the failure to
have a strong independent audit committee is a material
weakness to the internal controls, the auditors have no right
to take the assignment unless they first determine that there
is such an independent audit committee. I think that is the
law, but I cannot get anybody to say it.
Mr. Baker. But assuming for the moment that that is the law
and it is not an independent situation after you arrive on the
scene, ought there not be a place where you could go and get an
advisory opinion privately, not on the record, so that if later
you were dismissed or if the management chooses not to abide by
your recommendation that there is a methodology for protection
of that audit team?
Mr. Hills. Yes, I said in my written statement that the PRO
that the bill provides for is an ideal place for the auditor to
go and say, ``I have this account, but I don't have an
independent audit committee. Would you look into it?''
We try to do that once in a while with the New York Stock
Exchange and they are willing, but they do not have the
capacity to do that. So the ability to go to something like the
PRO that is proposed in the bill to say, ``I have got a problem
here,'' is a tremendous assistance and I very strongly support
that.
Mr. Baker. And then with regard to corporate governance,
one of the concerns I have is manipulation of revenue or the
hiding of debt intentionally by management in the face of a
non-cost option being exercised to drive up share price,
retirement is in sight, and then 6, 7, 10 months later there is
a restatement of earnings and the shareholder takes it and the
individual who benefited from the precipitous increase in value
does not have to give the money back. What about the
advisability of some time period during which there is a
disgorgement required and the difficulty is markets are
volatile. You could have good management making good judgments,
exercises the option in good faith as part of the employment
contract and have these same circumstances develop.
Where are the equities in that argument, Mr. Hills?
Mr. Hills. Well, the law is pretty clear if we can find
people that are capable of enforcing it. And this again is a
function of corporate governance. I can give you the example of
Waste Management where many things like that happened, there is
the right of the company to sue the former officers that did
it. There is a shareholder derivative cases. The law is there.
Mr. Baker. But, in that case we are talking evidentiary
process, a court determination, the fellow is gone, the money
is tied up with his lawyers. If there were an automatic clock,
and then it would be maybe a hearing process, my thought was
let the executive come in and make his case.
Mr. Hills. Well, you have something called the bill of
attainder and that is difficult. We have a legal system--I
think you could spruce it up. I think it would not be wrong to
have a specific procedure for the independent committee to
decide that he is subject to it. That would give a road map for
a lawsuit. You could make the lawsuit easier. I would be very
reluctant to give up the notion that somebody could take
substantial sums of money away from somebody without due
process. You could make the due process faster or specific, but
I think it is--and you could give the SEC the capacity to make
the first decision as long as it was a subject of judicial
review.
Mr. Baker. I don't dispute that. The problem is that with
the speed with which transactions are closed and the volume of
dollars involved and the ability for individuals who chose to
do so to move assets out of the reach of even the Government's
control. I think we have a problem that is not appropriately
responsive when given a judicial remedy.
Mr. Hills. It is hard, but give the SEC a little more
capacity. They have a judicial system. They have an
administrative body. The SEC could have the right to come in
and declare, you could have an automatic injunction relief that
would be subject to judicial review. There are a lot of things
you can do with the system you have.
Mr. Baker. Thank you. My time has expired.
Chairman Oxley. The gentleman's time has expired. Thank
you.
Let me conclude, and I apologize for being out of the room,
but I did want to first welcome all of you and we certainly
appreciate your concern. It is always difficult on the second
panel. But your testimony has been excellent and we have
appreciated your being here.
I want to, first of all, probe generally where--given what
we are faced with now in light of Enron and Global Crossing and
other accounting issues that are in front of us in the
legislation that we have, as well as the proposed regulations,
where each one of you see the accounting, the Big Five/Four
maybe accounting firms over the next 10 years, given your best
judgment as to where you see these large companies going, where
they resemble anything like they are today. What is your best
guess, Mr. Hills, on where that might go?
Mr. Hills. I think the most serious problem facing the
country is the failure or the fact that we could lose our
accounting profession as we know it. It is deteriorating. It
has deteriorated as I said earlier. The caliber of people going
into it no where near match what they were 20 years ago. We
have a real responsibility to get them back into the
profession. So it is a danger. As I said before, partly it is
because the whole audit process has become a commodity. There
is no quality involved in the securing of an audit assignment.
So we have a basic responsibility to put judgment back into it,
to bring people into it, to get the MBAs from the better
business schools, among others, to come into the profession. I
would say the accounting profession is in danger.
Chairman Oxley. And where are those MBAs going now if they
are not going into accounting?
Mr. Hills. Well, they go to consulting firms. They go to
investment banking. They even go to law school sometimes,
unfortunately. They have other places to go and they are not
being pulled in. Russ Palmer, some of you know, was the great
dean of the Wharton School. He had long before that been the
chairman of Touche Ross. Twenty-three percent of his graduates
were going to the accounting profession when he was the dean.
In the last 2 or 3 years, not one went.
Chairman Oxley. Ms. Roper, do you think it is important
that we have a strong public accounting firm, say five or
whatever number large, multi-faceted accounting firms in
existence, or do you think it ought to be shrunk considerably?
Ms. Roper. We generally do not think concentration in
industries benefits consumers, although it is not clear in this
area that they compete on the basis of benefits to investors.
But we do not look to shrink the accounting industry. And since
the first place that shrinkage would likely occur would be with
Arthur Andersen, I have to say there is the potential with the
Volcker Commission for Andersen to emerge from this if it can
survive as something of a model company. And we do not want to
see Andersen destroyed by the current situation.
I do not claim any particular talent for predicting the
future. And it seems to me that there are too many factors in
question right now to be able to look into the future with any
accuracy. We do not know what you will decide to do about
auditor independence. And we do not know what you will decide
to do about auditor oversight, although as we have said we see
real progress being made here.
I think it is absolutely essential that we have strong
independent accounting firms performing public audits. One of
the things that has changed--we have had scandals in the past,
one of the things that has changed since the 1970s and 1980s,
when we had previous major accounting scandals is that most
people did not invest then, and today most households do. And
they invest primarily to save for retirement.
And there was a statement earlier that seemed to imply that
this bill was designed to send the message to investors that it
is Congress' job to protect them from stocks going down. It
seems to me that this bill is designed, and Congressman
LaFalce's bill, are designed to ensure that investors get
accurate information so they can determine for themselves
whether the stocks should go up or down and that they should
not--it is not enough that Enron is now being punished when for
years its stock was artificially elevated based on
misinformation. And so we believe that if you take the steps
toward really enhancing auditor independence, enhancing auditor
oversight, doing a broad range of other things that we did not
talk about today to improve the quality of disclosure, that you
will significantly improve the ability of investors to make
informed decisions based on accurate information instead of
hype.
Chairman Oxley. Mr. Turner, are you good at predicting the
future?
Mr. Turner. Oh, I am right up there with you.
Chairman Oxley. I will look at your brackets for the NCAA
if you are.
Mr. Turner. I do believe the markets will drive where the
firms go to some degree. And I think the markets are already
reacting to that. In fact, there is evidence that the firms are
already reacting to it. And just 2 years ago, we had a unique
bonding arrangement with the firms when I was at the SEC over
the auditor independence rules and they were not willing to
give up a few things that they are now. Now that the markets
have turned around and said we do not want you doing certain
things, they are moving more in that direction. And I think, in
fact, that what we will see in the future is the firms to some
degree, not because of themselves, because I do not think they
would ever do it on their own, but because the markets and the
fact that now we have one out of ever two million American
investors in the market, 60 percent higher than just 10 years
ago, the investors are raising up after Enron, Global Crossing,
and all the others and saying we want some independent
auditors, I think it is going to drive them there.
Financially, that may actually leave them even stronger in
some respects than what they have been for the last 10 years.
Probably make them stronger, it takes them back about 30 years
ago when 70 percent of the fees were just audit, they were
principally audit and tax. In fact, if you go back to the mid-
1970s, there was only probably 5 to 10 percent in each of the
firms that were in consulting, and financially they did very,
very well at the time.
When you look at the gross margins, and as my resume says,
I have run one of these business units, the gross margin on the
audit practice, and this came out in our public hearings as
well, is actually higher than the margin that you make on the
consultant. It has just been that consulting has grown at a
much more rapid rate than the auditing, but that was because
the economy was good. As the economy turns down now, the
consulting won't be as important to them, the auditing will.
Given that financial side of it plus what I think the market is
demanding, as we have seen, and seen from the audit committees,
I think they are going to step back from being consulting firms
to becoming much more of an audit firm than they have been in
the past, market driven. And certainly I would encourage the
committee to take more steps in that direction to protect the
franchise.
Chairman Oxley. Thank you. My time has expired.
The gentleman from New York had a couple of extra questions
before we close.
Mr. LaFalce. Yes, first, just a brief comment. We focus an
awful lot on accounting firms and the audit, but most investors
do not have the vaguest idea of what that audit was, would not
be able to read it if it was put in front of them, and could
not interpret it, and that is why it is so important that we
not lose sight of the securities analyst because so often the
investor, and the less sophisticated the more this is true,
relies primarily on the recommendations of the Wall Street
analysts, and they have got to do a much better job. They have
just missed too much for one reason or another, to the point
where you could say some of their analysis has been grossly
negligent or reckless with disregard for reality.
But I believe, Ms. Roper and Mr. Turner, you are familiar
with both Chairman Oxley's bill and my bill. Mr. Hills, I am
not sure if you are familiar with my bill.
Mr. Hills. I am not.
Mr. LaFalce. Pardon?
Mr. Hills. I am not. I have been in Singapore all week.
Mr. LaFalce. OK, well, to the extent that any of you are
familiar there are similarities and then there are some clear
differences too. And we are going to be airing those
differences I am sure during the course of mark-up, which we
anticipate will be after Easter.
Ms. Roper and Mr. Turner, since you are familiar with both,
what do you think are some of the salient differences and why
do you favor with respect to each of those differences one
version over another?
Ms. Roper. OK, on the issue of auditor independence, as I
said, we believe that we need a broad ban on consulting
services. And while your legislation does not go quite as far
as perhaps we would, its provisions to go back to the original
SEC rule proposal language on the whole range of non-audit
services we think is very important, because although at the
time the attention was focused primarily on the questions of
internal audit and financial system design, all of those areas
were weakened in the final rule. We think it is very important
that once you define a list, once you have decided that you are
going to take the approach of defining a list of services that
are prohibited, that that list not be set in stone. And so we
favor the idea that the SEC would have ongoing responsibility
to review services that are provided to determine whether they
create independence problems for the auditors and to do that
according to the set of principles that were included in the
SEC rule proposal.
We also believe very strongly that the auditor should be
hired directly by the audit committee and that if we are going
to allow any non-audit services to be provided, that they
should be directly and specifically approved by the audit
committee in keeping with the idea that we need the board
rather than the management to be controlling these decisions.
And in addition we believe that mandatory periodic rotation
of auditors helps to reduce the inherent conflict of interest
that exists when the auditor is hired and fired by the audit
company and that an auditor who is looking at the--because of
the low turnover in the firm, an auditor is looking at a 20,
30, 50 year engagement with that audit client has way more to
lose than one who risks losing 2 years of audit fees because
they are near the end of the term of their rotation.
I mean, we are not married to a single idea of how long
that term would be. You have to balance the cost of the
learning curve at the start of the audit with the benefit that
we think it provides independence, but we do think that that is
an approach that deserves attention. We are willing to look at
other options as well to deal with that issue, but we think
that is a credible solution to that problem.
And, on auditor independence, if you look at the constant
flow of personnel from Andersen to Enron, or from Andersen to
Waste Management, where you had at Waste Management, since
1971, no chief financial officer or chief accounting officer
who did not come from the auditor, I think that creates a
climate in which the outside auditors are viewed as just
another part of the corporate community, and that that kind of
intimacy is not conducive to true independence. And so we also
strongly support the cooling off period for auditors.
Mr. LaFalce. Mr. Turner, and also could you include any
comments you might have about litigation reform efforts and
where at least my bill would address that?
Mr. Turner. I would be happy to. As far as the PRO goes,
which both of them have, which is actually excellent, I think
in your bill it is a much stronger SRO in that just in terms of
the ability to compel testimony and document production, which
is I think very important. It is probably more public--not only
in public in terms of what it can do as it comes out of a
disciplinary action, but also in terms of the board makeup
itself.
In the area of auditor independence, I would echo what has
just been said by Ms. Roper. Going further I think is needed at
this point in time than what has just been mandated there,
especially in light of what we have seen in a number of cases
that have come out since we did our rulemaking. We have got
Waste Management behind us now. We have got Enron behind us.
Global Crossing. I think those all beg out for a much stronger
independence standard.
On mandatory rotation, I certainly, having been an auditor,
understand the concerns of the profession. But if you do a
mandatory rotation, for example, once every 7 years, the
additional cost is not going to be great. If you say the
average audit for the 10,000 to 12,000 public companies is
about 2,000 hours, real cost is going to be in the first year.
On average, you provide about a third additional hour in the
first year. So over a 7-year time period, you would go from
about 14,000 hours up to about 14,600, 14,700 hours. And in
light of the losses that investors have incurred, that is a
drop in the bucket.
And the issues with first year audits, there are also
indications with the top 10 list that Congressman Sanders
pointed out, there is probably much greater losses and exposure
there in the continuing relationship the market has shown and
the losses have shown, much greater damage and much greater
exposure to problems if you don't have the mandatory rotation
provision billed in. And they talked about Greece and Italy and
some of the other countries, I don't know if I would use them
as a model.
On the litigation issue, I certainly would urge the
committee not to go back and undo the PSLRA. I have served as
an expert witness, in fact, for some of the accounting firms
and being a partner myself, there was too much ambulance
chasing quite frankly, and so I would not go back and roll that
out.
But I think there is a reasoned approach to dealing with
that today. These are not all frivolous litigation. In fact,
most of the cases have got some validity to them that are being
brought. I think that is one of the benefits that we have got
out at the PSLRA, the fact that there has been an increase in
litigation, just the increase itself does not mean anything
unless you turn around and look at it. There has not been as
much increase against the accounting firms, if you actually go
in and dig into the numbers. But what the surveys do show is
that, in fact, the incidence of financial misstatement
wrongdoing has increased significantly. Given that, I would
expect that there would be an increase in the amount of
litigation. I think the PSLRA has avoided frivolous litigation,
but perhaps swung--you heard the accounting firms talk about
``unintended consequences,'' maybe one of the unintended
consequences of that bill was it swung way too far to one side.
And I think we need to bring it back into the middle and
perhaps the best way to do that would be to undo the Central
Bank case and bring back aiding and abetting.
Mr. Hills. May I make one comment, Mr. LaFalce? As an
alternative to mandatory rotation, the notion that every 3
years the audit committee has the specific responsibility with
independent consultants to analyze the performance of the
auditors and must affirmatively decide it is in the best
interest of the company to retain them, that keeps authority
and responsibility in the audit committee. The mandatory
rotation for all practical purposes takes total responsibility
away from the audit committee. They no longer have any role to
play.
Mr. LaFalce. I understand where you are coming from Mr.
Hills, but the difficulty with that is I remember my days in
the Army when you had to be rated, if you were not rated in the
top 1 or 2 percentile, you were really doing terribly. And I am
afraid that it might become automatic.
Mr. Hills, I have no idea where you stand on the issue of
overturning the Central case and once again permitting lawsuits
based upon aiding and abetting liability. Do you have a
judgment on that? It seems to me that the accounting profession
is likely, if they only have proportional liability rather than
joint and several, and most especially if they are not subject
to private litigation from an aggrieved party for aiding and
abetting, they are much more likely to be lax in their
standards. What are your thoughts on that? And I shouldn't ask
the question unless I know the answer and here I don't know the
answer so I am proceeding at my own peril.
Mr. Hills. If you look at the 16 committees I have served
on, a whole lot of those audit firms paid a whole lot of money
to settle the claims that we brought. And I would say to you
that the punishment of the courts is really quite severe. In
the Waste Management case, in the Enron case, the monies
offered by, you cannot hardly think they could offer much more
money.
So something works. What works is conferring independence.
What works is a good independent audit committee. I say bolster
them. Give them the authority to do their job and you will have
a much better climate.
Mr. LaFalce. Thank you.
Chairman Oxley. The gentleman's time has expired.
Let me just close if I can, Mr. Hills. What role does
Congress play in this? That is, there was some concern
expressed in the first panel with trying to many I guess put a
one-size-fits-all solution to auditor independence and so I am
wondering exactly what we need to do? I am concerned that if we
do so, that we step in, we almost federalize the auditing
profession and I have some real concerns about that. Do you
share those concerns? And if you do, shouldn't the auditing
committees, as you indicated, and the SEC step in and deal with
these issues?
Mr. Hills. I think your Section 9 is an extraordinarily
good way to go about this. The SEC will respond very strongly
to that kind of request. The SEC can do most of the things you
want. They can require for example that the audit committee
affirmatively decide whether to retain the auditors. They can
decide whether or not there must be an independent nominating
committee. They can decide those things if you push them to do
it or you can legislate. I do believe that we have gone a long
time in a limbo. The audit committee reached a certain
pinnacle, maybe 10, 15, 20 years ago and it stayed there, and
we have not pushed them over to that last part. I think this
committee can do it. I think the Senate Banking Committee can
do it because the Commission will be responsive. It may take a
little bit of legislation, but I think a little bit of
legislation will provoke a wonderful response.
Two things the SEC has done since September. One they said
the auditors must propel the directors to understand the
alternative ways to understand the financial papers. That is a
big change.
The second thing happened just 3 weeks ago when the chief
enforcement officer or the chief accounting officer of the
enforcement division, said, ``By the way, the fact that you
satisfy all the rules does not mean that you are not violating
the laws if it is not overall fair.'' Those are huge
differences.
Now, when I was a kid, I thought those were the laws. But
they said it again and this committee can tell them well done
and make sure he does mean it.
Mr. LaFalce. Anything wrong with that 30 year old case that
has been rediscovered and codifying that into law?
Mr. Hills. I think that is a good idea.
Mr. LaFalce. Thanks.
Mr. Hills. I mean. I think there is a place for a push, a
barb, if you will.
Mr. LaFalce. Yes.
Chairman Oxley. We thank you so much for your patience and
excellent testimony and response to a myriad of questions from
the committee.
And with that the hearing stands adjourned.
[Whereupon, at 2:10 p.m., the hearing was adjourned.]
H.R. 3763--THE CORPORATE AND AUDITING ACCOUNTABILITY, RESPONSIBILITY
AND TRANSPARENCY ACT OF 2002
----------
WEDNESDAY, MARCH 20, 2002
U.S. House of Representatives,
Committee on Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:00 a.m., in room
2128, Rayburn House Office Building, Hon. Michael G. Oxley,
[chairman of the committee], presiding.
Present: Chairman Oxley; Representatives Roukema, Baker,
Royce, Ney, Kelly, Gillmor, Weldon, Ryun, Ose, Shays, Cantor,
Hart, Ferguson, Rogers, Tiberi, LaFalce, Kanjorski, C. Maloney
of New York, Bentsen, J. Maloney of Connecticut, Hooley,
Carson, Sherman, Meeks, Inslee, Schakowsky, Moore, Capuano,
Ford, K. Lucas of Kentucky, Crowley, and Israel.
Chairman Oxley. The hearing will come to order. Good
morning and welcome to the committee's second legislative
hearing on the Corporate and Auditing Accountability
Responsibility and Transparency Act of 2002, or CARTA.
Last week, the committee held its first hearing on CARTA.
We heard from a diverse panel of witnesses, including former
SEC officials and representatives from the securities industry,
a leading consumer organization and the accounting profession.
The testimony was very instructive. Our witnesses represented a
broad spectrum of views about the securities markets and the
role of Government in protecting investors. Some of the
witnesses said that CARTA regulates too much. Others said not
enough. Clearly we must be on to something that is reasonable.
CARTA was carefully crafted to strengthen the oversight of
the accountants who audit public companies without federalizing
the accounting profession. The legislation requires companies
to give investors accurate and immediate access to important
company information without drowning issues in red tape, and
the bill would make it a crime for company officials to mislead
auditors, ensuring both that corporate officers act responsibly
and that auditors can do their jobs effectively.
CARTA encourages business leadership by prompting
executives to act in the best interests of shareholders. It
requires greater transparency and prevents insiders from
benefiting when their employees cannot.
Today's witnesses will further eliminate the important
issues that face the committee as we seek to reassure investors
in the strength of America's capital markets. Already the
committee has held extensive hearings in the wake of the Enron
bankruptcy. Going as far back as December of last year, the
Financial Services Committee has held hearings on the Enron
collapse to ensure we fulfill our obligation to protect
investors. Our hearings have revealed that while some bad
actors may seek to take advantage of investors, ultimately the
laws in the marketplace will catch up with them.
No one should doubt that America remains the best place to
invest not only for the ability of our workers and the
ingenuity of our entrepreneurs, but also because America does
not tolerate cheats. CARTA represents our further efforts to
strengthen America's capital markets so that they may remain
healthy and vital, and I look forward to the testimony of our
witnesses.
I now recognize the Ranking Member, Mr. LaFalce, for an
opening statement.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 296 in the appendix.]
Mr. LaFalce. Thank you very much, Mr. Chairman. As we
continue our consideration of legislation to address the
serious systemic weaknesses that have undermined confidence in
financial reporting and in our capital markets, I think it is
useful to reflect on some of the testimony we have heard thus
far.
One witness warned last week that we should not overreact
to the failure of Enron. If Enron were an isolated instance it
would be one thing. But unfortunately, it is not. The use of
deceptive accounting practices to paint a false picture of a
company's financial health has become much too common at some
of our largest companies.
Enron is no longer even the most recent major failure
linked to accounting concerns. SEC and Justice investigations
into the failure of Global Crossing have again raised the
specter of another major United States company using accounting
practices to hide its true condition.
The safeguards intended to protect investors have been
overwhelmed by the temptations for companies to either cheat or
overstate or obscure financial disclosure, largely to improve
short-term results and meet analyst or investor expectations
and therefore enhance market capitalization.
Virtually all of our witnesses last week spoke of the need
for auditors to be willing to stand up to management and for
audit committees to take real responsibilities for audits and
auditors. To do this, I believe that we must fundamentally
alter the relationship of the auditor to its client and we must
strengthen the functioning of audit committees and we must
provide meaningful and ongoing oversight of the auditing
profession. Auditors and audit committees should be the first
line of defense in protecting investors, and our task in these
hearings is to determine how we can best restore the vitality
of these critical investor safeguards.
Equally important, we must ensure that the restoration is
permanent and not merely evolutional and therefore most likely
a temporary response to the headlines of the day. We should not
delude ourselves into believing that the market will provide a
lasting solution to the issues we have identified.
Now I have introduced legislation that seeks to do exactly
that, the Comprehensive Investor Protection Act, CIPA. The
measures included in CIPA on auditor independent, corporate
governance and oversight of the audit profession have been
strongly endorsed by both consumer and institutional investor
groups. The auditor independence requirements of my bill are
comparable to auditing standards adopted by the General
Accounting Office and proposed by New York State Comptroller
Carl McCall, who will be testifying before us this morning.
They were crafted after the very closest consultation with many
outstanding individuals, including, amongst others, the former
chief accountant of the SEC, Lynn Turner.
I look forward to working with Chairman Oxley, Members of
this committee and you, Chairman Pitt, as we seek to find a
legislative response that will help to restore confidence in
the financial reporting system on which our markets rely.
Chairman Oxley. Gentleman's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman. I commend you for
calling this hearing with regard to the important reforms
contained in CARTA. I certainly want to point out the work that
has already been done with regard to the reform of endless
conduct with Chairman Pitt and the exchanges under Chairman
Oxley's leadership, and I do believe that the provisions
contained in the underlying bill with regard to audit reform
are significant, important and I think timely for the committee
to pursue.
My focus today will be more toward the issue of corporate
governance and how we can incentivize those who are in
managerial responsibility to manage for the long term. It
appears that the events of Enron would indicate there was
manipulation of corporate assets for the benefit of enhancing
executive compensation, and it is not a unique, but very
troublesome problem in the business world today that management
is under extraordinary pressure to beat short-term quarterly
earnings estimates in order to maintain their positions in the
particular corporation they manage, all to the disadvantage of
the long-term shareholder interest and corporate growth. I
think we should explore with all diligence any remedies that
would incentivize management to work for the long haul and not
to manipulate the stock price, for example, that would enable
them to exercise no cost options that then results perhaps in a
few weeks later a restatement of earnings all to the
shareholders' detriment with no downside risk for the
executive. I think we should at least explore disgorgement as a
result of these events or any other mechanism that would make
it clear to management that short-term manipulation of values
to enhance one's own compensation is unacceptable behavior in
today's world.
Given the complexity of very large corporations and the
difficulty that the common investor has in understanding the
true financial condition, the executives find themselves in a
very advantageous position with no liabilities for this
performance.
I commend you, Mr. Chairman, for your work and I look
forward to engaging the witnesses today in pursuit of remedies
for the public interest and for the working families. Thank
you.
Chairman Oxley. The gentleman's time has expired.
The Chair would observe that we have a vote on the floor,
and I would like to recognize the gentleman from California for
a brief opening statement, and the Chair would recess the
committee for two votes on the House floor and return
immediately. Gentleman from California.
Mr. Sherman. Mr. Chairman, we have got a lot to do. There
is a lot of talk about how the fees for non-audit services are
significant. We ought to be looking at the amount of those fees
rather than the particular services rendered. Even tax services
can pose a conflict of interest as you plan to set up 100
Cayman Island corporations and then accrue a tax liability to
determine whether those corporations are going to succeed in
avoiding Federal income tax.
We need clear accounting principles. We need a structure of
our auditing firms so the technical review department makes the
final decision with all the information, not the engagement
partner whose chief job it is to go golfing with Ken Lay.
Finally at the SEC, I wish that you had read the Enron
financial statements and those of the top thousand corporations
in America with the same care that you read the little $15
million and $10 million IPOs that I was involved in long ago
where you made sure that the filings for those small offerings
were clear and complete, but the Enron financial statements
clearly did not meet that standard.
Thank you very much.
Chairman Oxley. Gentleman's time has expired.
The Chair would now declare a recess for a vote, and then
we will be pleased to hear from the Chairman of the SEC.
[Recess.]
Chairman Oxley. The hearing will come to order. We are
pleased to welcome back once again to the committee the
distinguished Chairman of the Securities and Exchange
Commission, Harvey Pitt. Mr. Pitt, it is good to have you back
again and it has been a real pleasure to work with you through
some very difficult issues over the last several months, and I
want you to know that the Chair, and I am sure I speak for all
the Members, appreciate your diligence and hard work and
positive attitude as we work through some very difficult
issues. So welcome and good to have you back.
STATEMENT OF HON. HARVEY L. PITT, CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION
Mr. Pitt. Thank you, Mr. Chairman, and it is a pleasure to
be back. Mr. Chairman, Congressman LaFalce, Chairman Baker,
Members of the committee, I am pleased to be here to discuss
H.R. 3763, the Corporate and Auditing Accountability
Responsibility and Transparency Act of 2002. As you will
recall, on February 4 of this year, I testified before Chairman
Baker, Congressman Kanjorski, and Members of the Subcommittee
on Capital Markets about possible solutions to problems arising
in the wake of the Enron implosion. The leadership and Members
of this committee have worked diligently since then to explore
the substantive issues at stake and to develop well thought out
reform proposals intended to help restore confidence in the
integrity of our financial markets.
Mr. Chairman, I would like to commend the leadership you
have shown, and I would like to commend the efforts of Ranking
Member LaFalce as well as Chairman Baker and Congressman
Kanjorski and all the Members of the committee. These are
difficult issues. These are difficult times, and your
leadership has been remarkable. We appreciate the opportunity
to work with you and your staffs on many ideas in your
legislative proposals, and we look forward to our continuing
cooperation. Whether by legislation, regulation or some
combination of legislation and regulation, we will work with
you to make our Nation's Federal securities laws more
responsive to the current day needs of investors.
I also want to say how very much the entire Commission and
its staff appreciate your support for funding pay parity and
for your concern for our agency's resources at this especially
critical time.
The past several months have tested the mettle and
resiliency of our markets and the investing public's
confidence. With the events of September 11, Enron's bankruptcy
and last week's indictment of Arthur Andersen, we have all
witnessed how critical our capital markets are to the country's
strength, security and spirit.
In the aftermath of Enron's meltdown, our staff is
investigating whether violations of Federal securities laws
occurred and, if so, who perpetrated them. Until that
investigation is completed, we cannot address the specific
conduct of Enron and those involved with it or the activities
under investigation. The public can be confident, however, that
our Enforcement Division is conducting a thorough investigation
and that we will address any and all wrongdoing and wrongdoers
swiftly and completely.
Even prior to Enron, we were working to make disclosures
and financial reports more meaningful and intelligible to
average investors. Investors are entitled to the best
regulatory system possible. To reassure investors and restore
their confidence, we must address flaws in our current
disclosure and accounting systems that languished unaddressed
for many years.
The Commission intends to reexamine our rules and
regulations in light of Enron. There are fundamental
longstanding flaws in our system. Now they are on the table. No
one yet knows what the final answers are or should be. But, at
the end of this process, we will have taken the best system of
corporate disclosure, regulation of the accounting profession
and fidelity to fiduciary duties by corporate managers and
directors, and made that system even better.
In the President's State of the Union address, he
appropriately demanded ``stricter accounting standards and
tougher disclosure requirements'' to hold corporate America
more accountable to employees and shareholders and to hold them
to the highest standard of conduct. We share and embrace these
principles and are firmly committed to achieving them.
We can achieve needed improvements by improving standards
and our regulations in three principal areas. First, disclosure
by public companies must be truly informative and timely.
Second, oversight of accountants and the accounting profession
must be strengthened, and accounting principles that underlie
financial disclosure must be made more relevant and timely.
Third, corporate governance must strengthen the resolve of
honest managers and directors who oversee management's actions
and make them more responsive to the public's expectations and
interests.
The Commission already has statutory authority to adopt
rules to implement virtually all of the President's program as
well as other improvements necessary to address systemic
problems brought to light by Enron's collapse. We will work
closely with you to ensure that the regulatory framework we
ultimately propose accommodates your views of what is
appropriate and in the public interest.
We have endeavored to move forward as quickly as we
responsibly can on these issues. First, in cautionary advice on
December 4 of last year, we gave guidance on the appropriate
use of, and limits on, pro forma financials. In further
cautionary guidance on December 12, we set forth initial
requirements and guidance on the obligations of public
companies to disclose critical accounting principles.
On December 21, we announced our Division of Corporation
Finance would monitor annual reports submitted by all Fortune
500 companies in 2002. This initiative significantly refocuses
and improves our review program for financial and non-financial
disclosures made by public companies.
On January 17, we announced our preliminary concept of a
new private sector regulatory body to oversee the accounting
profession. On January 22, we identified issues in Management's
Discussion and Analysis to be addressed in 2001 fiscal year end
reports regarding off balance sheet financing arrangements.
On February 4, the securities industry and its self-
regulators, acting under the leadership of Chairmen Oxley and
Baker as well as Ranking Members LaFalce and Kanjorski,
announced proposed rules to create more transparency for
analyst recommendations.
On February 13, we announced proposals to address aspects
of corporate disclosure meeting improvements. On the same day,
we called upon the New York Stock Exchange and Nasdaq to look
at specific components of corporate governance. And just this
past Monday, in response to the Andersen indictment, we
released orders and temporary rules to assure a continuing and
orderly flow of information to investors and the U.S. capital
markets.
In addition, over the past several months, we have been
seeking input broadly, from all concerned on both corporate
disclosure and auditor regulation. To that end, we held
roundtables on March 4th in New York and March 6th in
Washington, with distinguished business executives, lawyers,
accountants, academics, regulators, and public interest
representatives. We have scheduled our next roundtable for
April 4th in Chicago, and plan to hold additional roundtables
in the next 2 months. This May, we will hold our first ever
``investor summit'' to solicit additional investor input.
Congress, however, must make the final judgment whether
legislation is necessary or appropriate. We intend to continue
working with Members in both Houses and on both sides of the
aisle regarding legislation. We will continue these efforts and
will commit to implementing any legislative changes Congress
ultimately believes are necessary.
Last month, Chairman Oxley and subcommittee Chairman Baker
introduced H.R. 3763. This proposed legislation addresses many
of the key issues facing our capital markets today, most
notably, creating a statutory public regulatory organization to
oversee the public accounting profession. In my formal
testimony, I have addressed some of the key aspects of this
proposed legislation and I do ask that my formal testimony be
included in the record in its entirety.
Chairman Oxley. Without objection.
Mr. Pitt. Thank you. For present purposes let me offer a
brief overview on my comments on this legislation.
First, given our existing authority, combined with Section
12 of the bill, we believe that this legislation would give us
ample authority to enforce the bill's directives, if enacted.
Second, the proposed public regulatory organization the
bill mandates and our proposals for a public accountability
board share many common attributes and characteristics.
Third, if legislation is enacted, the key is giving us both
the authority and flexibility to ensure comprehensive and
effective regulation of accountants and accounting.
Fourth, the Commission shares the bill's underlying
philosophy of holding auditors to the highest standards of
independence, competence and ethics. We think it unwise to cast
solutions to issues of auditor independence in legislative
stone, but we do agree with the bill's fundamental precept that
auditor independence is a critical issue which requires
constant attention.
Fifth, the Commission embraces the bill's core concept that
financial disclosures must be timelier, more comprehensive,
more relevant and provide greater transparency.
Sixth, we agree with the bill's concept that the
Commission, through its staff, must significantly expand its
review of financial and non-financial disclosures. We must also
try to use our resources more effectively by targeting our
reviews at the most important areas of disclosure at any given
point in time.
Seventh, the bill requires us to perform or participate in
several studies that we believe would shed light on possible
additional reforms. We support each of these initiatives, and
yesterday the Commission voted to commence a formal inquiry of
rating agencies and their regulation.
Finally, a companion bill increases our authorized funding.
We have identified current needs and have worked with OMB to
reach common ground. OMB supports our additional request for
100 additional personnel. It does not as yet support
appropriating funds for pay parity in fiscal 2003. We hope to
persuade OMB to fulfill the implicit promise of pay parity once
the legislation authorizing pay parity was enacted into law.
Mr. Chairman, Congressman LaFalce, Chairman Baker, Members
of the committee, I thank you for the opportunity to testify
today, and I am pleased to try to respond to any questions the
committee may have.
[The prepared statement of Hon. Harvey L. Pitt can be found
on page 302 in the appendix.]
Chairman Oxley. Thank you, Mr. Chairman, and let me first
indicate we will help you on a bipartisan basis on your issue
on pay parity with OMB. This Congress spoke very clearly on the
pay parity issue along with the SEC fees legislation that were
contained therein, and we want to be equal partners with you on
convincing our friends at OMB and the Administration that pay
parity is the law of the land and that we have a firm
commitment to that ideal and we are going to continue on that
best effort.
And let me also congratulate you on a number of initiatives
within the SEC and working with our committee. It is
frustrating somewhat, I am sure it is to you, that many of
these initiatives go relatively unnoticed in the popular press
while high profile hearings get most of the attention, but I
have to tell you I think I share that with the other Members of
the committee. We understand the hard work it takes to
undertake these initiatives. And clearly the news conference we
had with you along with Mr. LaFalce and Mr. Kanjorski and Mr.
Baker on the analyst issue was a good example, I think, of what
we can do when we work together, and I want to thank you for
all of your help in that area and many others.
Let me begin the questioning, Mr. Chairman, with a question
that was raised last week. One of our witnesses testified that
the market incentives for responsible corporate governance and
accurate accounting are incredibly powerful. How would you
characterize the practices of post-Enron America from your
viewpoint?
Mr. Pitt. My belief is that the response in the post-Enron
era has been all that one could hope for in terms of
articulation of commitments to fiduciary obligations and
companies reexamining the qualities of their disclosure. We
have had an upsurge of companies coming to us asking for advice
and assistance on a number of these issues. That doesn't, in my
view, obviate the need either for legislation like yours and
Mr. Baker's or further regulatory work. But I do believe that
the market has now created very powerful incentives for people
to do the right thing, and, with the proper legal framework, we
can ensure everyone that that fidelity won't be short lived.
Chairman Oxley. That is an excellent point, and it is the
goal of our legislation, as you know, to provide for more
timely disclosure, more transparency, not necessarily more
difficult rules and regulations, but indeed to allow the great
forces of the marketplace to work effectively based on those
concepts of early disclosure and transparency, and we thank you
for your support in that regard.
Let me ask you, what is the relationship, if any, between
the Private Securities Litigation Reform Act of 1995 and the
ability of investors to recover for actual fraud?
Mr. Pitt. In my view, the Private Securities Litigation
Reform Act, which was a bipartisan effort, reflected sound
approaches to the problems it was designed to deal with. We
have taken a look at the statistics since the adoption of the
Act in 1995. In fact, there has been no diminution in the
number of class actions that have been brought on average in
the 7 years since it was enacted, and the average value of
settlements has increased. In point of fact, by encouraging
large institutions to take more of a role to ferret out the
frivolous from the meaningful, I think we are seeing a better
use of the class action mechanism, and in my view those who
suggest that the Private Securities Litigation Reform Act is
somehow responsible for any aspect of what we see in Enron, or
any of the other high profile matters, are very much mistaken.
Chairman Oxley. We have had some witnesses and other
commentators to say that there is a real danger if Congress
tries to create audit only firms. What kind of ideas do you
have in that regard?
Mr. Pitt. This is a subject that I think is very critical,
and you are correct to hone in on the significance of that. In
my view, there is no direct correlation between consulting work
and auditing failures, but there is a problem with respect to
the independence of auditors. Independence is the bedrock on
which the accounting profession was founded and all steps have
to be taken to strengthen it.
My concern is that, if we go to the absolute separation
that some people are proposing, over the next 5 years the
quality of audits will diminish, not improve. It stands to
reason that if accounting firms doing audits only engage in
auditing, they don't become more independent, they become more
dependent on their audit work. To me the problem is twofold. On
the first hand, and the most important aspect, are those on the
immediate firing line: the engagement partners and all of those
who do the audit work. Those people must scrupulously adhere to
independence notions. In my view, cross selling compensation to
those people, that is, enabling them to sell other services, is
absolutely inconsistent with the notion of independence.
On the other hand, you have the firms as a whole. Most
people have tried to deal with this issue as if it were a firm
wide issue and not as if it were the engagement partner and
engagement team's problems. For the firm, the issue is to
provide appropriate incentives and sanctions if the firms do
not properly supervise those people who are on the engagement
front line.
So, it is a twofold problem, but most people have looked
away from the individual audit partners and have looked at it
as if it were a firm wide problem.
In addition, one other point--and I apologize for going on,
but this is a very critical subject. If we take away much of
the expertise that auditing firms have developed, for example,
in the tax area, they will not be competent to perform audits.
Getting into the issues of tax work enables auditors to have a
clear sense of where the company is and how the issues can be
handled.
Chairman Oxley. The Chair's time has expired.
The gentleman from New York, Mr. LaFalce.
Mr. LaFalce. Thank you very much. Since you were just
discussing the separation of the auditing and the consulting
function and you mentioned taxation in particular, in my bill I
call for a separation, but not a complete separation, same way
as people can advocate a separation between church and state,
but we have never had a complete separation within the United
States. And I specifically would exempt the tax function.
Now, Chairman Levitt did articulate a rule, and I supported
it at the time although many others in the Congress generally
opposed it. What is the status of that rule right now and where
do you agree or disagree with the former Chairman of the SEC,
Mr. Levitt.
Mr. Pitt. I appreciate that question, because again I think
it goes to the heart of this issue. Eighteen months ago, the
Commission adopted its independence rule, and at that point
Chairman Levitt said, and I am quoting this from memory, but I
have the exact quotes: ``the rule we put in place today is
better than an absolute ban.'' I happen to agree with him. I
don't think 18 months has been a sufficient time for us to
allow the rule to take effect.
Mr. LaFalce. How did that rule compare with his original
proposal, which was not an absolute ban?
Mr. Pitt. Exactly. He did not have an absolute ban. My view
is that----
Mr. LaFalce. My question is how did the rule that was
promulgated 18 months ago compare with his original rule? Was
it watered down significantly, somewhat, not at all?
Mr. Pitt. No. What I am saying is I have read some people
say that the rules were watered down. Chairman Levitt's
comment, with which I fully agree, was not that the rules were
watered down, but that they were better than the absolute ban.
Mr. LaFalce. No. You originally said that he said they were
better than an absolute ban. You did not originally say that he
said that they weren't watered down. And so are you now saying
that he also said that the rules that were promulgated were not
watered down from his original proposal?
Mr. Pitt. I will tell you this. I have looked at, I think,
every statement I can get through computerized research and at
no time did I hear Chairman Levitt suggest, because I don't
think he believed it nor do I believe he should have, that the
rules were watered down. There was a process of discussion and
analysis with accounting firms, but eventually the rule that he
enacted he thought was much better than what he had originally
proposed, which was an absolute ban.
Mr. LaFalce. One of your predecessors other than Mr.
Levitt, Mr. Hill, argued last week before this committee, and
you were his General Counsel when he was Chairman, that we
should confer on audit committees a more formal legal status.
He argued that the SEC should make it clear the failure to
maintain an independent auditing committee constitutes a
material weakness in a company's internal controls.
My first question is do you agree with that?
He also recommended that independent directors should be
nominated by an independent nominating company rather than by
the CEO or chairman of a company and that this was in the
program of the SEC. Do you agree with that? Two specific
recommendations of your former Chairman, and do you agree or
disagree?
Mr. Pitt. It would be hard for me to question former
Chairman Hill's judgment since you are right, I did serve as
General Counsel during his tenure. But my view is that, if you
do not have a validly constructed and operating audit
committee, that that is a material weakness. I believe that
former Chairman Hill----
Mr. LaFalce. Well, is it necessary for you to promulgate a
rule to that effect to make that operative?
Mr. Pitt. No. I don't believe----
Mr. LaFalce. He suggested that it was.
Mr. Pitt. I think what I read him to say and certainly what
he has said in private discussions and communications with me
is that the Commission should make that point loud and clear. I
think I have just done that.
Mr. LaFalce. Could you explain that more explicitly in some
writing somewhere because the response to my question is one
thing. But something a bit more formal in writing would carry a
bit more weight, I believe. So I would be anxious to see that.
And now to the second question regarding his recommendation
for an independent nominating committee or the board of
directors as opposed to taking the recommendations of the
Chairman or President or CEO.
Mr. Pitt. I believe that those suggestions are quite
constructive. And as you may be aware and as I indicated in my
opening statement, we have asked both the New York Stock
Exchange and Nasdaq to come forward with corporate governance
standards.
Mr. LaFalce. Which they can do or which you can do,
correct?
Mr. Pitt. I believe they can do that, yes.
Mr. LaFalce. And you can also too, can you not?
Mr. Pitt. I believe we can do that. I believe it raises
some significant questions, and indeed there is an opinion in
the DC. Circuit, the Business Roundtable rule, that suggests
that the Commission has some limitations on its authority.
Mr. LaFalce. I would suspect you disagree with that, do you
not?
Mr. Pitt. I don't agree with the decision.
Mr. LaFalce. I thought so. You think you have the plenary
authority. I thought you would.
Chairman Oxley. Gentleman's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman.
Chairman Pitt, when CEO Berardino appeared before the
committee he responded to a question from me as to the
ownership issue of the financial statement in that it belonged
jointly to management and shareholders. I was a bit taken aback
by that view. Recently the GAO has issued a significant report
in which one of the recommendations of that report is to
statutorily define that the financial statement should reflect
the financial condition of the corporation for the
shareholders' evaluation and not be the subject of managerial
influence or control. Would it be of help to the Commission if
there was a provision of law that made it clear that the
financial statements should be prepared to reflect accurate
financial condition of the corporation for the benefit of
shareholders?
Mr. Pitt. The law already provides that, and I would be
concerned such a provision actually would create an implication
that the law does not require that.
Mr. Baker. Terrific.
With regard to incentives, it appears that there are
significant conflicts, whether it is an audit firm which is
consulting and is paid $50 million in the aggregate or whether
it is simply a $50 million dollar audit. There are 50 million
reasons in both cases to be influenced. Likewise, for
management to manipulate earnings, revenue streams, obfuscate
debt, the consequence of which is to increase stock values. It
is all too often the case that part of the employment contract
incorporates no cost options which are obviously intended. If
you do well and manage the company properly, those options
become more valuable, you exercise them. But then subsequently
if there is a restatement of earnings within some short-term
period, the shareholder takes the consequences of that loss
while the executive is able to retain those proceeds. I don't
know the appropriate remedy, but in both cases are there
incentives that could be considered by this committee for
inclusion in the mark, which would cause one to invest for the
long term, not for the benefit of the quarterly report, and are
there further incentives that might be provided for the audit
side of the function, for example, a cooling off period, where
if you are the principal audit firm engaged by a corporation,
that you could not be employed by that corporation in an
executive capacity for some period of time after you conduct
the audit, traditionally known as a cooling off period? With
regard to either of those, do you have recommendations or could
you make those at some future point to us?
Mr. Pitt. I do. With respect to incentives, I could not
agree more with you that there is a need to make sure that
management's incentives align with shareholders' interests.
Just last week, we brought a case that is a bit unusual for the
Commission in which we have sought to have a former CEO of a
public company disgorge his compensation in stock options and
bonuses because the appearance of profitability was an
illusion. I believe that the Commission has to be much more
aggressive in targeting misconduct. And where serious
misconduct has occurred, I think one incentive or sanction has
to be removing any benefits and making certain that benefits
are seen as a long-term proposition and not as a short-term.
The other thing, and this is a place where we do need
legislation, is that I believe that the Commission should be
given administrative authority to bar officers and directors of
public companies who commit violations of the Federal
securities laws from serving as officers and directors. We can
do that in the securities industry. The banking agencies can do
it with banks. I believe we should be able to do it with public
corporations, obviously subject to review.
Mr. Baker. Let me jump in with one quick statement.
Finally, with regard to our whole accounting system, although
we are taking important steps with the bill, as to the overall
system we have today, which tends to be historic in nature,
reporting activities 90 days old, we need to look more
thoroughly over the long term toward real-time forward
disclosure as opposed to the regular FD approach, which appears
in retrospect not to have worked very well at all. If reg FD
was intended to provide the investing public with a thorough
understanding of the markets, it would appear given recent
circumstance that it has been a failure at best and we have a
long-term project ahead of us to reconstruct our whole
accounting methodology to give investors real-time information
that is helpful to the forward direction of the company. My
time has expired.
Mr. Pitt. One of the propositions in the bill I support
that you and Chairman Oxley have authored is the notion of
moving to more current disclosure. My concern about regulation
FD, which I share in terms of the remarks you made, is that you
can satisfy the rule by saying nothing to anyone. We are
proposing affirmative disclosure requirements, and I think that
solves the concerns that the former Chairman had about
selective disclosure, but does so in a way about informing the
market rather than keep information away from the market.
Chairman Oxley. The gentleman's time has expired.
The gentleman from California.
Mr. Sherman. Thank you. Let me first suggest something that
I think you could probably do next week and might not be
terribly controversial, and that is to require that every audit
report filed with the SEC be signed by the head of the
technical review department within the accounting firm after
seeing all the information and that we not have a circumstance
where the final decisionmaker as to whether Arthur Andersen's
signature appears at the bottom of a report is made by the
billing partner, the engaging partner, the golfing partner, but
is instead made by someone whose loyalty is to the firm as a
whole and who is selected on the basis of the technical
expertise. Can you do that next week?
Mr. Pitt. I don't know if we can do it next week. But I
will say this, we are very much in favor of the concept you are
articulating, which is that in order to make sure that firms
apply their supervisory responsibilities, the national
technical office be assigned to every audit and not leave the
final decision in the hands of the engagement partner. We think
that would produce even better audits than we presently have,
and most firms I think are doing that.
Mr. Sherman. There was one Big Five firm that wasn't.
Mr. Pitt. You are right.
Mr. Sherman. The SEC under the Chairman's bill will be
reviewing, I believe, the top 500 firms when they file their
accounting statements with you, reviewing them I hope as you
review initial public offerings by small firms. I hope I have
that right. But can you provide us with how much money you will
need to do an outstanding job of reviewing either the 500 most
important financial statements or the Fortune 1,000 or the top
5,000 and would it be necessary to increase your budget by 50
percent or 100 percent so that we get the same kind of review
process there as I commented earlier I was used to with smaller
companies? Obviously you can't plan your budget on the back of
that envelope in front of you, but if you could submit that for
the record so that we know? And can you also comment now, do
you have the independence as the head of an independent agency
to come to Congress and say I need my budget doubled or are you
under the thumb of OMB and under the thumb of those looking at
the macro-budget situation from the Administration?
Mr. Pitt. I would like to assure you that, with the
exception of my four children and my wife, I am under the thumb
of no one. I will say this, that we have had a very positive
and constructive working relationship with OMB. We have
differences of view and at my confirmation hearing I stated
under oath that I will always come back to Congress and inform
you whenever there were differences of view if Congress wanted
to know what we had asked for.
Our major difference with OMB only relates to funding pay
parity for 2003. And, because I believe we have a good
relationship with them, I believe that we will ultimately
prevail, although I am an optimist by nature.
Mr. Sherman. You may disagree on that one point, and that
is how much your existing people get paid. You seem to comment
favorably on the idea of the SEC at least reading and demanding
clarification of the financial statements filed with you. That
is a lot of additional work. The President doesn't have a penny
in his budget to allow you to do that work. I assume that all
your people are working hard now and that they don't have free
time. So I would hope that you would submit to us something
that I guess would be your second potential difference with the
Administration, and that is how much you would need to carry
out either the kind of review that I believe the Chairman's
bill calls for and I am asking you also to expand that, not
from 500 firms, but to 1,000 and then 5,000.
Mr. Pitt. May I just say this. When we testified before the
Senate Commerce Committee on March 7, I had indicated that in
order to deal with the incredible vigor with which we are
approaching financial fraud cases and to deal with our review
of Fortune 500 filings we need 100 additional people. OMB
supported that, and indeed, after our testimony, my
understanding is that they asked whether, rather than waiting
until 2003, we would prefer to have it immediately, which, of
course, we would. I do want you to understand what the
relationship is.
I also believe that the Commission is not a separate
government. I believe the SEC has to be part of an overall
government and it is my view that we are under an obligation to
respect the fact that there are a lot of budget priorities.
With regard to the point you make about how many more
people we would need, I do think one point is critical to
stress. My hope had been that I would have taken the first
couple of months in office and done a thorough assessment of
how many people I thought we needed, whether there were
efficiencies. A funny thing happened to me on the way to the
Commission. And we are now dealing with our third crisis, and
so I haven't had the time. This week we will be announcing,
however, a 4-month in-depth internal review of our deployment
of resources and with an effort to figuring out before 2004
budget time what our actual needs are, and we are devoting
substantial attention to that. But you should be aware, and
this is the one concern I have, there is not enough money and
there aren't enough people to give you the kind of guarantee
that I think we all would like to have. And so there are always
tradeoffs.
But, one thing we did the minute Enron hit was to redeploy
our assets in the Corporation Finance Division to review
Fortune 500 filings. And one of the things that we want to do
with the additional 100 people is to hire risk management
specialists who will direct us to look for places where the
greatest likelihood is that problems will arise. I think that
will help us strategically.
Chairman Oxley. The gentleman's time has expired.
The gentleman from Ohio, Mr. Ney.
Mr. Ney. Mr. Pitt, can you give your view on how accounting
firms maintain their independence of their auditors when
members of their firm work for years with the same company? And
what I am trying to get at, the question I had asked in the
earlier hearing a few weeks ago, I raised the issue about how
Andersen employees were intertwined with Enron and were
actually mistaken for Enron employees. They even went as far as
to wear Enron golf shirts and went on Enron retreats and some
of the people thought they were Enron employees.
Could you tell us, in your opinion, if the reforms proposed
in H.R. 3763, whether the reforms you suggest will ensure
independence of future auditors, not just with golf shirts,
but----
Mr. Pitt. I believe they will, because both H.R. 3763 and
the proposition that the Commission has put forth are designed
to create a board that exclusively deals with the ethics, the
quality control and the independence of public accounting
firms. One concern I have is that we not write something in
stone, because if we put it in stone today we may discover
tomorrow that it creates a different problem, and that I would
like to avoid. But I believe both the legislation and our
proposal would respond to that concern of yours, which I think
is a legitimate concern.
Mr. Ney. And still have flexibility.
Mr. Pitt. Yes, we would have flexibility.
Mr. Ney. The other thing, Mr. Chairman, is it possible for
a company to meet the GAAP standards and still provide a full,
fair and complete picture of a company's financial condition?
If so, would the bill improve the standards to solve that
problem?
Mr. Pitt. I believe that it is possible and it has happened
that companies may comply literally with GAAP and still have
financial statements that may prove misleading. About 40 years
ago--actually less than that, but almost 40 years ago, Judge
Friendly in the Second Circuit in the U.S. Against Simon case
rejected as a defense the notion that financial statements were
done in accordance with GAAP and therefore the accountants
could not be held criminally liable. He held just the opposite.
Judge Stanley Sporkin in the Lincoln Savings case held the
same thing, that you can still create a misleading impression.
Notwithstanding that, we think there is a strong need to change
the way accounting principles are adopted and the way
accountants look at those principles. The current set of
principles facilitate a check the box mentality. That is
something that we believe has got to be changed.
We want professionals as well as management to ask
themselves, if I were an investor, does this disclosure tell me
everything that I would want to know. And the fact that it may
comply with GAAP is only one issue. If it still creates a
misleading impression, it should not be satisfactory to anyone.
Mr. Ney. Does it tell you everything you need to know and
also in a timely manner, also information gets there obviously
as quick as it can?
Mr. Pitt. Absolutely.
Mr. Ney. One other thing, if updating the accounting
standards has been lengthy and arduous, which I think we all
agree in recent years that task has been tough, do you think
the reforms that we are discussing today can change that?
Mr. Pitt. I am sorry, can they change----
Mr. Ney. It has been a lengthy process to update accounting
standards. Do you think that the reforms we are discussing
today will change that process, open it up, or is it still
going to be a lengthy and arduous task and possibly should be?
Mr. Pitt. I believe that, both under our proposal and this
legislation, we could improve the way accounting standards are
articulated. The FASB, which presents a full-time reflection on
accounting principles, is a wonderful concept. Its
implementation however, is troublesome. First, its funding is
not truly independent, because it is voluntary, and we believe
it needs to be mandatory. Second, we think that the Commission
in the past has been lax in overseeing what the FASB has been
doing, how quickly they do it and what matters they attend to.
One of the most important subjects in accounting is revenue
recognition. For 27 years, there has not been a statement of
principle on revenue recognition. So I believe the Commission
has to have clear authority to direct the FASB to respond to
questions.
And finally, I believe accounting principles have to be
principled and not Tax Code formulated. They have to be
designed to make use of professional experience and knowledge
without giving people such a detailed approach that all they do
is check the boxes. At the same time, they have to be
promulgated rapidly. The notion of taking 5 or 10 years or, as
I said, 27 years, with respect to revenue recognition just
doesn't cut it, and it has been allowed to go on way too long.
Chairman Oxley. Gentleman's time has expired.
Gentleman from Massachusetts, Mr. Capuano.
Mr. Capuano. Thank you, Mr. Chairman.
Thank you, Mr. Pitt. Before I ask you questions, I just
want to make sure you note that the budget that is on the floor
today, in the Budget Committee, an amendment to fund pay parity
this year was voted down. Mr. Moore made the motion and it was
voted down along party lines, just as a little footnote. So
your difference is not just with OMB, but with Members of
Congress as well.
I guess I need to go back about a month or so ago, and this
is the first time you have appeared before this committee. Mr.
Berardino testified at the same table. And during my
questioning he made a comment that I found a little shocking,
because I suggested every auditor has an opportunity, if they
differ with what a client wants to do, to either add a comment
to the audit report or qualify that audit report, which is a
kiss of death on many levels. And his reaction was something
along the lines, well, we can't do that under GAAP, which I
found a bit shocking. And at some point if you could clarify my
understanding of that, because I am still under the impression
that any auditor can either add a comment at the least or
qualify that audit report any time they find a client kind of
crossing the line or not doing something within the four square
of what they need to do.
Mr. Pitt. Let me say that the concept that you articulate
is one that I embrace, which is I believe that auditors have to
have the responsibility as well as the backbone to question and
take issue with management's selection of auditing principles
or their application. Whether or not current law permits a
qualified opinion, which is generally given under certain
circumstances, may be a more technical question, but as your
question suggests, we shouldn't be interested in
technicalities. That is one of the reasons why we have proposed
and will be implementing the rule which requires companies to
identify their critical accounting policies, explain what would
have happened if they had chosen different policies and also
discuss what assumptions they made and what would have happened
if they had operated under different assumptions. We believe
that is going to get us to the place that you want to be and,
as I say, I support the notion that we have to have accountants
reflect independent judgment on the financials they review.
Mr. Capuano. And the other thing I suggested to him is in
the final analysis even if you feel hamstrung you can always
walk away from the client, which in this particular case I
think in the final analysis is going to be proven to have been
less expensive walking away from a $100 million client than
what is going to end up happening. But we will let history be
the judge of that.
And that leads me to the next question and some of my
concerns on both the bills that are filed before us is on
proper influence. Arthur Andersen was my auditor when I was the
mayor of my city, and one of the ways they kept me from doing
some things I wanted to do to make the city look good on the
books is if you do that we are going to have a qualified
report. If you do that, OK, fine. My job was to make the city
look as best it could in front of investors, as is the job of
anybody else.
So my concern in some of the language that is used in this
improper influence, what is the line that I can't cross. My job
is to push. The auditor's job is to say that is enough, you
can't cross this line. And my concern with some of these
languages, improper influence, what does that mean? I
understand if I say I got a picture of you and your girlfriend,
that is improper influence. But for me to say I want to go
here, I want to report this in this manner and don't you think
you should count this revenue, under some of this language I am
a little concerned that could be considered improper influence.
And as we go through these bills, I would like you and your
people to kind of keep that in mind, because I don't want this
committee doing something that I don't think we really want to
do.
Mr. Pitt. Let me again say I share with you the underlying
principles that your question implicitly raises. Both the bill
and the Commission's proposal would set up an independent body
that would be reviewing the quality of audits, not just
providing discipline when something has gone wrong, but
reviewing every major accounting firm on a yearly basis.
Unfortunately, the present mechanism, the public oversight
board which had been in effect for 25 years, was dramatically
flawed. It wasn't given the powers and authority it needed.
Under the proposal that we have raised and under the bill, you
have a body that would effectively go through quality review
and have the power to strip an audit firm of a client if it
found that the audits were not of the highest quality. We
believe that will create exactly the kind of incentive that you
want to see occur.
Mr. Capuano. Though my time is out, I would like to add a
footnote. If and when that is the way we end up, I would hope
that such action on your behalf would be somehow publicly
notified. If it is a private thing in the back of a room and
nobody knows you did it, it really won't accomplish much.
Mr. Pitt. Let me say that discipline in secret does not
achieve its purpose. When we take disciplinary action, when the
stock exchanges and the NASD take disciplinary action, we
publicize it. The public has a right to know if people have not
lived up to appropriate standards.
Mr. Capuano. Thank you, Mr. Chairman.
Chairman Oxley. The gentleman from Connecticut, Mr. Shays.
Mr. Shays. Thank you, Mr. Chairman.
Mr. Pitt, thank you for being here. I have a number of
questions. Let me begin by saying, by asking this question.
Some have told this committee that there is a danger in
creating audit-only firms. Do you agree or disagree?
Mr. Pitt. I agree completely with that. I think it is a
simplistic solution to a complicated problem. And it will
produce worse audits than we presently have. I believe that, as
I have said earlier in response to I think a question from
Chairman Oxley, that the problem is a twofold problem. One is
with the engagement team, where they must have absolute
scrupulous impartiality and independence, and then at the firm
level, there has to be incentivization to make sure that the
firm enforces the right supervisory techniques.
Unfortunately, this issue with a total separation would
only deal with the firm-wide question and not deal with the
real problems here.
Mr. Shays. Let me get to another question. A witness on our
next panel has taken the position he supports mandatory audit
firm rotation, and what is your position on that?
Mr. Pitt. My view is that mandatory audit rotation would
write in stone a process that could prove detrimental. I
believe that when an audit firm is not living up to the highest
standards, then a disciplinary body should require mandatory
rotation of that client. But I don't believe that setting in
stone a rote process of a new auditor every 7 years is
beneficial. There are a number of reasons for that.
Mr. Shays. Let me get to that later in the 5 minutes that I
have. In the Oxley-Baker bill, which I am a cosponsor of, is
there any new authority that you would like to see in the bill
that is not in the bill now?
Mr. Pitt. The principal authority that we would like to see
included is our ability administratively to bar someone from
serving as an officer or director of a company if we find that
they have engaged in egregious misconduct.
Mr. Shays. Is that the primary addition?
Mr. Pitt. That is the principal one.
Mr. Shays. Would you send that to this committee, suggested
powers that you want that aren't in the bill? Let us know what
they are.
Mr. Pitt. Well, there are----
Mr. Shays. In writing.
Mr. Pitt. Yes, I would be happy to do that.
Mr. Shays. In 1992, the SEC, the Treasury and the Federal
Reserve in a joint report recommended legislation to repeal the
GSE's exemption from the Federal securities law. As you know,
Fannie Mae and Freddie Mac are the only two publicly traded
firms that aren't. Does the SEC still adhere to the
Commission's 1992 report?
Mr. Pitt. We have not changed our general position, but we
have focused on it again. I will say that in this day and age I
believe transparency has to be the order of the day. To the
extent that the exemptions permit anything less than
transparency, which I believe is the case, I believe at least
that portion has to be removed. Frankly, I could care less
whether the GSEs pay registration fees or things of that
nature. But I do believe that disclosure is critical for the
GSEs as well as for other public companies.
Mr. Shays. You say it fairly strongly. But in your
statement where you say comprehensive information is the
lifeblood of strong and vibrant markets, our system and the
global markets supporting that system require accurate,
complete and timely disclosure of financial and other
information. The current system of Federal securities
regulation is premised on a full and fair disclosure of this
information. Companies choosing to access the public capital
markets must provide material information about their financial
results and conditions, businesses, securities and risks
associated with investments in those securities. Could I use
this as a strong support in some cases of such disclosure?
Mr. Pitt. Yes.
Mr. Shays. Thank you. I yield back, Mr. Chairman.
Chairman Oxley. The gentleman yields back.
The gentleman from Texas, Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Chairman Pitt, I have a few questions for you. I want to
talk for a second about the audit firms. Under the MSRB, isn't
there a rule for auditing firms that audit the books of issuers
of debt of public entities, cities, states, whatever, that
during that period of time those firms can't conduct other
services for that issuer? And you may not know off the top of
your head, but I just wonder if we already have some
experience.
I understand your concern about complete separations and
bans, but what I don't know, is there something wrong if we are
already doing it, is there something wrong with saying if you
are going to audit one firm, you can't consult with them, but
you can consult with everybody else? If you have 17,000 public
companies, there is plenty of business to go around.
Mr. Pitt. Let me say that neither the MSRB nor anyone else,
to my knowledge, has thus far taken the position that a firm
may only do audits as a way of business. What a firm can or
should be allowed to do for an individual client is a very real
issue. And there can be conflicts, for example, where the other
services would involve the auditor in reviewing its own work.
That would be a situation clearly where auditors shouldn't be
allowed to undertake those particular functions for a client.
What I was addressing, and what I continue to urge upon this
committee, is the notion that stripping down accounting firms
so that the only thing they do is audits will produce worse
audits in the future than we presently have.
Mr. Bentsen. I agree with that. I guess what I am saying is
just on a client-by-client basis, you know, the number one can
do the audit, the number two can do the other consulting
business. Whether or not there is merit in that, in saying you
just can't do both when one is say a public issuer.
Mr. Pitt. The problem with any generalization is that
somebody will always find circumstances to create problems, and
the tax area is a good one. If accounting firms provide tax
services to audit clients, they will be far more familiar with
the company they are auditing and they will be developing the
kind of expertise that is critical to do a qualified audit. So
my view is that if a particular function creates the
possibility of a lack of independence, it should not be
allowed. But I don't think we should have an absolute ban.
Mr. Bentsen. Let me go to the public regulatory
organization because I am curious about that. I think it is
generally--I think it is a good idea. I am curious about
exactly how you would envision it working and the ideas of
setting principles or guidelines for auditing firms to meet
which the Commission would have oversight over both the
drafting of those principles and the enforcement of those
principles, if I understand your testimony correctly. Are we
heading down a path where basically the Commission would be
overseeing the quality of audits and in effect you would have
to be giving an opinion just like you give a qualified tax
opinion for an issuance of debt or securities, that you would
be giving a qualified opinion that the audit meets the
standards as established by the PRO? And that may be where we
want to go. I just don't know. What do you envision how this
ultimately will come out?
Mr. Pitt. I think what we have in mind is somewhat
different from that. What we have in mind is having a vigorous
body that both can discipline individual accountants as well as
whole accounting firms or offices of accounting firms, that can
do quality control review to make sure that, even if there
hasn't been a violation, the standards are the highest, a body
that can enforce ethical requirements and that can enforce
existing auditing standards.
With respect to accounting principles, my view is that I
would leave that in the FASB. But in both cases, what I think
is critical is that the Commission has to provide meaningful
oversight. And I think over the last several years the
Commission has not provided meaningful oversight to those
functions, and that is something that we are pledged to change.
Mr. Bentsen. So this would be a form of registration for--
any auditing firm of a public company that is going to have a
registered issuance would then have to meet the principles and
would be subject to greater oversight than what is under
existing law or rule by the Commission?
Mr. Pitt. Any firm that wanted to be an auditor of public
statements by public companies would have to belong to the PAB,
as we call it, or the PRO, as the Oxley-Baker bill refers to
it. And they would have to adhere to all of the standards, and
they would have to be subject to discipline, and they would
have to be subject to all of the rules and requirements of that
organization. That is what we believe is a necessary approach
to restore public confidence in the accounting profession.
Chairman Oxley. The gentleman's time has expired.
The gentleman from California, Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman.
Thank you, Chairman Pitt. Let me ask you if you envision
any practical way of ensuring that the board of directors for
public traded companies are held accountable in their duty of
directing management with a view toward optimizing company
performance and increasing shareholder wealth. One of the
things you talked about was specifically giving the SEC the
ability to bar anyone who was engaged in egregious conduct. I
agree with that. But looking at it from the incentive side for
a minute, are there any changes that the Federal Government can
make to its best practices recommendations in regard to board
member selection and in regard to remuneration that would
incentivize members to pursue the interests of the stockholders
themselves rather than the interests of management?
Mr. Pitt. I think you will hear about that on the next
panel, among others from Mr. Livingston, who is with Financial
Executives International. At our request FEI reviewed its
existing code of ethics, which I thought was excellent when it
was promulgated, to see whether there ought to be some changes,
and indeed they have recommended a change in that. And, in
addition, they have taken a position on 12 critical issues
relating to this entire aftermath of Enron.
I believe that corporate officers and directors have to be
held to much higher standards. The question is how those
standards are articulated. If they can be articulated even
through the stock exchanges' listing standards, or through such
codes of ethics as the FEI has proposed to me, that is a very
sensible way of getting to the right result. And I think that
it would provide a real incentive, particularly if we have the
power to effectively sanction people who don't live up to those
highest standards.
Mr. Royce. We talked about incentives. Let's talk about
deterrence then. Short of having those involved in egregious
conduct simply barred, which is a good idea, what are some of
the other tools that the SEC would use or how would you
envision other sanctions on those corporate leaders who do not
act responsibly?
Mr. Pitt. Well, one of the things that we have discussed
here, but I think is worth mentioning again in response to your
question is the notion that whatever incentives corporate
officers and directors receive for performance should be
honestly earned. So, if officers and directors have been
compensated either by stock options or salaries or bonuses for
producing results that turn out to be shams, they should have
to give back every penny that they took from the shareholders.
That is another thing that we are proposing, and, as I said,
last week we filed a case in which we have sought that against
a former CEO of a public company.
Mr. Royce. Do you feel at this point in this legislation
are you crafting language that would give the SEC that ability?
Mr. Pitt. Well, on the removal of unearned incentives, I
believe that all the authority that is needed exists. When we
go into court, we can ask the courts to provide that relief.
Obviously if the courts don't agree with our case or for
whatever reason they think it is not an appropriate remedy, we
are not going to get it. But that system has worked quite well.
Mr. Royce. We would certainly with legislative intent in
this bill amplify that and state that it is Congress' desire
that you do have these powers, which you are now exercising or
attempting to exercise in the Enron case, but just to clarify
those powers to further assist in your court proceedings. I
think that would be a wise policy.
Mr. Pitt. I think that would be helpful.
Mr. Royce. I will be happy to follow up with you on that
language if you could assist me in developing the language that
you think would be most effective toward that end. And I thank
you very much. I thank the Chairman of the committee.
Chairman Oxley. The gentleman's time has expired.
The Chair now recognizes the gentleman from New York, Mr.
Meeks.
Mr. Meeks. Thank you, Mr. Chairman.
Chairman Pitt, let me ask, the regulatory structure that
you advocate for the auditing profession would move quality
review and discipline to an organization controlled by public
members rather than accountants. And it leaves the standards
that the auditors must meet subject to the rules of the
industry control organizations. Wouldn't it make more sense to
have the same entities set standards and enforce those
standards, you know, at one body as opposed to having two
separate?
Mr. Pitt. I think that is a suggestion that is worthy of
consideration. My own view is the difficulty isn't with the
ethical standards that have been promulgated. The difficulty is
with the adherence to those standards and the enforcement of
those standards. If we had reason to believe that the ethical
standards were lacking in some way, then I think your point
would be very well taken. At the present time it seems to me to
be a problem of enforcement, not of standard-setting.
Mr. Meeks. Let me ask this question, then. I believe in
your testimony earlier you said that the--it was too early to
tell if the auditor independent rules that were in place in the
year 2000 needed to be amended. As a result of the additional
corporate disclosure required under those rules, we have
already learned that some companies are paying the auditors as
much as 30 times more in fees for non-auditing services as they
do for auditing services. Auditing services have been turned
into a loss lender to enable firms to get contracts for non-
offered services. Do you think that it is appropriate for them
to make so much more consulting?
Mr. Pitt. I don't really feel that the question should
focus on whether that is appropriate or not. The question that
I think those facts suggest is whether or not that situation
could give rise to a lack of independence. That is what is
implicit in the question. I have to say it is always possible
that at some level, fees could create problems. But I think
that there are ways to deal with that issue. I don't think, for
example, that you and I sitting down together--I know you and I
could reach agreement--but I don't think that, if you and I sat
down together and said, fine, you can only make 50 percent of
your revenues from consulting, that that would necessarily
produce better audits.
In fact, I think if you look at the history of some of the
failures in the 1960s and 1970s, long before consulting was a
factor, you will find that we had some enormous audit failures.
And they had nothing to do with the consulting fees.
My concern is that we should be sensitive to the problem of
where the fees are coming from, how much auditors are earning.
But I don't feel that there is a right number or amount of
fees. What I think is there is a right way to conduct an audit
and there is a right way to discipline auditors who don't meet
the highest standards. That is what is critical.
Mr. Meeks. Finally, it caught my attention also you
mentioned your concerns about the time period to roll out FASB
standards and what they should be based on. Do you believe the
adoption of standards based on a simple majority would be
better than what is now instituted, the super majority,
especially when you consider there are only seven members on
the board?
Mr. Pitt. My answer is unequivocally ``yes.'' And the
reason is that we simply can't afford to wait. There is very
little unanimity on anything, any issue of the day. What we
need are principles that are sound, that are overseen by the
SEC to make sure that they are in the interest of shareholders
and that they promote full disclosure. But a reduction of the
size of FASB, which has been proposed to five, and then having
principles adopted by a 3-to-2 vote seems to me to be perfectly
sufficient. This body operates by standard majority. It is the
way the Senate operates. And I think it is appropriate for the
FASB as well.
Mr. Meeks. Thank you, Mr. Chairman.
Chairman Oxley. The gentleman's time has expired. If I
could just follow up briefly. Is it your understanding that the
Commission, the SEC, could overturn any decision made by FASB?
Mr. Pitt. Absolutely.
Chairman Oxley. Thank you.
The gentleman from Virginia.
Mr. Cantor. Thank you, Mr. Chairman.
Mr. Chairman, I just have a question concerning the Private
Security Litigation Reform Act of 1995, and there has been
some, I guess, renewed vigor around discussing sort of the
impact of that Act and opposed to the Enron situation that we
are in. I was just curious about your thoughts on the
relationship between the Act and the ability of investors to
receive any kind of results for actual fraud under the Act and
then if you think there was or is a relationship with the Act
and the Enron collapse.
Mr. Pitt. Let me say first that, if I thought that the Act
in any way created the possibility that we might have more
failures, I would be back here urging you to reconsider aspects
of that legislation. As I have said repeatedly, I don't think
any issue can be off the table. We have checked with a number
of entities, independent entities, that keep statistics,
including one run by Professor Grundfest at Stanford. The
statistics that have been reported to us show that the number
of class action suits has remained constant, may even be a
little bit larger, but that the amount of awards has increased
significantly. If anything, I believe that the legislation on
private securities litigation has actually strengthened bona
fide cases while weeding out those cases that are frivolous and
that simply seek to take advantage of a downturn in the market.
In my view, there is absolutely no connection that has been
shown between the collapse of Enron and the Private Security
Litigation Reform Act. Absolutely none.
Mr. Cantor. Thank you very much. Yield back, Mr. Chairman.
Chairman Oxley. The gentleman yields back.
The Chair now recognizes the gentlelady from New York, Mrs.
Maloney.
Mrs. Maloney. Welcome, Mr. Pitt. And I commend you and some
of the initial steps that the accounting and security
industries have take in recent weeks to eliminate conflicts of
interest. And I represent many employees in the accounting
business, and for the most part the vast majority of these
professionals are hard working and honest people. Yet I very
much support the Oxley bill and the LaFalce bill and really the
statement of the accounting firms themselves that we should
separate accounting and consulting and create a strong public
regulator for accounting. And many of our members have stated
that you could do consulting for other firms, but at least
separate it, as former Chairman Levitt advocated so strongly,
to put a firewall between auditing and consulting, and I think
this should be the first step. Even the consulting firms and
auditing firms themselves have called for this and say they are
doing it voluntarily. So we should put the statutory strength
behind it.
You mentioned that there is a difficulty in enforcement and
a number of professionals have come forward with an idea to
ensure that accounting firms do their jobs correctly without
heavy Government interference. And what do you think of the
proposal that the SEC could require that all publicly traded
companies hire a second auditing company to review its books
every 3 years? That would be built-in oversight without heavy
governmental interference.
Mr. Pitt. The difficulty with that suggestion, which I
believe is well motivated, is that there are only five major
accounting firms. And my concern is that would create a
taxation on investors effectively that wouldn't produce the
results you want. I think the goal is right.
Mrs. Maloney. A taxation on investors and accounting firms?
Mr. Pitt. Because both accounting firms would charge fees.
If you just take the Enron situation for example, it has been
reported that Andersen received $25 million for its audit. So
if you brought in a second firm, we have now upped it to $50
million. Somebody is going to have to pay that.
Mrs. Maloney. We are talking about rotating every 3 years.
Mr. Pitt. You are talking about rotation. I apologize. I
misunderstood. I am in favor of rotation where it has been
shown that an accounting firm has not lived up to the highest
standards of auditing professionalism.
Mrs. Maloney. But, it is difficult to see if you are living
up to the highest standards of auditing professionalism. Enron
was believed to be a model of a well run company up to months
before it failed. And I find it tremendously troubling that
Enron's techniques that duped the public were blessed by one of
the world's most prominent accounting firms. And it is equally
troubling that Enron is not an isolated case. It is by far the
largest and most spectacular of several failures and near
failures over the past several years, but they all had the same
elements.
So in many ways I see the Enron scandal, debacle, as the 9/
11 for the financial industry that we need to do something
about it. They were condoning what has been alleged to be
fraudulent accounting practices by one of our top accounting
terms. So if you rotated it, it wouldn't cost more money and it
would build in competition and build in oversight without
increasing bureaucracy which----
Mr. Pitt. My concern on that is there have been studies,
the Cohen Commission, the Treadway Commission and others, which
have shown that a large percentage of financial frauds occur in
the first 2 years of an audit-client relationship. I believe
that any per se mandatory rule removes flexibility from our
society, and what it might produce are worse audits rather than
better audits. You would have audit firms that weren't as
familiar with the companies they were auditing and would be
more susceptible to not catching fraud than they would
otherwise.
My view is that, if we establish a public accountability
board, as we have proposed, which would do quality control
review, not just where there has been a breakdown, but would do
quality control review every year for the major firms, we would
hopefully make certain that firms were providing the best
quality services. And, if they failed to do that, they would
lose their clients. The client would be automatically removed.
Mrs. Maloney. But we have a case before us and other
similar cases that took a tremendous toll on middle and lower
income company employees that were left impoverished while
politically connected insiders at the top walked away with
millions. And the practice was condoned by one of our best
accounting firms, or was considered to be one of our best
accounting firms. So I feel that we need to do something and
the Oxley and LaFalce bill certainly get us going in the right
direction.
Chairman Oxley. The gentlelady's time has expired.
Mrs. Maloney. May I please respond to his study and request
permission to place into the record another study that was
cited in Business Week recently that showed that companies that
use their auditors as consultants tend to manage earnings,
including moving debt of the books into partnerships, the MIT,
Michigan State and Stanford study that demonstrates that this
practice is widespread and cites that steps need to be taken
statutorily.
Chairman Oxley. Without objection. The gentlelady's time
has expired.
[The following information was subsequently furnished by
Hon. Carolyn B. Maloney for the hearing record.
The gentlelady from New Jersey, Mrs. Roukema.
Mrs. Roukema. I am sorry, Mr. Pitt, that I was not here for
your testimony and I unfortunately could not be here for all
the questioning, because I was in a markup in another
committee. But I read with great interest the Business Week
article which features an article called ``The Reluctant
Reformer,'' and they identified Harvey Pitt. Do you know him as
the rereluctant reformer? It did raise some questions in my
mind, and I wonder whether you have already responded to these
in one form or another. But, for example, where you were asked
a few questions and gave an answer, I have a question mark
beside a number of them, particularly, and I think this will
bear repeating even if you have gone over it, because I think
it is essential and the core of the issue before us. And the
question was posed to you do you still oppose a rule that bans
a firm from doing audits and consulting work for the same
company?
I know previously you had opposed any such rule. Your
answer here is not quite explicit. Could you give us a precise
answer as to your recommendations about audits and consulting
firms from the same company. Because I believe they have to be
separated. And I think our legislation indicates that requires
that.
Mr. Pitt. Let me----
Mrs. Roukema. Or should, anyway.
Mr. Pitt. Two things. First of all, those who know me know
that I am seldom right, but never in doubt. There is nothing
reluctant about me so ever.
Mrs. Roukema. You sound like quite a few people I know in
Government.
Mr. Pitt. And secondly, reform is something I pledged to do
when I came in. With respect to your question, do I believe
that there are certain combinations of certain consulting
activities that can create a conflict for accounting firms?
Yes, and those should not be permitted. What I don't believe is
prudent is an absolute separation of accounting from
consulting, that is to provide that a firm may only do auditing
work. That, I believe, would be a mistake.
Mrs. Roukema. Can you explain that? Because it sounds to me
as though you are endorsing the great potential for conflict of
interest here.
Mr. Pitt. Not at all. And, if I thought there were any
potential for that, I would move swiftly to prevent it. My view
is this: That restricting firms solely to audit work will
deprive those firms of the ability to produce more revenues
that will help them do better training of their auditors;
second, it will deprive them of critical knowledge that would
be useful for auditors to have when performing an audit; and
third, it will create----
Mrs. Roukema. Excuse me. That was your answer here. But it
does not address the question of the conflicts of interest. How
do you protect again the conflict of interest potential?
Mr. Pitt. I have said that there are certain types of
consulting work that inherently create the potential for
conflicts, such as an auditor reviewing his or her own work,
and auditors effectively acting in a management or a managerial
capacity. Those things have to be wholly prohibited.
I have also said that the SEC 18 months ago, under my
predecessor, adopted a series of rules to define what could be
done and what could not be done. And I believe that those rules
should be given a fair chance to see whether they solve the
problem or not.
What I am opposed to are the proposals that have been made
by some that a firm that does auditing cannot do anything else
for anyone. That is something I am totally opposed to at this
point.
Mrs. Roukema. Thank you very much.
Chairman Oxley. The gentlelady's time has expired. Let me
point out to the committee we have two votes on the floor. I
would like to get through the Members who are here for
questioning. And let's begin with the gentlelady from Oregon,
Ms. Hooley.
Ms. Hooley. Thank you very much. Mr. Pitt, thank you for
coming today. I want to make sure that we are all on the same
wave length, and as we look at all of these issues that we are
all here to protect the investors. Is that a common goal?
Mr. Pitt. It absolutely is.
Ms. Hooley. OK. To something that one of the other Members,
Mr. Sherman, talked about, do you pay enough money to your
auditors to be able to hire well qualified auditors in your
department?
Mr. Pitt. I am sorry?
Ms. Hooley. Are the salaries of your auditors enough to
hire well qualified auditors?
Mr. Pitt. I think at the present time the salaries are not
enough, and I think that there is a need for improvement. If
you are talking about the private sector, my own view is that--
--
Ms. Hooley. I am talking about within the SEC.
Mr. Pitt. We have steadfastly urged the passage of pay
parity, and funding for it. Since we don't have that funding
for 2003, I believe that our people do not make enough money.
Ms. Hooley. Let me just give you an example of a friend of
mine who has worked for a couple of different CPA firms, large
ones. One of the things that--comments she made to me recently
was, you know, in all of these large companies they pay--this
is the starting point for everyone. This is their training.
This is where they put their newest, most lowest paid employees
is out on auditing to sort of earn their way. What are we
doing--a company can do that. They can do whatever they want.
But what are we doing to make sure that we hold those companies
to some standard so in fact they are not putting their least
experienced out on the auditing road?
Mr. Pitt. Well, that to me is one of the gaps in the
existing set of regulations, including the Public Oversight
Board. In my view, it is absolutely critical that people be
appropriately trained as well as sensitized to both legal
requirements and ethical requirements in the accounting firms,
and then that there be diligent review by an independent body
to make sure that firms live up to those standards.
At the present time I don't believe that that is happening.
That is why we have proposed a public accountability board, and
Chairman Oxley and Chairman Baker have proposed a public
regulatory organization.
Ms. Hooley. Let me mention one other comment that another
person made, and she was doing some temporary work at a company
who I won't name. And she said half the people that worked in
that financial department had all come from the auditing firm.
And she said I can guarantee you when the auditing firm they
came in, they knew one another and they said they were never
going to get a very tough audit. And she said, and they knew
all the people working for this company got paid more than they
got paid as the auditors because they were the lowest paid. Do
you ever hear any comments about that? Is that common or----
Mr. Pitt. I do.
M. Hooley. Again, how does that protect the investor?
Mr. Pitt. I am concerned about the so-called private sector
revolving door problem. I think it is a legitimate issue, and
one that requires some attention. My big concern is that, for
middle and smaller size companies, it may not be possible for
them to attract from a wider pool of talent. And my only
concern is making certain that before we adopt any
restrictions--and I think there is a need for some guidance
here, and some guidelines--but, before we adopt an absolute
restriction, we make sure that smaller firms are not somehow
being disadvantaged. But the issue is a fair one.
Chairman Oxley. The gentlelady's time has expired.
The gentleman from Pennsylvania, Mr. Kanjorski.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Pitt, am I to assume that you are opposed to term
limits? I mean, it seems to me limiting an auditor's ability to
stay with a corporation to a certain number of years is very
analogous to term limits of Members of Congress. I think that
was a very popular, easy solution in the early 1990s that has
since faded. I expect that you favor or are opposed to term
limits in that regard, as you are for the auditors. Is that
correct?
Mr. Pitt. Well, let me say that I don't think that there is
a direct correlation between term limits on politicians and
term limits on auditors.
Mr. Kanjorski. So you would like us to have term limits,
but not the auditors?
Mr. Pitt. I haven't said that. I just said that the--I
think the issues----
Mr. Kanjorski. I am opposed to term limits. I was using the
analogy to say it seems to me the problem is the electorate.
The electorate, in this case, is the shareholders in the
corporation. They are the ones that elect the board. The board
is to proceed using due diligence to protect their interests.
They are allowed to make mistakes, I guess. They are allowed to
hire foolish or fraudulent auditors, as members of the
electorate are able to elect foolish or fraudulent Members of
Congress.
Mr. Pitt. Although that hasn't happened yet, to my
knowledge.
Mr. Kanjorski. No, that never happens, right?
I am a little worried about this rush to decision and
structuring a lot of rules to accomplish what appears to be a
lot of good purposes, but in the end, could result in great
damage to the system. So, when people come up with these
definite rules, it concerns me. What is the next thing? Well,
are we going to term-limit lawyers? Can we have a law firm
representing a corporation for only 4 years? That is
ridiculous. They are hiring professionals. The relationship is
of such a nature that you do not want to have someone telling
you that you can not hire your auditor or lawyer. Those are the
people you have the most trust in. They in turn have the
professional responsibility to perform to the highest
standards.
In between there, we have a board of directors, or
governors, to oversee and be sure that these professionals
protect the interest of the shareholders. If the shareholders
find they do not do that, they can kick them out. The only
problem is, it ends up Enron occurs before there is any value
in the shareholders having a meeting.
The one area that I----
Mr. Pitt. I share your concern about destroying what is
good about our system. That is a very real concern.
Mr. Kanjorski. I will hope that you will constantly remind
us up here to not be overly rambunctious in what we do, but try
to act deliberately and deliberatively, and hopefully take our
time on this.
It seems to me--of course, I am just a simple lawyer from
Pennsylvania--but it is awfully complicated stuff. I do not
know how many of our graduate professors up here are fully
aware of what the ramifications may be consistent with the
speed by which we seem to be moving.
But, there is something you said earlier in your testimony
that I just wanted to correct. We have an opportunity here to
assert that the New York Times made a fatal error when they
reported on February 3, 2002, you are reported here as saying:
``Now some in the group''--and this is referring to the people
that supported the change of the law in 1995, like Senator
Dodd--``have been having second thoughts about their opposition
to the tougher accounting rules. Others, like Harvey L. Pitt,
the Chairman of the Securities and Exchange Commission, say
they are beginning to rethink the wisdom of some provisions of
the 1995 law.''
You were obviously misquoted in that article.
Mr. Pitt. No, I believe the reporter who wrote that is very
careful, and quoted me accurately, at least on that
proposition. I think nothing is off the table. I believe that
people have legitimately raised an issue about the PSLRA and
therefore I thought it was appropriate to start collecting
statistics and look at the issue. What I have found thus far
leads me to believe that the Act has actually served its
purposes and is not responsible for Enron. But I believe that
we have to be open to changes in any aspect of our system in
light of what we have seen in Enron.
Chairman Oxley. The gentleman's time has expired.
The gentleman from Tennessee, to wrap things up.
Mr. Ford. Briefly. Thank you, Chairman Pitt. I know we are
fresh out of time here. When we had Mr. Barandino before the
committee, we talked a little bit about his announcement, I
guess, and some of the other accounting firms--and forgive me
of not going through all the pleasantries, you are great, I am
glad to see you here and all those things. We will do that
another time--but that they would no longer offer financial
information systems designed for implementation to their audit
clients. My friend Chairman Oxley's bill would prohibit
auditors from offering these services to audit clients as well
as internal audit services. This is probably a good start. But
there a whole range of business consulting and other services
that can and do create the possibility, at least the
appearance, of conflict of interest.
How significant are financial information systems
consulting and internal audit services to the non-auditing
revenue collected by accounting firms? And, two, what other
areas of consulting business do you believe could pose these
conflicts of interest? And in interest of time, that we have
two bills up here, Mr. LaFalce and Mr. Oxley, and I hope we
work everything out, but in Mr. LaFalce's version he has a
provision that would require accountants to preserve records
and documents relating to audits for 7 years after the audit is
completed. I am not going to be facetious and say do you think
that could have helped to at least expose some of the
challenges and problems involved with Enron. Obviously probably
it would have. But shouldn't we have a clear standard for
recordkeeping, I guess, is the larger and broader question that
is obvious to this committee and Congress will soon address. I
know we have a vote. I wanted to talk a little faster than my
part of the country expects me to. So if you could answer that,
I would appreciate it.
Mr. Pitt. A broader standard as to what might constitute a
conflict?
Mr. Ford. I was speaking to the 7-year mandate for
recordkeeping, number one, and do we need a clear standard.
And, yes, could you extrapolate clear standard even on
conflicts of interest. I didn't ask it that way, but that may
be a better way of framing it.
Mr. Pitt. Let me make a few observations on that, if I
might. First, before Enron reared its head, I had given a
speech in which I said that the Commission would not tolerate
people who come in and lie to us in investigations, people who
obstruct investigations or destroy documents.
Without commenting on the particular Enron situation,
destruction of documents cannot be condoned, because once
somebody gets away with it, everybody will try to get away with
it and the system falls apart. So I have very, very strong
views on document destruction and obstructing an investigation.
As to how long records ought to be kept, in my view, some
rational period may be useful. And with computers, now there is
an ability to store information electronically that may enable
them to be archived so that we have access to it even after 7
years. But I believe that auditors should, and I believe they
generally do try to, maintain records that reflect what audit
practices they went through in conducting a particular audit
for 5, 7 or 10 years after the audit is completed. Not
everything that gets generated in the course of an audit needs
to be retained.
Chairman Oxley. The gentleman's time has expired. I thank
you for the time. The Chair would note that Under Secretary
Peter Fisher has submitted written testimony for this hearing.
I would like to thank the Treasury Department. Without
objection, Secretary Fisher's testimony will be entered into
the record.
Mr. Pitt, thank you, Mr. Chairman, for your appearance
today. And the committee will reconvene at 1:00.
[The information can be found on page 409 in the appendix.]
[Recess.]
Chairman Oxley. The hearing will reconvene. Here comes the
Ranking Member.
Let me introduce the panel. Let me introduce our
distinguished panel: Mr. Franklin D. Raines, Chairman and CEO
of Fannie Mae, on behalf of the Business Roundtable; Mr. H.
Carl McCall, Comptroller, State of New York, Office of State
Comptroller; Mr. Joseph V. DelRaso, Partner, Pepper Hamilton,
LLP; Mr. Philip B. Livingston, President and CEO of Financial
Executives International; Mr. Jerry Jasinowski, President of
National Association of Manufacturers; and Mr. Peter C.
Clapman, Senior Vice President and Chief Counsel of Corporate
Governance TIAA-CREF. Gentlemen, thank you all for appearing
and your willingness to appear here today. Let me yield to the
gentleman from New York.
Mr. LaFalce. I too would like to welcome every member of
the panel. And so many of you I know so well: Mr. Raines with
whom I have had a long working relationship before his days at
Fannie Mae and the Administration; Mr. DelRaso with whom I have
worked over the years through the auspices of the National
Italian American Foundation; Mr. Jasinowski, going back 20, 30
years now; but most of all, I want to welcome Mr. Carl McCall,
the Comptroller of the State of New York. Again, Carl has been
one of the most outstanding public servants it has been my
pleasure to know, whether it was a State senator, whether it
was as a United States Ambassador, whether it was as a
Commissioner, whether it was in the private sector as a leading
vice president of one of the major financial institutions in
the world, and he has been elected to statewide office in the
State of New York by overwhelming margins on two separate
occasions. And one of his distinctions, among many, he is also
a member of the board of directors of the New York Stock
Exchange.
So, not to slight the other members of the panel, but I
just don't know you quite as well. Thank you, Mr. Chairman.
Chairman Oxley. Thank you. All you New Yorkers stick
together, I notice that. I understand Mr. McCall has some
issues and has to get back to New York, and I appreciate that.
Let us begin with Mr. McCall.
STATEMENT OF H. CARL McCALL, COMPTROLLER, STATE OF NEW YORK,
OFFICE OF THE STATE COMPTROLLER
Mr. McCall. Thank you, Mr. Oxley. As I said in my prepared
remarks, I had a note here that I am to start off by saying
good morning. I guess that is not now appropriate, but thank
you for this opportunity. And, unfortunately, I do have to go
back to New York, but I hope I can stay for some of the
questions.
Chairman Oxley. Mr. Raines is shaking his head because he
has been on several second panels. So good afternoon.
Mr. McCall. I want to thank the Ranking Member, Congressman
LaFalce, for all he has done, and I appreciate the long
relationship I have had with him and to all the Members of the
committee.
I want to thank you for giving me this opportunity to
address issues of corporate accountability and investor
confidence. In the past few months, Americans have learned that
the integrity of the financial markets and, in fact, the
economic well-being of our country depend on these issues.
I commend this committee for holding a hearing. It is
essential that we have a national discussion on these issues. I
assure you our future depends on it. We need action at the
Federal level to prevent another Enron in the future.
I applaud my good friend, Congressman LaFalce, for his
leadership in introducing the Comprehensive Investor Protection
Act of 2002. As comptroller of the State of New York, I serve
as the sole trustee of the State's $112 billion Common
Retirement Fund, the pension fund for nearly 1 million New York
State and local government employees and retirees. The fund
owned nearly 4 million shares of Enron through its index
portfolio and active managers prior to the company's
catastrophic downfall. Our losses are expected to exceed $58
million.
While our fund is strong enough to absorb the financial
blow inflicted by this corporate collapse, we are deeply shaken
by the lack of diligent oversight by the independent auditors,
board of directors, rating agencies and analysts on whom
investors rely.
And we are not alone. In fact, I believe that the loss of
investor confidence is the most devastating effect of the
corporate collapse experience over the last several months. And
if we don't restore that confidence quickly and completely, the
consequences will be immeasurable.
The bill before the committee today, the Corporate and
Auditing Accountability Responsibility and Transparency Act of
2002, offers measures for enhanced auditor oversight. However,
this is no time for small steps. I believe additional standards
are necessary to ensure the restoration of investors'
confidence in auditors and their findings.
The Comprehensive Investor Protection Act that Congressman
LaFalce introduced goes much further toward that goal. I urge
the committee to consider a legislative compromise that
includes some form of the provisions included in the
Comprehensive Investor Protection Act that would correct what
is currently a failed regulatory structure. I am speaking in
particular of provisions that align with recommendations I have
made as New York State comptroller.
Let me explain. First we need standards to make auditors
more independent from the companies they audit. I submitted
proposals to the Securities and Exchange Commission and to the
Big Five auditing firms and called on companies to take three
steps:
One, prohibit auditors from providing non-audit services to
audit clients except under limited circumstances.
Two, limit audit relationships to a maximum of 7 years.
Three, restrict auditors from accepting employment with
clients for 2 years following work on an audit.
In short, auditor independence is critical to long-term
shareholder value and confidence. That is why I supported the
SEC's proposed revision of auditor independence requirements in
2000. And that is why I submitted these proposals, and that is
why I pushed for change in my various roles as a public
official.
I have introduced legislation that would require all New
York State agencies to adopt these standards in their
relationships with auditing firms. In addition, I issued an
executive order to implement these standards in the Office of
the State Comptroller. I believe these are important steps
toward achieving meaningful auditor independence.
But we can't achieve comprehensive reform on a State-by-
State basis. We also need a national effort. For this reason,
the provisions in the Comprehensive Investor Protection Act
that promote auditor independence are extremely important. As a
shareholder, I have adopted a proxy voting policy to oppose the
appointment of any auditor that also performs non-audit
services to the company. I also sent a letter to the Common
Retirement Fund's 50 largest portfolio companies, explaining
our proposed standards and requesting information about how
long companies have retained their current auditor.
As comptroller, I can take these steps at the Common
Retirement Fund, and I can encourage my counterparts around the
country to do likewise, but it is essential that we hear from
Washington on these matters. It is essential to know that our
legislators share our commitment to investor protection.
The work of this committee sends a vital signal to all
investors. To ensure that I continue to develop appropriate
proposals to increase investor protection, I have also created
a panel of advisors who will focus specifically on measures
that enhance board independence and corporate accountability
and minimize conflicts of interest in the marketplace. As a
last resort, I have also taken legal action against Enron. I
have filed a notice of joinder in United States District Court
for the Southern District of Texas in support of a legal
application to freeze the assets of directors and executives
who may have benefited from stock sales based on information
that was not available to other shareholders.
I applaud this committee for seeking input from a variety
of sources, especially from the private sector. As a member of
the board of the New York Stock Exchange, I serve as co-
chairman of a recently created Committee on Corporate
Accountability and Listing Standards. The committee will review
corporate governance and shareholder accountability issues such
as the composition of corporate boards and committees,
disclosure requirements and the role of independent audit
committees. The committee will also consider new listing
standards that will have a profound impact on the marketplace.
In closing, I would like to say that I am acutely aware of
my fiduciary responsibility to the retirees and hard-working
people of New York State. Their ability to enjoy an
economically secure retirement depends on the faithful and
prudent investments of the Common Retirement Fund. In 9 years
as comptroller, I have never heard from as many members of the
pension systems as I have in the past few months. They are
nervous and frightened and beginning to question the
rationality of equity markets generally. This is not an
encouraging sign for the marketplace. We must restore their
confidence, each of us, fiduciaries, legislators and
regulators. We all have a role to play.
I thank you for your reasoned and constructive approach to
the important issues before us. I look forward to working
together with you to restore investor confidence and ensure the
long-term viability of the American marketplace.
Again, I thank you, Chairman Oxley, Ranking Member LaFalce,
and Members of the committee for allowing me to testify today.
[The prepared statement of H. Carl McCall can be found on
page 302 in the appendix.]
Chairman Oxley. Thank you, Mr. McCall. And feel free to
stay as long as you possibly can. Hopefully we can get to
questions before you have to leave.
Now I am pleased to go back to regular order and introduce
the gentleman, Mr. Raines.
STATEMENT OF FRANKLIN D. RAINES, CHAIRMAN AND CEO, FANNIE MAE;
CHAIRMAN, CORPORATE GOVERNANCE TASK FORCE, THE BUSINESS
ROUNDTABLE
Mr. Raines. Thank you, Chairman Oxley, and thank you,
Ranking Member LaFalce and Members of the committee. My name is
Franklin Raines and I am Chairman and CEO of Fannie Mae. I am
here today as Chairman of the Corporate Governance Task Force
of the Business Roundtable, and I appreciate the opportunity to
express the views of the Business Roundtable with respect to
the topic of today's hearing.
Before I do that, Mr. Chairman, let me take this
opportunity to recognize the foresight and leadership of this
committee in raising and addressing issues of financial
institution safety, soundness, and transparency, well before
the collapse of Enron brought these issues to national
attention. Let me recognize your leadership and that of Ranking
Member LaFalce, subcommittee Chairman Baker, and subcommittee
Ranking Member Kanjorski, for your consistent and strong
leadership over the years on issues of corporate
responsibility, transparency and market discipline.
The Business Roundtable is recognized as an authoritative
voice on matters affecting America's business corporations and,
as such, has a keen interest in corporate governance. Indeed,
as leaders of some of our Nation's largest businesses, the
Roundtable has the strongest interest in corporate governance
practices that secure the confidence of shareholders,
employers, policymakers, and other constituencies.
The Roundtable has been involved in corporate governance
issues since 1978. In 1997, we published our statement on
corporate governance, which suggests best practices regarding
matters including the functions of the board of directors,
board structure and operations, and shareholders' meetings. We
are pleased with the number of large corporations that have
adopted these practices.
In light of recent events, the Roundtable is reviewing its
1997 statement regarding corporate governance, and we expect to
issue a new statement on this subject later this spring. The
Business Roundtable has prepared a detailed analysis of H.R.
3763, and with your permission I would like to submit that
analysis for the record.
[The following information was subsequently furnished by
Franklin D. Raines for the hearing record.]
Chairman Oxley. Without objection.
Mr. Raines. This afternoon I would like to summarize what
the Business Roundtable believes should be the guiding
principles of corporate governance. The Business Roundtable has
issued a public statement regarding the issues related to the
bankruptcy of Enron, in which we expressed our view of Enron's
collapse and a set of principles we believe should guide the
discussion of proposed changes, practices, regulations and
laws.
With respect to Enron, the Business Roundtable believes
that a number of the actions and behaviors revealed in the
report of the special committee of the Enron Board of
Directors, which contributed to the collapse of the company,
are unacceptable. The Powers report describes a pervasive
breakdown in the norms of ethical behavior, corporate
governance, and corporate responsibility to internal and
external stakeholders. The Enron situation appears at this
point to derive fundamentally from a massive breach of trust.
We understand why the American people are stunned and
outraged by the failure of corporate leadership and governance
at Enron. It is wholly irresponsible and unacceptable for
corporate leaders to say they did not know, or suggest it was
not their duty to know about the operations and activities of
their company, particularly when it comes to risks that
threaten the fundamental viability of their company.
The success of the American free enterprise system follows
from the merger of corporate responsibility with individual
responsibility, and the Business Roundtable believes that
responsibility starts at the top.
The United States has the best corporate governance,
financial reporting, and securities market systems in the
world. These systems work because of the adoption of best
practices by public companies within a framework of laws and
regulations.
The collapse of the Enron Corporation is a profound and
troubling exception to the overall record of success. Other
less dramatic exceptions may also exist among the thousands of
United States public corporations, but there are exceptions in
systems that have generally worked very well.
In light of the public interest and issue drawing out of
the Enron situation, we thought it would be useful to
articulate a set of guiding principles of corporate governance:
First, the paramount duty of the board of directors of a
public corporation is to select and oversee competent and
ethical management to run the company on a day-to-day basis.
Second, it is the responsibility of management to operate
the company in a competent and ethical manner. Senior
management is expected to know how the company earns its income
and what risks the company is undertaking in the course of
carrying out its business. Management should never put personal
interests ahead of or in conflict with the interest of the
company.
Third, it is the responsibility of management under the
oversight of the board and its audit committee to produce
financial statements that fairly present the financial
condition of the company and to make sufficient disclosures to
investors to permit them to assess the business and financial
soundness of the company.
Fourth, it is the responsibility of the board and its audit
committee to engage an independent auditing firm to audit the
financial statements prepared by management and to issue an
opinion on these statements based on generally accepted
accounting principles. The board, its audit committee, and
management must be vigilant to ensure that the corporation or
its employees do not take any actions that compromise the
independence of the independent auditing firm.
Fifth, it is the responsibility of the independent auditing
firm to ensure it is in fact independent, is without conflict
of interest, employs highly competent staff and carries out its
work in accordance with generally accepted auditing standards.
It is also the responsibility of the independent accounting
firm to inform the board, through its audit committee, of any
concerns it may have about the appropriateness and quality of
significant accounting treatments, business transactions, and
about any weaknesses in internal control systems. The firm
should do so in a forthright manner and on a timely basis,
whether or not management has communicated to the board or
audit committee on the same matters.
Six, the company has a responsibility to deal with its
employees in a fair and equitable manner. Employee benefit
plans, once established, should be operated in a manner that is
fair and equitable to all employees. These responsibilities and
others are critical to the functioning of the modern public
corporation. No law or regulation alone can be a substitute for
the voluntary adherence to these principles by corporate
directors and management and by the accounting firms retained
to serve American corporations.
Several thoughtful proposals have been offered to create
new regulations or laws to deal with what appear to be breaches
of trust and failure of responsibility at Enron. Two weeks ago,
the President announced his plan to improve corporate
governance. The President's personal involvement in seeking
reform is welcome and underscores just how fundamental ethical
and responsible corporate governance is to the health of the
American economy.
Chairman Oxley, you and Mr. Baker have put forth a number
of laudable proposals to improve corporate governance we are
considering today, as has Mr. LaFalce and others. Some
legislation and regulatory changes are necessary and advisable.
The Business Roundtable worked closely with policymakers to
help ensure that any necessary changes to laws and regulations
are effective and efficient, taking care that our responses to
the unusual circumstances presented by Enron do not inhibit
U.S. Public corporations' ability to compete, create jobs, and
generate economic growth.
Mr. Chairman, that concludes my statement, and on behalf of
the Business Roundtable and its member companies, thank you for
the opportunity to participate in today's hearing.
[The prepared statement of Franklin D. Raines can be found
on page 320 in the appendix.]
Chairman Oxley. Thank you Mr. Raines.
And I now call on Mr. Joseph V. DelRaso.
STATEMENT OF JOSEPH V. DelRASO, PARTNER, PEPPER HAMILTON, LLP
Mr. DelRaso. Good afternoon, Chairman Oxley, Ranking Member
LaFalce, and distinguished Members of the committee. Thank you
for this opportunity to present my views on H.R. 3763,
legislation which I believe will do much to restore the faith
of investors in the way in which public companies report their
financial results.
I commend the committee for its level-headed and
responsible approach, especially at a time when many pundits
and commentators are generating more heat than light on these
important issues.
I am a partner in the law firm of Pepper Hamilton in
Philadelphia. My practice focuses on corporate and securities
matters, particularly on matters arising under the Investment
Company Act of 1940 and the Investment Advisors Act of 1940. I
served as an attorney advisor with the Securities and Exchange
Commission in the 1980s, and I serve as a member of the board
of directors of both public and private companies and non-
profit institutions.
Having experience on the regulatory side as a lawyer in
private practice and as a corporate board member, I believe I
offer the committee an important perspective on the practical
effect of key aspects of this legislation. Because this
committee has already heard a wealth of testimony on auditor
oversight provisions, I will focus my comments on other
sections, particularly the transparency of corporate disclosure
provisions of section 6, corporate governance provisions of
section 9, and accredited rating agencies of section 11. Each
of these sections, the committee should ensure that studies and
activities undertaken do not attempt to fix things that are not
broken.
Federal Reserve Board Chairman Alan Greenspan in his
earlier testimony to this committee noted a pronounced move
toward more transparent reporting and improved corporate
governance practices in the wake of the Enron collapse. As
Chairman Oxley said at the committee's hearings last week,
while Government may still need to take action, that action
should not stifle the ability and initiative of the financial
markets to self-correct.
In my practice as a lawyer, the vast majority of boards of
directors, especially those of publicly held companies that I
represent, take their responsibilities very seriously. In the
last few years in particular, I am sure even more so now in the
post-Enron and post-Global Crossing world, independent
directors have become increasingly aggressive in acting as
watchdogs over their respective shareholders' interests.
Audit committees have already been required to adopt
charters governing their operations.
But perhaps they even need more guidance in this area. And
I concur with some of the remarks earlier today that the stock
exchanges and the other self-regulatory organizations may look
into other areas with regard to adopting rules to help guide
audit companies in their role as the watchdogs on the financial
side of the shop.
Whether or not these policies and procedures are
aggressively enforced, obviously, vary from company to company.
On the one hand, given the proclivity of the plaintiffs' bar to
act as a self-appointed protector of shareholder interests,
even the most diligent board of directors is constantly
checking itself to avoid costly unnecessary litigation. This
serves as an important catalyst for directors instituting
improved corporate governance policies and procedures.
This also points to the need for appropriate government
action to craft legislation and implement rules that are
clearly understood and not easily manipulated.
Appropriate implementation and enforcement is just as
critical as the legislative effort. Again, while the actions of
the plaintiffs' bar keep directors and officers focused and
diligent, the appropriate deterrent is and always and will be
government enforcement and prosecution. The spectre of criminal
sanctions and incarceration for the most egregious behavior or
civil fines and sanctions for other transgressions serves the
public interest much more sensibly than allowing certain
members of the bar to extract their self-imposed penalties from
companies in the form of their sometimes very large contingency
fees. A more direct distribution of funds to compensate victims
of corporate malfeasance, or fines that are used to further
bolster Government enforcement efforts might be preferable, and
indeed are just plain common sense in some circumstances. Any
effort to roll back securities litigation reform may make
business only more expensive by increasing insurance costs and
the like and still produce inferior results.
Again, we heard studies undertaken by the SEC that point to
the fact that the plaintiffs' bar is alive and well and still
impacting the markets. On the other hand, prosecutorial
judgment most times is a markedly more effective approach to
handling some of these problems rather than ``strike suit''
targeting.
Below the board level, the President's Working Group,
referred to in section 9, should examine how the financial
markets can deter managers and other employees from interfering
or influencing third-party professionals, whether they be
auditors, rating agencies, and other parties that are relied
upon in one way or another to put their imprimatur on corporate
actions.
From a practical perspective, any additional Government
overlay from either a statutory or regulatory standpoint might
further dampen the enthusiasm of qualified people to serve as
independent directors. On the other hand, appropriate sanctions
for inappropriate behavior would be welcome. The overwhelming
majority of independent directors has been and continue to be
good corporate citizens, dedicated to discharging their duties
to protect shareholder interests.
Further initiatives, including personal liability expenses,
except in the most egregious cases of willful and wanton
misconduct, and other erroneous regulatory sanctions or
requirements may merely serve to deter good individuals from
accepting positions as independent directors.
Finally, corporate governance ties in with the provisions
in section 6 regarding the need for improved transparency of
corporate disclosures. Boards should be able to discern from
transparent reporting the correct state of affairs. There
should be little excuse for a well-informed board of directors
to fail or be victimized by obfuscation and financial high-
jinks constructed as off-balance-sheet transactions and other
clever financial tricks. Uniform standards of financial
reporting will not only sustain a level playing field, but will
uphold the integrity of the process.
I applaud the work of this committee in seeking improved
transparency, for without it, the efficient functioning of our
financial markets may be impeded. Financial investors expect to
see, and will demand more than ever, quality of earnings that
can be reported via clear and concise accounting standards
consistently applied. This is especially true in dealing with
non-exchange traded financial instruments and other instruments
that are not readily tracked in public markets. This
legislation, I believe, will put the ``fair'' back in fair-
value accounting.
Finally, with regard to credit agencies, I believe many of
the issues I noted regarding the corporate governance
procedures also apply in this field, particularly the
overwhelming need to avoid conflicts of interest. This again is
essential to the efficient operation of our financial markets.
Just as a ``seal of approval'' is expected by the auditor
certification accompanying audited financial results, the grade
awarded by rating agencies will only be worth the strength and
integrity of the name behind it.
Finally, Mr. Chairman Oxley and Ranking Member LaFalce, I
would like to thank you again for this opportunity to testify
today on this important piece of legislation. The dark cloud of
Enron and Global Crossing, while obviously dire to investors,
employees, and those most immediately affected, may have some
element of a silver lining if, as I believe, it serves as a
wake-up call to responsible independent directors and corporate
officers and if it provides the Congress the impetus to enact
some long-needed reforms to ensure responsible reporting of
corporate financial results.
[The prepared statement of Joseph V. DelRaso can be found
on page 360 in the appendix.]
Chairman Oxley. Thank you.
And I recognize Mr. Livingston.
STATEMENT OF PHILIP B. LIVINGSTON, PRESIDENT AND CEO, FINANCIAL
EXECUTIVES INTERNATIONAL
Mr. Livingston. Thank you, Chairman Oxley and Ranking
Member LaFalce. I am here today to represent FEI and its strong
support for H.R. 3763 and the leadership of this committee. As
Chairman Pitt kindly recognized this morning, the FEI released
its own recommendations for improving financial management,
financial reporting, and corporate governance. These
recommendations dovetail nicely with H.R. 3763.
Financial officers know that good corporate control
requires broad frontline defense mechanisms to prevent
problems. As a result, that is where our suggestions begin. Our
most important recommendation is that all senior financial
officers adhere to a special code of ethical conduct. We
recommend that this bill include an additional provision
calling upon the SEC to work with the stock exchanges to
develop a requirement that senior financial officers of all
public companies adhere to a code of ethical conduct similar to
that in use by FEI members today. We believe adherence to such
a code is a crucially important cornerstone of sound
management, appropriate atonement at the top, and successful
fiduciary stewardship.
In order to reinforce management and board awareness in the
maintenance of a strong ethical climate, we strongly recommend
that all senior financial officers annually sign such a code
and deliver it to their board. I will tell you that one of our
leading CFOs has required all of his company's 3,000 financial
professionals worldwide to sign such a code and deliver it back
to their corporate headquarters.
Unfortunately, the Enron case once again demonstrates the
need to improve audit committees. Three years ago, the Blue
Ribbon Panel on Audit Committee Effectiveness called for all
audit committee members to be financially literate and for each
committee to have at least one financial expert. Unfortunately,
the criteria for meeting the standard was set so low that no
real change or addition to audit committee personnel actually
occurred in the time leading up to Enron's demise.
We must get on with truly raising the bar and adding real
expertise to audit committees. We need Congress and the stock
exchanges and the SEC to act on this matter. The stock
exchanges should be required to write tougher standards into
their listing agreements. Explicit experience in financial
reporting must be required of such experts.
FEI is also proposing recommendations as to the issue of
auditor independence. As recently as last year, I testified
before the Senate Banking Committee in opposition to former
Chairman Levin's proposal to split audit and non-audit services
provided by accounting firms. I tell you, it is still my strong
personal opinion that consulting services do not corrupt the
integrity of independent audits. The truth, in my view, is
exactly the opposite. Consulting projects enable the auditor to
get out of the accounting department and learn about the
intricacies of the business and, in the end, conduct a more
effective audit.
However, the accounting profession is suffering from a
post-Enron crisis of confidence. Therefore, certain
restrictions should now be imposed on non-audit services
supplied by the independent audit. They should no longer
provide clients with internal audit services or consulting on
computer systems used for accounting. We strongly believe that
tax services should be allowed, as well as acquisition due
diligence, audits of employee benefit plans, and other
statutory audits. We do strongly recommend that audit
committees approve all large non-audit services provided by the
auditor.
I also want to address the controversial issue of stock
option accounting. Unfortunately, the current crisis has
encouraged some to attempt opportunistic initiatives to advance
narrow and unconstructive agendas with little regard for the
important matters in front of us. These very tactics were too
often employed over the last 10 years and are at the core of
many of our problems.
Unusable accounting standards and dysfunctional financial
statements result from processes and regulatory environments
unable to recognize the real problems, yet set out to achieve
narrow political-or governance-related objectives.
Stock option accounting is such a case. This debate has a
long and acrimonious history between shareholder activists,
enraged by cases of excessive executive compensation, and the
corporate preparers of financial statements that find
employees' stock options as hard to accurately measure as an
Enron energy contract or put agreement to sell broadband
capacity. A charge to the income statement for stock options is
the Trojan horse in the battle over governance controls of
options and executive compensation.
When recently asked about the ongoing accounting debate,
Sarah Teslik, the CEO of the Council of Institutional
Investors, was quoted as saying: ``If we can't get the vote on
these things, then we have to punish them on the balance
sheet.'' Her comments reflect the reality of the issue. It is
about the practices and the quantities of option grants, not
the quality of the income statement.
A real reform would be for shareholders to approve all
stock option plans and therefore control abusive levels of
shareholder dilution in the few cases that it occurs. Because
of the intense controversy around this subject, Congress can do
a great service by mandating shareholder approval of employee
stock option plans, and we urge you to act.
Briefly, FEI would like to add its continuing support for
the Private Securities Litigation Reform Act. The PSLRA is
working today and there is no need to change or modify the
current law. Enron's employees and shareholders will not be
hindered by the PSLRA in seeking restitution of their losses.
Now is the time for real reform, not opportunistic grabs of
narrow agenda items.
FEI also recommends that we increase the SEC's budget and
that a significant portion of the additional funds be earmarked
for attracting new high-caliber professional staff. Further,
FEI supports the creation of a new regulatory organization for
the auditing profession. We believe it is important to clarify
that the two-thirds members specified as ``not members of the
accounting profession'' be further defined as individuals who
are not currently practicing CPAs, but do have extensive
education and experience in financial management of public
companies, auditing, or accounting.
That concludes my remarks, and I would like to thank the
Chairman and the Members of the committee for allowing FEI this
opportunity.
[The prepared statement of Philip B. Livingston can be
found on page 365 in the appendix.]
Chairman Oxley. Thank you.
Our next witness is Mr. Jerry Jasinowski. I was so used to
having you testify in the committee across the hall, and we are
facing in different directions from the past, but I think this
year you made an appearance before our committee. Welcome. And
it is good to see you again and particularly under these
circumstances.
STATEMENT OF JERRY J. JASINOWSKI, PRESIDENT, NATIONAL
ASSOCIATION OF MANUFACTURERS
Mr. Jasinowski. Thank you very much, Chairman Oxley, for
your leadership on this, and allowing us to testify before this
committee.
With 14,000 manufacturing companies, both large and small,
we are a user of the auditing information and a producer of the
auditing and financial information, and so have a particularly
unique perspective on this and have thought very carefully
about it. Although we have not concluded all of our decisions
on it, we certainly feel that your bill 3763 is a good
framework.
I want to acknowledge, Congressman LaFalce, also our
longstanding relationship, and we look forward to working with
you in terms of the legislation you propose.
In our press release, Mr. Chairman, we put the emphasis on
best practices and enforcement, and suggest that we have a very
good system in this country which has been badly damaged by
Enron, Andersen, and other misjudgments which Frank Raines has
articulated rather well, and I would associate myself with his
remarks.
Our 14,000 members are outraged by what appear to be
certain transgressions on the part of both companies and
auditors, and feel that the bulk of our membership are
absolutely opposed to anything like that and strongly want to
affirm the need for honest and complete information. In fact,
as we indicate in the statement--which I would like included in
the record--information is critical to our capital markets, and
I think without it, we will not be able to have the growth and
productivity that we so badly need.
Let me make five points. And the first point is to stress
your bill H.R. 3763, although we do not yet endorse it, we
certainly feel it provides the framework for the kind of
reform--thoughtful balanced reform, that we need.
Disclosure beyond GAPP is important in getting better
information, public regulatory oversight, as you suggest, is
the kind of thing that we think is important in the legislative
area.
Having said that, we really put a lot of emphasis in our
testimony on best practices and the need for the private sector
to further improve the quality of the information that they
have--and not just the auditor, but also the companies. We do
have the best system in the world. But as Chairman Pitt said,
we can make it a lot better. And I think there are many ways in
which we can.
At the heart of that, of course, is strengthening the audit
committee and strengthening the oversight of the management,
having a more independent board, focusing on such matters as
the critical accounting policies and practices that have come
out of the SEC, and other matters where we think a good system
could be made much better if, in fact, it is fully employed. I
think the tone of much of your bill puts the emphasis on that
and we would want to associate ourselves with that.
And we think we have an obligation, Mr. Chairman, to speak
out to our own members and say look, we know most of you are
doing a fine job, but not everybody is, and you can do better;
and we will certainly encourage that within our own membership.
As I said, I thought that Chairman Pitt was very helpful in
terms of his proactive emphasis on enforcement, information and
clarity. We think we ought to be very tough with wrongdoers.
People make mistakes, they ought to pay. And it is important
that society generally, the SEC, and the Congress assure that
that happens.
Having said that, there may be some opportunities for
legislative reform, as you suggest, in your bill and beyond
that. Certainly the public regulatory organization to oversee
accounting standards, as you suggest, is something that we
think merits careful consideration. Also, it might surprise
some, but we think it is important to increase the funding for
the SEC in order to have the kind of education, clear
information, and enforcement that they need. We cannot expect
to get this job done if we do not have adequate resources
there, and we support that.
I am sure there are other measures as these hearings
continue, and in the market session we will support
legislatively. But again let me repeat, we don't think there
needs to be a whole set of new laws. There is an enormous set
of good laws on the books that, with proper enforcement and
good action on the part of the companies, will lead us to
improve this system as it now stands.
We think it is, finally, important not to take on some
measures which will do real harm; that is, to produce a lot of
new legislation, new liabilities, try to reinvent the wheel.
This committee, your own leadership, Congressman LaFalce, and
the SEC have been working on this for some time. The Enron-
Andersen affairs require us to redouble our efforts, to
strengthen our laws in some cases, but let us not try to
reinvent the wheel. Certainly we don't need new liability
provisions for the most part, and we ought to avoid increases
in costs.
Having said that, again, I think it is important for us in
the private sector to take responsibility to further improve
our own management and implementation of the accounting
provisions.
Thank you, Mr. Chairman.
[The prepared statement of Jerry Jasinowski can be found on
page 388 in the appendix.]
Chairman Oxley. Thank you, Mr. Jasinowski.
Mr. Clapman.
STATEMENT OF PETER C. CLAPMAN, SENIOR VICE PRESIDENT AND CHIEF
COUNSEL, CORPORATE GOVERNANCE, TIAA-CREF.
Mr. Clapman. Thank you. Thank you, Chairman Oxley, Ranking
Member LaFalce, and Members of the committee. I am Peter
Clapman. I am speaking from an investor and shareholder
perspective on the issues of the day. I will be talking not
only about the accounting regulation issues, but the board of
corporate governance issues as well.
TIAA-CREF has a fiduciary responsibility to over 2-1/2
million members of our pension system, which is the largest
pension system in the world. We have approximately $275 billion
under management. I also chair the most prestigious global
corporate governance organization in the world, and I must say
that the Enron episode has had a real detrimental effect on the
reputation of the United States and corporate governance.
TIAA-CREF has been a leader in corporate governance. We are
convinced that our initiatives to better corporate governance
will produce better returns for our pension participants and
shareholders. We also believe that it is our responsibility to
monitor the managements of our portfolio companies and hold
them accountable. Good corporate governance depends critically
on the performance of the board of directors and, in
particular, its most important board committees: compensation
committee, auditing committee and nominating committee. If the
board is not independent, if the directors lack the proper
qualifications, and if the directors do not pay sufficient time
and attention to fulfill this role, an Enron is not only
possible, but it is also likely. Are there other Enrons out
there? We can hope that there are not, but prudently cannot
trust that will be the case without reforms.
And I will now address some of the needed corporate
governance reforms and how I suggest they best be accomplished.
One area that must be addressed involves the conflicts within
the key professions. Too often accountants and lawyers,
ostensibly representing the company, in fact wind up
representing only its senior management. Such conflicts were at
the heart of the problems of Enron.
The professional organizations themselves have a key role
and must do a better job through education and discipline to
minimize these abuses. The regulation of the accounting
profession demands change, and already excellent proposals have
been made.
TIAA-CREF CEO John Biggs has urged, among other things,
that companies assure the integrity of the auditing process by
not giving the same audit firm that does its audits, consulting
work. We are not advocating the split of auditing and
consultant work for the organization, but that each company
should be conscious of this potential issue of conflict and
split its auditing and consulting work on that basis, and also
by periodically rotating the auditing firm or at least
considering such action.
He also proposed that an independent board oversee the
accounting profession, with its own funding source, and with
the legal authority to enforce rules and impose sanctions for
wrongdoing.
But on a broader scope, a related corporate governance
reform needed for more accurate financial reporting is on the
subject of executive compensation, particularly affecting the
use of stock options. The reforms needed are twofold: require
that the cost of options be reflected in the financial
statements; and, two, require shareholder approval for dilution
of option plans, introducing greater accountability in this
most important area of executive compensation. Stock options
are overused and abused, with the accounting rules largely to
blame for this problem. The true cost of fixed-price options
escape the earnings statement, encouraging this overuse and
abuse. This structural failure of corporate governance must be
addressed.
The National Stock Exchange as the New York Stock Exchange
and Nasdaq must be an important engine for needed reform. The
exchanges, however, have dual objective organizations. While
they must regulate companies and brokers in the public
interest, as businesses they also seek listings from the very
companies they must regulate. To the credit of Chairman Harvey
Pitt, the SEC has already requested that the exchanges evaluate
which corporate governance reforms are necessary. The exchanges
must respond by imposing stronger standards of director
independence, requiring shareholder approval of all material,
equity plans promoting education of directors, and implementing
more stringent policies to ferret out conflicts of interest. If
the exchanges fail to act, the SEC, using its regulatory powers
and persuasive influence, should press for needed reforms.
The education of directors is a major concern. Directors on
audit committees only recently had to meet a standard of
financial literacy; literally, to have the ability to
understand a financial statement. Directors on compensation
committees often do not take a proactive role on behalf of
their company, because they lack an understanding of
compensation issues and do not obtain independent consultants
when needed. The abuse and overuse of stock options results
from inadequate performance of many compensation committees and
the board as a whole.
What is the role for Congress? It is not clear to me how
many new laws are needed. But as a minimum, your oversight role
is critical. At some point, memories of Enron will fade as
other issues take center stage, but the corporate governance
problems that I have highlighted, and are highlighted by the
Enron experience, should be fixed.
I have outlined a number of corporate governance issues in
which I believe reforms are both necessary and possible:
One, dealing with the conflicts among the professionals.
Two, better regulation of the accounting profession.
Three, reforms in the area of executive compensation,
particularly in the area of stock options, and to require
shareholder approval.
And in the role of the stock exchanges, to deal with issues
in the public interest and recognize their responsibility
there.
And, finally, the education of directors.
You may be sure TIAA-CREF is an organization that will
continue to press for these reforms. We hope the current
widespread public interest in such issues will provide focus
and impetus for such reforms.
Thank you very much.
[The prepared statement of Peter C. Clapman can be found on
page 397 in the appendix.]
Chairman Oxley. Thank you Mr. Clapman.
Let me begin by asking Mr. Raines, what role corporate
management plays in assuring that audit firms are independent,
and how is it similar or different to the role of the audit
committee itself?
Mr. Raines. As we stated in our principles, it is not only
the obligation of the auditor to be independent, but it is also
the obligation of both management and the board to not take any
steps that would compromise its independence. And that means
from the management standpoint, that management should not ask
the auditors to undertake activities that may be inconsistent
with their role as independent auditors, and must ensure that
the practices with regard to the personnel of the auditors and
to the provision of information needed for the auditors to do
their work are consistent with the auditor's independence.
Sometimes it is easiest, if you have a task and you have a
professional firm working for you, to simply use the firm who
is there and use a different department of that firm. But that
easy path can lead to independence questions. If, for example,
you used the consulting arm of an auditor to create your
financial systems, and then the auditors then have to audit
those systems, that can impinge on the independence of the
auditors. So it is in part management's job to not even suggest
to the auditors that they put themselves into positions that
may create independence concerns.
Chairman Oxley. Mr. DelRaso, you mentioned that Congress
should be careful in trying to fix things that aren't broken.
What proposals specifically are you concerned about?
Mr. DelRaso. I think the CARTA legislation has done a
pretty good job of addressing the problems without going too
far. But I am still concerned about two areas in particular:
one, the groundswell that may be developing in terms of rolling
back the reforms made on securities litigation; and, number
two, I think in the area of auditor independence, Congress
should take a careful look at the real role of the modern-day
accounting firm and the services they provide across the board,
audit and consulting.
We have seen the worst in these recent cases. I represent a
number of companies that deal in the global markets, and I
think a little more work may have to be done to take a look at
the role of these firms in the non-audit areas, especially
overseas. When global companies are setting up subsidiary
operations and other types of international functions, the
auditing firm is the law firm in that jurisdiction and it
provides other areas of advice and, quite frankly, it is the
best source of that advice in that particular market. And at
the same time, that firm also has the institutional knowledge
of a particular client.
There are, I think, a number of functions that really
aren't necessarily in as deep a conflict as we believe.
Chairman Oxley. I don't know whether you were here for Mr.
Pitt's testimony, Chairman Pitt, but I think you and he share
the same concerns that perhaps I do as well; that is, we would
be very careful about putting things in stone, as Chairman Pitt
said, because it is much more difficult to extricate ourselves
from a bad decision. Better it be left for the most part to the
private sector, and indeed to regulators.
Let me ask, Mr. Jasinowski, Chairman Greenspan testified a
couple of weeks ago to this committee and, in response to a
question, seemed to indicate that in many cases, the
marketplace is the best way of disciplining unwanted behavior.
What do you think your members would fear the most, Government
reprisals or market reprisals?
Mr. Jasinowski. I think the market reprisals are already
taking place, Mr. Chairman, as you know, and I don't think
there is a company in my membership which isn't reviewing all
of its procedures to be absolutely sure they are not only
sound, but they are made stronger. And I think the markets, the
equity markets, have also reacted already. So we don't have any
choice about the private markets except within running our own
companies, where we do have a choice, and I think we are going
to do a lot better there.
I think the biggest concern is that people are going to try
to create a whole new legislative, regulatory, liability system
to go after some particular transgressions. And I think one of
the reasons why your particular legislation is appealing is
that you respond legislatively, you set up a framework to use
the SEC, you try to involve the private sector, and at the same
time, you have punitive actions if they are necessary.
I think you have got to have a balance. You have got to
have perspective. That is what all our members are really
looking for, and we are concerned that Congress may overreact.
Chairman Oxley. Mr. Livingston, while I may share your
philosophical opinion regarding the division of labor between
accounting and consulting, the fact is that several of the
accounting firms have already indicated that it is their desire
as the corporation or partnership to divide those. Some would
say that we need to make sure that maintains, by passing a law
that would forever divide those functions. What is your
reaction to that?
Mr. Livingston. I think it would be a great role for the
new oversight body that we are talking about for the accounting
profession. And the main reason it would be a great role for
that body is because there are many, many nuances. And our
group, while it feels strongly about continuing to get tax
services from the auditor, because most of that work is
compliance work, it is related to the tax return and ties into
all the work they do on the audit, there are areas in tax
preparation, tax advisory, that might be good for this
oversight body to be concerned about; tax structurings and tax
shelters that have been in the news, and where there are
contingency fees and tax savings. And that just illustrates the
kind of nuances that an oversight body could react much more
quickly to in a more focused manner.
Chairman Oxley. Thank you. My time has expired.
The gentleman from New York, Mr. LaFalce.
Mr. LaFalce. I think everybody agrees we need to have some
type of oversight board, correct? So I guess the question is,
what powers should it have and who should serve on it? Now,
with respect to powers, does anybody doubt that they have
should have their own independent investigatory powers, that
they should have their own ability to subpoena, to promulgate
standards, and see to its enforcement, adequate staff resources
to do the job? Does anybody have any quarrel with any of those
concepts?
Mr. Jasinowski, do you have a quarrel with those concepts?
Mr. Jasinowski. I do in the sense that it is not clear what
the relationship is to the SEC in that whole articulation.
Mr. LaFalce. It surely would be subject to the SEC.
Mr. Jasinowski. I think as long as the SEC is the one who
has the determination with respect to investigation.
Mr. LaFalce. I assure you, anything coming out of this
committee will absolutely ensure that the board is subject to
the jurisdiction of the SEC, which is subject exclusively to
the jurisdiction of this committee.
Having said that, the question is, who is going to be on
it? We know that Charlie Boucher resigned when he heard of the
appointment of certain individuals to a new board created by
Mr. Pitt. We know yesterday that Charlie Boucher said that the
new board should consist exclusively of public members. And I
don't know we have to go that far.
Suppose we put in legislation that the SEC's appointive
power of members of the board should be based upon
recommendations made by certain institutional investors; that
TIAA-CREF should make certain recommendations; that the Council
of Institutional Investors should make certain recommendations;
that private employees' pension plans and public employees'
pension plans should make certain recommendations. A slate of
candidates could then be decided upon by the SEC.
How does that sound to you, Mr. Jasinowski, because it is
important who is on it. Mr. Boucher would have rejected out of
hand those individuals that Mr. Pitt wanted.
Mr. Jasinowski. You have a lot of shareholders here, like
you, Congressman LaFalce, and employers are some of those.
Management, auditors, pension funds.
Mr. LaFalce. We want to check the employers, because it is
the employers that are the CEOs with the stock options, the
CFOs with the stock options that are the first line of defense
against earnings management or manipulation. Then it gets to
the audit committee who very often also has the same stock
options, perhaps not in the same quantity, and very often have
a policy of passivity that permeates the board. And so we need
to check that. And it is my judgment that the best check is to
have at least a majority of members coming from individuals
representative of these pension funds' institutional investor
groups.
It is not unreasonable in any event?
Mr. Jasinowski. No.
Mr. LaFalce. Thank you. Let us go to the next issue. Is
there anybody here who thinks we should permit auditors to
immediately leave the audit firm and become an employee of the
firm that they were auditing? Don't you think we ought to have
some ban on the time period? Wouldn't that be a good thing to
put in the legislation?
How about you, Mr. Raines?
Mr. Raines. We believe there ought to be a period of time
when someone who worked on the audit is not eligible for
employment.
Mr. LaFalce. OK, good. Anybody who disagrees with that
concept? We can accept that.
Mr. Livingston. That ought to be a company-driven thing, a
policy adopted by the companies. And I don't think you should
legislate.
Mr. LaFalce. You can say it, and I would strongly disagree
with it, because the problem is that 90 percent of the
companies you don't have to worry about would adopt it, and the
10 percent that you might have to worry about wouldn't adopt
it. And that is why you have laws. Most people don't murder,
but you have laws against murder. Publicly traded corporations,
if we are talking about publicly traded corporations--and we
are not talking about private corporations, Mr. Livingston--
publicly traded corporations subject to--invested by public at
large.
Let us go on to some other issues. Mr. Jasinowski, you were
very worried about adopting new laws dealing with grievances in
the securities markets. What about a return to old laws? Would
you consider that? I mean, you are opposed to new laws. What
about return to old laws?
Mr. Jasinowski. We are not opposed to new laws.
Mr. LaFalce. Let me focus in particular. What provisions in
the 1995 Securities Litigation Act were so important that you
think they are so wonderful that they shouldn't be changed?
What was done in the 1995 legislation that reformed or changed
securities litigation that was so important that you think it
should not be revisited? Would you please explain that?
Mr. Jasinowski. I think in general----
Mr. LaFalce. Not in general, in specific.
Mr. Jasinowski. I don't see any reason we ought to be
changing that law.
Mr. LaFalce. What did it do that it should not be changed?
What did it do specifically that is so good that we shouldn't
change it?
Mr. Jasinowski. I am not in a position----
Mr. LaFalce. All right. Thank you. OK, good. I know you
came out strongly.
Mr. Jasinowski. Again, it is not altogether new laws; I
didn't say we ought to go back and change that particular law.
Mr. LaFalce. That is the law you said should not be
changed, but it was enacted in 1995. And I want to know what
did it do that was so good that it ought not to be changed? And
I have a non-response. But I understand that this is an
institutional response as opposed to a specific response. Is
there any problem with making sure that it is the audit
committee that has the responsibility for the hiring and the
firing of the auditor? Is that a good idea?
Mr. Jasinowski. Congressman LaFalce, I particularly like
that aspect of your legislation, and I think having an
independent nominating committee making a decision about the
audit committee and establishing in-house as independent an
audit committee as you can have is a very good idea. Whether or
not you need to codify it in legislation I don't know, but I
think it's something we ought to be striving for.
Mr. Clapman. You made the point that the audit committee
should have the right to hire and fire the accountant. I think
that is embedded currently in the law. Whether it is followed
in practice is a different issue. But it does tie into----
Mr. LaFalce. What if we make it a material breach if they
do not?
Mr. Clapman. I think it already is.
Mr. LaFalce. Well, then, there is not an awful lot of
material breaches, I would suggest, that have not been----
Mr. Clapman. That is true. There is a tie-in to the
consultant aspect of what the audit firm does and why we take
the position that we do.
Mr. LaFalce. Speaking of the consultant, we do not say that
certain firms have to be auditors and can't be consultants. We
say they can't be the auditor and consultant for the same
employer. They could be a consultant for some other employers
and still retain all that capacity. And, of course, I do think
certain types of consulting such as tax should be allowed for
the same employer.
Mr. Clapman. But there is an aspect of that point that goes
to the heart of your question, and that is that the consulting
services typically will not be retained by the audit committee.
Typically, the consulting services are obtained by the
management of the company. And that is where the potential
conflict comes about: How does that firm view their loyalties?
Do they view their loyalties to the audit committee and the
shareholders, or do they owe their loyalties to the senior
management of the company? And that is the effect of having
large-scale consulting services by the same firm that does the
audit being hired by management, and how the audit firm then
assesses where their bread is buttered.
Mr. Baker. [Presiding.] We will come back for another
round.
Mr. Raines. If I could differ. My experience is different
than that. Audit committees typically are, in fact, shown the
entire workload by the audit firm, whether or not it is audit-
related or consulting, and it is the responsibility of the
audit committee to supervise that entire relationship; and in
the firms that I am aware, where best practices would include
the audit committee supervising the entire relationship,
regardless of the scope of services.
But on the scope of services issue, I would urge the
committee to make, as you are thinking about the legislation,
to not fall into these definitions of audit, audit-related, and
consulting, because they are in many ways very false
distinctions. Some of the audit-related are in fact audits of
the pension plan, and they are indistinguishable from audits of
the financial statements. So I think most people would believe
having the same auditor doing auditing is not a problem.
On the other hand, there are some things that are called
``consulting'' that look a lot like what you think an auditor
should do, such as looking and verifying information that is
going to be used for securities offerings. So, rather than
using these broad definitions, I think it is far better to try
to come up with something that says things that are consistent
with the attestation role of an auditor, where they are not to
do broad-gauge management consulting, but to provide assurance
to third parties that something is accurate. And I think that
is far better than these distinctions that are currently being
used, because I think they really confuse what it is that the
auditors are doing.
Mr. LaFalce. I think if you look at Mr. Levitt's
recommendations, they were about an inch or two thick. And
clearly, it would be the job of the SEC to articulate
regulations. We have separation between church and state, but
very often there must, of necessity, be a merger of the two. It
is absolutely impossible to have a complete separation.
Mr. Baker. The gentleman's time has expired.
Mr. Raines, I want to pursue this line you just initiated
with regard to the manner in which the Congress should act. And
I sense from a number of the other members of the panel that
with regard to the Congress being able to circumscribe current
business practice by certain definition and thereby preclude
inappropriate conduct in years to come, all of you are very
bright people who can construct a business model that would
meet whatever rule Congress comes up with, and that we should
address principles of governance and then empower the SEC to
enforce those principles where they don't already have the
authority to act--which I believe they do have authority to
act.
To that end, I think it was inappropriate for Enron
officials to have exercised no-cost options when, at the same
time, constrained employees may have been prohibited at
different intervals from acting on the exercise of their own
stock options. And if there had been a subsequent accounting,
there certainly would have been a restatement brought about
which would have caused shareholders, if they had been a viable
corporation still standing, to take significant loss while the
executives earned significant compensation during that same
environment.
Is it your understanding that participants generally in the
Roundtable, as a matter of business ethics, have in place today
some prohibition on those generalizations that I have
described? Or how can we construct rules that encourage long-
term earnings growth versus short-term profit and the extreme
pressures that I understand management faces?
Mr. Raines. I think you outlined the core problem, and let
me give you my perspective on that. For example, in our
statement with regard to the treatment of employees and
treating them fairly, I think it would be entirely appropriate
for Congress to say that one of the tests of fair treatment
under the pension laws is that the fair treatment would go to
questions of when can individuals trade or not trade. That is a
broad principle that doesn't go to the Enron case, that says in
this particular instance, here is what the rules can be. And
then the Labor Department, as necessary, can begin to elaborate
on how that might apply.
But we don't believe there should be special treatment for
one set of employees of the corporation versus another as to
when they have access to the market. And most companies have
tried to hold any such periods to be very small. But I think it
would not be unreasonable for that specification to be there,
because it establishes a principle without establishing exactly
how it should be done for all times; because, you know, 20
years ago we didn't have 401Ks. And 20 years from now we may
have something different that is in place.
But, I think the broad principle that employees should be
treated similarly in the implementation of these plans and
should not be disadvantaged vis-a-vis other employees in the
exercise of their rights to purchase or sell stock, I think is
a broad principle that would make an enormous amount of sense.
Mr. Baker. Do shareholders generally today, as members of
the Roundtable, have the authority to approve or disapprove
option plans?
Mr. Raines. The vast majority of option plans are presented
to the shareholders for approval; not all, but the vast
majority of the plans are presented to shareholders for their
approval, and they are not always approved. Indeed, a number of
the shareholder activist groups have taken very strong
positions with regard to the size of these plans, and many
corporations go to great efforts to comply with the views of
these shareholder activist groups when they put their plans
together.
Mr. Baker. I have suggested, as one incentive to preclude
manipulation of stock value, exercising no-cost option with a
subsequent restatement of earnings, to require disgorgement
within a certain time period of the restatement occurring if
there is a finding by the SEC of manipulation of stock price.
And the reason for that mechanism as opposed to the litigation
route is the SEC can act while there are still resources
available to act upon, where if we rely on litigation under
Section 10(b)(5), it could be years. What is your reaction to
that general line of thought?
Mr. Raines. Mine? With regard to disgorgement, the SEC does
have authority now to undertake that. And in cases where there
has been wrongdoing that leads to a misstatement of the
information given to the public that has a material impact on
the stock, I don't believe it is unreasonable at all for the
SEC to pursue disgorgement among the senior management of the
proceeds from options that would have occurred under those
circumstances. I think you are going to have to define who was
covered and what the circumstances will be. But as you
described the situation, that would be a prime case in which
the SEC should take action.
Mr. Baker. As a general matter for the panel, does anyone
dispute the observation that the financial statement should be
an accurate reporting of corporate financial condition for the
shareholder, and that it is not the property of the management?
Does anyone dispute that particular view? Because we had the
CEO of a significant accounting firm indicate it was a joint
property of management and the shareholder, and I found that to
be a bit distressing that that conflict would be publicly
acknowledged by a CEO of an auditing corporation.
Did you want to comment?
Mr. Clapman. Yes, I did. I just wanted to add to the
response of Mr. Raines to your question about whether
shareholders have the right to approve stock options. I think
the vast majority of the companies within the Business
Roundtable do present their stock option plans for shareholder
approval, but we have been tracking this and there are,
increasingly, companies adopting plans without shareholder
approval. So if you want to look at the direction, without some
reforms in this area, the direction is toward more plans being
put into effect without shareholder approval at the current
time.
Mr. Baker. I am sure we may come back to a second round,
but Mr. LaFalce wanted to get 15 seconds.
Mr. LaFalce. Mr. Chairman, pursuant to rule 11 of the Rules
of the House and rule 3 of the rules of our committee, I would
like to have an additional day of hearings on the matters
related to comprehensive reforms and, most particularly, both
Mr. Oxley's bill and my bill so we can see the best merits of
each.
Mr. Baker. I thank the gentleman.
Mrs. Maloney.
Mrs. Maloney. Thank you, Mr. Chairman, and welcome to all
the panelists.
I would like to ask Mr. Raines, we currently have five big
accounting firms, and with the indictment of Andersen there is
a possibility that we may soon be down to four; and doesn't the
fact that only four auditors will be reviewing the financial
statements of America's largest companies require that the
industry regulator be a stronger public entity than those that
have been proposed by the SEC? Could you comment on what the
impact may be with only four firms?
Mr. Raines. Well, I think that it is a bad thing that we
might face the prospect of having only four major accounting
firms in the United States. There are other accountings firms
other than these current five. But I think the reduction in the
number of accounting firms is not a good thing. I think
competition in that market is a good thing. I think having
multiple firms is a good thing. And that is a matter of
concern, and I hope that is taken into account in future years
as firms look to merge or otherwise reduce the number of
competitors.
With regard to an oversight body, I agree wholeheartedly
that it needs to be a strong body and needs to be one with the
power to actually investigate and the power to actually come to
conclusions and to make determinations that might include
penalties. And you ought to have on it those people who can
both instill confidence in the public, but also those people
who have some knowledge of the profession and the work to be
able to come to decisions.
But it should not be a body that is nearly honorific. It
ought to have the ability to not only discipline, but also to
look at the quality control procedures within accounting firms
to ensure that they are working to become better and they are
becoming better at what they do; because I believe the biggest
impact they could have is not on the penalty side, but it is in
quality control. It is ensuring they are hiring good people and
they are training them and they have systems of conflict of
interest in place; that they are enforcing their own internal
rules, in fact, and actually going to look and review periodic
audits and see if those audits meet standards. I think that
kind of approach from an oversight body can have a tremendous
effect on the quality of audits.
Mrs. Maloney. There were two questions that have been asked
by the prior panel by members of this company. One was rotating
auditors, your feeling on that. And another of, say, every 3
years having an auditor come in and look at the audit. And what
is your response to those two proposals?
Mr. Raines. In terms of the rotation of auditors, there are
instances, and particularly in public bodies, that do require
rotation. The concern that you have is that in the first year
and last year of the audit, you may not have the same quality
of the audit that you were looking for. I believe the SEC's
evidence is that more frauds occur in the first year of a new
audit relationship than in any other time. So I believe the
members of the Roundtable would say it ought to be on a case-
by-case basis.
In our company we have adopted the practice now of
essentially requiring a de novo review of our auditor each year
where we would have the same process we would have as though we
were doing a new audit selection, where they have to present
their credentials and identify their quality control and all
the aspects to make a determination should they continue to be
the auditor in the next year. And I think that practice can
take the place of an automatic rotation, as a rule.
Mrs. Maloney. With the proposal having, say every third
year, another auditor review the work.
Mr. Raines. Well, currently there is a process in the
auditing profession of having another firm come and do a
review. But this is a relatively private process in which the
SEC is informed of the results, but it is a relatively private
process. I personally believe that that is a process that
should be overseen by the new oversight body, and that these
reviews are used as a way to improve audits, not only to say
how did this one firm do, but what did you learn in this case,
in this type of a firm, or this type of an industry, and let
other people know so that if they run into the same problems,
they will know how to go about handling them.
We don't have a good enough feedback loop so people are
learning about what went right and what went wrong in audits.
If you have someone come in every 3 years to review the entire
audit, that is a massive undertaking for multinational
companies that may be in 100 different countries, that to go
replicate that audit would be a massive undertaking. I think it
would be impractical. But I do believe having these periodic
quality reviews, taking random audits and really thoroughly
looking at them, could be a very important learning tool.
Mrs. Maloney. Last week, former SEC Chairman Robert Hills
suggested before this committee that audit committees should be
given more formal legal status and that independent directors
should be nominated by an independent nominating committee
rather than by the CEO or chairman of a company. And what is
your view of these suggestions?
Mr. Raines. At least my experience since last fall is that
audit committees have quite a status now within corporations. I
think our general view would be that designating a particular
committee as being independent of the board itself is not a
good idea. Committees are just subsets of the boards. Audit
committees should be populated by independent directors. And
all committee assignments should be made, in our view, through
a nominating committee, and that no one person----
Mrs. Maloney. An independent nominating committee?
Mr. Raines. Nominating committee of the board.
Mrs. Maloney. But most board members are appointed by the
CEO, so then you would have the CEO control.
Mr. Raines. I don't believe the Chairman was really talking
about a nominating committee that was independent of the board.
I believe he meant an independent committee made up of
independent board members. So it would be the nominating
committee within the board that would be approving that. That
is the practice of the corporations that I am familiar with
personally in any event. Certainly the CEO is likely to have
ideas, but I also know that very often that the CEO's ideas
don't prevail in well-managed companies and that the nominating
company ultimately has responsibility of picking both committee
Members and members of the board.
Mrs. Maloney. There has been some suggestion after the
Enron debacle that there is a massive hole in our financial
services regulatory system for entities like Enron, entities
like Enron that act as financial services companies, but do not
fit the current regulatory scheme. And do you believe that
simply the reporting requirements for public companies to the
SEC is regulation enough for these companies? In many cases,
banks are very heavily regulated. And in many cases, these
entities like Enron are larger than the banks in practicing
formal banking practices. So either the bank shouldn't be
regulated or possibly these entities should be regulated.
Mr. Baker. That will be your last question, because your
time has expired.
Mr. Raines. I think you have raised an important issue. We
have been talking here about the regulation of financial
disclosures. But you are talking about as important, if not
more important, safety and soundness regulation. Enron could
have disclosed much of this and still have been unsound. And
the rise of financial institutions who are not subject to
safety and soundness regulation is a matter of concern, because
just as surely as a large regulated financial company could
cause concerns in the economy and concerns with other
investors, you could have that same concern arise with a
financial company that does not have a safety and soundness
regulator.
So I think it is important to keep in mind that we need to
have appropriate disclosure, but also we need appropriate
safety and soundness regulation to ensure that our financial
institutions are contributing to a sound economy and not
putting our economy in danger.
Mrs. Maloney. With Enron, do you think there is a gaping
hole for these type of entities? Should there be some type of
regulation?
Mr. Raines. I believe that that is an issue that ought to
be given very careful regulation. Enron was becoming a
financial company. It had no safety and soundness regulation or
oversight of any kind. And where we see very large companies
becoming financial institutions without safety and soundness
regulations, I think that is a concern.
Mr. Baker. Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. I want to go back to
a comment you had a few moments ago and this whole issue of
whether or not you preclude an auditor from providing other
services. And I agree that you don't want to get caught up in
the minutia of saying, well, it can't be this or that, and I
understand there is some synergy between tax return preparation
and auditing.
But you raise an interesting point which I was trying to
raise earlier today with Mr. Pitt; and that is, there are
certain things that auditors provide that are verification
oriented for investors. And it would seem to me, and again I
recall--you may recall from your prior experience--I seem to
recall there was an MSRB rule or other rule that precluded
auditors from providing other verification numbers in the same
issuance that was being done.
Now, I may be wrong about that, but it does seem to me that
is really what we are trying to get at. And I would be curious
and, Mr. Livingston, I would like your comments, because you
talked a little bit about this in your testimony, whether or
not if we proscribe something a little more broadly in the way
that Mr. Raines discussed it, that that would be an acceptable
form of separating out, saying if you are going to be providing
auditing for public companies and even tax return preparation
that you can't--at least in the same issuance of a registered
issuance--provide other forms of verification. Because I think
our concern is not just that there is perhaps padding of other
accounts in order to get a more favorable audit, but I think
our other concern in the case of Andersen was that they were
providing qualified opinions and verification for off-balance-
sheet financing which, had they put all the pieces all
together, they very likely would have said perhaps it wasn't
being properly disclosed.
Mr. Raines. I may not have been clear, but let me try to
answer that. It has been 20 years since I looked at any MSRB
rules. I think in my experience in dealing with entities, both
entities in financial trouble and entities that are financially
strong, is that the auditing firm often is the only consistent
source of information. And well done, they require that numbers
in one place match up with numbers in another place. And it is
a very valuable service that they provide and they typically
are very loath to sign off on anything that they haven't had a
chance to verify what the source of the information was.
And that is something we don't want to discourage companies
from having; having someone who sees all the numbers, so you
don't have a case where companies can show part of the numbers
to one audit firm and another set of numbers to another audit
firm and no one ever compares the two.
So I think you want to try to have your verification things
in one place. But I think what you don't want to do is take the
person who is doing verification and then have them doing
fundamentally different things that will get them off of what
their particular expertise is and into this.
There was an unfortunate phase in the auditing profession
where they stopped looking at themselves as auditors and
assurance firms and got into being full-scale multipurpose
professional services firms. And I think that was a mistake,
and I think most of the auditing firms are correcting that
mistake now. But I do believe that there is importance in
having one firm that looks at all the numbers when you are
verifying and making representations to the public, so you
don't have things falling between the cracks.
Mr. Livingston. I would comment, a couple of years ago when
we did pass the--the SEC enacted those rules they extended the
list of services that auditors should not do, which resulted in
a product on which they might end up relying upon. And the
problem is, is that it gets--that is a good list of things that
they shouldn't prepare the books and then audit the books or
build receivable systems and then audit receivable systems.
But the problem gets into when a company is doing very
complex transactions and they show the transactions to the
auditor. And I think in the Enron case, the auditor may have
gotten too involved in the actual design and then auditing the
transactions. It takes ethical conduct and professional
standards at the local level to regulate that gray area.
Mr. Bentsen. And I think that was the problematic situation
with respect to Enron.
Let me ask you one other question, Mr. Livingston. In your
testimony, you briefly referenced the need that your
organization is calling for to review FASB and their rules. Can
you expand upon that a little bit?
Mr. Livingston. Yeah. We have gotten into a bad
circumstance in accounting standards over the last 10 years,
and we have had accounting standards like FASB 133 which is
accounting for derivatives, which is 850 pages long and is
unusable by the most sophisticated local audit partners out in
the field. There are a handful of people in the world that know
how to apply this accounting standard. And that is the
unfortunate circumstance we have gotten ourselves into.
We have gone too far in getting away from principle-based
accounting standards. In this Enron and accounting for
derivatives, FASB 133 has exposed the need to have a new
process, a new mind-set, principle-based accounting standards
that get back to substance of reform.
When I learned accounting and I studied for the CPA exam,
there was one principle called ``substance of reform'' that we
have lost in the last 10 years. Form over substance has taken
over. And it is an unfortunate lesson, but I think the lesson
has been learned and I think we are heading toward faster
standard setting that are principle-based, that get back to
substance of reform.
Mr. Bentsen. You sound like the architects have taken over
FASB, but I always thought of FASB as being more of an
accounting-based institution, as it was. And you say it doesn't
work in its current form.
Mr. Baker. That has to be your last question.
Mr. Livingston. It has gotten too focused on narrow
problems and not prioritized. It hasn't kept pace with the
modernization of technology and hasn't thought about financial
reporting as much as here is a problem and we are going to
swarm in and spend a lot of time on that. The consolidations
project, we spent a lot of time on that. There were many of us
that encouraged the FASB to break up the consolidations
project, which they worked for 20 years on, and break it up and
focus on the SPE issue. And a lot of people said that. And they
couldn't step back and divorce themselves of the other part of
the consolidations project. They wouldn't let that go and focus
on SBEs.
And that is part of the whole problem that has been going
on for the last 10 years. I think we have a new mind-set and a
new attitude, and I think we will get to the right place.
Mr. Baker. The gentleman's time has expired.
Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman. I was going to ask Mr.
Frank Raines of Fannie Mae, a lot of what we talked about
today, one of the things we have focused on is compensation
structure and making sure that when you have got a board of
directors that you are increasing their independence and that
you are ensuring that the interests of the shareholder are
being represented there on the board and not the interests of
management. And I was going to ask, how does Fannie Mae
compensate its own board of directors and its audit committee,
with an eye toward that specific objective?
Mr. Raines. Well, it has been our philosophy for quite some
time not to concentrate the compensation of our directors or of
our management using only one tool, so we use a variety of
tools. Our board is compensated through an annual retainer,
meeting fees, and then they also have stock options. And the
idea there is to have their focus not just on what is happening
this year, but also the longer-term interest of the
shareholders.
Similarly for our executives, we compensate with a
combination of salary, bonus that is focused on 1 year's
performance. In some cases we have focused on 3 years of
performance and then options, which is for the longer term. So
we don't have any one focus. And, indeed, we provide a
disincentive to try to move the stock in the short run, because
if stock then goes down, you will disadvantage your
compensation which is not going to be paid to you for 3 or 4 or
5 years. So we found that a mix gives us the right balance,
that no one tool does the job, but also you don't overweight
toward one thing or another.
Mr. Royce. You know, if there is a best practices approach
to this, what would be gained or lost by requiring all publicly
traded companies to submit to a structure--or do you think that
is feasible?
Mr. Raines. I think you can suggest best practice, but I
don't know that any of us are smart enough to think that
something is going to work in all of these different companies.
The companies really all have different personalities and
different circumstances. So I would be loath to say that I
would know that our structure would be perfect for everyone.
But I do think that in the compensation philosophy, these are
the kinds of things that should be looked at. And, indeed, now
the SEC requires that in proxy statements there be a report
from the compensation committee stating the philosophy. And if
investors believe strongly in one philosophy or another, that
is their opportunity to communicate that to the company. And I
think that process has worked for other kinds of reforms,
including holding down the number of options so as not to
dilute the interest of the shareholders.
Mr. Royce. One other question I was going to ask. How does
Fannie Mae report management trades that occur in the company?
How do you report those to the marketplace and what timeframe
do you report those management trades in company stock?
Mr. Raines. Fannie Mae is a non-SEC registrant. It doesn't
report or use the forms of the SEC. But we have had an insider
trading compliance program for many years which prohibits
executives from trading at all, except during an open period,
and that open period only occurs after we have reported our
earnings for the quarter. So we only permit very limited
windows. All trading done during that period has to be reported
to the company, which is then--all the trading is reviewed by
our counsel and reviewed by our regulator.
We have, though, taken note of the proposals that Chairman
Pitt has suggested on contemporaneous reporting of these
trades. And so we intend starting next month to provide
contemporaneous reporting. So within several days of the
trades, we will post on our websites all trades by all insiders
of the companies. And I believe that will make us one of the
first companies to, in fact, implement the idea that Chairman
Pitt has put forward.
Mr. Royce. I think that is a good move, and I would hope
all corporations follow suit with the SEC's suggestion there.
And, frankly, I think having that reported in real-time will do
a lot to end the abuse there. But I thank you for answering
those questions.
Mr. Baker. Ms. Carson.
Ms. Carson. Thank you very much Mr. Chairman. Let me assure
you, gentlemen, that I come here with no preconceived notion in
terms of what we need to do. What I seek personally are quality
control, disclosure, consumer confidence and integrity,
business ethics, fairness, understand what constitutes
wrongdoing and how the shareholder and then the stakeholders
are protected throughout the process.
And I would also hasten to add that I think it is very
troublesome that an institution like Arthur Andersen, who has
for years been one of the premier accounting firms in this
country, has had to go down based on the acts of a few bad
apples in a bushel. I am not one who believes you need to throw
the bushel out.
I have two quick questions, one of Mr. Raines in terms of
on behalf of the Roundtable. You said it is the responsibility
of management under the oversight of the board and its audit
committee to produce financial statements that fairly present
the financial condition of the company and make sufficient
disclosures to investors to permit them to access the financial
and business soundness of the company.
Can such responsibility be legislated by the United States
Congress? I just sent back my shareholder proxy yesterday, and
always check yeah. Want to know if you want these people to be
on the board, yeah; do you want this kind of committee. It
doesn't make to me any difference because I trust the company.
I don't know how in the world Congress can legislate all
these things. And additionally, because I know we have a vote
on, there was an article in the Wall Street Journal, Mr.
Chairman, that talked about Enron, and that is why we are here,
this one company. Information was that servicing Enron's
derivatives, trading may have been used to mask weaknesses in
the company's other businesses such as fiber optic bandwidth,
retail gas and power, and water systems.
Can any of you gentlemen tell me how we can as a Congress
ensure that all of these lists of sundry outside entities under
one big umbrella can be regulated and audited so that the
stockholders and the shareholders will know fully well what the
condition of a company is?
Those were two questions. If you don't have time to answer,
you can write me, because I know we have a vote on.
Mr. Baker. Let me suggest Mr. Sherman has a remark, and if
you will work with me here, we have an end in sight; because if
you don't, we are going to have to come back after a 20-minute
delay. And hopefully that will encourage a prompt and courteous
response to Mr. Sherman's inquiries.
And thank you, Ms. Carson, for your comments. We are asking
for a direct written response, Ms. Carson.
Mr. Sherman. Thank you. I first want to comment that I hope
that we move toward the most thorough rules with all the
identifiable loopholes plugged, rather than just announce that
we want to be principles-based.
I would point out that the form over substance principle is
part of the rule now, and we never raised that, and it was
completely insufficient. I think if we all sing patriotic songs
and rededicate ourselves to form over substance, that might
work for a year or two. But eventually the people who come to
head the aggressive firms will be the aggressive financial
managers, and the firms that are selling for 25 times reported
earnings will be the aggressive firms, and maybe it will be the
aggressive firms that claim that they are not aggressive.
And I am an old tax guy and I can just imagine what would
happen if we went to a principles-based tax system. And keep in
mind, the Tax Code and FASB regulations are doing the same
things. There are two different systems for determining what
your net income is. And if we just urged taxpayers to pay their
fair share and relied on principles rather than the most
definitive rules, we would have a lot larger deficit than we
have now.
I wish I could ask a question, but you would have to stay
for another 20 minutes. What I hope that we do is have a third
day of hearings and invite those who represent investors to be
here. One of the things that I think is one of the problems in
this Enron situation is that those who represent investors,
mutual funds, pensions, are not represented in Washington given
the degree of their importance to our economy, and that most of
the people who have come before us are issuers of financial
statements, not those who read them with an interested eye. And
I look forward to a third day of hearing, but not a 1 minute of
questioning.
Mr. Baker. I want to thank each of the witnesses for their
appearance today, and I want to say a word, Mr. Livingston. I
appreciate some of the recommendations your organization has
made in the testimony today. The Chairman would want me to
encourage you, in the days that remain before the committee
would proceed to markup of this important bill, that you
forward any recommendations or suggestions based on the
exchanges you heard today. We have a significantly important
task ahead of us, and we need all the best minds we can get to
succeed.
Thank you for your testimony and our hearing is adjourned.
[Whereupon, at 2:45 p.m., the hearing was adjourned.]
H.R. 3763, THE CORPORATE AND AUDITING
ACCOUNTABILITY, RESPONSIBILITY AND
TRANSPARENCY ACT OF 2002
----------
TUESDAY, APRIL 9, 2002
U.S. House of Representatives,
Committee on Financial Services,
Washington, DC.
The committee met, pursuant to call, at 2:05 p.m., in room
2128, Rayburn House Office Building, Hon. Mike Ferguson
presiding.
Present: Chairman Ferguson; Representatives Roukema, Baker,
Gillmor, Cantor, Ryun, Biggert, Rogers, LaFalce, Kanjorski,
Watt, Bentsen, Carson, Sherman, Inslee, Shakowsky, Capuano,
Hinojosa, Israel, Maloney of New York, Meeks, and Maloney of
Connecticut.
Chairman Ferguson. The hearing is called to order.
Today, the Committee meets for the third day of hearings on
H.R. 3763, the Corporate and Auditing Accountability,
Responsibility and Transparency Act. Today's hearing is being
held at the request of the Minority.
The Chair now recognizes himself for a brief opening
statement.
Good afternoon. Welcome to the Committee's third
legislative hearing.
Last December, this Committee, which oversees the financial
and capital markets, held the first congressional hearing on
the Enron collapse and its impact on investors and employees in
the financial markets. When the Committee set out to
investigate the Enron collapse, we had several clear goals in
mind.
First, we wanted to make sure the Congress now knew how the
biggest corporate collapse in American history occurred.
Second, we wanted to work toward restoring the confidence
of investors in accounting, regulators and the rules governing
our markets.
Third, we wanted to formulate an appropriate response that
would ensure that the free market system and the regulatory
system that underpins it emerged stronger as a result of our
work.
The American people deserve to know the facts directly and
to hear them specifically from those most directly involved. I
commend Chairman Oxley for working closely with major
investigators, the Justice Department, the SEC and Enron and
Andersen's internal teams to achieve these goals.
The introduction of the Corporate and Auditing
Accountability, Responsibility and Transparency Act, or CARTA,
represents the culmination of this process. It has allowed us
to move forward and investigate comprehensive and practical
solutions that will undoubtedly strengthen the overall
financial system.
The past few legislative hearings have been very
constructive. We have heard from a diverse group of witnesses
representing a broad spectrum of views regarding the securities
market and the Government's role in protecting investors. The
distinct difference is in the testimony of these individuals,
including former SEC officials and representatives from the
securities industry, a leading consumer organization and the
accounting industry have confirmed that the Committee has taken
the necessary steps to improve the current regulatory system
through CARTA.
CARTA is clearly the product of a multitude of views and
months of work by the Committee to improve the public's
confidence in the capital markets and to strengthen the overall
financial system in the most appropriate manner. CARTA is
effective because it gets to the heart of these foundational
issues that will prevent future Enrons without drowning
businesses in a sea of red tape. It is important that this
legislation avoids the temptation to overreact and legislate in
a manner that will cripple the entire business community.
In fact, Federal Reserve Chairman Alan Greenspan has
testified that the Enron collapse has already generated a
significant shift in corporate transparency and responsibility,
highlighting the market's ability to self-correct.
Overlegislating would be counterproductive and make it
impossible for the markets to function properly.
Despite these concerns, there is no dispute that Congress
must be involved in some capacity to ensure that the free
market will emerge stronger than ever. America needs a strong,
vibrant and healthy accounting industry to keep companies
financially sound and to provide investors with solid
information. CARTA was carefully crafted by Members of Congress
to provide our current system with this base without
overstepping our boundaries in a way that could ultimately have
a negative impact on the world's strongest markets.
CARTA rightfully establishes new firewalls and increased
oversight to ensure independent reviews and avoid conflicts. It
establishes a new public regulatory body under the SEC with
strong oversight authority and prohibits firms from offering
certain controversial consulting services to companies they are
also auditing.
This legislation also requires accountants who audit
financial statements of publicly traded companies to be
federally certified by the public regulatory organization and
highlights the concept of corporate responsibility by requiring
companies to ensure their accountants are in good standing.
The oversight board has the authority to discipline
individuals who violate securities laws or breach standards of
ethics or independence.
Investors of all types rely on accurate and accessible
information to make their financial decisions. In the Enron
debacle, thousands of investors were deprived much-needed
resources to make sound investment decisions. It is an outrage
that any company would prohibit its employees from selling
their stock within their retirement plans, while at the same
time its executives were selling millions of dollars of stock
because they were privy to more up-to-date information.
This legislation meets our responsibility to shareholders
and employees of publicly traded companies who deserve to know
more and know it in real-time about a company's financial well-
being. It also fittingly prohibits corporate executives from
buying or selling company stock when 401(k) plan participants
are unable to buy or sell securities.
We have a moral obligation to ensure that safeguards are
established to prevent the disasters of this magnitude in the
future. CARTA correctly holds corporate America more
accountable to the employees and shareholders through stricter
accounting standards and stiffer disclosure requirements.
But legislating should not be the end of Congress's role in
addressing these issues. The collapse of Enron represents a
combination of irresponsible actions on the part of
decisionmakers with knowledge of the company's financial well-
being and a meltdown of the financial safeguards used to
identify problems at a stage when corrective action might still
be taken.
We must work directly with the private sector to instill a
spirit of corporate responsibility by challenging America's
business leaders to meet the highest standards of ethics and
responsibilities to their employees and shareholders.
There have been dozens of legislative measures introduced
by both sides of the aisle to address these issues. It is time
to put partisan squabbling aside and to move forward with
practical solutions that will actually help. These hearings
have helped the Committee assess the effectiveness of CARTA in
preventing future accounting and stock irregularities in
publicly traded companies. However, to ensure that no questions
are left unanswered, Chairman Oxley has agreed to this final
hearing before we move forward with the consideration of CARTA.
I want to thank the witnesses for their attendance, and at
this time I would like to yield to the distinguished Ranking
Member, the gentleman from New York, Mr. LaFalce.
Mr. LaFalce. Thank you very much, Mr. Chairman.
Let me put this in perspective. In your opening statement,
you just said that the Chairman has agreed to this hearing.
This is a hearing which we demanded as a matter of right under
the rules of the House and the rules of the Committee. The
timing for it was set over the recess for 2 o'clock today, a
day when the Congress does not begin voting until 6:30. If we
didn't demand our rights, we would have just proceeded to a
markup on Thursday with but 2 days of hearings.
So you have said it is time to put partisan squabbling
aside. What does that mean, that we should just discuss and
vote upon exclusively the bill that was prepared by the
Republican staff to the Chairman of the Committee without
Democratic input? That is not putting partisan squabbling
aside. That is just saying ``succumb to our will.'' So let us
not kid ourselves or kid the public as to is going on here.
The Minority Members of this Committee wanted today's
hearing out of a concern that we mark up legislation as soon as
Thursday on issues facing our securities markets without giving
adequate consideration to many aspects of the legislative
proposals before us. There are many aspects of the legislative
proposal before us in which no one has testified, much less
haven't had a diversity of testimony. And there have been
significant developments.
On Monday, you all read in the New York Times, the
Washington Post, and so forth, about the role of investment
banks that has been added to the Enron lawsuit. We have not
explored that. That is certainly within the jurisdiction of our
Committee. It is an important issue to which we have given no
consideration.
Today, you read in the New York Times and the Washington
Post and the Wall Street Journal, and so forth, about the
action of the Attorney General of the State of New York with
respect to securities firms who were violating their own rules,
flagrantly. These are allegations, but he was able to obtain a
court order.
Under any circumstances, though, these come within the
jurisdiction and concern of our Committee; and before we mark
up legislation, we should give attention to those issues.
It is clear to me that this should not be the last hearing
before we go to markup. It seems to me there would be a rush of
judgment, and the judgment should be a very partisan one. That
is, go along with the bill prepared by the majority staff ab
initio.
Well, there is consensus on certain things. There is a
consensus that we need a new public oversight body for the
accounting profession, but there is not a consensus on the
attributes such a regulator must have to be credible and
effective, and there has been no conversation between the
Democrats and the Republicans, at least as far as I am
concerned, on this issue.
For example, my bill explicitly establishes the powers and
duties of the new regulator, while H.R. 3763 leaves these
matters exclusively to the SEC rulemaking, effectively leaving
these rules up for jump ball, totally up to the SEC.
Now, certainly the SEC must make rules and they must have a
certain amount of discretion, but I think, given what we have
seen, we ought to have certain legislative powers that are
clearly established. And that is a serious issue. I think that
the new regulator should have the authority to set quality
standards rather than just enforcing industry standards and
should have clear disciplinary and investigative powers. And
that is not in the Chairman's mark, and it is in my bill.
We need a discussion of that issue. What should the
legislation have? Should the legislation establish the clear
disciplinary and investigative powers of the regulatory body?
Auditor independence. We have barely scratched the surface
in considering that issue. We have not discussed the services
that create conflicts for the auditor or measures to give the
audit committee authority to determine the non-audit services
the auditor should provide. Other corporate governance reforms
that would enhance the functioning of the audit committee and
are inextricably linked to auditor dependence. As the Enron
collapse made sure, we also must ensure that the independent
directors of our public companies are truly independent.
Now, my bill includes these provisions. They deserve
further discussion. They have not been discussed before our
Committee.
The Committee has given little consideration to the role of
the securities analysts in the Enron collapse. My bill would do
more to reduce the conflicts that cause analysts to look the
other way when companies present rosy but misleading pictures
of financial health.
As the New York State Attorney General said yesterday in
bringing action against Merrill Lynch, such actions jeopardize
the integrity of our securities marketplace, and we should
examine that issue fully.
Finally, we must consider the need to enhance the ability
of private litigants to enforce the securities laws,
particularly with respect to aiding and abetting by accountants
and other professionals. We restored the ability of the SEC to
bring aiding and abetting actions in 1995, and we should
consider restoring the ability of private litigants to do the
same, and we have had no hearing devoted to that extremely
important issue.
Further, I am pleased to announce that today I introduced
another bill, a bill that would give legislative substance and
real teeth to meritorious portions of President Bush's 10-point
plan on corporate disclosure and accountability. The Corporate
Responsibility Act of 2002 requires disgorgement of incentive
compensation and certification of financial statements and
allows the SEC to administratively bar unfit officers and
directors from serving in public companies.
There is much to be done. I look forward to working with
Chairman Oxley and all of the Members of the Committee to bring
about a strong legislative response. I think we need additional
time and hearings and consultation and conversations and
compromise in order to bring that about, and I thank the Chair.
Chairman Ferguson. The gentleman's time is expired.
The gentlelady from Illinois, Mrs. Biggert, you are
recognized for an opening statement for 5 minutes.
Mrs. Biggert. Thank you very much, Mr. Chairman.
Mr. Chairman, this morning hundreds of Andersen employees
in my district rolled out of bed with a simple question on
their minds. When I return home tonight, will I still have a
job? If I do make it through the day, will my job be there at
the end of the week or the month? Sadly, for many of them, the
answer will likely be no. Through absolutely no fault of their
own, they will be looking for employment elsewhere. As Andersen
finalizes plans to cut its workforce, my thoughts and prayers
are with the more than 500 Andersen employees in my district
and the thousands more across the Nation who had nothing
whatsoever to do with the case at hand, but nonetheless are
feeling the aftershocks.
We can debate privately or publicly the end result of the
actions taken over the past months and how actions can lead to
unintended consequences. As one Andersen employee from my
district asked in a letter to me last week, if one out of our
535 Congressman and Senators gets in trouble, should you all be
fired? The short answer is no; and yet it is true that, to a
certain extent, we all lose public confidence when one Member
abuses his or her office. It is not right, and it is not fair,
but it is what happens.
I think everyone can agree that change is needed in the
accounting industry, and I think several good proposals are on
the table. We must, however, strike the right balance to ensure
that the decisions we make in the coming days will help solve
the problems at hand without creating those unintended
consequences down the road.
H.R. 3763 is an important step in the right direction. With
this legislation, we will avoid any more blanket charges
against groups of accountants and instead punish the particular
accountants at fault. H.R. 3763 provides more immediate and
closer scrutiny of the accounting profession in general and
specific accountants in particular.
I should add that, at the same time, there is much more
that the accounting industry must do. They should not wait for
Congress to point them in the right direction.
A good place to start is with the recommendations of former
Federal Reserve Board Chairman Paul A. Volcker. I commend the
efforts that he has made to begin to restore some of the
credibility that is much needed in the accounting profession.
I look forward to hearing from the witnesses today and
thank you very much and yield back the balance of my time.
Chairman Ferguson. The gentlelady yields back.
The gentleman from California, Mr. Sherman, is recognized
for 5 minutes for an opening statement.
Mr. Sherman. Thank you very much.
It is good that we are having these hearings. It is
unfortunate who is not here. We have those very many
organizations who don't get fees as investment bankers, but do
control trillions of dollars of capital--professional
investors, mutual funds, pension advisers--who have been, I
think, underrepresented in the overall process before Enron and
even after Enron in giving us guidance as to what information
they need and what steps need to be taken so that they can rely
on that information.
CARTA I think is a good bill, but it is less than the
minimum we should do, and I think our constituents will be
unimpressed with those Members of this Committee who vote for
final passage of CARTA, but vote against the amendments
necessary to make it a strong enough and meaningful enough
piece of legislation.
Alan Greenspan is correct when he points out that there has
been a shift in business culture so that the greatest abuses of
the past will not be repeated in the immediate future, but that
is only the immediate future. The pressures that created the
atmosphere of 2001 will return within a few years. The hottest
executives at the hottest companies will be those reporting the
hottest growth in their earnings and reporting the lowest
liabilities. We need to legislate, not just rely upon what I
fear is a short-term change in the business culture.
There are three amendments I am certain to offer to this
bill.
The first is to tell the SEC they have to read the
financial statements of the 2,000 largest companies every year,
and then when they find something that is incomplete or
confusing, they will then demand that additional material be
filed. The request or demand for additional information will be
immediately public. The material filed in response would be
made immediately available to the public, and this is an answer
to the fact that an awful lot of what is in those Enron
financial statements isn't false. It is just unintelligible.
Not unintelligible to the uninitiated. Unintelligible to
anyone. The SEC doesn't read the financial statements filed by
the big companies. They only read financial statements filed by
the small companies. That has got to stop. And by the small
companies, I mean the IPOs.
Second, Arthur Andersen was the one of the Big Five--then
Big Five--that had its salespeople, the people in charge of
selling more services to Enron and collecting the fee, the
engagement partner, in final control of whether to sign the
audit opinion. The other Big Four accounting firms--or the
other of the Big Five--put their quality and technical review
people in charge of making that final decision. We should not
leave it to the accounting firms to structure themselves any
way they want. The people insulated from the sales decision and
who are steeped in accounting literature need to make the final
decision.
Finally, Mr. Chairman, recently Arthur Andersen indicated
that, while it had offered over $700 million to settle, it was
now cutting its offer to only $300 million because, oops, they
don't have any capital. We need a minimum capital requirement
for accounting firms of at least half a year's audit fees.
Right now, Arthur Andersen is saying they don't have any money
to pay those damaged by their inaction, and we cannot tell
accounting firms that they can go practice virtually without
malpractice insurance, with virtually no capital and then, if
they make a mistake, the investors get nothing.
There are two other issues. One is that if we are going----
Chairman Ferguson. If the gentleman could just wrap up
here.
Mr. Sherman. OK.
Chairman Ferguson. We are past expired.
Mr. Sherman. My time is expired. Let me simply say that
those who don't learn from history are doomed to repeat it, and
those who do not pass legislation triggered by recent history
are doomed to see those same mistakes repeated.
Chairman Ferguson. The gentleman's time is expired.
The Chair recognizes the gentleman from Louisiana, the
distinguished Chairman of the Subcommittee on Capital Markets,
Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman.
I think in the aftermath of the demise of one of the
largest corporations in American enterprise it would be
inappropriate for us to rely on additional lengthy studies or,
worse yet, lengthy investigations with a failure to act. It
would be really unacceptable consequences for the market as
well as individual investors, and if we start in good faith
today and act quickly, I can suggest to you that the
congressional process will require a very long and tortuous
path before we all wind up in the Rose Garden and exchange good
wishes. So moving quickly at this juncture is not ill-advised.
I think it is highly appropriate, especially in light of the
fact the SEC, FASB, the GAO, the SROs and many other outside
observers all have strongly held opinions about the directions
we should be taking, coming to the consensus those elements
will be enhanced by the legislative process. And I think it
entirely appropriate for us to proceed.
I am particularly pleased with the panel of witnesses we
have here today, to get their insights on the remedies
appropriate in light of the consequences we face and to quickly
implement not only their recommendations, but the 10-point plan
outlined by the President, which I think was responsive to our
current difficulty.
In fact, there are too many employees today watching every
morning the fund balance in their 401Ks erode. Where retirement
plans were certain, now we are thinking about second careers.
The consequences of this are enormous not just for the
individual employee, but for capital formation itself. The
enhanced volatility in market performance is directly related
to the fear that there is an undisclosed liability or
inappropriate revenue stream that is not creating a correct and
accurate picture of true financial condition. We all agree,
disclosure, transparency and consequences for those who fail to
comply by the rules. I think how we construct those rules are
the difficult aspect, but as to the principles underlying the
resolution of this terrible difficulty, I think we are in
agreement, and we should move forward.
Thank you, Mr. Chairman.
Chairman Ferguson. The Chair recognizes the gentleman from
North Carolina, Mr. Watt, for an opening statement, 5 minutes.
Mr. Watt. Thank you, Mr. Chairman. I hope I don't take 5
minutes, but sometimes we don't know how long these things will
take.
I, during the consideration of the Gramm-Leech-Bliley bill,
was accused of being one of the few Members of the Committee
who actually read the bill, and I have to confess that I have
made the same mistake again, this time over the break. I have
actually been reading these bills, and I want to start by
saying something complimentary about the Chairman's bill. It
clearly moves in the right direction. It would be a substantial
improvement over nothing, and I think we should keep that in
mind, but I hope that this hearing today and the markup itself,
if we are going immediately to a markup, will result in a
deliberation about improvements or revisions that can be made
to the bill to make it stronger.
I think there are a number of instances in which I would
prefer to have stronger language, stronger provisions in a
number of respects. The Chairman's bill punts just a whole
panoply of issues to the Securities and Exchange Commission or
other bodies. Maybe some of that is necessary and desirable to
get more information and input over time, but I think there are
some basic principles that the legislative process has already
agreed upon or should agree upon to put into the bill before we
punt the rest of it to the SEC for further study.
The way to get there can be one of two ways. We can either
do it by discussions off the record outside the context of a
markup, or we can have a very, very protracted markup. Because,
as many of you remember in the Gramm-Leech-Bliley process,
there will be a number of amendments to be debated and
considered. If we don't have the opportunity to put those
amendments into the process, have some discussion about them
before we get to the markup, then I think this markup is going
to be a lot longer than perhaps is being contemplated at this
point.
So one of the things I particularly feel strongly about is
that there is a very important role for private litigants to
enforce rights in this context. We can't give responsibility
solely to the SEC and say you have got absolute authority to do
this, and if you don't do it, then nobody is going to have the
authority to do it. Our whole accountability system in this
country is based on the rights of individuals to hold
corporations and other individuals accountable when they feel
like they have been wronged. So, at a minimum, we need to put
some of those provisions in the bill to provide for private
litigants to protect their own rights, and that I think is a
hallmark of the way our system should work.
I appreciate the gentleman bearing with me, and I will
yield back the balance.
Chairman Ferguson. The gentleman has, in fact, used the
balance of his time.
The Chair recognizes the gentlelady from Illinois, Ms.
Schakowsky, for an opening statement for 5 minutes.
Ms. Schakowsky. Thank you.
I want to thank the Chairman and particularly Ranking
Member LaFalce for his leadership in assembling these witnesses
here today that I think will make a very important contribution
to the ultimate legislation, and I want to associate myself
with the concern expressed by my colleague from Illinois for
the Andersen employees who have, through no fault of their own,
lost their jobs. For this reason, as well as many others, it is
important that we do act in order to prevent those kinds of
layoffs and to protect investors and pension holders from
conflicts of interest and from corporate greed.
We all know that, if not for Enron's collapse, we would
almost certainly not be considering these important matters
today. I am concerned that some want to characterize the Enron
collapse as just a case of one bad actor in the marketplace. I
disagree with that interpretation, as I think do most people on
this Committee, and that is why we are considering legislation.
Because Enron's collapse does have systemic causes. Corporate
boards of directors, Wall Street analysts and the Big Five
accounting firms all have an economic incentive to provide
biased analysis of large profitable companies.
Enron used its political ties to persuade the Government to
carry out its business plan. Just take a look at California.
President Bush, his regulators and congressional Republicans
who opposed price caps for consumers, while Enron manipulated
the market, causing the energy crisis. Enron had incredible
access to the White House. President Bush received over
$736,000 throughout his career as an elected official. Vice
President Cheney had at least six meetings with Enron officials
while drafting the Administration's national energy plan.
Enron's economic and political power effectively muted people
who were skeptical of the company's economic stability. Enron
is not an isolated case, and this is not only a business
scandal, but I am afraid it is also a political scandal.
The fact of the matter is we do not have the laws and
procedures in place to protect common investors. If we don't
take swift action, I have little doubt that corporate
executives' greed and deception will victimize more people.
Simply relying on free market dogma will not suffice.
Employees and pension managers must be involved in corporate
decisionmaking. Boards that are dominated by corporate
executives are inherently flawed.
Enron's collapse had a significant impact on working
families. In the case of Enron, hard-working people lost their
life savings, while Enron's executives gained millions. It is
estimated that Illinois' State pension fund lost $25 million.
That means that hard-working teachers, police officers and
firefighters who worked for the public good may not be able to
enjoy their hard-earned retirement, and that I don't think is
what public servants deserve for their future.
Of course, I agree that we must proceed in a careful and
deliberate manner, but we must proceed. That is why I am a
proud cosponsor of the Comprehensive Investor Protection Act,
and I look forward to making sure that, as we move to the
markup, that critical provision of that bill will be included
in any measure that passes out of this Committee. This
legislation will help protect investors and workers in the
future.
I thank Congressman LaFalce for his efforts on this
legislation. We have the responsibility to enact significant
reforms. I look forward to hearing the witnesses' testimony
today, and I yield back. Thank you.
Chairman Ferguson. The time of the gentlelady is expired.
The gentleman from Texas, Mr. Hinojosa, for 5 minutes for
an opening statement.
Mr. Hinojosa. Thank you, Mr. Chairman.
I want to say that I come from Texas. I have travelled
throughout my district, and that is the first thing that our
constituents want to know, just what are the members of the
financial services going to do with regard to the losses that
they have experienced, and I am looking forward to listening to
the witnesses today so that, as we go through the markup, that
we can make intelligent decisions and come up with a national
policy that is going to protect not only the investors, but
protect employees of Andersen and companies like Andersen who
have lost their jobs as a result of somebody at the top who
made decisions that obviously were incorrect and very damaging.
I look forward to listening to the facts that the witnesses
are going to present, because I am very interested in both of
the bills presented by Chairman Oxley and our Ranking Member
that I think is much more comprehensive and one that is, in my
opinion, going to be necessary to consider and give every
opportunity to pass through this Committee so that it can go
down to the whole Congress. Mr. LaFalce, I commend you for the
comprehensiveness of the bill that you have given us to
consider, and I yield back the balance of my time.
Chairman Ferguson. The gentleman yields back.
The gentleman from New York, Mr. Israel, for 5 minutes for
an opening statement.
Mr. Israel. Thank you, Mr. Chairman.
I also spent a considerable amount of time in the last 2-
and-a-half weeks travelling throughout my district and hearing
from constituents who routinely asked what we are going to do
to ensure the integrity of investments; and I want to commend
the Ranking Member, Mr. LaFalce, for the work that he has done
on his bill. I also commend our Chairman for his work.
Ultimately, it is my hope to support legislation that has a
number of features: number one, that provides the strongest
oversight protections; number two, that facilitates
transparency; number three, that ensures accountability; and,
finally, that ensures an even standard among investors and
management.
I look forward to working with my colleagues on the
Committee to these ends, and I yield back the balance of my
time.
Chairman Ferguson. The gentleman yields back.
The Chair sees no other Members seeking time for an opening
statement.
The Committee will now hear testimony from our panel of
witnesses. We thank the witnesses for their patience and for
their presence here today. They are, from the Chair's left to
right, the Honorable David Walker, Comptroller General of the
United States, U.S. General Accounting Office; the Honorable
Richard Breeden, former Chairman of the SEC, now with Richard
C. Breeden and Co.; Professor Donald Langevoort from the
Georgetown University Law Center; and Mr. Damon Silvers,
Associate General Counsel of the AFL-CIO.
Mr. Walker, you are invited to give your testimony. You
have 5 minutes. Thank you for being here.
STATEMENT OF HON. DAVID M. WALKER, COMPTROLLER GENERAL OF THE
UNITED STATES, U.S. GENERAL ACCOUNTING OFFICE
Mr. Walker. Thank you, Mr. Chairman, Members of the
Committee.
With your permission, I would like the entire statement to
be entered into the record.
Chairman Ferguson. Without objection, so ordered.
Mr. Walker. Thank you. I will now summarize that statement.
I appreciate the opportunity to share our perspectives on a
range of issues emanating from the sudden and largely
unexpected bankruptcy of Enron Corporation and financial-
related activities relating to several other large
corporations.
As the Committee knows, GAO has conducted an extensive
amount of work dealing with the accounting profession and has
issued a number of reports over several years. More recently,
in order to assist the Congress in framing needed reforms, on
February 25th, 2002, we convened a forum on corporate
governance, transparency and accountability to discuss a
variety of systemic issues. On March 5, 2002, we issued
highlights of the forum meeting which, Mr. Chairman, we will
make available for the record if you so desire.
As you requested, my comments today will primarily focus on
oversight of the accounting profession and related auditor
independence and corporate governance issues raised by Enron's
failure.
The issues raised by Enron's failure are multi-facetted,
involving many different problems and players with various
roles and responsibilities. In that respect, needed changes to
the Government's role should vary depending upon the specific
nature and magnitude of the problem. Specifically, the
Government's role can range from direct intervention to
encouraging certain non-governmental and private sector
entities to take certain steps designed to enhance trust and
better protect the public interest.
With regard to the possibility of a new oversight body, the
issues of fragmentation, ineffective communication and
limitations on disciplines surrounding the accounting
profession's self-regulatory system strongly suggests that the
current self-regulatory system is not adequate in effectively
protecting the public's interest, particularly in the auditing
area. We believe these are structural weaknesses that require
congressional action. Specifically, we believe that the
Congress should create an independent statutory Federal
Government body to oversee financial audits of public
companies.
The functions of the new independent body should include:
Establishing professional standards dealing with auditing
standards, including standards for attestation and review
engagements, independence standards, and quality control
standards, for both public accounting firms and key members of
those firms who audit public companies.
Second, inspecting public accounting firms for compliance
with applicable professional records and standards;
And investigating and disciplining public accounting firms
and/or individual auditors of public accounting firms who do
not comply with applicable professional standards.
This new body should be independent from, but should
closely coordinate with the SEC in connection with matters of
mutual interest.
There are alternative models which we would be more than
happy to discuss if you so desire.
In addition, we believe that the issues concerning
accounting standard-setting can be addressed by the SEC working
more closely with the FASB, rather than putting that function
under the new body.
The new body should be created by statute as an independent
Federal Government body. The new body should have resources of
funding independent from the accounting profession. For
accountability, we believe the new body should report annually
to the Congress and the public on the full range of its
activities, including setting professional standards,
inspections of public accounting firms and related disciplinary
activities. The Congress may wish to have GAO review and report
on the performance of the new body after the first year of its
operations and periodically thereafter.
We believe that the effectiveness of boards of directors
and committees including their working relationship with
management of public companies can be enhanced by the SEC
working with the stock exchanges to enhance certain other
listing requirements for public companies.
We also believe that the issues surrounding the financial
reporting model can effectively be addressed by the SEC in
conjunction with the FASB without statutorily changing the
standard-setting process. However, we do believe that more
active and ongoing interaction between the SEC and the FASB is
needed in order to facilitate a mutual understanding of
priorities for standard setting, realistic goals for achieving
expectations and timely actions when expectations are not met.
Over the last decade, securities markets have experienced
unprecedented growth and change. At the same time, the SEC has
been faced with an ever-increasing workload and ongoing human
capital challenges, most notably high staff turnover and
numerous staff vacancies. We believe it is important for the
SEC to be provided with the necessary resources to effectively
discharge its current and any increased responsibilities that
the Congress may wish to give it.
Finally, we believe the SEC should be directed to report
annually to the Congress on certain matters that I outline in
my testimony.
In closing, Mr. Chairman and Members of the Committee, the
United States has the largest and most respected capital
markets in the world. Our capital markets have long enjoyed a
reputation of integrity that promotes investor confidence.
However, this long-standing reputation is now being challenged
by certain parties.
Today, I have discussed our suggestions to assist the
Congress in crafting needed reforms. We strongly believe that
an independent Federal Government body created by statute to
regulate audits of public companies is needed in order to
better protect the public's interest. However, currently we do
not believe that it is necessary or appropriate for the
Government to assume direct responsibility for other key areas,
such as generally accepted accounting principles or corporate
governance requirements. We do, however, believe that Congress
should provide the SEC with direction to address certain
related issues.
In the end, no matter what system exists, bad actors will
do bad things with bad results. We must, however, strive to
take steps to minimize the number of such situations and to
hold any violators of the system fully accountable for their
actions. Thank you, Mr. Chairman.
[The prepared statement of Hon. David M. Walker can be
found on page 422 in the appendix.]
Chairman Ferguson. Thank you, Mr. Walker.
I would ask the witnesses to do your best to stay within
the 5-minute time constraint, something that we all up here
have enough difficulty doing on our own. Thanks very much.
Mr. Breeden, 5 minutes.
STATEMENT OF HON. RICHARD C. BREEDEN, FORMER CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION, RICHARD C. BREEDEN & CO.
Mr. Breeden. Thank you, Mr. Chairman, Ranking Member
LaFalce, Members of the Committee. It is a great pleasure to
have the opportunity to testify before you today at your
request to discuss the provisions of H.R. 3763 and H.R. 3818,
as well as to address various issues raised by the Committee
arising out of the tragic and disturbing events at Enron.
I had the great privilege of serving as Chairman of the
Securities and Exchange Commission back when dinosaurs roamed
the earth. It was an era in which we were successful in passing
several major pieces of legislation, both when I was in the
White House, the savings and loan reform legislation and the
Market Reform Act and Securities Enforcement Remedies
Enhancement Act of 1990. And both in our legislation and the
work of the Commission in that era, I had the great pleasure of
working with both sides of the aisle in Congress.
It has been a great tradition in the area of financial
services regulation and particularly in the areas governed by
the SEC of bipartisanship, and it is a good thing to see you
working together to try and address these problems. It is
important that that tradition of bipartisan cooperation remain
the prevailing spirit in this area.
At the outset, I would like to congratulate all the Members
and the staff of the Committee for the fine work you have done
in developing legislative proposals to respond to the
weaknesses in our current system that this situation has
brought to light. Both bills contain many sensible provisions
that should enhance our extremely good system and make it more
resistent to problems in the future. Both bills follow
generally similar principles and demonstrate many areas of
common agreement. This is particularly apparent in the
provisions of both bills concerning a new approach to oversight
for the accounting profession, enhancements to the quality and
speed of disclosure and enhancing healthy practices in
corporate governance.
While H.R. 3818 goes beyond the provisions of H.R. 3763 in
a number of areas, it appears clear to me that there is good
common ground in the two bills and plenty of room to craft a
bill that is reasoned and measured. Certainly the President has
shown leadership in this area as well, and with Presidential
leadership in both Houses of Congress and both parties
considering these issues, there is plenty of room to try and
craft a bill that would reflect a consensus approach to these
issues.
Of course, some have said the market has already fixed all
of the problems of Enron, and with that I respectfully
disagree. There is no question the market has reacted to the
events at Enron. Boards of directors and audit committees are
more sensitive and wary about conflicts and overstatements of
income. Many people have learned more about SPEs than they ever
thought they would learn in their life in recent weeks, and I
doubt if many boards will be suspending corporate codes of
conduct and conduct standards any time soon.
Hopefully, auditors at other firms realize both the
importance of sharing concerns with the audit committee, rather
than keeping silent about major issues and alternatives, and
investors are exacting a price from companies where they
perceive a higher level of accounting risk and lower levels of
transparency. These are all very healthy and welcome
developments.
While improvements have been made, market responses can be
short-lived, and many memories can be too short. Unfortunately,
companies that don't need the reforms often adopt the better
practices, but companies that pose the greatest risk to
investors may not change their policies at all.
There are many issues involved in the Enron-Andersen case
that cannot be solved entirely by market, and there is not any
reason we should be reluctant to admit where our system has
weaknesses we should address.
The system for oversight and discipline of the performance
of audit firms and their personnel is one area that would
benefit from a legislative change. Our previous system of peer
review and self-regulation of certain types of issues through
the Public Oversight Board did not work. The SEC needs at least
some additional resources to allow it to handle the volume of
financial fraud cases it should be pursuing, as well as
providing more frequent review of filings by high cap and
widely held issuers.
Legal standards today for disciplining accountants and
their firms for audit failures are subject to more litigation
than is desirable. Certain enhanced types of remedies such as
stronger officer and director bars and disgorgement authority
to recover profits on sales of stock by insiders prior to a
bankruptcy would be desirable. Standards need to be set
regarding consulting services by audit firms for audit clients,
and the system for developing and interpreting accounting
principles through the FASB needs to be improved.
These and other modest steps can complement market
disciplines and help restore balance and confidence to our
system. None of these steps need involve excessive regulation
or interference with healthy market developments.
In drafting the specific bill, we should not stake all on
trying to do too much, and we should not allow ourselves to do
too little. We have to make sure, for starters, that existing
law is vigorously enforced, because much of the Enron-Andersen
case involves violations of existing laws. Beyond that, you
have identified a number of reasoned and careful steps that
will enhance the qualities of the existing system.
My written testimony responds to a number of questions from
the Committee, and I would be happy to discuss any of those
questions further, and I would only like to very, very briefly
summarize my views on the establishment of a new oversight body
for the accounting profession.
Both bills contain provisions concerning establishment of a
new oversight body. In my testimony I urge you not to create a
new governmental body, but rather to reinforce the role of the
SEC in dealing with such issues. Whatever body is created and
whatever its exact mission, any such group should be a private
sector entity with oversight by the SEC. We should not repeat
now the mistake that was made when the CFTC was created that
set us on a course of endless competition of jurisdiction
between Government bodies with closely paralleled missions.
The SEC is there. It has the history, the culture and the
tradition and the tools for dealing with these kind of
problems; and it should be the body that then provides
oversight to an effective self-regulatory organization, along
the lines of the NASD or the New York Stock Exchange. There the
organizations have strong staffs, a good record of promoting
healthy ethics and law enforcement, while not creating
additional Government bodies.
Again, thank you very much for having me, and I commend the
strong efforts of both parties to date in seeking to build
legislation that can command broad-based support. Our
disclosure and accounting system has stayed viable over the
years because we have not been afraid to learn from major
problems and to change some of the rules of the game. In my
judgment, this case demands a reasoned and measured response,
but a response nonetheless. Thank you.
[The prepared statement of Hon. Richard C. Breeden can be
found on page 454 in the appendix.]
Chairman Ferguson. Thank you very much.
Professor Langevoort, you are recognized for 5 minutes for
an opening statement.
STATEMENT OF PROFESSOR DONALD C. LANGEVOORT, GEORGETOWN
UNIVERSITY LAW CENTER
Mr. Langevoort. Thank you, Mr. Chairman, and let me try and
be very brief.
The last few months have brought public attention to bear
on the seriousness of a problem--that economic forces have
increased the temptation and techniques many companies'
executives face to be dishonest with the investing public and
that these temptations and techniques have translated into an
unacceptable level of corporate fraud, mismanagement and
concealment.
My invitation here today is not to address all of the
possible reforms that could come from this but, rather, touch
on private securities litigation as one touchstone for reform;
and I will try to be very, very brief by focusing my oral
remarks, as opposed to my written testimony, on the two reforms
that I consider most important and indeed whose merits to me
are beyond doubt.
First, restoring a system in which those who aid and abet
securities fraud become liable to the victims. When the Supreme
Court in 1994 eliminated aiding and abetting and private rights
of action, it didn't do so on policy grounds or through careful
legal reasoning. Rather, it said, as a matter of statutory
construction, that job is for Congress, not the courts. I urge
you today to take up the court's invitation and respond
accordingly.
It is very difficult to argue that somebody who provides
substantial assistance to a securities fraud shouldn't have to
compensate the victim. The common law has for centuries imposed
that liability. Congress has recognized that aiding and
abetting is a Federal crime and in 1995 gave the SEC specific
authority to proceed in that direction. It is clearly wrongful.
Why then wouldn't you make the aider and abetter compensate the
victim? The answer, we are told, is fear of litigation abuse,
that these kinds of claims can be abused.
Now, I have to confess, I am one of those people who takes
litigation abuse seriously. I think Congress in 1995 acted
appropriately in addressing the issues, even if I don't agree
with all of the specific outcomes. But litigation abuse and its
fear is no excuse for saying that somebody who provides the
brains, the talent, often the motivation behind a fraud should
avoid responsibility to the victims simply because their
appearance is not made visible to the investing public, and
sadly that is the state of the law that we have today. Those to
whom the fraud is not attributed and who are not identified to
the investing public have grounds to avoid liability.
It seems to me clear that we ought to change that rule in
the name of common sense, without regard to debate about the
statistics of whether the incidence of private securities
litigation has gone up or down. It simply makes sense to impose
liability on those people.
Second, the other reform I want to address in my oral
testimony is redressing the rather foolish statute of
limitations that we have today for private securities actions.
The Supreme Court once again gave us this rule, again as a
matter simply that since Congress hadn't done anything about it
since 1934, who are we to impose a different standard? The
result is that we have in private securities litigation a rule
that was adopted in 1934 before Rule 10b-5 existed, before
class actions existed, before the depth of our securities
markets and its breadth could have been imagined. It is silly
to assume that a rule adopted then should be the rule adopted
today simply a result of history.
That rule that actions have to be brought within 1 year
after notice is much too short today to develop a complex,
well-grounded lawsuit. And, even worse, the rule that if
somebody can hide the fraud for 3 years they get away
completely simply as a result of their success is also
something that makes no sense in our highly complicated, highly
complex financial markets.
Now, I make no claims that these two reforms or the others
that I address in my written testimony would prevent the next
Enron, would change things dramatically, but they are very
important first steps, very important pieces of the puzzle that
we ought to take as we begin to address the problem.
Thank you.
[The prepared statement of Prof. Donald C. Langevoort can
be found on page 482 in the appendix.]
Chairman Ferguson. Thank you very much.
Mr. Silvers, 5 minutes for your testimony. Thank you for
being here.
STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL, AFL-
CIO
Mr. Silvers. Thank you and good afternoon, Mr. Chairman,
and Ranking Member LaFalce.
On behalf of the AFL-CIO 65 member unions and our 13
million working family members, I want to thank the Committee
for the opportunity to appear here today.
The collapse of Enron and similar events at Global
Crossing, Waste Management and other public companies are a
window into a set of pervasive conflicts of interest that
defeat the purposes of corporate governance and threaten the
retirement security of America's working families.
This Committee has heard in prior hearings from those who
would still have you believe what Enron used to preach in this
town, that unregulated markets will solve all problems if they
are just left alone. Now that may be the view from the K Street
offices of the people who do the heavy lifting for the audit
firms here in Washington, but it is not how things look for
thousands of working families in Houston and Portland, Oregon,
and Rochester, New York, and clearly in Chicago who have lost
their jobs or their retirement savings and their health care
because they believed what they were told by their employers,
by their employers' accountants and the analysts that
interpreted the accountants' numbers.
H.R. 3813, the aptly named Comprehensive Investor
Protection Act of 2002, is the most comprehensive legislation
introduced in this Congress in response to the conflicts of
interest in the capital markets and in the boardrooms of
America's public companies.
Let me briefly review the areas where Congress needs to act
to protect investors, the provisions of H.R. 3818 that respond
to that need, and the key differences between H.R. 3818 and
H.R. 3763, which the Chairman discussed in his opening remarks.
First, public company boards need strong, independent
directors, so investors need complete disclosure of all the
ties that exist between the board members, the company and
company management. H.R. 3818 requires just that, while 3673
has no such requirement. This higher standard of independence
should be the relevant standard for measuring the independence
of company auditor and compensation committees.
Furthermore, shareholders should have access to
management's proxy not just for shareholder proposals on a
handful of subjects, but for director candidates, independent
director candidates. We urge these corporate governance
provisions be added into any reform package this Committee
takes up.
The second area in need of reform is the practice of public
accounting. Here again H.R. 3818 takes the right approach to
auditor independence by giving the SEC the authority to ban a
wide range of consulting by auditors and requiring that the
audit committee or the full board of directors of a company
approve in advance the provision of consulting services by the
company's audit firm that are still allowed by the SEC.
In contrast, H.R. 3673 bars only certain types of
consulting and would allow the sorts of consulting that led to
the most egregious abuses at Enron by Arthur Andersen to
continue.
The next issue is auditor oversight. Former SEC Chair
Arthur Levitt has outlined in testimony before the Senate
Governmental Affairs Committee what we believe are the key
characteristics of a much-needed auditor oversight body:
members independent of the Big Five, full investigative and
disciplinary powers, and independent funding. H.R. 3818 creates
a public accounting regulatory board that meets these tests.
H.R. 3763's provisions do not meet these tests.
Then there are the Wall Street analysts. H.R. 3818 requires
the SEC to ban analyst compensation tied to investment banking
performance. The Majority's bill goes no further than requiring
a study.
All these reforms, though, are of little benefit if there
is no enforcement. The Ranking Member's bill provides both
adequate resources to fund pay parity for the SEC and to expand
the Commission's oversight and enforcement activity. The
Majority's bill has no such provision.
Finally I want to address the ultimate accountability
measures available to shareholders: recourse to the courts. As
Professor Langevoort has mentioned, the restoration of
investors' right to sue those who aid and abet securities fraud
is a vital and important step that must be taken immediately. I
would add, in addition to the statute of limitations issue,
that the restoration of joint and several liability is critical
in cases where the wrongdoers start filing for bankruptcy.
These provisions are included in H.R. 3818 and not in the
Majority's bill.
In conclusion, H.R. 3818 gets at the heart of the problem
of conflicts of interest, whereas H.R. 3763, the Majority's
bill, leaves untouched the central conflicts of interest,
conflicts of interest that brought us Enron and will no doubt
continue to cause losses to workers' retirement savings if not
addressed. At the heart of what happened at Enron are systemic
problems that need systemic solutions. These solutions will no
doubt offend powerful interests, but they will protect
America's working families. H.R. 3818 contains within it these
necessary solutions and has the AFL-CIO's strong support.
The AFL-CIO is grateful for the opportunity to share our
views with the Committee on these bills and welcomes the
opportunity to continue to work with the Committee as you move
forward in addressing these important issues. Thank you.
[The prepared statement of Damon A. Silvers can be found on
page 492 in the appendix.]
Chairman Ferguson. Thank you very much to all of our
witnesses. We appreciate your presence here and lending of your
insights and expertise to some of the very important matters
before the Committee particularly regarding this legislation.
We are now going to be begin our question period. Each
Member will be allotted 5 minutes to ask questions of the
witnesses. I would like to begin the question period by
yielding to the distinguished subcommittee Chairman of the
Capital Market Subcommittee Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman, for that courtesy. I do
appreciate it very much.
Mr. Walker, I noted in your written testimony reference to
the fact that the audit clients should have clearly an
understanding that he has a primary responsibility to the
shareholders. I recall having read in the earlier report also
another line which indicated it should be made statutorily
clear that the financial statement is the property of the
shareholder.
In testimony before this Committee Mr. Berardino, the
former CEO of Andersen, in response to a question from me
indicated that the financial statement was the property of
management and the shareholder, which I thought flew in the
face of Accounting 101 in that the audit committee's engagement
of the audit team is to prepare an accurate and true picture of
the financial condition for the shareholder. Although the
financial data must be arrived at in consultation with
management to understand the true operations of the business
plan, management should not be involved in the alteration,
manipulation or intimidation of the preparation of the numbers
as the audit team sees them in light of this responsibility. Is
that an accurate reflection of your understanding?
Mr. Walker. My understanding, Mr. Baker, is that first the
board of directors work for the shareholders. Second, under the
current literature, management is responsible for the financial
statements, but the financial statements are for shareholders
and other stakeholders.
I personally believe that one of the real keys that has to
be focused on here is determining who is the client and who are
the parties that are representing the client. I would assert
that when you are talking about an audit, when you are talking
about related financial reporting associated with that audit,
that the client should be the shareholders and other
stakeholders who are relying upon that information. But their
representatives should be the audit committee, which would be
an independent body that is part of the board which should be
responsible for hiring the auditors. The audit committee should
assume additional responsibility above and beyond what it has
right now in order to ensure that there is a convergence of
interests between the board, which is supposed to be working
for the shareholders, and the independent auditors, who should
be working for the shareholders, but in addition to that,
should serve a broader public interest.
Mr. Baker. If I may, let me take that as a long yes,
because I have a follow-up. There is inherently a conflict
between the management's interest to enhance stock performance,
thereby enhancing their own remuneration, perhaps at the
expense of the shareholder in unfortunate cases. To
disincentivize that type of manipulative conduct in relation to
the preparation of the statement, would it be advisable for us
to consider making the CEO personally responsible and liable
for the accurate preparation of the financial statement? I know
there is clearly a responsibility, but do we need to make that
more clear?
I will jump to the next one while you are rolling that one
around because I would like Mr. Breeden to comment as well.
To go perhaps further, it has been represented that there
are cases in which management, through collusive efforts of
many, have enhanced appearances of the corporation to increase
the value of stock, exercise no cost options granted as a part
of their employment arrangement, and then subsequently have a
restatement of earnings so that the shareholder takes the net
effect of loss, and the executive remains enriched through that
manipulative process. For example, in that case, should we
authorize the SEC to make inquiries into matters of that sort
and be given the rules and authority to take appropriate action
including disgorgement, so if there is a downturn as a result
of manipulative bookkeeping, that there are consequences for
the corporate executive?
I make these comments in light of Chairman Greenspan's
remarks and others' who have encouraged us to find ways to
disincentivize short-term earnings pressures and long-term
corporate asset growth. Would either of you comment, please?
Mr. Walker. There are several things in my testimony where
I talk about things that I think the SEC should be required to
look into in order to provide better checks and balances, and
to better protect not only the shareholders' interests or the
public's interests. They include the composition of the board,
the composition of the key committees on the board, and
providing additional transparency and checks and balances,
again the kind of actions you are talking about.
Right now management does have a responsibility to sign a
management representation letter in conjunction with an audit,
and they are supposed to make certain assertions that to the
best of their knowledge and belief, that certain things are
true and correct. I think that could be an area that you may
want to have whichever body that you decide should be
responsible for the auditing area for better protecting the
public interest to take a look at that and determine whether or
not additional steps should be necessary.
Mr. Breeden. Congressman, it is nice to see you. I would
only add, number one, on your question of the financials
themselves, financial statements have to be prepared by
management. The starting point is--the only correction to what
you said, the auditors are not engaged to prepare the
financials. That is management's duty and responsibility. The
auditors are there then to check those financials and test
them, and that check-and-balance system is at the heart of how
we go about preparing financial reports.
I think absolutely CEOs should be responsible for what is
in the financial statements. I think they are legally today
already. The system today, however, provides also full
indemnification from the company as well as insurance if they
have any liabilities. So you have liabilities.
Mr. Baker. With your due diligence, I know time has
expired, I just want to emphasize that one point in the event
there is an allegation against the corporate CEO for
misrepresentation of material elements of the preparation of
the financials, the corporate attorney defends the CEO, where
the shareholder has to fund the personal litigation expense out
of their pocket. My point is should there be a down side where
it is defined after appropriate inquiry that the manipulation
that did, in fact, occur, there was a loss incurred, should not
the CEO then out of his own pocket have some liability which
does not now today exist?
Mr. Breeden. I think your point of there being a down side
is important. I think the President's messages have emphasized
that. Chairman Pitt's remarks have emphasized that. My own
testimony suggests that we do need to do more in the
disgorgement area.
I am particularly worried about the situation where an
executive may be selling, in Gary Winnick's case in Global
Crossing, $750 million worth of stock on the eve of bankruptcy
and whether or not you should trigger it by a restatement. I
think Congress should consider whether stock sales within a
certain period of time of the company going into bankruptcy,
whether the profits from those sales by senior officers
shouldn't be recaptured into the bankruptcy estate.
Mr. Baker. I have much more, but I am way out of time.
Thank you very much.
Mr. Cantor. [Presiding.] The Chair now recognizes Ranking
Member LaFalce.
Mr. LaFalce. Thank you very much.
Today, I introduced a bill to give legislative teeth to a
number of the recommendations that President Bush called for:
Number one, with respect to disgorgement of bonuses and other
incentive compensation for either false or misleading
statements or other misconduct; number two, requiring the CEO
and CFO to personally vouch for and certify to the veracity,
fairness of their company's public disclosures, including their
financial statements and certification that certain internal
control procedures are in place; and third, enhancing the
ability of the SEC to bring an enforcement case prohibiting a
person from acting as an officer or director of a public
company by lowering the standard. Right now the standard is
substantial unfitness. We would simply eliminate the word
``substantial.''
It may be unfair to ask you to comment on a bill that you
have not been asked to testify on at this juncture, but it
would be fair, I think, to ask you to submit a letter to the
Committee giving your views on that bill once you have had time
to consider it, hopefully before markup on Thursday.
OK. Now to go on.
Mr. Walker, you have indicated, I believe, correct me if I
am wrong, that a new oversight body for the auditing profession
is necessary; that it should have the authority to establish
professional standards for the auditors of public companies;
that this new regulatory organization should be able to set
independence standards; that the new regulator should be able
to charge annual fees to public companies as a means of
financing itself. Is that basically correct?
Mr. Walker. That is true. Our recommendation----
Mr. LaFalce. You find those provisions in H.R. 3818, I
would assume, and not in the other bill.
Mr. Walker. I would find----
Mr. LaFalce. Wherever they are found, would you favor them?
Mr. Walker. Some of the provisions are in H.R. 3818.
Mr. LaFalce. Why do you think they are important?
Mr. Walker. My personal view is that we should not have
direct Government intervention unless we believe that it is
called for. If there are other bodies which Government could
encourage to take the right steps, we should first try to do
that. If they fail to act, direct Government intervention
should be considered.
I think the area where direct Government intervention is
necessary is in the auditing area. I do not believe that you
are going to achieve the objective of best protecting the
public's interests without more direct Government involvement
dealing with the independence setting for auditors of public
companies, the quality assurance procedures associated with
those auditors, the disciplinary process associated with those
firms and the individual members, and certain other matters
laid out in our testimony.
Mr. LaFalce. I appreciate that. Both Mr. Oxley and I
believe that we do need a new auditing body. The question is
what power should it have. It certainly should have at least
those powers and maybe more. It is something that Mr. Breeden
suggested, subject to compromise, we can talk about. But
another question is who should be on that board? And that is a
very important question. And I have said that the SEC should
appoint them, but from lists that were submitted from certain
type of organizations such as pension plans of private
employees, pension plans of public employees, and so forth.
Otherwise you might have a situation where you have Mr. Pitt
appointing a board that Mr. Boucher would look at and say, this
is so bad I am resigning, which is exactly what happened.
So do you have any thoughts as to the type of individual
that should be on that board? Do we leave it totally to the
discretion of the SEC, or do we put some language in the
legislation which tries to make sure that the individuals on
that board will be interested first and foremost and
exclusively in the protection of investors?
Mr. Walker. My personal view is there should be some
standards for the individuals who would be appointed to the
board. I would note in your bill, Mr. LaFalce, there is one
provision in there that I think may raise a constitutionality
issue, and that is----
Mr. LaFalce. I will take that one out, whatever it is.
Mr. Walker. It is the one that talks about the Comptroller
General being part of the appointment process. The Comptroller
General can make recommendations.
Mr. LaFalce. You don't want it, you don't get it. You are
out.
Mr. Breeden, you described two concerns with the non-audit
services that auditors currently provide to audit clients, one
specific service that creates conflicts for the auditor, and,
two, the volume of non-audit fees in relation to audit fees.
Does either bill address it adequately, more adequately? Are
both inadequate? Do you have a preferred approach other than
the approach in either of the two bills?
Mr. Breeden. Congressman, I think both bills have made a
very good start looking at what is--I tried to--in my usual
excessively wordy way, I tried to in my testimony show that
there are some real complexities in that issue. It is hard to
just say no consulting at all, because things like tax services
are not pure audit, but would rob the audit of its vitality if
you took them away.
Mr. LaFalce. Which I specifically say should not be done.
Mr. Breeden. Neither bill takes the tax services away,
although some of the proposals in the marketplace have done
that. I think they would do significant damage if you went that
far.
Consulting on internal controls is something I used to do
in the 3 years I spent at Coopers & Lybrand, and I think that
it contributes to the quality of audits. So I think that we
need to identify any cases where the auditors are, in essence,
auditing themselves. If they have built a data system that is
the system used for financial reporting, if they are doing
something in the consulting side that their own auditors are
supposed to go and audit, it is unreasonable to expect that
they will give the same level of diligence that they would if
an independent person had done that. The magnitude of all the
whole shebang is too much; then you also have distortion.
Mr. Cantor. The gentleman's time has expired.
Mr. Walker. Real quickly, Mr. Chairman, can I?
In my testimony we recommend that the Committee consider a
principles-and-safeguards-based approach that we have already
promulgated for Federal entities and entities that receive
Federal funds. As you know, Mr. LaFalce, the GAO actually
promulgates auditing standards for Federal entities and
entities that receive Federal funds. We believe that that
guidance would be helpful in considering what should be done
with regard to public companies. Thank you.
Mr. Cantor. The Chair thanks the gentleman.
At this time the Chair would like to address for a moment
Mr. Breeden. I take it you are familiar with Chairman
Greenspan's remarks when he addressed this Committee several
months ago. While he was here, he expressed a concern that
Congress could go too far in overregulating the capital markets
in response to the issues at hand. Can you comment on that?
What do you make of those concerns?
Mr. Breeden. Well, I think any time you have a scandal of
this kind that has touched so many people and caused such
widespread losses, and between the losses to investors in Enron
and the losses to Andersen employees and so on, there is an
enormous amount of damage here. And so I think Chairman
Greenspan was--as many others have done--noting a concern that
Congress be careful in responding to events that naturally
cause outrage on the part of good people everywhere, that we
not go too far in fashioning a legislative response, and I
agree with that sentiment.
At the same time I also believe that there are some areas
that have been exposed in this overall situation that would
benefit from legislative changes, that we not do too much, but
we not do too little. I think actually that Mr. Oxley's
legislation together with Mr. LaFalce's legislation, both bills
here attempt to--and one goes further than the other, but maybe
something in between is an area where people can coalesce
around. It is important not to go too far, but I think there
are some areas where real change needs to be made.
Mr. Cantor. Mr. Walker, can you respond to those concerns?
Mr. Walker. Yes. As I said in my statement, you should only
have direct Government intervention where you believe that the
problem cannot be effectively addressed by other parties. In
that regard, we believe the greatest need is in the auditing
area, and what we are recommending is that there be a
qualified, independent and adequately resourced body to be able
to assume those responsibilities rather than the Congress
trying to get into the details, trying to make those decisions
through legislation. I think that is critical in order to make
sure that you don't over react, that you have a balancing of
interests.
As you know, Chairman Greenspan has also said that he
believes that additional action is necessary in certain areas
such as in the auditing area and has expressed some concerns
about current accounting and reporting with regard to certain
types of compensation arrangements.
Mr. Cantor. Thank you.
If I could turn to Mr. Silvers for a moment. In 2000,
former SEC Chair Levitt proposed auditor independence rules
targeting 10 consulting services for prohibition, the final SEC
rule prohibiting seven of these services. Another was dropped
because it was deemed unworkable. The Oxley bill bans the other
two. The LaFalce bill bans all 10. Again, seven are already
prohibited under the current rules. Isn't this provision
redundant?
Mr. Silvers. I am sorry, sir, which provision do you think
is redundant?
Mr. Cantor. The Oxley bill bans the other 2, but the
LaFalce comes in and bans all 10, while 7 are already
prohibited by the rules as they exist now.
Mr. Silvers. My understanding from reading the bills, Mr.
Chairman, is that Mr. LaFalce's bill provides the Commission
with the authority to take a look at a practice such as that
which occurred at Enron where Arthur Andersen participated in
structuring SPEs and then came back, and partly did so, I
believe, under the rubric of tax consulting. Certainly they
could have done so under the rubric of tax consulting. They
structured the SPEs and came back and audited the SPEs and
generated a $5 million fee for doing so.
The challenge of this problem of conflict of interest is
that the Commission needs to have the authority to draw these
fine lines, and the Chairman's bill simply does not give the
Commission the clear authority and direction to do that. Mr.
LaFalce's bill does that. The difference, frankly, is that
under the Chairman's bill, if a firm was to feel that it made
sense for them economically to go and do what Arthur Andersen
did at Enron, there really would be no reason per se under the
Chairman's bill that they couldn't do that, whereas Mr.
LaFalce's bill clearly directs the Commission to promulgate
rules under that conduct. I don't believe that distinction is
by any means redundant, as you would suggest.
Mr. Cantor. Mr. Breeden, if I could turn to you in an
attempt to elicit a response about the potential redundancy in
one of the bills that attempts to address the rules that are
already in place.
Mr. Breeden. Mr. Chairman, I have not looked in detail at
the language of the Commission's current rules compared to the
bill to see whether they are completely overlapping or whether
there are gaps there. I could do so afterwards and send you a
letter about it, but I really haven't done so, and so I can't
tell you whether they are fully redundant or not.
Mr. Cantor. It would be appreciated. Thank you.
Mr. LaFalce. Would the gentleman like me to give an answer?
Number one, they are not fully redundant at all because there
were carve-outs within the rule. Number two, if the worst sin
in redundancy is that codification into law of regulations, I
will accept that sin.
Mr. Cantor. The Chair thanks the gentleman.
The Chair now recognizes Mr. Kanjorski.
Mr. Kanjorski. All of the testimony in the pending bills
makes certain presumptions that, one, we know the full extent
of the Enron disaster, and also obviously in regard to its
accounting firm, Arthur Andersen, with its $25 million in
auditing fees and $27 million in consulting fees. I would like
to know whether these were overcharges, whether the work
performed was unethical or improper, and if it was, to what
extent. Are any of you aware of any studies that have analyzed
what work was done, how competent the work was, and whether or
not, in fact, any of it was improperly done?
Mr. Walker. I am not aware of a study. I am also aware of
the fact that Arthur Andersen at least was performing certain
internal audit services that would be banned under both of
these bills, which I think is noteworthy.
Mr. Breeden. Congressman, I am not aware of any studies,
but $52 million in fees combined for auditing and consulting is
an enormous fee. That would put--Enron's payments to Andersen
clearly would have had to have been among the top of not only
Andersen's clients, but any accounting firm's clients.
Mr. Silvers. Mr. Kanjorski, I would make two points in
response to your question. One is the conflict that was alluded
to in response to the Chairman's questions is discussed on page
5 of the Powers Report and gone into in some detail later on in
the report in terms of the specific conflicts that were at work
here. I would add that prior to the appearance of the Powers
Report, that both Andersen and Enron made some efforts to
conceal from Congress in several different committees,
including this one, the extent of those conflicts, but the
Powers Report itself documents them quite adequately.
I could also say that although that fee is very large, it
is very interesting that the multiple of the consulting fee in
relationship to the audit fee at Enron was not even close to
the high end. There have been several surveys of the ratios
that the SEC's recent disclosure rules have divulged to us of
these ratios in other major public companies which I would be
happy to provide to the Committee. I would know one sticks in
my mind, which is Motorola, which had a board overlap with
Enron until very recently. Motorola was 16-to-1, the ratio of
consulting fees to audit fees.
Mr. Kanjorski. The consulting fees were 16 times more than
the audit?
Mr. Silvers. Precisely.
Mr. Kanjorski. So maybe Andersen undercharged?
Mr. Silvers. Perhaps you could raise that with them.
Mr. Kanjorski. The reason for that question is, obviously,
that the Congress is going to act. Whenever anything happens in
our society, we either pass a law or we form a commission.
Obviously, we are not going to be able to form a commission to
address this problem, so we are going to pass a law.
I am a little worried about the unintended consequences of
what we may be passing. I am not absolutely certain that the
Congress has the clarity of either the Enron problem, if it
represents an endemic problem, and just how endemic that
problem is, or whether or not we are in a position to move this
legislation through as quickly as we seem to be. Should we take
more deliberative time? Do any of you see some great risk to
our economic system if we take a couple of more months in
resolving this problem, or do we have to do this before
Memorial Day because it fits into the political schedule?
Mr. Silvers. I am the only person willing to take a risk on
this proposition. Obviously I think the people that I represent
here would like Congress very much to take action in this
session. I would defer to the wisdom of the Committee as to
what precise calendar that requires. It seems to me that the
more important question is are you going to take the right
direction or not.
I think, Mr. Kanjorski, your questions get at one issue in
which I am not sure that this Committee is heading in the right
direction. It would be better to take the time to get it right
than to do something that won't protect America's working
families against a future Enron.
Mr. Kanjorski. I tend to agree, too. That question is
structured along the idea that we have 17,000-plus public
corporations. It would seem to me they do not all fall into
Enron's category. Anything we do will also cause additional
expenses for those corporations and to the Government in order
to police the law we are enacting. I am just worried: are we
going to do what sometimes we have done in other Congressional
actions? We could just end up just ignoring the cost and the
burden to struggling companies that have to get equity and have
to get out there. They have not done anything, but they will
have to comply with all these rules and regulations at great
expense to the company and ultimately to the shareholders, and
maybe actually put their long-term success in jeopardy.
What I am thinking, is whether or not we should put a tier
operation into effect with any bill and look at only the top
1,000 or 5,000 corporations. But all 17,000 of these companies?
We initially did that with all banks when we enacted CRA. To a
large extent, it was my experience that we initially put
unusual burdens on small community banks to go through the
legal work and expense to comply with CRA. Before we changed
the law, I visited banks that were spending a sixth of their
income on legal and accounting fees to prove compliance with
CRA--little banks that could not exist outside of their
community. So, anything they were doing, they were complying
with CRA.
Yes?
Mr. Cantor. Will Mr. Walker answer the question, then the
gentleman's time has expired.
Mr. Walker. I think in the final analysis it is better to
get it right rather than do it fast, but I think there is a
need for some expeditious attention to the critical area,
especially in connection with the auditing area. Obviously, as
you know, Mr. Kanjorski, this is the beginning of the
legislative process on this side of the Hill, and the Senate
has to act as well. There are a lot of things that have to
happen before this will get finalized.
We do recommend in our approach that it is important to
have qualified, independent and adequately resourced bodies
deal with a lot of the details. The Congress may want to ask
for those bodies to look at certain issues and to make sure,
for example, that in the area of independence that they
consider a principles-and-safeguard-based approach, that they
can look at certain services in particular as to whether or not
they should be allowed, and if so, under what circumstances. I
think if you take that approach where you are making sure you
have a qualified, independent, adequately resourced body, you
are providing that body with the power to do what needs to be
done, you are providing it some guidance, but not getting too
detailed with regard to how much you are prescribing
legislatively, that might be a reasonable balance because,
after all, markets evolve over time. What you say today may not
be appropriate tomorrow. So some other body has to be empowered
to deal with changes over time.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Cantor. The Chair recognizes Mr. Rogers from Michigan.
Mr. Rogers. Thank you, Mr. Chairman.
I am going to take maybe a bit of a different direction.
One of the concerns I have is in this whole episode, we have
been--we being Congress--in a hurry to find a villain, and I am
not sure exactly we have identified the crime yet. I was hoping
to ask Mr. Breeden, one of the things I am concerned about is
that we are trying to treat this with a pill rather than laser
surgery. I am not so sure that laser surgery isn't the order of
the day here. We have a real possibility here to cause some
real problems for lots of folks, UAW members and you name it
out there, families who are investing more and more in 401K
plans all across the United States. And sometimes just
questioning the company's accounting practices by any official
entity can be devastating to the stock of that particular
company. We haven't done any investor in the United States any
good if we do that maliciously or at least without good intent.
I want you to help me understand how we can make the
corrective actions I think we all know we have to make here,
certainly for transparency, without jeopardizing investor
confidence. And those families out there who are working very
hard every day, they send their money into their mutual funds
knowing that that is what they are going to retire on, and they
are counting on all of us, those here in Congress as well as
you, auditors, regulators and those in the business community,
to make sure that there is honesty and true brokering going on
out there in those companies.
Mr. Breeden. Congressman, I think both you and Congressman
Kanjorski raise similar, in a way, concerns and good points.
One of the best things we have been able to accomplish over the
last couple decades is to foster a broader participation in our
capital market, and as my colleague here from the AFL-CIO
points out, we have working men and women through pension
plans, we have investors through mutual funds and directly to
the tens of millions, and that has been a wonderful
accomplishment.
So we have as a Nation a great deal at stake in protecting
the confidence those people have that our markets work with
honesty and integrity, and they can believe the numbers they
look at and that they make investment decisions on, and that
this is a huge system with 17,000 public companies, and in
fixing it a couple things are apparent. Number one, we have to
be careful that we don't go too far, we don't fall into the law
of unintended consequences when we try to fix one problem that
we create another one, that we don't go too broadly and don't
create excessive costs, as the Congressman is mentioning, in
CRA, which is a very real risk.
We need to start with what we have, which is the world's
finest system. It is not perfect. It has some flaws. No system
designed by human beings and run by human beings is ever going
to be perfect. But I genuinely believe, notwithstanding Enron,
that the U.S. accounting and disclosure system is the best in
the world. So let's not throw the baby out with the bath water.
Let's start with what we have and look to see how can we build
on that. If there are gaps here and there that we need to
address, then let's do it.
I think that now on the question of investor confidence, I
don't think there is--I am not aware of a situation where
anyone has maliciously questioned people's financials, but
certainly the market itself should raise questions about
companies that have very aggressive accounting practices. We
certainly have seen that post-Enron with aggressive selling
against Tyco and other stocks that are perceived to have some
accounting issues. I think those market disciplines are very
healthy. In fact, I wish we had more of them, not that people
should do it based on rumor or fear, but that a healthy
skepticism looking hard at what numbers companies are reporting
and making sure that investors do their homework to worry about
the risk that they may be undertaking.
So this whole area is one in which it is extremely complex,
and we have to be extremely careful that we don't get things
out of balance. But at the same time I think it is clear that
we can do things to speed up disclosure and make disclosure
more comprehensive. For 40 percent of the assets of Enron to be
hidden off the books was unacceptable. That is disclosure? That
is a joke. It shouldn't have happened. The parties responsible
should have known there was--whether or not it was proper
accounting, it was lousy disclosure.
And so we need to look starting at the Commission, but also
here at Congress, are there things we can do to make disclosure
faster and make it more comprehensive? Can we have better
information about executive stock sales? That is very important
to individual investors across the country. They know enough to
know--they may not understand an SPE, but they know if the CEO
is bailing out of the stock, they don't want to be investing
themselves at the very same time the top guys are getting out.
So speeding up those disclosures is another healthy thing.
Making sure that auditors don't sell their integrity. We
can't station an SEC enforcement agent at the shoulder of every
accounting professional, but at the top trying to make sure
that the system encourages quality auditing, and that the firms
themselves realize how important their public trust is, and the
strong efforts they themselves need to make to do a good job.
So there are a lot of things where I think we can make some
improvements that are consistent with our traditions and
consistent with our systems and make it a little better.
Mr. Cantor. The Chair thanks the gentleman.
The Chair recognizes Mrs. Maloney.
Mrs. Maloney. I thank the Chairman and the Ranking Member
and all of the panelists.
I am sure all of you are aware that today Andersen
announced they are laying off 7,000 of their employees and that
this represents a quarter of their total employees. And
furthermore, the long-term viability of the company is truly in
question. And as I have said many times before, the
overwhelming majority of the professionals in the industry are
hard-working and honest and have a great respect for the title
``certified public accountant.''
I am concerned, quite frankly, about some of these
employees, many of whom are my constituents. I would like to
ask Mr. Breeden from what you know, do you think it is
appropriate for the Justice Department to have targeted the
whole of Andersen, or should we allow the Volcker plan to go
forward and have it put in place and go after a limited number
of employees known to have been involved in the Enron audit? Do
you have feelings on this?
Mr. Breeden. Congresswoman, thank you. The Andersen
situation is a very sad one. It is certainly one that is
regrettable on many different planes, and I certainly hope that
anything possible that Paul Volcker or anyone else can do to
stabilize the firm and allow it to survive and then worry in
the future about rebuilding, I wish it every possible success.
On the other hand, we used to have debates when I was in
the White House working on financial services about whether
banks were too big to fail, and I don't believe Arthur Andersen
is too big to fail, and I don't believe any of the other Big
Four are too big to fail. If they ever got that notion in their
head that they somehow have carried their monopoly on auditing
and the oligarchy that exists in competition in this world that
no one could bring an action against them if they broke the
law, then that would be a mistake. We went through Watergate to
prove that the President of the United States is not above the
law. I think that the general counsel and the CEO and other
staff members of Arthur Andersen are also not above the law.
I don't take a position on whether or not the Justice
Department has the--we can only know when a trial takes place
and we see what evidence the Justice Department has. But in my
experience working with the Department of Justice in law
enforcement over many years, they don't indict people or firms
capriciously. They do it on the basis of a very sober and
careful calculation of whether they have the evidence of
wrongdoing, and it is a responsible act.
I think some of the people worrying about the consequences
for Andersen should be asking the question about isn't it sad
that Andersen's management engaged in the acts that led to the
permanent injunction in Waste Management; that Andersen's
management tolerated massive destruction of documents on the
eve of Government investigation; that chimpanzees could know
that the documents at Enron were going to be subpoenaed high
and low by every Government agency and private litigants all
over the place, and if you destroy documents, you may be
affecting the rights of the University of California to recover
against Enron executives or others, and in that context
destroying documents is wrong.
And so it is a tough issue, because nobody likes to see
what is happening to other people at Andersen, and yet Andersen
finds itself where it is largely through its own actions.
Mrs. Maloney. You mentioned earlier, Mr. Breeden, that we
should have faster and fuller disclosure, and one area that
really isn't disclosed now except by consent or individual
choice is the code of ethics for the board of directors or the
code of ethics for firms. Do you think it would be helpful that
the code of ethics was printed in the annual report, and if the
board of directors took the unusual step of overriding the code
of ethics of their board, that it be reported to the SEC and
printed in the annual report?
As you know, in Enron, as reported in press accounts, the
board of directors voted to overturn their own code of ethics
to allow their CFO Mr. Fastow to head these special SPEs. So I
was wondering when I called for fuller disclosure, would this
be an area that you think might be helpful to the investor, to
the general public?
Mr. Breeden. Yes, Congresswoman, I think very much so. In
fact, in both testimony on the Senate side and in this
testimony, I did say I believe that any time a board acts to
suspend the corporate code of ethics, that not only publication
in the annual report is way too slow, they should have to file
an 8(k), do it within 10 days anyway, but almost immediate
disclosure should be made. I think corporate codes of ethics
should be at least posted on their website. It might add quite
a few pages to the annual report, but I think somewhere it
should be noted.
I did call for disclosure in the proxy statement or in some
other vehicle for the board to set forth its policies on
conflicts among senior executives. The conflicts in Enron at
the CFO level were among the most dangerous possible things
that a corporation could do, because the outside auditors and
the audit committee and the full board all are looking at
numbers provided by a CFO. So if the CFO has got a personal
financial reason to give distorted numbers, it can defeat
simultaneously the ability of the board, the audit committee
and the outside auditors to check up on that. It is the one
vital spot where--it is the hub and the spokes of the wheel. So
any conflicts involving a CFO should be, in my judgment,
prohibited under State law, and there should be required to be
immediate disclosure if a company goes down that road, which
hopefully they will not.
Mr. Cantor. The gentlelady's time has expired.
The Chair now recognizes Chairman Baker.
Mr. Baker. Thank you, Mr. Chairman.
Mr. Cantor. He was assuming the time of the Chair who was
here before I was. So this is on his own time.
Mr. Chairman.
Mr. Baker. Thank you very much for clarifying. Don't want
to misrepresent my account here.
In the earlier round, Mr. Breeden, we talked about
disgorgement and insider trading prohibitions, bailing out on
stock the night before the bankruptcy filing. We talked about
clarity in the liability for the CEO for the preparation of the
financials. There are other elements that I think I would like
to get your comment on. One is the subject of a cooling-off
period where the auditor is the principal engaged as an outside
auditor for company X; upon retirement immediately goes to work
for that company as the chief financial officer. There are
prohibitions which apply to Members of Congress, for example,
in what we can do in post-congressional life. Do you look at
that in an advisable way? Is that something we should consider?
Mr. Breeden. Yes, sir, I believe that you should. I
remember back in my days at the Commission, we had the then
infamous Lincoln Savings collapse. An awful lot of people were
hurt in that. That was another case where this CFO that was in
place at Lincoln Savings had come over from the outside
auditor, which means the people who audit his work the very
next year are all the people who used to be his subordinates at
the audit firm.
So without knowing exactly how it should be done, I think
cooling-off periods are healthy and is something that would
probably make sense.
Mr. Baker. As to structure on all of these, it is my
thought to authorize, mandate the SEC to study and implement
rules governing these points raised by the Congress as a policy
matter. I think it may be difficult and take us years to get a
plan that is enforceable and not disruptive to markets if we do
the specifics, but at least to have a goal within 6 months, a
year for the SEC and staff to determine the most appropriate
manner for prohibiting whatever is an unreasonable corporate
practice.
Audit committee and their ability to do their work.
Provisions for independent counsel. In other words, not having
to rely on internal corporate officials to do the work for the
audit committee. It's difficult if you have a CFO who is
conflicted, but if you are really trying to do the job on the
audit committee, and you are asking the guys who are employed
by the corporation, isn't that equally troubling?
Mr. Breeden. I serve on three audit committees, and I chair
two of them. I can't imagine anybody telling us--and I don't
think it is just me--I can't imagine anyone saying to an audit
committee that they can't hire outside counsel. The board can
do what it wants. The problem is that--it is a little bit of a
chicken-and-egg situation. One of the problems in both Waste
Management and Enron was that the auditors never said boo to
the audit committee. They knew there were problems and didn't
bring the audit committee into the loop. So they were, in many
respects, oblivious or appeared to be ignorant to many of the
issues that might have caused them to go and hire outside
counsel, but they have to know that they need it.
Mr. Baker. That was my point is that rather than making it
a permissible activity to do it, is that a mandatory obligation
to construct your audit analysis based on outside counsel?
Mr. Breeden. I think we have enough make work acts for
lawyers, but I wouldn't require it, but I think certainly as a
matter of good corporate practice and maybe through listing
standards it is something that can be encouraged. Certainly any
audit committee has to have the right to speak to independent
counsel and independent financial advisors if they believe they
need the advice.
Mr. Baker. Lastly, with regard to stock option plans,
shouldn't that require shareholder approval?
Mr. Breeden. I believe so.
Mr. Baker. And there is one other piece of work may I
compliment you on. In 1992, there was a report issued by the
SEC, and it also supports a statement of Chairman Pitt before
the Committee just before the Easter recess relative to the
reporting to the SEC by the GSEs. As I recall it, your work at
that time indicated it was advisable policy for the GSEs to
file as all other Fortune 500 companies do in compliance with
SEC standards. Is that still your view?
Mr. Breeden. Congressman, I don't remember that specific
report. I seem to remember getting the tar beat out of me by
folks at the time over that issue. I haven't looked at it since
then. So with respect, I will just stay out of that hornet's
nest.
Mr. Baker. If your bruises haven't gone away, I can assure
you that the report contains that information, because I have
the bruises myself.
Mr. Breeden. One of the great things about being in the
private sector as opposed to being in Government service is you
can duck a few of the fastballs that you have to go ahead and
stand at the plate when you are in Government.
Mr. Baker. I commend you for your bravery while on duty.
Mr. Cantor. The Chair now recognizes the gentleman from
North Carolina, Mr. Watt.
Mr. Watt. Thank you, Mr. Chairman.
I want to start by applauding the testimony of Professor
Langevoort. I may not be pronouncing his name right. His
testimony has gone unnoticed in the question-and-answer period,
but he should know that as far as I am concerned, it is among
the most important testimony that has been given here today. In
my opening statement I emphasized the importance of allowing
individuals to hold people accountable and corporations
accountable in addition to Government bodies, and your
testimony seems to me to be consistent with that.
First of all, we have to reestablish the legal standard
that makes other parties have legal liability to anybody, and
then we have got to give individual people who are damaged by
those activities the right to take up their own private
litigation and enforce those rights, and in some cases that may
result in less Government bureaucracy. I keep having trouble
convincing my Republican counterparts of that, but they may
come around.
The problem is that--and I am certainly going to try to
pursue this in the course of this markup--the problem I have
already identified, however, is that the rules of germaneness
in the legislative context are probably more rigorous than the
rules of evidence in the evidentiary context. If we start with
the Chairman's bill, I am not sure we can craft an amendment
that gets that on the table for discussion and debate, so I am
not going to spend a lot of time asking you questions about it.
But I did want you to know that what you said did not go
unnoticed by at least one Member of this Committee.
Mr. Langevoort. Thank you. I was actually happy not to get
all the fastballs.
Mr. Watt. Now I want to go to another issue that I am
trying to resolve or reconcile, the differences between Mr.
Walker and Mr. Breeden, and try to figure out which one of them
I agree with more. As I understand it, Mr. Breeden--no, I am
sorry, as I understand it, Mr. Walker thinks that we ought to
have another Federal board of some kind in addition to FASB and
the SEC. We ought to have some third agency. And as I
understand Mr. Breeden's testimony, he rigorously disagrees
with that. I would like for the two of you to try to reconcile,
if they are reconcilable, your views on that issue. I tend, I
think, to come down more on Mr. Breeden's side than Mr.
Walker's side, I believe.
It is coincidental that right across the hall here where I
am on the Judiciary also, as you may have gathered by my legal
bent here, we are debating whether to break up the INS into
about five or six different parts on the theory that if you
break it up, it will all of a sudden become more efficient even
if you keep the same people and the same rules and regulations
and everything. It seems to me that one approach we might be
using is trying to make the SEC and FASB more efficient rather
than creating another institution in the process.
So let me hear from Mr. Walker first. Then I want to ask
another question. I will give Mr. Breeden equal time to defend
his position.
Mr. Walker. Mr. Watt, right now you have one Federal
Government entity involved, and that is the Securities and
Exchange Commission. As you know, the FASB is not a Federal
Government entity, it is a self-regulatory body.
Mr. Watt. But wouldn't this bill put those kind of agencies
kind of under the jurisdiction, supervision of the SEC?
Mr. Walker. What we were proposing at GAO is that the SEC
has more than enough to say grace over right now. Some can
debate----
Mr. Watt. One way to solve that is to add some more people.
Mr. Walker. That is one issue. Mr. Watt, we are saying that
the area of most acute need for intervention is in the auditing
area. The SEC is already overtaxed as it relates to enforcing
the securities laws and dealing with significant accounting and
reporting issues that have to be dealt with.
There are many people on this Committee and others in
Congress who believe that the CFTC ought to be merged with the
SEC. So the point is there are a lot of things that the SEC has
to do right now.
Our view is that you could have an independent entity
within the SEC. You could have a body within the SEC that would
have Presidential appointees with Senate confirmation who have
the authority to make final decisions with regard to certain
auditing activities, but would allow them to be able to
coordinate as appropriate with the SEC on accounting issues and
on securities regulation. We think that is possible to be able
to do that, but one of the concerns that we have is that the
auditing area is the one that we think there is the most need
and there needs to be appropriate accountability to the
Congress, and we don't know that you get appropriate
accountability to the Congress unless you have the parties
responsible and reportable to the Congress.
Furthermore, we question whether or not the commission
members and their staff can effectively discharge these
additional responsibilities because they are already having
difficulty dealing with their current responsibilities.
Mr. Cantor. The gentleman's time is expired. Thank you.
Mr. Breeden. Mr. Chairman, if I could have the liberty of
responding to this, because I think it really is a pivotal
issue.
Mr. Cantor. Without objection.
Mr. Breeden. Thank you very much. I, of course, have
boundless regard for GAO and its analytic capabilities. This is
a matter that is a matter of principle and philosophy, I
suppose, but I could not feel more strongly about it than I--
and Mr. Watt, I appreciate your asking the question and giving
me a chance to give you my side of things.
For about 68 years now, the SEC has been the Federal agency
with responsibility for overseeing the accounting profession.
It has a long history. It has a long culture and a long
tradition of being able to put the public interest first to
have an effective enforcement program. I do not think there is
any wrongdoer out there, be it corporate, individual or a
partnership, that the SEC and its history would not tackle. It
has built up a long history there without fear or favor of any
person, irrespective of party, irrespective of any other
factor, and to say that, well, that is very nice, but they are
awfully busy doing some other things, we should put it aside
and start all over again and build a brand new agency that has
no history, no culture, no existing staff, nothing. We are
going to start from the beginning and build it all up, and 10
or 15 years from now it will have experience and culture and
tradition, and we are going to hope at that time it is going to
do a better job than the agency that for 68 years has done a
great job for America's investors.
Now the Commission is starved for resources and has been
underfunded since 1934, and I would appreciate the efforts of
many Members of Congress to expand its staff so that we could
keep pace with growth in the markets, and that is an ongoing
problem today. But I really think that there is not a need for
another Federal agency.
Now I agree with a great deal of what Mr. Walker has said
in terms of the importance of integrity and independence and
good powers, and all of those things can be in a body like the
NASD that would be a subsidiary, private sector organization,
out doing a lot of work, doing a lot of enforcement, bringing
all those fine qualities to bear, but reporting up through the
existing Government agency so we don't lose the benefit of
nearly 70 years of public service.
Mr. Cantor. Thank you.
The Chair now recognizes Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Let me thank my colleague from North Carolina, because I
wanted to be the devil's advocate on that, but he is much more
eloquent than I am, and I agree with his line of reasoning, and
I think it is problematic.
I think, Mr. Breeden, you are right on point that what we
are talking about doing now is starting over from scratch to
create a new agency, and I guess--that John is correct.
Redundancy is not necessarily a sin, but what I keep coming
back to is does not the commission already have a tremendous
amount of authority in this area? And perhaps the commission
should be under some attack for not necessarily exercising that
authority, and perhaps the commission can argue that they have
been underfunded and haven't had the resources, but it seems to
me--I have always been under the impression that the commission
had this authority. You yourselves stated that, in fact,
audited financials are--in fact, the financials themselves are
prepared by the public company as a function under the 1934
Act, and then audited and given a blessing by the auditor, but
in fact they are all compelled by securities law in the first
place, and it is the commission that governs securities law.
And so I think that your point is right or--your line--of
reasoning is right on point.
I furthermore think that now we are talking about in the
GAO--and I don't think John's bill goes this way or Mike's bill
goes this way, necessarily, but the idea of registration of
auditing firms with this new authority. And the next question
is, which I have asked with other panels, are we going to have
to have qualified opinions with an audit that is given, for
each audit that is given, that it meets certain standards? And
do we know exactly where we are going in setting the standards?
But let me ask--I want to move on to some other points.
Everyone talks about the need of sort of a division of labor
between audit and non-audit services, and I do not disagree
with that, but we have a number of lists that are out there,
what ought to be precluded or prohibited, and what ought not to
be prohibited. Are we better off trying to write in the statute
what services can be provided and what services cannot be
provided, or are we better off providing the commission, if
that is the route we go, or whoever the ultimate authority is--
and again, I would argue that it is the commission--with the
same authority that we have done in banking law, for instance,
to say something that creates the appearance of a conflict and
leave it up to the rulemaking bodies to determine what is
appropriate and what is not appropriate? Would we be better off
than providing a list? Either one or all.
Mr. Breeden. Congressman, I think the question of what is a
permissible service is a very important one. Certainly at a
minimum, if it were left to an agency, there would have to be
some guidelines and standards of what should the policy be
here, and I think Congress has an important role to play in
trying to answer that. You know, in my mind, if Arthur Andersen
had not done one penny's worth of consulting work for Enron,
the exact same problem would have happened. We are in part
discussing a red herring here, because the audit fee that
Andersen was collecting from Enron was more than big enough to
correct the behavior and create all the pressure, whether or
not they were also on top of that getting consulting fees. And
so let us don't kid ourselves that if we forced the people to
get out of all consulting, these pressures on independence are
not going to go away. In some ways they get worse, because if
you have said that the entire firm is dependent on nothing but
the audit fee, then the CFO who can threaten to take away the
audit fee has even more leverage over the auditor than not.
So, on the other hand, we want the public to understand
that audit opinions cannot be bought and the audit relationship
ought to be the primary focus, and as one of the other
witnesses pointed out, we have now seen some cases where
companies have many multiples, the consulting fees, as the
audit fee.
So what should the policy be? And if Congress sets out
standards, whether it is conflict or specific types of risk,
yes, then you could give the jobs of drawing the lines to an
agency.
Mr. Bentsen. My time is coming up and I want to follow up
with two other points. Mr. Breeden----
Mr. LaFalce. Mr. Walker, is----
Mr. Cantor. The gentleman's time is expiring.
Mr. Bentsen. Well, I do not think it is expired, because it
is----
Mr. Cantor. I said ``is expiring.'' Yes, you are correct.
Mr. Bentsen. I would like to hear from Mr. Walker, but I do
want to ask one other thing of Mr. Breeden. An issue was raised
with respect to Enron that goes back to some of the law and
rule changes in the 1980s with respect to insider trading as we
know it, not sales by insiders and sort of the Chinese wall
that was established between underwriting and sales and
trading, and some have raised the question that the unintended
consequence of that was that deals that were being structured,
primarily private placement deals that were being structured
for Enron that had the effect of diluting stock value and
taking debt off balance sheet while increasing the leverage of
the company, had the brokerage side known that, they may well
not have made a market in their public securities. Is that an
unintended consequence, and is there a way to address that in
going back to that 1980s law, or was that just something we
have to live with?
Mr. Breeden. The whole idea of Chinese walls is to
deliberately deprive certain parts of an organization of
information that is possessed by other parts, and so assuming
that that information is valuable, it is almost always the
case, for example, that the investment banking side of a firm
might know that a tender offer is going to happen or that there
might be an LBO going to--something is going to happen to
change the capital structure that would cause your brokers to
either recommend the stock or not recommend it and you
consciously and deliberately say we cannot allow that
information to be used, because only the customers of that firm
would have that information. It is not out in the broad
marketplace. So I think Chinese walls are not perfect, and they
do have the effect that you mentioned in particular cases, but
they also prevent essentially institutionalized insider trading
that would happen if knowledge from the banking side can filter
over into one group of brokers, but not everybody else in the
rest of the marketplace.
Mr. Bentsen. But under--and if----
Mr. Cantor. The gentleman's time is expired.
Mr. Bentsen. With the indulgence of the Chair. Under things
such as Reg FD and others, when deals are being structured that
are increasingly leveraging the company to the detriment of the
public shareholders, should the underwriting side be dutybound
to disclose that? And I understand the original intent, why you
would put the Chinese wall in. It made perfect sense. But now
you have the reverse effect occurring. Or is that just an
unintended consequence we have to live with?
Mr. Cantor. Mr. Breeden, if you can expedite your answer,
as the gentleman's time is expired.
Mr. Breeden. Always a problem. I guess I would just say I
think that is worth taking a look at, in the context of what we
have seen in this case, and see if there are not ways we can
mitigate those negative effects.
Mr. Bentsen. Thank you. Thank you, Mr. Chairman.
Mr. Cantor. The Chair now recognizes Mr. Sherman.
Mr. Sherman. Mr. Chairman, thank you. Let me make sure I
anger virtually everyone in the room with at least a couple of
quick points. First, as we praise the SEC, let us remember that
that is the Government agency responsible for our capital
markets, and we have just had the largest capital markets
failure in history. And while we focus on an accounting
industry that is about to go down from the Big Five down to the
Big Four, we should remember that we could have an SEC rule
that no one firm can audit more than 15 percent of the publicly
reporting issuers and force the breakup of the Big Four and do
something that has kind of a catchy title, the Big Eight. To us
old guys, that has a catchy title. And I do not have time for
oral responses, but I hope our panel would respond on whether
having only 4 accounting firms auditing publicly traded
companies is a good idea for our capital markets.
It has been pointed out that management prepares these
financial statements and the auditor just expresses an opinion
on them. We should point out that what auditors do is demand
changes to those financial statements which management can
implement or not implement. The reason I make this point is
that there has been a lot of talk of criminalizing speech, that
is to say, prohibiting the ``undue influence of management on
the auditors.'' And what worries me is that that is just a
pejorative vagueness for talking, and that if we are going to
criminalize some discussions between auditors and management,
we ought to figure out how financial statements are going to be
created or who is going to decide which talking is necessary
and which is criminal.
Shifting to a question to Messers. Langevoort and Silvers,
you folks have pointed out the importance of private
litigation, which is the only economic incentive auditors have
to do a good job and to stand up to that other economic
incentive they have to do whatever Ken Lay wants them to do.
The one concern I have is back in those old days, these
accounting firms were general partnerships. Everybody was
liable for whatever the accounting firm was liable for. All
multithousands of partners and an awful lot of assets. Now they
are all limited liability companies. Does it make any sense to
allow lawsuits against accounting firms unless we have a
requirement that they have malpractice insurance or malpractice
reserves or some other capital? And should that capital
requirement be set at one half a year's audit fees or at some
other level?
Mr. Langevoort. Certainly you need to address the question
of whether there is money. I think we have yet to learn what
the protective shield of limited liability partnership or
limited liability company is, but you are absolutely right. If
the deterrent effect is going to be there, there has to be some
way of reaching the wealth generated by performing the services
and capturing that.
Mr. Sherman. I am not so much thinking of this as a hammer
that is going to take away the house of every partner of Arthur
Andersen, so much as a compensation fund. If we are going to
tell people they can sue because they have been harmed, they
ought to be able to recover something, and I would point out
that the amount being offered by Arthur Andersen now is just 6
years' fees to one client.
Mr. Langevoort. I do not disagree with that, but I would
keep the club and the hammer there, too.
Mr. Sherman. Shifting to the scope of service, there is
discussion of making a laundry list, perhaps 10 items, that
auditors are not allowed to do. But the main impetus for this
is to say, well, maybe $25 million in fees is a necessary evil
if you are going to have privately paid-for audits, but $52
million is way too much. Do we need just a laundry list of
services not to be provided, or do we need a rule that says
your total non-audit fee cannot exceed, say, 50 percent, 80
percent, 100 percent of your total audit fee? The ratio was
commented on by, I believe, Mr. Silvers, should there be a
requirement that that ratio not exceed 50 percent or 100
percent?
Mr. Silvers. I think that the issue here really is, as you
mentioned, with the laundry list, that it is possible to evade
the intention, which is to end the conflict, by the change in
practices within the marketplace. Our view is, is that what you
need here is a--and I believe one of the witnesses--one of my
co-panelists spoke to this earlier. You need a statutory
mandate to the commission, right, that in general bars
consulting services, allows for consulting services that are
intrinsic to the audit function, all right, and gives the
commission the discretion to sort out as the marketplace and
practices change which are which. Right?
Mr. Sherman. But if, say, tax services are an integral part
of the traditional accounting function or auditing function, is
it acceptable to have a million dollar audit fee in a $3
million tax fee?
Mr. Silvers. Well, I think there are two answers to that.
One is, as I said earlier, there are tax services and there are
tax services that are preparing the audit. Then there is
structuring the partnership designed to keep everything off the
books. They are very different and that is why you need the
commission to have this discretion. But to answer your question
directly, the question of the ratio, it seems to me that if we
have got the general rule right and the SEC is complying with
the intent of Congress here, that you would never see a
situation in which audit firms exceeded by multiples, right,
consulting fee--audit fees exceeded by multiples consulting
fees. Thus the kind of measure you are suggesting might be a--I
think what Mr. LaFalce referred to as a helpful redundancy.
I think, though, that what really is critical here is, is
that the Commission be given both the discretion and the clear
direction.
Mr. Sherman. I would point out that the commission----
Mr. Cantor. The gentleman's time has expired.
Mr. Sherman.----has for the last 50-plus years--I believe
my time is expired.
Mr. Cantor. Thank you, gentlemen.
The Chair now recognizes Mr. LaFalce.
Mr. LaFalce. I thank the Chair very much.
Mr. Silvers, we have not really spent too much time
considering the issue of mandatory rotation of auditors, and I
might say that all of my accounting provisions or auditing
provisions were discussed at great length with the former chief
accountant to the SEC, Mr. Lynn Turner. As you know, in my
bill, I would say that you could have an audit for a 4-year
period, and it could be renewed. It could be renewed basically
if you have got the Good Housekeeping Seal of Approval of the
SEC for an additional 4-year period. But then that would be it.
I think that might well ensure for 8 years of good audits and
then another auditor could come in and say what a great job the
previous auditor did or point out where there is need for
improvement.
No, what are your thoughts on that concept? It seems to me
that that concept is even more important, or at least equally
as important, as the separation of the auditing and non-
auditing functions.
Mr. Silvers. Yes. I would very much agree with your
characterization of that language. I think that--and the AFL-
CIO has proposed a rulemaking petition to the SEC that the SEC
put such a requirement in place by rulemaking. I think that the
critical issue here again goes to what Chairman Greenwood was
talking about, which is the sort of confluence of forces that
are at work to compromise the audit. All right? And one of the
most important is this sense of cash flows in perpetuity that
come from keeping a client happy, and the way in which there is
a kind of melding of the audit firm and the staff of the people
they are auditing. I think that Chairman Baker made some
reference to his concern about that earlier in this hearing.
Both the firm rotation and the prohibition on individuals
flipping over that Chairman Baker alluded to would get at that.
Mr. LaFalce. Well, prohibition and flipping over and
cooling-off period is a provision of my bill.
Mr. Silvers. I left that to you to say.
Mr. LaFalce. OK. And you favor that.
Mr. Silvers. Absolutely.
Mr. LaFalce. Let me just ask the other gentlemen. On the
issue of the cooling-off period, I have a 2-year time period
wherein the chief auditors of a particular company could not
then be employed by that company. Would you favor that, Mr.
Walker, Mr. Breeden?
Mr. Walker. I think the issue of a cooling-off period needs
to be looked at. Some changes are necessary. I think you have
to recognize that there are ways to potentially get around
that. While it is not appropriate for them to serve in the CFO
position, some of the things that Chairman Breeden has talked
about, you also can hire people as consultants, and they are
not employees, and the question is, what are they doing. So I
think you have to recognize and look at substance over form and
make sure you are accomplishing the objective.
Mr. Breeden. Congressman, as I said earlier, I think the
cooling off is an important principle. Without looking at the
specifics of how to do it--for example, I would let a company
hire someone from their audit team to come in and have another
position in the company for 2 years without being CFO. I think
the real risk comes when the CFO is dealing with his or her own
former staff over at the audit team, and I----
Mr. LaFalce. Let us not kid ourselves. Some accounting
firms have a policy of encouraging early retirement, creating
incentives for early retirement, so that you do become the CFO
of the company that you have been auditing, and you cement the
relationship, the tie between the firm and your former auditing
firm. We have got to deal with that problem in some way.
Now we can always point out, well, this is not crossed
right or that T is not dotted right, but there is a fundamental
problem. And let us cure the problem. If we do it imperfectly,
well, then we can correct it, but let us deal with the very
imperfect problem that exists. Let me go on, though, because I
have so many other questions I want to ask.
Mr. Langevoort, you have been neglected and I do not want
to neglect you any more, because Mr. Watt was talking about
what he considers to be so important. But that is one of the
most important provisions of our bill. We specifically would
give legislative sanction to aiding and abetting liability for
accountants and other professionals, and we specifically alter
the statute of limitations.
Now there has been some confusion. Everybody says you ought
not to change the 1995 Securities Reform Act or the 1998
Securities Reform Act. Do either of those provisions change the
1995 or 1998 Securities Reform Act?
Mr. Langevoort. No, and thank you for the softball
question.
Mr. LaFalce. See, everybody here is under the impression
that we are undoing what is done in 1995 and 1998.
Mr. Langevoort. These two changes would carry out things
that predate the 1995 legislation and that the SEC has endorsed
previously. They are compelling as a matter of public policy.
Mr. LaFalce. And yet witness after witness from industry
comes in and says, oh, you cannot do this, because you would be
undoing the 1995 and 1998 legislation, and they really do not
know that it has nothing to do with the 1995 and 1998
legislation.
Mr. Cantor. The gentleman's time is expired. The Chair is
going to yield himself time for an additional round of
questions.
Mr. Breeden, I would like to ask you on the question of
rotating audits, do you feel that there will be an increased
quality of audit if a company is required under all
circumstances to replace its auditors every 4, every 8 years?
Do you really feel there will be an increase in quality of
audits, given the subsequent increase and expense the company
will incur?
Mr. Breeden. Mr. Chairman, in my testimony I said that I do
not personally favor mandatory rotation because I think
rotation in some cases would be a benefit, and in other cases
would be a disadvantage. In a very complex company, it takes a
number of years to get up to speed and really understanding
where the risks in that company are, and if you rotate--and
particularly if you rotate every 4 or 5 years, I think you
would have periods of time, blackout periods, almost, where the
auditors are getting up to speed. That could be overcome.
People could spend more money to throw more people at getting
up to speed faster, but in general I think that is something as
a requirement that goes farther than we need.
What I would like to see us do is to move more to a system
where auditors are engaged for a 3 or 4-year period, not for a
1-year period, and that at the end of that time, the audit
committee has to go out for proposal and at least hear what the
other firms propose and how they would structure the audit and
how many hours they think should be involved, and then leave it
to the audit committee to make a decision on whether that firm
should be retained or whether you should rotate.
Mr. Cantor. I would respond and ask you what value would it
be for there to be an imposition and to require going out for
bid again under all circumstances, because that, too, does take
time, and obviously someone participating in a response to a
bid will not have the knowledge of the company the way that an
existing auditor will have, and is that the best way? Are we
really gaining some safeguards there?
Mr. Breeden. I am not sure I understand the question. You
are saying what value is there in going out for proposal?
Mr. Cantor. Just for going out's sake.
Mr. Breeden. Well, I would not require that as a matter of
legislation. But I think as a matter of audit committee good
practice, that every few years you should put your periscope up
above the surface of the ocean and take a look around and see
what other options are out there. I think the audit committee--
I wrote on this subject in the Wall Street Journal a week or so
ago. The audit committee needs to become more active than has
been traditional, and we have been moving in that direction for
the last 10 or 20 years. We keep--through the exchanges they
keep encouraging better literacy, higher quality membership on
audit committees. They are positioned to be a check-and-balance
on the CFO, but we cannot expect audit committees to attract
good people, and you want them to have the responsibility, and
yet put them in a straitjacket and say, well, the law itself
tells you what you have to do and not do.
So I would leave some of these questions to the audit
committee.
Mr. Cantor. Thank you.
The Chair now recognizes Mr. LaFalce.
Mr. LaFalce. Well, thank you very much. I do think that
there are a number of threshold questions that are important.
First of all, we ought to not lose sight of the fact that it is
more than accounting and auditing that we have to be concerned
about. We had problems with corporate officers. We had problems
with boards of directors. We had problems with the auditing
firms. We had problems with the rating agencies. We had
problems with the securities firms and their analysis. We had
problems with the law firms and probably an awful lot of
others, too. What I am fearful of is that--or not fearful, that
we are going to overreact. Industry is too strong, too
powerful, too influential. Let us not kid ourselves. It is
going to be tough to get anything at all passed that is
meaningful, that is more than cosmetic. Our problem is not
overreacting. Our problem is underreacting, coming in with a
cosmetic. And let us not kid ourselves. If we don't understand
that, we do not understand the governmental process as it
really works, as opposed to you know how it is supposed to
work.
I want to go into some differences between the bills, and I
really--it is not a question of his bill, my bill or anything
like that, but I want these issues to be addressed. I would
like for there to be dialogue between us. There has been no
dialogue. Before we have a markup. I make a public call for an
opportunity to have dialogue, private dialogue, on these issues
that we can come to some compromise on them. But I would like
at least a public comment on some things that are new.
To the extent that you have knowledge, and you probably do
not have too much knowledge other than newspaper knowledge, but
please give me your thoughts about it.
The lawsuit against Enron has been expanded to include a
number of the investment banks, about 10 or so. What is the
theory of liability there? It is not just lending. I think it
is more than lending. It is some type of active participation.
Is it more than aiding and abetting?
And then also some people think that aiding and abetting in
an action brought by the SEC simply requires a show of
negligence, and I think the standard is substantially higher
than that. I would like some explanation on that. And then also
the Attorney General of the State of New York has obtained a
court order. I am not exactly sure what the order says or does,
but it was against Merrill Lynch, apparently--and, again, only
speaking now from what I know about it from the newspaper--for
making recommendations that are contrary to opinions that were
expressed by an overwhelming percentage of the analysts of the
firms in their e-mail conversations. Who wants to swing at that
one?
Mr. Langevoort. Let me start with what I think was the
first question. With respect to the pending lawsuit against a
variety of participants in Enron, I have not read the 500-and-
whatever-page complaint so I cannot address the specifics.
Going back to my testimony, the uphill battle plaintiffs
have is in trying to trace a way in which the investor banker's
involvement was more than just behind-the-scenes assistance. It
tries to do that by saying the investment banks used their
analyst conduits to speak directly to the market. That is more
than assistance. There may have been some participation in
preparation of documentation that made it into the hands of the
investing public. Those are all possibilities, but I guess my
bottom line concern is that is really an unfair burden to put
on the plaintiffs, if what you are really complaining about was
that the bankers were the brains in some respect behind all of
this.
Second, with respect to aiding and abetting----
Mr. LaFalce. One of the difficulties I have is we have not
examined that before our Committee. We have not examined what
the nature of the law is that would cover and what the nature
of the law should be to cover them, and that could be a large
part of the problem. I do not say that it is.
Mr. Silvers. Congressman, I am not familiar with the
complaint, obviously, as it has been amended, but I am a little
familiar with some of the transactions that may be part of the
complaint. There have been--and because there has been
litigation both in the bankruptcy court and in the Southern
District of New York around some of these banking transactions,
and essentially what some of that litigation seems to show--and
there are traditional opinions backing up what I am about to
say--is that in at least the case of JPMorgan Chase, that
company engaged in what was treated as a market derivative
transaction, but in effect was a loan to Enron, because it was
a loan paired with two energy derivatives contracts which
essentially canceled each other out, and in one case they both
ran through--JPMorgan Chase subsidiaries based in the Island of
Jersey off the United Kingdom, which is an offshore bank haven,
and the result of that transaction was that Enron got a billion
dollar loan, did not show up on Enron's balance sheet.
Mr. LaFalce. The whole issue of derivatives and the
regulation of derivatives is very important, because the
industry officials that engage in derivatives have said, well,
these are counterparties who are so sophisticated that there
need not be any type of regulation for them at least, and yet
there are innocent people who are not parties to those actions
that can suffer serious consequences, and then that is an issue
smack dab before the jurisdiction of our Committee which we
have not looked into.
Mr. Cantor. If the gentleman will expedite his answer. The
gentleman's time has expired.
Mr. LaFalce. Well, I want to take another round.
Mr. Silvers. Just to conclude, that transaction, unless
some particular facts have arisen, that would--Chase directly
communicated that transaction to Enron investors. That
transaction will not be litigable because of this aiding and
abetting issue. But, nonetheless, as you point out, real people
were very badly hurt here. I spent some time with some of them
in Houston on Friday, and those people have no--if it is merely
aiding and abetting, those people have no cause of action.
Ironically enough, Chase Manhattan Bank, though, is acting
on their behalf on the creditors committee of Enron and
depriving those same people their severance money, while they
see if they can bob and weave out of the liability generated by
these transactions. It is really scandalous, frankly.
Mr. LaFalce. Mr. Chairman, I know my time is expired, but
Mr. Langevoort did not respond, did not have the opportunity to
respond to the question of the standards that have to be met in
aiding and abetting liability, whether it is negligence or
something considerably greater than negligence.
Mr. Langevoort. Congress made absolutely clear when it
restored the SEC's aiding and abetting authority that
intentional misconduct was the standard, and that is clearly
the law with respect to aiding and abetting generally.
Mr. LaFalce. And, therefore, if we extend aiding and
abetting liability to private litigation, we would adopt the
same standard, and so you would have to prove intent.
Mr. Langevoort. The bill 3813 would mirror the standard for
intent in private securities.
Mr. LaFalce. It need not, but----
Mr. Langevoort. Yes. That is correct.
Mr. Cantor. The Chair yields to himself this time for an
additional question. Mr. Breeden, in your written testimony,
you unequivocally state that you would not support any steps to
restore joint and several liability, aiding and abetting
liability and other measures. Can you speak just sort of
briefly to the adequacy of the remedies available under the
1995 Act?
Mr. Breeden. The 1995 Act was discussed earlier. I guess
the only thing I would add to the 1995 Act was this same issue
of whether aiding and abetting should be--whether Central Bank
should be overturned was before the Congress in the 1995 Act.
The Congress in that legislation could have done so, and it did
not. The absence of action rather than the actuality of action
was part of what Congress ended up doing there.
My own view is that we have struck a balance in the private
litigation area, and there will always be cases that will cause
us to say we should give more rights of action, but there are
also--that opens the door, in my opinion--and I respect the
differences from others on this point, but I believe it does
open the door to abusive litigation, and the costs of that are
very, very real, not only to the economy and to businesses, but
to shareholders, too, who pay the ultimate cost of that whole
process.
Mr. LaFalce. Mr. Chairman, if I can just follow up with the
question with Mr. Breeden on that point.
Mr. Cantor. If he can just finish his response and I will
yield back to you for plenty more time.
Mr. Breeden. I guess my view would be twofold. One, in the
context of this legislation of trying to do something positive
and meaningful to respond to the Enron situation, I think if we
refight the battle of litigation reform all over, as part of it
I think it will make the chances of doing anything constructive
here much lower and, therefore, I would not like to see that
happen, because I think there are some improvements that should
be made and there are a lot of good things in your bill that
ought to be done.
Second, even if it were not a question of tactics and
timing, I do not substantively favor the expansion of the
rights as has been described.
Mr. Cantor. Thank you very much.
The Chair now recognizes Mr. LaFalce.
Mr. LaFalce. Mr. Breeden, I just do not know how any
person, unless they have a philosophic disposition, that says
individuals should not be able to go into a court of law to
obtain redress for a wrong, can say that if an individual or a
firm has intentionally aided and abetted in false or misleading
statements, that they should not be able to be held liable. You
know, it is absolutely beyond the capacity of the SEC on its
own to go after all of those instances when it is done. They
have got a paltry record on this in the past. The FTC, which
has the ability to go into court--and you can't go into court
if you are an individual--has come into Congress and said,
restore the right of an individual who has been aggrieved,
because it is wildly beyond our capacity to bring lawsuits
where lawsuits are necessary to be brought.
And, Mr. Breeden, I understand the philosophic mind that
just wants to cut back--for example, the mind of this
Administration. They want a terrorism insurance bill, but only
if it is coupled with the cutback of an individual's right to
go after individuals who may have participated in that
terrorism and caused injury.
Well, having said that, let me just say that that is one
issue where you and I have profound differences on, and I hope
that the Congress, at least this Committee, will be given the
opportunity to consider that as you--and not confuse it with
undoing the 1995 or the 1998 legislation which simply did not
address those issues. And I will not be offering the joint and
several. I will be offering the aiding and abetting and I will
be offering the statute of limitations and I will be offering
them separately so that we can have discrete issues before us.
Now, going back to the issue of mandatory rotation, Mr.
Silvers, you favor it--I do not know that you have an opinion
one way or the other, Mr. Langevoort. Mr. Breeden, you have
said you opposed it. Mr. Walker, you said you certainly think
it should be on the table for study. Is that fair enough?
Mr. Walker. We are saying two things. One, more things need
to be done on key personnel on the engagement and that the
other issue should be studied. I have some personal concerns
about mandatory rotation of audit firms.
Mr. LaFalce. Well, I brought this up with Mr. Lynn Turner,
the former chief accountant, who favors rotation, and he said
to me, let me tell you, he says, I used to be one of the Big
Five, he says, and mandatory rotation of the chief partner just
does not work. He says no partner is going to go in and replace
another partner and blow the whistle on the other partner and
say everything he did was wrong. He says it does not work. If
you are going to get to the heart of it, you are going to have
to go to mandatory rotation.
Now he may be right and he may be wrong, but my
recommendation in the bill is not without significant
authoritative support. But let us assume we should not do that.
Now, Mr. Breeden, you have said, well, what we ought to do is
have audit committees, consider hiring audit firms for maybe a
3 or 4-year period and then consider other audit firms, too.
Maybe submit proposals.
Well, the only thing is, if we do not mandate that, how do
we get at the bad guys rather than the good guys? Won't we have
a situation where the good guys are the ones who are going to
do that and the bad guys are the ones who will not do it
voluntarily? And that is the problem with volunteerism.
Now you would have the SEC do it, but, look it, you have
sang the praises of the SEC. The problem is the SEC has
deferred almost 100 percent over the years to the SROs. They
have had almost no watchdog role over the SROs, whether it is
the securities industry, and most especially the accounting
industry. They have been silent.
Mr. Breeden. Congressman, on the issue of rotation, while I
do not personally favor mandatory rotation, it is an extreme
step, and I do not think we are necessarily sure that applied
to 17,000 companies in this country, that it would be a good
idea.
On the other hand, my idea of having a 3 or 4-year
engagement could lend itself to having a statute that said that
beyond, say, one initial term and two renewals, that specific
standards and findings might have to be made by the audit
committee in order to pick the incumbent and keep going. You
could encourage and the commission itself could encourage
through proxy rule its audit committee--require the audit
committee to say why after a dozen years or so, but some--pick
some number, why they did not consider--or did they consider
rotation. If so, why did not they do it. There are ways you can
put a little pressure on to make sure people do look hard at
the question. Would it serve the shareholders' interest to
rotate.
Mr. LaFalce. Mr. Walker.
Mr. Walker. As far as the interest of full and fair
disclosure, I am a CPA and practiced for a number of years;
and, number two, I have been with two of the Big Five firms and
I know how things work; and, number three, I think if you look
at the issue of rotation of the key personnel, right now the
rules are not adequate. You could have an individual or a
person who was serving as engagement manager, then engagement
partner, then the second partner, so they can end up being on
the engagement for many, many years in a row.
Mr. LaFalce. You mean the SEC, having the power to change
that since their existence, has not?
Mr. Breeden. Congressman, I think this is an excellent
issue, though, that pointed out why the proposal of both Mr.
Oxley and yourself, both bills call for a body here to be
created that would begin to resolve some of these issues, and I
think you have put your finger on this is one of the number of
such----
Mr. LaFalce. That is why I wanted to have this hearing,
because we have not discussed this issue, and I would love to
discuss it, and I would love to reach a compromise short of
legislatively mandating rotation, if it is a good compromise.
Mr. Cantor. The gentleman's time is expired, and Mr.
Sherman is in wait.
Mr. Walker. One quick thing, Mr. Chairman, please. I think
one of the things you have to be concerned about is if you are
looking at the public interest, I think you have to be
concerned with how many firms are there that can perform the
service. I think the number of firms does matter.
Mr. LaFalce. That is an important issue, too. Now are there
not a lot of auditing and accounting firms below the Big Five
that really could do much more work than they presently do.
Mr. Walker. They could do more work, except when you are
dealing with highly complex and global enterprises.
Mr. LaFalce. But an awful lot of the publicly traded
companies--what are there, about 17,000?
Mr. Walker. They do not fit this----
Mr. LaFalce. They can do it for--we have got to be able to
encourage--I had a chairman of an accounting firm in my office
today saying I favor mandatory rotation. It is the only way we
are going to be able to get a piece of the action.
Mr. Walker. I understand. It depends where you sit. Number
one, the number of firms that are qualified to do the work is
important. Number two, we need to be concerned with firm
quality and related internal quality assurance procedures. And
number three, the quality of the people is key.
One of the concerns that I have about mandatory rotation is
that could end up putting more pressure on price, and the last
thing you want to do is create a further commoditization of the
audit business, especially if you are going to end up taking a
way a lot of non-audit services, because in the end you have
got to have a viable economic model, and if you do not have a
viable economic model, you are not going to attract and retain
quality people.
Mr. LaFalce. It is a pittance and----
Mr. Cantor. The gentleman's time has expired and the Chair
is going to recognize Mr. Sherman.
Mr. Sherman. Thank you, Mr. Chairman, for giving me a
chance to combine my third, fourth and fifth round questions
into one block.
One of the witnesses mentioned Jersey Island, and of course
we have also seen a lot of Enron activity in the Cayman
Islands. I commend this Committee and the Ranking Member and
the Chair for having these hearings on Enron and responding,
but the Ways and Means Committee is strangely silent. There are
two sets of accounting games that were played by Enron. One, to
cheat the shareholders; the other, to cheat the United States
Government and all taxpayers.
Now, the first is a little bit more apparent, because the
victims are there. The employees, everybody who held stock at
Enron, and in a way every stockholder in every company in the
country, because I am convinced the market would be several
hundred points higher if everybody didn't have to factor into
their investment decisions the fact that the company that they
invest in has a number of risks, including the risk that they
might be the next Enron.
The hidden cost and victims of the accounting games, the
trips to Cayman Islands that had nothing to do with snorkeling,
are the taxpayers, the citizens of the country, everyone who
depends upon Government, our efforts to combat world terrorism,
and it is not just Enron, but hundreds of companies that have
each established dozens of subsidiaries in the Cayman Islands,
in Jersey Island, in Barbados, in the other tax havens, and I
would call upon our sister committee to be as vigorous as this
committee has been. We have to defend investors. They have to
defend citizens.
But shifting to our responsibility and the scope of the
outside auditor, the whole problem arises, because financial
reporting is the only game where the umpire is paid by one of
the teams. And that means under the current system if you say
no, we will not give you an unqualified opinion, you are not
just giving up this year's audit fee, you are giving up this
year's consulting fee. And you are not just giving up this
year's auditing and consulting fee, but those fees could
continue for ten or 20 or 30 years into the future.
Now one thing that I do not think will solve the problem
right away--and I used to work for one of what we call the
Little Six accounting firms--as long as investors, as they
have, always demanded from the big companies they buy stock in
that are widely traded that a Big Five, Big Eight, Big Four
firm be the auditor, I do not know a way to break that up just
with rotation. I think you would end up rotating among the Big
Four, which may have some advantages and disadvantages. I think
if you want smaller firms, we would have to break up the firms
we have got now, because I do not think Horwath is going to be
able to stand up and say, we audited General Motors or we
audited even Pacific Gas and Electric, and you should buy their
stock, or at least rely on our financial statements to decide
whether or not to buy the stock.
We then focus, though, on that financial relationship that
an accounting firm has with its clients, and one thing that Mr.
Silvers and I were talking about is the non-audit fee. And the
question there is whether you can just list a number of
different services and say, OK, from time to time we will
change the list and we will prevent the client from having too
much clout with the accountant because we will always have a
list of prohibited services or limited services that prevent
the client's total fee package from being too important to the
accounting firm, and I wonder whether that is even possible
without the backstop that I have suggested Mr. Silvers referred
to as a perhaps useful redundancy. And I would like the members
of the panel to comment. Is there any way you could list some
services, but not other services and not have a situation where
the client's total fees to the accountant might possibly be as
large or larger than the audit fee? Can we do this by
enumeration, or must we do it by ratio?
Mr. Walker. My personal view is--and as our testimony
states--you may want to have certain principles that you say
that under no circumstances can the auditor violate certain
principles, which are clearly articulated.
Second, you may want to have certain safeguards to make
sure that people are not auditing their own work, either firms
or people within the firm. You should delegate to an
independent qualified authoritative body which is able to make
the tough decisions on what should and should not be allowed
based upon changing market conditions. I think it is difficult
to establish any particular level to say that merely because
non-audit fees exceed a certain number, that there is a problem
per se.
Mr. Sherman. So if I can interrupt, let us say it was
thought to be acceptable that an accounting firm also provide
executive recruitment. You are not auditing your own work,
except to the extent that----
Mr. Cantor. The gentleman's time is expired. If we can
expedite the answer.
Mr. Sherman. I didn't even get through to the question. So
I would withdraw it.
Mr. Cantor. The gentleman may proceed.
Mr. Sherman. If we--whatever the allowable service is, say
executive recruitment, is there--if it makes sense to allow a
little bit of it, can you allow so much of it that the
accounting firm is receiving more from those services than from
the auditing fee?
Mr. Walker. Under the approach that we have taken under
generally accepted Government auditing standards, which is
outlined in my testimony, we say there are certain things you
cannot do irrespective of the comments involved. There are
other things that you should be able to do, but certain
safeguards must be met, and we do not propose any arbitrary
dollar or percentage limit. We also think that the audit
committee should end up being more actively involved in
reviewing and approving certain types of services.
Mr. Sherman. I believe my time is expired.
Mr. Cantor. Thank you.
Mr. LaFalce. Yes. I just want to thank the panel very, very
much. I think this has been very constructive and helpful. I
just wish there were more Members from both sides of the aisle
who could have listened to the issues that were discussed by
both of you.
Also, Mr. Breeden, I do want to say that it was a pleasure
working with you in the Bush Administration when
representatives of the Administration used to talk with
Democratic Members of the House. That is not the case. I used
to virtually live with representatives from the Treasury
Department and from the White House in those days, maybe
because we were in the majority then and they used to talk with
us. That is why I developed such a close working relationship,
not only with you, but with the President himself and so many
of his cabinet officials. That is missing in Bush 2, and it is
a sad--I am sad that it is missing. Thank you.
Mr. Breeden. Congressman, can I only say and just respond
and say it was a great pleasure working with you then and all
of the Members of--some of the Members who are still on the
Committee here, that I really think the savings and loan
legislation was an opportunity--a great challenge faced by the
country, and you played a tremendous leadership role then and
it was a great pleasure. I have never forgotten working with
you.
Mr. LaFalce. Well, let me say this, that one of the
difficulties--probably, in my judgment, the biggest
difficulty--is that there was a cutback in examiners and in
regulators for our savings and loan in the mid-1980s. I think
that was the single greatest contributing factor. In the
beginning of 2001, when our Committee assumed jurisdiction, I
pointed out that the biggest shortcoming in Government today
was the inadequacy of resources at the SEC, and I called at the
beginning of 2001 for another 2 or 3 percent increase, but a
200 or 300 percent increase in the resources of the SEC. I was
at least figuratively laughed at in calling for such a huge
increase.
Now that Enron has happened, at least the President has
called for a 6 percent increase in his budget. But that is not
good enough.
Mr. Cantor. The Chair would also like to express his
thanks, and members of the panel, for your indulgence and
patience. The hearing now stands adjourned.
[Whereupon, at 4:52 p.m., the hearing was adjourned.]
A P P E N D I X
March 13, 2002
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A P P E N D I X
March 20, 2002
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A P P E N D I X
April 9, 2002
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