    [Senate Hearing 107-948]
    [From the U.S. Government Publishing Office]

                   ACCOUNTING REFORM AND INVESTOR PROTECTION
                                   VOLUME II

                                                            S. Hrg. 107-948

                             ACCOUNTING REFORM AND
                              INVESTOR PROTECTION

    =======================================================================

                                    HEARINGS

                                   before the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                          ONE HUNDRED SEVENTH CONGRESS

                                 SECOND SESSION

                                   VOLUME II

                                       ON

           THE LEGISLATIVE HISTORY OF THE SARBANES-OXLEY ACT OF 2002:
     ACCOUNTING REFORM AND INVESTOR PROTECTION ISSUES RAISED BY ENRON AND
                             OTHER PUBLIC COMPANIES

                                   ----------

                      MARCH 5, 6, 14, 19, 20, AND 21, 2002

                                   ----------

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

    87-708              U.S. GOVERNMENT PRINTING OFFICE
                                WASHINGTON : 2003
    ____________________________________________________________________________
    For Sale by the Superintendent of Documents, U.S. Government Printing Office
    Internet: bookstore.gpr.gov  Phone: toll free (866) 512-1800; (202) 512�091800
    Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001

                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      PAUL S. SARBANES, Maryland, Chairman
    CHRISTOPHER J. DODD, Connecticut     PHIL GRAMM, Texas
    TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
    JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
    CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
    EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
    ZELL MILLER, Georgia                 CHUCK HAGEL, Nebraska
    THOMAS R. CARPER, Delaware           RICK SANTORUM, Pennsylvania
    DEBBIE STABENOW, Michigan            JIM BUNNING, Kentucky
    JON S. CORZINE, New Jersey           MIKE CRAPO, Idaho
    DANIEL K. AKAKA, Hawaii              JOHN ENSIGN, Nevada

               Steven B. Harris, Staff Director and Chief Counsel
                 Wayne A. Abernathy, Republican Staff Director
                      Martin J. Gruenberg, Senior Counsel
                           Dean V. Shahinian, Counsel
                       Stephen R. Kroll, Special Counsel
                           Lynsey Graham Rea, Counsel
                            Vincent Meehan, Counsel
                            Sarah A. Kline, Counsel
                      Judith Keenan, Senior Policy Advisor
        Alexander M. Sternhell, Staff Director, Securities Subcommittee
                    Linda L. Lord, Republican Chief Counsel
                  Stacie Thomas Morales, Republican Economist
                    Michelle R. Jackson, Republican Counsel
         Geoffrey P. Gray, Republican Senior Professional Staff Member
                      Mark F. Oesterle, Republican Counsel
                    Katherine McGuire, Republican Economist
             Michael D. Thompson, Republican Legislative Assistant
       Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                           George E. Whittle, Editor
                    Irene Whiston Carroll, Assistant Editor
                       Frank E. Wright, Assistant Editor
                        Kevin D. High, Assistant Editor

                                      (ii)

                                C O N T E N T S

                                  ----------

                                    VOLUME I

                                  ----------

                           TUESDAY, FEBRUARY 12, 2002

                                                                       Page

    Opening statement of Chairman Sarbanes...........................     1

    Opening statements, comments, or prepared statements of:
        Senator Shelby...............................................     3
        Senator Miller...............................................     4
        Senator Enzi.................................................     4
        Senator Corzine..............................................     6
        Senator Hagel................................................     7
        Senator Stabenow.............................................     7
        Senator Bayh.................................................     8
        Senator Carper...............................................     8
        Senator Johnson..............................................     9
            Prepared statement.......................................    55
        Senator Schumer..............................................    10
        Senator Dodd.................................................    11
        Senator Akaka................................................    56

                                   WITNESSES

    Arthur Levitt, Chairman, U.S. Securities and Exchange Commission,
      1993 to 2000...................................................    14
        Prepared statement...........................................    56
    Richard C. Breeden, Chairman, U.S. Securities and Exchange
      Commission, 1989 to 1993.......................................    16
        Prepared statement...........................................    58
        Response to written questions of Senator Hagel...............    94
    David S. Ruder, Chairman, U.S. Securities and Exchange
      Commission, 1987 to 1989.......................................    20
        Prepared statement...........................................    69
        Response to written questions of Senator Hagel...............    94
    Harold M. Williams, Chairman, U.S. Securities and Exchange
      Commission, 1977 to 1981.......................................    23
        Prepared statement...........................................    75
        Response to written questions of Senator Hagel...............    95
    Roderick M. Hills, Chairman, U.S. Securities and Exchange
      Commission, 1975 to 1977.......................................    26
        Prepared statement and exhibits..............................    78
        Response to written questions of Senator Hagel...............    95

                                  ----------

                          THURSDAY, FEBRUARY 14, 2002

    Opening statement of Chairman Sarbanes...........................    97

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................    98
            Prepared statement.......................................   141
        Senator Stabenow.............................................    99
            Prepared statement.......................................   141
        Senator Enzi.................................................    99
        Senator Bayh.................................................   100
        Senator Crapo................................................   101
        Senator Bunning..............................................   101
        Senator Shelby...............................................   113
        Senator Carper...............................................   113
        Senator Akaka................................................   114
            Prepared statement.......................................   142
        Senator Miller...............................................   128
        Senator Corzine..............................................   129
        Senator Johnson..............................................   142

                                   WITNESSES

    Paul A. Volcker, Chairman, International Accounting Standards
      Committee Foundation; Chairman, Arthur Andersen's Independent
      Oversight Board; Former Chairman, Federal Reserve System.......   102
        Prepared statement...........................................   143
    Sir David Tweedie, Chairman, International Accounting Standards
      Board; Former Chairman, United Kingdom's Accounting Standards
      Board..........................................................   107
        Prepared statement...........................................   147

                  Additional Material Supplied for the Record

    Letter from Paul A. Volcker, Chairman, International Accounting
      Standards Committee Foundation; Chairman, Arthur Andersen's
      Independent Oversight Board; Former Chairman, Federal Reserve
      System to Chairman Paul S. Sarbanes, dated May 17, 2002........   159
    Editorial from The Wall Street Journal by Paul A. Volcker,
      Chairman, International Accounting Standards Committee
      Foundation, dated February 19, 2002............................   164
    Memo from Sir David Tweedie, Chairman, International Accounting
      Standards Board; Former Chairman, United Kingdom's Accounting
      Standards Board on Funding of the UK Accounting Standards Board   166
    Article from Sir David Tweedie, Chairman, International
      Accounting Standards Board; Former Chairman, United Kingdom's
      Accounting Standards Board, dated January 2002.................   168

                                  ----------

                           TUESDAY, FEBRUARY 26, 2002

    Opening statement of Chairman Sarbanes...........................   181

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................   183
        Senator Miller...............................................   184
        Senator Enzi.................................................   184
        Senator Stabenow.............................................   186
        Senator Allard...............................................   187
            Prepared statement.......................................   234
        Senator Shelby...............................................   187
            Prepared statement.......................................   234
        Senator Corzine..............................................   188
            Prepared statement.......................................   234
        Senator Schumer..............................................   219

                                   WITNESSES

    Walter P. Schuetze, Chief Accountant, U.S. Securities and
      Exchange Commission, 1992 to 1995..............................   189
        Prepared statement...........................................   235
    Michael H. Sutton, Chief Accountant, U.S. Securities and Exchange
      Commission, 1995 to 1998.......................................   193
        Prepared statement...........................................   239
    Lynn E. Turner, Chief Accountant, U.S. Securities and Exchange
      Commission, 1998 to 2001.......................................   196
        Prepared statement...........................................   243
    Dennis R. Beresford, Former Chairman, Financial Accounting
      Standards Board, 1987 to 1997..................................   201
        Prepared statement...........................................   258
        Response to question raised by Senator Miller................   270

                  Additional Material Supplied for the Record

    Article by Walter P. Schuetze in Abacus, a Journal of Accounting,
      Finance, and Business Studies, ``What Are Assets and
      Liabilities?'' dated February 2001.............................   271
    Article by Walter P. Schuetze, 2001 RJ Chambers Research Lecture,
      dated November 27, 2001........................................   288
    Letter from Walter P. Schuetze to Senator Charles E. Schumer,
      dated March 25, 2002...........................................   296
    Letter with attachments from Lynn E. Turner, Director, College of
      Business, Colorado State University, dated March 1, 2002.......   302

                                  ----------

                          WEDNESDAY, FEBRUARY 27, 2002

    Opening statement of Chairman Sarbanes...........................   341

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................   342
        Senator Miller...............................................   343
        Senator Corzine..............................................   362

                                   WITNESSES

    John H. Biggs, Chairman, President, and CEO, Teachers Insurance
      and Annuity Association-College Retirement Equities Fund (TIAA-
      CREF)..........................................................   343
        Prepared statement...........................................   373
    Ira M. Millstein, Co-Chairman of the Blue Ribbon Committee on
      Improving the Effectiveness of Corporate Audit Committees;
      Senior Partner, Weil, Gotshal & Manges, LLP....................   350
        Prepared statement...........................................   378

                  Additional Material Supplied for the Record

    Miscellaneous exhibits submitted by Ira M. Millstein, Co-Chairman
      of the Blue Ribbon Committee on Improving the Effectiveness of
      Corporate Audit Committees; Senior Partner, Weil, Gotshal &
      Manges, LLP....................................................   388

                                  ----------

                                   VOLUME II

                                  ----------

                             TUESDAY, MARCH 5, 2002

    Opening statement of Chairman Sarbanes...........................   505

    Opening statements, comments, or prepared statements of:
        Senator Bunning..............................................   506
        Senator Dodd.................................................   507
        Senator Miller...............................................   507
        Senator Crapo................................................   508
        Senator Corzine..............................................   508
            Prepared statement.......................................   550
        Senator Stabenow.............................................   515
            Prepared statement.......................................   550
        Senator Bennett..............................................   515

                                   WITNESSES

    David M. Walker, Comptroller General of the United States, U.S.
      General Accounting Office; accompanied by: Thomas McCool,
      Managing Director, Financial Markets and Community Investment;
      and Robert Gramling, Former Director, Corporate Financial
      Audits.........................................................   508
        Prepared statement...........................................   551
    Robert R. Glauber, Chairman and Chief Executive Officer, National
      Association of Securities Dealers, Inc.........................   527
        Prepared statement...........................................   569
    Joel Seligman, Dean and Ethan A.H. Shepley University Professor,
      Washington University School of Law in St. Louis; Public
      Member, American Institute of Certified Public Accountants
      Professional Ethics Executive Committee........................   530
        Prepared statement...........................................   573
    John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia
      University School of Law.......................................   534
        Prepared statement...........................................   582

                  Additional Material Supplied for the Record

    GAO Report, SEC Operations, Increased Workload Creates
      Challenges, dated March 2002...................................   594
    GAO Report, Highlights of GAO's Corporate Governance,
      Transparency and Accountability Forum, dated March 2002........   638
    Business Week article submitted by Senator Paul S. Sarbanes,
      dated March 11, 2002...........................................   653
    The Wall Street Journal article submitted by Senator Robert F.
      Bennett, dated February 25, 2002...............................   654
    Letter from GAO Comptroller General of the United States David M.
      Walker to Senator Paul S. Sarbanes, dated May 3, 2002..........   657
    Letter from John C. Coffee, Jr., Bevis Longstreth, and Joel
      Seligman to Senator Paul S. Sarbanes, dated July 1, 2002.......   670
    Letter from SEC Chairman Harvey L. Pitt to Senator Phil Gramm,
      dated July 3, 2002.............................................   674
    Letter from SEC Attorney General Eliot Spitzer to Senator Paul
      Sarbanes, dated June 5, 2002...................................   676

                                  ----------

                            WEDNESDAY, MARCH 6, 2002

    Opening statement of Chairman Sarbanes...........................   679

    Statement of Senator Gramm.......................................   680

                                   WITNESSES

    Shaun F. O'Malley, Chairman, 2000 Public Oversight Board Panel on
      Audit Effectiveness (O'Malley Commission); Former Chairman,
      Price Waterhouse; Past President, Financial Accounting
      Foundation.....................................................   681
        Prepared statement...........................................   716
    Lee J. Seidler, Deputy Chairman of the 1978 AICPA Commission on
      Auditors' Responsibilities; Managing Director Emeritus, Bear
      Stearns........................................................   685
        Prepared statement...........................................   725
    Arthur R. Wyatt, CPA, Former Chairman, American Institute of
      Certified Public Accountants' Accounting Standards Executive
      Committee; Former Chairman, International Accounting Standards
      Committee; Former Partner, Arthur Andersen & Co.; Professor of
      Accountancy Emeritus, University of Illinois...................   689
        Prepared statement...........................................   739
    Abraham J. Briloff, Emanuel Saxe Distinguished Professor
      Emeritus, Bernard M. Baruch College, CUNY......................   692
        Prepared statement...........................................   745
    Bevis Longstreth, Member of the O'Malley Commission; Former
      Commissioner of the Securities & Exchange Commission, 1981-
      1984; Retired Partner, Debevoise & Plimpton....................   696
        Prepared statement...........................................   793

                  Additional Material Supplied for the Record

    Letter from Chairman Paul S. Sarbanes to President George W.
      Bush, dated March 6, 2002......................................   802
    Letter from the National Association of State Boards of
      Accountancy to Chairman Paul S. Sarbanes and Members of the
      Banking Committee, dated March 22, 2002........................   804

                                  ----------

                            THURSDAY, MARCH 14, 2002

    Opening statement of Chairman Sarbanes...........................   809

    Opening statements, comments, or prepared statements of:
        Senator Bunning..............................................   811
        Senator Gramm................................................   811
        Senator Corzine..............................................   813
        Senator Enzi.................................................   813
        Senator Dodd.................................................   815
        Senator Bayh.................................................   816
        Senator Stabenow.............................................   817
            Prepared statement.......................................   860
        Senator Miller...............................................   817
        Senator Carper...............................................   842

                                   WITNESSES

    James G. Castellano, CPA, Chairman, Board of Directors, American
      Institute of Certified Public Accountants (AICPA); Managing
      Partner, Rubin, Brown, Gornstein & Company, LLP................   818
        Prepared statement...........................................   860
        Response to written question of Senator Miller...............   888
    James E. Copeland, Jr., CPA, Chief Executive Officer, Deloitte &
      Touche, LLP....................................................   820
        Prepared statement...........................................   862
    William E. Balhoff, CPA, CFE, Chairman, Executive Committee,
      AICPA Public Company Practice Section; Senior Audit Director,
      Postlethwaite & Netterville, A.P.A.C...........................   823
        Prepared statement...........................................   865
    Olivia F. Kirtley, CPA, Former Chairman, Board of Directors,
      AICPA (1998-1999); Retired Vice President and CFO, Vermont
      American Corporation...........................................   825
        Prepared statement...........................................   866
    James S. Gerson, CPA, Chairman, Auditing Standards Board, AICPA;
      Partner, PricewaterhouseCoopers, LLP...........................   827
        Prepared statement...........................................   868
    Robert E. Litan, Vice President and Director, Economic Studies
      Program, The Brookings Institution.............................   848
        Prepared statement...........................................   870
        Response to written question of:
            Senator Gramm............................................   889
            Senator Miller...........................................   890
    Peter J. Wallison, Resident Fellow and Co-Director, Project on
      Financial Market Deregulation, American Enterprise Institute...   853
        Prepared statement...........................................   879

                                  ----------

                            TUESDAY, MARCH 19, 2002

    Opening statement of Chairman Sarbanes...........................   893

    Opening statements, comments, or prepared statements of:
        Senator Gramm................................................   894
            Prepared statement.......................................   939
        Senator Corzine..............................................   894
        Senator Dodd.................................................   917
        Senator Carper...............................................   936
        Senator Akaka................................................   939

                                   WITNESSES

    Charles A. Bowsher, Chairman, Public Oversight Board; Former
      Comptroller General of the United States; accompanied by: Alan
      B. Levenson, Counsel to the Public Oversight Board.............   895
        Prepared statement...........................................   939
    Aulana L. Peters, Member, Public Oversight Board; Former
      Commissioner, U.S. Securities and Exchange Commission; Retired
      Partner, Gibson, Dunn & Crutcher...............................   902
        Prepared statement...........................................   963
    John C. Whitehead, Former Co-Chairman, Goldman Sachs & Co.;
      Former Deputy Secretary of State...............................   918
        Prepared statement...........................................   965
    L. William Seidman, Former Chairman, Federal Deposit Insurance
      Corporation; Former Chairman, Resolution Trust Corporation.....   921
        Prepared statement...........................................   967
    Michael Mayo, Managing Director, Prudential Securities, Inc......   925
        Prepared statement...........................................   969

                  Additional Material Supplied for the Record

    The Road to Reform, a White Paper from the Public Oversight
      Board, dated March 19, 2002....................................   973
    Letter from Harvey L. Pitt, Chairman, U.S. Securities and
      Exchange Commission to Charles A. Bowsher, Chairman, Public
      Oversight Board, dated January 22, 2002........................   994
    Fortune news article, The Price of Being Right, dated February 5,
      2001...........................................................   996

                                  ----------

                           WEDNESDAY, MARCH 20, 2002

    Opening statement of Chairman Sarbanes...........................  1003

    Opening statements, comments, or prepared statements of:
        Senator Akaka................................................  1004

                                   WITNESSES

    Senator Howard M. Metzenbaum (Ret.), Chairman, Consumer
      Federation of America..........................................  1004
        Prepared statement...........................................  1032
    Sarah Teslik, Executive Director, Council of Institutional
      Investors......................................................  1009
        Prepared statement...........................................  1040
        Response to written questions of Senator Akaka...............  1056
    Thomas A. Bowman, CFA, President and Chief Executive Officer,
      Association for Investment Management and Research.............  1012
        Prepared statement...........................................  1043
    Damon A. Silvers, Associate General Counsel, American Federation
      of Labor and Congress of Industrial Organizations..............  1016
        Prepared statement...........................................  1053

                                  ----------

                            THURSDAY, MARCH 21, 2002

    Opening statement of Chairman Sarbanes...........................  1059

    Opening statements, comments, or prepared statements of:
        Senator Dodd.................................................  1060
        Senator Bunning..............................................  1060
        Senator Corzine..............................................  1061
        Senator Enzi.................................................  1062
        Senator Gramm................................................  1064
        Senator Bennett..............................................  1084
        Senator Schumer..............................................  1087
        Senator Carper...............................................  1089
        Senator Johnson..............................................  1102

                                    WITNESS

    Harvey L. Pitt, Chairman, U.S. Securities and Exchange Commission  1065
        Prepared statement...........................................  1103

                  Additional Material Supplied for the Record

    The Washington Post article, submitted by Harvey L. Pitt,
      Chairman, U.S. Securities and Exchange Commission, dated
      November 15, 2000..............................................  1167
    Letter from Stephen M. Cutler, Director, Division of Enforcement,
      U.S. Securities and Exchange Commission, to Chairman Paul S.
      Sarbanes and Congressman Michael G. Oxley, dated July 23, 2002.  1168

                                  ----------

                                   VOLUME III

                                  ----------

                              MONDAY, JULY 8, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1171

                                  ----------

                             TUESDAY, JULY 9, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1225
    Continuation of the Senate Floor Debate in Regard to the
      Accounting Reform and Investor Protection Act of 2002 taken
      from the Congressional Record..................................  1247

                                  ----------

                            WEDNESDAY, JULY 10, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1261

                                  ----------

                             THURDAY, JULY 11, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1355
    Continuation of the Senate Floor Debate in Regard to the
      Accounting Reform and Investor Protection Act of 2002 taken
      from the Congressional Record..................................  1387

                                  ----------

                             FRIDAY, JULY 12, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1423
    Continuation of the Senate Floor Debate in Regard to the
      Accounting Reform and Investor Protection Act of 2002 taken
      from the Congressional Record..................................  1429

                                  ----------

                             MONDAY, JULY 15, 2002

    Senate Floor Debate in Regard to the Accounting Reform and
      Investor Protection Act of 2002 taken from the Congressional
      Record.........................................................  1463

                                  ----------

                            THURSDAY, JULY 25, 2002

    Senate Floor Debate in Regard to the Sarbanes-Oxley Act of 2002
      Conference Report taken from the Congressional Record..........  1613
                                  ----------

                                   VOLUME IV

                                  ----------
    Transcript of President Bush's remarks at the Signing Ceremony
      for the Sarbanes-Oxley Act of 2002 on July 30, 2002............  1653
    The Sarbanes-Oxley Act of 2002, Public Law 107-204 signed by
      President Bush on July 30, 2002. Text is identical to
      Conference Report on H.R. 3763 passed by the House of
      Representatives on July 25, 2002, by a vote of 423 Yeas to 3
      Nays and by the Senate by a vote of 99 Yeas to 0 Nays..........  1657

    H.R. 5118, Corporate Fraud Accountability Act of 2002, passed by
      the House of Representatives on July 16, 2002, by a vote of 391
      Yeas to 28 Nays................................................  1723

    S. 2673, Public Company Accounting Reform and Investor Protection
      Act of 2002, passed by the Senate on July 15, 2002, by a vote
      of 97 Yeas to 0 Nays. For procedural purposes, the bill is
      renamed H.R. 3763..............................................  1737

    Senate Committee on Banking, Housing, and Urban Affairs report on
      S. 2673, Public Company Accounting Reform and Investor
      Protection Act of 2002, filed by Chairman Sarbanes on June 26,
      2002...........................................................  1879

    S. 2673, Public Company Accounting Reform and Investor Protection
      Act of 2002, passed by the Senate Committee on Banking,
      Housing, and Urban Affairs on June 18, 2002, by a vote of 17
      Yeas to 4 Nays.................................................  1953

    Senate Committee on the Judiciary Report on S. 2010, Corporate
      and Criminal Fraud Accountability Act of 2002, filed by
      Chairman Leahy on May 6, 2002..................................  2071

    S. 2010, Corporate and Criminal Fraud Accountability Act of 2002,
      passed by the Senate Judiciary Committee on April 25, 2002, by
      a vote of 19 Yeas to 0 Nays....................................  2109

    H.R. 3763, Corporate and Auditing Accountability, Responsibility,
      and Transparency Act of 2002, passed by the House of
      Representatives on April 24, 2002, by a vote of 334 Yeas to 90
      Nays...........................................................  2135

    House Committee on Financial Services Report on H.R. 3763,
      Corporate and Auditing Accountability, Responsibility, and
      Transparency Act of 2002, dated April 22, 2002.................  2193

    H.R. 3763, Corporate and Auditing Accountability, Responsibility,
      and Transparency Act of 2002, passed by the House Committee on
      Financial Services on April 16, 2002, by a vote of 49 Yeas to
      12 Nays........................................................  2257

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                                   VOLUME II

                                  ----------

                             TUESDAY, MARCH 5, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:10 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, the Senate Banking, Housing, and Urban
    Affairs Committee conducts the fifth in a series of hearings on
    accounting and investor protection issues raised by the
    problems of the Enron Corporation and other public companies.
    As the serious and far-reaching ramifications of the Enron
    situation continue to ripple through our capital markets, and
    also through our economy, the Committee seeks to identify
    underlying systemic and structural weaknesses that contributed
    to the problems, and to seek remedies that will minimize the
    possibility of future events of this kind.
        The failure of Enron raises numerous important issues that
    have arisen on occasion in connection with other public
    companies. Among those that have been foremost in the minds of
    the witnesses at our earlier hearings are the following: The
    integrity of certified financial audits; accounting
    restatements; accounting principles and auditing standards;
    accounting regulatory oversight system; auditor independence;
    corporate disclosure; the SEC's ``selective review'' of
    filings; conflicts of interest; stock analyst recommendations;
    corporate governance; and the adequacy of SEC resources. And,
    indeed, other items as well.
        In our previous hearings, the Committee received testimony
    on these and other issues from witnesses with long and
    distinguished experience in both the public and private
    sectors. We have heard from five former Chairmen of the SEC;
    the Chairman of the International Accounting Standards Board,
    as well as the Chairman of its Trustees; a panel of former SEC
    Chief Accountants, a former Chairman of the Financial
    Accounting Standards Board, the CEO of a preeminent pension
    fund serving the education and research community, and an
    authority on corporate governance. Our witnesses have offered
    recommendations for legislative and regulatory measures to
    address the problems confronting us.
        Our witnesses today bring important new perspectives to the
    issues under consideration. They are: David Walker, Comptroller
    General of the United States; Robert Glauber, the CEO of the
    National Association of Securities Dealers, one of the capital
    markets' principal self-regulatory organizations; and Joel
    Seligman and John Coffee, two of the Nation's most
    distinguished law school securities professors.
        First, the Committee will hear from Comptroller General
    Walker, who is the Nation's chief accountability officer and
    the head of the General Accounting Office. Mr. Walker is a
    Certified Public Accountant, and formerly was a Partner and
    Global Managing Director of Arthur Andersen's Human Capital
    Services Practice. Prior to joining Andersen, he was Assistant
    Secretary of Labor for Pension and Welfare Benefit Programs and
    Acting Executive Director of the Pension Benefit Guaranty
    Corporation.
        I should note that last spring, I, joined by two of my
    colleagues on this Committee, Senators Dodd and Corzine, wrote
    to the Comptroller General asking him to ``review whether the
    Securities and Exchange Commission's resources are adequate to
    stay abreast of the market and technological changes that are
    occurring in the domestic and global financial markets.'' We
    specifically asked in that letter ``whether the resources
    available to the SEC are adequate for its ongoing efforts
    regarding full and fair disclosure, enforcement and investor
    education.'' Of course, we have now confronted these major
    systemic challenges to the workings of the market and they make
    those questions even more pertinent and relevant. And we look
    forward to receiving from the Comptroller General the results
    of the GAO investigation.
        We have also invited the Comptroller General to share his
    views on the oversight of the accounting industry, auditor
    independence, corporate governance, and related issues.
        The second panel will address the regulation of accountants
    and the advisability of creating a new organization to regulate
    the accounting profession, as well as such issues as conflict
    of interest and the proliferation of accounting restatements.
    We just recently asked the GAO to conduct a study on the
    ``proliferation of restatements of earnings and other financial
    data which have been issued in recent years by publicly-traded
    companies.''
        I will introduce the individual members of the second panel
    at the conclusion of the Comptroller General's testimony.
        Before I turn to you, Mr. Walker, let me turn to my
    colleagues to see if they have any opening statements.
        Senator Bunning.

                    STATEMENT OF SENATOR JIM BUNNING

        Senator Bunning. A short opening statement, Mr. Chairman.
        [Pause.]
        Chairman Sarbanes. Is that it?
        Senator Bunning. No.
        [Laughter.]
        I won't keep you long, Mr. Walker.
        First, I want to thank the Chairman for holding this
    important hearing and I would like to thank our witnesses for
    testifying.
        It is very important to continue to look at the accounting
    side of the Enron scandal. We have had some good hearings on
    the issue already and I know that we have another hearing
    tomorrow. I am fairly certain that we will have more after
    that.
        The industry has already started to move in the right
    direction. All of the major firms have now fully separated
    their consulting and auditing arms, but I think we need to do
    that permanently. I would prefer to do it legislatively,
    although the SEC is doing it by regulation. We have to make
    sure that 10 or 20 years from now, we do not have auditors
    doing consulting and start the whole process over again. I do
    not believe that auditors doing consulting caused the Enron
    collapse. It was certainly caused by greed. But it surely did
    not stop the collapse.
        There are a number of other options that we need to look at
    on accounting standards. I look forward to hearing from our
    witnesses. I also am very interested in hearing from our
    witnesses on what they think of the role of analysts in Enron
    and what we should do, if anything, about them.
        I spent 25 years in the securities business. I am very
    concerned about the so-called firewalls between the analysts
    who are supposed to be thinking of their customers first and
    foremost, and other aspects of a financial firm. We had
    firewalls at the firm that I worked at, but believe me, I knew
    what the rest of the firm was doing and so did everyone else.
        I am looking forward to your testimony and I thank you for
    coming before us today.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you very much, Senator Bunning.
        Senator Dodd.

                COMMENTS OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Thank you, Mr. Chairman, for holding this
    hearing. This has been a very, very helpful set of hearings.
        Having had a chance to look at the GAO report, this is
    going to be a very worthwhile document I think in making the
    case that we have tried to make for some time now. The
    rationale for asking the GAO to look at this was based on some
    very strong feelings of inadequate resources and other
    problems. And as you point out, this is not just a question of
    resources, but turn-over rates and also the workload we are
    imposing on the SEC as well, contribute to some of the problems
    we are facing. But I think this will do a great deal to help us
    as we try to fashion some suggestions legislatively to deal
    with the issue.
        So, Mr. Chairman, I am appreciative of this set of hearings
    and look forward to the testimony.
        Chairman Sarbanes. Thank you very much.
        Senator Miller.

                    COMMENTS OF SENATOR ZELL MILLER

        Senator Miller. Thank you, Mr. Chairman. I have no opening
    remarks. But I want to say again, thank you for holding these
    hearings and I thank our witnesses for being here to testify.
        Chairman Sarbanes. Thank you very much.
        Senator Crapo.

                     COMMENTS OF SENATOR MIKE CRAPO

        Senator Crapo. Thank you, Mr. Chairman. I also have no
    opening remarks and again, thank you for holding these
    hearings.
        Chairman Sarbanes. Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. I have a statement I will put into the
    record.
        This has been a very revealing set of hearings and
    informative to all of us. I think the report on the increased
    workload is a very, very positive piece and I appreciate the
    response and I look forward to your comments on some of the
    structural issues with regard to how we go forward.
        I appreciate it very much, Mr. Chairman.
        Chairman Sarbanes. Thank you very much. We would be happy
    to turn to you, Mr. Walker.

                      STATEMENT OF DAVID M. WALKER

                COMPTROLLER GENERAL OF THE UNITED STATES

                     U.S. GENERAL ACCOUNTING OFFICE

                     ACCOMPANIED BY: THOMAS McCOOL

     MANAGING DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT

                  AND ROBERT GRAMLING, FORMER DIRECTOR

                       CORPORATE FINANCIAL AUDITS

        Mr. Walker. Thank you, Mr. Chairman, Senators. It is a
    pleasure to be here today to address certain systemic issues
    designed to better protect the public interest in light of
    Enron and other recent earnings misstatements and business
    failures.
        I would like, Mr. Chairman, to enter into the record, if I
    can, a copy of my full statement, which I think has been
    provided to you, of which I might note, the last two pages
    represent a copy of these two charts that I will refer to a
    little bit later.
        Chairman Sarbanes. The full statement will be included in
    the record.
        Mr. Walker. Thank you, Mr. Chairman. In this statement,
    there are a number of key questions dealing with a variety of
    elements of our current system that we believe need to be
    addressed. We look forward to working with the Congress and
    others in doing that, but let me summarize some of the key
    points, if I can, Mr. Chairman.
        I will not address Enron directly. As you know, there are
    many players on the field already with regard to Enron. At the
    same point in time, there are a number of systemic issues I
    think that are raised by the Enron situation, as well as other
    recent earnings restatements and other business failures.
        There is a need to examine a range of important and
    interrelated systemic issues. I will touch on four this
    morning. First, corporate governance. Second, independent
    audits. Third, the regulatory and oversight structure. And
    fourth, the accounting and financial reporting model.
        I will also touch on the recently issued report on the SEC
    that you just noted, Mr. Chairman, and I would like to have
    that inserted into the record as well, if at all possible.
        Chairman Sarbanes. It will be included in the record.
        Mr. Walker. Mr. Chairman, I am also going to refer to
    another document that is being released today which represents
    a summary of a roundtable discussion that we held last Monday
    with a number of top experts whose names are included herein,
    to talk about a range of corporate governance, transparency and
    accountability issues that I would also commend to you and the
    Members, and would like for that to be inserted into the
    record, if at all possible.
        Chairman Sarbanes. Without objection, it will be so
    included.
        Mr. Walker. Thank you.
        In addressing these issues, I would like to note that there
    are three key principles that, in our view, need to be
    addressed in order to ensure that any system functions
    effectively.
        First, there needs to be adequate incentives in place for
    people to do the right thing. Second, there needs to be
    adequate transparency in order to provide reasonable assurance
    that the right thing will be done. Third, there needs to be
    appropriate accountability if the right thing is not done. And
    these three elements, in our view, relate to the entire
    testimony, as well as other areas.
        I will start with the corporate governance area.
        Clearly, serving on a board of directors is an important,
    difficult, and challenging responsibility in today's times.
    Boards of directors work for the shareholders and they need to
    have an adequate number of qualified, independent, and
    adequately resourced members in order to do their job
    effectively.
        Audit committees have a particularly important role to play
    in connection with interaction with both internal and external
    auditors, as well as in connection with making sure that the
    enterprise has a sound and effective system of internal
    controls and that they are properly reporting their results in
    accordance with applicable standards.
        With regard to independent audits, external auditors or
    independent auditors play a critically important role in
    assuring that our capital markets function effectively and
    efficiently. External auditors work for the shareholders and
    they hold a public trust. This trust must not be violated.
        Auditors need to be both qualified and independent. While
    audit firms have the ability to provide a broad range of
    services to their clients, they should not perform certain
    nonaudit services given related conflict-of-interest issues.
        There are certain nonaudit services that should not be a
    problem. There are other nonaudit services that do present
    problems. In this regard, Mr. Chairman, GAO within the last 2
    months has issued a new independence standard, which is
    generally included in accepted auditing standards for the
    Federal Government entities, the so-called ``Yellow Book,'' in
    which we have outlined a principles- and safeguards-based
    approach which we believe provides a sound framework for
    addressing some of the concerns that have been expressed about
    auditors performing certain nonaudit services.
        We are in the process of providing additional guidance,
    questions and answers commentary that is necessary in a
    principles-based approach. We are working with interested
    parties to do that and are hopeful that the AICPA will end up
    following the GAO's lead in taking a similar approach in
    dealing with a range of other independence issues that are
    beyond our direct authority to address.
        It is very important that auditors focus not just on
    whether or not the statements are presented in accordance with
    Generally Accepted Accounting Principles. It is also critically
    important that they make an affirmative determination as to
    whether or not the statements are fairly presented in all
    material respects.
        Both of these elements are critical. As a result, auditors
    have a responsibility to try to assure that there are not
    material misstatements. They should assure that the financial
    statements are free of these material statements and in
    addition, in today's complex and rapidly changing world, it is
    critically important, both for boards of directors, as well as
    auditors, that they focus adequate attention on the entity's
    systems and internal controls. They are critically important.
        GAO has for years done additional work on internal controls
    with regard to Federal Government entities and in fact, we
    express an opinion on whether or not those controls are
    effective.
        We believe that the same needs to be considered for the
    private sector, for at least public companies, as to whether or
    not auditors should have a responsibility for expressing an
    opinion on these key controls which are becoming increasingly
    important given rapid changes in emerging technologies.
        With regard to the regulatory and oversight structure,
    these two charts, which are presented as the last two pages of
    my testimony, provide an illustrated summary of who some of the
    key players are who are relying on our current system. You have
    individual investors, institutional investors, banks and
    lenders or other creditors, and rating agencies, among others.
        They are relying upon a wide array of players who have
    various rules and responsibilities under the current system.
        Time does not allow for me to explain the chart on the
    right, but nonetheless, I think it serves to illustrate that
    there are a lot of players on the field. It is not always very
    clear as to what the different role and responsibility of each
    player is. In some cases, there are overlaps. In some cases,
    there are gaps. And in some cases, there may be
    inconsistencies.
        In summary, the current self-regulatory system is deemed by
    many to be fragmented, not well-coordinated, and has a
    discipline function that is not timely and does not contain
    effective sanctions. For example, the AICPA's disciplinary
    function is to kick you out of the AICPA. Well, I am a member
    of the AICPA and I am a CPA in at least three States, and
    obviously, I do not want to be kicked out of the AICPA. If I
    get kicked out of the AICPA, and there is no requirement to
    join the AICPA, it saves me some annual dues.
        I would hardly suggest that that is an effective sanction.
        On the other hand, with regard to the State regulatory
    authorities, the State boards of accountancies, they have the
    ability to pull my license to practice and pull the certificate
    of any auditor who violates their standards, the so-called
    nuclear device. But they rarely, if ever, use that sanction. As
    a result, we need to understand whether or not we have really
    meaningful sanctions in order to provide appropriate checks and
    balances.
        With regard to the accounting and reporting model, the
    current accounting and reporting model is inadequate to meet
    the needs of the users and it is not properly aligned with our
    knowledge-based economy in the 21st Century. Accounting must be
    based on the economic substance of a transaction, irrespective
    of its form. Additional focus is needed in connection with a
    variety of value and risk-related factors inherent in our 21st
    Century economy.
        In addition, the timeliness and usefulness of current
    reporting is also an issue and additional emphasis needs to be
    placed on key trend and performance-related data.
        Mr. Chairman, with regard to our SEC report, which you have
    so kindly put in the record, in summary, I would say the
    following.
        There is a growing mismatch between the SEC's
    responsibilities and their resources. Resources are not just
    financial resources, they are human resources, as well as
    technological capabilities. There is a need for a comprehensive
    and integrated plan to address these matters, focusing on value
    and risk. The SEC's human capital challenge or people challenge
    is of particular importance given their turn-over rates and the
    current environment in which they are
    operating.
        It is also critically important that the SEC have a strong,
    effective and credible enforcement function which will include
    both civil, as well as criminal penalties in appropriate
    circumstances.
        Our current system, as you know, is based largely on civil
    sanctions and that is understandable for a variety of reasons.
    However, when people violate the law in ways that could violate
    criminal statutes, it is critically important that there be
    full accountability. You do not have to give very many people
    wide stripe suits in order to send a strong signal.
        In summary, the effectiveness of our current systems of
    corporate governance, independent audits, regulatory oversight,
    and accounting and financial reporting, which are the
    underpinnings of our capital markets and are designed to
    protect the public interest, have been called into question as
    a result of Enron and other recent activities.
        Many of these issues that are being raised have previously
    surfaced from other business failures and restatements of
    financial statements that significantly reduced reported
    earnings or equity.
        The results of the forum that we held last week on
    governance, transparency, and accountability identified a range
    of major issues that should be addressed and I have touched on
    some of those today.
        As is usually the case in issues of this magnitude and of
    this importance, there is no single silver bullet to quickly
    make repairs needed to the systems that support our capital
    markets. The fundamental principles of having the right
    incentives, adequate transparency and full accountability
    provide a good sounding board to evaluate proposals that are
    advanced. A holistic approach is also important as the systems
    are interrelated and weak links can severely strain their
    effective functioning.
        Finally, Enron's recent decline and fall, coupled with
    other recent business failures, pose a serious range of
    systemic risks that must be addressed. Effectively addressing
    these issues should be a shared responsibility involving a
    number of parties, including top management, boards of
    directors, various board committees, stock exchanges, the
    accounting profession, standard setters, regulatory oversight
    agencies, analysts, investors, and the Congress.
        In the end, no matter what system exists, bad actors will
    do bad things with bad results. We must 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.
        Chairman Sarbanes. Thank you very much. Did you want to
    discuss those charts at all? They are such a large presence in
    the Committee room----
        [Laughter.]
        I think we ought to direct your attention to them, if only
    for a few minutes.
        Mr. Walker. Well, I will give you a couple of highlights,
    Mr. Chairman.
        Chairman Sarbanes. All right.
        Mr. Walker. Time doesn't allow going into a lot of depth.
        You have several different components of our system on
    which the public relies. And it is not just the shareholders,
    obviously, that we are talking about, but it is also the
    confidence of the investing community and a variety of other
    parties in our capital markets including the key players that
    have important roles to play.
        There are at least four major elements. You have public
    regulation. Public regulation, by and large, is done by the
    Securities and Exchange Commission and by the various State
    boards of accountancies who regulate the license of independent
    certified public accountants to practice.
        A variety of private-sector or nongovernmental type
    entities are involved in providing regulatory oversight. In
    some cases, they are self-regulatory organizations. In some
    cases, they are professional associations like the AICPA.
        With regard to the self-regulatory concept, on the
    accounting side, you have the Financial Accounting Standards
    Board, which is noted on the chart. You also have
    responsibilities on the audit side, which are divided between
    the SEC, the AICPA, and the Public Oversight Board.
        You have other key players which have been alluded to, such
    as the exchanges, who set certain requirements for being listed
    on the exchanges, broker-dealers, and analysts who work for
    those broker-dealers. On the far right, you have our overall
    corporate governance structure, the board of directors, the
    audit committees, and the various sub-entities of the board.
        There are various codes of conduct and requirements that
    apply. Finally, the public accounting firms obviously have
    interaction with a variety of these different parties.
        This chart serves to illustrate, Mr. Chairman, that we have
    a fragmented system. We have a lot of players on the field.
    Quite frequently, there is not adequate coordination.
    Timeliness is a question and also the effectiveness of some of
    the sanctions when there are violations are a real question as
    well.
        I will give you an analogy real quickly, Mr. Chairman.
        I used to be the Assistant Secretary of Labor for Pensions
    and Welfare Benefits, the fiduciary responsibility provisions
    involving trillions of dollars and millions of individuals.
        The IRS had responsibility for administering the tax
    qualification requirements. Their most significant sanction was
    they could disqualify a plan. That would have very adverse
    consequences on employers, on employees, and on a variety of
    other parties.
        As a result, they hardly ever utilized that sanction for
    understandable reasons. And so, there was a need for more
    effective sanctions, both civil and criminal, beneath that, in
    order to make the system work.
        The analogy also applies to the State boards of
    accountancy, in the case of the CPA's, who can pull somebody's
    license, but there are not adequate enough sanctions and
    incentives short of putting somebody out of business.
        Chairman Sarbanes. I understand that the GAO has recently
    issued an independent standard for Government audits. It says
    that the auditors should not provide both audit services and
    material consulting services. Is that correct? And could you
    describe those rules and rationale a little more fully?
        Mr. Walker. Mr. Chairman, we have issued something dealing
    with generally accepted Government auditing standards that
    deals with independence. That is the so-called ``Yellow Book.''
    Basically, what we have done is we have taken a principle-based
    approach.
        It is important to note that there are certain types of
    nonaudit services or ``consulting services,'' that present
    potential conflicts which need to be avoided. However, not all
    nonaudit or consulting services present those types of
    conflicts. So, therefore, what we did was to, through a several
    year process involving a number of parties, come up with a
    proposed standard that first relies on two basic principles--
    that auditors should not perform management functions or make
    management decisions. And second, auditors should not audit
    their own work or provide nonaudit services in situations where
    the amounts or services involved are significant or material to
    the subject matter of the audit. Namely, the subject matter on
    which they are expressing an opinion.
        In addition to that, we provided examples of services that
    would not violate these principles, as well as services that
    would violate them. For example, auditors should not maintain
    the basic books and records on the entity in which they are
    conducting an audit and expressing an opinion. Under the
    current AICPA standards, it is possible for that to be done. We
    believe that is a fundamental conflict and is inappropriate.
        At the same point in time, there are certain types of work
    that auditors can do dealing with the systems of internal
    controls, et cetera, which would be fine for them to do, which
    could be above and beyond the audit.
        To the extent that an auditor does not violate these
    standards, we also have incorporated certain safeguards that
    would provide additional protection not only to shareholders,
    but also to other persons who are relying upon the independent
    auditor. I think it is important to note that our standard does
    not relate to public companies. Our standard relates to audits
    of Federal Government entities and certain entities that
    receive Federal funds, not to the private-sector entities. That
    is the responsibility of the AICPA and the SEC. We are
    coordinating with Chairman Pitt and the AICPA in hopes of
    reconciling some of the differences here.
        Chairman Sarbanes. Well, you seem to have set the AICPA off
    because they have now sent out a key alert to all of their
    constituency here. I just want to quote from some parts of it:
        ``Thank you very much for your efforts to reach your Member
    of Congress during the President's Day recess. It is important
    that you contact your Member of Congress again, and contact
    your Representatives and Senators.
        ``As you are aware, Congress continues to focus on the
    Enron failure and its fall-out. More than 30 legislative
    proposals have been introduced so far, with more to come. Many
    of these bills will not move toward enactment and many
    proposals deal with issues that are peripheral to the CPA
    profession. However, there is one overriding issue that we must
    be especially vigilant about--the prevention of a cascade
    effect if legislation is adopted that is intended only to
    affect public trading companies or their auditors.''
        And then they go on later to talk about the recently issued
    GAO independence standard which applies to Yellow Book audits
    and so forth. Then everyone is urged to communicate with their
    Senators and so forth, about the harmful potential.
        ``This issue has the potential of being harmful in more
    profound ways than any issue we have faced. Your help is
    necessary to deflect it before the public and the profession
    are adversely affected.''
        That is from the AICPA out to its--I think they call them
    key persons, the action alert team.
        I might note that they have been invited and will be
    testifying before the Committee next week. So, they have an
    opportunity very directly in open session to make these points
    and we look forward to receiving with an open and objective
    attitude whatever proposals they bring. But I just thought it
    was interesting to see these alarm bells being sounded here,
    and I wanted to get some aspects of this into the record.
        Mr. Walker. May I respond real quickly, Mr. Chairman?
        Chairman Sarbanes. Certainly.
        Mr. Walker. First, I think that the AICPA's statement is
    clearly an overstatement.
        Second, this is not something that GAO started working on
    as a result of Enron. We have been working on it for over 2
    years.
        Third, in the profession, there is a tension, the CPA
    profession. And I am a CPA. There is a tension between the
    professional side, which I would argue is the public interest
    side, and the business side or the economic side.
        Reasonable people can differ on where you should draw those
    lines. However, it took decades for the profession to build
    public trust and gain public confidence. It can be lost very,
    very quickly.
        We believe it is critically important that one of the
    things that has to be addressed is the independence issue and
    part of the independence issue is what type of nonaudit or
    consulting services are appropriate and which ones aren't?
        We feel very comfortable that we have struck a reasoned and
    reasonable balance in that regard. But we look forward to
    working with the AICPA and other interested parties to answer a
    number of questions that have arisen, which is understandable
    when you have a principle-based approach. We cannot answer
    every situation. We are trying to get people to rise up and
    say, hey, do what is right.
        It is what I said before about the idea of are the
    financial statements fairly presented in all material respects?
    It is not just whether you check the boxes off. Is the bottom
    line right? Does it pass The Washington Post test? Does it pass
    the Congressional committee test?
        Chairman Sarbanes. We have been joined by Senators Stabenow
    and Bennett. I will yield to them briefly if they have any
    opening comments, and then, Senator Bunning, it is your turn to
    question.
        Senator Stabenow.

                  COMMENTS OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Mr. Chairman, I would just ask that my
    statement be put into the record and I want to thank you again.
    I realize that this may not have the same headlines as when Ken
    Lay and Andrew Fastow come before other committees, but this is
    where I believe the real work will be done in terms of the
    future and what is in the best interests of the American
    people.
        So, I want to thank you for this continuation of the
    hearings.
        Chairman Sarbanes. Thank you.
        Senator Bennett, did you have anything?

                  COMMENT OF SENATOR ROBERT F. BENNETT

        Senator Bennett. No, thank you, Mr. Chairman, I do not have
    a statement at this time.
        Chairman Sarbanes. Senator Bunning.
        Senator Bunning. Thank you, Mr. Chairman. Let me see if I
    can weed out what you have said and what you haven't said.
        Your recommendations are for governmental entities. What we
    are really struggling with is recommendations for the private
    sector, their auditors being consultants and auditing the same
    books that they are consulting with, financial consultants.
        I don't think you can separate 80 percent and let them do
    20. In other words, I think there has to be a complete
    separation for the public to get the confidence back that was
    lost with Global Crossing or Enron, I find it impossible to
    believe that an analyst for First Boston or J.P. Morgan or
    whoever, would not have knowledge that they were in the
    underwriting group, the selling group, or have a financial
    position in a security. And yet, they are free to make a
    recommendation to buy or sell the stock.
        What are your solutions to that position? In other words, I
    need your help in the publicly-traded companies.
        Mr. Walker. I see, let me start with the auditors first.
    You are correct, Senator Bunning, that our standard only deals
    with the audits of Federal Government entities and entities
    that receive Federal funds. However, we believe the principle-
    based approach, which would say, you must comply 100 percent of
    the time with this principle-based approach, and in addition,
    to the extent that you perform certain nonaudit or consulting
    services that do not violate those standards, again, you have
    to comply with certain additional safeguards.
        We believe that type of approach has the potential to be
    applied in the public company arena, as well as in other arenas
    in addition to the governmental arena. I have already talked to
    Chairman Pitt about it and they are looking at it and
    considering it as well.
        I have also talked to the head of the AICPA because they
    promulgate independent standards for CPA's, no matter what type
    of work they do, as well as the State boards of accountancy.
    They have an interest in this. For example, the Texas State
    Board just contacted us within the last couple of days and they
    might be interested in adopting our independence rules in lieu
    of the current AICPA rules because they see them as addressing
    some of the issues that need to be strengthened.
        Senator Bunning. What sanctions would you recommend if you
    think the current standards are inadequate?
        Mr. Walker. I think sanctions are a different issue. I
    think one of the things that you ought to consider with public
    companies is not just what you should be able to do and what
    you shouldn't do. My belief is that one of the biggest problems
    we have in the current system is the definition of who is the
    client?
        I would respectfully suggest that in the case of the
    external auditors, the client is the shareholders, not
    management. The proxy for the shareholders would be the audit
    committee and that you may want to consider whether or not the
    audit committee is the entity that ends up making decisions not
    only on who is going to be recommended to be hired and retained
    as auditors or discharged as auditors, but also you may want to
    consider whether or not the audit committee has some role in
    overseeing these standards. You may want to think about whether
    or not the audit committee should receive the resources for the
    corporation to make sure that the right thing is being done by
    the auditors.
        Senator Bunning. Don't we have a direct conflict here
    because sometimes, the audit committee is not well informed by
    the auditors. Therefore, they have been either lied to or
    distorted audits, audits that are not truthful. And because of
    the conflict on the other side, we have a direct effect of what
    audit comes out. Therefore, the board of directors or the
    auditors on the board of directors that are hired by the audit
    committee, maybe, are not getting factual truth and they have
    been distorted and lied to by the auditor because of the other
    side of the public-held corporation.
        Mr. Walker. I believe that it is important to have
    qualified, independent, adequately resource members on the
    audit committee. They have to meet all of those standards. They
    have to be qualified, independent, and adequately resourced. In
    certain circumstances, they may need their own staff. They need
    to have control over who is doing the audit and what resources
    are available for that audit to be done.
        I believe that there should be a mutuality of interest
    between the audit committee, who is working for the
    shareholders, and the auditors, who are supposed to be working
    for the shareholders. But in addition to the auditors working
    for the shareholders in a public company, they also hold a
    public trust because the entire system relies upon certain key
    players to do the right thing. If they do not do the right
    thing, I think they need to be held accountable.
        Senator Bunning. Accountable, to the point of when they
    have defrauded, that they be brought before the justice system
    and taken care of ?
        Mr. Walker. My personal view is that most of the sanctions
    are civil in nature for understandable reasons. But there are
    appropriate circumstances where criminal sanctions should be
    imposed.
        Senator Bunning. Thank you.
        Chairman Sarbanes. Senator Dodd.
        Senator Dodd. Thank you, Mr. Chairman. And thank you to the
    panelist. This has been most worthwhile. Mr. Walker, we thank
    you for your work. I have two questions I would like to raise
    with you. I will try to get through both of them in the time we
    have.
        Your report indicates, as I mentioned in my opening
    comments, that SEC resources are inadequate. That is a point
    that Senator Sarbanes has made. We have talked about this over
    the past number of hearings. The SEC Commissioners have made
    the point that there is significant understaffing and you
    highlight the reasons why. Turnover rates, and I suspect a lot
    of it has to do with parity and pay, just trying to keep
    accountants and lawyers and analysts that are being offered
    substantial increases in their annual pay to leave Government
    and join private firms, I presume, makes it very difficult for
    people to stay.
        What I would like to get at, if I can with you, is what
    divisions are in most need of additional staff based on your
    study? Corporate finance? Enforcement? The accountants'
    offices? I would like to get some sense of where the gaps are
    here in light of the circumstances that have occurred. Could
    you shed some light on that for us?
        Mr. Walker. I would like to have Mr. McCool, the Managing
    Director of the relevant team, come up, who oversaw that work.
        Senator Dodd. Fine.
        Mr. McCool. Senator Dodd, we did not actually----
        Chairman Sarbanes. Mr. McCool, why don't you identify
    yourself, name and position, for the Reporter.
        Mr. McCool. Yes. Thomas McCool, Managing Director of
    Financial Markets and Community Investment.
        Senator Dodd. Mr. Chairman, you cite one example here in
    the report. You say, for example, staffing limitations and
    increased workload have resulted in SEC reviewing a smaller
    percentage of corporate filings and important investment
    protection functions.
        In 2001, the SEC reviewed about 16 percent of annual
    corporate filings or about half of its annual goal of 30 to 35
    percent. That would be one area, for instance.
        Mr. McCool. We found that there are issues across the board
    at most of the major divisions at SEC. I think that we did not
    necessarily find that one division was more in need or needed
    more resources of a particular type than another.
        I would suggest, however, that I think our work did shed
    light on the fact that probably corporate finance and
    enforcement are the areas where the workload has increased
    relative to resources in a more significant fashion than some
    of the others.
        Senator Dodd. How about accounting? I was told there are
    about 25 to 30 people in the chief accountant's office. Am I
    wrong in that? Is that number too low?
        Mr. McCool. I am not actually sure how many are in the
    chief accountant's office. I am sorry.
        [Pause.]
        That is about right. That is about right, 25. I am sorry.
        Senator Dodd. Mr. McCool, a freshman Congressman has a
    bigger staff than that.
        [Laughter.]
        Seriously.
        [Laughter.]
        Chairman Sarbanes. Just to show how bad things really are.
        [Laughter.]
        Senator Dodd. It is stunning. That is a stunning number.
        Mr. McCool. Again, I think it also does reflect what we
    talked about earlier, about the role of SEC in the system. One
    of the thoughts would be how you rethink that role, which is
    part of the larger question.
        Senator Dodd. All right. In other words, you are not
    prepared or--some of the examples you cite--what I was looking
    for was some additional information that may not be in the
    report, where you get into specific areas that you would
    recommend that seem to be particularly short.
        Mr. McCool. Again, for reasons of lack of data at the SEC
    and the time constraints to gather original data, we were
    unable to find measures of what were the real impact and where
    the impact was differentially greater for one division versus
    others.
        Senator Dodd. Yes, Mr. Walker?
        Mr. Walker. Senator Dodd, I would suggest that one of the
    things that needs to be done at the SEC is there is clearly a
    mismatch between what they are being asked to do and the
    resources they have to be able to do it.
        I would assert that there is a need for them to kind of
    fundamentally step back and reassess what are they trying to
    accomplish, how do they measure success, to what extent are
    they relying upon some of these other players in order to do
    things that otherwise they might do, to what extent is that
    reliance justified?
        They need to then come up with what do they think are the
    adequate numbers of people that they need in order to discharge
    their responsibilities?
        It is a comprehensive workforce plan linked to their
    strategic plan and their role with regard to the overall
    system.
        I also think they need to place additional emphasis on
    technology. When you look at the number of filings that they
    receive every year, it doesn't make any difference how many
    people you have. It is going to be virtually impossible to be
    able to ever have enough people to do what needs to be done
    manually. Therefore, they need to be leveraging technology to a
    much greater extent to identify risk areas that they can focus
    whatever human resources they have on the areas that likely
    represent the greatest risk.
        We had this problem when I was at the Labor Department
    where we had 900,000 filings every year on pension and other
    employee benefit plans. We had people manually going through
    them. We designed and implemented an automated system that
    helped to leverage those resources to make them more effective.
        Last, it is not just a matter of how much you pay people,
    and clearly, there is an issue there. It is a matter of on what
    basis you pay people. In other words, obviously, people that
    have greater skills and knowledge and better performance ought
    to be paid a greater amount than other individuals. And I know
    that Chairman Pitt has talked about the need to pay people
    more. No doubt about that, and he needs to get adequate funding
    to get that done.
        But he has also expressed an interest to try to relook at
    how people are paid. To what extent would be variable pay
    versus fixed pay? To what extent would it be based on factors
    other than the passage of time and the rate of inflation?
        Senator Dodd. When you were looking at the SEC, to answer
    your own first question, are they doing it? There is a new
    building going up. So there is a new effort here. Are you
    satisfied that
    they are, in fact, looking at technology to do exactly what you
    are
    suggesting?
        Mr. Walker. We believe that more needs to be done in the
    work force planning area and the leveraging of technology,
    given the mismatch between what they are being asked to do and
    what they have to do it with.
        Senator Dodd. I will get back. Thank you, Mr. Chairman.
        Chairman Sarbanes. This is an opportune time, I think, to
    include in the record, given this questioning, this article
    from the March 11 Business Week--``Can The SEC Handle All This
    Scandal?--Its Chief Enforcer Faces a Swelling Caseload and a
    Frozen Budget.'' This obviously bears very much on what Senator
    Dodd has been asking. So, without objection, we will include
    that article in the record.
        Senator Bennett.
        Senator Bennett. Thank you, Mr. Chairman.
        Mr. Walker, welcome to the Committee. We always appreciate
    hearing from you and appreciate the work you do.
        I cannot let the opportunity pass without thanking you and
    the GAO for the work that you have all done on auditing the
    various statements that have been made about the Olympics. We
    understand that you are going to do an after-action report once
    the Paralympics are over. We look forward to that.
        Chairman Sarbanes. I think we should congratulate Senator
    Bennett and the Utah delegation for a job well done with
    respect to the winter Olympics.
        Senator Dodd. Mr. Chairman, I actually went out and spent a
    couple of days. My wife's family is from Utah.
        Senator Bennett. He had the youngest credentialed----
        Senator Dodd. The only criticism I have is they made my
    five-month-old daughter be credentialed.
        [Laughter.]
        There are various explosions that she was involved in, but
    I did not think----
        [Laughter.]
        The only threat she posed was to her father in that regard,
    I might add.
        [Laughter.]
        But we had a wonderful experience. The people of Utah, the
    volunteers, there are a lot of wonderful organizations, but the
    thousands of people who volunteered their time from that State
    to make this happen--that was the most important feature I saw
    in the entire event, the volunteers. So, my congratulations.
        Chairman Sarbanes. Yes. Apparently, their hospitality and
    their grace drew really terrific plaudits, not only here, but
    also abroad as well.
        Senator Bennett. Thank you very much. I appreciate that. As
    I say, Mr. Walker played a role in that, as did his agency.
        I would like unanimous consent to put in the record an
    article that appeared in The Wall Street Journal online,
    ``Listing in a Material World,'' by Andy Kessler.
        Chairman Sarbanes. It will be included in the record.
        Senator Bennett. I would like to pursue that with you for
    just a minute, Mr. Walker. Mr. Kessler says we can solve a
    whole lot of these problems if we define more clearly the word
    materiality. What is material and what is not?
        Senator Dodd and I lived through the Y2K experience and
    worked with Arthur Levitt. We tried to get disclosure from
    companies as to where they were with respect to their Y2K
    preparation. We had some resistance from some companies that
    would say, well, we do not have to disclose that because it is
    not material. And both Senator Dodd and I would say, the
    potential that none of your computers will work and your entire
    IT system might shut down is not material?
        They said, well, the amount of money that we would spend to
    fix it falls below the percentage threshold of materiality, so
    we do not need to tell you where we are. And Senator Dodd,
    particularly in some of the health care issues, was very
    aggressive in naming those companies that would not tell us
    where they were.
        It was clearly a material fact with respect to the
    survivability of the firm. Yet because the numbers fit below
    the percentage threshold that the accountants would look at, we
    had some problems. Now Arthur Levitt worked with us on that,
    and there were SEC regulations on that and they were very
    helpful.
        I think the point that Mr. Kessler makes is a good one, and
    I would like your comment on it, that many times, restructuring
    of earnings come about because the original statement is judged
    to be immaterial.
        In Enron, there was a little bit of immateriality here, and
    a little bit of immateriality there. And pretty soon, the old
    Everett Dirksen statement applied--a billion here and a billion
    there, and pretty soon, you are talking about real money.
        So is this something, in your professional judgment, that
    could be pursued with profit to get more transparency in all of
    these statements?
        Mr. Kessler makes another point that I will give you, and
    then I will listen to your response. He said the materiality
    threshold should be voluntary. If I might read from his
    article, he said, ``Want to stay at 10 percent? Fine, just tell
    me. Oh, your stock may trade at a lower earnings multiple,
    though, since no one can trust your earnings. Want to claim a 1
    percent materiality threshold? Great, but you better back it up
    with all sorts of details about how revenues break down,
    prices, larger customers, and so on.''
        For his final comment, he said: ``Don't have that much
    detail at hand about your own company? I would get your number-
    crunchers on it real quick. And if you do not want to disclose
    information, stay private, and try borrowing money from your
    local bank.''
        I think these are very significant observations, and I
    would like your response.
        Mr. Walker. In addition to the issues of who is the client
    being a fundamental question, I think the issue of materiality
    is also a fundamental question.
        Auditors are supposed to focus on the concept of
    materiality, not just in quantitative terms, but also in
    qualitative terms. Some things cannot be translated into
    numbers, if you will.
        I think the idea of trying to focus more time and attention
    on what is a reasonable definition of that, the idea of trying
    to couple that with additional transparency to the extent that
    judgment is being used, then what are the parameters that
    individuals have chosen as the basis of making that type of
    judgment, is something that is worthy of further discussion and
    debate.
        Senator Bennett. Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Miller.
        Senator Miller. I will pass, Mr. Chairman.
        Chairman Sarbanes. Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman.
        I would like to go through a little bit of this chart, if I
    could, and try to get at the question of who audits the
    auditors and how that would flow through this method of
    oversight of the current structure, and is it with a bias of
    trying to find out whether it is a clear flow of
    accountability.
        Mr. Walker. Basically, if we focus on public companies, you
    have the SECPS, which is the SEC practice section, which deals
    with public companies. And for firms that audit public
    companies, a peer review must be conducted.
        Senator Corzine. What does the SEC do with regard to----
        Senator Dodd. Jon, can you pull that microphone a little
    closer to you?
        Senator Corzine. Can you say what the SEC has to do with
    regard to the auditing? Is there any oversight function or is
    there any auditing of the auditors by the SEC?
        Mr. Walker. They have mandated that a peer review be done.
    But they have basically relied upon the Public Oversight Board
    as the entity that would actually oversee the peer review
    process. The Public Oversight Board is an entity that was
    created through consultation between the AICPA and the SEC.
        Senator Corzine. The AICPA is a trade association.
        Mr. Walker. A professional and a trade association. It has
    features of both.
        Senator Corzine. Not publicly-chartered, though.
        Mr. Walker. No, it is not publicly-chartered, that is
    correct.
        Senator Corzine. And does the POB have peer reviews of
    every audit?
        Mr. Walker. No. Basically, there is a requirement that
    every major firm must have a peer review on a cycled basis.
        Practically, what has happened in the past is that firms
    hire other firms to do that review.
        Senator Corzine. Every audit or of----
        Mr. Walker. No. It is the system. Basically, what is
    audited----
        Senator Corzine. So Enron's audits were never reviewed on a
    peer-review basis by another auditor.
        Mr. Walker. I cannot comment on whether or not Enron
    specifically was. It has been reported that Enron was not the
    subject of the initial peer review by Deloitte & Touche, which
    was the firm that Arthur Andersen had hired to do their peer
    review work. And since that case was in litigation, I am not
    sure whether or not they subsequently went back and did
    anything or not.
        My understanding is, no, they did not.
        Senator Corzine, what is important here is whether or not
    they looked at Enron because, by definition, they are going to
    look at a sample of engagements. They are not going to look at
    every audit.
        Senator Corzine. Sure.
        Mr. Walker. Part of the question is, on what basis are they
    picking the ones they are going to audit? I would assert that
    one of the things that needs to be done, not only by the SEC,
    but also by the self-regulatory organizations, is they need to
    have a more risk- oriented approach to determining which ones
    are going to be looked at, and----
        Senator Corzine. You mean like restatements.
        Mr. Walker. Right. What caused them to occur? What are the
    factors and how can that be worked into the oversight process,
    the peer-review process, to minimize, but not eliminate, the
    possibility of it happening again?
        Senator Corzine. Let me get this straight. POB, through its
    supervision of the peer-review process, is not looking at an
    individual audit to see whether the operations of that audit
    are conforming with the rules and regulations.
        To try to pick an analogy, it is not the same thing that
    you would see from the New York Stock Exchange coming in and
    looking at a broker-dealer firm to see whether you were
    complying with capital adequacy rules.
        Mr. Walker. No. The individual firms that--for example, it
    is my understanding that Arthur Andersen hired Deloitte &
    Touche. Deloitte & Touche is conducting the peer review on
    Arthur Andersen. That involves looking at their overall system
    and it also involves them selecting a number of engagements
    that they would end up testing. And the POB ends up overseeing
    the process at a higher level, typically not down to the
    individual engagement level.
        Senator Corzine. First of all, what is the output of those
    reviews? Are there any disciplinary or correcting
    recommendations that come from that process? And are they
    public?
        Mr. Walker. There are reports that are issued--in fact, if
    you do not mind, Senator Corzine, I would like Bob Gramling,
    who is our expert on all the details here, to come forward. He
    has done the most recent work here and I know there have been
    some recent changes. So, I would like to have the benefit of
    his thoughts, if at all possible.
        Mr. Gramling. I am Bob Gramling, and I am a former GAO
    employee of 30-some years who retired 2 years ago as the
    Director of Corporate Financial Audits. I have come back to
    help the GAO on a consultant basis here in doing some of this
    work related to the accounting profession.
        The peer review results in publicly-available reports. Also
    there is another entity within the SEC practice section that is
    called the Quality Control Inquiry Committee. We did not put
    all the alphabet soup on here because the poster board just
    wouldn't be large enough.
        Chairman Sarbanes. And the room wouldn't be large enough
    for the poster board.
        [Laughter.]
        Mr. Gramling. The Quality Control Inquiry Committee also
    looks at the results of peer review and deals at the firm level
    with necessary corrections or, I should say, enhancements that
    may be necessary to their internal quality control and
    assurance system to make sure they are living up to the
    required standards. In addition, the Committee will look at
    individual performance in terms of relationship to complying
    with the auditing standards. The firm will be given a plan of
    action to address those weaknesses.
        There is, though, no disciplinary function there on
    individual members. If an issue like that were to arise, then
    that particular case where there is, say, legal action involved
    in terms of a legal suit, an alleged audit failure, the
    discipline of the individual members involved, is handled in
    another place within the AICPA--the Professional Ethics
    Executive Committee.
        Senator Corzine. The SEC does not have disciplinary
    responsibility, nor has it delegated disciplinary
    responsibility directly. It is a self-initiative of the AICPA.
        Mr. Gramling. Well, that is correct in actions initiated by
    the self-regulatory system. The SEC does provide oversight over
    the Public Oversight Board, as well as annually picking certain
    peer reviews and selective work papers and actually looking at
    those from its own standpoint of whether the peer review system
    is measuring up.
        Senator Corzine. Have there been any significant
    disciplinary actions that are the outgrowth of the SEC's review
    of the peer review system?
        Mr. Gramling. I would say the significant disciplinary
    actions result from the filing of lawsuits.
        Senator Corzine. Thank you.
        Chairman Sarbanes. Senator Stabenow.
        Senator Stabenow. Thank you, Mr. Chairman.
        Thank you, again, Mr. Walker for being here, and members of
    your staff. I appreciate your service. It was important to hear
    from you last week in the Budget Committee and I hope our
    Federal budget will have the same credibility that we are
    asking of others. So, we have some real challenges ahead of us.
        In your testimony, you talk about the accounting industry
    needing to create the right incentives to protect the public
    interest. And part of what we are talking about really is
    cultural. I am wondering at this point what your feeling is
    about the culture of corporate America. We have heard from
    others about the incentives right now, the short-term
    incentives. And I am wondering if you could comment about the
    culture of corporate America that does or does not allow
    dissent.
        I have real questions about whether or not the culture
    involved right now allows dissent, or whether earnings
    management and interest in the short-term profits of the day
    will win out at this point in time. I know that this is not
    easy to change. But if we are talking about a large measure of
    private-sector regulation, it seems to me that there has to be
    the right incentives to protect the public interest. I wondered
    if you would speak to this challenge and what you think we
    should do about it.
        Mr. Walker. There is a major challenge at the present point
    in time in that there is a real emphasis on short-term results.
    The market, to a great extent, has penalized entities who have
    not hit projected earnings.
        Although, let's face it, management has the responsibility
    to come up with what those projected earnings are. There has
    been a feeling that one has to continue to show growth or
    profitability in order to continue to grow stock price and
    shareholder value.
        I think that, as I mentioned before, there are some
    cultural challenges here. One of the key things that has to be
    focused on is who is the client? What role do each of the
    respective parties play in trying to make sure that there are
    adequate checks and balances in the system to make it work?
    Also certain other definitions such as what is materiality and
    what is the proper materiality format?
        I think the short-term focus is a problem. I think it is a
    problem, quite frankly, in the public sector, too. At the
    Budget Committee hearing last week, we talked about how we look
    short-term versus how we look long-term. What are we going to
    do to provide adequate incentives, transparency, and
    accountability to make sure we don't be overly short-term
    focused in the public sector as well.
        Senator Stabenow. I agree with that. In your testimony you
    talk about the fact that Enron's November 2001 8-K filing
    restating its earnings acknowledges the fact that their
    financial reports from 1997 to 2002 did not follow Generally
    Accepted Accounting Principles and therefore, could not be
    relied upon.
        Now given the fact that this was a bad-faith reporting by
    Enron and it had such a devastating impact on so many thousands
    of individuals and, frankly, the confidence in the whole system
    at this point, should Congress consider creating penalties for
    corporate leaders or auditing firms who misrepresent earnings?
        On the other hand, how might we balance such penalties with
    the need to encourage timely and honest updates on previous
    accounting misrepresentations or mistakes?
        Mr. Walker. My personal view is I think that there are
    actions that need to be taken by a variety of parties, many of
    which do not require legislation.
        You have the SEC, who can do certain things on its own. You
    have the self-regulatory entities that have the ability to make
    certain changes. You have the stock exchanges that have the
    ability to make certain requirements in order to be listed or
    continue to be listed, if you will.
        You have some of these fundamental definitions that I
    think, quite frankly, would be difficult to legislate, but need
    to be addressed, like who is the client and what is
    materiality?
        I do think that there are possibilities for the Congress to
    be involved in certain ways, including to try to make sure that
    there is adequate transparency in certain critical areas and
    that there are adequate penalties if people violate their
    responsibilities.
        Frankly, we would have to do a lot more work for me to get
    to a level of specificity with regard to what we think the
    Congress might want to consider doing in that regard. In part,
    I think it depends upon what others do. In other words, do you
    want the Congress to be the first resort or do you want to see
    if others do what they should do and then, if they do not, then
    take action?
        I think we need to work at this in a coordinated manner.
        Senator Stabenow. Thank you.
        Senator Dodd. Mr. Chairman, may I ask one more thing?
        Chairman Sarbanes. We could keep the Comptroller General
    here obviously all day. And since we have him here in town and
    fairly easily available to follow up with, I do want to get the
    other panel on, a majority of whom have come from out of town.
    But I will yield to you.
        Senator Dodd. Just quickly because I did not realize you
    were a CPA, Mr. Walker, until you mentioned it in your comments
    here.
        Mr. Seligman will be testifying shortly, and I recall him
    saying, and I am paraphrasing, that the historical calamity of
    1929 involved 1.2 percent of the population that owned shares
    in public companies. Today, roughly 50 percent of the American
    public do in one form or another. And so, when you face an
    Enron kind of situation, you get a sense of the magnitude we
    are talking about.
        Which raises the question, without getting into the
    specifics, and I understand that you cannot do that, but I
    wanted you to, just for a minute, take off your GAO hat and
    answer the question that in a sense has been referenced both by
    Senator Corzine and Senator Stabenow, and that is who
    arbitrates for the public, in a sense, when you have an Enron-
    type of calamity?
        Just a reaction here to the notion of an independent
    regulatory organization rather than a POB over here that has
    raised some serious concerns about the independence. What is
    your reaction to that, as a CPA now, about having an
    independent regulatory body rather than this Public Oversight
    Board?
        Mr. Walker. Without getting into a lot of detail, I can
    tell you that I believe that steps need to be taken to increase
    the interaction between the green and the yellow, for there to
    be more green involvement in order to deal with the public
    interest aspects of what CPA's are responsible for.
        Senator Dodd. Okay.
        Mr. Walker. It is more than just the shareholders. But
    there is the public interest aspect as well.
        Senator Dodd. That is what I meant by the public. I did not
    mean just the shareholder because when 50 percent of the
    American public are engaged is, I think it is the point that
    Professor Seligman makes, which is a dramatic point, the 1.2
    percent in 1929 versus 50 percent today, that there is a lot
    more at stake in this--public confidence and trust, and who
    does arbitrate at that particular point on behalf of the
    public, speaking just beyond the shareholder interest.
        Mr. Walker. Exactly.
        Senator Dodd. In other words, we need more green on that
    chart than yellow.
        Mr. Walker. Or at least interaction between the green and
    the yellow. The green needs to play a more significant role
    than it does right now. And while, obviously, not everybody
    owned Enron stock, the fact of the matter is a significant
    percentage of the American population owns some stock, and
    their question is--is that me, but for the grace of God? What
    about the stocks that I own? And that is where you deal with
    trust and confidence as a system as a whole, rather than just--
    --
        Senator Dodd. And investigating.
        Mr. Walker. Exactly.
        Senator Dodd. Thank you, Mr. Chairman. I apologize.
        Chairman Sarbanes. Well, Mr. Walker, we thank you very
    much. A great deal of work has gone into these reports and we
    will work through them very carefully. We look forward to
    coming back to you and your associates about them as we
    continue to probe this matter and as we address seeking
    systemic and structural changes.
        Mr. Walker. Thank you, Mr. Chairman. A lot of good people
    contributed to this and I appreciate your interest.
        Chairman Sarbanes. We understand that. Thank you.
        Now, we will turn to our next panel, if they would come
    forward and take their seats at the table.
        [Pause.]
        Before turning to the panel, I just want to reiterate a
    point that I made previously. It is my own very strongly held
    view that the Administration should be seeking now a
    supplemental budget for the SEC. I think the SEC clearly does
    not have adequate resources to deal with the challenge that
    confronts them. Maybe they should re-study their mission and
    all the rest of it as some people have suggested. But in the
    very short run, they need to get at it.
        They are losing skilled and expert staff because of the
    failure of the Administration to do the pay parity, which was
    part of the legislation that this Committee reported out and
    that was passed. They have a number of positions down there
    that aren't filled. They have a great deal on their plate, as
    this Business Week article noted when it raised the question,
    ``Can the SEC handle all this scandal?''
        While we work through to get these systemic and structural
    changes, immediately the SEC, it seems to me, should be
    enhancing its capacity.
        Now, we have written to the President urging that they
    address this budget situation. I intend to repeat that request.
    But it seems to me that they should be in to the Congress with
    a supplemental request with respect to their budget to get on
    about the task.
        Our concluding panel this morning has three very able and
    distinguished people on it, Robert Glauber, who is the Chairman
    and Chief Executive Officer of the NASD, a self-regulatory
    organization for securities broker-dealers. Mr. Glauber was
    Under Secretary for Finance at the Treasury Department from
    1989 to 1992. He was the Executive Director of the Brady
    Commission Task Force which studied the 1987 stock market crash
    and had a very distinguished academic career on the faculty at
    the Harvard Business School, and also at the Kennedy School of
    Government. We are very pleased to have him back with us.
        Professor Joel Seligman, who is Dean of the Washington
    University School of Law in St. Louis. Actually, Professor
    Seligman joined with Professor Coffee in the classic textbook
    on securities law, called ``Securities Regulation.'' He has
    also written a number of interesting books, including this
    one--``The Transformation of Wall Street''--we will put a plug
    in for your publisher here.
        [Laughter.]
        Then Professor John Coffee, who has been a very
    distinguished professor of law at Columbia Law School, where he
    has taught since 1980. Professor Coffee is also on the SEC's
    Advisory Committee on the Capital Formation and Regulatory
    Processes, and on the legal advisory boards of the NASD and the
    New York Stock Exchange.
        Both Professor Seligman and Professor Coffee have been very
    active in various professional bodies dealing with the
    financial markets, securities laws, corporate governance, and
    finance.
        We are very pleased to have this panel with us today.
        I think, Mr. Glauber, we will start with you and we will
    just go right across the panel, and Professor Coffee can
    conclude the testimony this morning.

                     STATEMENT OF ROBERT R. GLAUBER

                  CHAIRMAN AND CHIEF EXECUTIVE OFFICER

            NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.

        Mr. Glauber. Thank you, Mr. Chairman. I will read a short
    statement and then I would request that my full testimony be
    entered into the record.
        Chairman Sarbanes. Your full statement will be included in
    the record.
        Mr. Glauber. Thank you.
        Mr. Chairman and Members of the Committee, thank you for
    this opportunity to testify on the vital, troubling and timely
    issues of investor protection and accounting regulation
    revealed by the collapse of Enron.
        Let me begin with a quick overview of the NASD--because who
    we are bears directly on both the substance of what I will be
    saying and on the usefulness of the private-sector self-
    regulatory model that we embody.
        The National Association of Securities Dealers is not a
    trade association, but rather, the largest self-regulatory
    organization, or SRO, in the world. Under Federal law, every
    one of the roughly 5,500 brokerage firms and almost 700,000
    registered representatives in the U.S. securities industry
    comes under our jurisdiction.
        For more than six decades, our mission and our mandate from
    Congress has been clear--to bring integrity to the markets and
    confidence to investors. We do this by writing rules to govern
    the conduct of brokerage firms and their employees, licensing
    industry participants, and maintaining a massive registration
    data base of brokers and firms, educating our members on legal
    and ethical standards, examining them for compliance with the
    NASD rules and the Federal securities laws, investigating
    infractions, and disciplining any members who fail to comply.
        A professional staff and independent governance provide
    needed expertise and indispensable credibility. And the
    standards we set are not mere trade group best practices, but
    enforceable regulatory requirements.
        As detailed in my written statement, the NASD's history is
    to a large degree the history of successful self-regulation in
    the United States. Every brokerage firm in the country that
    does business with the public must, by law, be a member of the
    NASD. With a staff of 2,000, 15 district offices, and an annual
    budget of some $400 million, we touch virtually on every aspect
    of the securities business and monitoring all trading on Nasdaq
    and on selected other markets.
        By providing this layer of private-sector regulation
    between the SEC and the industry, the NASD is not only a
    guardian for investors, but also a bargain for taxpayers. If we
    did not exist, the SEC would have to increase its budget by
    roughly two-thirds and its staff by about half, just to pick up
    all the regulatory duties now performed by the NASD.
        It is little wonder that Congress and the SEC throughout
    the years have repeatedly identified securities industry self-
    regulation as a national asset worth preserving and enhancing.
    Of course, our evolution has not been without its false steps.
        In 1996, the SEC, in its Section 21(a) report, criticized
    the NASD in part for putting its interests as the operator of
    Nasdaq ahead of its responsibilities as the regulator of the
    entire industry. The NASD responded promptly by carving out
    NASD regulation and Nasdaq as two distinct corporate entities
    with separate boards, management, and staff. And since then, we
    have spun off Nasdaq entirely, selling our last 27 percent
    stake in the company earlier this year.
        As a result, NASD over the past half-dozen years has
    returned to its regulatory roots with greater independence,
    resources, and focus than ever before. And I believe that we
    are in a unique position to contribute to the vital national
    discussion this Committee is helping to lead on how to
    strengthen investor protection by improving accounting industry
    regulation.
        Given the limited time, Mr. Chairman, I think the best way
    for me to do that quickly is to identify the attributes that
    are key to the NASD's effectiveness from which I have sought to
    derive some first principles for successful private-sector
    regulation.
        An essential ingredient of the NASD's success is
    independent, strong governance. At least half our board of
    governors comes from outside the securities industry and our
    large, experienced, professional staff is not beholden in any
    way to the industry.
        The NASD's benefits from the combined ability to write
    rules, examine for compliance, and provide tough enforcement,
    all under one roof. This consolidation of the industry's chief
    regulatory functions reinforces our authority, competence, and
    credibility.
        Our governing structure also relies on parties that have
    the right incentives to insist upon market integrity and
    investor confidence.
        Our board includes representatives of the public, corporate
    issuers, and institutional investors, as well as brokerage
    firms that make up our membership. The beauty of this system is
    that all of these interests, including the brokerage industry,
    want markets that investors will recognize as fair, efficient,
    and safe.
        This leads to our next key attribute, which is assured
    funding, from that part of the private sector having the
    greatest interest in our effectiveness. The right people pay
    for the NASD's services. Namely, the brokerage firms who know
    that market integrity leads to investor confidence, which is
    good for their business.
        This steady and sufficient funding means that we can afford
    the sophisticated technology, techniques, and infrastructure it
    takes to regulate a fast-charging, technology-intensive
    industry. NASD's technology budget alone is $150 million per
    year. No private-sector regulator can succeed without
    sufficient ways and means.
        Next, I cannot overstate the importance of the NASD being
    empowered to discipline our members with tough public
    sanctions. Last year, we brought more than 1,200 disciplinary
    actions resulting in over 800 expulsions or suspensions from
    the industry.
        It is a big stick--the ability to bar someone from earning
    a livelihood in their chosen field.
        In an average year, we levy well in excess of $10 million
    in monetary sanctions. Already this year, acting jointly with
    the SEC, NASD sanctioned Credit Suisse First Boston $50 million
    for violations relating to its allocation of hot IPO's.
        I should contrast this with the accounting industry where
    no Big 5 firm has ever failed a peer review conducted by
    another.
        The lesson is clear--strong private-sector regulation leads
    to one serious body keeping its industry clean. Weak private-
    sector regulation leads to one hand washing the other.
        Of course, with authority comes responsibility. Just as our
    members are accountable to the NASD, so are we accountable to
    the SEC. Strong oversight by governmental regulators protects
    investors by ensuring that someone is watching the industry
    watchdog.
        Mr. Chairman, this is not the time and it is not the place
    to prescribe in detail what a new regulatory regime for the
    accounting industry might look like. But based on our
    experience in the securities industry, the question can fairly
    be asked whether a private-sector regulator could help restore
    confidence in the accounting industry and if so, what are its
    essential characteristics?
        First, the threshold question.
        It is my judgment that if properly designed, a new private-
    sector regulator can make a major contribution by tapping
    industry resources and insights not available to the
    Government. To get the best of both worlds, however, these
    advantages should be matched with tough SEC oversight under the
    watchful eye of Congress.
        So the question becomes how best to obtain these potential
    benefits. To do so, the new body would need to follow these
    essential features.
        One, a new private-sector regulator should be an
    independent organization with a sizable professional staff and
    with sufficient technology and infrastructure to stay apace of
    the accounting profession. It should seek maximum industry
    input consistent with maximum industry accountability.
        Two, it should have a strong mandate from the Government
    that sets its structure and empowers its enforcement arm with
    full authority to discipline the industry. And it should bring
    under one roof as many of the essential regulatory functions
    outlined earlier as is feasible.
        Three, it should have a governance structure based on
    enlightened self-interest. Namely, the need for effective
    auditing to produce numbers that investors can rely on and
    markets can trust. This implies a board with many of the same
    parties as the NASD's--reputable corporate issuers who want
    their financial statements to carry weight, institutional
    investors, broker-dealers, and the public. Accountants should
    be a small minority.
        Four, it should have assured funding from some of these
    same self-interested parties, especially those with the biggest
    stake in the success of the system. Good candidates might be
    issuers, broker-dealers, and certainly, since they have a major
    stake in the credibility of their audits, the accounting firms
    themselves.
        Finally, the private-sector regulators should be subject to
    strong, appropriate oversight from the SEC and from Congress.
        Mr. Chairman, I am convinced that even in the accounting
    industry, where self-regulation has suffered a bad name, there
    is a vital role to be played by private-sector regulation.
    Clearly, shaping such a system represents a great challenge,
    but the benefits to be gained are even greater.
        The NASD and I stand ready to help in any way we can.
        Thank you.
        Chairman Sarbanes. Thank you very much.
        Professor Seligman.

                       STATEMENT OF JOEL SELIGMAN

            DEAN AND ETHAN A.H. SHEPLEY UNIVERSITY PROFESSOR

            WASHINGTON UNIVERSITY SCHOOL OF LAW IN ST. LOUIS

             PUBLIC MEMBER, AMERICAN INSTITUTE OF CERTIFIED

                 PUBLIC ACCOUNTANTS PROFESSIONAL ETHICS

                          EXECUTIVE COMMITTEE

        Mr. Seligman. Mr. Chairman, I would ask that my statement
    be entered into the record.
        Chairman Sarbanes. Your full statement will be included in
    the record. I want to thank all three witnesses for the obvious
    work and effort that went into these prepared statements. We
    appreciate that very much.
        Mr. Seligman. Let me paraphrase a little bit of the
    statement and emphasize certain points.
        First, we have the most successful securities markets in
    the world at this point, which have just been through an
    extraordinary period where the aggregate worth of securities
    traded increased 11-fold, between 1981 and 2000. Senator Dodd
    suggested nearly half of American households today own stock.
    The challenge before this Committee is to maintain and, indeed,
    strengthen, that level of confidence in our securities markets.
        Second, it is worth remembering that most of the people in
    the securities industry, in corporations, and in accounting are
    honest, hard-working, decent people. But Enron and related
    cases have powerfully reminded us that even a small number of
    dysfunctional firms can provide enormous challenges to
    confidence in our system.
        Third, it is very, very important to appreciate how complex
    the relevant regulatory systems involved are. Professor Coffee
    and I, as was mentioned, coauthor a casebook which has an
    1,800-page supplement, which includes SEC statutes, rules, and
    forms today. It doesn't so much grow, as metastasize from year-
    to-year.

        [Laughter.]

        It is very constructive for Congress to play a leadership
    role here. But it will be important to recognize that the SEC
    can be terribly important in filling in the details and
    carrying out the mission you prescribe to them.
        I want to highlight the mandatory disclosure system which
    focuses on the SEC's disclosure requirements, auditing and
    accounting. I also agree with the point made by Senator
    Sarbanes that among the most critical needs at this moment is
    to address a veritable crisis in the SEC's budget.
        It seems to me when you look at the Enron case, the two
    most sobering aspects of it are that the SEC last examined an
    Enron annual report called Form 10-K in 1997, in spite of the
    fact that this was a firm that quadrupled in size between 1996
    and 2000, and for a variety of reasons, should have received
    some attention.

        I am very concerned that we are meeting at a time when the
    Office of Management and Budget has recommended, in effect, a
    flat budget for the SEC next year.

        The SEC only desperately needs more staff, but you have to
    focus on the pay parity issue. That is, how do you hold onto
    the very best of the staff ? It is the SEC employees who have
    been there 3 years who you can keep up to 10 years, who are the
    key, I would submit, to strengthening the Division of
    Corporation Finance, strengthening the Division of Enforcement,
    and strengthening the Office of Chief Accountant, all of which
    are vitally necessary now.

        With respect to the specific issues before you, I think the
    focus of this Committee has devoted to accounting standard
    setting and auditing is particularly appropriate at this time.

        Accounting standard setting, which is currently
    administered by the private organization, Financial Accounting
    Standards Board, should be sharply questioned at this moment.
    The notion that transactions as obviously material in
    retrospect, as the off balance sheet transactions that Enron
    and other corporations engaged in, were not required to be
    disclosed in financial statements or notes.

        I would submit to you, in looking at the Financial
    Accounting Standards Board, as former SEC Chairman Levitt so
    aptly recognized, the big challenge is independence. How do we
    create a FASB or a new similar Financial Accounting Standards
    Board which can both focus on how one articulates a fair
    presentation of financial data and deals with the many detailed
    standards. And the bottom line, I would submit to you, the key
    here, as will often be in your investigations, is money. You
    cannot expect a FASB to operate in a truly independent way
    without a more assured source of funds than the FASB currently
    has.
        I would encourage you to explore means to legislate some
    user or accounting firm fee system that will provide to the
    FASB, or whatever the standard setting is called, true
    independence.

        Enveloping the Generally Accepted Accounting Principles
    that the FASB develops is the SEC mandatory disclosure system.
    This too deserves to be under sharp question today. One must
    ask, how could financial reporting practices sufficient to
    bankrupt the seventh largest industrial firm in this country,
    so long go undisclosed? Is this simply an isolated instance of
    bad disclosure practices, or is Enron suggestive of more
    systematic failure?
        The SEC, under its current chairman, to its credit, has
    begun to grapple with the latter, more disturbing possibility.
    In the last few months, it has issued cautionary releases in
    areas like pro forma financial statements, selection and
    disclosure of critical accounting policies and practices, and
    the management, discussion and analysis item. I would urge,
    however, much more needs to be done.
        The last time the SEC systematically reviewed its corporate
    disclosure system was in the mid-1970's when commissioner, and
    then private citizen, Al Sommer led an advisory committee on
    corporate disclosure. It examined the great disclosure issues
    of the day.
        A similar systematic approach is now well overdue. It
    should focus not only on SEC's requirements, but also on their
    link to accounting and auditing.
        At its core, Enron involved an audit failure. The outside
    auditor in that case both appeared to operate with significant
    conflicts of interest and to have been far too beholden to a
    highly aggressive corporate management. Several aspects of the
    Enron audit failure deserve particular focus.
        First, I would urge, and here I support the testimony that
    Mr. Walker gave earlier, it is time for a new auditing self-
    regulatory organization to be created. It should replace not
    just the Public Oversight Board, but also a positively
    Byzantine structure of accounting disciplinary bodies which
    generally lack adequate and assured financial support, clear
    and undivided responsibility for discipline, and an effective
    system of SEC oversight.
        The success of such a new auditing SRO will be in careful
    attention to detail. I would particularly recommend a legal
    structure similar to that in Sections 15(a) and 19 of the
    Securities and Exchange Act which apply today to securities
    associations such as the NASD and other self-regulatory
    organizations in the securities industry, and address in some
    detail such topics as purposes, powers, and discipline.
        Second, a clear scope provision articulating which auditors
    should be subject to the new auditing SRO and a mandate that
    the auditors be subject to the SRO.
        Third, a privilege from discovery of investigative files to
    facilitate auditing discipline during the pendency of other
    Government or private litigation.
        Part of the reason auditing discipline doesn't work very
    well now is it is often held in abeyance while the SEC or the
    Justice Department pursues a case. It is strikingly different
    than the more appropriate ways in which the NASD and the New
    York Stock Exchange, among others, look at such cases.
        Crucially, the new SRO's should be permitted, subject to
    SEC oversight, to adopt new auditing standards that can evolve
    over time. These rules would be limited by SEC rulemaking and,
    of course, Congressional legislation.
        As with the accounting standards body, a key question
    involves funding. To effectively operate over time, any new
    auditing SRO must have an assured source of funding. The most
    logical basis of such funding may prove to be a Congressionally
    mandated fee on covered auditing firms.
        The new SRO should draw on the expertise of the accounting
    profession to ensure technical proficiency, a supervisory board
    with a minority of industry representatives, and a majority of
    public representatives may prove to be an appropriate balance.
    The chair of such board, however, I would recommend should be a
    public member.
        I believe the most significant issue may prove to be who
    conducts periodic examinations and inspections of auditors. To
    paraphrase a classic adage--who will audit the auditors?
        I would urge serious consideration be devoted to replacing
    peer review with a professional examination staff in the new
    auditing SRO. Peer review has been to some degree unfairly
    maligned. But even at its best, it involves competitors
    reviewing competitors. The temptation to go easy on the firm
    you review lest it be too critical of you is an unavoidable
    one. While the inspection and examination processes of the New
    York Stock Exchange and the NASD are not panaceas, they suggest
    a workable improvement.
        Finally, it may prove particularly wise to statutorily
    replicate Section 15(b)(4)(e) of the Securities Exchange Act
    which can impose liability on a broker-dealer who has failed
    reasonably to supervise. Particularly in firms with as many
    offices as the leading auditing firms, a clearly delineated
    supervision standard strikes me as vital to effective law
    compliance.
        A separate, not mutually exclusive, approach would be to
    require mandatory rotation of auditors at specific intervals
    such as 5 or 7 years. I thought that you received thoughtful
    testimony from the former SEC Chairman Harold Williams on
    February 12.
        I would particularly emphasize, however, the SRO as the
    most constructive element, if you will, to emphasize.
        Third, particular attention has been devoted to the wisdom
    of separating accounting firm audit services from consulting.
    One early result of Enron has obviously been an acceleration of
    this process by voluntary means in the Big 5 accounting firms.
        Congress or the SEC should consider whether a statute or
    regulation should require such separation and if so, how best
    to define which consulting services and which accounting firms
    should be subject to the new law or rule.
        Finally, a key reform of the 1970's--the board of directors
    audit committee--has been sharply criticized for its
    ineffectuality. I was particularly struck by the testimony of
    the former SEC Chairman Roderick Hills at your February 12
    hearing. He concluded with recommendations that I strongly urge
    you to consider to find ways to strengthen the independent
    audit committee, to find ways to create an independent
    nominating committee with the authority to secure new directors
    and to appoint all members of the audit committee, and
    crucially, that audit committees be solely responsible for the
    retention of auditing firms and be responsible for the fees
    paid.
        Thank you, Senator Sarbanes.
        Chairman Sarbanes. Thank you very much. It was a very
    helpful statement.
        Professor Coffee.

                    STATEMENT OF JOHN C. COFFEE, JR.

                    ADOLF A. BERLE PROFESSOR OF LAW

                   COLUMBIA UNIVERSITY SCHOOL OF LAW

        Mr. Coffee. Thank you, again, Mr. Chairman, and I want to
    second enthusiastically everything that I have heard on this
    panel.
        I, however, am going to cover a slightly different topic.
    In my prepared remarks, I also go at length through the
    structure of an SRO for the auditing profession and I think
    that is one of the most important things that is before your
    Committee. But I want to talk about the securities analyst,
    because I think that has received less attention. Let me start
    with a simple comparison.
        Analysts and auditors basically are very much alike. They
    both are in the business of serving investors as watchdogs who
    examine and verify financial information. What is sauce for one
    should be sauce for the other and it is noteworthy that we
    already have an SRO covering the analyst in the NASD, and that
    is an argument for why the other body, the auditor, should be
    similarly regulated.
        Let me take this comparison further.
        I think it is true to say, difficult as it will be to
    accept, that both the auditor and the analyst are compromised
    by the unavoidable fact that they receive their compensation
    from those that they are supposed to watch. That is simple but
    fundamental. It means that there is going to be an inherent
    conflict always. And in both the cases of the analysts and the
    auditors, something significant and relatively invisible
    happened during the decade of the 1990's.
        Let me give you just two statistics and then I won't bore
    you with statistics. From 1990 to 1997, earnings restatements
    were fairly flat and level and they averaged 49 times a year,
    publicly-held companies restated their prior earnings. In 1998,
    that number soared to 98. Then in 1999, it went to 150; and in
    2000, it went to 156. That is an over 300 percent rise in just
    a 2 to 3 year period. Something lies behind that spike because
    earnings statements are something that companies bitterly
    resist. They are both painful, embarrassing, and they will
    trigger often litigation and SEC investigations. But, suddenly,
    they spiked.
        Let me return now to the analyst. There is a study by
    Thompson Financial, which runs the First Call service, that
    finds that the ratio of buy recommendations to sell
    recommendations increased from 6 to 1 in the early 1990's, to
    the now-proverbial 100 to 1 by 2000.
        I personally do not put great weight on what the number is.
    It is the fact that there was this very rapid change over the
    decade that again suggests to me that in the case of both of
    these watchdogs, there was an increasing problem from
    conflicts.
        And my generalization would be that both the analyst and
    the auditor became more compromised by conflicts of interest as
    the decade wore on. In the case of the analyst, let me give you
    again some studies because we all talk about Enron, but to the
    social scientist, Enron is just one data point, vivid and
    tragic though it be. But there is a lot more data points that
    suggest there is a pervasive problem.
        With regard to the research securities analyst, there is a
    study by McHaley & Wolmack that finds that the long-run
    performance of firms recommended by securities analysts who
    were associated with an underwriter were significantly worse
    than the long-run performance of firms recommended by analysts
    who were independent of any underwriter. And this was a broad
    data sample.
        By the way, they also found that the market knows this. The
    market responds much more positively to a buy recommendation
    from an independent analyst than from an analyst who is
    affiliated with an underwriter. They tend to discount those
    recommendations greatly. So the market knows something and I
    think it is based on real evidence.
        Another study by CFO magazine finds that analysts who work
    for full-service investment banking firms, firms that provide
    underwriting services, tend to make earnings forecasts that are
    6 percent higher on average than analysts who work only for
    independent firms that do not do underwriting, and these
    affiliated analysts tend to have 25 percent more buy
    recommendations than analysts who again are not associated with
    any full-service brokerage firm.
        There is more research--I won't bore you with it--but the
    common denominator in these and other studies is just what you
    would intuitively expect. Conflicts of interest count and
    analysts and auditors tend to become compromised by these
    conflicts, meaning that the analyst who is associated with an
    underwriter tends to behave differently and more deferentially
    toward companies that are their clients than independent
    analysts behave.
        That is one line of research. There is one other line of
    research I want to point you to.
        A lot of studies have shown that analysts are frequently
    pressured and intimidated basically to cause them to temper
    negative research reports or not to make changes that downgrade
    earnings forecasts. Sixty-one percent of all analysts surveyed,
    one fairly large study, said that they had personally
    experienced threats of intimidation by representatives of
    management of a client that they had surveyed and did a
    negative report on. Twenty percent of all CFO's in a study
    cited by former SEC Acting Chairman Laura Unger, self-reported
    that they had made complaints to brokerage firms about analysts
    who put out negative research and asked that broker be somehow
    disciplined.
        Early in their career, the typical analyst learns that
    negative research reports can be hazardous to your health and
    many analysts learn that, therefore, they had better be very
    cautious and better temper what they say. The truth suffers in
    that process.
        Now what regulatory response is appropriate given this
    description of current reality?
        In part, this depends on what the self-regulators are
    already going to do. The NASD has posed, I think, a very
    sensible, sound rule, Rule 2711, which has just been proposed,
    which would try to change some of the internal structure so
    that analysts no longer report or are responsible to and no
    longer clear research reports with the investment banking side
    of the firm.
        All of that is desirable. There are a number of exceptions
    and qualifications in these rules and how this will play out in
    practice, it is a little too early to predict. But I would have
    to tell you that, much as I would endorse Rule 2711, it is not
    going to be a complete solution to the problem. Analysts will
    always know who is paying their salary and it is the deal side
    of the firm. Thus, analysts are not going to be completely
    objective when they know that their compensation comes from
    investment banking, and Rule 2711 doesn't change that. There is
    a basic choice to be made.
        One way to go is to take what I would call the radical
    Glass-Steagall approach and to try to divorce investment
    banking from securities research. Some people, serious
    commentators, would recommend that route on the grounds that
    nothing else will make the analyst independent.
        I personally fear that approach. I think we spent 50 years
    trying to crawl out from underneath Glass-Steagall and its
    separation of commercial from investment banking. I think it is
    far more dangerous in this context because I do not believe
    that securities research is self-sustaining or self-supporting.
    It can only be financed by revenues that come from the
    investment banking side. And my great fear is that if we took
    the simple Glass-Steagall approach of cutting the baby in two,
    one half the baby is not going to survive and we are going to
    have far less securities analysts out there, far fewer
    companies would be covered, and there would be a danger of real
    social loss, much of a significant portion of the market not
    regularly followed by securities analysts.
        So, I at least would say that I wouldn't recommend that
    course. Others would. But having aside from that more radical
    step, I think we have to talk about how we can police conflicts
    in this field. And I think that there are more rules that
    Congress needs to encourage.
        My suggestion would be not that Congress itself try to
    write these rules and legislation, but that Congress can pass
    some legislation, a general instruction to both the SEC and the
    other SRO's, and there are multiple SRO's, telling them that
    they should fine-tune rules that address the following
    Congressional goals. Congress has done this before in other
    legislation.
        Let me just give you four rules briefly that I think need
    to be an integrated approach to the problem of conflicts of
    interest among securities analysts.
        First, I think we need an antiretaliation rule. Congress
    should seek to protect analysts by requiring the drafting of
    rules, both at the SEC and the NASD, which would protect an
    analyst who has his compensation reduced or loses his job in
    retaliation for a negative research report or other unfavorable
    research. Of course, that involves a very fact-specific issue.
    Why was the analyst reduced in salary or terminated? It may
    have been a poor performance.
        We have a body that can deal with this. We have an
    elaborate arbitration system already set up under the NASD and
    it would be possible to give the analyst recourse to that,
    possibly with the right to get some kind of penalty, double his
    salary or double the loss, if there were a demonstration before
    that panel that he had been the victim of intimidation or of
    retaliation because of the published research.
        That is one kind of approach. There are different ways of
    going at this, but the goal of an antiretaliation rule responds
    to evidence that retaliation is there regularly.
        Second, I think that we have to address what I call a no-
    selling rule. This will be more controversial. If we want the
    analyst to be a neutral umpire, he cannot also be a salesman.
    Today, the analyst regularly participates in the roadshows,
    regularly sells the IPO's to the various clients and
    institutional investors who attend the roadshows.
        That selling is inconsistent, in my view, with the goal
    that we may have of wanting the analyst to be a more careful,
    objective, neutral umpire. It also takes the analyst over the
    proverbial Chinese wall--and I think if we want that Chinese
    wall, and I agree with Senator Bunning that the Chinese wall
    can often be permeable--I think we should make it more
    respected by not allowing the analyst to hop over that wall,
    participate in the roadshow, and then come back and be an
    analyst. I do not think you can keep playing those two
    different roles more or less simultaneously without there being
    problems.
        A third rule, which I won't go into at any length, I think
    that there is one abuse called the booster shot under which
    analysts are under great pressure to make a favorable
    recommendation of the issuer's stock just before stock lock-ups
    expire. This is because the issuer management is not able to
    sell its shares at the time of the IPO. They are only able to
    sell their shares typically under stock lock-up arrangements 6
    months later. And there often have been norms that are more
    implicit than negotiated, under which the analyst puts out a
    very favorable recommendation just 1 or 2 days before the
    management of the IPO firm becomes able to sell its own shares.
        Recommendations at that point are both dubious and
    dangerous and I would think that at least those analysts who
    are related to the underwriter, who are associated in any way
    with that client, should be prohibited from putting out buy
    recommendations during the period of time shortly before and
    shortly after the expiration of stock lock-ups. It is really
    the important period.
        Now, last, and most importantly, I think Congress should
    ask the SEC and the SRO's to define the term, independent
    analyst. This has been done by the SRO's for purposes of
    directors who serve on the audit committee. But if there is one
    lesson that should be learned by investors, it is that the
    investor cannot trust reliably the recommendation of a single
    sell-side analyst--that is, the individual sell-side analyst--
    but instead, should look at what the consensus is of
    independent analysts.
        I think that could easily be prepared by the industry. If
    we distinguish between who's independent and who's not and
    permit only the former to use the term, independent analyst, it
    will be very simple for the industry, people like First Call,
    to quickly produce on websites everywhere the consensus of
    independent analysts.
        This is not a disqualification. It doesn't say other
    analysts could not put out research. I have no need at all to
    bar analysts from putting out research. I am merely saying that
    the term, independent analyst, should be elevated so that the
    public gets greater confidence looking at the recommendations
    of the independent analyst, who empirically turns out to be
    more accurate and a better, less biased judge.
        I think these are the less drastic alternatives and the
    less drastic alternatives are superior. They recognize that we
    want essentially a private system of corporate governance. But
    in the last analysis, our system of corporate governance relies
    on the credibility of the numbers. And those numbers are
    principally guarded by auditors and analysts and they are
    probably the most important side of this still-developing Enron
    story.
        Thank you.
        Chairman Sarbanes. Thank you very much.
        I have a few questions and then I will yield to Senator
    Corzine.
        Do you have a scheduling problem, Jon?
        Senator Corzine. [Nods in the negative.]
        Chairman Sarbanes. Mr. Glauber, would you just outline the
    funding mechanism for the NASD?
        Mr. Glauber. Certainly. Essentially all of our funding
    comes from the broker-dealer community. Most of it is raised by
    assessments on broker-dealers which reflect their size.
        Chairman Sarbanes. Okay. Now the broker-dealer is required
    to be a member of the NASD. Is that correct?
        Mr. Glauber. That is correct.
        Chairman Sarbanes. And if he is evicted by membership under
    your disciplinary procedures, he can no longer be a broker-
    dealer. Is that right?
        Mr. Glauber. He cannot be a broker-dealer that deals with
    the public, that is correct.
        Chairman Sarbanes. So, you levy a fee on each firm.
        Mr. Glauber. On each firm.
        Chairman Sarbanes. Related to the size of the firm?
        Mr. Glauber. Related to its size, related to its trading
    operations, as well as we levy some user fees that cover the
    cost of maintaining our central depository of registration
    information. And we levy user fees on actually new issues. When
    a company files a new issue, we have to read the prospectus and
    we levy a user fee on that.
        Chairman Sarbanes. So that is all an automatic process.
    They have to pay that as, in a sense, the cost of doing
    business. Is that correct?
        Mr. Glauber. Absolutely.
        Chairman Sarbanes. Well, it is very interesting because one
    of the things that is obvious in the accounting context is that
    these people go around with a tin cup trying to beg money to
    run the FASB and the international group. Volcker is running
    around now with his tin cup out trying to get funding for these
    things.
        Mr. Glauber. Mr. Chairman, I think you are absolutely
    right. And as I said in my statement, I believe assured funding
    of this private-sector regulator is absolutely crucial. I think
    one can look to issuers, to broker-dealers, and to the
    accounting industry as the source of that funding.
        Chairman Sarbanes. I want to ask the two academics--this
    American Institute of Certified Public Accountants action alert
    that they have sent out has caught my attention here. They talk
    about the cascading effect and then they raise the specter that
    restrictions will be adopted that will impact on small- and
    medium-sized businesses. They say, what would small business
    clients do if they could not go to their CPA for tax services
    or other business advice? They would pay substantial additional
    fees to hire someone else to perform the necessary services.
    And then they say, Members of Congress have to be made acutely
    aware of this.
        It raises the question of whether, in addressing this
    issue, we separate out accounting for public companies from
    other accounting, and whether our focus should be primarily on
    the accounting for public companies or a structure that in
    effect, it may be a two-level structure, or a bifurcated
    structure, however you want to describe it. Could you address
    that issue for us? Because I am very concerned.
        We have the danger here that they are going to get all up
    in arms to try to forestall very important and needed changes
    by raising a specter which is really a scarecrow and not a
    realistic danger, although you can always argue the slippery
    slope. But the answer to the slippery slope is you just do not
    go down the slippery slope. It ought not to be used to
    bootstrap an argument that you do not do anything, at least it
    seems to me.
        Mr. Coffee. I suggest that the SEC's auditor independence
    rule was always intended to apply only to publicly-held
    companies. And I do not know that you need to deal with the
    relationship between the auditor of a family controlled firm.
        In that world, where you have a family controlled firm, you
    know who the client is--it is the family that owns 98 percent
    of the stock and six or seven people. And they may well want
    you to be both the tax advisor and the auditor.
        When we have the publicly-held firm, with 150,000
    shareholders or more, there is no way to get the true decision
    from the shareholders who we believe are the client. Therefore,
    we need a more prophylactic rule in that context to represent
    the public shareholders who have no voice and no real
    mechanism. But there is no need to adopt these strong rules and
    auditor independence beyond the context of the publicly-held
    company, the company that the SEC has jurisdiction over. And I
    do not believe the SEC or anyone else has been intimating that
    they mean to regulate the behavior of accountants dealing with
    family controlled companies.
        Mr. Seligman. I think those points are exactly right. Since
    the time of the POB and certain experiments in the 1970's, a
    clear distinction has been drawn in existing auditing
    regulation between those firms which regularly have clients
    that appear before the SEC and those that do not.
        In suggesting a new SRO mechanism to you, I think that you
    can address this type of issue through the scope provisions. If
    you can focus just on the public impact of the accounting
    profession, the firms that are before the SEC that make up our
    securities markets, you will have done a great service.
        Mr. Glauber. Mr. Chairman, I agree completely with the
    other members of the panel. This is an issue of investor
    confidence and it is an issue of investor confidence in
    publicly-traded securities. That is what you ought to attack
    and you shouldn't be, I think, thrown off the job by concerns
    raised about the way auditing is done for small family
    companies.
        Chairman Sarbanes. What I am concerned with here is an
    argument is going to be advanced for the small family
    companies, the conclusion of which will be that we ought not to
    address the public companies.
        Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman.
        I want to explore a little bit the analogue of Nasdaq with
    the accounting industry and how FASB fits into that analogue.
    It is one of the more difficult pieces for me to get a
    conceptual view about. If I understand it right, Nasdaq does
    set out standards for behavior and the rules with which markets
    operate, if I am not mistaken. Is that true, Mr. Glauber?
        Mr. Glauber. It does, indeed. Since we have just sold our
    last shares in Nasdaq and are now completely separate from
    Nasdaq, I want to emphasize that it is the NASD that does the
    regulation of broker-dealers and, in fact, sets out a group of
    rules that deal with conduct. It is different from the FASB,
    the FASB deals with standards. Really, ours are conduct or
    behavior or ethics rules.
        Senator Corzine. How would any of you comment FASB might
    fit into a structure where we developed an SRO or an IRO, an
    independent regulatory organization of some form that fits the
    analogy of Nasdaq or the New York Stock Exchange for
    supervision of the accounting industry?
        Mr. Seligman. Could I take a stab at that one because I
    thought about that to some degree.
        I really think the distinction between accounting standard
    setting which could be done under a strengthened FASB with, I
    would submit, heightened SEC oversight, and auditing, and
    particularly the disciplinary functions, can be treated
    separately.
        I would submit that what is of clearest analogy between the
    NASD and a new auditing SRO is the requirement that broker-
    dealer firms and representatives in effect are subject to the
    NASD regulation, which is subject to SEC oversight and
    ultimately, the SEC can independently bring actions as well.
    When you compare that with the current structure of auditing
    oversight, there are just too many steps. It takes too long.
    There is no clear body that has responsibility. The SEC's
    oversight is attenuated.
        To be sure, the SEC, in a parallel way, can bring what are
    called Rule 102(e) actions and disbar or condition someone from
    practicing before the Commission. But the initial
    investigations take so long, that it is almost a dysfunctional
    process. And I would submit, I think the FASB is largely an
    issue of independence, largely an issue of revivification of
    the fair presentation concept, and giving them support through
    financial means so that they can deal with what will be a lot
    of detailed rules. I think, in contrast, the auditing
    discipline function is a lot further from the mark today and
    needs, in effect, a clean slate and needs an approach similar
    to what NASD has.
        Senator Corzine. The reason that I think there is reason
    for debate about this, both parties need funding. Are we going
    to have separate funding, independent funding sources for FASB
    and some new SRO?
        That is a question, perfectly reasonable. We have two sets
    of fees, but you may want to all have that combined into one
    independent source of funding for both FASB and the SRO, if
    that is the direction you would want to take.
        And the second element is, is it possible that the
    information that one gains, the knowledge, the synergies that
    one gains from auditing the auditors and the questions that
    come up and the challenges that are revealed through that
    process, are the reasons that you get actions out of FASB with
    regard to the direct questions that need to have clarification
    and rule setting and standard setting in the FASB process?
        So, I can make the case on the one hand. I can also say
    that we are making it a more complex structure. I think I am
    hearing Professor Seligman say that he would separate the two.
    But I would love to hear the other witnesses and their pros and
    cons.
        Mr. Coffee. Let me add one word to this, if I can. I think
    I also am happier with the relative insularity of the FASB. If
    FASB was immediately subject to the control of the SRO body, it
    might be forced to make changes more quickly than we would
    like. For the future, the problem with debating FASB standing
    alone is that----
        Senator Corzine. We do not have that problem now.
        Mr. Coffee. Well, the problem in the future is that there
    is something else called the International Accounting Standards
    Committee. And FASB is part of the process of reaching uniform
    international accounting standards which is going to transfer,
    I think, the most critical decisions to the International
    Accounting Standards Committee.
        So if you really want to raise the standard setting issue
    of where standard setting belongs in this total structure, you
    have to focus at least as much, and probably more, on this
    international body in London, the International Accounting
    Standards Committee. And for that reason, I think that I would
    advise you as a matter of prudence, do what you can today
    because dealing with FASB really doesn't for the future resolve
    the standard setting process.
        Chairman Sarbanes. We had Sir David Tweedie, who is the
    Chairman of the International Accounting Standards Board, here
    to testify before the Committee.
        The European Union, apparently, by 2005, will adopt the
    standards, or it is expected to adopt the standards of the
    International Accounting Board. That is a powerful economic
    player worldwide, the European community. So, we are moving
    toward this situation where there is going to be this standard,
    the international standard that applies in the European Union.
    And I guess the United States--I do not know where our standard
    will be at that point. But the old game where our standard was
    the standard and everyone else had to follow it, is going to
    be, it seems to me, impacted by that, once you have a body of
    the economic size of the European Union with a set of
    standards.
        Excuse me. Go ahead, Jon.
        Senator Corzine. I am curious about this funding
    arrangement as well. I am sympathetic that there are problems,
    or at least concerns that one could have by having FASB, the
    rule setter and the auditors on a regulatory basis combined. I
    can see where that is.
        My own experience with the New York Stock Exchange and the
    NASD is that those are combined functions, although it is not a
    perfect match. But I am concerned on funding. You are going to
    end up with two separate, additional charges which are going
    out to some element of our economic system. I think we are
    going to get a lot more letters like the Chairman is mentioning
    about how burdensome we are now, creating a structure that will
    impose on the very viability of a lot of companies. Does anyone
    want to comment on that?
        Mr. Seligman. I think I am troubled by the fact that FASB's
    funding, to some degree, comes from the organizations that will
    be subject to FASB's regulation, that there have been threats
    from time to time that if a rule is adopted that the issuers or
    registrants do not like, they will cut off the funding. And
    that just doesn't work. You have to have a more automatic
    mechanism.
        I sympathize with your point that it is complex, that there
    will be more than one charge, in all probability, that there
    will be more than one ultimate treasury here, but that is the
    reality today. When you go public with a corporation, you will
    end up with fees to the SEC, to the NASD. You will have
    registration fees on the securities exchange, conceivably, as
    well as NASD. The question is, how can we get the most
    effective overall body of regulation?
        Mr. Glauber. I think a tolerable argument can be made to
    keep the FASB separate. But you raise the two correct issues.
    First of all, the funding. And think, clearly, there, it has to
    be some kind of automatic funding so that it is not subject to
    challenge. And the second is governance, so that you can make
    certain that the FASB functions as an independent operation and
    it has not always succeeded in doing that. That is just what
    Professor Seligman said. If you are going to have it stand
    separately, you have to have some kind of governance in place
    to protect it.
        Chairman Sarbanes. Professor Seligman, you said that it was
    the difficulty of getting the money to fund the operation from
    the people that are being regulated. If they do not like it,
    they won't pay the money. But NASD gets the money from the
    people that they regulate. The only difference is that it is a
    mandatory requirement. It is just like lawyers who have to pay
    into the bar association that runs the grievance process. So it
    seems to me, as long as it is mandatory or automatic or
    required, we get over that hurdle, don't we?
        Mr. Seligman. One hopes. But that is clearly the direction
    that you have to go.
        Senator Corzine. Does the SEC, given the overall mandate
    and mission, even though maybe we ought to step back and have a
    strategic planning session with regard to what the SEC does,
    does it have the wherewithal to adequately supervise FASB?
        We are the 25 accountants that we heard about in the
    accounting division, to really be plugged into the supervision
    and oversight of FASB, to make sure that it is moving forward?
        Mr. Seligman. I think that needs to be augmented. Clearly,
    it will be much more of a priority for the Commission in the
    next couple of years. But you need more staff in the Office of
    Chief Accountant and you need high-quality staff.
        Mr. Coffee. I think you are hearing from all of us that the
    SEC is resource-constrained and I think the less visible
    casualty of that are the offices such as the Office of Chief
    Accountant, where you cannot really measure the output until a
    scandal like Enron comes along, and you suddenly say, why did
    they ever think that even 3 percent was enough? Now that is a
    strange, bizarre feature of Enron that you say, 3 percent
    equity, even if you had that much, it still is a glaring
    failure of disclosure to the market.
        Senator Corzine. Can I ask one other?
        Chairman Sarbanes. Yes, go ahead. We may turn it into a
    free-form here.
        [Laughter.]
        Senator Corzine. I apologize for the follow-up on this FASB
    issue. I think that this is actually one of the more difficult
    calls.
        An IRO or an SRO seems sensible to me. I wonder whether we
    are going to miss some of the synergies that come from looking
    at the real problems of auditing, actual auditing statements
    and what are questions that come up, and whether you will get
    the kind of resources for the SEC to be able to stay on top of
    that FASB process, which has apparently not occurred as
    effectively as people would like.
        Chairman Sarbanes. Now, Mr. Glauber, you all combine the
    two, don't you?
        Mr. Glauber. We write rules which are mainly rules of
    behavior and ethics. We do not have something which is
    equivalent to a standard setting like the accountants. If you
    look at the kinds of rules that we write, they are rules of
    quality control and behavior, conduct.
        Chairman Sarbanes. Well, who writes the standards?
        Senator Corzine. That is not entirely true, is it? If I go
    back to my experience of 1996 and 1997, we set up some specific
    rules in NASD with regard to both standards and procedures,
    with regard to spreads and over-the-counter markets and how
    they actually operate. It is very much similar in some ways to
    the kinds of standards that one might put down with regard to
    accounting rules. It wasn't law. It was sort of----
        Mr. Glauber. Rules.
        Senator Corzine. They were rules that people had to abide
    by, unless I am mistaken.
        Mr. Glauber. No, that is perfectly correct, Senator. They
    are. And if you want to characterize those as standards, then I
    think you are quite right. I think they are not quite the same
    thing as accounting principles, and that is why it is very
    difficult.
        Senator Corzine. I am quite in concurrence that we have
    different functionalities going on here, so you are going to
    have little differences in analogy.
        Mr. Glauber. Yes.
        Mr. Seligman. Senator, if I could just add, the current
    structure of NASD is to separate the standard setting from the
    NASD reg, which is the enforcement arm. But your point is well
    taken. It is not essential that it be done that way. If you
    separate them, you obviously have to have effective
    coordination. I would submit to you, the key, though, is
    however you structure it, you need to focus on independence and
    insured sources of funds.
        Senator Corzine. I think we are all in agreement there.
        I have one question for Professor Coffee.
        I appreciate the kinds of commentary you are making with
    regard to security analysts and, in fact, I have seen some of
    that intimidation that you are referencing. But you did not
    speak to the rating agencies which play almost an equally
    important analytical role and commentary and observation. I
    think if you put statistics down with regard to the independent
    rating agencies, you ended up with results that weren't a lot
    different than what you saw from your so-called conflicted
    investment banking analysts.
        Mr. Coffee. I think the level of conflict and the level of
    compromise is somewhat less. But the fundamental fact is there
    in all three of these cases--auditors, analysts, and debt-
    rating agencies are all paid by the people they are supposed to
    watch and does not create the absolutely optimal incentives
    that you would like.
        I am not sure in the rating agencies that I have a simple
    solution for you at this moment. It is possible that there
    could be heightened liabilities, but I do not need to
    necessarily endorse that.
        I don't know that either the rating agencies or the
    securities analysts should be exposed to massive class-action
    attacks. I think more surgical remedies, such as dealing with
    the process and dealing with the particular prophylactic rules
    you want to adopt are better than just always universally
    heightening liabilities.
        Senator Corzine. I think that is one of the positives of,
    hopefully, our efforts in this Committee and the Congress, is
    to come up with some rules of the road that actually do not
    make it a legal courtroom process to bring about enforcement or
    redress, but where the rules of the road are actually laid out
    ahead of time and people then have a disciplinary process.
        Mr. Coffee. Let me suggest this. Although there has been a
    good deal of study of what has gone wrong with securities
    analysts, and we have found out that independent ones behave
    better than ones that are associated with the client, there has
    been very little empirical investigation of the debt-rating
    agencies. I think that, there, the information basis for a
    quick solution is right now lacking. It may well be that you
    want the SEC or someone else to conduct a more thorough study.
        Chairman Sarbanes. We will keep going here because this is
    a very helpful panel. On the analyst issue, I wanted to ask
    this question. First of all, Professor Coffee, I am not sure
    here. You said that you had some analysts that were not
    connected with investment houses. Then later, you said you
    could only finance the securities research from the investment
    side. So, you could not really create some bright line of
    separation because then you could not function. How do I square
    those two?
        Mr. Coffee. Okay. What I am telling you is, you could
    certainly have a rule under which analysts could only work for
    brokerage firms that did not do underwriting. There are such
    firms. Names like Sanford Bernstein stand out as independent
    analyst firms.
        If we adopted such a firm, I think the consequence of it
    would be a very sharp reduction in the number of analysts who
    would be employed in this industry because most of the revenue
    that supports research analysts comes from the sell side. This
    is a consequence of the very desirable ending of fixed
    brokerage commissions back in 1975. It made the brokerage
    commissions so thin, that I do not think that they are able to
    support from the buy side the analysts who are employed in
    these firms.
        The consequence would be that we would still have the
    Sanford Bernsteins and many other such firms, but we might have
    a reduction in the total number of analysts by a very large
    fraction. And I think that this would inflict a social injury
    because we would have less firms follow.
        There is the bottom side of the Nasdaq market right now
    that is very thinly followed by analysts. And if we reduce that
    population by half, we would have a darker, less transparent
    market.
        Chairman Sarbanes. Did you want to add to that?
        Mr. Glauber. I would like to underline what Professor
    Coffee just said. I think the consequences of a surgical
    solution, a Glass-Steagall type solution of separating security
    analysis from investment banking services, would be a very
    substantial reduction in the amount of information available to
    investors. I think a better approach is, indeed, the right
    kinds of rules imposed by the NASD and others. We have just, as
    Professor Coffee said, put out what is a very comprehensive and
    very tough rule. Some of the proposals he made, I hope he will
    include in comments on that rule. The rule is presently out
    from the SEC for comment.
        Chairman Sarbanes. You mean these four suggestions he had
    here, like the booster shot, for example.
        Mr. Glauber. The antiretaliation provisions. Because they
    are very useful alternatives to consider as part of that rule.
    But I think the best, most effective way to approach this is
    through rules.
        Chairman Sarbanes. How about disclosure? Is it adequately
    disclosed now that the analyst is connected with a firm that is
    doing underwriting as well, and therefore, you should perhaps
    take his recommendation with a grain of salt?
        Mr. Coffee. Well, as he will point out, Rule 2711 also
    addresses the disclosure that should be given. I think that is
    also desirable.
        Chairman Sarbanes. Does that address the analyst's own
    holdings as well? And that was not heretofore the case?
        Mr. Glauber. That is correct. What it does do is require
    disclosure by the analyst of his holdings and it requires a
    disclosure by the firm of its investment banking relationship.
        Chairman Sarbanes. You may do a lot of good if the analyst
    has to say up front, my firm is underwriting this company and I
    own this amount of stock. You are going to look at it and say,
    what kind of recommendation is this? You will, presumably,
    discount it.
        Mr. Glauber. We believe that disclosure plays a very
    important role. The rule contained both of these disclosure
    provisions, including, I might add, one in which the analyst
    has to publish a history of the price of the stock, together
    with his or her recommendations superimposed on that price
    history, so that you can see where the analyst was saying buy
    and where the analyst was saying sell.
        I think disclosure plays a very important role and then
    there are specific prohibitions. For example, no pre-IPO stock.
    The analyst cannot receive cheap stock as part of his
    compensation. I think those together are a very effective rule.
    It perhaps could be embellished and that is why I hope that
    Professor Coffee will add these suggestions to his comments.
        Mr. Coffee. All I was suggesting, Senator, was that it is
    difficult for the individual investor to go through all the
    boilerplate that you are likely to get, even under a much-
    improved system. And if you were to define a term, like
    independent analyst, and say only analysts who have met the
    following standards. I would say the first standard is, you are
    making a recommendation about a company that your firm has no
    economic relationship with.
        Now there are many in the industry who would disagree and
    say analysts are independent, even though their firm is
    underwriter.
        I think we would give a lot more value to investors if we
    tried to define a simply understood term, independent analyst,
    and say that you can only use that term if you meet the
    following qualifications. That condenses the disclosure to the
    bottom-line fact that I think is most important to the
    investor.
        Chairman Sarbanes. I want to ask two more questions----
        Senator Corzine. Mr. Chairman, I have to leave. I would
    make one observation. I do not think this should be limited
    just to underwriting. The relationships that drive some of
    those retaliation actions, some of the interests go well
    beyond. Actually, they are more subtle.
        Mr. Coffee. I certainly agree with you. I did not mean to
    limit it that way.
        Mr. Glauber. Absolutely.
        Senator Corzine. We have to be careful about the
    characterization of only tying it to IPO's or----
        Mr. Coffee. I agree entirely with you. That is why you need
    a rule-based approach, because only an agency can draft those
    full rules.
        Mr. Glauber. That is right.
        Chairman Sarbanes. Let me ask two more questions.
        One is, in the Enron situation, we apparently have
    instances in which banks extended loans to Enron in very
    substantial amounts because it was then being connected to the
    possibility of underwriting or other business that would flow
    from Enron to the lending institution.
        Now, we went through this Glass-Steagall thing here over a
    sustained period of time. And in the end, you used the phrase,
    came out from under it, or something. In any event, now we have
    this situation where this issue has now come before us. What is
    your reaction to that?
        Mr. Coffee. Well, we each may have different reactions.
        Chairman Sarbanes. No, no. You do not all have to have the
    same reactions.
        [Laughter.]
        We invite different reactions.
        [Laughter.]
        Mr. Coffee. I think we have two distinct problems here. One
    is the problem of the Chinese wall, while necessary, sometimes
    can work to the injury of the public investor.
        This is where the investment bank or the commercial bank
    has gone out and found investors for private equity deals, such
    as the private partnerships that were involved in the Enron
    story. And pursuant to that, you learn a lot of nonpublic
    information, none of which ever reaches the public side of your
    firm, which is making recommendations to investors. And one of
    the ironies and problems is that you may be touting a stock
    that one half of the firm knows is a very risky, highly
    leveraged firm. That is a problem that the schizophrenia within
    the firm doesn't work to the best interests of the investor and
    I think it needs some further study.
        The other problem you are raising is that a lot of banks
    felt pressured to raise this equity or to form these services
    in order to be first in line to serve as commercial lenders.
    And I think that is a problem, but I actually do think that
    banks are capable of protecting themselves and you should focus
    more on the problems of the public investor, who is not as
    capable of protecting himself and doesn't know that there may
    be very adverse information that is not reaching the market
    because of this partial penetration of the information through
    the firm.
        Mr. Seligman. If I can just amplify the first point that
    Professor Coffee made.
        There were some very troublesome journalistic stories and
    some intimations in the Powers report prepared about Enron to
    the effect that different financial data was provided to
    private investors, I believe including banks, than was being
    made publicly available.
        Now this may be effectively addressed by enforcement
    actions of some sort. But this is an issue which I think is
    worth exploring with Chairman Pitt when he testifies before
    you, and addressing how it can be possible that, at least if
    the newspaper accounts are accurate, that nearly
    simultaneously, the assets described publicly were only about
    two-thirds of those that were being described privately. I do
    not understand how you can reconcile those data. It is
    plausible. There may be ways to do it. But it hasn't been
    presented in a way that makes sense to date.
        Mr. Glauber. Well, let me return to the second issue. That
    is, the commercial pressures between the commercial banking
    side and the investment banking side or underwriting side of
    now these complex institutions.
        Chairman Sarbanes. Right.
        Mr. Glauber. I think the pressures flow both ways. The
    pressures may be, indeed, to offer a loan as a way to perhaps
    encourage the investment banking services. Those exist. One
    hopes, and I believe that, over time, the managements, for
    their own commercial interests, will manage the sets of
    tensions and pressures because, to make a bad loan in order to
    get the investment banking business, is just a very bad
    commercial decision. I believe that they will find a way to
    manage those pressures, and the shareholders will demand that
    they do. But it is the early stages of having both of these
    under one roof and mistakes will be made, I am sure.
        Chairman Sarbanes. Let me ask you this question. This is a
    broader question. It is fairly clear that the existing
    structure, had it worked or had the will been there to be
    strong or tough or however you want to phrase it, they could
    have done a lot of things that--I mean, the exchanges could
    have had listing requirements or the SEC could have pushed the
    exchanges to have had listing requirements.
        The SEC itself could have done a host of things. FASB could
    have done standards, on and on and on. Of course, the way the
    system works, FASB is thinking about doing a standard and the
    next thing you know, everyone is beating down FASB's door,
    including Members of the Congress, not to do the standard.
        Now, everyone's saying, FASB should have done this
    standard. Where was FASB? Why didn't they do the standard we
    needed? FASB is moving to do some standards. The exchanges, I
    think to their credit--we had Ira Millstein in here on the
    audit committees and they are making, as I understand it, some
    constructive changes with respect to audit committees.
        But one of the decisions we are going to have to face, or
    judgments, is how much we have to move in with legislation--
    well, one area, and Senator Corzine was focusing on it, is what
    structural changes we need, systemic changes, like with an SRO
    for accountants that is different from the current because the
    current thing obviously is not working.
        The other question is whether we have to move in with
    standards of some sort on the argument, this is the only way we
    can prevent sliding back. Maybe the current regulatory
    arrangements will do these standards, but maybe not. Or maybe
    if they do them later, they will fall back from them. It is
    kind of a broad, somewhat vague question, but I would be
    interested in getting your perceptions of that issue.
        Mr. Glauber. Starting from the left and working to the
    right, I guess.
        [Laughter.]
        Mr. Coffee. I think the priority should be on the
    governance of auditing. I think that is the demonstrated
    failure, the data about the number of earnings restatements and
    the way in which earnings management peaked in the late 1990's,
    should give you the number-one priority, focusing on creation
    of an SRO.
        Now your second point, which I agree with, is that there
    are times when one way that Congress can interact with SRO's
    and other bodies, is to give them standards for their future
    rulemaking.
        This would not impose a fine-tune obligation, but you could
    tell the SRO's that you want them to address in rules the
    problem of conflicts of interest among research analysts or you
    want them to study and direct and adopt appropriate rules to
    deal with enhancing the objectivity of analysts and disclosing
    any possible biases.
        I don't think that really hurts the SRO's. It tells them
    this is a Congressionally mandated priority and it leaves the
    front-line problem of drafting, of making things work, in the
    hands of the body with the greatest expertise, either the SEC
    or the SRO.
        I believe there are things you can do, but I would be
    cautious about trying to cut through the Gordian Knot with a
    single stroke, such as by legislating the complete separation
    of securities research from investment banking.
        Mr. Seligman. I mentioned earlier Section 15 and 19(a) of
    the Securities and Exchange Act. I think that gives you a
    useful model in response to your very thoughtful question.
        It seems to me, at a kind of constitutional law level,
    there are certain principles you should delineate. You should
    require a new SRO to be created and you should require it to
    register with the SEC. You should have in place an adequately
    funded SEC staff, whether it is in the Office of Chief
    Accountant or otherwise, that can carefully review the filing
    with the Commission to ensure compliance with the standards you
    have established.
        There is a great deal of highly detailed work and fine-
    tuning that will have to evolve over time, subject to SEC
    oversight. When you periodically have the Commission before
    you, you can question whether they are doing it well enough.
    But to try to delineate all of that level of detail, I think
    would be unwise and too rigid.
        Chairman Sarbanes. Mr. Glauber.
        Mr. Glauber. You have now three, between you, Mr. Chairman
    and these two gentlemen, wise lawyers discussing this issue. I
    am not a lawyer.
        Chairman Sarbanes. It puts you at an advantage.
        [Laughter.]
        Mr. Glauber. I tread here very, very lightly. I think that
    what Professor Coffee said is right. The Congress could easily
    sketch out some broad principles that it wanted. But I hope
    that it would not get into the position of writing detailed
    rules.
        This is a fast-changing scene that requires flexibility and
    I think the right way to get rules written is through either
    the SEC or some independent regulatory organization that would
    be created. So, I just would simply encourage you in that
    direction.
        Chairman Sarbanes. Well, one of the first things that I did
    when I became Chairman was to begin an oversight process. I do
    think that there is much more that the Congress can do in terms
    of oversight to make sure that the regulatory authorities are
    anticipating and measuring up to the problems.
        That is actually where this drumbeat that we continue to
    sound about giving adequate resources--you put the SEC out
    there as a front-line agency for all of this, we call it the
    jewel in our regulatory crown. It has an incredibly
    distinguished history over the years. We constantly brag about
    the integrity of the American markets and how integral this has
    been to our economic success and how it commands worldwide
    respect and everything.
        Then the very agency who carries the prime burden for all
    of this is so short-changed in its resources--we have not had a
    witness yet who has come before us who has even entertained the
    idea of arguing that their existing level of resources is
    adequate to their task. Now, they may differ about how far we
    ought to go, but no one has come in and said, oh, no, they have
    plenty of resources. That just underscores that situation.
        Well, gentlemen, you have been enormously helpful. I hope,
    as we work through this, we can come back to you for further
    counsel because we think that that would be very helpful.
        Let me simply say, tomorrow, we will have a further
    hearing. We will be hearing from: Shaun O'Malley, who is Chair
    of the 2000 Public Oversight Board Panel on Audit
    Effectiveness, the so-called O'Malley Commission; Lee Seidler,
    who is Deputy Chairman of the 1978 American Institute of CPA
    Commission on Auditor's Responsibilities; Arthur Wyatt, Past
    President of the American Accounting Association; Professor
    Abraham Briloff, Professor Emeritus of Baruch College of the
    City University of New York; and Bevis Longstreth, who is a
    member of the O'Malley Commission and a distinguished member of
    the SEC.
        So this panel will, in a sense, follow along very much with
    some of the issues that have been developed here today.
        Thank you all very much.
        This hearing is adjourned.
        [Whereupon, at 12:45 p.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]

                  PREPARED STATEMENT OF SENATOR JON S. CORZINE

        Mr. Chairman, thank you for holding this hearing.
        In the wake of the Enron debacle, Congress has an enormous
    responsibility to take a careful look at the factors that contributed
    to the company's precipitous fall.
        Enron Corporation, along with other high-profile business failures,
    and the growing discomfort with reported earnings restatements, have
    highlighted the need for a comprehensive review of our financial
    reporting system and the regulatory structure that supports it.
        For the past few decades, Washington has been focused on
    deregulation and the development of pro-business policies. Often, these
    policies have been necessary to adjust for excessive rigidities in our
    regulatory structure.
        To be certain, deregulating our financial system has had many
    benefits, including the democratization of the market. Productivity has
    improved dramatically and we have created millions of new jobs. That
    said--excesses accompanied the good--and once clearly defined
    boundaries have now become blurred.
        The pendulum seems to have swung too far. And as we have heard from
    many of our witnesses, the culture of business has increasingly become
    a culture of excess.
        Mr. Chairman, with occurrences like we have witnessed at Enron,
    Global Crossing, Tyco, and PNC Bank, more and more investors are
    becoming uncomfortable with what they perceive to be a lack of full
    disclosure in financial statements--those concerns ultimately hurt our
    markets. And they highlight the glaring need for the SEC to be better
    prepared, better funded, and better staffed in order to fulfill its
    enormous mission. We will hear about the challenges the SEC confronts
    as a result of their increasing workload shortly.
        It also shows the need for an improved regulatory structure, one
    that provides sufficient checks and balances and promotes the integrity
    of the audit function. A structure that provides the SEC with the
    resources it needs, and provides independence to the Financial
    Accounting Standards Board, so that it too may be better equipped to
    serve its vitally important purpose.
        Mr. Chairman, in holding these hearings, I hope we will seek to
    find out not only ``what happened,'' but also move forward with a plan
    to diminish the increasing pressures on companies to ``play in the
    gray.''
        Last week, Senators Dodd, Stabenow, Johnson, and I introduced
    legislation to address many of these issues.
        Mr. Chairman, we look forward to working with you, and the other
    Members of this Committee to bring a bill before this Committee that
    will not only provide investors with greater confidence, but also
    restore credibility to the accounting profession and ensure that the
    SEC is able to fulfill its oversight responsibility--and has the
    resources to do so.
        The train wreck has occurred. And now that it has, we have a
    responsibility to ensure that it never happens again.
        I look forward to the testimony of our witnesses.

                                   ----------

                 PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

        Thank you, Mr. Chairman. Let me begin by commending the thorough
    approach this Committee is taking under your leadership.
        While the work of this Committee may not attract the headlines that
    we see when the Ken Lays and Andrew Fastows of the world are subpoenaed
    to appear before Congress, I believe that the careful and deliberative
    work of this Committee is what will ultimately reform the shortcomings
    in our current accounting system.
        Mr. Chairman, I have approached the issues before us with an open
    mind and have no predetermined conclusions. I appreciate the
    interesting and diverse opinions of the witnesses we have had so far. I
    welcome the witnesses before us today.
        We need to continue to explore the serious policy questions at
    hand.
        In particular, we have heard repeatedly that there is a culture of
    gamesmanship where earnings management is commonplace. We should
    explore this issue further. Changing a culture is a lot more
    complicated than changing the law.
        In addition, I hope that we will continue to examine: The issue of
    the best oversight mechanism for the accounting industry; how an
    oversight board, as well as the Financial Accounting Standards Board
    should be financed; and, what should be done about perceived problems
    in the accounting industry's long-standing peer review process.
        I also think it is worth exploring what should be done to help
    whistleblowers who are trapped in a corporate culture that discourages
    dissent, and to ask what more needs to be done to promote investor
    education.
        All of these issues are complicated. There are differing points of
    view on many of these matters and we must carefully consider how best
    to proceed. However, I have every confidence that by working
    cooperatively, we can put an end to the problems in the industry and we
    can reassure the American people that our securities market is the best
    in the world.
        Thank you, Chairman Sarbanes.

                                   ----------

                     PREPARED STATEMENT OF DAVID M. WALKER

                    Comptroller General of the United States
                         U.S. General Accounting Office
                                 March 5, 2002

        Mr. Chairman and Members of the Committee, I appreciate the
    opportunity to discuss with the Committee my perspectives on some of
    the issues that are now receiving extensive national interest following
    the rapid and unexpected decline of Enron Corporation (Enron) and the
    resulting huge losses suffered by Enron's shareholders and employees.
    The rapid failure and bankruptcy of Enron has led to severe criticism
    of virtually all areas of the Nation's financial reporting and auditing
    systems, which are fundamental to maintaining investor confidence in
    our capital markets. At last count, 12 Congressional committees, the
    Department of Justice, the Securities and Exchange Commission (SEC),
    and the Department of Labor's Pension and Welfare Administration all
    have ongoing investigations of Enron. The individuals responsible for
    the Enron debacle should be held accountable for any misdeeds. At GAO,
    accountability is one of our core values and must be a critical
    component of any system in order for it to function effectively.
        The facts regarding Enron's failure are still being gathered to
    determine the underlying problems and whether any civil and/or criminal
    laws have been violated. Therefore, I will not comment on the specifics
    of the Enron situation and who is at fault. At the same time, the Enron
    situation raises a number of systemic issues for Congressional
    consideration to better protect the public interest. It is fair to say
    that other business failures or restatements of financial statements
    have also sent signals that all is not well with the current system of
    financial reporting and auditing. As the largest corporation failure in
    U.S. history, Enron, however, provides a loud alarm that the current
    system may be broken and in need of an overhaul.
        I will focus on four overarching areas--corporate governance, the
    independent audit of financial statements, oversight of the accounting
    profession, and accounting and financial reporting issues--where the
    Enron failure has already demonstrated that serious, deeply rooted
    problems may exist. It should be recognized that these areas are the
    keystones to protecting the public's interest and are interrelated.
    Failure in any of these areas places a strain on the entire system. The
    overall focus of these areas should be guided by the fundamental
    principles of having the right incentives for the key parties to do the
    right thing, adequate transparency to provide reasonable assurance that
    the right thing will be done, and full accountability if the right
    thing is not done. These three overarching principles represent a
    system of controls that should operate with a policy of placing special
    attention on those areas of greatest risk. In addition, an established
    code of ethics should set the ``tone at the top'' for expected ethical
    behavior in performance of all key responsibilities. The 1980's savings
    and loan crisis, for which this Committee was instrumental in shaping
    the reforms to protect deposit insurance and the public interest, is a
    prime example of the serious consequences that can result when one or
    more components of an interrelated system breaks down.
        My comments today are intended to frame the broad accountability
    issues and provide our views on some of the questions and options that
    must be addressed to better safeguard the public interest going
    forward. There will no doubt be many views on what needs to be fixed
    and how to do it. We look forward to working with the Congress to
    provide assistance in defining the issues, exploring various options,
    and identifying their pros and cons in order to repair any weaknesses
    that threaten confidence in our capital markets and that inhibit
    improvements in the current system and appropriate actions by the key
    players. In considering changes to the current system that gave rise to
    Enron and other earlier financial reporting failures, it will be
    important that the Congress consider a holistic approach to addressing
    the range of interrelated issues. From all that has been heard from the
    inquiries to date, it is clear that there is no single silver bullet to
    fix the problems. It is also clear that many parties are focusing on
    various elements of the issues but do not seem to be taking a
    comprehensive approach to addressing the many interrelated issues. This
    is what we are trying to do for the Congress.
        On February 25, 2002, GAO held a forum on various governance,
    transparency, and accountability issues that was attended by experts in
    each of these areas. A summary of the results of the forum is being
    released today and is available at our website.\1\ Also, we have
    completed the study of the SEC's resources that you requested and the
    report is being released today.\2\ I will discuss the results of that
    work today as well.
    ---------------------------------------------------------------------------
        \1\ Highlights of GAO's Forum on Corporate Governance,
    Transparency, and Accountability (GAO-02- 494SP, March 5, 2002).
        \2\ SEC Operations: Increased Workload Creates Challenges (GAO-02-
    302, March 5, 2002).
    ---------------------------------------------------------------------------
        Before discussing these matters, I would like to quickly provide an
    overview of the current corporate governance system, the independent
    audit function, regulatory oversight, and the accounting and financial
    reporting framework. An attachment to my prepared testimony graphically
    illustrates the interrelation and the complexity of these systems.
    Overview of the Current Governance, Auditing, Oversight Systems,
    and Financial Reporting
        Public and investor confidence in the fairness of financial
    reporting is critical to the effective functioning of our capital
    markets. The SEC, established in the 1930's following the stock market
    crash of 1929 and the Great Depression, protects investors by
    administering and enforcing Federal securities laws, and its
    involvement with requirements for financial disclosures and audits of
    financial statements for publicly-traded companies. In this respect,
    the public accounting profession, through its independent audit
    function, has received a franchise to audit and attest to the fair
    presentation of financial statements of publicly-traded companies.
    However, such a franchise brings with it not only the important role of
    attesting to the reliability of financial statements and related data,
    but also the concomitant responsibility of protecting the public
    interest and ensuring the public confidence through appropriate
    independence, professional competence, and high ethical standards for
    auditors.
        The SEC, the primary Federal agency involved in accounting and
    auditing requirements for publicly-traded companies, has traditionally
    relied on the private sector for setting standards for financial
    reporting and independent audits, retaining a largely oversight role.
    Accordingly, the SEC has accepted the rules set by the Financial
    Accounting Standards Board (FASB) \3\--Generally Accepted Accounting
    Principles (GAAP)--as the primary standard for preparation of financial
    statements in the private sector. The SEC has accepted rules set by the
    American Institute of Certified Public Accountants' (AICPA) Auditing
    Standards Board--Generally Accepted Auditing Standards (GAAS)--as the
    standard for conducting independent audits of financial statements for
    private sector entities. The SEC monitors the performance of the
    standard setting bodies and also monitors the accounting profession's
    system of peer review, which checks compliance with applicable
    professional standards.
    ---------------------------------------------------------------------------
        \3\ FASB, as part of the Financial Accounting Foundation (FAF), is
    a not-for-profit organization supported by contributions from
    accounting firms, corporations, and the other entities that are
    interested in accounting issues. FASB consists of seven full-time
    members who are selected and approved by the FAF.
    ---------------------------------------------------------------------------
        The SEC also oversees the activities of a variety of key market
    participants. It does this using the principle of self-regulation.
    According to this principle, the industry regulates itself through
    various self-regulatory organizations (SRO's) overseen by the SEC.
    SRO's are groups of industry professionals with quasi-governmental
    powers to adopt and enforce standards of conduct for their members.
    They include the nine securities exchanges, such as the New York Stock
    Exchange (NYSE) which regulate their marketplaces and the National
    Association of Securities Dealers (NASD) which regulates the over-the-
    counter market. In addition to regulating member broker-dealers, the
    SRO's establish listing standards for those firms that list on their
    market.
        The AICPA administers a self-regulatory system for the accounting
    profession that includes setting auditing and independence standards,
    monitoring compliance, and disciplining members for violations of ethic
    rules and standards. The Public Oversight Board, administratively
    created by the AICPA in consultation with the SEC in 1977, monitors the
    public accounting firms' compliance with professional standards and
    oversees the Auditing Standards Board. State boards of accountancy
    license public accounting firms and individuals to practice public
    accounting within each State's jurisdiction.
        The audit is a critical element of the financial reporting
    structure because it subjects information in the financial statements
    to independent and objective scrutiny, increasing the reliability and
    assurance that can be placed on those financial statements for
    efficient allocation of resources in a capital market where investors
    are dependent on timely and reliable information. Management of a
    public company is responsible for the preparation and content of the
    financial statements, which are intended to disclose information that
    accurately depicts the financial condition and results of company
    activities. In addition, public companies registered with the SEC must
    maintain an adequate system of internal accounting control. The
    independent auditor is responsible for auditing the financial
    statements in accordance with generally accepted auditing standards to
    provide reasonable assurance that the financial statements are fairly
    presented in accordance with GAAP. The auditor's opinion on the
    financial statements is like an expert's stamp of approval to the
    public and the capital markets.
        United States stock exchanges require listed companies to meet
    certain corporate governance standards, including that boards of
    directors have independent audit committees to oversee the accounting
    and financial controls of a company and the financial reporting
    process. Audit committees can help protect shareholder interests by
    providing sound leadership and oversight of the financial reporting
    process by working with management and both internal and external
    auditors.
        The interrelation and complexity of the systems of corporate
    governance, auditing, oversight, and accounting and financial
    reporting, which cumulatively are the foundation for maintaining
    investor confidence in our capital markets, is graphically illustrated
    in the charts attached to this statement. The many links within and
    between the systems further illustrate the strain that can be placed on
    the overall system when weaknesses occur within any part of the system.
        I would now like to focus on each of the four overarching areas
    that I mentioned earlier, starting with corporate governance.

    Corporate Governance
        I want to acknowledge immediately that serving on the Board of
    Directors of a public corporation is an important, difficult, and
    challenging responsibility. That responsibility is especially
    challenging in the current environment with increased globalization and
    rapidly evolving technologies having to be addressed while at the same
    time meeting quarterly earnings projections in order to maintain or
    raise the market value of the corporation's stock. These pressures, and
    the related executive compensation arrangements, unfortunately often
    translate to a focus on short-term business results. This can create
    the perverse incentives, such as managing earnings to inappropriately
    report favorable financial results, and /or failing to provide adequate
    transparency in financial reporting that disguises risks,
    uncertainties, and/or commitments of the reporting entity.
        On balance though, the difficulty of serving on a public
    corporation's board of directors is not a valid reason for not doing
    the job right, which means being knowledgeable of the corporation's
    business, asking the right questions, and doing the right thing to
    protect the shareholders and the public interest. A board member needs
    to have a clear understanding of who is the client being served.
    Namely, their client should be the shareholders of the company, and all
    their actions should be geared accordingly. Audit committees have a
    particularly important role to play in assuring fair presentation and
    appropriate accountability in connection with financial reporting,
    internal control, compliance, and related matters.
        Enron's failure has raised many questions about how its Board of
    Directors and audit committee were performing their duties and
    responsibilities. These questions include the following:

     Did the board of directors fulfill its fiduciary
        responsibility to shareholders and protect the public interest in
        overseeing Enron's management?

     Did the board operate in a proactive manner and raise the
        appropriate questions designed to identify key problems and
        mitigate related risks?

     Did the board have the appropriate industry, financial, or
        other appropriate expertise?

     Did board members have personal or business relationships that
        may have either in fact or in appearance affected their
        independence?

     Did the board, especially its audit committee, have an active
        interface and appropriate working relationship with Enron's
        internal and external auditors?

     Did the board and its audit committee have appropriate
        resources to do the job including staff and independent advisors?

     Did the board and its audit committee report meaningfully on
        their activities?

        These are fundamental questions that as I previously mentioned are
    being addressed by various investigations and, therefore, I will not
    comment on those issues. However, these issues are instructive and, as
    a minimum, call for a review of the applicable rules and regulations
    that govern boards of directors. In that respect, the Administration
    recently formed a group of top financial policymakers and regulators to
    consider corporate governance and disclosure reforms. The SEC has asked
    the NYSE and Nasdaq to review corporate governance and listing
    standards, of public companies, including the important issues of
    officer and director qualifications and the formal codes of conduct.
    The SEC Chairman recently announced that the NYSE has established a
    Special Committee on Corporate Accountability and Listing Standards to
    examine corporate governance issues, including the possibility of
    requiring continuing education programs for officers and directors, and
    the Nasdaq also is taking similar steps. The corporate chief executives
    who make up the Business Roundtable have stated that they are reviewing
    their voluntary standards for corporate governance. The AFL - CIO has
    petitioned the SEC to amend its proxy disclosure requirements regarding
    conflicts of interest reportable by Board members. The California
    Public Employees' Retirement System (CalPERS) is also reviewing
    definitions and standards for independent corporate directors.
        These examples are not intended to be a complete listing of reviews
    underway on corporate governance requirements. We applaud these
    initiatives. Hopefully, they will provide the opportunity for a
    thorough review of corporate governance requirements. These efforts
    will help to identify and frame the issues and to serve as a basis for
    determining whether the fundamental underpinnings for effective
    performance of boards of directors and audit committees are in place
    along with controls to monitor performance. Some basic factors to
    consider in reviewing the various requirements that govern membership
    and responsibilities of boards of directors of public companies include
    the following:

     Is there a clear understanding of whom the board is serving
        and its fiduciary responsibility to shareholders and related impact
        on the capital markets?

     What type of relationship should the board have with
        management (for example, constructive engagement)?

     What, if any, selection process changes are necessary in order
        to assure the proper identification of qualified and independent
        board members?

     Is the nominating process for board membership designed to
        ensure that the board is getting the right mix of talent to do the
        job?

     Do board membership rules address who other than management
        would nominate board members?

     Are the independence rules for outside directors and audit
        committee members sufficient to ensure the objectivity of the
        members?

     Do board membership rules address whether the corporation's
        CEO should be allowed to be the board chairman?

     Do board membership rules address whether independent board
        members should nominate the chairman of the board?

     Do board membership rules address whether members of
        corporation management, including the CEO, should be allowed to be
        board members, and if so, what percentage of total board
        membership?

     Do board membership rules address whether corporation service
        providers, such as the major customers or other related parties,
        should be allowed to be board members?

     Do requirements ensure that the board will have access to the
        resources and staff necessary to do the job, including its own
        staff and access to independent legal counsel and other experts?

     Do requirements ensure that the responsibilities of board
        members, including the members who serve on audit committees and
        other committees, such as the nominating, finance, and compensation
        committees, are required to be committed to a charter that governs
        their operation?

     Do requirements address the appropriate working relationship
        between the audit committee and the internal and external auditors?

     Do requirements provide for the board of directors to
        establish a formal code of conduct to set the tone for expected
        personal and business ethical behavior within the corporation?

     Do requirements provide that waivers of the code of conduct
        are not expected and should such circumstances arise, which should
        be extremely rare, that any exceptions must be approved by the
        board of directors and publicly reported?

     Do requirements provide for public reporting on the
        effectiveness of internal control by management and independent
        assurances on the effectiveness of internal control by the
        corporation's independent auditors?

     Do requirements provide for public reporting by the board of
        directors, the audit committee, and other committees of the board
        on their membership, responsibilities, and activities to fulfill
        those responsibilities?

     Do the stock exchanges and the SEC have sufficient authority
        to enforce requirements governing boards of directors and audit
        committees and to take meaningful enforcement actions, including
        imposing effective sanctions when requirements are violated?

     Does the SEC have sufficient resources and authority to
        fulfill its responsibilities under the Federal securities laws and
        regulations to operate proactively in monitoring SEC's registrants
        for compliance and to take timely and effective actions when
        noncompliance may exist?

     Is the SEC efficiently and effectively using technology to
        manage its regulatory responsibilities under the Federal securities
        laws by assessing risks, screening financial reports and other
        required filings, and accordingly prioritizing the use of its
        available resources?

        Boards of directors and their audit committees are a critical link
    to fair and reliable financial reporting. A weak board of directors
    will also likely translate into an ineffective audit committee. That
    combination makes the difficult job of auditing the financial
    statements of large corporations, which usually have vast, complex, and
    diversified operations, much more challenging.
    Regulation and Oversight of the Accounting Profession
        The model for regulation and oversight of the accounting profession
    involves Federal and State regulators and a complex system of self-
    regulation by the accounting profession. The functions of the model are
    interrelated and their effectiveness is ultimately dependent upon each
    component working well. Basically, the model includes the functions of:

     Licensing members of the accounting profession to practice
        within the jurisdiction of a State, as well as issuing rules and
        regulations governing member conduct, which is done by the State
        boards of accountancy.

     Setting accounting and auditing standards, which is done by
        the Financial Accounting Standards Board and the Auditing Standards
        Board, respectively, through acceptance of the standards by the
        SEC.

     Setting auditor independence rules, which within their various
        areas of responsibility, have been issued by the AIPCA, the SEC,
        and GAO.

     Oversight and discipline, which is done through systems of
        self-regulation by the accounting profession and the public
        regulators (the SEC and the State boards of accountancy).

        The Enron failure has brought a direct focus on how well the
    systems of regulation and oversight of the accounting profession are
    working in achieving their ultimate objective that the opinions of
    independent auditors on the fair presentation of financial statements
    can be relied upon by the investors, the creditors, and the various
    other users of financial reports.
        The issues currently being raised about the effectiveness of the
    accounting profession's self-regulatory system are not unique to the
    collapse of Enron. Other business failures or restatements of financial
    statements over the past several years have called into question the
    effectiveness of the system. A continuing message is that the current
    self-regulatory system is fragmented, is not well-coordinated, and has
    a discipline function that is not timely nor does it contain effective
    sanctions, all of which create a public image of ineffectiveness.
    Reviews of the system should consider whether overall the system
    creates the right incentives, transparency, and accountability, and
    operates proactively to protect the public interest. Also, the links
    within the self-regulatory system and with the SEC and the State boards
    of accountancy (the public regulatory systems) should be considered as
    these systems are interrelated and weaknesses in one component can put
    strain on the other components of the overall system.
        I would now like to address some of the more specific areas of the
    accounting profession's self-regulatory system that should be
    considered in forming and evaluating proposals to reshape or overhaul
    the current system.

    Accounting Profession's Self-Regulatory System
        The accounting profession's current self-regulatory system is
    largely operated by the AICPA through a system, largely composed of
    volunteers from the accounting profession. This system is used to set
    auditing standards and auditor independence rules, monitor member
    public accounting firms for compliance with professional standards, and
    discipline members who violate auditing standards or independence
    rules. AICPA staff support the volunteers in conducting their
    responsibilities. The Public Oversight Board oversees the peer review
    system established to monitor member public accounting firms for
    compliance with professional standards. In 2001, the oversight
    authority of the Public Oversight Board was expanded to include
    oversight of the Auditing Standards Board. The Public Oversight Board
    has five public members and professional staff, and receives its
    funding from the AICPA.
        On January 17, 2002, the SEC Chairman outlined a proposed new self-
    regulatory structure to oversee the accounting profession. On January
    20, 2002, the Public Oversight Board passed a resolution of intent to
    terminate its existence no later than March 31, 2002. The Public
    Oversight Board's Chairman was critical of the SEC's proposal and
    expressed concern that the Board was not consulted about the proposal.
    The SEC's proposal provided for creating an oversight body that would
    include monitoring and discipline functions, have a majority of public
    members, and be funded through private sources. No further details have
    been announced.
        The authority for the oversight body is a basic but critical factor
    that can influence its operating philosophy, its independence, and,
    ultimately, its effectiveness. Related factors to consider include:

     Determining whether the body should be created by statute or
        administratively, such as is the case for the current Public
        Oversight Board.

     Deciding the basic scope of the body's enabling authority,
        such as whether oversight authority should be limited to coverage
        of the public accounting firms that audit SEC registrants, which is
        the authority of the current Public Oversight Board, or whether it
        should be expanded to other public accounting firms that also
        provide audit services to a broader range of entities.

     Determining mission objectives clearly to ensure that
        protecting the public interest is paramount.

        Membership of the oversight body and its funding may also influence
    the body's operating philosophy (proactive as opposed to reactive),
    independence, and resolve to actively assess and minimize risks within
    the system that affect protecting the public interest. Factors to
    consider include:

     Whether the membership should be limited to public members
        (exclude practicing members of the accounting profession), such as
        is the case for current Public Oversight Board.

     Whether membership should allow some practicing members of the
        accounting profession to sit on the board.

     How the members will be selected, including the chairman,
        their term limits, and compensation.

     How the amount and source of funding will be established since
        a problem with either may present potential conflicts or limit the
        oversight body's ability to effectively protect the public
        interest.

        The responsibilities of the oversight body and its powers to
    perform those responsibilities will largely define whether the
    oversight body is set up with a sufficient span of responsibility to
    oversee the activities of the accounting profession and to take
    appropriate actions when problems are identified. Related factors to
    consider include:

     Whether the current system of peer review should be continued
        in its present form and monitored by the oversight body, such as
        was done by the Public Oversight Board, with oversight by the SEC.

     Whether the oversight body should have more control over the
        peer review function, such as selecting and hiring peer reviewers,
        managing the peer review, and being the client for the peer review
        report.

     Whether the oversight body's authority should extend to all
        standard setting bodies within the accounting profession so that
        accounting, auditing, quality control and assurance, and
        independence standards are subject to oversight (currently the
        Public Oversight Board does not oversee the setting of accounting
        standards or auditor independence rules).

     Whether the oversight body's authority related to standard
        setting should be expanded to direct standard setting bodies to
        address any problems with standards and approve the adequacy of
        revised standards (currently the Public Oversight Board does not
        have such direct authority).

     Whether the oversight body's authority should extend to the
        discipline function (currently the Public Oversight Board does not
        oversee the discipline function).

     Whether the oversight body should have investigative authority
        over disciplinary matters (currently this function is housed within
        another component of the AICPA) or authority to request
        investigations.

     Whether the body within the self-regulatory system responsible
        for investigations of disciplinary matters should have power to
        protect investigative files from discovery during litigation to
        facilitate cooperation and timeliness in resolving cases.

        Accountability requirements can provide for stewardship of
    resources, help to set the operating philosophy of the oversight body,
    and provide a means of monitoring the oversight body's performance. The
    current Public Oversight Board, POB, issues an annual report and its
    financial statements are audited. Related factors to consider include:

     Whether the oversight body should prepare strategic and annual
        performance plans.

     Whether the oversight body should have an annual public
        reporting requirement and what information should be included in
        the report, such as whether the report should be limited to the
        oversight body's activities or whether the report should provide
        more comprehensive information about the activities of the entire
        self-regulatory system, and whether the oversight body should have
        audited financial statements.

     Whether and, if so, how Congress should exercise periodic
        oversight of the performance of the self-regulatory system and the
        performance of the oversight body.

        At this time, the outcome of the SEC's proposal to establish a body
    for overseeing the accounting profession that would include monitoring
    and discipline functions is uncertain. There is considerable overlap in
    the functions of the current self-regulatory system and the functions
    of the SEC related to the accounting profession. For example, the AICPA
    sets auditor independence rules applicable to its membership, and the
    SEC sets auditor independence rules for those auditors who audit the
    SEC's registrants. Also the AICPA disciplines its members for
    noncompliance with independence rules or auditing standards. The SEC,
    through its enforcement actions, disciplines auditors of SEC
    registrants who violate its laws and regulations, which include
    noncompliance with independence rules and auditing standards. In
    addition, the SEC also conducts various activities to oversee the peer
    review function of the self-regulatory system.
        As proposals are considered for reshaping or for overhauling the
    self-regulatory system, the overlap of functions with the SEC's
    responsibilities should be considered to provide for oversight of the
    accounting profession that is both efficient and effective. Related
    factors to consider include the following:

     Whether current independence rules are adequate to protect the
        public interest.

     Whether independence rules for auditors should be consistent
        and set by the Government or private sector, or whether the status
        quo is acceptable.

     Whether the current system of peer review is acceptable or
        whether the SEC should play a role that exercises more direct
        control or oversight of the accounting profession's compliance with
        standards.

     How the investigative/enforcement functions of the self-
        regulatory system and the SEC can be jointly used to efficiently
        and to effectively achieve their common objectives to resolve
        allegations of audit failure.

        Similarly, the discipline functions of the SEC and the self-
    regulatory system overlap with the State boards of accountancy, which
    are the only authorities that can issue or revoke a license to practice
    within their jurisdictions. The communication and working relationship
    opportunities for efficiency and effectiveness that exist between the
    SEC and the self-regulatory system also exist for their relationship
    with the State boards of accountancy in resolving allegations of audit
    failure.

    The Independent Audit Function
        For over 70 years, the public accounting profession, through its
    independent audit function, has played a critical role in enhancing a
    financial reporting process that facilitates the effective functioning
    of our domestic capital markets, as well as international markets. The
    public confidence in the reliability of issuers' financial statements
    that is provided by the performance of independent audits encourages
    investment in securities issued by public companies. This sense of
    confidence depends on reasonable investors perceiving auditors as
    independent expert professionals who have neither mutual nor conflicts
    of interests in connection with the entities they are auditing.
    Accordingly, investors and other users expect auditors to bring to the
    financial reporting process integrity, independence, objectivity, and
    technical competence, and to prevent the issuance of misleading
    financial statements.
        The Enron failure has raised questions concerning whether auditors
    are living up to the expectations of the investing public; however,
    similar questions have been repeatedly raised over the past three
    decades by significant restatements of financial statements and
    unexpected costly business failures. Issues debated over the years
    continue to focus on the auditor independence concerns and the
    auditor's role and responsibilities, particularly in detecting and
    reporting fraud and assessing the effectiveness of and reporting on
    internal control.

    Auditor Independence Concerns
        The independence of public accountants--both in fact and in
    appearance--is very crucial to the credibility of financial reporting
    and, in turn, the capital formation process. Auditor independence
    standards require that the audit organization and the auditor be
    independent in fact and in appearance. These standards place
    responsibility on the auditor and the audit organization to maintain
    independence so that opinions, conclusions, judgments, and
    recommendations will be impartial and will be viewed as being impartial
    by knowledgeable third parties.
        Since the mid-1970's, many observers of the auditing profession
    have expressed concern about the expanding scope of professional
    services provided by the public accounting profession. Specifically,
    questions have been raised by the media, the Congress, and others
    concerning the propriety of performing both audit and certain nonaudit
    services for the same client. While these services and their perceived
    impact on accounting firms' independence have been the subject of many
    studies and while actions have been taken to strengthen auditor
    independence, the Enron failure has brought this issue once again to
    the forefront and has sparked new proposals to prohibit or limit
    auditors from providing nonaudit services to audit clients. A common
    concern is that when auditor fees for consulting services are a
    substantial part of total auditor fees, this situation can create
    pressures to keep the client happy and can threaten auditor
    independence.
        Auditors have the capability of performing a range of valuable
    services for their clients, and providing certain nonaudit services can
    ultimately be beneficial to investors and other interested parties.
    However, in some circumstances, it is not appropriate for auditors to
    perform both audit and certain nonaudit services for the same client.
    In these circumstances, the auditor, the client, or both will have to
    make a choice as to which of these services the auditor will provide.
    These concepts, which I strongly believe are in the public interest,
    are reflected in the revisions to auditor independence requirements for
    Government audits,\4\ which GAO recently issued as part of Government
    Auditing Standards.\5\ The new independence standard has gone through
    an extensive deliberative process over several years, including
    extensive public comments and input from my Advisory Council on
    Government Auditing Standards.\6\ The standard, among other things,
    toughens the rules associated with providing nonaudit services and
    includes a principle-based approach to addressing this issue,
    supplemented with certain safeguards. The two overarching principles in
    the standard for nonaudit services are that:
    ---------------------------------------------------------------------------
        \4\ Government Auditing Standards, Amendment No. 3, Independence
    (GAO/A-GAGAS-3, January 2002).
        \5\ Government Auditing Standards were first published in 1972 and
    are commonly referred to as the ``Yellow Book,'' and cover Federal
    entities and those organizations receiving Federal funds. Various laws
    require compliance with the standards in connection with audits of
    Federal entities and funds. Furthermore, many States and local
    governments and other entities, both domestically and internationally,
    have voluntarily adopted these standards.
        \6\ The Advisory Council includes 20 experts in financial and
    performance auditing and reporting drawn from all levels of Government,
    academia, private enterprise, and public accounting, who advise the
    Comptroller General on Government Auditing Standards.

     The auditors should not perform management functions or make
        management
    ---------------------------------------------------------------------------
        decisions.

     The auditors should not audit their own work or provide
        nonaudit services in situations where the amounts or services
        involved are significant or material to the subject matter of the
        audit.

        Both of the above principles should be applied using a substance
    over form determination. Under the revised standard, auditors are
    allowed to perform certain nonaudit services provided the services do
    not violate the above principles; however, in most circumstances
    certain additional safeguards would have to be met. For example: (1)
    personnel who perform allowable nonaudit services would be precluded
    from performing any related audit work, (2) the auditor's work could
    not be reduced beyond the level that would be appropriate if the
    nonaudit work were performed by another unrelated party; and (3)
    certain documentation and quality assurance requirements must be met.
    The new standard includes an express prohibition regarding auditors
    providing certain bookkeeping or recordkeeping services and limits
    payroll processing and certain other services, all of which are
    presently permitted under current independence rules of the AICPA.
        The focus of these changes to the Government Auditing Standards is
    to better serve the public interest and to maintain a high degree of
    integrity, objectivity, and independence for audits of Government
    entities and entities that receive Federal funding. However, these
    standards apply only to audits of Federal entities and those
    organizations receiving Federal funds, and not to audits of public
    companies. In the transmittal letter issuing the new independence
    standard, we expressed our hope that the AICPA will raise its
    independence standards to those contained in this new standard in order
    to eliminate any inconsistency between this standard and their current
    standards. The AICPA's recent statement before another Congressional
    committee that the AICPA will not oppose prohibitions on auditors
    providing certain nonaudit services seems to be a step in the right
    direction.\7\ In 2000, the SEC considered a principle-based approach
    for auditor independence rules applicable to auditors of the SEC's
    registrants, but decided in the end to set specific rules by types of
    nonaudit services. We believe a principle-based approach is more
    effective given the wide variety of nonaudit services provided by
    auditors and the continuing evolution of the market.
    ---------------------------------------------------------------------------
        \7\ Testimony of AICPA Chairman before the House Energy and
    Commerce Committee (Subcommittee on Communications, Trade and Consumer
    Protection), February 14, 2002.
    ---------------------------------------------------------------------------
        The new independence standard is the first of several steps GAO has
    planned in connection with nonaudit services covered by Government
    Auditing Standards. In May 2002, we plan to issue a question and answer
    document concerning our independence standard, and I will ask my
    Advisory Council on Government Auditing Standards to review and monitor
    this area to determine what, if any, additional steps may be
    appropriate. In addition, the Principals of the Joint Financial
    Management Improvement Program, who are the Comptroller General, the
    Secretary of the Treasury, and the Director of the Office of Management
    and Budget, have agreed that the 24 major Federal departments and
    agencies covered by the Chief Financial Officers Act should have audit
    committees. The scope, structure, and timing of this new requirement
    will be determined over the next several months. This will include
    determining what role these audit committees might play in connection
    with nonaudit services.
        Another auditor independence issue, which also existed with Enron,
    concerns the employment by the client of its former auditor. The
    revolving door between auditors and the companies they audit has
    existed for years. This is due in part to the mandatory retirement of
    partners from public accounting firms, often before the partners are
    ready to leave the profession. Another contributing factor that entices
    auditors to work for audit clients is the lucrative compensation for
    executives in public companies. Employment by the client of its former
    auditor can have a clear implication on the quality of audits and has
    been cited as a factor in the savings and loan scandal of the late
    1980's. The AICPA asked the SEC in 1993 to prohibit public companies
    from hiring their audit partner for a year after an audit. The SEC
    rejected the proposal as too difficult to enforce. However, Enron has
    resurfaced the issue. One Congressional proposal would prohibit an
    accounting firm from providing audit services to a company whose
    controller or chief financial officer had worked for that public
    accounting firm. This issue again raises the auditor independence
    perception problem and provides another opportunity to further enhance
    auditor independence. A factor to consider in this debate includes
    mandating a ``cooling off period'' in which a partner or senior auditor
    from a firm cannot go to work for a former audit client for a period of
    time after separating from their firm.
        A related issue is whether an audit firm should be allowed to serve
    as the client's auditor of record without a limit on the period of
    time. Currently, there are no time limits for rotation of audit firms,
    although the AICPA requirements for member firms that audit SEC
    registrants require partner rotation every 7 years. The concerns are
    that the auditor may become too close to management over a period of
    years and, therefore, threaten the auditor's objectivity. Also the
    auditor's familiarity with the business operations of the client may
    result in a less than thorough audit. Opposing arguments against
    auditor rotation include that there is a significant learning curve for
    a new auditor and, during that time, there is a greater risk of the
    auditor overlooking transactions that may result in misleading
    financial statements. Also, auditor rotations can increase audit costs
    for the client.\8\ Building on the current AICPA requirement for
    rotating the audit engagement partner every 7 years, rotating
    additional key members of the audit team is another alternative to
    consider. Rotating additional key members of the audit team should have
    less of an impact of the auditor's learning curve and not increase
    audit costs, although this option would still leave open the appearance
    of an independence issue for the firm.
    ---------------------------------------------------------------------------
        \8\ Federal, State, and local government auditors generally have
    their responsibilities defined by law or regulation. Therefore,
    rotation of Government auditors raises different considerations than in
    the private sector. However, the rationale behind rotation of auditors
    (enhancing auditor independence) is addressed in Government Auditing
    Standards. The standards add organizational criteria that consider
    factors in the appointment, removal, and reporting responsibilities of
    the head of the audit organization to ensure independence. The
    organizational criteria for determining auditor independence are in
    addition to personal and external requirements that are considered in
    judging the independence of Government auditors.
    ---------------------------------------------------------------------------
        Study groups over the years have recognized that corporate boards
    and their audit committees could and should play a more significant
    role in strengthening the independence of audits. The situation with
    Enron and its auditors is another event that highlights the necessity
    to reexamine relationships of boards of directors, audit committees,
    and management with the independent auditor in order to strengthen the
    objectivity and professionalism of the independent auditor and to
    enhance the independent audit. Factors to consider in making changes
    include the following:

     Who should be the client for the audit?

     Should the audit committee be actively responsible for hiring,
        determining fees, and terminating the auditor?

     Should there be more required communication and interaction
        between the auditor and the audit committee?

     Should the audit committee preapprove the provision of certain
        nonaudit services by audit firms?

     Should the audit committee be required to review and to
        approve the staffing of audit firm personnel?

    Auditor's Roles and Responsibilities for Fraud and Internal Control
        Under current auditing standards, auditors are responsible for
    planning and performing the audit to obtain reasonable, but not
    absolute, assurance about whether the financial statements are free of
    material misstatement, whether caused by error, illegal acts, or fraud.
    As stated over the years by many who have studied the profession, no
    major aspect of the independent auditor's role has caused more
    difficulty than the auditor's responsibility for detecting fraud. In
    August 2000, the Panel on Audit Effectiveness concluded that the
    auditing profession needs to address vigorously the issue of fraudulent
    financial reporting, including fraud in the form of illegitimate
    earnings management.\9\ The study expressed concern that auditors may
    not be requiring enough evidence, that is, they have reduced the scope
    of their audits and level of testing, to achieve reasonable assurance
    about the reliability of financial information that the capital markets
    need for their proper functioning. The study recommended that auditing
    standards be strengthened to effect a substantial change in auditors'
    performance and thereby improve the likelihood that auditors will
    detect fraudulent financial reporting. The AICPA is working on a new
    auditing standard to improve auditor performance in this area, which it
    expects to issue by the end of this year.
    ---------------------------------------------------------------------------
        \9\ The Panel on Audit Effectiveness Report and Recommendations
    (August 31, 2000). The Panel was formed by the Public Oversight Board
    at the request of the SEC to study the effectiveness of the audit model
    and other issues affecting the accounting profession.
    ---------------------------------------------------------------------------
        We have long believed that expanding auditors' responsibilities to
    report on the effectiveness of internal control over financial
    reporting would assist auditors in assessing risks for the opportunity
    of fraudulent financial reporting or misappropriation of business
    assets. Currently, the auditor's report on a public company's financial
    statements does not address internal control or purport to give any
    assurance about it, and auditors are not required to assess the overall
    effectiveness of internal control or search for control deficiencies.
    The important issues of the auditor's responsibility for detecting and
    reporting fraud and for reporting on internal control overlap since
    effective internal control is the major line of defense in preventing
    and detecting fraud. Taken together, these issues raise the broader
    question of determining the proper scope of the auditor's work in
    auditing financial statements of publicly-owned companies. The auditor
    would be more successful in preventing and detecting fraud if auditors
    were required to accept more responsibility for reporting on the
    effectiveness of internal control. The Congress recognized the link
    between past failures of financial institutions and weak internal
    control when it enacted the Federal Deposit Insurance Corporation
    Improvement Act of 1991 that grew out of the savings and loan crisis.
    The Act requires an independent public auditor to report on the
    effectiveness of internal control for large financial institutions.
        And for all of the financial statements audits that we conduct,
    which include the consolidated financial statements of the Federal
    Government, and the financial statements of the Internal Revenue
    Service, the Bureau of Public Debt, the Federal Deposit Insurance
    Corporation, and the numerous smaller entities' operations and funds,
    we issue separate opinions on the effectiveness of internal control
    over financial reporting and compliance with applicable laws and
    regulations. We require extensive testing of controls and of compliance
    in our audits. We have done this for many years because of the
    importance of internal control to protecting the public interest. Our
    reports have engendered major improvements in internal control. And as
    you might expect, as part of the annual audit of our own financial
    statements, we practice what we recommend to others and contract with a
    CPA firm for both an opinion on our financial statements and an opinion
    on the effectiveness of our internal control over financial reporting
    and compliance with applicable laws and regulations. We believe
    strongly that the AICPA should follow suit and work with the SEC to
    require expanded auditor involvement with internal control of public
    companies.
        The AICPA Chairman recently expressed the accounting profession's
    support for auditor reporting on the effectiveness of internal
    control.\10\ Auditors can better serve their business clients and other
    financial statements users and protect the public interest by having a
    greater role in providing assurances of the effectiveness of internal
    control in deterring fraudulent financial reporting, protecting assets,
    and providing an early warning of internal control weaknesses that
    could lead to business failures. The SEC, the AICPA, and the corporate
    boards of directors are major stakeholders in achieving realistic
    auditing standards for fraud and internal control. However, as we
    stated in our 1996 report on the accounting profession,\11\ the SEC is
    the key player in providing the leadership and in bringing these
    parties together to enhance auditor reporting requirements on the
    effectiveness of internal control. We believe it would be difficult for
    the AICPA to unilaterally expand audit requirements without SEC
    support.
    ---------------------------------------------------------------------------
        \10\ See footnote 7.
        \11\ The Accounting Profession Major Issues: Progress and Concerns
    (GAO/AIMD-96-98, September 24, 1996).
    ---------------------------------------------------------------------------
    Accounting and Financial Reporting Model
        Business financial reporting is critical in promoting an effective
    allocation of capital among companies. Financial statements, which are
    at the center of present-day business reporting, must be relevant and
    reliable to be useful for decisionmaking. In our 1996 report on the
    accounting profession,\12\ we reported that the current financial
    reporting model does not fully meet users' needs.
    ---------------------------------------------------------------------------
        \12\ See footnote 11.
    ---------------------------------------------------------------------------
        We found that despite the continuing efforts of standard setters
    and the SEC to enhance financial reporting, changes in the business
    environment, such as the growth in information technology, new types of
    relationships between companies, and the increasing use of complex
    business transactions and financial instruments, constantly threaten
    the relevance of financial statements and pose a formidable challenge
    for standard setters. A basic limitation of the model is that financial
    statements present the business entity's financial position and results
    of its operations largely on the basis of historical costs, which do
    not fully meet the broad range of user needs for financial
    information.\13\
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        \13\ The accounting and reporting model under Generally Accepted
    Accounting Principles is actually a mixed-attribute model. Although
    most transactions and balances are measured on the basis of historical
    cost, which is the amount of cash or its equivalent originally paid to
    acquire an asset, certain assets and liabilities are reported at
    current values either in the financial statements or related notes. For
    example, certain investments in debt and equity securities are
    currently reported at fair value, receivables are reported at net
    realizable value, and inventories are reported at the lower of cost or
    market value. Further, certain industries such as brokerage houses and
    mutual funds prepare financial statements on a fair value basis.
    ---------------------------------------------------------------------------
        In 1994, the AICPA's Special Committee on Financial Reporting,
    after studying the concerns over the relevance and usefulness of
    financial reporting and the information needs of professional investors
    and creditors, concluded that the current model is useful as a reliable
    information basis for analysts, but concluded that a more comprehensive
    model is needed that includes both financial information and
    nonfinancial information. In addition to financial statements and
    related disclosures, the model recommended by the study would include:

     High-level operating data and performance measures that
        management uses to manage the business.

     Management's analysis of changes in financial and nonfinancial
        data.

     Forward-looking information about opportunities, risks, and
        management's plans, including discussions about critical success
        factors, as well as information about management and shareholders.

     Background about the company, including a description of the
        business, its industry, and its objectives and strategies.

        The Committee acknowledged that many business entities do report
    nonfinancial information, but it stressed the need to develop a
    comprehensive reporting package that would promote consistent reporting
    and the need to have auditors involved in providing some level of
    assurance for each of the model's elements. Opposing views generally
    cite liability concerns as a risk to reporting forward-looking and
    other related nonfinancial information, concerns over the cost of
    preparing the information, and concerns whether more specific
    disclosures would put business entities at a competitive disadvantage.
    Although standard setters have addressed certain issues to improve the
    financial reporting model, a project to develop a more comprehensive
    reporting model has not been undertaken.
        Enron's failure and the inquiries that have followed have raised
    many of the same issues about the adequacy of the financial reporting
    model, such as the need for transparency, clarity, and risk-oriented
    financial reporting, addressed by the AICPA's Special Committee on
    Financial Reporting. The limitations of the historical cost-based model
    were made more severe in the case of the Enron failure by accounting
    rules and reports designed for a pipeline operator that transitioned
    into a company using numerous offshore, off balance sheet, quasi-
    affiliated, tax shelter entities to operate, invest in, trade or make a
    market for contracts involving water, electricity, natural gas, and
    broadband capacity. However, criticism of the financial reporting model
    should also consider the criticisms of the corporate governance system,
    the auditing profession, and the regulatory and the self-regulatory
    oversight models which may impact the quality of financial reporting.
    Also, human failure to effectively perform responsibilities in any one
    or in all four of these areas has been raised by the many inquiries
    following Enron's sudden failure. In addition, Enron's November 8, 2001
    reporting to the SEC (Form 8-K filing), which restated its financial
    statements for the years ended December 31, 1997 through 2002, and the
    quarters ended March 31 and June 30, 2001, acknowledges that the
    financial reports did not follow Generally Accepted Accounting
    Principles and, therefore, should not be relied upon.
        Among other actions to address the Enron-specific accounting
    issues, the SEC has requested that the FASB address the specific
    accounting rules related to Enron's special purpose entities and to
    related party disclosures. Therefore, the SEC is expecting the FASB to
    revise and to finalize the special purpose accounting rules by the end
    of this year. The FASB has stated it is committed to proceed
    expeditiously to address any financial accounting and reporting issues
    that may arise as a result of Enron's bankruptcy. In that respect, the
    FASB at a recent board meeting set a goal of publishing an exposure
    draft by the end of April 2002 and a final statement by the end of
    August 2002 that would revise the accounting rules for special purpose
    entities. The SEC has also announced specific areas for improving
    disclosures, and they include:

     More current disclosure, including ``real-time'' disclosure of
        unquestionable material information.

     Disclosure of significant trend data and more ``evaluative''
        data.

     Financial statements that are clearer and more informative for
        investors.

     Disclosure of the accounting principles that are most critical
        to the company's financial status and that involve complex or
        subjective decisions by management.

     Private-sector standards setting that is more responsive to
        the current and immediate needs of investors.

        In addition, the SEC has announced plans to propose new corporate
    disclosure rules that will:

     Provide accelerated reporting by companies of transactions by
        company insiders in company securities, including transactions with
        the company.

     Accelerate filing by companies of their quarterly and annual
        reports.

     Expand the list of significant events requiring current
        disclosure on existing Form 8-K filings (such events could include
        changes in rating agency decisions, obligations that are not
        currently disclosed, and lock-out periods affecting certain
        employee plans with employer stock).

     Add a requirement that public companies post their Exchange
        Act reports on their websites at the same time they are filed with
        the SEC.

     Require disclosure of critical accounting policies in
        Management's Discussion and Analysis of Financial Condition and
        Results of Operations contained in annual reports.

        The SEC Chief Accountant has also raised concerns that the current
    standard setting process is too cumbersome and slow and that much of
    the FASB's guidance is rule-based and too complex. He believes that (1)
    principle-based standards will yield a less complex financial reporting
    paradigm that is more responsive to emerging issues, (2) the FASB needs
    to be more responsive to accounting standards problems identified by
    the SEC, and (3) the SEC needs to give the FASB freedom to address the
    problems, but the SEC needs to monitor projects and, if they are
    languishing, determine why.
        We support the SEC's stated plans to specifically address the
    accounting issues raised by the Enron failure and the broader-based
    planned initiatives that begin to address some of the overarching
    issues with the current financial reporting model. It will be important
    that these initiatives be aimed at the end result of having a financial
    reporting model that is more comprehensive while, at the same time,
    more understandable and timely in providing current value financial
    information and nonfinancial information that will provide users with
    data on the reporting entity's business risks, uncertainties, and
    outlook, including significant assumptions underlying the nonfinancial
    information. We also support a more direct partnering between the SEC
    and the FASB to facilitate a mutual understanding of priorities for
    standard setting and realistic goals for achieving expectations.
        On balance, standard setting is inherently difficult and subject to
    pressures by those parties most affected by proposed changes. Today's
    business environment that includes increased globalization, rapid
    technological advances, real-time communication, and extremely
    sophisticated financial engineering is a difficult challenge for
    accounting standard setters as our commercial world moves from an
    industrial base to an information base. Further more, creative use of
    financial reports, such as the recent phenomenon of using ``pro forma''
    financial statements to present a ``rosier picture'' than GAAP may
    otherwise allow, adds another challenge for standard setters and
    regulators. On December 4, 2001, the SEC issued FRR No. 59, Cautionary
    Advice Regarding the Use of ``Pro Forma'' Financial Information in
    Earnings Releases. One of the key points in the cautionary advice
    release was that the antifraud provisions of the Federal securities
    laws apply to a company issuing ``pro forma'' financial information.
        With that said, we believe that the underlying principles of
    accounting and of financial reporting are still valid, namely, that
    financial reporting must reflect the economic substance of
    transactions, be consistently applied, and provide fair representation
    in accordance with Generally Accepted Accounting Principles. In
    applying these underlying principles, it is important to recognize the
    variety of users of financial information and their financial acumen.
    One size will not likely fit all, and targeted audiences for reported
    financial information may need to be identified, such as sophisticated
    investors, analysts, and creditors versus the general public. We also
    believe that the auditors need to be active players in developing a
    more comprehensive model with the objective of adding value to the
    information through independent assurances. Finally, effective
    corporate governance, independent auditors, and regulatory oversight
    must accompany accounting standards and financial reporting. For
    meaningful and reliable financial reporting, it is not enough to say
    the rules were followed, which is the minimum expectation. Those with
    responsibilities for financial reporting and their auditor must ensure
    that the economic substance of business transactions is, in fact,
    fairly reported.
        I would now like to turn to the results of the work that you
    requested in asking us to look at the resource issues at the SEC.

    The SEC's Ability to Fulfill Its Mission
        Over the last decade, securities markets have experienced
    unprecedented growth and change. Moreover, technology has fundamentally
    changed the way that markets operate and how investors access markets.
    These changes have made the markets more complex. In addition, the
    markets have become more international, and legislative changes have
    resulted in a regulatory framework that requires increased coordination
    among financial regulators and requires that the SEC regulate a greater
    range of products. Moreover, as I discussed earlier, the recent, sudden
    collapse of Enron and the other corporate failures have stimulated an
    intense debate on the need for broadbased reform in such areas as
    financial reporting and accounting standards, oversight of the
    accounting profession, and corporate governance, all of which could
    have significant repercussions on the SEC's role and oversight
    challenges. 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 vacancies.
        In our work requested by this Committee, for which our report is
    being released at this hearing, we found that the SEC's ability to
    fulfill its mission has become increasingly strained due in part to
    imbalances between the SEC's workload (such as filings, complaints,
    inquiries, investigations, examinations, and inspections) and staff
    resources.\14\ Although industry officials complimented the SEC's
    regulation of the industry given its staff size and budget, both the
    SEC and industry officials identified several challenges that the SEC
    faces. First, resource constraints have contributed to substantial
    delays in the turnaround time for many SEC regulatory and oversight
    activities, such as approvals for rule filings and exemptive
    applications.\15\ Second, resource constraints have contributed to
    bottlenecks in the examination and inspection area as the SEC's
    workload has grown. Third, limited resources have forced the SEC to be
    selective in its enforcement activities and have lengthened the time
    required to complete certain enforcement investigations.\16\ Fourth,
    certain filings were subject to less frequent and less complete reviews
    as workloads increased. Fifth, today's technology-driven markets have
    created ongoing budgetary and staff challenges. Finally, the SEC and
    industry officials said that the SEC has been increasingly challenged
    in addressing emerging issues, such as the ongoing internationalization
    of securities markets and technology-driven innovations like
    Alternative Trading Systems \17\ (ATS's), and exchange-traded funds.
    ---------------------------------------------------------------------------
        \14\ Staff resources are measured in this report in terms of full-
    time equivalent staff years.
        \15\ A company files an exemptive application when it seeks an SEC
    decision to exempt a new activity from existing rules and laws.
        \16\ The SEC Chairman has recently announced an initiative called
    real-time enforcement, which is intended to protect investors by (1)
    obtaining emergency relief in Federal court to stop illegal conduct
    expeditiously, (2) filing enforcement actions more quickly, thereby
    compelling disclosure of questionable conduct so that the public can
    make informed investment decisions, and (3) deterring future misconduct
    through imposing swift and stiff sanctions on those who commit
    egregious frauds, repeatedly abuse investor trust, or attempt to impede
    the SEC's investigatory processes. According to the SEC, insufficient
    resources may inhibit the effectiveness of this initiative, which
    depends upon prompt action by enforcement staff.
        \17\ An ATS is an entity that performs functions commonly performed
    by a stock exchange.
    ---------------------------------------------------------------------------
        The SEC routinely prioritizes and allocates resources to meet
    workload demands, but faces increasing pressure in managing its
    mounting workload and staffing imbalances that resulted from its
    workload growing much faster than its staff. Critical regulatory
    activities, such as reviewing rule filings and exemptive applications
    and issuing guidance, have suffered from delays due to limited
    staffing. According to industry officials, these delays have resulted
    in forgone revenue and have hampered market innovation. Oversight and
    supervisory functions have also been affected. For example, staffing
    limitations and increased workload have resulted in the SEC reviewing a
    smaller percentage of corporate filings, an important investor
    protection function. In 2001, the SEC reviewed about 16 percent of the
    annual corporate filings, or about half of its annual goal of 30 to 35
    percent. Although the SEC is revamping its review process to make it
    more risk-based, recent financial disclosure and accounting scandals
    illustrate how important it is that the SEC rise to the challenge of
    providing effective market oversight to help maintain investor
    confidence in securities markets.

    SEC Staff Turnover
        In addition to the staff and workload imbalances, other factors
    also contribute to the challenges the SEC currently faces. SEC
    officials said that although additional resources could help the SEC do
    more, additional resources alone would not help the SEC address its
    high staff turnover, which continues to be a problem. Furthermore, in
    recent years the staff turnover and large differentials in pay between
    the SEC and other financial regulators and industry employers resulted
    in many staff positions remaining vacant as staff left at a faster rate
    than the SEC could hire new staff. Although the SEC now has the
    authority to provide pay parity, its success will depend upon the SEC's
    designing an effective implementation approach and the agency receiving
    sufficient budgetary resources. We found that the SEC's budget and
    strategic planning processes could be improved to better enable the SEC
    to determine the resources needed to fulfill its mission. For example,
    unlike recognized high performing organizations, the SEC has not
    systematically utilized its strategic planning process to ensure that
    (1) resources are best used to accomplish its basic statutorily
    mandated duties and (2) workforce development addresses the resource
    needs that are necessary to fulfill the full scope of its mission,
    including activities to address emerging issues.\18\
    ---------------------------------------------------------------------------
        \18\ High performing organizations are organizations that have been
    recognized in the current literature or by the GAO as being innovative
    or effective in strategically managing their human capital.
    ---------------------------------------------------------------------------
        As we noted in our 2001 report on the SEC's human capital
    practices, about one-third of the SEC's staff left the agency from 1998
    to 2000.\19\ The SEC's turnover rate for attorneys, accountants, and
    examiners averaged 15 percent in 2000, more than twice the rate for
    comparable positions government-wide. Although the rate had decreased
    to 9 percent in 2001, turnover at the SEC was still almost twice as
    high as the rate government-wide. Further, as a result of this turnover
    and inability to hire qualified staff quickly enough, about 250
    positions remained unfilled in September 2001, which represents about
    8.5 percent of the SEC's authorized positions. SEC officials said that
    they could do more if they had more staff, but all cited the SEC's high
    turnover rate as a major challenge in managing its workload. Likewise
    industry officials agreed that many of the challenges that the SEC
    faces today are exacerbated by its high turnover rate, which results in
    more inexperienced staff and slower, often less efficient, regulatory
    processes.
    ---------------------------------------------------------------------------
        \19\ Securities and Exchange Commission: Human Capital Challenges
    Require Management Oversight (GAO- 01-947, September 17, 2001).
    ---------------------------------------------------------------------------
        Although the SEC and industry officials said that the SEC would
    always have a certain amount of turnover because staff can
    significantly increase their salaries in the private sector and some
    staff only plan to stay at the SEC for a period of time, many said pay
    parity with other financial regulators could enable the SEC to attract
    and retain staff for a few additional years. The SEC estimated that a
    new employee generally takes about 2 years to become fully productive
    and that pay parity could help them keep staff a year or two beyond the
    initial 2 years. Although industry officials said they were generally
    impressed by the caliber of staff that the SEC hires and the amount of
    work they do, they said that staff inexperience often requires senior
    SEC officials to become more involved in basic activities. Industry
    officials also said that certain divisions, such as Market Regulation,
    could benefit from staff with a fundamental understanding of how
    markets work and market experience. They said that such experience
    could help speed rulemaking and review processes. However, SEC
    officials said that they have a difficult time attracting staff with
    market experience, given the Government's pay structure.
        Some officials said that the SEC's turnover rate should decrease
    after pay parity is implemented? Presently, the SEC professional staff
    are paid according to Federal general pay rates. On January 16, 2002,
    the President signed legislation that exempted the SEC from Federal pay
    restrictions and provided it with the authority necessary to bring
    salaries in line with those of other Federal financial regulators. That
    legislation also mandated that we conduct a study to look at the
    feasibility of the SEC becoming a fully self-funded agency. Although
    the SEC now has the authority to implement pay parity, as of March 1,
    2002, the SEC has not received an additional appropriation to fund its
    implementation. In addition, the SEC has to take a number of steps to
    effectively implement this new authority.
        Although the SEC's workload and staffing imbalances have challenged
    the SEC's ability to protect investors and maintain the integrity of
    securities markets, the SEC has generally managed the gap between
    workload and staff by determining what basic statutorily mandated
    duties it could accomplish with existing resource levels. This
    approach, while practical, under the circumstances, has forced the
    SEC's activities to be largely reactive rather than proactive. For
    instance, the SEC has not put mechanisms in place to identify what it
    must do to address emerging and evolving issues. Although the SEC has a
    strategic plan and has periodically adjusted staffing or program
    priorities to fulfill basic obligations, the SEC has not engaged in a
    much needed, systematic reevaluation of its programs and activities in
    light of current and emerging challenges. Given the regulatory
    pressures facing the SEC and its ongoing human capital challenges, it
    is clear that the SEC could benefit from an infusion of funding and
    possibly additional resources. However, a comprehensive, agency-wide
    planning effort, including planning for use of technology to leverage
    available resources, could help the SEC better determine the optimum
    human capital and funding needed to fulfill its mission.

    Closing Comments
        A number of witnesses who have recently appeared before this
    Committee and other Congressional committees to discuss Enron's failure
    have stated that our Nation's system of capital markets is recognized
    around the world as the best. I share that view. Our capital markets
    enjoy a reputation of integrity that promotes investor confidence that
    is critical to our economy and the economies of other nations given the
    globalization of commerce. This reputation is now being challenged. The
    effectiveness of our systems of corporate governance, independent
    audits, regulatory oversight, and accounting and financial reporting,
    which are the underpinnings of our capital markets, to protect the
    public interest has been called into question by the failure of Enron.
    Many of the issues that are being raised have previously surfaced from
    other business failures and/or restatements of financial statements
    that significantly reduced previously reported earnings or equity.
    Although the human element factor, and the basic failure to always do
    what is right, are factors that can override systems of controls, it is
    clear that there are a range of actions that are critical to the
    effective functioning of the system underlying our capital markets that
    need attention. In addition, a strong enforcement function with
    appropriate civil and criminal sanctions is also needed to deal with
    noncompliance.
        The results of the forum that we held last week on governance,
    transparency, and accountability identified major issues in each of the
    areas, which I have addressed in my remarks today, that endanger their
    effective functioning to protect the public interest. As is usually the
    case in issues of this magnitude and this importance, there is no
    single silver bullet to quickly make the repairs that are needed to the
    systems supporting our capital markets. The fundamental principles of
    having the right incentives, adequate transparency, and full
    accountability provide a good sounding board to evaluate proposals that
    are advanced. A holistic approach is also important as the systems are
    interrelated and weak links can severely strain their effective
    functioning. I have framed a number of the key issues today for
    Congressional consideration. As always, we look forward to working with
    you to further refine the issues, and develop and analyze options and
    take other steps designed to repair the system weaknesses that today
    pose a threat to investor confidence in our capital markets.
        In summary, Enron's recent decline and fall coupled with other
    recent business failures pose a range of serious systemic issues that
    must be addressed. Effectively addressing these issues should be a
    shared responsibility involving a number of parties including top
    management, boards of directors, various board committees, stock
    exchanges, the accounting profession, standard setters, regulatory/
    oversight agencies, analysts, investors, and Congress. In the end, no
    matter what system exists, bad actors will do bad things with bad
    results. We must strive to take steps to minimize the number of such
    situations and to hold any violators of the system fully accountable
    for their actions.
        Mr. Chairman, this concludes my statement. I would be pleased to
    answer any questions you or other Members of the Committee may have at
    this time.

                    PREPARED STATEMENT OF ROBERT R. GLAUBER

                      Chairman and Chief Executive Officer
                National Association of Securities Dealers, Inc.
                                 March 5, 2002

    Introduction
        Chairman Sarbanes, Ranking Member Gramm, Members of the Senate
    Banking Committee, thank you for this opportunity to testify today on
    the vital, troubling, and timely issues of investor protection and
    accounting highlighted by the collapse of Enron. It would be hard to
    overstate the human tragedy for Enron's employees, pension-holders, and
    investors caused by the failure of America's seventh largest company.
        Yet it is my firm hope that significant good can come of the
    collapse of Enron--in the form of better policies, oversight and
    regulatory structures to help restore the public's trust in the
    fairness of our markets. That is the purpose of today's hearing, and I
    am privileged to contribute my thoughts and the NASD's experiences to
    this Committee's thoughtful search for solutions.

    Overview

        Let me begin with a real quick overview of the NASD--because who we
    are bears directly on both the substance of what I will be saying and
    on the usefulness of the private sector self-regulatory model that we
    embody.
        The National Association of Securities Dealers, NASD, is not a
    trade association, but rather, the world's largest self-regulatory
    organization, or SRO. Under Federal law, every one of the roughly 5,500
    brokerage firms, nearly 90,000 branch offices and almost 700,000
    registered representatives in the U.S. securities industry comes under
    our jurisdiction. To give you a sense of our scope and authority, it is
    vital to know that every brokerage firm in the United States that does
    business with the public must by law be a member of NASD. We have a
    staff of over 2,000 employees in Washington, Rockville, and district
    offices across the country and an annual budget exceeding $400 million.
        For more than six decades, our mission and our mandate from
    Congress has been clear: To bring integrity to the markets and
    confidence to investors. We do this by licensing and setting
    qualification standards for industry participants, maintaining a
    massive registration database that includes qualification and
    disciplinary histories of all brokers and firms, writing rules to
    govern the conduct of brokerage firms and their employees, providing
    investor education and outreach, educating our members on legal and on
    ethical standards, examining them for compliance with the Federal
    securities laws and NASD and Federal rules, investigating infractions,
    and disciplining those who fail to comply.
        The NASD's staffing and governance gives us independence from the
    industry, but we use industry expertise and resources extensively to
    accomplish our mission. The standards we set are not mere ``best
    practices,'' but enforceable regulatory rules; violations may result in
    significant fines or even expulsion from the securities industry.

    History of Securities Self-Regulation

        The NASD's history to a great degree is the history of securities
    self-regulation in our country. The stock exchanges, options and
    futures markets have self-regulatory responsibilities, but they are
    centered on the trading that takes place within their respective
    markets and relate only to the members of their markets.
        Self-regulation of the securities markets has deep roots in the
    United States.
        The Securities Exchange Act of 1934 (Exchange Act or 1934 Act) is
    the legal foundation for self-regulation of the exchange markets. In
    that Act, Congress set up a system under which the New York Stock
    Exchange, the American Stock Exchange, and other securities exchanges,
    and through them their member seat holders, would form a regulatory
    front line for the newly created governmental regulator, the Securities
    and Exchange Commission (SEC).
        Four years later, Congress felt that the market regulation focus of
    the 1934 Act was not sufficient and passed the Maloney Act of 1938. The
    Maloney Act authorized the formation and registration of national
    securities associations, which would supervise the conduct of their
    members subject to the oversight of the SEC.
        In this way, Congress sought to ``bring about self-discipline in
    conformity to law'' and to foster ``obedience to ethical standards''
    that went beyond the law. Senator Maloney intended that the securities
    industry ``handle the problems of technical regulation,'' with the SEC
    ``policing the submarginal fringe.'' The next year the National
    Association of Securities Dealers became the first--and still the
    only--registered national securities association.
        From the creation in the 1930's, to strengthened SEC oversight of
    self-regulation in the 1970's, the industry and the Government have
    worked together successfully. The concept of self-regulation is now so
    ingrained in our capital markets' regulatory structure and the markets
    themselves are now so enormous in every sense of the word--the numbers
    of investors, the types of products, volume, and dollar value of
    trading--that it has become almost impossible to imagine their success
    without self-regulation.
        This evolution has not been without its false steps. In 1996, the
    SEC criticized the NASD in part for putting its interests as the
    operator of Nasdaq ahead of its responsibilities as the regulator of
    the entire industry. The NASD's response was both decisive and
    instructive. It acted almost immediately to carve out NASD Regulation
    and the Nasdaq Stock Market (Nasdaq) as two distinct corporate
    entities, with separate Boards, management, and staff. And since then,
    we have taken this principle of independence even further, by spinning
    off Nasdaq entirely--with the sale of our last 27 percent of the
    company completed earlier this year.
        While there were many other changes of less significance that
    resulted from the SEC's report with respect to the NASD, the bottom
    line was a much-strengthened role for the NASD's staff and a paring
    back of many roles traditionally played by the industry. Nonetheless,
    the active involvement of the industry in self-regulation has remained
    the mainstay of its success. And during the more than six decades since
    this system was established, investors worldwide have flocked to our
    markets.

    The NASD's Responsibilities

        The NASD has a comprehensive regime of regulatory duties. We writes
    rules to govern the conduct of our member firms, examine them for
    compliance with these rules, and discipline members if they fail to
    comply. Our market integrity services include professional testing and
    training, licensing and registration; examination of our member firms;
    investigation and enforcement; dispute resolution; and investor
    education. We also monitor all trading on Nasdaq, the largest volume
    market in the world, and other select securities and derivative
    markets.

    Our Rulemaking Process

        After an initial NASD staff determination that a rule or rule
    change is necessary to protect the public or strengthen market
    integrity, we begin a rigorous process to vet the rule and solicit
    industry and public input. The proposed rules or rule modifications are
    the result of input from our Board, industry, the SEC, consumer groups,
    the public, Congress, as well as arising from our own experience
    tracking markets and regulatory trends.
        The NASD's rules must be approved by the SEC prior to becoming
    effective. Once a rule is finalized, our members are required to comply
    and put into place supervisory systems designed to achieve compliance
    with the new rule. NASD examiners, through routine cycle exams,
    surveillance monitoring and examinations for cause, evaluate firm
    compliance and recommend remedial actions by the firm, or disciplinary
    action by the NASD where compliance does not meet our standards.

    Enforcement

        Tough and even-handed enforcement is a fundamental part of NASD's
    mission. It not only ensures compliance and punishes wrongdoing, but
    also benefits the vast majority of our members who obey the rules and
    place investors first. For investors feel more confident using the
    markets when they know a tough cop is patrolling the beat. This is a
    fundamental aspect of our value to both the public and the industry.
        On average, the NASD files more than 1,000 new disciplinary actions
    annually, with sanctions ranging from censures to fines and suspensions
    to expulsion from the securities industry. We supplement our
    enforcement efforts with referrals to criminal authorities and the SEC.
    In one important settlement alone this year, reached jointly with the
    SEC, the NASD, and the SEC each imposed sanctions of $50 million
    against a major investment bank for violating SRO rules by extracting
    illegal paybacks from favored customers to whom it allocated ``hot''
    IPO's.
        While this role as writer and enforcer of rules is familiar
    territory for this Committee, I would like to highlight some of the
    aspects of the NASD with which you may not be as familiar and some of
    the ways we carry out our regulatory functions.
        For instance, we have created and we maintain a vast database of
    well over one million current and former registered representatives
    that enables us to provide the public with information on securities
    firms and professionals. This Central Registration Depository (CRD) is
    the largest such vehicle on the Internet. In 2001, we responded to over
    2 million public disclosure inquiries. Using this same technology, we
    developed and operate through a contract with the SEC and State
    securities regulators the Investment Adviser Registration Depository
    (IARD). We have registered some 10,000 investment advisers through
    IARD.
        It is also important to note that NASD Dispute Resolution is the
    largest dispute-resolution forum in the securities industry, with a
    docket that contains more than 90 percent of the cases in the industry.
        And a point of particular importance to this Committee, considering
    its focus on financial literacy, is that we have an active Office of
    Individual Investor Education that brings increased attention and focus
    to this area of burgeoning importance.

    Why NASD Works: Some ``First Principles'' for Private Sector Regulation

        Private sector regulators bring to bear a keen practical
    understanding of the industry. They can tap industry expertise and
    resources that are not readily available to governments. They foster
    investor protection and industry involvement. And they foster higher
    standards that go beyond simply complying with the law.
        Self-regulation works because the brokerage industry understands
    that market integrity leads to investor confidence, which is good for
    business. The overwhelming majority of the NASD's members comply
    willingly with the rules and the law. They view their own reputation
    for fair dealing and high standards as a competitive asset in a
    competitive industry.
        Private sector regulators are uniquely qualified to identify and
    respond to emerging regulatory issues and keep their members
    appropriately informed. The NASD has developed a proactive program to
    ensure that members are timely apprised of emerging industry regulatory
    issues. Private sector regulators also are uniquely qualified to alert
    the general public to emerging regulatory issues. In this regard, the
    NASD has taken steps to reach out to the public through investor alerts
    and a host of written in-person and Internet-based investor education
    offerings.
        All this explains how private sector regulation can work. But why
    specifically does it work well in the securities industry?
        The first essential ingredient of the NASD's success is
    independence. At least half our Board of Governors are a nonindustry
    representative. And our large, experienced professional staff is not
    beholden to the industry.
        Our governance structure relies on parties that have the right
    incentives to insist upon market integrity and investor confidence.
    Specifically, our Board includes representatives of the public,
    corporate issuers, and institutional investors, as well as the
    brokerage firms that make up our membership. The beauty of our system
    is that all these interests want markets that are fair, efficient, and
    safe. And no one stands to benefit from this more than the brokerage
    industry--which knows well that market integrity leads to investor
    confidence, which is good for business.
        This leads to our next key attribute, which is assured funding from
    that part of the private sector having the greatest interest in our
    effectiveness. The right people pay for the NASD's services: Namely,
    the brokerage firms that profit from the investor confidence that stems
    from market integrity.
        We are funded three ways: (1) through a gross assessment on firms
    based on their revenue; (2) a regulatory fee on every transaction that
    occurs on Nasdaq and on the InterMarket as our cost of regulating those
    trades generally; and (3) user fees, including various application
    costs and test fees, continuing education courses, and so forth. Every
    registered representative must also pay a small assessment when he or
    she registers.
        This steady and sufficient funding means that we can afford the
    sophisticated technology, techniques, and infrastructure it takes to
    regulate a fast-changing, technology-intensive industry. NASD's
    technology budget exceeds $150 million per year. No private sector
    regulator can succeed without sufficient ways and means.
        Another key to our success is that we have the combined ability to
    write rules, examine for enforcement of these rules and enforce the
    rules with teeth all under one roof. This consolidation of central
    regulatory functions reinforces our authority, competence, and
    credibility.
        As was discussed in detail in the preceding section, the NASD is
    empowered to discipline our members with sanctions tough enough to
    punish violations and deter future misconduct. Last year, we brought
    more than 1,200 disciplinary actions, resulting in over 800 expulsions
    or suspensions from the industry. That is a powerful sanction--the
    ability to bar someone from earning a livelihood in his or her chosen
    field. In an average year we levy well in excess of $10 million in
    monetary sanctions. Of course, with authority comes responsibility.
    Just as our members are accountable to the NASD, so we are accountable
    to the SEC. Strong oversight by Government regulators protects
    investors by ensuring that someone is watching the industry watchdog.

    What Desirable Features Congress Should Consider in Fashioning an
    Oversight System For the Accounting Industry

        There are strong policy reasons to move in the direction of private
    sector regulator with strong SEC oversight for accounting. The
    advantages of such a solution over a purely governmental solution
    include the fact that when industry is involved, the regulator is able
    to tap private expertise in a way the Government cannot. And with
    industry assessed for the cost, the regulator can be better funded.
    This way the professional staff of lawyers, examiners, administrators,
    technologists, and analysts remain top notch and able to keep pace with
    industry. This model provides the best of both worlds: Tough SEC
    oversight of a well-funded, well-staffed, frontline private sector
    regulator.
        While we would never presume to prescribe in detail what a new
    private sector regulator for the accounting industry should look like,
    we can, based on our analysis of what has been successful in the
    securities industry, illuminate the implications for such a body in the
    accounting industry, should Congress decide to move in this direction.
        First, the private sector regulator should be an independent
    organization, with a sizable, professional staff, and sufficient
    technology and infrastructure to stay apace of the accounting
    profession. It should seek maximum industry input consistent with
    maximum industry accountability. And it should consolidate as many of
    the industry's central regulatory functions--especially in the areas of
    licensing, registration, examination, and strong enforcement--under one
    roof as is feasible. This will reinforce its authority, competence, and
    credibility all at once.
        Second, it should have a strong mandate from the Government that
    sets its structure and empowers its enforcement arm with full authority
    to discipline the industry. Any form of private sector regulation must
    be empowered to effectively enforce the rules: The ability to levy
    meaningful fines, place conditions on continued participation in the
    industry, suspend, and where appropriate, banish those who misbehave
    from the industry. This ``ultimate sanction'' is both a powerful
    deterrent for would-be violators and an important investor protection.
        Third, it should have a governance structure based on enlightened
    self-interest--namely, the need for effective auditing to produce
    numbers that investors can rely on and markets they can trust. This
    means a Board with interested parties much the same as the NASD's:
    Solid public companies that want investors to have confidence in their
    financial statements; institutional investors; broker-dealers; and the
    public--with accountants being a small minority.
        Self-regulation does not mean that industry is left to its own
    devices. Public participation on an SRO Board is important not only to
    prevent any conflicts of interest, but also the appearance of such
    conflicts.
        Fourth, it should have assured funding from some of these same
    self-interested parties, especially those with the biggest stake in the
    success of the system that have the most to gain from thorough, fair,
    and transparent accounting practices. The best candidates might be
    issuers (with a small fee on new share registrations, 10-K or 10-Q
    filings) and broker-dealers. And since they, of course, also have a
    major stake in the credibility of their audits, another source of
    funding could be examination fees charged to the accounting firms
    themselves.
        An effective private regulatory system requires infrastructure,
    technology, and processes to provide quality, timely services. As we
    all know, monitoring compliance with accounting standards and
    principles in today's global economy is a complex and technology-
    intensive process. The regulator for the accounting profession must be
    equally up-to-date and technology-intensive.
        And finally, it should be subject to strong, appropriate oversight
    from the SEC to institutionalize accountability. Oversight by
    Government regulators is essential to ensure the integrity of the
    process. It also provides an appropriate appellate forum for
    disciplinary actions.

    Conclusion

        Self-regulation in the securities industry has helped make the U.S.
    capital markets the most successful and respected in the world. This
    system was the legislative embodiment of the belief that additional
    protections were needed to ``protect the investor and the honest dealer
    from dishonest and unfair practices by the submarginal element in the
    industry.'' These words are really the roots of the NASD's central
    rule: ``A member, in the conduct of his business, shall observe high
    standards of commercial honor and just and equitable principles of
    trade.''
        No one is under the illusion that the systemic flaws revealed by
    Enron can be set right without significant Government involvement. Even
    in the accounting industry, where self-regulation has suffered a bad
    name, there is a vital role to be played by private sector regulation
    which fully understands the industry but is not co-opted by it; which
    commands respect with accountants and credibility with investors; and
    which allows the SEC to focus its scarce resources where they are most
    needed to police the honesty of the financial reporting that underpins
    the success of the U.S. capital markets.

                                   ----------

                      PREPARED STATEMENT OF JOEL SELIGMAN

                Dean and Ethan A.H. Shepley University Professor
                Washington University School of Law in St. Louis
             Public Member, American Institute of Certified Public
              Accountants Professional Ethics Executive Committee
                                 March 5, 2002

        Nearly 70 years ago, Supreme Court Justice Harlan Stone memorably
    observed at the dedication of the University of Michigan Law School
    Quadrangle:

              I venture to assert that when the history of the financial
            era which has just drawn to a close comes to be written, most
            of its mistakes and its major faults will be ascribed to the
            failure to observe the fiduciary principle, the precept as old
            as holy writ, that ``a man cannot serve two masters.'' More
            than a century ago equity gave a hospitable reception to that
            principle and the common law was not slow to follow in giving
            it recognition. No thinking man can believe that an economy
            built upon a business foundation can permanently endure without
            some loyalty to that principle. The separation of ownership
            from management, the development of the corporate structure so
            as to vest in small groups control over the resources of great
            numbers of small and uninformed investors, make imperative a
            fresh and active devotion to that principle if the modern world
            of business is to perform its proper function. Yet those who
            serve nominally as trustees, but relieved, by clever legal
            devices, from the obligation to protect those whose interests
            they purport to represent, corporate officers and directors who
            award to themselves huge bonuses from corporate funds without
            the assent or even the knowledge of their stockholders,
            reorganization committees created to serve interests of others
            than those whose securities they control, financial
            institutions which, in the infinite variety of their
            operations, consider only last, if at all, the interests of
            those whose funds they command, suggest how far we have ignored
            the necessary implications of that principle. The loss and the
            suffering inflicted on individuals, the harm done to a social
            order founded upon business and dependent upon its integrity
            are incalculable.\1\
    ---------------------------------------------------------------------------
        \1\ 48 Harv. L. Rev. 1, 8 (1934).

        The same year, 1934, that Justice Stone offered these observations,
    the Securities and Exchange Commission (SEC) began operations. By 1940,
    the SEC enforced six Federal securities laws.\2\
    ---------------------------------------------------------------------------
        \2\ There are now seven Federal securities laws: The Securities Act
    of 1933, 15 U.S.C. Sec. 77a; the Securities Exchange Act of 1934, 15
    U.S.C. Sec. 78a; the Public Utility Holding Company Act of 1935, 15
    U.S.C. Sec. 79; the Trust Indenture Act of 1939, 15 U.S.C. Sec. 77aaa;
    the Investment Company Act of 1940, 15 U.S.C. Sec. 80a-1; the
    Investment Advisers Act of 1940, 15 U.S.C. Sec. 80b-1; and the
    Securities Investor Protection Act of 1970, 15 U.S.C. Sec. 78aaa. For
    general description, see 1 Louis Loss & Joel Seligman, Securities
    Regulation 224-273 (3d ed. rev. 1998).
    ---------------------------------------------------------------------------
        In the years since the SEC began operations, the U.S. securities
    markets have experienced an almost unimaginable growth and vitality.
        The number of U.S. stockholders has increased from 1.5 million (or
    1.2 percent of the population) in 1929 to 84 million (or 43.6 percent
    of the adult population) in 1998.\3\ As long ago as 1980, 133 million
    U.S. citizens indirectly owned shares through such intermediaries as
    mutual funds or pension plans.\4\
    ---------------------------------------------------------------------------
        \3\ Cf. Joel Seligman, The Obsolescence of Wall Street: A
    Contextual Approach to the Evolving Structure of Federal Securities
    Regulation, 93 Mich. L. Rev. 649, 654 (1995); N.Y. Stock Exch., Fact
    Book, 55-56 (2000).
        \4\ Seligman, supra n.3, at 658.
    ---------------------------------------------------------------------------
        When the stock market began its collapse in September 1929, the
    aggregate value of all shares on the New York Stock Exchange (NYSE) was
    approximately $90 billion.\5\ By 2000, NYSE capitalization had grown to
    nearly $12.4 trillion.\6\ Perhaps most remarkably in 2000, over $2.3
    trillion in new securities was sold in some 16,481 corporate
    underwritings and 3,540 private placements.\7\
    ---------------------------------------------------------------------------
        \5\ Joel Seligman, The Transformation of Wall Street 1 (rev. ed.
    1995).
        \6\ Securities Indus. Assoc., 2001 Securities Industry Fact Book at
    48.
        \7\ Id. at 12.
    ---------------------------------------------------------------------------
        Underlying these remarkable numbers was the longest sustained bull
    market in U.S. history. Focusing on year-end closing indexes, the Dow
    Jones Industrial Average rose from 875 in 1981 to 11,497 in 1999,
    paralleling similar surges in other leading composite indexes.\8\ To
    put this in other terms, between 1981 and 1999, the New York Stock
    Exchange stock market capitalization increased nearly 11 fold from $1.1
    to $12.3 trillion.\9\
    ---------------------------------------------------------------------------
        \8\ Id. at 54.
        \9\ Id. at 48.
    ---------------------------------------------------------------------------
        With this unprecedented success there also appears to have come a
    lulling of our institutional sensibilities. A widespread belief appears
    to have evolved in the U.S. financial community that time honored rules
    such as those that discourage conflicts of interest are quaint and
    easily circumvented. Too frequently, in recent years, sharp
    practitioners in business, investment banking, accounting, or law
    appear to have challenged the fundamental tenets of ``full disclosure
    of material information'' or ``fair presentation of accounting
    results.'' A deterioration in the integrity of our corporate governance
    and mandatory disclosure systems may well have advanced, not because of
    a novel strain of human cupidity, but because we had so much success,
    for so long, that we began to forget why fundamental principles of full
    disclosure and corporate accountability long were considered essential.
        No recent case better illustrates this deterioration than Enron.
    Enron was an extraordinarily fast growing provider, primarily of
    natural gas, electricity, and communication products and services,\10\
    whose total assets quadrupled between 1996 and 2000 from $16.137 to
    $65.503 billion.\11\ Its 2000 Form 10-K annual report filed with the
    SEC was a consistently upbeat review of its many claimed successes,
    only unusual because of Exhibit 21 to the certified financial
    statements which was a 49 page list of subsidiaries. In 2001, Enron was
    seventh on the Fortune 500 list, with revenues in 2000 of $100.8
    billion.\12\
    ---------------------------------------------------------------------------
        \10\ Enron Corp. Form 10-K Item 1--Business General.
        \11\ Id., Item 6 --Selected Financial Data.
        \12\ Fortune, April 16, 2001 at F-1.
    ---------------------------------------------------------------------------
        Then, abruptly, essentially without warning, Enron melted down. A
    November 8, 2001 Form 8-K stunningly stated: ``Enron intends to restate
    its financial statements for the years ended December 31, 1999 through
    2000 and the quarters ended March 31 and June 30, 2001. As a result the
    previously issued financial statements for those periods and the audit
    reports covering the year-end financial statements for 1992 to 2000
    should not be relied upon.'' \13\
    ---------------------------------------------------------------------------
        \13\ Item 5, Enron Corp. Form 8-K (November 8, 2001).
    ---------------------------------------------------------------------------
        This Committee, I know, is already familiar with the Enron Special
    Investigative Committee Report [Powers Report], chaired by University
    of Texas Law School Dean William Powers. Let me not here revisit its
    fact finding. I would like, however, to augment one type of fact
    finding made by the Special Investigative Committee.
        The Powers Report was critical of the required public disclosure of
    the LJM partnerships which it characterized as systematically
    inadequate.\14\ In Note 16 to the Enron Corporation 2000 Form 10-K,
    related party transactions are described in these terms:
    ---------------------------------------------------------------------------
        \14\ [T]hese disclosures were obtuse, did not communicate the
    essence of the transactions completely or clearly, and failed to convey
    the substance of what was going on between Enron and the partnerships.
    The disclosures also did not communicate the nature or extent of
    Fastow's financial interest in the LJM partnerships. This was the
    result of an effort to avoid disclosing Fastow's financial interest and
    to downplay the significance of the related-party transactions and, in
    some respects, to disguise their substance and import. The disclosures
    also asserted that the related-party transactions were reasonable
    compared to transactions with third parties, apparently without any
    factual basis. The process by which the relevant disclosures were
    crafted was influential substantially by Enron Global Finance (Fastow's
    group). There was an absence of forceful and of effective oversight by
    Senior Enron Management and in-house counsel, and objective and
    critical professional advice by outside counsel at Vinson & Elkins, or
    auditors at Andersen. Id. at 17.

              In 2000 and 1999, Enron entered into transactions with
            limited partnerships (the Related Party) whose general
            partner's managing member is a senior officer of Enron. The
            limited partners of the Related Party are unrelated to Enron.
            Management believes that the terms of the transactions with the
            Related Party were reasonable compared to those which could
            have been negotiated with unrelated third parties.
              In 2000, Enron entered into transactions with the Related
            Party to hedge certain merchant investments and other assets.
            As part of the transactions, Enron (i) contributed to newly
            formed entities (the Entities) assets valued at approximately
            $1.2 billion, including $150 million in Enron notes payable,
            3.7 million restricted shares of outstanding Enron common stock
            and the right to receive up to 18.0 million shares of
            outstanding Enron common stock in March 2003 (subject to
            certain conditions) and (ii) transferred to the Entities assets
            valued at approximately $309 million, including a $50 million
            note payable and an investment in an entity that indirectly
            holds warrants convertible into common stock of an Enron's
            equity method investee. In return, Enron received economic
            interests in the Entities, $309 million in notes receivable, of
            which $259 million is recorded at Enron's carryover basis of
            zero, and a special distribution from the Entities in the form
            of $1.2 billion in notes receivable, subject to changes in the
            principal for amounts payable by Enron in connection with the
            execution of additional derivative instruments. Cash in these
            Entities of $172.6 million is invested in Enron's demand notes.
            In addition, Enron paid $123 million to purchase share-settled
            options from the Entities on 21.7 million shares of Enron
            common stock. The Entities paid Enron $10.7 million to
            terminate the share-settled options on 14.5 million shares of
            Enron's common stock outstanding. In late 2000, Enron entered
            into share-settled collar arrangements with the Entities on
            15.4 million shares of Enron common stock. Such arrangements
            will be accounted for as equity transactions when settled.

        The first paragraph is an exercise in obfuscation. What
    transactions? How much money is involved? What risk is there to Enron?
    Who is the senior officer of Enron? How much is he or she paid? Who are
    the limited partners? What basis is there for management's belief that
    the terms of these transactions ``were reasonable compared to those
    which could have been negotiated with unrelated parties?'' The second
    paragraph is more detailed but it is equally confusing. Why did Enron
    enter into these transactions? Who is the Related Party? What risk does
    Enron bear? \15\
    ---------------------------------------------------------------------------
        \15\ The Powers Report concluded: Overall, Enron failed to disclose
    facts that were important for an understanding of the substance of the
    transactions. The Company did disclose that there were large
    transactions with entities in which the CFO had an interest. Enron did
    not, however, set forth the CFO's actual or likely economic benefits
    from these transactions and, most importantly, never clearly disclosed
    the purposes behind these transactions or the complete financial
    statement effects of these complex arrangements. The disclosures also
    asserted without adequate foundation, in effect, that the arrangements
    were comparable to arm's-length transactions. We believe that the
    responsibility for these inadequate disclosures is shared by Enron
    Management, the Audit and Compliance Committee of the Board, Enron's
    in-house counsel, Vinson & Elkins, and Andersen. Id. at 178.
    ---------------------------------------------------------------------------
        There were other significant public disclosure issues that the
    Powers Report did not address in the same detail as it did related
    party transactions. The Report, for example, noted that the LJM2
    entities had approximately 50 limited partners, ``including American
    Home Assurance Co., Arkansas Teachers Retirement System, the MacArthur
    Foundation, and entities affiliated with Merrill Lynch, J.P. Morgan,
    Citicorp, First Union, Deutsche Bank, G.E. Capital, and Dresdner
    Kleinworth Benson.'' \16\ Newspaper accounts have raised the quite
    troublesome possibility that at least some of these limited partners
    had been shown different financial statements than were publicly
    disclosed.\17\
    ---------------------------------------------------------------------------
        \16\ Id. at 73.
        \17\ A Fog Over Enron, and the Legal Landscape, N.Y. Times, January
    27, 2002. Cf. McGeehan, Enron's Deals Were Marketed to Companies by
    Wall Street, N.Y. Times, February 14, 2002 at C1.
    ---------------------------------------------------------------------------
        The Enron debacle has raised fundamental policy and regulatory
    questions, notably including the following in corporate and securities
    law:
        (1) Perhaps most significant is the empirical question: Was Enron
    an isolated, but serious, breakdown or are the problems exposed there
    more widespread? By early February 2002, newspapers were reporting a
    market wide dampening of stock prices because of uncertainty whether
    the accounting, auditing, and corporate governance problems at Enron
    would prove widespread.\18\ One article reported: ``Last year, a study
    by Financial Executives International, a trade group for corporate
    executives, found that public companies had revised their financial
    results 464 times between 1998 and 2000, nearly as many restatements as
    in the 20 previous years combined, and the problem probably worsened
    last year.'' \19\
    ---------------------------------------------------------------------------
        \18\ Berenson, The Biggest Casualty of Enron's Collapse of
    Confidence, N.Y. Times, February 10, 2002 at Sec. 4 at 1.
        \19\ Ibid.
    ---------------------------------------------------------------------------
        Nonetheless, the hard empirical work to gauge the magnitude of
    dysfunction
    either at Enron or generally is far from complete. The more we learn
    about incidence, types of dysfunction, and the causes of dysfunction,
    the more intelligently we can consider remedies. We are still very far
    away from a comprehensive analysis of Enron. Systematic review of other
    company's SEC filings can reveal similar patterns of dysfunction, but
    not all, particularly, if like Enron, a key problem is unreported off
    balance sheet transactions.
        The first and most urgent need in the wake of Enron is not
    solutions, but facts.
        (2) Will the type of problem illustrated by Enron prove self-
    correcting, at least for the foreseeable future? Already there appear
    to be underway SEC, Justice Department, and private investigations or
    litigation. The SEC has now begun a series of regulatory initiatives,
    including proposed changes in corporate disclosure rules, that, among
    other points, significantly broaden the list of significant events that
    require current disclosure on Form 8-K.\20\ Inevitably, without further
    legislative or regulatory action, it is reasonable to anticipate
    enhanced board review of transactions, more detailed and precise
    disclosure in SEC filings, more demanding internal accounting controls
    and outside audits, and more skeptical investment analyst reports.
    ---------------------------------------------------------------------------
        \20\ SEC to Propose New Corporate Disclosure Rules, Press Rel.
    2002-22 (February 13, 2002). This Press Release explained in part:
        The Commission believes that markets and investors need more timely
    access to a greater range of important information concerning public
    companies than what is required by the existing reporting system.
    Accordingly, the Commission intends to expand the types of information
    that companies must report on Form 8-K. Some of the items that the
    Commission is evaluating for inclusion in these reports include:

         Changes in rating agency decisions and other rating agency
    contacts.
         Transactions in the company's securities, including
    derivative securities, with the executive officers and directors.
         Defaults and other events that could trigger acceleration
    of direct or contingent obligations.
         Transactions that result in material direct or contingent
    obligations not included in a prospectus filed by the company with the
    Commission.
         Offerings of equity securities not included in a
    prospectus filed by the company with the Commission.
         Waivers of corporate ethics and conduct rules for
    officers, for directors, and for other key employees.
         Material modifications to rights of security holders.
         The departure of the company's CEO, CFO, COO, or president
    (or persons in equivalent positions).
         Notices that reliance on a prior audit is no longer
    permissible, or that the auditor will not consent to use of its report
    in a Securities Act filing.
         Definitive agreement that is material to the company. . .

         Any loss or gain of a material customer or contract.
         Any material write-offs, restructurings, or impairments.
         Any material change in accounting policy or estimate.
         Movement or de-listing of the company's securities from
    one quotation system or exchange to another.
         Any material events, including the beginning and end of
    lock-out periods, regarding the company's employee benefit, retirement,
    and stock ownership plans.

        Given the significance of current disclosure of these events to
    participants in the secondary markets, the Commission intends to
    propose that companies file reports of these events no later than the
    second business day following their occurrence. The Commission also is
    considering whether some of these events require filing by the opening
    of business on the day after the occurrence of the event.
    ---------------------------------------------------------------------------
        It is too early to judge whether voluntary steps will suffice. We
    need both to better understand the problems involved and what voluntary
    steps will occur. There will be other steps from the self-regulatory
    organizations such as the NYSE that also need to be taken into
    account.\21\
    ---------------------------------------------------------------------------
        \21\ See, e.g., SEC Review of Corporate Governance, Conduct Rules,
    SEC Press Rel. 2002-23 (February 13, 2002).
    ---------------------------------------------------------------------------
        A caveat is in order here. Voluntary steps often work well when
    there is a mood of crisis or a fear of legislation or regulation. There
    is a different type of uncertainty regarding whether voluntary steps
    will endure after a crisis mood has abated.
        (3) If structural or standard reform does prove necessary, there
    appears to be broad support for focusing on accounting standard setting
    and auditing regulation. In mid-January 2002 SEC Chairman Harvey Pitt
    proposed a new industry organization that will oversee auditor
    discipline.\22\ In response, the Public Oversight Board, shortly later,
    voted to disband because of concern it was being ``shunted aside.''
    \23\ Regardless of the fate of the POB the time seems ripe for a
    systematic review of accounting standard setting by the FASB, auditing
    oversight by the POB and other private and State agencies, and
    accountant independence.\24\
    ---------------------------------------------------------------------------
        \22\ See Schroeder, SEC Proposes Accounting Disciplinary Body, Wall
    Street Journal, January 17, 2002 at C1; Pitt Elaborates on Proposal for
    New Board to Govern Accountants, Asks for Dialogue, 34 Sec. Reg. & L.
    Rep. (BNA) 153 (2002).
        \23\ In Protest, POB Votes to Disband; Panel to Consider SEC
    Chief 's Urging Reversal, 34 Sec. Reg. & L. Rep. (BNA) 154 (2002).
        \24\ See, e.g., former SEC Chairman Levitt Renews Call for
    Additional Restrictions on Auditing Firms, 34 id. 155; Accounting
    Debacles Spark Calls for Change: Here's the Rundown, Wall Street
    Journal, February 6, 2002 at C1; Leonhardt, How Will Washington Read
    the Signs? N.Y. Times, February 10, 2002 at Sec. 3 at 1.
    ---------------------------------------------------------------------------
        The need for significant reform of the accounting profession has
    been particularly stressed in recent Congressional hearings.\25\
    ---------------------------------------------------------------------------
        \25\ Former SEC Chairman Roderick M. Hills, for example, testified
    on February 12, 2002 to the Senate Committee on Banking, Housing, and
    Urban Affairs:

        . . . The system itself needs a major overhaul. The head of NYU's
    Accounting Department, Paul Brown, put it well:

        ``It is the old adage of a F.A.S.B. rule. It takes 4 years to write
    it, and it takes 4 minutes for an astute investment banker to get
    around it.''
        Second, it is increasingly clear that the accounting profession is
    not able consistently to resist management pressures to permit
    incomplete or misleading financial statements, and the profession has
    serious problems in recruiting and keeping the highly qualified
    professionals that are needed.
        Third, the audit committees of too many boards are not exercising
    the authority given to them or the responsibility expected of them. . .

        The financial papers produced dutifully each year by publicly-
    traded companies have become a commodity. Companies produce them
    largely because they are required to do so. Few CEO's regard this work
    product as having any intrinsic value. Accounting firms compete for
    business more on price than on the quality of their personnel or
    procedures.
        If a company does take an interest in the structure of its balance
    sheet and profit and loss statement, it is far more likely to be caused
    by a desire to be innovative in how they report their profits than in
    the quality of the auditor's work. They hire bankers and consultants to
    design corporate structures that will give them a stronger looking
    balance sheet and, perhaps, keep the profits and losses of related
    companies off of their financial papers.
        Senate Committee on Banking, Housing, and Urban Affairs, Hearing on
    ``Accounting and Investor Protection Issues Raised in Enron and Other
    Public Companies,'' February 12, 2002 (Testimony of Roderick M. Hills)
    at 1-2.
    ---------------------------------------------------------------------------
        It is worth disaggregating several specific issues.
     The off balance sheet transactions that Enron employed were
        made in accordance with generally accepted accounting standards.
        This has appropriately focused attention on the quality of the
        existing accounting standard setting organization, the Financial
        Accounting Standards Board (FASB). Long before Enron, the political
        and financial weaknesses of the FASB were much discussed. As former
        SEC Chairman David Ruder has stated:

              Despite its attempts to seek the views of the business
            community, the FASB faces difficulty in obtaining financing
            from business, which often
            objects to FASB standards that affect business interests. The
            FASB is
            financed through sales of its work product and through
            contributions by accounting firms and businesses. When
            businesses do not like the FASB's standards or its process for
            creating then, they sometimes withdraw financial support, or
            fail to provide it in the first place. The FASB continually
            faces difficulties in financing its operations. The accounting
            profession is supportive, but generally speaking business is
            not. Institutional investors and investment bankers, who
            benefit greatly from financial statement disclosures,
            contribute little to the FAF, creating a classic free rider
            problem.

        I believe the solution to the financial pressures on the FASB would
    be to provide a system of financing . . . FASB should be financed by
    payments by preparers and users of financial statements. If a voluntary
    system cannot be established, Congress should enact legislation
    creating financing for the FASB.\26\
    ---------------------------------------------------------------------------
        \26\ Senate Committee, supra n. 25 (Testimony of David S. Ruder) at
    5- 6.
        After the bankruptcy of Enron in December 2001, SEC Chairman Harvey
    Pitt published How to Prevent Future Enrons, Wall Street Journal,
    December 11, 2001 at A18, which stated in part:

         Private-sector standard setting that responds
    expeditiously, concisely and clearly to current and immediate needs. A
    lengthy agenda that achieves its goals too slowly, or not at all, like
    good intentions, paves a road to the wrong locale.
         An effective and transparent system of self-regulation for
    the accounting profession, subject to our rigorous, but nonduplicative,
    oversight. As the major accounting firm CEO's and the American
    Institute of Certified Public Accountants recently proposed, the
    profession, in common with us, must provide assurances of comprehensive
    and effective self-regulation, including monitoring adherence to
    professional and ethical standards, and meaningfully disciplining firms
    or individuals falling short of those standards. Such a system has
    costs, but those who benefit from the system should help absorb them.
        See also Pitt Renews Call for Modernization of Disclosure,
    Regulatory Processes, 33 Sec. Reg. & L. Rep. (BNA) 1630 (2001).
    ---------------------------------------------------------------------------
        Paul A. Volcker, now Chair of the International Accounting
    Standards Committee Foundation, similarly has testified:

              . . . [P]roblems, building over a period of years, have now
            exploded into a sense of crisis. That crisis is exemplified by
            the Enron collapse. But Enron is not the only symptom. We have
            had too many restatements of earnings, too many doubts about
            ``pro forma'' earnings, too many sudden charges of billions of
            dollars to ``good will,'' too many perceived auditing failures
            accompanying bankruptcies to make us at all comfortable. To the
            contrary, it has become clear that some fundamental changes and
            reforms will be required to provide assurance that our
            financial reporting will be accurate, transparent, and
            meaningful.\27\
    ---------------------------------------------------------------------------
        \27\ Senate Committee, supra n. 25 (Testimony of Paul A. Volcker,
    February 14, 2002) at 1.

        Congress or the SEC should systematically review the process and
    substance of accounting standard setting. It is urgently necessary to
    restore and strengthen the fundamental premise that financial
    statements will provide a ``fair presentation'' of an entity's
    financial position. This both involves addressing specific disclosure
    items such as off balance sheet transactions, stock options, and
    derivatives and strengthening the independence of accounting standard
    setting. The key here, as elsewhere, is money. You cannot expect a
    Government agency or private entity to be truly independent without an
    assured source of funds. Congress should explore means to legislate a
    ---------------------------------------------------------------------------
    user or accounting firm fee system that will provide such independence.

     Enveloping Generally Accepted Accounting Principles is the SEC
        mandatory disclosure system. The mandatory disclosure system
        deserves to be under sharp question. How could financial reporting
        practices sufficient to bankrupt the seventh largest industrial
        firm in the country so long go undisclosed? Is this simply an
        isolated instance of bad disclosure practices or is Enron
        suggestive of more systematic failure?

        The SEC has begun to grapple with the latter, more disturbing
    possibility. In December 2001 the Commission issued a cautionary
    Release on ``pro forma'' financial information,\28\ rapidly followed by
    a similar statement regarding the selection and disclosure of critical
    accounting policies and practices,\29\ and in January 2002 by a
    consequential and broad new interpretation of the pivotal management
    discussion and analysis disclosure item.\30\
    ---------------------------------------------------------------------------
        \28\ Sec. Act Rel. 8039, 76 SEC Dock. 896 (2001).
        \29\ Sec. Act Rel. 8040, 76 SEC Dock. 983 (2001).
        \30\ Sec. Act Rel. 8056, ____ SEC Dock. ____ (2002).
        This Commission statement delineated additional disclosure that
    should occur concerning (1) off balance sheet arrangements, (2)
    commodity contracts, including those indexed to measures of weather,
    commodity prices, or quoted prices of service capacity, such as energy
    and bandwidth capacity contracts; and (3) related party transactions.
    The Commission statement was premised on the assumption that Item
    303(a) of Regulation S-K already requires disclosure of ``known
    trends'' or ``known uncertainties'' that could result in a registrant's
    liquidity or capital resources increasing or decreasing in a material
    way.
    ---------------------------------------------------------------------------
        More needs to be done. The Commission and Congress should carefully
    review whether SEC oversight of the Generally Accepted Accounting
    Principles and the context of its mandatory disclosure system has
    unacceptably deteriorated.
        The Commission also needs to seriously and patiently review whether
    we today have the right construct of disclosure requirements,
    proceeding item by item, and whether changes in timing and delivery of
    data would be appropriate given evolving changes in technology and
    international securities trading.

     At its core Enron involved an audit failure. The outside
        auditor both appeared to operate with significant conflicts of
        interest and to have been too beholden to a highly aggressive
        corporate management.

        Several aspects of the Enron audit failure deserve particular
    attention.
        First, the Public Oversight Board, primarily responsible for
    overseeing the SEC's auditors, has been much criticized. Former SEC
    Chairman Harold Williams, for example, recently stated:

              The Public Oversight Board was created by the profession
            during my Chairmanship as an effort at self-regulation. We
            expressed concern at the time whether the peer review process
            administered by the profession would be adequate. But as
            believers in the principle of self-regulation, we concluded
            that the Board should have the opportunity to prove itself. In
            my opinion, the events over the intervening years have
            demonstrated that it does not meet the needs and is not
            adequate. Under the peer review system adopted in 1977, the
            firms periodically review each other. To my knowledge, there
            has never been a negative review of a major firm. However, the
            peer review is not permitted to examine any audits that are
            subject to litigation. The reviews focus on the adequacy of
            quality control procedures and do not examine the audits of
            companies to see if the peer would have arrived at a different
            conclusion. Peer review has proved itself insufficient.
            Particularly as the Big Eight has become only the Big 5, peer
            review in its present form becomes too incestuous. A system
            needs to be established which is independent of the accounting
            profession, transparent and able to serve both effective
            quality control and disciplinary functions.
              Further, the Board is not adequately funded and is beholden
            for its funding to the very people it is supposed to oversee. I
            suggest that the SEC consider a requirement that a percentage
            of the audit fees of public companies be assessed to pay for
            independent oversight, whether it is the Public Oversight Board
            or a successor body, so that its funding is assured.\31\
    ---------------------------------------------------------------------------
        \31\ Senate Committee, supra n. 25 (Testimony of Harold M.
    Williams) at 3.

        The former SEC Chairman David Ruder would go further and replace
    the POB with ``a new body which will be separate from the AICPA and
    whose board will be composed entirely of public members who have no
    connection to the accounting profession.'' \32\
    ---------------------------------------------------------------------------
        \32\ Senate Committee, supra n. 25 (Testimony of Ruder) at 4. Ruder
    explains in ibid:
        The POB has functioned well in the past, and there is much to learn
    from its organization and operations. However, although the POB's
    powers have been strengthened, it does not have sufficient budget to
    allow it to function effectively. It does not have the power to force
    accounting firms to provide the documents necessary to complete
    investigations, nor does it have the power to promise that documents
    received will be protected against discovery in private litigation. It
    is forced to rely upon the accounting profession itself to engage in
    enforcement activities. Most important, its connection to the AICPA
    creates an appearance of control by that body.
    ---------------------------------------------------------------------------
        I believe at this time a new auditing self-regulatory organization
    is necessary. It should replace not just the POB, but also a Byzantine
    structure of accounting disciplinary bodies which generally have lacked
    adequate and assured financial support; clear and undivided
    responsibility for discipline; and an effective system of SEC
    oversight. The success of such a new SRO will be in careful attention
    to detail. I would recommend:

     A legal structure similar to that in Sections 15A and 19 of
        the Securities Exchange Act which apply to the securities
        associations and other securities industry self-regulatory
        organizations and addresses such topics as purposes, powers, and
        discipline.\33\
    ---------------------------------------------------------------------------
        \33\ 6 Louis Loss & Joel Seligman, Securities Regulation 2692-2723,
    2787-2830 (3d ed. 1990).
    ---------------------------------------------------------------------------
     A clear scope provision articulating which auditors should be
        subject to the new SRO and a mandate that they be subject to the
        SRO.
     A privilege from discovery of investigative files to
        facilitate auditing discipline during the pendency of other
        Government or private litigation.
     Crucially the new SRO should be permitted, subject to SEC
        oversight, to adopt new auditing standards that can evolve over
        time. These rules would be limited by SEC rulemaking and, of
        course, Congressional legislation.
     As with the accounting standard setting body a pivotal
        decision involves funding. To effectively operate over time any new
        auditing SRO must have an assured source of funding. The most
        logical basis of such funding may prove to be a Congressionally
        mandated fee on covered auditing firms.
     The new SRO will need to draw on the expertise of the
        accounting profession to ensure technical proficiency. A
        supervisory board with a minority of industry representatives and a
        majority of public representatives may prove to be an appropriate
        balance. The chair of such a board, however, should be a public
        member.
     I believe the most significant issue may prove to be who
        conducts periodic examinations and inspections. To paraphrase the
        classical adage: Who will audit the auditors? I would urge serious
        consideration be devoted to replacing peer review with a
        professional examination staff in the new SRO. Peer review has
        been, to some degree, unfairly maligned. But even at its best it
        involves competitors reviewing competitors. The temptation to go
        easy on the firm you review lest it be too critical of you is an
        unavoidable one. While the inspection processes of the New York
        Stock Exchange and the NASD Reg are not panaceas, then suggest a
        workable improvement.
     Finally, it may prove particularly wise to statutorily
        replicate Sec. 15(b)(4)(E) of the Securities Exchange Act which can
        impose liability on a broker-dealer who has ``failed reasonably to
        supervise.'' Particularly in firms with as many offices as the
        leading auditing firms, a clearly delineated supervision standard
        strikes me as vital to effective law compliance.

        Second, a separate, not mutually exclusive approach, would be to
    require mandatory rotation of auditors at specific intervals such as 5
    or 7 years.\34\
    ---------------------------------------------------------------------------
        \34\ Former SEC Chairman Harold Williams has advocated this
    approach:
        I would urge the Commission to consider a requirement that a public
    company retain its auditor for a fixed term with no right to terminate.
    This could be for 5 years or perhaps the Biblical seven. After that
    fixed term, the corporation would be required to change auditors. As a
    consequence of such a requirement, the auditor would be assured of the
    assignment and, therefore, would not be threatened with the loss of the
    client and could exercise truly independent judgment. Under such a
    system the client would lose its ability to threaten to change auditors
    if in its judgment the assigned audit team was inadequate. It would
    also reduce the client's ability to negotiate on fees, and almost
    certainly the audit would cost more. The required rotation of auditors
    would also involve the inefficiency of the learning curve for the new
    auditor. I view all of these potential costs acceptable if it
    reinforces the auditor's independence and makes the work more
    comprehensive. The client could be given a right to appeal to a
    reconstituted independent oversight organization if it believes that it
    is not well served by its auditor and needs some relief. Senate
    Committee, supra n. 56 (Testimony of Williams) at 2.
    ---------------------------------------------------------------------------
        Third, particular attention has been devoted to the wisdom of
    separating accounting firm audit services from consulting. One early
    result of Enron has been an acceleration of this process by voluntary
    means in the Big 5 accounting firms.\35\ Congress or the SEC should
    consider whether a statute or regulation should require such separation
    and, if so, how best to define which consulting services and which
    accounting firms should be subject to the new law or rule.
    ---------------------------------------------------------------------------
        \35\ Former Chairman David Ruder thoughtfully explained:
        One of the substantial worries regarding the Andersen audit of
    Enron has been that Andersen not only audited Enron, but also was paid
    approximately the same amount for nonaudit services. It has been
    reported that in the year 2000 Andersen was paid audit fees of
    approximately $25 million and nonaudit fees of approximately $27
    million. Comparisons of the amounts of audit fees to nonaudit fees for
    a range of companies and auditors have revealed ratios of nonaudit to
    audit fees ranging as high as nine to one. The expressed general
    concern is that an audit cannot be objective if the auditor is
    receiving substantial nonaudit fees.
        The accounting profession seems to have recognized that management
    consulting services, which involve accounting firms in helping
    management make business decisions, should not be performed for an
    audit client. Three of the Big 5 accounting firms (Andersen, Ernst &
    Young, and KPMG) have now separated their management consulting units
    from their audit units by contractual splits and spinoffs, and a fourth
    (PricewaterhouseCoopers) has announced its intention to split off its
    management consulting unit in a public offering. (Wall Street Journal,
    p. 3, January 31, 2002) The fifth firm should also do so, or at least
    refrain from offering management consulting services to audit clients.
    Senate Committee, supra n. 25 (Testimony of Ruder) at 2.
    ---------------------------------------------------------------------------
        Fourth, a key SEC reform of the 1970's, the Board of Directors
    audit committee, has also been sharply criticized for its
    ineffectuality. Former SEC Chairman Roderick Hills, during whose term
    in 1977, the New York Stock Exchange adopted the requirement of the
    independent audit committee was both detailed in his delineation of
    shortcomings and in his proposed solutions:

     Audit committees may consist of people who satisfy the
        objective criteria of independence, but their election to the board
        is too often the whim of the CEO, who decides each year who will
        sit on the audit committee and who will chair it.
     Audit committees too often seek only to reduce the cost of the
        audit rather than to seek ways to improve its quality. They do not
        play a sufficient role in determining what the fair fee should be.
     Audit committees seldom ask the auditor if there is a better,
        fairer way to present the company's financial position.
     Audit committees seldom play a role in selecting a new audit
        firm or in approving a change in the partner in charge of the
        audit. They may well endorse an engagement or the appointment of a
        new team, but they are not seen as material to the selection
        process.
     Audit committees seldom establish themselves as the party in
        charge of the audit.

        Congress may wish . . . to require that:

     Corporations of a certain size with publicly-traded stock have
        an effective, independent audit committee in order to avoid a
        finding that there is a material weakness in the corporation's
        internal controls.
     Corporations of a certain size have an independent nominating
        committee with the authority to secure new directors and appoint
        all members of the audit committee.
     Audit committees be solely responsible for the retention of
        accounting firms and be responsible for the fees paid them.\36\
    ---------------------------------------------------------------------------
        \36\ Senate Committee, supra n. 25 (Testimony of Hills) at 5, 8.

        I believe former Chairman Hills proposals should be seriously
    considered.
        (4) A separate principal culprit at Enron was a dysfunctional
    corporate management, broadly potentially including senior executives,
    the board, board committees, internal accounting systems, the outside
    auditor, and both internal and outside legal counsel.\37\ The genius of
    U.S. corporate law, if genius there be, is its redundant systems of
    corporate accountability. The Board is intended to monitor the
    principal executives. Outside accountants and outside legal counsel are
    supposed to buttress this accountability system as are a series of
    legal devices, most notably including board and executive potential
    liability for false and misleading filings with the SEC and State
    corporate law negligence liability.
    ---------------------------------------------------------------------------
        \37\ As former SEC Chairman David Ruder testified:
        The primary fault in the Enron failure seems to be poor management.
    From all accounts it appears that Enron became overly aggressive in its
    efforts to dominate the energy trading markets, engaged in highly
    leveraged off balance sheet financing, engaged in extremely aggressive
    accounting, overstated its earnings, failed to disclose the true nature
    of its corporate and financial structure, and eventually lost the
    confidence of its creditors and trading counter parties. Enron
    management appears to be primarily to blame. . . .
        . . . the Enron problems represent a failure in corporate
    governance. One striking aspect of this failure is Enron's apparent
    lack of respect for the accounting system that underlies financial
    reporting. Enron seems to have purposely attempted to avoid disclosure
    of its true finances. Instead it should have utilized the accounting
    system as a means of assisting it to make sound management decisions
    and as a source of information helping it to provide the securities
    markets with a truthful statement of financial condition. Senate
    Committee, supra n. 25 (Testimony of Ruder) at 6 -7.
        Similarly former Chairman Hills observed:
        Finally, it must be said on this point that unless one has been
    subjected to a serious corporate meltdown, you cannot possibly
    appreciate the enormous discretion that management has under GAAP to
    present its financial position. By changing depreciation schedules, by
    using different estimates or by adopting different strategies or
    assumptions, a company can make enormous changes in its annual income.
    Management too often makes these ``top-level'' adjustments without
    adequate disclosure to the public about how much their current earnings
    depend on such adjustments. A corporate meltdown in which I was
    involved 3 years ago was caused by top-level adjustments that accounted
    for 40 percent of the company's total income and led to a corporate
    admission that billions of dollars of income had been improperly
    reported. Senate Committee, supra n. 25 (Testimony of Hills) at 3.
    ---------------------------------------------------------------------------
        The overlapping accountability systems can individually fail. What
    made Enron unusual is that they all appeared to fail simultaneously.
        I am skeptical that similar simultaneous dysfunction will prove
    widespread.
        I am also mindful that poorly designed new regulatory solutions
    could stultify the type of product innovation and risk-taking that has
    been consequential to the recent growth of the U.S. economy. I am also
    aware that corporate governance has largely been addressed by State
    corporate law.
        At the Federal level, I anticipate that reforms related to the
    dysfunction in Enron management will be indirect, based on the more
    effective use of the mandatory disclosure system and litigation, rather
    than direct such as proposals for the SEC to audit each registered firm
    or select directors. Among other proposals that should be thoughtfully
    reviewed will be:
        First, increasing the size of the SEC staff to increase the number
    of filings reviewed and enforcement investigations conducted.\38\
    ---------------------------------------------------------------------------
        \38\ Cf. Norris, Will SEC's Needs Be Met? Not by Bush, N.Y. Times,
    February 8, 2002 at C1.
    ---------------------------------------------------------------------------
        Second, considering whether to strengthen private enforcement of
    the Federal securities laws by reviewing whether the Private Securities
    Litigation Reform Act of 1995 has deterred or needlessly delayed
    meritorious lawsuits.\39\
    ---------------------------------------------------------------------------
        \39\ See 10 Louis Loss & Joel Seligman, Securities Regulation 4636-
    4669 (3d ed. rev. 1996).
    ---------------------------------------------------------------------------
        Third, considering whether it would be wiser to permit private
    aiding and abetting actions against attorneys and auditors and reverse
    through legislation the 1994 U.S. Supreme Court decision in Central
    Bank,\40\ which held that such actions could not be implied from the
    key Federal securities law fraud remedy, Securities Exchange Act Rule
    10b-5.\41\
    ---------------------------------------------------------------------------
        \40\ Central Bank of Denver, N.A. v. First Interstate Bank of
    Denver, N.A., 511 U.S. 164 (1994).
        \41\ 9 Louis Loss & Joel Seligman, Securities Regulation 4479-4488
    (3d ed. 1992 & 2001 Ann. Supp.).
    ---------------------------------------------------------------------------
        (5) One step removed from Enron, but strongly suggested by its
    failure are serious questions of the integrity of investment analysts.
    As former SEC Chairman Arthur Levitt, Jr. emphatically testified in
    February 2002:

              . . . For years, we have known that analysts' compensation is
            tied to their ability to bring in or support investment banking
            deals. In early December, with Enron trading at 75 cents a
            share, 12 of the 17 analysts who covered Enron, rated the stock
            either a hold or buy.
              Two years ago, I asked the New York Stock Exchange and the
            National Association of Securities Dealers to require
            investment banks and their analysts to disclose clearly all
            financial relationships with the companies they rate. Last
            week, we finally saw a response from the self-regulators. But
            it is not enough. Wall Street's major firms--not its trade
            group--need to take immediate steps to reform how analysts are
            compensated. As long as analysts are paid based on banking
            deals they generate or work on, there will always be a cloud
            over what they say.\42\
    ---------------------------------------------------------------------------
        \42\ Senate Committee, supra n. 56 (Testimony of Arthur Levitt,
    Jr.) at 2.

        Congress should broadly investigate whether investment banks have
    adequately maintained ``Chinese walls'' between the retail brokerage
    and underwriting and whether, more fundamentally, securities firms that
    underwrite should be separated from retail brokerage.\43\ These are not
    new questions \44\ but they have been revived by Enron. I am very
    skeptical that separation here will prove wise. But to put the matter
    bluntly, the quality of investment advice has raised fundamental
    questions.
    ---------------------------------------------------------------------------
        \43\ Wayne, Congress's Scrutiny Shifts to Wall Street and Its Enron
    Role, N.Y. Times, February 19, 2002 at A1.
        \44\ See, e.g., 6 Louis Loss & Joel Seligman, Securities Regulation
    2977-2980 (3d ed. 1990). (Proposed segregation of brokerage and
    underwriting in 1930's), 8 Louis Loss & Joel Seligman, Securities
    Regulation 3618-3631 (3d ed. 1991) (Chinese Wall).
    ---------------------------------------------------------------------------
        An alternative approach worth considering would be a new form of
    adviser liability for recommendations without a reasonable basis.
    Increased SEC inspection cycles to review the basis of adviser
    recommendations is also now in order.
    Conclusion
        There will be other proposals, both within the framework of
    corporate and securities law and without, no doubt, that should receive
    serious consideration. At its core Enron was a triumph of aggressive
    and of financial chicanery over time honored concepts such as ``fair
    presentation'' of financial information and ``full disclosure'' of
    material information. After thoughtful and diligent investigation, I
    anticipate at least one inevitable result. Our traditional commitment
    to avoiding or fully disclosing conflicts of interest will be
    systematically reinvigorated.

                                   ----------

                   PREPARED STATEMENT OF JOHN C. COFFEE, JR.

       Adolf A. Berle Professor of Law, Columbia University School of Law
                                 March 5, 2002

    Introduction
        I want to thank the Committee for inviting me to appear today.
    Because I realize that you are covering a broad range of issues and
    have only limited time to listen to any individual witness, I believe
    that my contribution will be the most useful if I focus on just two
    issues: (1) What powers, duties, and standards should Congress include
    in any legislation that establishes a self-regulatory body to oversee
    the auditing profession? and (2) How should Congress respond to the
    evidence that conflicts of interest do bias the recommendations and
    research of securities analysts?
        If we focus only on Enron, it cannot prove by itself that there is
    a crisis or that either auditors or securities analysts have been
    compromised by conflicts of interest. By itself, Enron is only an
    anecdote--bizarre, vivid, and tragic as it may be. But Enron does not
    stand alone. As I elaborated in detail in testimony before the Senate
    Commerce Committee on December 17, 2001 (and thus will not repeat at
    any length here), Enron is part of a pattern. As the liabilities faced
    by auditors declined in the 1990's and as the incentives auditors
    perceived to acquiesce in management's desire to manage earnings
    increased over the same period (because of the opportunities to earn
    highly lucrative consulting revenues), there has been an apparent
    erosion in the quality of financial reporting. Assertive as this
    conclusion may sound, a burgeoning literature exists on earnings
    management, which indicates that earnings management is conscious,
    widespread, and tolerated by auditors within, at least, very wide
    limits.\1\ Objective data also shows a decline in the reliability of
    published financial results. To give only the simplest quantitative
    measure, from 1997 to 2000, there were 1,080 earnings restatements by
    publicly-held companies.\2\ Most importantly, there has been a
    significant recent increase in the number of earnings restatements.
    Earnings restatements averaged 49 per year from 1990 to 1997, then
    increased to 91 in 1998, and soared to 150 in 1999 and 156 in 2000.\3\
    Put simply, this sudden spike in earnings restatements is neither
    coincidental nor temporary.
    ---------------------------------------------------------------------------
        \1\ I summarize much of this literature and the absence of any
    meaningful effort at internal self-discipline in a recent article. See
    Coffee, The Acquiescent Gatekeeper: Reputational, Intermediaries,
    Auditor Independence and the Governance of Accounting (2001). This
    article, written well before the Enron story broke, is available on the
    Social Science Research Network (SSRN) at www.ssrn.com at id=270994.
        \2\ See George Moriarty and Philip Livingston, ``Quantitative
    Measures of the Quality of Financial Reporting,'' 17 Financial
    Executive 55 (July 1, 2001).
        \3\ Id. 715 of these restatements involved Nasdaq listed companies;
    228 involved New York Stock Exchange companies; the rest were listed
    either on the American Stock Exchange or were traded in the over-the-
    counter market. Premature revenue recognition was found to be the
    leading cause of restatements.
    ---------------------------------------------------------------------------
        Worse yet, the accounting profession is conspicuous by its lack of
    any meaningful mechanism for internal self-discipline. This void
    contrasts starkly with the governance structure of the broker-dealer
    industry, where the National Association of Securities Dealers (NASD)
    administers a vigorous and effective system of internal discipline.
    Because both brokers and auditors ultimately serve the same
    constituency--for example, investors--this disparity is unjustifiable.
    Put simply, American corporate governance depends at bottom on the
    credibility of the numbers. Only if financial data is accurate can our
    essentially private system of corporate governance operate effectively.
    Today, there is doubt about the reliability of reported financial
    data--and also about the independence and objectivity of the two
    watchdogs who monitor and verify that data: Namely, auditors and
    securities analysts.
        What should Congress do about the crisis? While there is a case for
    raising the liabilities that auditors and analysts face, I am fully
    aware that many are skeptical of private enforcement of law through
    class and derivative actions. Essentially, this asks a third watchdog--
    the plaintiff 's attorney--to monitor the failings of the first two
    (auditors and analysts), and plaintiff 's attorneys may have their own
    misincentives. Also, it may still be too early to ask Congress to
    revisit the Private Securities Litigation Reform Act of 1995 (the
    PSLRA). Thus, both in my December appearance before the Senate Commerce
    Committee and again today, I urge Congress to give fuller consideration
    to public enforcement through the creation or strengthening of self-
    regulatory organizations (SRO's). An SRO already exists with
    jurisdiction over securities analysts (for example, the NASD), but one
    needs to be created from whole cloth in the case of auditors. Thus, my
    comments will focus first on the creation of a new SRO for auditors and
    then how to strengthen the oversight of analysts.
    An SRO for Auditors: Some Suggested Standards
        The governance of accounting is today fragmented and indeed
    Balkanized among (1) State boards of accountancy, (2) private bodies,
    of which there are essentially seven, and (3) the SEC, which has broad
    antifraud jurisdiction, but less certain authority under Rule 102(e) of
    its Rules of Practice.\4\ Disciplinary authority is particularly
    divided within the profession. The Quality Control Inquiry Committee
    (QCIC) of the SEC Practice Section of the American Institute of
    Certified Public Accountants (AICPA) is delegated responsibility to
    investigate alleged audit failures involving SEC clients arising from
    litigation or regulatory investigations, but it is charged only with
    determining if there are deficiencies in the auditing firm's system of
    quality control. The Professional Ethics Executive Committee (PEEC) of
    the AICPA is suppose to take individual cases on referral from the
    QCIC, but as a matter of ``fairness'' PEEC will automatically defer, at
    the subject firm's request, any investigation until all litigation or
    regulatory proceedings have been completed. In short, the investor's
    interest in purging corrupt or fraudulent auditors from the profession
    is subordinated to the firm's interest in settling litigation cheap,
    uninfluenced by any possible findings of ethical lapses.
    ---------------------------------------------------------------------------
        \4\ 17 CFR Sec. 201.102. The SEC's authority under Rule 102(e) was
    clouded by the D.C. Circuit's decision in Checkosky v. SEC, 139 F.3d
    221 (D.C. Cir. 1998) (dismissing Rule 102(e) proceeding against two
    accountants of a ``Big 5'' firm). The SEC revised Rule 102 in late 1998
    in response to this decision (see Securities Act. Rel. No. 7593
    (October 18, 1998), but its authority in this area is still subject to
    some doubt that Congress may wish to remove or clarify.
    ---------------------------------------------------------------------------
        Little in this system merits retention. Legislation is necessary to
    create a body that would have at least the same powers, duties and
    obligations as the NASD. In truth, however, the legislation that
    created the NASD in 1938 (the Maloney Act) is not an ideal model, given
    its general lack of specific guidance. Rather, model legislation should
    have the following elements:
        1. Rulemaking Power. The SRO should be specifically authorized to
    (1) address and prohibit conflicts of interest and other deficiencies
    that might jeopardize either auditor independence or the public's
    confidence in the accuracy and reliability of published financial
    statements, and (2) establish mandatory procedures, including
    procedures for the retention of accountants by publicly-held companies
    and for the interaction and relationship between the accountants and
    audit committees. This is a broad standard--and deliberately so. It
    could authorize the SRO to require that auditors be retained and/or
    fired by the audit committee and not by the company's management. In
    addition, the SRO should be authorized to affirmatively mandate the
    adoption and use of new or improved quality control systems, as they
    from time to time become accepted.
        2. Mandatory Membership. All outside auditors preparing or
    certifying the financial statements of publicly-held companies or of
    companies conducting registered public offerings would be required to
    be members in good standing, and suspension or ouster from the SRO
    would render an auditor unable to certify the financial statements of
    such companies.
        3. SEC Supervision. SEC approval of the initial registration of
    such an SRO and of all amendments to its rules would be mandated, just
    as in the case of the NASD. The SEC would also have authority to amend
    the SRO's rules in compliance with a statutory ``public interest''
    standard. Finally, the SEC should have authority to sanction, fine, or
    suspend the SRO and to remove or suspend its officers or directors for
    cause.
        4. Enforcement Powers. The SRO should have the same authority to
    impose financial penalties or to suspend or disbar an auditor from
    membership, or to suspend, disbar, fine, or censure any associated
    professional. Such fines and penalties should not require proof of
    fraud, but only a demonstration of negligent or unethical conduct.
    Subpoena authority should also be conferred, and a failure to cooperate
    or to provide evidence should be grounds for discipline or dismissal.
        5. Duties of Supervisory Personnel. A common response of
    organizations caught in a scandal or a criminal transaction is to blame
    everything on a ``rogue'' employee. Yet, such ``rogues'' are often
    responding to winks and nods from above (real or perceived) or to an
    organizational culture that encourages risk-taking (Enron is again
    symptomatic). The Federal securities laws impose duties on supervisory
    personnel in brokerage firms to monitor their employees, and a parallel
    standard should apply to supervisory personnel in auditing firms.
        6. Governance. The SRO should have at least a supermajority (say,
    66\2/3\ percent) of ``public'' members, who are not present or recently
    past employees or associated persons of the auditing industry.
        7. Prompt Enforcement. The practice now followed by PEEC of
    deferring all disciplinary investigations until civil litigation and
    regulatory investigations have been resolved is self-defeating and
    unacceptable. It might, however, be possible to render the findings and
    disciplinary measures taken by the SRO inadmissible in private civil
    litigation.

    Securities Analysts
    What Do We Know About Analyst Objectivity
        A number of studies have sought to assess the impact of conflicts
    of interest upon the objectivity of securities analyst recommendations.
    Additional evidence was also recently collected at hearings held in
    June 2001 by the Subcommittee on Capital Markets, Insurance and
    Government Sponsored Enterprises of the House Financial Services
    Committee. This data is probably more germane, and merits greater
    reliance, than the well-known statistic that an alleged 100:1 ratio
    exists between the ``buy'' recommendations and ``sell'' recommendations
    made by securities analysts. Although the actual ratio may be somewhat
    less extreme than 100:1,\5\ the real problem with this statistic is
    that it is not necessarily the product of conflicts of interest. That
    is, analysts employed by brokerage firms (as all ``sell-side'' analysts
    are) have a natural incentive to encourage purchase or sale
    transactions. For this purpose, ``buy'' recommendations are more useful
    than ``sell'' recommendation, because all clients can buy a stock, but
    only existing holders can sell as a practical matter.
    ---------------------------------------------------------------------------
        \5\ A December 2000 Thomson Financial Survey reported that 71
    percent of all analyst recommendations were ``buys'' and only 2.1
    percent were sells. Apparently, only 1 percent of 28,000
    recommendations issued by analysts during late 1999 and most of 2000
    were ``sells.'' This study also finds that the overall ``buy'' to
    ``sell'' ratio shifted from 6:1 in the early 1990's to 100:1 by
    sometime in 2000. Of course, this shift also coincided with the Nasdaq
    bull market of the 1990's.
    ---------------------------------------------------------------------------
        Other data better illustrates the impact of conflicts of interest
    on analysts. Among the most salient findings from recent research are
    the following:
        1. Conflict of Interests. Several studies find that ``independent''
    analysts (for example, analysts not associated with the underwriter for
    a particular issuer) behave differently than analysts who are so
    associated with the issuer's underwriter. For example, Roni Michaely
    and Kent Womack find that the long-run performance of firms recommended
    by analysts who are associated with an underwriter was significantly
    worse than the performance of firms recommended by independent
    securities analysts.\6\ They further find that stock prices of firms
    recommended by analysts associated with lead underwriters fall on
    average in the 30 days before a recommendation is issued, while the
    stock prices of firms recommended by analysts not so associated with
    underwriters rose on average over the same period. Finally, the mean
    long-run performance of buy recommendations made by analysts on
    nonclients is more positive than the performance of recommendations
    made on clients--at least for 12 out of 14 brokerage firms.
    ---------------------------------------------------------------------------
        \6\ See R. Michaely and K. Womack, Conflict of Interest and the
    Credibility of Underwriter Analyst Recommendations, 12 Review of
    Financial Studies 653 (1999).
    ---------------------------------------------------------------------------
        Still another study by CFO Magazine reports that analysts who work
    for full-service investment banking firms have 6 percent higher
    earnings forecasts and close to 25 percent more buy recommendations
    than do analysts at firms without such ties.\7\ Similarly, using a
    sample of 2,400 seasoned equity offerings between 1989 and 1994, Lin
    and McNichols find that lead and co-underwriter analysts' growth
    forecasts and particularly their recommendations are significantly more
    favorable than those made by unaffiliated analysts.\8\
    ---------------------------------------------------------------------------
        \7\ See S. Barr, ``What Chinese Wall,'' CFO Magazine, March 1,
    2000.
        \8\ H. Lin and M. McNichols, Underwriting Relationships and
    Analysts' Earnings Forecasts and Investment Recommendations, 25 J. of
    Accounting and Economics 101 (1997).
    ---------------------------------------------------------------------------
        2. Pressure and Retaliation. In self-reporting studies, securities
    analysts report that they are frequently pressured to make positive buy
    recommendations or at least to temper negative opinions.\9\ Sixty-one
    percent of analysts responding to one survey reported personal
    experience with threats of retaliation from issuer management.\10\
    Similarly, former Acting SEC Chairman Laura Unger noted in a recent
    speech that a survey of 300 chief financial officers found that 20
    percent of surveyed CFO's acknowledged withholding business from
    brokerage firms whose analysts issued unfavorable research.\11\ This is
    a phenomenon that is almost certain to be underreported.
    ---------------------------------------------------------------------------
        \9\ J. Cote, Analyst Credibility: The Investor's Perspective, 12 J.
    of Managerial Issues 351 (Fall 2000).
        \10\ D. Galant, ``The Hazards of Negative Research Reports,''
    Institutional Investor, July 1990.
        \11\ Laura Unger, ``How Can Analysts Maintain Their Independence?''
    Speech at Northwestern Law School (April 19, 2001).
    ---------------------------------------------------------------------------
        This data should not be overread. It does not prove that securities
    research or analyst recommendations are valueness or hopelessly biased,
    but it does tend to confirm what one would intuitively expect: Namely,
    conflicts of interest count, and conflicted analysts behave differently
    than unaffiliated or ``independent'' analysts.
    The Regulatory Response
        In light of public criticism regarding securities analysts and
    their conflicts of interest, the National Association of Securities
    Dealers (NASD) proposed Rule 2711 (Research Analysts and Research
    Reports) in early February 2002.\12\ Proposed Rule 2711 is lengthy,
    complex and has not yet been adopted. Nonetheless, because its adoption
    in some form seems likely, a brief analysis of its contents seems
    useful as an introduction to what further steps Congress should
    consider.
    ---------------------------------------------------------------------------
        \12\ See File No. SR-NASD-2002-21 (February 8, 2002).
    ---------------------------------------------------------------------------
        Basically, Rule 2711 does seven important things:
        (1) It places restrictions on investment banking department's
    relationship with the ``research'' or securities analyst division of an
    integrated broker-dealer firms.
        (2) It restricts the prepublication review of analyst research
    reports by the subject company and investment banking personnel.
        (3) It prohibits bonus or salary compensation to a research analyst
    based upon a specific investment banking services transaction.
        (4) It prohibits broker-dealers from promising favorable research
    or ratings as consideration or an inducement for the receipt of
    business or compensation.
        (5) It extends the ``quiet period'' during which the broker-dealer
    may not publish research reports regarding a company in an IPO for
    which the firm is acting as a manager or co-manager for 40 calendar
    days from the date of the offering.
        (6) It restricts analysts ability to acquire securities from a
    company prior to an IPO or to purchase or to sell for a defined period
    before or after the publication of research report or a change in a
    rating or price target.
        (7) It requires extensive disclosure by an analyst of certain stock
    holdings or compensation or other conflict of interest relationships.
        All of these prohibitions are subject to substantial exceptions
    and/or qualifications, and it is debatable whether some can be
    effectively monitored. Only time and experience with proposed Rule 2711
    can tell us whether its exceptions will overwhelm the rule.
    Nonetheless, Rule 2711 represents a serious and commendable effort to
    police the conflicts of interest that exist within broker-dealer firms
    that both underwrite securities and provide securities research and
    recommendations. In this light, the most important question is: What
    else can or should Congress do? Are these topics or areas that Rule
    2711 has not addressed that Congress should address? These are
    considered below:

    Congressional Options
        The overriding policy question is whether conflicts of interest
    relating to securities research should be prohibited or only policed.
    As I will suggest below, this question is not easily answered, because
    there are costs and imperfections with both options:
        1. Radical Reform: Divorce Investment Banking From Securities
    Research. Congress could do what it essentially did a half century ago
    in the Glass-Steagall Act: \13\ namely, prohibit investment banking
    firms that underwrite securities from engaging in a specified activity
    (here, providing securities research to all, or at least certain,
    customers). Arguably, this is what Congress and the SEC have already
    proposed to do with respect to the accounting profession: For example,
    separate the auditing and consulting roles performed by accountants.
    Here the conflict might be thought to be even more serious because the
    empirical evidence does suggest that the advice given by conflicted
    analysts is different from the advice given by independent analysts.
    ---------------------------------------------------------------------------
        \13\ See the Glass-Steagall Act of 1933, 12 U.S.C. Sec. 36 et. seq.
    (separating commercial and investment banking).
    ---------------------------------------------------------------------------
        But this divestiture remedy is here even more problematic than in
    the case of the original Glass-Steagall Act. Put simply, securities
    research is not a self-sufficient line of business that exist on a
    freestanding basis. To be sure, there are a limited number of
    ``independent'' securities research boutiques (Sanford C. Bernstein &
    Co. is probably the best known and the most often cited example) that
    do not do the underwriting, but still survive very well. Yet this is a
    niche market, catering to institutional investors. Since May 1, 1975
    (Mayday) when the old system of fixed commissions was ended and
    brokerage commissions became competitively determined, commission have
    shrunk to a razor-thin margin that will not support the costs of
    securities research. Instead, securities research (for example, the
    salaries and expenses of securities research) is essentially subsidized
    by the investment banking division of the integrated broker-dealer
    firm. The problematic result is at the same time to subsidize and
    arguably distort securities research.
        This point distinguishes the securities analysts from the
    accountant. That is, if the auditor is prohibited from consulting for
    the client, both the auditing and the consulting function will survive.
    But, in particular because the costs of securities research cannot be
    easily passed on to the retail customer, a Glass-Steagall divorce might
    imply that the number of securities analysts would shrink by a
    substantial fraction.\14\ A cynic might respond: Why seek to maximize
    biased research? Yet if the number of analysts were to fall by,
    hypothetically, one half, market efficiency might well suffer, and many
    smaller firms simply would not be regularly covered by any analyst.
    Hence, the divestiture approach may entail costs and risks that cannot
    be reliably estimated.
    ---------------------------------------------------------------------------
        \14\ I recognize that the number of ``buy side'' analysts employed
    by institutional investors might correspondingly increase, but not, I
    think, to a fully compensating degree. Moreover, ``buy side'' analysts
    do not publish their research, thus implying increased informational
    asymmetrics in the market.
    ---------------------------------------------------------------------------
        2. Piecemeal Reform: Policing Conflicts. Proposed Rule 2711
    represents an approach of trying to police conflicts and prevent
    egregious abuse. The practical ability of regulators to do this
    effectively is always open to question. For example, although proposed
    Rule 2711 generally prohibits investment banking officials from
    reviewing research reports prior to publication, it does permit a
    limited review ``to verify the factual accuracy of information in the
    research report'' (see Rule 2711(b)(3) ). It is easy to imagine veiled
    or stylized communications that signal that the investment banking
    division is displeased and will reduce the analyst's compensation at
    the next regular salary review. Such signals, even if they consist only
    of arched eyebrows, are effectively impossible to prohibit. Still, at
    the margin, intelligent regulation may curtail the more obvious forms
    of abuse. Although proposed Rule 2711 addresses many topics, it does
    not address every topic. Some other topics that may merit attention are
    discussed below, but they are discussed in the context of suggesting
    that Congress might give the NASD general policy instructions and ask
    it to fine tune more specific rules that address these goals:
        1. An Anti-Retaliation Rule. According to one survey,\15\ 61
    percent of all analysts have experienced retaliation--threats of
    dismissal, salary reduction, etc.--as the result of negative research
    reports. Clearly, negative research reports (and ratings reductions)
    are hazardous to an analyst's career. Congress could either adopt, or
    instruct the NASD to adopt, an anti-retaliation rule: No analyst should
    be fired, demoted or economically penalized for issuing a negative
    report, downgrading a rating, or reducing an earnings, price, or
    similar target. Of course, this rule would not bar staff reductions or
    reduced bonuses based on economic downturns or individualized
    performance assessments. Thus, given the obvious possibility that the
    firm could reduce an analyst's compensation in retaliation for a
    negative report, but describe its action as based on an adverse
    performance review of the individual, how can this rule be made
    enforceable? The best answer may be NASD arbitration. That is, an
    employee who felt that he or she had been wrongfully terminated or that
    his or her salary had been reduced in retaliation for a negative
    research report could use the already existing system of NASD employee
    arbitration to attempt to reverse the decision. Congress could also
    establish the burden of proof in such litigation and place it on the
    firm, rather than the employee/analyst. Further, the Congress could
    entitle the employee to some form of treble damages or other punitive
    award to make this form of litigation viable. Finally, the Congress
    could mandate an NASD penalty if retaliation were found, either by an
    NASD arbitration panel or in an NASD disciplinary proceeding.
    ---------------------------------------------------------------------------
        \15\ See Galant, supra note 10, and Cote, supra note 9.
    ---------------------------------------------------------------------------
        2. A No-Selling Rule. If we wish the analyst to be a more neutral
    and objective umpire, one logical step might be to preclude the analyst
    from direct involvement in selling activities. For example, it is today
    standard for the ``star'' analyst to participate in ``road shows''
    managed by the lead underwriters, presenting its highly favorable
    evaluation of the issuer and even meeting on a one-to-one basis with
    important institutional investors. Such sales activity seems
    inconsistent with the much-cited ``Chinese Wall'' between investment
    banking and investment research.
        Yet from the investment banking side's perspective, such
    participation in sales activity in what makes the analyst most valuable
    to the investment banker and what justifies multimillion dollar
    salaries to analysts. Restrict such activities, they would argue, and
    compensation to analysts may decline. Of course, a decline in salaries
    for the super-stars does not imply a reduction in overall coverage or
    greater market inefficiency.
        Although a ``no-selling'' rule would do much to restore the
    objectivity of the analyst's role, one counter-consideration is that
    the audience at the road show is today limited to institutions and high
    net worth individuals. Hence, there is less danger that the analyst
    will overreach unsophisticated retail investors. For all these reasons,
    this is an area where a more nuanced rule could be drafted by the NASD
    at the direction of Congress that would be preferable to a legislative
    command.
        3. Prohibiting the ``Booster Shot.'' Firms contemplating an IPO
    increasingly seek to hire as lead underwriter the firm that employs the
    star analyst in their field. The issuer's motivation is fueled in large
    part by the fact that the issuer's management almost invariably is
    restricted from selling its own stock (by contractual agreement with
    the underwriters) until the expiration of a lock-up period that
    typically extends
    6 months from the date of the offering. The purpose of the lock-up
    agreement is to assure investors that management and the controlling
    shareholders are not ``bailing out'' of the firm by means of the IPO.
    But as a result, the critical date (and market price) for the firm's
    insiders is not the date of the IPO (or the market value at the
    conclusion of the IPO), but rather the expiration date of the lock-up
    agreement 6 months later (and the market value of the stock on that
    date). From the perspective of the issuer's management, the role of the
    analyst is to ``maintain a buzz'' about the stock and create a price
    momentum that peaks just before the lock-up's expiration.\16\ To do
    this, the analyst may issue a favorable research report just before the
    lock-up's expiration (a so-called ``booster shot'' in the vernacular).
    To the extent that favorable ratings issued at this point seem
    particularly conflicted and suspect, an NASD rule might forbid analysts
    associated with underwriters from issuing research reports for a
    reasonable period (say, 30 days) both before and after the lock-up
    expiration date. Proposed Rule 2711 stops well short of this and only
    extends the ``quiet period'' so that it now would preclude research
    reports for this first 40 days after an IPO. Such a limited rule in no
    way interferes with the dubious tactic of ``booster shots.''
    ---------------------------------------------------------------------------
        \16\ This description of the analyst's role (and of the
    underwriter's interest in attracting ``star'' analysts) essentially
    summarizes the description given by three professors of financial
    economics, Rajesh Aggarwal, Laurie Krigman, and Kent Womack, in their
    recent paper, Aggarwal, Krigman, and Womack, Strategic IPO
    Underpricing, Information Momentum, and Lockup Expiration Selling
    (April 2001) (available on SSRN).
    ---------------------------------------------------------------------------
        4. Summary: The most logical and less overbroad route for Congress
    to take with regard to securities analysts and their conflicts is to
    pass legislation giving the NASD more specific guidance and
    instructions about the goals that they should pursue and then instruct
    the NASD to conduct the necessary rulemaking in order to fine tune this
    approach. NASD penalties might also properly be raised. This approach
    spares Congress from having to adopt a detailed code of procedure,
    avoids inflexibility and rigid legislative rules, and relies on the
    expertise of the SEC and the NASD, as paradigms of sophisticated
    administrative agencies.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                            WEDNESDAY, MARCH 6, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:10 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        Because of the nature of the Senate schedule and the time
    constraints that some Members have, I am going to invite the
    panel of two people to come on up. We will just do one panel
    because, otherwise, I am afraid that we are just going to run
    over.
        So if we could just take the other two witnesses and put
    them on either end, I think Senator Gramm and I will be able to
    work that within the time constraints. As you well know, you
    never can control the Senate schedule from 1 day to the next.
        Today, the Committee continues its examination of auditing
    standards, corporate financial reporting, and investor
    protection. As almost all of our previous witnesses have
    pointed out, Enron is but one example of underlying weaknesses
    within our system. In fact, The Wall Street Journal noted
    yesterday, and I quote them:

        It is hard to deny that the boom of the 1990's produced
    some faster and looser behavior by business. John Goble, the
    former head of Vanguard, recently pointed out that U.S.
    companies restated their earnings 607 times in the past 3
    years, more than in the entire previous decade. Granted a
    company's income statement is not everything, but it ought to
    be more than fiction.

        Accounting abuses and lagging standard setting are not new
    problems. Neither are attempts to solve those problems through
    private studies.
        The debate about purchase versus pooling for business
    combinations in the 1960's led ultimately to the creation of
    the Financial Accounting Foundation--Financial Accounting
    Standards Board structure, after a report written by a group
    headed by former SEC Commissioner Francis Wheat.
        The Commission on Auditors' Responsibilities, headed by
    former SEC Chairman Manny Cohen, was created in 1977, after the
    Penn Central failure and the equity funding and foreign bribery
    scandals of the 1970's. Its job--in words that are actually
    still appropriate--was to: ``Develop recommendations regarding
    the appropriate responsibilities of independent auditors . . .
    [and] consider whether a gap may exist between what the public
    expects or needs and what auditors can and should reasonably
    expect to accomplish.''
        The failures at Penn Square Bank, Continental Illinois,
    Drysdale Government Securities, and Baldwin United, among
    others, in the 1980's, led to the creation of a National
    Commission on Fraudulent Financial Practices, led by former SEC
    Commissioner James Treadway.
        An SEC request that the Public Oversight Board ``examine
    whether recent changes in the audit process serve and protect
    the interests of investors'' led to creation in 1998 of the
    Panel on Audit Effectiveness, Chaired by Shaun O'Malley, former
    Chairman of Price Waterhouse. The O'Malley Report was issued in
    August 2000.
        Unfortunately, only a fraction of the recommendations made
    by these reports have been adopted.
        So, we have some veterans of this process here with us this
    morning and we are looking forward to hearing from them.
        Mr. O'Malley, I will yield to Senator Gramm for a moment
    for a statement, and then we will go to you first, since you
    did the most recent study of audit effectiveness. And then we
    will branch out across the panel with Mr. Seidler, Mr. Wyatt,
    Mr. Longstreth, and Professor Briloff.
        Senator Gramm.

                    STATEMENT OF SENATOR PHIL GRAMM

        Senator Gramm. Mr. Chairman, I will be brief. First, I want
    to again, as I have on all the other occasions that we have
    held hearings in this area, commend you. I think of all the
    Congressional hearings held on issues related to Enron and
    similar problems, that yours have been the most productive.
        Chairman Sarbanes. Potentially, the most productive.
        [Laughter.]
        Senator Gramm. Well, I think that they have been the most
    productive in terms of focusing on the real role of Congress,
    which is forward-looking in terms of what we can do to improve
    the system. I think it is a compliment that you are due to be
    paid.
        Second, let me thank all of our witnesses today. We are in
    the midst of, I think, excellent hearings. Accounting is not as
    simple as I thought it was after I completed my two mandatory
    courses as a sophomore in college. I knew it was burdensome
    when I had to do the old practice sets, which made me decide
    that I did not want to be an accounting major.
        We have talked about real issues in accounting and in
    dealing with our changing financial structure as we have looked
    at how you account for mergers and acquisitions, as we have had
    a long and heated debate about how you account for stock
    options, it is clear that this is a complicated issue.
        The principles are simple. The applications are
    complicated.
        On this Committee, we are going to try, once we have
    gathered all the facts we can and gotten the input we can, try
    to see what we can do to improve the situation, recognizing
    that for every change, there are costs and benefits.
        One of the principles that I have tried to live by as a
    lawmaker is, ``Do no harm.'' I think what we have to do is to
    figure out what we can do that will clearly be beneficial,
    where the benefits in terms of economic growth and job
    creation, the ultimate test of a capital market, exceed the
    costs. And so, your input in that, given your vast experience
    and your involvement in these debates over these many years, is
    much appreciated.
        Chairman Sarbanes. Thank you very much.
        Mr. O'Malley, I should have also mentioned, is the retired
    Chairman of Price Waterhouse. As I said, he Chaired the Panel
    on Audit Effectiveness, and was the President of the Financial
    Accounting Foundation in the early 1990's.
        Mr. O'Malley, we are pleased to have you here this morning.
    We would be happy to hear from you.

                     STATEMENT OF SHAUN F. O'MALLEY

             CHAIRMAN, 2000 PUBLIC OVERSIGHT BOARD PANEL ON

               AUDIT EFFECTIVENESS (O'MALLEY COMMISSION)

                   FORMER CHAIRMAN, PRICE WATERHOUSE

            PAST PRESIDENT, FINANCIAL ACCOUNTING FOUNDATION

        Mr. O'Malley. Thank you very much, Mr. Chairman.
        I would just like to ask, I notice my game clock here says
    5 minutes, and I was told that we would have up to 10 minutes.
        Chairman Sarbanes. Yes. This thing is set in a way----
        Senator Gramm. We lied.
        [Laughter.]
        Chairman Sarbanes. Five to 10 minutes, if you could.
        Mr. O'Malley. All right.
        Thank you very much. I should say also by way of
    introduction, I spent 36 years working in the accounting
    profession, the vast majority of them as an auditor.
        Like everyone, I am shocked by the Enron debacle. As I
    explain in more detail in my written statement, it appears that
    Enron represents a breakdown in every one of the safety nets
    that guard our corporate reporting process--corporate
    management, the board of directors and audit committees, law
    firms, auditing firms, securities analysts, commercial and
    investment banks, credit-rating services, the Financial
    Accounting Standards Board, and the SEC--all seem to have
    failed in some respect and their combined failure led to the
    largest bankruptcy in corporate history.
        There have been a number of proposals concerning reform of
    the accounting profession. I would like to assist in your
    consideration of these proposals by sharing with you the
    recommendations of the Panel on Audit Effectiveness, which I
    Chaired from 1998 to 2000.
        The Panel was appointed by the POB at the request of the
    Securities and Exchange Commission, to review, to evaluate, and
    to recommend improvements in the way independent audits are
    conducted and to assess the effects of recent trends in
    auditing on the public interest. The almost 2 years of work by
    the Panel involved a massive undertaking, a description of
    which may be found in my written statement.
        In the end, the Panel published a report that set forth our
    findings and our recommendations for hundreds of changes in the
    way audits are conducted. Of the more than 250 pages of this
    report, the Panel spent three full chapters discussing a host
    of recommendations designed to improve audit quality.
        Let me emphasize that.
        At the end of the day, enhancing audit quality has to be
    the primary goal of our response to the problems at Enron. It
    is a matter of concern to me that in the context of proposed
    reforms that target the accounting profession, so little is
    being said in the media about whether or how the various
    proposed solutions will improve audit quality. Yet that is the
    issue upon which we must ultimately focus our attention if
    something positive is to come out of these unhappy events.
        The recommendation of the Panel made prior to Enron's
    collapse bears some similarity to proposals discussed by the
    SEC and in Congressional hearings. I will describe the thrust
    of the Panel's recommendation in the context of three themes.
    First, the need for improved audit quality. Second, the call
    for the separation of audit and nonaudit functions. And third,
    proposals for change in the governance of the accounting
    profession.
        First, our recommendations for improved audit quality. The
    Panel made some 150 specific recommendations toward furthering
    the quality and reliability of audits. Some of the most
    important of these recommendations were: One, that auditors be
    required to adopt new forensic-type procedures and an overall
    new approach to detecting fraud; Two, that the Auditing
    Standards Board issue clearer, more definitive auditing
    standards; Three, that auditors be required to attain a much
    deeper understanding of an issuer's business and internal
    controls, and that accounting firms take to heart the
    importance of the investing public of quality audits and that
    firms emphasize this importance in every way possible, from
    communications by top management to compensation and
    advancement decisions.
        Let me comment on what I believe to be the boldest of these
    initiatives, which is that auditors be required to approach
    their audits with more of an eye toward the detection of fraud
    by a company's management.
        The Panel recommended that auditing standards be enhanced
    to require auditors in planning and performing certain phases
    of their exam to presume the possibility of dishonesty at
    various levels of the company's management, including the
    possibility of collusion.
        The Panel also recommended a number of specific forensic
    measures to be taken during any audit, with the principal
    objective of detecting material financial statement fraud. An
    auditor's ability to investigate fraud will always be limited.
    The Panel believed, however, that this dramatic shift in
    approach would not only help auditors to discover material
    fraud, but would also more likely deter fraud from occurring in
    the first place.
        I was heartened to see that last week, the Auditing
    Standards Board issued an exposure draft which would, if
    adopted, replace the current audit standard relating to fraud.
    I am reviewing the proposal to determine whether it will
    accomplish what the Panel sought to achieve in its
    recommendation.
        Let me now turn to the topic of auditor independence and
    the scope of services issue. Because of the fundamental
    importance of auditor independence to the quality of and
    confidence in public
    audits, the Panel dedicated a full chapter of its report to
    auditor independence and specifically, to accounting firms'
    provision of nonaudit service to clients. Of the 126 publicly-
    related audit engagements studied by the Panel, the Panel
    identified 37 of those engagements in which services other than
    audit and tax had been provided. The Panel's reviewers did not
    find any instances in which providing those services to audit
    clients had a negative effect on audit effectiveness. Indeed,
    the Panel found that on roughly a quarter of such engagements,
    nonaudit services actually had a positive impact on the
    effectiveness of the audit.
        Based on an independent survey, we found that many people
    remain concerned that the performance of nonaudit services for
    audit clients creates at least the appearance of an impairment
    to auditor independence. And considering this thorny issue, the
    Panel did not reach a unanimous recommendation as to whether or
    not a ban on nonaudit services to clients was advisable, and if
    so, which services should be in or out. However, since that
    time, the SEC by rule has banned the provision of many nonaudit
    services to audit clients. And recently, all five of the major
    firms have agreed to end the performance of two types of
    nonaudit services to clients: First, financial information
    systems design and implementation; and second, internal audit
    out-sourcing.
        These types of engagements generate substantial fees for
    accounting firms, and as the Panel found, create at least a
    perceived threat to auditor independence.
        The net result of the action by the SEC and the decisions
    by the firms is that substantial amounts of so-called
    consulting dollars are off the accounting firms' table.
        Going forward, I am not confident that the lines drawn in
    the political or legislative process with regard to permissible
    scope of services will most effectively enhance the quality of
    public audits. I believe some expert entity, like the now-
    defunct Independent Standards Board, could develop a framework
    to identify independence threats and provide guidance on
    appropriate safeguards.
        I would strongly urge that whoever is charged with
    oversight of this issue, utilize the framework and methodology
    developed by the ISB, a clear guide to appropriate regulation.
        I also believe that audit committees should take it upon
    themselves to review nonaudit engagements with the company's
    auditor using certain guiding principles such as those
    recommended in the Panel's report.
        Let me now discuss the issue of governance of the
    accounting profession.
        The profession's combination of public oversight and
    voluntary self-regulation is extensive, Byzantine, and
    insufficient. The Panel found that the current system of
    governance lacks sufficient public representation, suffers from
    divergent views among its members as to the profession's
    priorities, implements a disciplinary system that is slow and
    ineffective, lacks efficient communication among its various
    entities and with the SEC, and lacks unified leadership and
    oversight.
        In light of these significant shortcomings, the Panel
    recommended the formation of a strong, unifying oversight body
    to help ensure the effective working of the profession's
    standard setting, monitoring, disciplinary, and special review
    functions.
        In the Panel's opinion, the experience and expertise of the
    Public Oversight Board could have served as a sound foundation
    for such an organization, a body to whom the SEC, the State
    boards, the auditing profession, and the public would look for
    leadership.
        Unfortunately, the POB has all but disbanded. There are,
    however, many similarities between our Panel's proposals and
    those considered by the SEC and the Congress.
        I am in favor of the creation of an organization to oversee
    the accounting profession, whether it is created by regulation
    or by legislation. If carefully structured to ensure effective
    oversight, disciplinary proceedings and rulemaking in an
    unpoliticized environment, such an organization could serve the
    same purpose we had in mind for an expanded POB.
        There are important considerations in structuring a new
    entity.
        First, it must be decided whether the new organization will
    assume an oversight role similar to that proposed by the panel,
    or whether it will assume some or all of the responsibilities
    of existing bodies. In this regard, if the new body is created
    by statute, the Congress should provide statutory
    confidentiality protection for the materials, interviews, and
    findings developed as part of the new organization's peer
    review, investigatory, and disciplinary functions.
        I believe the Auditing Standards Board remains the
    appropriate entity for establishing audit standards. But a new
    organization should oversee its activities and ensure that the
    ASB continually reexamines and addresses emerging auditing
    issues on a timely basis. And although today, the FASB is beset
    with political pressure that directly hampers the accounting
    standard setting process, in my view, the FASB remains the
    right entity for determining accounting standards.
        A second consideration is that any new oversight
    organization must remain independent from the profession, but
    mindful of current issues and trends affecting the profession.
    There should be an appropriate balance of members from outside
    the profession, public members, and the profession.
        Third, Congress should ensure that the oversight
    organization is sufficiently staffed and funded to carry out
    its sizable mandate. If a new organization assumes review
    responsibilities currently undertaken as part of the peer
    review system, it will have to do the job that is now done by
    hundreds of experienced employees, managers, and partners
    assigned by the firms.
        Finally, in view of the various efforts at the State level
    in the wake of Enron, I believe if a new oversight organization
    is created, Congress should ensure that national accounting
    firms are subject to a clear and consistent set of regulations
    and do not find themselves guided by multiple, conflicting sets
    of rules.
        Our capital markets are not broken. They may have been bent
    a little, but they are wonderfully resilient and have stood the
    test of time. I believe that much can and should be done by the
    accounting profession, and by the other participants in our
    safety net, to restore confidence in our capital markets and
    protect the investing public. And, I believe that Congress can
    play a constructive role in holding the type of hearings that
    have been undertaken by this Committee and, if necessary, once
    all the facts are gathered, by crafting legislation in the
    public interest. I do want to urge caution in whatever
    legislative proposals are advanced, because I fear that a
    hastily-crafted package could potentially harm, rather than
    help, the cause of audit reform.
        I appreciate the opportunity to give you my views, and I
    will be pleased to assist this Committee in whatever manner
    would be most helpful.
        Mr. Chairman, that concludes my remarks and I am sorry that
    I went a minute over here on my time.
        Chairman Sarbanes. We are very pleased to have you, sir.
        We will next hear from Lee Seidler, a General Partner and
    Senior Managing Director of Bear Stearns. Actually, he is now
    Managing Director Emeritus, as I understand it. And as I
    mentioned earlier, was the Deputy Chairman of the Commission
    headed by former SEC Chairman Manny Cohen.
        Mr. Seidler was a Professor of Accounting at New York
    University's Graduate School of Business Administration for 20
    years. He is the author of a number of books on accounting and
    taxation. And he served on the audit committees of a number of
    companies where he has been a member of the board of directors.
    And so, we are very much looking forward to his perspectives
    this morning.
        We would be happy to hear from you, Dr. Seidler.

                      STATEMENT OF LEE J. SEIDLER

                   DEPUTY CHAIRMAN OF THE 1978 AICPA

                COMMISSION ON AUDITORS' RESPONSIBILITIES

                MANAGING DIRECTOR EMERITUS, BEAR STEARNS

        Mr. Seidler. Thank you, Mr. Chairman and Senator Gramm, for
    inviting me to testify today.
        I should mention that from time to time I act as an expert
    witness for the Enforcement Division of the SEC. My title of
    Managing Director Emeritus of Bear Stearns calls for no work,
    no pay, but it does entitle me to free lunch at the partners
    table on occasion.
        [Laughter.]
        I will be presenting a summary of my written testimony, and
    I would request that my written testimony be placed in the
    record.
        Chairman Sarbanes. The full written testimony will be
    included in the record.
        Mr. Seidler. Mr. Chairman, you read the charge to the Cohen
    Commission. I would like to read a couple of sentences that
    follow, which are our conclusions:

        The charge suggests the possibility that a gap exists
    between the performance of auditors and the expectations of the
    users of financial statements. The Commission concludes that
    such a gap does exist. However, the principal responsibility
    does not appear to lie with the users of financial statements.
    In general, users appear to have reasonable expectations of the
    abilities of auditors and the assurances they can give. The
    burden of narrowing the gap falls primarily on auditors and
    other parties.

        We said that in 1978. And in 1978, we also said:

        The public accounting profession has failed to react and
    evolve rapidly enough to keep pace with the speed of change in
    the American business environment.

        And unfortunately, a quarter of a century later, I have to
    repeat that. It is identical.
        As you said earlier, most of our recommendations were not
    taken. I would like to mention a few that I would consider the
    most critical that were not taken, then move to a suggested
    action on your part.
        First of all, the Commission recommended that we stop
    auditing financial statements and instead, convert into an
    audit function. That is that the auditor be essentially the
    auditor of the auditor of the company and that the audit be
    essentially a continuous function. From that flowed our
    recommendation, which was revolutionary in those days, that all
    published quarterly reports be reviewed by auditors. And that
    was ultimately taken. However, if we move ahead 25 years, it
    would seem to flow that now all quarterly reports ought to be
    audited as part of an integrated audit with the year-end
    financial statements.
        Second, we recommended that auditors evaluate the financial
    statements as a whole. Commission member Leroy Layton called
    that the smell test.
        Then, and now, auditors have to evaluate the cumulative
    effect of uncorrected misstatements and decide what that is on
    the financial statements as a whole, and I will talk a bit more
    about that. We said, take a positive look. Evaluate the
    cumulative effect of the selection application of all the
    accounting principles and decide if the total picture presented
    by the financial statements is there. No steps have been taken
    on that at all.
        Auditors today, and then, opine that the accounting
    principles used by the company are acceptable. Then, as now, if
    a company changes an accounting principle as between one
    alternative to another acceptable alternative, the auditor and
    the company must opine that the new accounting principle is
    preferable.
        The Cohen Commission said, we see no reason to opine on
    preferability only when a change is made. So, we suggested that
    the auditor always ought to opine that when there are
    alternative accounting principles, the principles selected by
    the company are preferable. No action has been taken on that
    suggestion, either.
        And I would add that, certainly, a lot of the disclosures
    in Enron and some other cases have suggested another form of
    accounting principles, barely acceptable accounting principles,
    where transactions have been structured to fit under a line. I
    think if a preferability requirement were put in, that would
    eliminate the notion of just squeezing in under the line of
    acceptability.
        Materiality is an accounting concept that most people do
    not know about. Materiality, however, is the very strongest
    accounting principle. Every statement issued by the Financial
    Accounting Standards Board, and by its predecessors, the APB,
    includes the following statement:

        The provisions of this statement need not be applied to
    immaterial items. In other words, if the decision is made that
    an item is not material, it does not have to be accounted for
    correctly. No matter how egregious, no matter how authoritative
    the particular standard is, if it is not material, it does not
    have to be accounted for
    correctly.

        In my written testimony, I describe some of the bizarre
    accounting used by Waste Management, audited by Arthur
    Andersen, taking it from the SEC release. And that accounting
    was ultimately, although totally egregious, would have been
    spotted by one of my Accounting 101 students, was simply
    decided to be not material and therefore, was permitted to go
    through.
        The problem, however, is that there is no workable
    definition of materiality. There is a legal or legalistic
    definition, but really is not one that accountants can apply on
    a day-to-day basis.
        The Cohen Commission in 1978 noted that in 1975, the FASB
    had issued a discussion memorandum on materiality. That is the
    predecessor to going to work on a statement. Unfortunately,
    since then, not a single piece of paper has emerged from the
    FASB on materiality. The SEC issued a slight clarification
    recently, but still, there is no definition.
        I propose a simple standard that would resolve many of
    these problems. I said earlier that uncorrected misstatements
    in financial statements have to be aggregated and the
    conclusion has to be that they are not material.
        I raise this simple question--why have any uncorrected
    misstatements in financial statements? If the auditors find an
    error in the financial statements, why not correct it, no
    matter what it is, no matter how large it is?
        In the old days, if you will, precomputer days, making a
    correction near the end of the audit meant changing lots of
    schedules and changing the statements that have been produced.
    Today, I have a $149 accounting program in my laptop computer.
    If there is a set of financial statements in there and I put in
    a journal entry, one correcting entry, in about a hundredth of
    a second, new financial statements are created and it is all
    corrected. Therefore, there seems to be absolutely no logic in
    doing anything other than saying, when an auditor finds an
    error, correct it. Forget about the materiality.
        I will also tell you that, in my experience in testifying
    for the SEC, materiality was the major issue, and usually the
    major issue on uncorrected misstatements found by the auditors.
    This would eliminate that major problem.
        I won't dwell on the last one extensively, and that is to
    eliminate nontraditional management consulting because there
    seems to be a great deal of agreement that consulting outside
    the traditional realm of accounting should be eliminated.
        I will say that my conclusion is not based on empirical
    evidence, but as it was said by my companion here, it is the
    fees that are the real problem, the huge fees from consulting
    which make it much more difficult for an auditor to be the one
    who lost the Enron account or the Waste Management account. And
    I would like to take as much fee temptation away.
        I will offer a note of caution, however.
        Smaller businesses, nonpublic businesses, benefit greatly
    from the advice of their auditors. And in carving out any
    restriction on consulting, I would hope that you would take
    caution with the smaller businesses.
        I would point out that and I am, for example, on the board
    of a small public company, too small to afford an investment
    banker, and we have received some time ago a buy-out offer. Our
    audit partner came to the board and actually gave the best
    advice about how to deal with this particular buy-out.
        I would suggest that any advice, consulting, that can be
    given by the audit staff, by the audit partner, should not be
    precluded.
        My conclusion is that the profession hasn't acted in 25
    years, as you say. The question is, where do we go? I suggest
    my solution reluctantly.
        I am a CPA. My father was a CPA. I taught for 23 years. In
    a largely unregulated profession, I believe now we need to
    create a regulatory body and I would suggest a body in the
    image of the NASD, which has done an excellent job of
    regulating the securities industry. And I would propose that in
    that body, we do not have to create a new group from scratch. I
    propose taking the standard setting portions of the AICPA--that
    is, the Auditing Standards Board, the Accounting Standards
    Executive Committee, along with the SEC practice section--and
    move those into the new statutory self-regulatory organization.
        I would also suggest taking the Financial Accounting
    Standards Board and moving that into the same organization. I
    think by doing that, we would create a body which has both the
    standard setting and the regulatory ability, and would be able
    to act much better to create change.
        I would also say be careful not to interfere with the State
    societies when you do this because some of the State societies,
    particularly New York State Society of Certified Public
    Accountants, are far more creative than the American Institute
    of CPA's. I would like to allow them to continue in their way.
        In finishing, I would like to make a plea or just a
    recommendation that is not within your legislative purview, and
    that concerns accounting education.
        Twenty-five years ago, the Cohen Commission pointed out
    that there is no graduate professional education in accounting.
    Accountants have to go to undergraduate school, basically.
    There is no graduate professional schools, no graduate
    professional degrees
    offered. And we said that was robbing the accounting profession
    of some of the best manpower, those people who go through
    undergraduate and opt for graduate school later on.
        Twenty-five years later, with the number of students
    following that career perhaps tripling, the accounting
    profession, unlike law, medicine, architecture, compute
    science, business, physical and social sciences, and even
    pharmacy, does not offer a graduate degree.
        The accounting profession is essentially starving for
    manpower. It reminds me of the story of the farmer who, in
    order to save money, decided to cut down on feeding his cow a
    little bit every day. It was going very successfully, he
    finally got the feed down to zero, and the cow fouled the whole
    thing up by dying.
        [Laughter.]
        The accounting profession is doing about the same thing in
    its manpower. And I urge you--you cannot legislate it, but
    perhaps you can recommend to the State boards of accountancy,
    that they try to increase the accounting education
    requirements.
        In conclusion, I would just like to read a very brief
    statement which came from Senator Francis T. Maloney, who
    sponsored the 1938 Maloney Act Amendment of the Securities
    Exchange Act of 1934, which created the NASD. He said: ``This
    Act is designed to effectuate a system of regulation in which
    the members of the industry will themselves exercise as large a
    measure of authority as their natural genius permit.'' I hope
    you can do the same thing for the accounting profession.
        Thank you.
        Chairman Sarbanes. Thank you very much. It is very helpful
    testimony.
        We will now hear from Arthur Wyatt, retired Managing
    Director of Arthur Andersen, Professor Emeritus of Accountancy
    at the University of Illinois, his alma mater. Mr. Wyatt has
    served as President of the American Accounting Association, has
    been a member of the Financial Accounting Standards Board,
    Chairman of the International Accounting Standards Committee.
        I ought to mention that both Mr. O'Malley and Professor
    Wyatt are members of the Accounting Hall of Fame, which is
    located at Ohio State University.
        Actually, that group includes Arthur Andersen himself, who
    had a very distinguished career, as I have noted here on a
    couple of occasions. And Charles Bowsher, former Comptroller
    General of the United States, who will be before the Committee,
    not next week, but the week after next.
        Mr. Wyatt, we would be happy to hear from you, sir.

                   STATEMENT OF ARTHUR R. WYATT, CPA

                 FORMER CHAIRMAN, AMERICAN INSTITUTE OF

                CERTIFIED PUBLIC ACCOUNTANTS' ACCOUNTING

                     STANDARDS EXECUTIVE COMMITTEE

               FORMER CHAIRMAN, INTERNATIONAL ACCOUNTING

                          STANDARDS COMMITTEE

                 FORMER PARTNER, ARTHUR ANDERSEN & CO.

                   PROFESSOR OF ACCOUNTANCY EMERITUS

                         UNIVERSITY OF ILLINOIS

        Mr. Wyatt. Thank you, Mr. Chairman, Senator Gramm, Senator
    Miller. I am pleased to be before you today. I have some brief
    prepared remarks----
        Senator Gramm. Arthur, would you pull that microphone up a
    little bit?
        Mr. Wyatt. Yes. And I would respectfully request that the
    full text of my written testimony previously submitted to you
    be entered into the public record.
        Chairman Sarbanes. Without objection, it will be included
    in the record in full.
        Mr. Wyatt. Before dealing with the specific issues raised
    in your invitation to appear here today, however, it may be
    helpful to provide some background on the evolution of the
    large public accounting firms over the last 35 years. My
    observation is that over this period, the attitude of the
    leadership of the large accounting firms has gradually shifted
    from an emphasis on the quality of accounting and auditing
    services provided to clients, to emphasis on growing top-line
    revenues. The impact of this attitudinal change within the
    firms has been significant, in my view.
        No longer is technical expertise and leadership the obvious
    avenue to progress within the firms. Rather, expansion of
    clients served and expansion of client services are viewed as
    the primary drivers. And obviously, the loss of a client is a
    negative in one's career path.
        Since many decisions required of audit firm managers and
    partners are judgmental in nature, rather than clearly
    prescribed by external forces, such judgments are, at the
    margin, sometimes influenced by perceptions of the attitudes of
    leaders of a given firm.
        If those perceptions by audit firm personnel are that the
    loss of a client is damaging to one's career path, the
    judgments made may be more in the direction of keeping the
    client than to achieving fair presentation in financial
    statements.
        I believe the leadership in the various firms needs to
    evaluate how well their existing organizational structures and
    reward policies are serving what has to be their primary
    focus--the delivery of high-quality, professional accounting
    and auditing services to their audit clients.
        While these observations may not be very helpful in
    considering legislative initiatives, I believe they are crucial
    for the major accounting firms to address if the firms wish to
    survive in the private sector as respected reporters on the
    financial situation and results of operations of business
    enterprises.
        The evolution of the drift toward increased emphasis on
    commercialization and reduced emphasis on professionalism led
    the large accounting firms to expand the range of services
    provided to their audit clients.
        Many of these services are logically best provided by the
    audit firms--tax return preparation and tax planning,
    evaluation of the accounting alternatives for planned
    transactions, assistance with
    financial statement preparation for regulatory purposes, audits
    or reviews of prospective acquirees in business combinations,
    are some examples. Indeed, any additional services that are
    directly related to assuring the fairness of presentation of
    client financial statements are proper activities for audit
    firms to undertake.
        On the other hand, as the range of services provided
    broadened, some were clearly creating potential for conflicts
    with the basic audit services. For example, rendering internal
    audit services for audit clients was never a sound idea.
    Likewise, services related to the design of financial reporting
    systems places the auditor in an awkward position if the system
    does not function as anticipated.
        Actuarial services, executive searches, advice on specific
    investment decisions, and many more services of this nature
    that evolved over the years to generate increased revenues, but
    either have little relationship to the annual audit or may
    create conflicts of interest, should no longer be permitted by
    audit firms for their audit clients.
        Drawing lines in this area will not be an easy task. Given
    the current environment, it is certainly possible that some
    regulations or legislation will suggest scope-of-service
    restrictions that will damage the auditor's ability to develop
    the best possible basis for expressing an opinion on the
    fairness of presentation of the client's financial statements.
        The initiatives in this area need to be undertaken, but
    they must be undertaken with care so that they do not frustrate
    the auditor's ability to complete top-quality audit services.
        Now some comments on accounting standard setting.
        Too often, the Financial Accounting Standards Board, FASB,
    has departed in its final standards from the concepts that it
    has represented will guide its decisions, generally because
    interested parties have not only raised objections to
    conclusions tentatively expressed, but also have effectively
    lobbied against adoption of those decisions the Board has
    signaled.
        If the accounting standard setting process is to achieve
    its objectives of providing guidance on appropriate accounting
    for transactions and events of an entity, the process must be
    recognized by all participants as being primarily an
    intellectual process and not primarily a political process.
        The Board often receives negative comments from industry
    constituents, from auditing firm representatives, from Members
    of Congress, as well as others. When these comments become part
    of an organized campaign to undermine the direction a standard
    is taking and recommend alternative conclusions that are not
    conceptually sound, the mission of the Board is frustrated. Now
    this is particularly true when the interveners are Senators and
    Representatives, who, as part of their commentaries, threaten
    some type of legislation to frustrate the direction that the
    Board is moving.
        While Senators and Representatives have a legitimate
    interest in the workings of the Board, they need to recognize
    that their interventions may well lead to Board decisions that
    are not in the best interests of investors and the broad
    business community.
        Standards that are conceptually sound need not run hundreds
    of pages to thwart those who would attempt to subvert the
    intent of the standards. Each standard issued by the Board
    should contain in the clearest English possible the objective
    or intent the Board intends to achieve by issuing the standard.
        Each standard issued by the Board should contain a clear
    statement that any one who is applying the standard should
    review carefully its application to satisfy himself or herself
    that the objective specified by the Board has in fact been best
    achieved through the application that has been adopted.
        With regard to audit committees, at least the audit
    committee chairman, and preferably all audit committee members,
    should have experience in evaluating the business risks and
    should be sufficiently conversant with accounting issues to
    raise appropriate questions with an ability to evaluate
    responses received.
        Audit committees should be especially curious about the so-
    called audit adjustments proposed by auditors, but not made by
    company accounting personnel.
        Audit committees should pressure company accountants and
    the auditors to resolve any open adjusting entries, either by
    the company accepting the entry for recording or the auditor
    concluding that the proposed entry should never have been on
    the schedule in the first place.
        The audit committee concept is a sound one. Through efforts
    of the New York Stock Exchange and the SEC, improvements in
    committee composition and mission should continue to evolve.
    Honest managements and responsible auditing firms should
    welcome audit committee involvement when such committees are
    constituted properly, with knowledgeable individuals willing to
    gain an understanding of the underlying business risk issues
    and raise questions on appropriate accounting and disclosure
    matters.
        My experience with disciplinary mechanisms, as well as my
    knowledge base in this area, is sparse. The current mechanism
    under the auspices of the American Institute of Certified
    Public Accountants, however, is clearly not working.
        Over the years, the Securities and Exchange Commission has
    been a generally effective agency working toward improvements
    in financial reporting. Even so, its resources have probably
    been far too limited to achieve the optimum level of success in
    its diverse objectives.
        I would be inclined to provide increased funding to the
    SEC, to have it become and assume the principal role in
    overseeing the
    effectiveness of the financial reporting process. Creation of a
    new agency to undertake this responsibility seems unnecessary
    in view of the record established by the SEC over the past 65
    years.
        Thank you, Mr. Chairman. I very much appreciate this
    opportunity and would be pleased to respond to questions.
        Chairman Sarbanes. Thank you, sir. Very helpful testimony.
        We will now hear from Professor Briloff who is the Emanuel
    Saxe Distinguished Professor Emeritus at Baruch College of the
    City University of New York. He holds a doctorate from NYU
    Graduate School of Business Administration, and is a Certified
    Public Accountant in the State of New York. Professor Briloff
    has practiced public accountancy since 1944, almost 60 years.
    He is the author of a number of books and hundreds of articles
    bearing on many of the topics that are before the Committee.
        Professor Briloff, we are pleased to have you with us this
    morning. We would be happy to hear from you now.

                    STATEMENT OF ABRAHAM J. BRILOFF

             EMANUEL SAXE DISTINGUISHED PROFESSOR EMERITUS

                    BERNARD M. BARUCH COLLEGE, CUNY

        Mr. Briloff. Thank you, Mr. Chairman. I appreciate the
    opportunity to appear before you today.
        About the only light moment for the next 10 minutes might
    be derived from the quotation that you read from The Wall
    Street Journal, which reminded me of the old quip going way
    back, that financial statements are very much like bikini
    bathing suits--what they reveal is interesting, what they
    conceal is vital.
        [Laughter.]
        I would like for my prepared statement----
        Chairman Sarbanes. Professor Briloff, you are going to have
    to try to keep that microphone close to you. Otherwise, the
    system doesn't work so well.
        Mr. Briloff. I would like for my prepared statement to be
    included in the record: ``Accountancy and Society: The Covenant
    and the Desecration.''
        Chairman Sarbanes. The full statement will be included in
    the record, without objection.
        Mr. Briloff. Mr. Chairman and Members of the Committee on
    Banking, everyone who is privileged to enter into a profession
    is presumed to have entered into a covenant, a covenant with
    the forbears of his or her profession who have created a status
    and stature of that calling. And by definition, since a
    profession demands service to society, there is also the
    covenant with society.
        The profession of accountancy has a very special covenant
    because, in the infancy of the securities laws, about 1934 or
    1935, by a 3 to 2 vote, mind you, the accounting profession,
    and the private-sector of the accounting profession, was given
    the responsibility, the franchise of auditing the financial
    statements of publicly-owned companies, the registrants with
    the SEC.
        That is a most valuable franchise bestowed on my profession
    by the action of the Securities and Exchange Commission some 65
    years or so ago. It is that covenant which I say is being
    violated.
        Now the responsibility of the auditing profession, of the
    accounting profession to society, Mr. Chairman and Members of
    the Banking Committee, goes beyond just the financial
    statements, beyond the debits and credits, beyond the balance
    sheets and the income statements and the statements of cash
    flows.
        It goes to reviewing the entire process of corporate
    governance and accountability, the totality of governance and
    accountability, because some agency has to be there to make
    certain that the corporate engine, the catalyst for the
    American capitalistic system, American capitalism, is
    functioning optimally. That is the role and the responsibility
    of the accounting/auditing profession, which we should be
    charged to fulfill.
        If we reflect for just a brief moment on the effectiveness
    of the corporate operations impacts on the individuals more
    directly, more intimately, more regularly, more continuously,
    than does Government. That which we eat and drink, where we
    live, how we live, how we carry on our activities, our
    mobility, all are dictated and directed by corporate activities
    and corporate decisionmaking.
        Certainly, our economic present and our economic future are
    critically impacted by the way in which our corporate
    enterprise and our American capitalistic system is functioning,
    again, with corporations as the catalyst. So it is beyond the
    mere financial statements toward which I look at in terms of
    the canvas of the auditor's role and responsibility.
        Now to assure the effectiveness of that corporate
    enterprise, where, mind you, as things have worked out, we have
    that power-without-property syndrome, as Adolf Berle described
    it, whereby enormous resources have been delegated by the
    owners of those resources to managements which, in turn, or
    who, in turn, exercise the power.
        It is to assure the effective exercise of that power that
    we have created the system of corporate governance and
    accountability which, if it were to function optimally, would
    assure the fulfillment of that American corporate enterprise.
    That system with management at its center then moves outwards
    to the board of directors, to the management committee, to the
    independent audit committee, to the independent auditors, to
    the Securities and Exchange Commission, to the Congress, to the
    courts, including at various points the professions of the
    journalists and the lawyers.
        All are embraced by what might be termed the system of
    corporate governance and accountability. It is when that system
    breaks down and where the auditors fail to fulfill their
    responsibility that we run into the Enron syndrome.
        Now some benchmarks to history which were provided by Mr.
    O'Malley, Professor Seidler, Professor Wyatt and by repeating
    them, it is saddening. We have had all of these things
    occurring heretofore. They are all so self-evident. Why hasn't
    the situation been improved in order to accomplish what
    everyone recognized over the years as being essential?
        In 1976, there was the staff study prepared for the
    Committee under Senator Lee Metcalf called the Accounting
    Establishment, which described the apparatus which prevailed.
    And we then had hearings under Senator Metcalf in 1977, from
    which there then evolved the AICPA's Division for Firms, where
    they were going to be doing all of this self-discipline and
    self-regulation, especially with the Public Oversight Board to
    be overseeing all of this.
        Why should it not have been accomplished?
        Following that, fortunately, we do have the independent
    audit committee proposals, which are very, very vital. We then
    have the S&L crisis in the 1980's. We have the Foreign Corrupt
    Practices Act in 1977. We have Title III of the Private
    Securities Litigation Reform Act of 1995. All of those were
    supposed to correct the problems which we then recognized. And
    here we are in 2002, seeing the problems, even more critical,
    even more serious than had prevailed heretofore.
        Where do we go from here? That is the reason I know that
    you invited me to appear before you today.
        First, I mean this reasonably seriously, we do not need any
    new promulgations from the Financial Accounting Standards
    Board. I maintain that we have a surfeit of accounting rules
    because the Board does not promulgate standards. They
    promulgate rules. And the moment they promulgate rules, the
    firms go back to their Ouiji boards or their computers and they
    develop programs--how can we circumvent those rules if we want
    to circumvent those rules, as we saw in the cases of leases, as
    we saw in the cases of business combinations.
        Thirty-two years ago, Mr. Chairman, Members of the
    Committee, I testified before Senator Hart on the very matter
    of business combinations. I spoke against pooling.
        Some months ago, the FASB aborted pooling, requiring
    purchase accounting. And I say to you in all seriousness, Mr.
    Chairman, Members of the Committee, and others who are here,
    the rules that they now have for purchase accounting makes the
    situation even more grievous than that which prevailed before
    the FASB promulgations aborting pooling because of the
    presumptions that are implicit in purchase accounting in the
    nonamortization of goodwill. But I want to pass from that.
    Where do we go from here?
        Very quickly, Mr. O'Malley referred to the introduction of
    the
    forensic accounting procedures. I say, amen. We know what to do
    when we are involved in the pathological process of a post-
    mortem after a fraud has been discovered.
        Arthur Andersen did an extraordinarily beautiful job when
    they did the post-mortem in the Cendant situation, identifying
    all that Ernst & Young should have done. They did an
    extraordinary job. And after I completed my analysis of that
    and congratulating
    Arthur Andersen, lo and behold, Sunbeam surfaced where Arthur
    Andersen, as the auditor of Sunbeam, replicated some of the
    matters that were found with respect to Ernst & Young.
        So, we know what to do. Let's do it.
        Second, consistent with what Mr. O'Malley indicated, an
    agency under the SEC maintain a registry of firms who have
    committed themselves to the audit of registrants with the SEC,
    who, by demonstrating their quality, and the system of checks
    and balances within the firms, have demonstrated that they are
    qualified to be there. And such an agency would be in the
    position of disciplining and possibly delicensing or removing
    them from the registry.
        Third, this involves a sea change. I do not want to deceive
    you.
        As a part of the proxy material where the shareholders vote
    to approve the designation of auditors, the shareholders should
    direct that the auditors, on their own initiative, prepare the
    financial statements which would best replicate or reflect
    economic reality as the auditors see it, without hindrance.
        Now the sea change comes about in this fashion. If you look
    at the auditor's opinion, they do not say, we prepared the
    financial statements. They do not say, these are our financial
    statements. No, they say these are management's financial
    statements, which, somehow or other, have gone above the
    threshold of GAAP.
        Now maybe that is not as high a threshold as we would like.
    It may not be as close to economic reality as it could be. But,
    yet, it passes. On their initiative, clearly and overtly, that
    it is there, the auditor's statements.
        Then I come to the sine qua non, which I know is most
    difficult to accomplish, but yet, so very important. For those
    firms who have qualified to be the auditors of publicly-held
    enterprises and applied for that listing, I propose that the
    statements be developed by the independent auditors on their
    initiative, clearly and overtly that its their, the auditors
    statements--absolute--repeat, absolute, underscored--
    divestiture of all nonaudit services.
        I want the auditors of publicly-owned enterprises to be
    something of a priesthood, as I have indicated in different
    contexts, one where they recognize, as I indicated in the
    opening remarks, the importance of their role. By doing so and
    emphasizing the transcendent import of the audit, the firm's
    personnel would realize how important that audit is. The whole
    chain of command would be oriented toward the independent
    audit, and it would have a salutary effect because the
    downsizing would permit the tone at the top, which we would
    presume to be the kind that Professor Wyatt had in mind and
    that Mr. Treadway had in mind when he spoke of the tone at the
    top, when he spoke of where the profession should be, would be
    filtered down.
        So instead of rainmaking being the sine qua non within the
    firm, it would be the quality of the audit.
        Then, I concluded my prepared statement by saying, what if
    we continue to fail by saying, okay, another committee to be
    designated by the AICPA. Yet another commission like the Cohen
    Commission. Another period of study.
        I say, nonsense.
        If we fail, then I respectfully suggest that the SEC
    pronounce, we do not require certification of the financial
    statements by independent auditors. Rely on the financial
    statements from management, reviewed by the independent audit
    committee, with whatever counselors they might want to select.
    But then add at the end,
    caveat emptor, because to me the worst deception is to continue
    to pretend that the public is getting a safe product when we
    know, as we have heard from all the testimony going over 25, 30
    years, that there is a quagmire under us.
        Thank you. I do not know how many minutes I have exceeded,
    and if I have, I am sorry.
        Chairman Sarbanes. Thank you very much, Professor Briloff.
        We will turn to our concluding panelist, Bevis Longstreth.
    I am pleased to welcome him back before the Committee. Mr.
    Longstreth is a retired Partner at Debevoise & Plimpton in New
    York. He was an SEC Commissioner in the early 1980's, a Member
    of the Board of Governors of the American Stock Exchange, and
    he has written frequently on corporate governance, banking, and
    securities law.
        Bevis, we are very pleased to have you here. We would be
    happy to hear from you.

                     STATEMENT OF BEVIS LONGSTRETH

                   MEMBER OF THE O'MALLEY COMMISSION

                       FORMER COMMISSIONER OF THE

              SECURITIES & EXCHANGE COMMISSION, 1981-1984

                 RETIRED PARTNER, DEBEVOISE & PLIMPTON

        Mr. Longstreth. Thank you, Senator. It is a pleasure to be
    here.
        I agree with so much that has been said. But I will try to
    say a few things and perhaps put specific points on a few of
    the observations that have already been made.
        I want to say that I am not an altruist in my interest in
    this subject. I serve on the board of two very large money
    management firms. We have a great stake in the trustworthiness
    of financial statements.
        I am going to talk about reforming the audit profession,
    which is our theme. My thesis on that is simple. I think the
    profession needs reforms in two major respects. First, an
    effective rule that prevents the delivery of most nonaudit
    services to audit clients. And second, an effective system of
    self-regulation.
        Despite the SEC's tortured process which gave birth to a
    new rule, 2-01, just a year ago, the threat to an auditor's
    independence from performing nonaudit services allowed by that
    rule remains palpable. And despite the enlarged charter that
    the Public Oversight Board was given after extensive
    negotiations led by the SEC, the POB being until recently the
    most promising vehicle for some kind of at least partially
    effective self-regulation, the truth is an effective system
    does not exist and cannot be achieved without legislative
    reform.
        So let me start--what is wrong with the new SEC rule beyond
    its hideous complexities?
        In many respects, it can be criticized, but I just want to
    talk about one. The SEC adduced strong evidence that providing
    to one's audit client nonaudit services of any kind or kinds,
    if large enough in terms of fees paid, may impair independence.
        Despite this powerful predicate that the SEC established
    for rulemaking, the rule adopted fails absolutely in addressing
    this concern. It is a giant omission and it touches upon one of
    the two fictions that I want to address today.
        Fiction number one is the profession's claim, and it has
    been a consistent claim for decades, that payments by an audit
    client to its auditor for consulting and other nonaudit
    services, no matter how large, will never impair independence.
        Appearances, that is a problem, but in fact, don't worry
    about it.
        Now it defies common sense to claim that large payments for
    nonaudit services, which management could easily purchase or
    threaten to purchase from service vendors other than the
    auditor, do not function as a powerful inducement to gain the
    auditor's cooperation on how the numbers are presented.
        I was delighted to hear Mr. Seidler make the same point.
        Audit account partners are expected by their firms to
    establish close relationships with the managements they serve.
    They are expected to cross-market to management as full a range
    of nonaudit services as possible, and that is a natural thing
    to do if they are allowed to do it. They are compensated by
    their firm on the basis, among others, of how much revenue they
    produce from their audit clients. Their stake in maximizing
    revenue from these clients through cross-marketing is as
    natural and compelling as any financial reward could be.
        To claim that these incentives have no adverse impact on
    both the fact and the appearance of independence is a fiction,
    pure and simple.
        One basic problem with nonaudit fees which exists
    regardless of their magnitude, but grows more serious as the
    fees grow larger, is a basic conflict of interest. The conflict
    derives from the fact that in performing both audit and
    nonaudit services, the audit firm is serving essentially two
    different sets of clients--management, in the case of nonaudit
    services, which typically are commissioned by and performed for
    management, and the audit committee, in the case of audit
    services, which now are by rule commissioned by the audit
    committee and performed for that committee, the shareholders
    and all those who rely on the audited financials in deciding
    whether to invest.
        So the audit committee is a fiduciary in respect to each of
    these two very distinct client groups, duty-bound to serve each
    with undivided loyalty. It is obvious, and a matter of common
    experience, that in serving these different clients, the firm
    will be regularly subjected to conflicts of interest. And these
    conflicts will tear at the heart of independence.
        What is independence? It is the absolute freedom to
    exercise undivided loyalty to the audit committee and the
    investing public. That is what we are trying to protect; to
    assure the auditor has the absolute freedom to be independent.
        When other loyalties tug for recognition, and especially
    when they come from those in a position to enlarge or shrink
    one's book of business, on which depends one's partnership
    share, and the share of one's staff, the freedom necessary to
    meet one's professional responsibilities as an auditor is
    challenged.
        So there is a big hole in the rule.
        To plug the hole, I suggest a simple exclusionary rule
    covering most nonaudit services. And I am not suggesting
    Congress should get into the business of writing that rule. But
    I am suggesting the rule needs to be written by an SRO or by
    the SEC, and the SRO is the other subject that I will come to
    shortly.
        An exclusionary rule would define the category of services
    to be barred as including everything other than the work
    involved in performing an audit and other work that is integral
    to the function of an audit.
        In general, the touchstone for deciding whether a service
    other than the straightforward audit itself should be excluded
    is whether the service is rendered principally to the client's
    audit committee acting on behalf of investors to facilitate or
    improve the quality of the audit and the financial reporting
    process, or is rendered principally to provide assistance to
    management in the performance of its duties.
        The exclusionary rule could include a carefully
    circumscribed exception to permit certain types of nonaudit
    services to be rendered by the audit firm to its client, where
    special circumstances are found by the audit committee to
    justify so doing. The rule would be refined and enforced by a
    legislatively empowered SRO, which is the subject of my second
    recommendation for reform.
        Beyond the two-client problem I have described, and the
    conflict, there are many additional arguments for exclusion and
    they are summarized in my written testimony, which I hope can
    be included in the record.
        Chairman Sarbanes. Without objection, the full statement
    will be included in the record.
        Mr. Longstreth. I want to mention just one argument here
    because it seems so compelling to me.
        Independence is given important meaning in many situations
    analogous to auditing, where potential conflicts, while not
    always certain to impair independence, nonetheless are
    prohibited in the interest of avoiding the problem. And here's
    the example.
        Consider the independence necessary for a director to serve
    on an audit committee of a public corporation. For a director
    to be independent for that purpose, as now generally defined by
    bodies that have looked at this, a blue ribbon committee,
    actually, that looked at it--Shaun's committee was not blue
    ribbon, but I think it was a great committee. I served on it.
        Chairman Sarbanes. Well, you have bestowed a blue ribbon
    it.
        [Laughter.]
        Mr. Longstreth. But the blue ribbon committee said, for a
    director to be independent enough to serve on the audit
    committee, he must not accept any compensation from the
    corporation for any service other than the service of being a
    director. Now, he may be extremely valuable in serving that
    corporation in some other way. And management may really feel
    frustrated that they cannot hire him for that purpose. But they
    cannot because it would impair his independence.
        The common-sense parallel to the auditor is both exact and,
    in my view, compelling. Compensation for services other than
    the audit function can threaten independence.
        Now the second fiction I want to address, fiction number
    two, is the profession's three-fold claim that: First, the
    profession has the ability and motivation to regulate itself
    voluntarily; second, it has done so effectively over the past
    several decades; and third, there is no need for a
    legislatively empowered regulatory body led by persons
    independent of the profession. And if you haven't heard this
    argument enough yet, you are going to hear it in spades as the
    possibility of legislation on this subject increases.
        The present system of voluntary self-regulation is
    completely unsatisfactory. If one looks closely at that system,
    what one sees is a bewildering maze of overlapping committees,
    panels and boards piled one on top of the other. They are
    characterized by complexity and ineffectiveness in matters of
    central importance to any effective system of regulation.
        And since I am out of time, I am going to jump over----
        Chairman Sarbanes. Take a couple of minutes to finish up.
        Mr. Longstreth. Okay. There are very specific reasons why
    only a legislatively empowered SRO can have a chance at
    effectiveness.
        The NASD is such an animal and it has not had an
    unblemished record of effectiveness. It had a chance and it has
    gotten better, and it is doing now, I think, a very important
    job, which the SEC simply does not have the resources to do
    itself. So, we need to
    replicate some thing like that. But the specific reasons, which
    are
    rooted in issues of antitrust law, self-incrimination and so
    on, are laid out in my testimony.
        I won't go through that now because it is somewhat
    technical. But it is critically important to realize that
    voluntary action will never do the job. And the big element
    that is missing from volunteerism are these protections against
    abusing the right against self-incrimination, the protections
    against violating the antitrust laws, the ability to throw
    people out of the profession if they do not cooperate, give
    evidence, turn over documents, testify before the SRO, and so
    forth.
        So it is an easy conclusion to reach when you understand
    the details. It has to be legislatively empowered.
        Now, I just want to make one more point. We have had a lot
    of history. I am going to go back even further than the others,
    if I may, because I think there is an important historical
    analogue that gives meaning to the opportunity you have now on
    the back of Enron, as momentum builds, to actually do an
    important legislative job.
        Senator Gramm has returned, I want to say something because
    I was impressed with your statement at the outset of this
    hearing. You said your first rule was to do no harm, and I
    applaud that.
        I am not a fan of lots of legislation, take a law kind of
    thing, to solve every ill. But in regard to audit reform, I
    hope that you and all the others in the Senate will seize the
    opportunity that only lawmakers have right now to prevent
    further harm.
        I think, as you have heard--if you look at the sweep of
    history--the harm from bad financials has been increasing,
    there is a problem, and it can only be solved by the
    legislature, by lawmakers.
        But the analogue I wanted to make was to the Great
    Depression and the fact that, with the huge losses of
    depositors, the Congress recognized the need that the public
    had to feel that the money they put in banks was safe. It had
    to be safe and they had to feel it was safe. And the result of
    that was many laws, maybe too many laws. But the FDIC was
    created and that law and the safety net for deposits that it
    provided has been around a long time.
        The problem is that since the 1930's, money has migrated
    out of bank deposits and into the capital markets, from bank
    deposits to money market mutual funds and, increasingly, to
    equities. And with this shift in how the public saves its
    money, saves its retirement funds, should come a shift by
    lawmakers in fashioning the kinds of protections that public
    investors need.
        I am not suggesting a safety net under equities. That would
    do more harm than good. But what I am suggesting is a system
    that you can help create, indeed, must be the absolute
    essential element in creating, a system assuring that, when our
    corporations present their financial condition to the world,
    what they present is worthy of public trust.
        The auditors are the last line of defense. Security
    analysts, you can fuss with them, but you are never going to
    fix their conflicts entirely. But auditors are not
    entrepreneurs. They are the last line of defense. Their job is
    to vouch for, render trustworthy the financial statements of
    the corporations they serve in this way, and the public that
    they serve in this way.
        We know in recent years with disturbing frequency the
    numbers are fudged, earnings are managed, and sometimes, on the
    slippery slope, they become false and misleading deliberately.
        So legislative action is needed now because, with these
    growing numbers of audit failures, culminating, but not ending,
    with Enron, the public's trust and confidence has really been
    badly shaken, just as in the Depression. But now, it is
    shaken--the public is shaken as investors, not as depositors,
    and the loss of trust is directed to the reliability of
    financial statements, not to the bank deposit.
        I hope that the hearings will convince Congress that it can
    and must restore the public's confidence in the financial
    statements by taking the steps I have outlined to create an
    effective SRO with independent leadership, which is critical.
        Now there has been consideration given to rotation of
    auditors, and I think that is worth studying.
        I thank you for the extra time and I will stop now.
        Chairman Sarbanes. Well, thank you very much. This has been
    an extremely helpful panel, not only for your testimony, but
    also the evident care and effort that went into the prepared
    statements that have been fully included in the record and
    which will be subject to careful study.
        Senator Gramm has another conflicting engagement. I will
    yield to him to do his questioning first, and next to Senator
    Miller, and then I will pick up myself.
        Senator Gramm. Mr. Chairman, let me try to be brief, given
    your generosity.
        First, I want to thank each of you for outstanding
    presentations.
        I believe there is a growing consensus on this Committee
    that we need to strengthen this independent accounting standard
    setting board. And so, I want to pose a question to each of you
    that is counter to the principle that I am moving toward, or at
    least raising a concern about it.
        I think maybe I am the only person who has this concern.
    The concern basically is, there is a growing recommendation
    that we need more people who are not CPA's on this accounting
    board. There is a growing recommendation that we have more
    independent people involved in the process. There is a growing
    recommendation that we give this board unchecked substantial
    increases in power.
        Mr. Wyatt brought up setting standards and talked about
    political involvement, and I can comment on it because I have
    consistently taken the view that while some of the proposals of
    FASB are proposals that I have never been able to understand,
    not that I think I lack the analytical powers. It is just--the
    issue about stock options and how they should be treated is an
    example. But I have consistently taken the position that
    whatever they decided, it was infinitely superior to anything
    Congress could decide.
        So, I agree with part of the point Mr. Wyatt makes, but not
    all of it. I have always taken the position that, whether I
    agreed with the board or not, I did not want to get in their
    business.
        That is the do-no-harm part.
        But here's the point. If we create this board and we give
    it increased power, which I believe we are going to and that I
    am going to support, does anybody have concern about it losing
    touch with the reality of the accounting profession? Does
    anybody have concerns about when we give it financial
    independence and so it doesn't have to go out and get people to
    contribute to its support, that we could lose the kind of
    feedback and input from grassroots accounting that at least I
    believe is important?
        I guess the oldest example of the concern that I am raising
    goes back to Plato's Republic. The ancient Greek philosophers
    believed that the solution was to produce perfect men, and then
    they would be given authority. Our founders understood there
    has only been one perfect man and that you had to do checks and
    balances.
        But the whole thesis of this board, it raises the question,
    and I will get to the question, that was raised in response to
    the concern about Plato's Republic--who is to guard the
    guardians? Where are the checks and balances? I understand the
    need for independence. But where are the checks and balances?
    And do any of you all have a concern that, if we go too far in
    isolating and insulating this board, that we could create a
    problem in that direction?
        Let me just start over here on the left and we will just go
    down, if you could give me your response.
        Mr. Longstreth. When you talk about the board, you are
    talking about the FASB. Is that right?
        Senator Gramm. I'm talking about this new successor board
    that we will give subpoena power, that we are going to give
    lots of power to. We are going to give them a permanent funding
    source.
        Mr. Longstreth. Okay.
        Senator Gramm. And we are going to give them a lot of
    power. The concern I have is, that I am raising is, does
    anybody have concern about the loss of--that they might cease
    being responsive to the profession, that they might lose touch
    with people who are actually doing audits every day?
        Mr. Longstreth. Yes, I understand. Well, I think the checks
    and balances that you would build into it would start with very
    clear oversight by the SEC, just as we have now with the NASD.
    Of course, you would have constant Congressional oversight
    because it would be created by Congress and it could be changed
    or eliminated by Congress. You would have limited terms for the
    leadership. And I hope that they would be appointed by people
    who are public officials charged with public responsibility.
        Senator Gramm. You do not want that, believe me.
        [Laughter.]
        Mr. Longstreth. You do not?
        Senator Gramm. No, I do not think so.
        Mr. Longstreth. Well, it is worth a debate.
        Chairman Sarbanes. Like the Chairman of the Fed, Chairman
    of the SEC, that panel that appoints the group.
        Mr. Longstreth. That is what I was talking about, yes. That
    is right. Sort of like the Chrysler board that was created.
    That was an ad hoc board, but it had the comptroller general,
    it had the chair of the Federal Reserve Board.
        I think there should be a committee of public officials who
    are responsible to the public, the investing public, in a
    certain way, who would, as a committee, fill the slots and fill
    the vacancies. They would include, it would seem obvious, the
    chair of the SEC or the SEC itself, the Fed, the comptroller
    general, and maybe someone else. And it could have some
    private-sector people, too.
        It seems to me that those are the classic checks and
    balances we have--limited terms, appointment by other people,
    oversight by the SEC, including sanctioning powers of the SEC.
    They can sanction the NASD, and in fact did a few years ago.
    The same formula.
        Chairman Sarbanes. Mr. Seidler.
        Mr. Seidler. I do share your concern. I think one example
    we have is FASB, which, although it has accountants on it, sits
    in bucolic Connecticut, almost isolated from the rest of the
    world and has produced almost other worldly pronouncements in
    certain cases.
        I foresaw in my proposal that the membership of the Board,
    of the SRO, which I call the National Financial Reporting
    Board, contain a significant number of practicing professional
    accountants.
        I won't get into the majority/minority issue, but I think
    we have to look back in history to the old Accounting
    Principles Board, which did a far better job and contained
    frequently the top technical partners in the firms who were, as
    Professor Wyatt has said, also the managing partners of their
    firm. So, I would like to see substantial representation from
    practicing or very recently retired practicing.
        Chairman Sarbanes. Can I invite you to get into the issue
    of whether substantial means majority or minority?
        Mr. Seidler. Well, I would think it would be minority
    because I can see three groups represented. First would be
    public people. There would have to be people with an overview,
    I think. Second, I would like to see the financial community
    represented. And third, the professional accountants, depending
    on the number that one had and, possibly, at least one member
    from industry.
        Industry has exhibited a great self-interest in the
    standards----
        Senator Gramm. What do you mean by industry?
        Mr. Seidler. Representatives like a CFO from a major
    company.
        Senator Gramm. Okay.
        Mr. Seidler. Industry has been showing its self-interest.
    Nevertheless, the preparer community has to have some say over
    the structure. So, no, I do not see a majority of practicing
    professionals, but I see a significant minority.
        Mr. O'Malley. I would agree with that, Senator. I think
    history shows us that the failure of the self-regulatory model
    that we have identified in our panel's report suggests that the
    tilt toward public interest ought to be weighed, if it is 4-3
    or something like that.
        I do think you need some very knowledgeable, practicing
    public accountants who are very much involved in the process
    because I would fear that if you had too much, if you had a 6-3
    or something like that, you could potentially lose sight of
    what the real issues are to these people out in the field, and
    that is very important. But at the same time, I am saying,
    whatever the body is, whether it is created by legislation or
    by regulation, it ought to have that tilt toward the public
    interest, for appearance, as much as for the importance of
    operating it.
        Senator Gramm. You could have a majority that are
    accountants, but require a super-majority to act. I mean there
    are a lot of ways that you could do it.
        Mr. O'Malley. True.
        Mr. Wyatt. Yes, Senator. I share the concern. I think that
    we are dealing with a highly technical subject and we need as
    participants on the board those people who are most expert in
    dealing with the issues and have a background of having dealt
    with them. So, I probably would favor a slight majority from
    the practicing profession, but I could live with a strong
    minority.
        The challenge would be to get people who do not have such
    expertise to agree to involve themselves in an activity which
    they had not prepared themselves for in their careers. Getting
    good people under those circumstances is a challenge.
        Senator Gramm. Would you all see this as a full-time board?
        Mr. Wyatt. You bet.
        Senator Gramm. So, you would want it to be highly
    compensated and this would be their only source of income?
        Mr. Seidler. No, I would demur from that. I am not certain
    that it should be a full-time board. The FASB are full-time
    people and they have been divorced from practice and I think
    that has shown up. I could see a board which functioned to a
    great extent as a board of directors with a staff under them. I
    would like to permit practicing technical partners from
    accounting firms to serve while they are still practicing in
    their firms.
        Mr. Briloff. Senator Gramm----
        Senator Gramm. Grab that microphone, if you will,
    Professor.
        Mr. Briloff. The question that you ask--forgive me--is what
    I sometimes refer to as a plumbing problem. Let's first try to
    think in terms of the overall architecture and if we move
    consistent with what Mr. O'Malley or Professor Longstreth might
    have suggested, Professor Wyatt, and think in terms of creating
    an SRO, I believe that then the personnel and the functioning
    would fall into place very, very effectively.
        The only single standard I would urge, separated absolutely
    in funding and operationally from the American Institute of
    Certified Public Accountants because it has become a trade or
    industry association. It is not any longer a professional
    organization.
        Senator Gramm. Thank you, Mr. Chairman.
        Chairman Sarbanes. First, let me say by way of preface to a
    line of questioning that I want to develop, I feel very
    strongly, and have for quite a long time, almost since I came
    to Congress, that the SEC is not given sufficient resources to
    meet its responsibilities.
        We constantly brag about the integrity of the American
    securities capital markets, how important that is to the
    functioning of our economic system, that they are the best in
    the world--and I still believe they are. But the SEC plays an
    important role in making that possible. Its workload has just
    grown at a geometric progression. Its staff resources hardly
    match that.
        We passed a package last year that was pressed very hard by
    industry to reduce trading fees because it was said that they
    were bringing in a lot more money than the SEC budget, which
    was the initial rationale for it. We linked that with providing
    pay parity to SEC employees with the other Government
    regulators, not pay parity with the private sector, which still
    remains a difficult problem. But in any event, pay parity with
    the Government sector.
        I think all of us here when we passed that bill, assumed
    that it would go into place as a package. Well, lo and behold,
    the fee reduction went into place, but the budget submission
    from the Administration did not implement pay parity.
        The SEC currently has a significant number of unfilled
    positions because of the budget shortfall. Most people have
    testified that they think they should have additional personnel
    over and above what they now have, so that you really do need a
    significant infusion. Their budget is $460 million--that is the
    request this year, roughly speaking, for all of the SEC's
    functions.
        So, I have been in touch with the Administration. I have
    just written to the President again, urging him to send a
    supplemental request to the Congress because, obviously, and I
    want to move to this in a moment, we are probing what structure
    we have, what systemic and structural changes we should make to
    significantly lessen the risks of these things occurring again.
    But while that process is developing, it seems clear to me that
    immediately, additional resources to the SEC would enable it to
    move ahead and exercise the authorities it now has in order to
    meet its responsibilities. We continue to press for that. I
    take it all the panelists agree with the observation that we do
    need to provide an additional infusion of resources into the
    SEC to meet its responsibilities. Is there anyone who would
    dissent from that?
        [No response.]
        Fine. Thank you very much.
        Now let me explore the possible structure. Some of these
    will be advanced as a devil's advocate. I just want to explore
    the possibilities. One possibility I guess would be to say,
    well, the SEC is going to do it all. This would be a major
    expansion--not what I am talking about here in terms of the
    budget request I am putting to the Administration. But this
    would have to be a very significant expansion in personnel and
    budget and the SEC then would, in effect, set the standards,
    monitor the standards, really be at the top and carry it on
    through.
        Now the magnitude of this and what it involves may be to
    some extent illustrated by the testimony we had from Bob
    Glauber just yesterday, the Chairman and Chief Executive
    Officer of the NASD, and I want to quote it for a minute:

        The National Association of Securities Dealers is not a
    trade association, but, rather, the world's largest self-
    regulatory organization, or SRO. Under Federal law, every one
    of the roughly 5,500 brokerage firms, nearly 90,000 branch
    offices, and almost 700,000 registered representatives in the
    U.S. securities industry come under our jurisdiction. To give
    you a sense of our scope and authority, it is vital to know
    that every brokerage firm in the United States that does
    business with the public must by law be a member of NASD. We
    have a staff of over 2,000 employees in Washington, Rockville,
    and district offices across the country and an annual budget
    exceeding $400 million.
        For more than six decades, our mission and our mandate from
    Congress has been clear: To bring integrity to the markets and
    confidence to investors. We do this by licensing and setting
    qualification standards for industry participants, maintaining
    a massive registration database that includes qualification and
    disciplinary histories of all brokers and firms, writing rules
    to govern the conduct of brokerage firms and their employees,
    providing investor education and outreach, educating our
    members on legal and on ethical standards, examining them for
    compliance with the Federal securities laws and NASD and
    Federal rules, investigating infractions, and disciplining
    those who fail to comply. And, of course, violations may result
    in significant fines or even expulsion from the securities
    industry.

        What is your perception of the idea that we should just
    have the SEC do it? No one has suggested that here. I just want
    to get some benchmarks.
        Mr. Longstreth. I think that is a completely acceptable
    alternative. I really do not know whether it is preferable to
    an SRO for the audit profession.
        The truth is that if you go back to the creation of the
    first SRO, which James Landis, I think, was responsible for as
    Chair of the SEC, it was the New York Stock Exchange. And as
    Joel Seligman's book thoroughly and persuasively points out,
    the New York Stock Exchange, on all issues of fundamental
    economic importance to its members, beat back reform efforts by
    the SEC for decades.
        The most critical issue was fixed commission rates. The SEC
    only acted in the face of imminent legislative action to force
    it to act on May Day of 1975.
        So the record was not good from 1933 to 1975 on major
    economic issues. And it remained very bad with the NASD on the
    major economic issue right up until the present because
    billions of dollars of investors' money was lost because there
    was basically some price-fixing going on which the NASD
    ignored. That led to the reforms that Senator Rudman led and
    which made things better. But the record is not great for SRO's
    in regard to major economic things.
        Now what is a ``major economic thing'' for the audit
    profession? Well, it could be nonaudit services. That is why I
    emphasize the importance of the leadership and the way in which
    the leadership is appointed, to make sure that they really are
    there on the SRO Board to represent the public interest.
        I think having the SEC do it is a viable alternative and
    one that ought to really work on the question of why isn't that
    approval a good idea? Maybe you will be led to conclude it is
    not or that there is a better idea, which is a well-established
    SRO. That is my view.
        Chairman Sarbanes. Mr. Seidler.
        Mr. Seidler. I do not think it would be a good idea. I
    think that the SEC has demonstrated over most of its lifetime
    the ability to essentially guide and direct--not always
    perfectly, sometimes quite imperfectly--the various bodies
    under its jurisdiction.
        With respect to accounting, there hasn't been an SRO, as a
    practical matter. The SEC's input, frequently by direction,
    frequently by indirection, has pushed the various accounting
    standard setting bodies in the direction that the Commission
    wanted to move. I think the Commission has enough problems in
    getting resources and I greatly doubt that, given enough
    resources, it would suddenly undertake for its first time a
    production function, which is what this would be.
        So, I would much prefer to take a model, and I guess that
    is because I have always tried to copy something that works
    reasonably well, take a model that does work reasonably well,
    and that is an SRO under the direction of the SEC.
        Chairman Sarbanes. Right.
        Mr. O'Malley.
        Mr. O'Malley. My own sense is they ultimately are
    responsible anyway. The SEC will be over any SRO or any other
    organization that is set up to respond to these concerns. My
    own sense is that I would talk to them first and see whether
    they can feel they can do it best this way or with an SRO. I
    don't have any particular preference. I just want to make sure
    that all the issues--whether it is discipline, standard
    setting--all of these issues get somehow covered by an
    oversight body, whether it is created by SRO or created under
    the SEC, with continued Congressional oversight of the SEC,
    would be acceptable to me.
        As long as we get these subjects taken care of in the
    group, I do not care how it is constructed, to be honest with
    you, Senator.
        Chairman Sarbanes. Right.
        Mr. Wyatt.
        Mr. Wyatt. I think I would prefer to have the standard
    setting be independent and everything else be under the aegis
    of the SEC.
        The FASB and the SEC work together very, very closely
    currently and I would see them continuing to do so. But I think
    that having an independent body removes to some extent the
    political influence, and I think that is important.
        Chairman Sarbanes. Professor Briloff.
        Mr. Briloff. I would not want to have the responsibility
    that we are here talking about directly under the SEC. The SEC
    is the over-arching body for the administration of the nexus of
    securities laws, not only the 1933 and 1934 Acts.
        I would look to the SEC as possibly saying to the
    accounting profession, under the FCPA 1977 Act, you are
    required to implement the internal control procedures. Under
    the 1995 Act, you are required to do that even more fully. Go
    out and do it.
        I would look to the SRO for that registry and the
    disciplinary process that we have been talking about, with the
    SEC there as the others have indicated, as the over-arching
    body, just to see that all of these bodies are functioning
    optimally.
        Chairman Sarbanes. All right. That is at one end of the
    spectrum. Now at the other end, we have had this system of
    voluntary effort, which I think everyone indicates has
    obviously had significant deficiencies in it. It really is
    falling short.
        I am struck by the quality of the reports by the various
    commissions, yours, Mr. O'Malley, and much earlier, the Cohen
    Commission. And yet, our inability to implement or put into
    place most of the recommendations.
        We get a problem and we do a commission, we do a very good
    study, we get very able people to draw these conclusions. And
    then the recommendations are out there and a few get put into
    place. But in terms of instituting some system or structure
    that really addresses the problem, we seem to be unable to do
    that.
        Mr. O'Malley. Senator, we were very aware of that problem
    and I think attendant to it. We thought that if the POB, which
    was our proposal, was so strengthened and empowered to carry
    out this mission, that one of the things that we would require
    them to do, was to regularly report on whether these
    recommendations had been implemented, and if not, why not, and
    to publicize that information in our annual report, so that the
    public, the Congress, and everybody would know exactly whether
    or not the profession was responding to these proposals.
        That had been agreed upon. And I am not sure that was in
    the charter, but the POB agreed that was an appropriate way to
    go. They would oversee whether these recommendations were being
    implemented and report publicly on the status of that.
        Chairman Sarbanes. First of all, I take it that you all
    think it would need to be done by statute and not by regulation
    by the SEC. Is that correct?
        Mr. O'Malley. I am neutral, Senator. I do not know which
    would be better. If the SEC can do the job, as far as I am
    concerned, that is fine. If an SRO can somehow do it better,
    that is fine.
        Chairman Sarbanes. Of course, they have been unable to do
    it up to this point. That is one of the problems, I think.
        Mr. Wyatt made the point that, and I think it is a very
    well taken point, that you had Members of Congress who had
    intervened with FASB as they were prepared to do some standard.
    I would just make the observation that that wasn't a
    spontaneous intervention. It is not as though Members of
    Congress sit around and try to keep tabs on what FASB is doing
    and then decide that they want to intervene. They are
    intervening because they are hearing from elements of the
    industry who are resistant to what FASB is thinking of doing.
    And the same thing with the SEC.
        Levitt was thinking of instituting certain things, and then
    there was a big outcry about that, both from the industry and
    from the Congress. But the Congress was really, at least those
    who moved ahead, were reflecting what they were hearing from
    the industry.
        So it seems to me that we have to get a change in attitude
    at the top within the accounting profession in terms of where
    their responsibilities lie. One of the challenges is, how do we
    achieve that?
        Mr. Seidler. Could I comment on that?
        Chairman Sarbanes. Let me just say one thing about the NASD
    because I want to come back and ask you to what extent you
    think they have done a good job and should constitute some
    example or benchmark that we should look to as we think about
    this problem.
        Mr. Glauber, in his testimony, said:

        On average, the NASD files more than 1,000 new disciplinary
    actions annually, with sanctions ranging from censures to fines
    and suspensions to expulsions from the securities industry. We
    supplement our enforcement efforts with referrals to criminal
    authorities and the SEC. In one important settlement alone this
    year, reached jointly with the SEC, the NASD, and the SEC each
    imposed sanctions of $50 million against a major investment
    bank for violating SRO rules by extracting illegal paybacks
    from favored customers to whom it allocated ``hot'' IPO's.

        Is the NASD a model to which we should pay some attention
    as we address the issues that we are confronting here?
        If I could get quick answers from everyone.
        Mr. Longstreth. Yes, I think it is. It is a model which has
    been vastly improved through the Rudman recommendations and
    changes. NASD Regulation now, I think, is much better
    structured to represent the investor interest as opposed to the
    interest of the brokerage community.
        But just to answer the earlier question which is relevant
    to this question, I do not think the SEC has the power to
    create the kind of SRO that you would want to create to assure
    effectiveness. Maybe I am wrong about that, but I do not think
    it does.
        Of course, you could empower it. And I would think if you
    are going to have an SRO, one way to do it is to tell the SEC
    largely what to do, and the other is to empower them to do it
    in their own best judgment, with some broad principles.
        I do think that the NASD is vastly improved. But any SRO
    serving the fundamental economic interest of its members is
    going to have a struggle between that self-interest and the
    public interest. However, as long as one recognizes that and
    works against it through publicity, transparency, and so on, it
    seems to me that an SRO can be an effective tool.
        Chairman Sarbanes. Mr. Seidler.
        Mr. Seidler. I think Mr. Wyatt referred to the impact
    perhaps of greed on the accounting profession, going into too
    much consulting. I worked on Wall Street for a large part of my
    career. The greed in the accounting profession, by comparison
    to the greed on Wall Street, looks like Little Red Riding Hood.
        The NASD has dealt with a group of people who are intent on
    making a great deal of money and overall, has done a very good
    job of controlling that.
        If you see the size of the problem, the number of people
    they have dealt with, they have, I think, done quite an
    effective job with a very, very difficult problem.
        I was in charge of Bear Stearns internal audit department
    for some time and also sat on the operating committee, and
    therefore, saw the interface with the NASD. Was it perfect? No.
    Did they always control this perfectly? Probably not. But they
    did constantly cause us to change, to operate, to see what they
    were doing, and to respond.
        In general, I felt that this model was quite effective and
    I would see it applying, in some sense, easier to apply it to
    the accountants than it would be to a bunch of my partners in
    Bear Stearns.
        Chairman Sarbanes. Mr. O'Malley.
        Mr. O'Malley. Senator, you mentioned discipline and I think
    that was one of the keys in our report, the total lack of
    discipline in the existing organization of the profession.
        I do not know what the best answer is for making sure that
    there is discipline and that the justice is swifter than it had
    been in the 8 or 9 years that it takes today.
        But I think, if I can just say, on accounting standards, we
    think that should be essentially an independent body, but with
    oversight by this new body, whatever the organization is. And
    the same thing with auditing standards. That should be put
    together by experts that are relatively independent. This
    oversight group would be appointing the chairman, approving
    other appointments, and overseeing in the sense that they would
    be telling them you are not moving fast enough or addressing
    this problem. But those two standard setting bodies should be
    relatively independent in setting the standards, but with
    oversight from this body. The key for this body is going to be
    the discipline because that to me brings back my favorite
    subject, and that is improving audit quality.
        If you put some teeth in the discipline, I think it is
    going to help overall in the improvement of audit quality.
        Chairman Sarbanes. Well, who is doing the monitoring of the
    standards under your scenario?
        Mr. O'Malley. Monitoring would be this group. But the
    standard setting itself would not be done by this group.
        Chairman Sarbanes. Does everyone agree with that or can you
    bring the standard setting into the group as well?
        Mr. Seidler. We have, for example, NASDR under the NASD. I
    would see the SEC practice section perhaps being like NASDR.
        I would see the FASV as another subsidiary of this board.
    The auditing standard setting as yet another subsidiary, each
    one developing its own standards but under the direction,
    selection of leadership, control----
        Chairman Sarbanes. Monitoring.
        Mr. Seidler. Monitoring--of the overall board.
        Chairman Sarbanes. So the overall board would have under it
    the sub-boards or sub-groups that established the standards and
    also, whatever group did the monitoring of the standards and
    the disciplining. Is that correct?
        Mr. Seidler. That is correct.
        Chairman Sarbanes. All right.
        Mr. Wyatt.
        Mr. Wyatt. Yes.
        Chairman Sarbanes. Why don't you speak now and then we will
    come back to Professor Briloff. I know he has something to
    offer to this discussion.
        Mr. Wyatt. Let me start by saying, I am not as familiar
    with the NASD as obviously the fellow on my right is. But a
    structure that would permit the expertise needed to set
    accounting standards and auditing standards to function
    properly, the failure we have had, I believe, is more in the
    area of disciplinary action.
        The AICPA disciplines, I do not know, hundreds, maybe
    thousands, of practicing accountants every year, but they are
    single practitioners. They haven't done anything with the
    bigger firms, I suspect, partly at the risk of losing the
    revenue from all of the members of those firms who are members
    of the institute. I don't know, but that is my perception. That
    has to change.
        Chairman Sarbanes. Professor Briloff.
        Mr. Briloff. The only comment I want to make is that I
    would like to have the standards themselves left to those
    within the profession. I believe that is part of their
    professional undertaking. However, this SRO would act as a
    mandate under the Congress or the SEC to make certain that the
    profession has, in fact, fulfilled the responsibilities vested
    in it, whether by the Congress or by some mandate from the SEC.
        What I am driving at here is, as I indicated earlier, and
    forgive me for repeating, we have the Foreign Corrupt Practices
    Act and Title III of the 1995 Act, which the profession has
    blithely essentially ignored. If there were an SRO, it would
    direct the profession to take cognizance of it and to then make
    certain that the profession is responding meaningfully and
    effectively to what the legislation anticipated.
        Chairman Sarbanes. Now, I am struck by the fact that under
    the current arrangements, the standard setting bodies, both
    FASB and the international, because we do have this
    international dimension now developing, and I think we need to
    keep an eye on that. But they are funded by basically going
    around with a tin cup. So, you go to the very people who are
    going to be most intimately affected by the standards. You ask
    them for money to support the operation, and if they do not
    like what they think the standard
    setting body is going to do, they are obviously either
    unwilling or reluctant to give money.
        It was dramatized when Volcker was soliciting a number of
    the largest corporations to give contributions for the
    International Accounting Standards Foundation, to fund that
    work. And amongst the companies that was on the list that was
    solicited was Enron. Then, internally, within Enron--Paul
    Volcker knew nothing about this. They were passing memos back
    and forth trying to decide whether to make a contribution. And
    the big question was, what kind of influence could this get
    them in whatever standards were going to be set.
        What are your views on how we should fund this SRO, so you
    are not dependent upon the voluntary contribution of the people
    in the industry that are being affected, either by the
    standards or by the monitoring or disciplinary action?
        Mr. Longstreth. The NASD's $400 million budget is paid, I
    believe, through members--the catch is that everybody who hangs
    out a shingle as a broker-dealer or registered representative,
    has to be a member.
        Chairman Sarbanes. And they have to pay a fee.
        Mr. Longstreth. They have to pay a fee.
        Chairman Sarbanes. Right.
        Mr. Longstreth. I guess that adds up --you said $400
    million--almost as much as the SEC.
        Chairman Sarbanes. Right.
        Mr. Seidler. I would see every company's securities that
    are publicly-traded having to pay a certain amount and every
    auditor or auditing firm that was registered to audit such
    companies also paying a mandated fee.
        Mr. O'Malley. Something like that, some kind of a fee
    structure.
        At present, the FASB is funded--each of the major
    accounting firms contribute something like a million dollars to
    the FASB, and then industry essentially makes up the rest of
    the FASB's budget.
        So in the final analysis, it is going to be the companies
    that are registered that are going to pay the cost, whether it
    is through fees or through indirectly the charges they pay to
    the auditing firms.
        Chairman Sarbanes. Yes.
        Mr. Wyatt.
        Mr. Wyatt. I would disagree with my colleague. The FASB's
    budget, the last I saw, was approximately two-thirds from the
    sale of publications.
        Chairman Sarbanes. Right.
        Mr. Wyatt. And one-third from these contributions from
    accounting firms and industry.
        Chairman Sarbanes. Of course, the International Standards
    Board, the Europeans have indicated, the EU, that by 2005, they
    expect to adopt the standards of the International Accounting
    Standards as their accounting standards in the EU countries,
    which I regard as a significant development because this is a
    very significant economic actor, the EU community. Its economy
    combined is almost equivalent to the United States. When they
    do that, they won't be able to charge for materials because the
    EU is taking the position that the materials--since these are
    requirements that you have to meet, you ought to get the
    materials without paying for them, in order to abide by them.
        Mr. Wyatt. Different mindset over there.
        Chairman Sarbanes. Yes.
        Mr. Wyatt. I think that the defect in the FASB structure
    currently is that the trustees fundamentally are
    representatives of the groups that are paying in the money. The
    trustees of the foundation should not be representatives of
    those organizations, but should be people from the public who
    have independent interest. I think that is where part of the
    problem with the FASB has rested.
        Chairman Sarbanes. Professor Briloff, did you want to add
    anything to this point?
        Mr. Briloff. Very little at this point. Any one of these
    funding mechanisms would work, either charging for those who
    are registered, the registrants, or the firms.
        Again, forgive my applying that notion of ``a plumbing
    problem.'' I want to resolve the matters in principle, spelled
    with an ``l-e,'' and everything else will fall into place.
        Chairman Sarbanes. Yes.
        Mr. Seidler.
        Mr. Seidler. Mr. Chairman, if I could add one caveat.
        There are many smaller public accounting firms that have
    several public companies whose securities are traded. Their
    main practice is private, but they have a few.
        In recent years, with the increasing problems of dealing
    with new pronouncements and so on, there has been a tendency
    for them to drop that business, to find that it is just too
    difficult to handle. I would hate to see those smaller
    accounting firms stifled by a new structure.
        So to the extent that it is possible, it would be useful to
    keep the structure, particularly fees, in such a way as to not
    force out this body of smaller accounting firms. Some of them
    are very excellent in specialties, sometimes better than the
    major firms.
        Chairman Sarbanes. Well, that is an interesting point. We
    will have to wrestle with it. But it seems to me that there is
    a significant break between accounting firms that take on
    publicly-listed companies because the nature of their
    responsibilities at that point, very significant dimensions are
    added to it, as opposed to just handling private companies. In
    fact, we had a discussion in here yesterday with a panel about
    that very subject.
        The American Institute of Certified Public Accountants is
    putting out an alert now to all their key people about the
    terrible things that may happen here in the Congress as we
    wrestle with this problem and how they have to start contacting
    their Representatives and their Senators to begin to build a
    groundswell in the other direction.
        One of the points they make is that the very small
    accounting firms with private clients are going to be impacted
    by all of this. Of course, the level at which we are thinking
    has this kind of differentiation point between private and
    public. But once you start representing companies that are
    listed on the exchanges, which then gets you into questions of
    the integrity of the capital markets and the reliability of the
    information, and all the rest of that flows from that, it seems
    to me that you are dealing in a different realm.
        Now, we will have to look at that. The danger, I think, is
    any exception becomes the loophole that is then exploited and
    is broadened and widened, you see. And all of a sudden, you
    have undercut what you are trying to do. But I think it is a
    reasonable point and it is one we will have to consider.
        I think then we will draw it to a close.
        Everyone seems now to agree that at least some of the
    consulting activities that accounting firms are doing, while
    also doing auditing, ought not to be done. Now some take the
    position that they should not do any of those activities at
    all. Professor Briloff has held that position today. Others
    have held it before the Committee in the course of our
    hearings. Others say, well, certain things should be precluded,
    but not everything. And then the question is, how do you define
    that?
        In the Superior Bank failure in Chicago, which this
    Committee has been looking at, the accounting firm established
    the internal financial process of the company, of the bank, by
    which they would value residuals. Then in the auditing
    function, approve the company's valuation of the residuals
    developed by their process. Now, of course, it turned out they
    were grossly overvalued and it was one of the reasons why the
    bank collapsed and it is now going to cost the insurance fund
    probably somewhere around $500 million. Who should draw this
    line in the structure we are talking about?
        Mr. O'Malley. Senator, could I respond to that?
        I think, and this is a little historic, the SEC, working
    with the profession, set up the Independent Standards Board.
    And that Board, Chaired by William Allen, who was a former head
    of the Delaware Chancery Court, set up a structure for
    resolving independence issues. They listed what the basic
    principles of independence were. They listed all the threats to
    independence, and they set up a system for evaluating and
    addressing the threats and then taking some services and
    saying, they clearly should be off the table, others should
    not.
        The basic principle is that you shouldn't be self-auditing.
    You shouldn't be able to audit your own work. And that would
    address the issue you raised in the Superior Bank situation.
        The other is that you cannot be part of management. You
    cannot replace management or then you clearly are not
    independent both in form or in appearance or in substance.
        So the SEC, when it announced its rulemaking initiative,
    essentially ended the life of the Independent Standards Board,
    which it had set up just 2 years before. And this group did a
    lot of valuable work. I said in my written statement, I would
    hope, however we resolve this issue, that the principles they
    set up, which were a clear and positive guide for regulating
    independence, be utilized by the new body going forward and
    making these decisions.
        And I would emphasize, I do not think we ought to have
    legislation that says you can do this service and you cannot do
    that service. This body should make those decisions and they
    should do it based on a sound conceptual framework.
        Chairman Sarbanes. Should you have legislation that didn't
    try to set the specific line, but try to provide some broader
    guidance to where they might go?
        Mr. O'Malley. That would be totally acceptable to me. If we
    had a conceptual framework that said you cannot audit yourself,
    you cannot be part of management, that addresses any threat.
        Chairman Sarbanes. A general statement.
        Mr. O'Malley. Yes, exactly.
        Chairman Sarbanes. But then to be developed out.
        Mr. O'Malley. Exactly. That would be my approach.
        Mr. Longstreth. I would agree with that.
        Chairman Sarbanes. Okay. Yes.
        Mr. Longstreth. Shaun and I have talked a lot about this
    subject together. I just want to add one comment to what he
    said, most of which I agree with.
        I think I have read all of the ISB stuff. The big hole in
    the SEC rule which I described, namely, that it fails to
    acknowledge that large, nonaudit fees, for whatever kind of
    nonaudit services might be involved, can have an impact on
    independence.
        But the SEC did not say so and neither, as far as the ISB
    got, did the ISB. I do not think there is any recognition there
    of that fundamental, common sense observation. The point at
    which large amounts of money are paid to you for services that
    management could send elsewhere, could retain other people put
    at risk for one's professional reputation, which can be
    subordinated to the amount of fees being paid and the annuity
    that those fees can represent.
        The prospect of fees, in the case of Enron, who paid
    Andersen $27 million in 2001. So $27 million this year. But you
    can look forward to that kind of payment far into the future.
    That is a principle I would add to the two very important
    principles that Shaun mentioned as being developed by the ISB.
        Mr. O'Malley. I would only add to that point that, to me,
    it doesn't matter what service you are being paid for. If you
    are being paid--whether it is auditing or another service--
    there is an inherent conflict in the relationship to begin
    with. If you are being paid $20 million to do an audit and you
    are going to be doing the audit for some years, it is no
    different than if you are being paid another $5 million for
    another service.
        To me, the inherent conflict is there. I think it is up to
    the structure of this oversight board to make sure that the
    audit committees are deeply involved in any nonaudit service
    decisions, as long as we have eliminated self-auditing and
    acting as management.
        Chairman Sarbanes. But this could be a handy benchmark. If
    the nonaudit services, in terms of recompense, dwarf or
    overwhelm the audit service, even if they are for services that
    we generally have said, do not create your problem, they are
    okay services. But somehow, the size and the magnitude of them
    grows to the point that the recompense dwarfs the other, then
    you may have created a problem. Perhaps some kind of percentage
    test or something at least avoids that more extreme or
    egregious situation.
        Mr. O'Malley. I agree. I saw the one case that was cited. I
    do not know what the company was, where the auditors were paid
    $3 million for the audit and $60 some million. And to me, I
    would imagine that would be eliminated by this agreement not to
    do major financial systems design and implementation. That is
    where the big dollars are. They have taken that off the table
    entirely. But I agree with you. In that instance, if I were on
    the audit committee, I would be saying, wait, wait a minute on
    this. Let's see if we can get some other proposals.
        Chairman Sarbanes. Let me ask you about auditor rotation,
    if I could, or term-limited auditors, or however you want to
    describe it. Actually, we have received some interesting
    testimony, including from former chairmen of the SEC who have
    really advanced the 5 or 7 year rotation for auditors. I would
    just be interested to get your quick reactions to that.
        Mr. Seidler. The Cohen Commission examined it and concluded
    considering economic and noneconomic costs and benefits, that
    the costs were greater than the benefits and said not to have
    rotation. On the other hand--that was 25 years ago. That was 25
    years before audit fees grew and before we had some cases that
    we had recently where we see the influence of the fee and the
    influence of a simple question--would you like to be the audit
    partner who lost the XYZ audit, getting greater and greater.
        The one factor in favor of rotation is, when the auditor
    says, no, you cannot do it, and risk giving up the fee, he's
    not giving up this year's fee, he's giving up the stream of
    future fees. If there were auditor rotation, he would be giving
    up a finite stream of future fees, if it were a 5 year or 7
    year rotation.
        I was silent on it because I could not come to a
    conclusion. But there is no question that if we did have
    rotation, that evil would be cut tremendously. On the other
    hand, changing auditors involves a lot of other evils, one of
    them being, as we discovered, most frauds occur in the early
    years of the audit. It does take a while to learn about the
    business. So it is almost a toss-up.
        Mr. O'Malley. I would say, I am 6 years out of doing
    audits, but I am still opposed to auditor rotation, Senator,
    and I think for good reason. One of the keys to being a good
    auditor and we heard this today, is looking at the whole
    business, understanding the whole business, the culture, the
    systems, the people, what is going on.
        To do that, you have to be in place for a period of time. I
    think the way to deal with this, and some companies already do
    that, they require the auditors to repropose regularly for the
    audit, to submit a proposal to be continued as auditors.
    Sometimes that is done in competition with other firms where
    they are reproposing and other firms are proposing against
    them. I think it is the responsibility of the audit committee
    to satisfy itself that you are getting the kind of service that
    you need and then deciding whether to go ahead. That decision
    to reappoint auditors should be taken very seriously. I think
    in my experience on audit committees, it was taken very
    seriously. I would be against rotation of auditors.
        Mr. Briloff. Mr. Chairman, at one time I was very much
    opposed to the rotation of auditors for various reasons. But I
    am now very much in favor of it, particularly as we look upon
    these audit fiascoes, we all too frequently find the incestuous
    relationships that prevail. Namely, members of the auditing
    firm becoming CFO's or importantly positioned as management
    people within the firm that had been the subject of the audit.
    So there is too much of that buddy system. We had it in Enron.
    I saw it in the CUC situation in Cendant.
        Therefore, I am in favor of the rotation now. And that
    brings to mind an observation made by Jack Seidman, one of the
    profession's greats, who made it probably 35, 40 years ago, who
    referred to the fact that Mrs. Seidman was a most meticulous
    housekeeper. But he said, when she expects company to be
    coming, she is especially so. The house is even more
    effectively kept.
        [Laughter.]
        So it is that if a firm expects that they will be
    superceded 2 or 3 years down the line, they try as much as they
    can to make sure that they are leaving with a clean slate.
        Chairman Sarbanes. Thank you.
        Mr. Longstreth. I would like to second the point that was
    just made. One way of thinking about it is that the centerpiece
    of such self-regulation as has existed has been the peer
    review, where one of the Big 5 reviews another Big 5's audit.
        That has not been thought of as a great success in the
    sense that there has never been much of a problem found. That
    is because what goes around comes around. There are only five
    firms and it is not likely that, unless something terribly bad
    is found, that they are going to slam their colleagues.
        So the most effective peer review we could have would be a
    peer review that results basically from a new auditor coming in
    through rotation with the old auditor having a sure knowledge
    that a new auditor is coming in. I think the balance that Dr.
    Seidler put on this on the pros and cons leading him, I guess,
    to not making a clear decision in his own mind at this point is
    where I am, too.
        I think there are some powerful arguments to consider this
    now, given the growing risks that we face through nonaudit
    services. It is one possible solution anyway, to the problem of
    trying to limit nonaudit services that ought not to be limited
    because there is so much synergy involved in using the auditor.
        It deserves a lot of close study, but I am not in a
    position to come out one way or the other at this point.
        Chairman Sarbanes. Well, this has been an enormously
    helpful panel and we appreciate it very much.
        This hearing stands adjourned.
        [Whereupon, at 12:35 p.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]

                    PREPARED STATEMENT OF SHAUN F. O'MALLEY

                 Chairman, 2000 Public Oversight Board Panel on
                   Audit Effectiveness (O'Malley Commission)
                       Former Chairman, Price Waterhouse
                Past President, Financial Accounting Foundation
                                 March 6, 2002

        Thank you for inviting me to testify before the Committee about the
    important decisions facing the accounting profession, its regulators,
    and the Congress.
        I am Shaun O'Malley. I spent 36 years working in the accounting
    profession, the last 7 of those as Chairman of Price Waterhouse until
    my retirement in 1995. Since that time, I have served on various
    corporate and nonprofit boards and audit committees. In 1998, I was
    asked to serve as Chairman of the Panel on Audit Effectiveness, which
    was appointed by the Public Oversight Board (POB) at the request of the
    Securities and Exchange Commission. The Panel was asked to conduct a
    comprehensive review and evaluation of the way independent audits are
    conducted and to assess the effects of recent trends in auditing on the
    public interest.
        The Panel was formed in the wake of a number of high profile
    restatements, which were followed by massive declines in market values
    of the companies involved. Concerns were raised at that time about the
    overall reliability of financial statements and, in particular, about
    the role of auditors. On August 31, 2000, the Panel issued a report in
    which we made a number of significant recommendations aimed at
    improving audit quality.\1\ I will address what I believe to be the
    Panel's key recommendations later in my statement.
    ---------------------------------------------------------------------------
        \1\ The Panel on Audit Effectiveness, Report and Recommendations,
    August 31, 2000 (``Report'').
    ---------------------------------------------------------------------------
        The Enron debacle has been the catalyst for a reexamination of
    current methods of corporate reporting and audit oversight. While my
    testimony will focus primarily on the latter, I first want to comment
    on the specific issues highlighted by the Enron failure.
    Failures in the Corporate Reporting Safety Nets
        There exist numerous safety nets in the corporate reporting
    process--corporate management, the board of directors and audit
    committee, law firms, auditing firms, securities analysts, capital
    providers and intermediaries such as commercial and investment banks,
    credit rating services, the Financial Accounting Standards Board, and
    the Securities and Exchange Commission. Most, if not all, seemed to
    have failed in the case of Enron. We need to examine what caused these
    shortcomings and decide how to remedy them.
        As far as I can tell from Congressional testimony and press
    coverage to date, the overriding cause of the Enron failure can best be
    identified as ``systems breakdowns.'' Practically every element of our
    system of safeguards failed until it was too late to repair the damage.
    The list of breakdowns is a long one. It includes:

     The apparent willingness of a number of Enron employees to set
        aside their responsibilities and to manipulate the numbers, subvert
        control systems, and mask the true status of Enron's financial
        condition and performance.
     The apparent willingness of certain senior management
        personnel to promote off balance sheet activities for personal gain
        at the expense of the shareholders, employees, and creditors.
     The apparent failure of Enron's Board of Directors and of its
        audit committee to
        understand what was happening inside the company; their
        corresponding willingness to accept, without more penetrating
        inquiries, management and auditors' assurances that accounts were
        properly stated; and their willingness specifically to waive the
        company's own ethics rules in order to permit some of the now-
        infamous off balance sheet transactions involving company insiders.
     The apparent failure of the auditors to detect irregularities
        and/or their apparent willingness to support transactions and
        related accounting and disclosures that do not stand up to
        scrutiny.
     The unexplained waiver by the SEC of important disclosure
        requirements for Enron on two occasions, and the Commission's
        failure to review Enron's financial statements for several years
        despite an announced step-up in annual report reviews and despite
        Enron's huge growth and its position as one of the top 10 U.S.
        companies as measured by revenues.
     The failure of the FASB and the SEC to promulgate timely
        accounting and disclosure requirements in the face of ever-changing
        and increasingly complex business transactions, the growth in the
        use of derivatives, and the increased use of off
        balance sheet partnerships and special purpose entities.
     The apparent affirmation of some of the special entity off
        balance sheet transactions by the attorneys retained by Enron's
        chairman.
     The financial analysts' apparent failure to understand
        adequately Enron's business, financial statements, and results,
        which led to their recommending the purchase of Enron stock
        virtually up to the moment of the company's collapse.
     The lenders' apparent failure to gain an accurate picture of
        Enron's true financial position and operating results, while
        extending large amounts of credit to the company.
     The apparent failure of debt rating agencies to understand
        Enron's precarious
        position until it was too late.

        In short, just about every element of our financial system's
    safeguards failed for an extended period of time, often until the final
    collapse of the company.
        In light of this widespread breakdown of our systems of control and
    regulation, there is a need to address each element of the system with
    the goal of repairing what appears to be broken and strengthening
    controls, accountability, and responsibility. I will leave the task of
    repairing most of these elements to others and will restrict my
    recommendations to issues affecting the accounting profession and its
    governance and oversight.

    Role of the Accounting Profession
        Accurate financial reporting has long been viewed as the bedrock of
    strong capital markets. Investor confidence in the reliability of
    financial statements lowers the cost of capital and increases the
    effectiveness of the capital markets in allocating resources. Enhancing
    the effectiveness of audits is key to improving the reliability of
    financial statements.
        In this regard, the primary goal of the Panel on Audit
    Effectiveness, which I chaired, was to thoroughly review, evaluate, and
    recommend improvements to the way independent audits are performed and
    to assess the effects of recent trends in auditing on the public
    interest. The Panel was appointed in the fall of 1998 by the POB at the
    request of the SEC. It included retired and active leaders in the audit
    profession, two former SEC Commissioners, and a staff of experienced
    auditors.\2\ Pursuant to the SEC's charge, the Panel undertook a
    detailed study of the effectiveness of audits, the impact of nonaudit
    services on auditor independence, and the adequacy of the auditing
    profession's current governance system.
    ---------------------------------------------------------------------------
        \2\ See September 28, 1998 letter from Lynn Turner, Chief
    Accountant of the SEC, to A.A. Sommer, Chairman of the Public Oversight
    Board, Report, Exhibit 1.
    ---------------------------------------------------------------------------
        Over a period of 2 years, the Panel's investigation encompassed a
    wide range of activities. Its principal effort was its Quasi Peer
    Reviews, which were in-depth reviews of the quality of 126 audits of
    SEC registrants in 28 offices of the eight largest accounting firms. In
    addition to the engagement reviews, meetings with two focus groups were
    held in most of the 28 offices--one with senior accountants/auditors
    and the other with audit managers, most of whom work on audits of
    public companies. This process also included in-depth interviews with
    the partner-in-charge of the office's audit practice. Panel members
    attended most of the Quasi Peer Reviews, and the Panel staff planned
    and directed all of them. The Quasi Peer Reviews were a major source of
    the Panel's findings and recommendations for improving the conduct of
    audits.
        The Panel's other activities included:

     Focus group meetings with chief financial officers and
        controllers, internal auditors, peer reviewers, and representatives
        from the eight largest firms.
     Regular meetings with the Office of Chief Accountant of the
        SEC throughout the Panel's work to report progress.
     A survey requesting opinions on issues of audit effectiveness,
        distributed to over 500 selected individuals and organizations
        representing a very wide range of constituencies.
     Public hearings in the early stages of the Panel's work at
        which 21 organizations testified, including the SEC, auditors,
        financial statement preparers, analysts, plaintiffs' and
        defendants' attorneys, standard setters and educators.
     Reviews of the eight largest firms' audit methodologies,
        policies and procedures, manuals and other guidance materials, risk
        management information, professional development activities, and
        policies and procedures for recruiting, evaluating, compensating,
        and promoting audit personnel.
     Meetings with representatives of various private sector bodies
        involved in the governance of the profession.
     Research, with the assistance of the SEC staff, into the
        causes and circumstances that led to recent SEC Accounting and
        Auditing Enforcement Releases.
     Analysis of academic, professional, and regulatory literature
        on the effects of nonaudit services on auditor independence.
     Studies of the profession's current governance structure and
        analysis of alternatives.
     Collection of information on recent international initiatives
        to strengthen audit effectiveness on a global basis.
     Further public hearings on the May 31, 2000 Exposure Draft of
        the Panel's Report and Recommendations at which 18 organizations
        testified including the SEC, the auditors, the State boards of
        accountancy, professional organizations, standard setters, and
        educators.
     Analysis of 42 comment letters received on the Exposure Draft.

        On August 31, 2000, the Panel issued its findings and
    recommendations, copies of which have been provided to each of you in
    advance of today's testimony.
        The Panel concluded that ``while many specific recommendations . .
    . for improvements in the conduct of audits and the governance of the
    profession'' are necessary, ``our report demonstrates that both the
    profession and the quality of its audits are fundamentally sound.'' \3\
    This remains my opinion today, although the aforementioned totality of
    breakdowns in the Enron situation underscores the need to accelerate
    implementation of many of the Panel's recommendations.
    ---------------------------------------------------------------------------
        \3\ Letter from Shaun O'Malley to the POB and Other Interested
    Parties, preceding the Report.
    ---------------------------------------------------------------------------
        Of the more than 250 pages of its report, the Panel spent three
    full chapters discussing a host of recommendations targeted to
    furthering audit quality. Let me emphasize that, at the end of the day,
    the goal of enhancing audit quality has to be the primary goal of both
    private and public sector responses to the problems that Enron and
    other recent failures highlight. It is a matter of concern to me that,
    in the context of audit reform, so little is being said in the media
    about how the various proposed solutions will improve audit quality.
    Yet that is the issue upon which we must ultimately focus our attention
    if something positive is to come out of these unhappy events.
        The recommendations of the Panel, made prior to Enron's collapse,
    bear some similarity to many of the proposals discussed in
    Congressional hearings over the last 2 months, as well as the proposal
    announced by the SEC. In my testimony, I will describe the thrust of
    the Panel's recommendations in the context of three themes recurrent in
    post-Enron proposals for reform: (1) the need for improved audit
    quality; (2) the call for separation of audit and nonaudit functions;
    and (3) the proposals for change in the governance of the auditing
    profession.

    The Need for Improved Audit Quality
        Although the Panel found that an overwhelming majority of the 126
    audits it studied were of a high caliber, the Panel also found
    significant room for improvement in the audit process. Indeed, the
    Panel made some 150 specific recommendations toward furthering the
    quality and reliability of audits. I do not intend to discuss each of
    these recommendations today, many of which pertain to the application
    of detailed auditing standards. However, I will discuss a number of
    areas in which I believe the Panel's recommendations were most
    significant.

    New Audit Approach to Detecting Fraud--``Forensic-Type'' Procedures
        The Panel found that the risk assessment and response process
    called for under existing Generally Accepted Auditing Standards (GAAS)
    \4\ ``falls short in effectively deterring fraud or significantly
    increasing the likelihood that the auditor will detect material fraud,
    largely because it fails to direct the auditing procedures specifically
    toward fraud detection.'' \5\ Rather, an auditor's duty is to report
    fraud if it is discovered,\6\ but not to search actively for it. Such a
    policy reflects the practical limitations on an auditor's ability to
    investigate. The enormous cost inherent in uncovering the presence of
    fraud is rivalled only by an auditor's lack of the means to do so (that
    is, the power to subpoena).
    ---------------------------------------------------------------------------
        \4\ Beginning in 1948, the membership of the American Institute of
    Certified Public Accountants (AICPA) adopted 10 statements referred to
    as ``Generally Accepted Auditing Standards'' or GAAS. The Auditing
    Standards Board (ASB), a senior technical committee of the AICPA, has
    responsibility for interpreting GAAS through Statements on Auditing
    Standards (SAS's). The SAS's and the 10 GAAS statements are referred to
    collectively as Generally Accepted Auditing Standards. Report at 2.3.
        \5\ Report at 3.46. See SAS 82.
        \6\ An auditor also may have a legal obligation to report fraud to
    the audit committee and, ultimately, to the Commission under certain
    circumstances. See Section 10A, Securities Exchange Act of 1934, 15
    U.S.C. 78j-1.
    ---------------------------------------------------------------------------
        The Panel concluded, with respect to the matter of fraud detection,
    that a very dramatic shift in auditors' approach to their audits is not
    only possible, but also necessary. Thus, the Panel recommended that
    GAAS require auditors, in planning and performing certain phases of
    their examinations, to suspend the neutrality of their professional
    skepticism and presume the possibility of dishonesty at various levels
    of management, including the possibility of collusion.\7\ The Panel
    further recommended a number of specific forensic measures that should
    be taken during any audit, with the principal objective of detecting
    material financial statement fraud.\8\ The Panel believed that this new
    approach to audits would not only help to discover material fraud
    before its effects are felt by the market, but would also more likely
    deter fraud from occurring in the first place.
    ---------------------------------------------------------------------------
        \7\ Report at 3.51.
        \8\ Id.
    ---------------------------------------------------------------------------
        It is important to note that, even in the event that the Panel's
    recommendation is adopted, an auditor's ability to investigate fraud
    will always be limited. Auditors do not possess the power to subpoena
    documents or testimony, nor are auditors trained experts in the
    identification of falsified documents. Moreover, clients will not pay
    auditors for the enormous labor and resources inherent in even the
    simplest SEC-style investigation. That said, it was the opinion of the
    Panel that the recommended approach would have a significant impact on
    the profession's ability to safeguard our markets from fraud.
        In this connection, last week, the Auditing Standards Board issued
    an Exposure Draft which would, if adopted, replace the current audit
    standard relating to fraud. I am reviewing the proposal to determine
    whether it will accomplish what the Panel sought to achieve in its
    recommendations in this area.

    Adopt Clearer and More Specific Audit Standards
        All auditors are required to perform audits in accordance with GAAS
    promulgated by the Auditing Standards Board (ASB) of the AICPA. The SEC
    historically has accepted GAAS as necessary and sufficient to comply
    with the requirements of the securities laws that call for independent
    audits of financial statements.
        The Panel noted that the guidance given to auditors in the
    Statements of Auditing Standards (SAS's) issued by the ASB lacks
    imperatives that compel auditors to take definitive steps in specified
    circumstances. For example, in some cases an SAS may indicate what an
    auditor ``should'' do, while in other cases a SAS might only indicate
    what an auditor ``should consider,'' allowing significant latitude for
    the exercise of judgment based on the circumstances of the engagement
    and on the auditor's assessment of risk and materiality. The Panel
    believed that auditing standards must provide both reasonable and
    measurable benchmarks for performance by auditors.\9\ Therefore, the
    Panel urged the ASB to modify, to amend, or to improve its standards by
    making them more specific and definitive.
    ---------------------------------------------------------------------------
        \9\ Standards need to be reasonable in that they should not force
    auditors to adhere to rules that do not take into account the myriad of
    circumstances that may exist on audits. To serve as effective measures
    of the quality of performance, however, auditing standards need to
    provide clear, concise, and definitive imperatives for auditors to
    follow.
    ---------------------------------------------------------------------------
        The Panel also noted that the ASB and its staff issue audit
    standards and guidance in various, sometimes conflicting forms--that
    is, standards, interpretations, audit guides, auditing practice
    releases, statements of position--without establishing a hierarchy of
    authority to guide in their application.\10\ Without such a hierarchy,
    auditors find themselves searching for a rule among competing
    guidelines issued by any number of committees and subcommittees. In
    response to this problem, the Panel recommended that the ASB define a
    hierarchy of GAAS and collect existing guidance in a readily accessible
    source.\11\ The ASB has since issued an SAS covering the hierarchy of
    GAAS.
    ---------------------------------------------------------------------------
        \10\ Report at 2.220-222.
        \11\ Report at 2.232.
    ---------------------------------------------------------------------------
    Require Auditors to Obtain a Deeper Understanding of the Issuer's
            Business
    and Related Internal Controls
        The Panel recommended that auditing standards ``require auditors to
    possess a far deeper understanding of the entity's business processes,
    risks, and controls'' than is currently called for under GAAS.\12\ This
    is particularly important, given that today's businesses are far more
    complex, often technology-based, and global in scope than ever before.
    ---------------------------------------------------------------------------
        \12\ Report at 2.26.
    ---------------------------------------------------------------------------
        In order to plan and conduct an effective audit, an auditor must
    have a full understanding of an issuer's business and internal
    controls,\13\ particularly its information systems. An understanding of
    the internal controls of an issuer helps an auditor to determine how an
    issuer's financial reporting might go awry. The Panel found that,
    although auditors generally investigate issuers' internal controls,
    auditors do so with neither the necessary depth nor the requisite
    specificity of guidance from the ASB. The Panel therefore recommended
    that the ASB provide more specific guidance on the required depth of
    auditor knowledge and understanding about internal controls, as well as
    the nature and extent of testing of controls.\14\ The Panel also
    recommended that audit firms ``place a high priority on enhancing the
    overall effectiveness of auditors' work on internal controls,
    particularly with respect to the depth and substance of their knowledge
    about companies' information systems.'' \15\ The Report noted a number
    of areas to be addressed by audit firms, including professional
    development and the increasing need for auditors to have a higher level
    of technology skills and far more effective participation in audits by
    information systems specialists.\16\
    ---------------------------------------------------------------------------
        \13\ Internal control is ``a process--effected by an entity's board
    of directors, management, and other personnel--designed to provide
    reasonable assurance regarding the achievement of objectives in the
    following categories: (a) reliability of financial reporting, (b)
    effectiveness and efficiency of operations, and (c) compliance with
    applicable laws and regulations.'' SAS No. 78, cited at Report at 2.50.
    Controls that are relevant to an audit are those that pertain to or
    impact the entity's preparation of financial statements for external
    purposes.
        \14\ Report at 2.77.
        \15\ Report at 2.78.
        \16\ Id.
    ---------------------------------------------------------------------------
    Risk Assessments and Designing Substantive Audit Tests
        GAAS includes an audit risk model that requires auditors to use
    their judgment in assessing risks, selecting an audit approach, and
    deciding what tests to perform.\17\ The model allows an auditor to take
    a variety of circumstances into account in selecting the audit approach
    for a particular engagement, including the auditor's understanding of
    the entity's business and industry and the entity's system of internal
    controls.\18\
    ---------------------------------------------------------------------------
        \17\ In order to determine the depth of testing necessary for a
    particular item on an issuer's financial report, an auditor must first
    assess the risk that the item is misstated. For example, complex
    transactions are more easily misstated than simple ones; an auditor
    will, therefore,
    assess a complex transaction to be high risk and test that transaction
    more thoroughly than
    others.
        \18\ Report at 2.7.
    ---------------------------------------------------------------------------
        For example, if an issuer's internal control over sales and
    accounts receivable is strong, the auditor might confirm only a limited
    number of accounts receivable at an interim date and rely in part on
    the company's internal controls and certain other tests for updating
    the accounts to year-end. Conversely, if a company's internal controls
    are not strong, the auditor might confirm a larger number of accounts
    receivable and do so at year-end.
        The Panel believed that professional standards, guidance, and
    practices with respect to assessing inherent risk need to be
    strengthened given GAAS's increased emphasis on inherent risk
    assessments in determining the nature, timing, and extent of audit
    tests. In addition, because the assessment of inherent risk is such a
    crucial element of an audit, the Panel recommended that the engagement
    partner be involved in making the inherent risk assessment.\19\
    Finally, the Panel encouraged audit firms to review their policies and
    procedures with respect to linking the risk assessment to the actual
    nature, timing, and extent of tests performed during
    the audit.
    ---------------------------------------------------------------------------
        \19\ Report at 2.49.
    ---------------------------------------------------------------------------
    Top Management of Accounting Firms Must Emphasize the Importance of
            Quality
    Audits, Including with Respect to Compensation and Advancement
            Decisions
        The Panel found that messages from accounting firm management to
    audit personnel do not stress often enough the importance of quality
    audit work, either in terms of the work's importance to the firm or its
    role in protecting the interests of the investing public.\20\ Indeed,
    the Panel's focus groups strongly indicated that the audit is commonly
    regarded by the audit firm personnel foremost as a commodity, and one
    of little value standing alone.\21\ As a result, the Panel recommended
    that top management of accounting firms emphasize to all audit
    personnel the importance, both to the firm and to the public, of
    performing quality audits. According to the Panel, ``[t]he message
    should be a positive, constructive message that is refreshed frequently
    so it commands attention, rather than becoming a tired slogan that is
    ignored.'' \22\
    ---------------------------------------------------------------------------
        \20\ Report at 4.3.
        \21\ Report at 4.4.
        \22\ Report at 4.5.
    ---------------------------------------------------------------------------
        In addition, audit firms should ingrain ``the importance of the
    role and responsibility of audit professionals, as well as the concepts
    of integrity and objectivity, independence, professional skepticism and
    accountability to the public'' at the earliest stages of an employee's
    training.\23\ Furthermore, throughout an employee's tenure, the
    performance of quality audits should be applauded and publicized,
    especially in situations where auditors take difficult stands on
    earnings management issues, issues involving possible fraud, or
    contentious accounting issues. In short, the Panel recommended a top-
    to-bottom reaffirmation within audit firms of their public duties as
    auditors.
    ---------------------------------------------------------------------------
        \23\ Id.
    ---------------------------------------------------------------------------
        Similarly, the Panel also recommended that audit firms ``ensure
    that performing high quality audits is appropriately recognized as the
    highest priority in performance evaluations and in compensation,
    promotion, and retention decisions for all personnel.'' \24\ The Panel
    recommended that performance and compensation measures should focus on
    such matters as: (1) the depth of understanding of the client's
    business, (2) responsiveness to unexpected conditions encountered in an
    audit, (3) professional skepticism and persistence, and (4) knowledge
    of accounting standards and principles.\25\ By emphasizing quality
    audits in compensation and advancement decisions, the Panel reasoned,
    the quality of audits will inevitably increase.
    ---------------------------------------------------------------------------
        \24\ Report at 4.21.
        \25\ Id.
    ---------------------------------------------------------------------------
    Enhanced Communication with Audit Committees
        There are several auditing standards that govern independent
    auditors' communications with audit committees. In general, the
    standards require that auditors inform audit committees about
    significant accounting policies and their application, management
    judgments and the process used in formulating particularly sensitive
    accounting estimates, significant audit adjustments, disagreements with
    management, consultation by management with other accountants, major
    issues discussed with management prior to being retained, and
    difficulties encountered in performing the audit.\26\ In addition, two
    new standards regarding auditor's communications to audit committees
    were recently issued. The first requires auditors to communicate
    uncorrected misstatements, the effects of which management believes are
    immaterial. The second requires auditors to discuss their judgments
    about the quality, not just the acceptability, of the entity's
    accounting principles and the estimates underlying the financial
    statements.\27\
    ---------------------------------------------------------------------------
        \26\ Report at 2.205.
        \27\ Report at 2.205.
    ---------------------------------------------------------------------------
        Notwithstanding these requirements, the Panel advocated that
    stronger relationships be established between auditors and the boards
    of directors and their audit committees that recognize that auditors
    are ultimately accountable to the board of directors and the audit
    committee as representatives of the shareholders.\28\ The Panel further
    recommended the development of explicit mutual expectations of the
    board and audit committee, management, and the auditors as an essential
    first step in the process of developing a stronger relationship among
    these parties.\29\ Finally, the Panel recommended that the auditor and
    company management advise the audit committee of the company's plans to
    hire any of the audit firm's personnel into high-level positions. On
    this last point, I personally believe the audit committee should be
    tasked with approving the hiring of any audit firm personnel above a
    certain level who worked on the company's audit.
    ---------------------------------------------------------------------------
        \28\ Report at 2.216.
        \29\ Id.
    ---------------------------------------------------------------------------
    Auditor Independence/Scope of Services
        As the Panel's Report stated, ``Independence is fundamental to the
    reliability of auditors' reports. Those reports would not be credible,
    and investors and creditors would have little confidence in them, if
    auditors were not independent in both fact and appearance.'' \30\ The
    Panel noted that the effect of providing nonaudit services on auditor
    objectivity has long been an area of concern. We, therefore, focused
    specific attention on this issue. A full discussion of auditor
    independence is contained in Chapter 5 of the Panel's Report.
    ---------------------------------------------------------------------------
        \30\ Report at 5.1.
    ---------------------------------------------------------------------------
        As an initial matter, let me state that the Panel fully supported
    the role of the Independence Standards Board (ISB), a body constituted
    by the joint effort of SEC and the accounting profession. The work of
    the ISB resulted in a clear definition of auditor independence, a
    comprehensive inventory of the potential threats to independence, and a
    listing of the ways such threats could be eliminated or satisfactorily
    mitigated. Most importantly, out of this work came a methodology for
    addressing independence issues based on a conceptual framework, not
    simply upon a set of wooden rules.
        To the dismay of many in and out of the profession, the ISB was
    effectively terminated by the SEC's rulemaking initiative in 2000--the
    outcome of which was an essentially pragmatic, but incomplete
    resolution, which lacked a conceptual framework for addressing
    independence issues. I would very much like to see the restoration of
    ISB's conceptual framework and methodology so that emerging
    independence issues can be addressed and guidance developed promptly
    and consistently.
        The SEC's November 2000 rule prohibits the provision of many
    nonaudit services to audit clients. However, two important services
    were not adequately addressed in the rule. These services constitute a
    significant part of the nonaudit services being performed by audit
    firms: (1) financial information systems design and implementation, and
    (2) internal audit outsourcing. Engagements to design and implement
    financial information systems often involve large numbers of
    professionals, last 2 to 3 years in duration, and generate substantial
    fees. Internal audit outsourcing refers to a company hiring its auditor
    for the purpose of conducting an internal audit.
        All five major firms now have agreed to the proscription of such
    services to audit clients, and the AICPA also has supported that
    position with respect to public companies. The net result of the
    combined action of the SEC and the elimination of the two services I
    have described takes substantial amounts of the so-called
    ``consulting'' dollars off of the accounting firms' table and greatly
    reduces the magnitude of the nonaudit services issue.
        In light of concerns that had been raised in prior years regarding
    the effects of these types of services on auditor independence, the
    Panel on Audit Effectiveness included in its review a study of
    engagements relating to issuers who received both audit and nonaudit
    related services from the auditing firm. And of the 126 public related
    audit engagements studied, the Panel identified 37 engagements in which
    services other than audit and tax had been provided.
        As stated in the Report, the Panel's reviewers did not identify any
    instances in which providing nonaudit services had a negative effect on
    audit effectiveness.\31\ To the contrary, the Panel found, ``[O]n
    roughly a quarter of such engagements, the reviewers concluded that
    such services had a positive impact on the effectiveness of the
    audit.'' \32\ The additional knowledge of the company's business and
    the skill sets enhanced by the performance of nonaudit services
    actually assisted the work of the audit team.
    ---------------------------------------------------------------------------
        \31\ Report at 5.18.
        \32\ Id.
    ---------------------------------------------------------------------------
        However, based on an independent survey and public hearings, we
    found that many people continue to be concerned ``that the performance
    of nonaudit services could impair independence or that there is at
    least an appearance of the potential for impairment.'' \33\
    ---------------------------------------------------------------------------
        \33\ Report at 5.20.
    ---------------------------------------------------------------------------
        Thus, the Panel did not reach unanimity with regard to a
    recommendation in this area. Rather, the Panel published a statement in
    support of an exclusionary ban on nonaudit services to audit clients,
    as well as a statement against such a ban.
        The Panel did agree on the importance of the independence issue,
    and, therefore, made a number of recommendations in furtherance of the
    need for close monitoring of proposed nonaudit services. Among these
    recommendations, the Panel provided ``guiding principles'' to be
    considered by audit committees in contemplating whether to hire the
    company's auditor to provide certain nonaudit services.\34\ According
    to the SEC's November 2000 rule on independence, the Panel's guiding
    principles
    ``represent a thoughtful and appropriate approach to these issues by
    audit committees, and [the SEC] encourage[d] audit committees to
    consider the Panel's recommendations.'' \35\
    ---------------------------------------------------------------------------
        \34\ Report at 5.29. The Panel recommended that, in determining the
    appropriateness of a particular service, one guiding principle should
    be whether the service facilitates the performance of the audit,
    improves the client's financial reporting process, or is otherwise in
    the public interest. Id.
        \35\ 17 CFR 210, at 24.
    ---------------------------------------------------------------------------
        It is my own opinion that the profession's decision to forego
    financial information systems design and implementation and internal
    audit outsourcing services to audit clients is correct. Despite the
    lack of evidence that these services, in fact, erode the independence
    of auditors, the evidence is strong that such services are perceived as
    a threat to independence. Furthermore, both services should typically
    be performed by the management of an issuer, not by its auditors.
        With respect to other nonaudit services, I believe the conceptual
    framework that was under development by the ISB as the underlying
    rationale for independence standards--that the ISB would develop as
    necessary--would have provided a meaningful and proper way to
    distinguish which services should be allowed and which not. Whether the
    ISB's framework were to be applied by one of the audit profession's
    self-regulatory organizations or by a regulatory organization yet to be
    formed is less important than the need for some type of framework that
    will identify independence threats and provide guidance on appropriate
    safeguards in areas where acceptable practice is unclear or existing
    practice should be improved. Furthermore, it is my opinion that audit
    committees should take it upon themselves to review each nonaudit
    engagement with the company's auditor pursuant to the ISB's standards
    and the guiding principles set forth in the Panel's Report.
        However, a rule banning all nonaudit services to audit clients
    would throw out the baby with the bath water, while failing to increase
    the level of auditor independence. Indeed, in light of the Panel's
    findings of the importance of an auditor's knowledge of the company and
    the importance of the auditor possessing related information technology
    skills, I believe banning all nonaudit services for audit clients could
    hinder audit effectiveness.

    A Change in Governance of the Audit Profession
        The accounting profession's combination of public oversight and
    voluntary self-regulation is extensive and overlapping, and yet in
    certain respects, insufficient to accomplish the goals of monitoring
    the activities of the profession, providing disciplinary action where
    appropriate, and establishing ethical standards and rules that will
    lead to enhanced public confidence in the profession. A veritable
    alphabet soup of organizations provides governance for the profession,
    a summary of which appears in Appendix C of the Panel's Report. Yet
    despite this extensive network of oversight (and, indeed, in part
    because of it), the Panel concluded that the profession's self-
    regulatory system suffers from certain limitations, some of which may
    be inherent in a voluntary system.\36\
    ---------------------------------------------------------------------------
        \36\ Report at 6.15.
    ---------------------------------------------------------------------------
        Specifically, the Panel found that the current system of
    governance: (1) lacks sufficient public representation; (2) suffers
    from divergent views among its members on what should be the
    profession's priorities; (3) implements a disciplinary system that is
    slow and ineffective; (4) lacks efficient communication among its
    various entities and with the SEC; and (5) lacks unified leadership and
    oversight.\37\
    ---------------------------------------------------------------------------
        \37\ Report at 6.15.
    ---------------------------------------------------------------------------
        In light of these significant shortcomings, the Panel recommended
    that there be a strengthened, unifying oversight body to help ensure
    the effective working of the governance system. In the Panel's opinion,
    the experience and the expertise of the independent POB would serve as
    a sound foundation for such an organization. We believed that, pursuant
    to a new charter, an expanded POB could aggressively oversee the
    profession's standard setting, monitoring, disciplinary, and special
    review functions. The POB would, therefore, serve as the oversight body
    to whom the SEC, the State boards of accountancy, the auditing
    profession, and the public would look for leadership.
        Under the Panel's proposal, the POB would have the sole authority
    to determine the profession's financial obligations to the POB and the
    sole authority to determine its expenditures. The POB would also
    approve of the appointment of the chairs of various self-regulatory
    bodies (such as the ASB, which would continue to establish auditing
    standards) and approve all other appointments to such bodies; evaluate
    whether the funding of those bodies is sufficient for them to meet
    their mandates; and oversee the evaluation, compensation, hiring, and
    promotion of many of the entities' employees. The Panel also
    recommended the creation of a coordinating task force, composed of the
    chairs of each body within the POB's oversight, that would be
    responsible for sharing information related to each body's
    activities.\38\
    ---------------------------------------------------------------------------
        \38\ Report at 6.23-25.
    ---------------------------------------------------------------------------
        Although membership of the POB already consists primarily of
    nonaccountants, the Panel recommended that members be term-limited and
    nominated by a committee comprised of members of public and of private
    institutions that are most
    concerned with the quality of audits and financial reporting. Members
    of these same constituencies would also comprise an advisory council to
    advise the POB on issues related to audit quality and financial
    reporting matters. And finally, the Panel recommended that the POB be
    given the authority to commission special reviews related to
    significant professional matters that affect the public's confidence in
    the audit profession.
        I believe that a strengthened POB would have served the interests
    this Committee seeks to protect. Unfortunately, the POB has all but
    disbanded. There are, however, many similarities between the Panel's
    proposal and those being discussed by the SEC and the Congress. In
    theory, I am in favor of the creation of an organization to oversee the
    accounting profession, whether it is created by regulation or by
    legislation. If carefully structured to ensure effective oversight,
    disciplinary proceedings, and rulemaking in an unpoliticized
    environment, such an organization could serve the same purpose we had
    in mind for an expanded POB.
        There are important considerations, however, in structuring a new
    entity to carry out these responsibilities:
        First, it must be decided whether the new organization will assume
    an oversight role similar to that proposed by the Panel, or whether it
    will assume some or all of the responsibilities of existing self-
    regulatory bodies. With regard to the latter possibility, the Committee
    may wish to consider the following:

     One advantage in having Congress establish a new organization
        to assume the peer review, investigatory, and disciplinary
        functions of the profession is that Congress can provide statutory
        confidentiality protection for the materials, interviews, and
        findings developed as part of the organization's review and/or
        disciplinary processes. These processes in the past have been
        hampered by distrust and by concerns that the materials developed
        were not protected. Providing confidentiality will expedite and
        vastly improve the review, investigatory, and disciplinary
        processes.
     The ASB should remain the appropriate entity for establishing
        auditing standards, but I believe that an expanded POB--or if
        Congress determines, a new organization--should oversee the ASB's
        activities to the extent of appointing its chair and approving
        appointments of the remainder of the ASB and regularly evaluating
        its performance. This type of oversight could help assure that the
        ASB continually reexamines and timely addresses auditing issues
        that arise in the review and disciplinary activities conducted by
        the new oversight entity.
     The proposed new organization should not have the power to
        set, or even influence, the issuance of accounting standards. FASB
        today is beset with political pressure that directly hampers
        efficiency and, in some cases, the substance of the standard
        setting process. However, FASB, in my view, remains the right
        entity for determining accounting standards. The most important
        step Congress can take in improving accounting standards is to
        ensure that FASB is adequately funded and free from undue political
        influence.

        Second, a new organization must remain independent from the
    profession, while remaining cognizant of current issues and trends
    affecting the profession. Congress or the principal regulator should
    determine an appropriate ratio of members from the profession versus
    public members. Moreover, the organization's funding should not be, in
    fact or appearance, reliant on the profession.
        Third, the Congress should work hard to ensure that the oversight
    organization is sufficiently staffed and funded to carry out its
    sizable mandate. Already, the SEC struggles to keep up with its
    oversight responsibilities. If a new organization assumes the review
    responsibilities currently undertaken as part of the industry's peer
    review system, it will have to do the job that now is done by many
    hundreds of experienced employees, managers, and partners assigned by
    their firms to conduct peer reviews. It will be extremely difficult, if
    not impossible, as well as costly for a new organization to hire,
    train, and supply the hundreds of experienced staff that will be
    necessary to conduct reviews of the entire public audit profession.
        Fourth and finally, I am aware of various efforts at the State
    level in the wake of Enron's collapse to provide greater substantive
    regulation of auditors. Congress should take steps to ensure that
    national accounting firms are subject to a clear and consistent set of
    regulations and do not find themselves guided by multiple, potentially
    conflicting, sets of rules. Such a system not only would be costly for
    accounting firms, but also it might actually create, rather than close,
    holes in audit oversight and could harm the efficiency of the capital
    markets.

    Mandatory Rotation
        Let me comment briefly on one recent proposal that I do not
    support.
        There have been recent suggestions that audit effectiveness would
    improve by forcing issuers to change auditors every few years. I
    believe such a requirement would undermine audit effectiveness. The
    findings of the Panel reinforced the commonly-held understanding that
    audit effectiveness increases proportionately with an auditor's
    familiarity with an issuer's business, its inherent risk factors, and
    its
    internal controls. In light of the growing complexity of today's
    business operations--in terms of technology, business processes,
    financial control procedures, and globalization--such knowledge,
    accumulated over time by members of the audit team, is critical to
    effective auditing.
        The empirical evidence supports this notion. A study conducted by
    the AICPA into over 400 cases of alleged audit failure between 1979 and
    1991 indicated that the alleged failures occurred almost three times as
    often when the auditor was performing his first or his second audit of
    the company. And similarly, the 1987 Treadway Commission's review of
    fraud-related cases revealed that a ``significant number involved
    companies that had recently changed their independent public
    accountants. . . .''
        I know there have been a number of failures, as well, where the
    company's auditors had been on the scene for many years. But logic
    simply tells you--and the recommendations of our Panel support this--
    that knowledge of and experience with the audit client's business,
    internal controls, and culture form the basis for an effective audit. I
    firmly believe that mandatory rotation would introduce inefficiencies
    and greater costs and, in the end, would diminish, rather than enhance,
    audit quality.

    Conclusion
        Our capital markets are not broken. They may have been bent, but
    they are wonderfully resilient and have stood the test of time. I
    believe that much can and should be done by the accounting profession
    itself to improve audit effectiveness. I also believe that much can and
    should be done by other professionals and entities that comprise the
    safety nets that combine to build confidence in our capital markets and
    protect the investing public. And I believe that the Congress certainly
    can play a constructive role in holding the type of hearings that have
    been undertaken by this Committee and, if necessary when all of the
    facts are gathered, by crafting legislation in the public interest. I
    do want to urge caution in whatever legislative proposals are advanced,
    because I fear that a hastily crafted package could potentially harm,
    rather than help, the cause of audit reform.
        I appreciate the opportunity to give you my views, and, going
    forward, I will be pleased to assist this committee in whatever manner
    would be most helpful.

                                   ----------

                      PREPARED STATEMENT OF LEE J. SEIDLER

                       Deputy Chairman of the 1978 AICPA
                    Commission on Auditors' Responsibilities
                    Managing Director Emeritus, Bear Stearns
                                 March 6, 2002

        Mr. Chairman, I thank you for your invitation to participate in
    these hearings. I served as the Deputy Chairman of the Commission on
    Auditors' Responsibilities, in charge of the day-to-day operations of
    the Commission and its staff and, with Douglas Carmichael was the
    principal writer and editor of the Commission's Report. And this group
    was more commonly known as ``The Cohen Commission'' after its Chairman
    Manuel F. Cohen. ``Manny'' unfortunately died in June 1977, shortly
    after the Commission \1\ issued its Report of Tentative Conclusions.
    Thus, the largely unchanged final Report, Conclusions, and
    Recommendations of the Cohen Commission reflects the former SEC
    Chairman's lifelong commitment to the public interest and to improving
    the functioning of American securities markets.
    ---------------------------------------------------------------------------
        \1\ To avoid confusion in this testimony, I will refer to the
    Commission on Auditors' Responsibilities as the ``Commission'' or the
    ``Cohen Commission'' and to the Securities and Exchange Commission as
    the ``SEC.''
    ---------------------------------------------------------------------------
        The Commission was appointed by the American Institute of Certified
    Public Accountants (AICPA) to:

              Develop conclusions and recommendations regarding the
            appropriate responsibilities of independent auditors. It should
            consider whether a gap may exist between what the public
            expects or needs and what auditors can and should reasonably
            expect to accomplish. If such a gap does exist, it needs to be
            explored to determine how the disparity can be resolved.\2\
    ---------------------------------------------------------------------------
        \2\ Report, Conclusions, and Recommendations at xi. Hereinafter
    ``Report.''

        The seven-member Commission was drawn from the accounting
    profession, industry, financial services and academe. It met monthly
    for 66 meeting days between 1974 and 1978. The Commission conducted 26
    separate research projects and surveys and held a variety of
    conferences and interviews with members of Government, the accounting
    and the legal professions in the United States and Canada, stock
    exchanges and others. After the Report of Tentative Conclusions was
    issued, the members of the Commission and the staff participated in
    seminars and made presentations of the Commission's positions to more
    than 60 meetings of professional and business organizations. The AICPA
    and the State societies of CPA's conducted 123 member forums.
        The final Report, Conclusion, and Recommendations, 195 pages and
    approximately 100,000 words, was fully and unanimously agreed to by all
    the members of the Commission. That there were no dissents was due to
    the cordial working relationship between the members, the excellent
    work of the highly qualified, conscientious staff and to Manny Cohen's
    belief that to be effective we had to be unanimous. We were unanimous,
    but not necessarily effective. Most of our important recommendations
    were never acted upon.
        Although at times the administration of the AICPA disagreed with
    many of the conclusions that the Commission was reaching, the
    Commission received all the
    resources and the full cooperation it required from the AICPA.

    Conclusions: The Expectation Gap Exists
        The fundamental conclusion of the Commission was summarized as:

              The charge suggests the possibility that a gap exists between
            the performance of auditors and the expectations of the users
            of financial statements. . . . The Commission concludes that
            such a gap does exist. However, principal responsibility does
            not appear to lie with the users of financial statements.
              In general, users appear to have reasonable expectations of
            the abilities of auditors and of the assurances they can give.
              The burden of narrowing the gap . . . falls primarily on
            auditors and other parties.\3\
    ---------------------------------------------------------------------------
        \3\ Report at xii.

        If a ``gap'' existed in 1978, it is a chasm in 2001. In a comment
    that sadly foreshadowed the current furor generated by disclosures
    ---------------------------------------------------------------------------
    about Enron, the Commission noted:

              The public accounting profession has failed to react and
            evolve rapidly enough to keep pace with the speed of change in
            the American business environment.\4\
    ---------------------------------------------------------------------------
        \4\ Report at xii.

        As might be expected, until preparing for this testimony I have not
    reread the Commission's Report for many years. I am pleased to say that
    in most respects the analyses, conclusions, and recommendations in the
    Report remain valid. I believe that had some of our most critical
    recommendations been adopted, many of today's issues would not have
    arisen.
        In the following testimony, I will emphasize those recommendations
    of the Commission, still not adopted by authoritative bodies, that
    would help close today's chasm and speed the evolution of the
    accounting profession. In addition, I will present several of my own
    recommendations in areas that were addressed by the Commission, but
    which today appear to require stronger medicine than was prescribed by
    the Commission in 1978. The passage of a quarter century (and the
    difficulty of finding them) has prevented me from reviewing these
    recommendations with other Commission members. While here I speak only
    for myself, I believe that my fellow Commission members would agree
    that changed conditions, the increased complexity of business
    transactions and the deterioration of many aspects of the accounting
    profession warrant these more stringent measures.
        I hope the actions proposed here will receive early consideration
    by the Committee. The impacts of Enron, in isolation, while costly to
    Enron shareholders and devastating to employees' retirement plans,
    would have had no significant effects on markets or the economy.
    However, the realization that some other companies use the accounting
    techniques employed by Enron has already had a short-term impact on
    market volatility. The validity of the financial reporting of many
    companies,
    supposedly in accord with Generally Accepted Accounting Principles
    (GAAP) and audited by independent accountants, is daily questioned by
    investors and analysts.
        In the 1970's, I was the first brokerage analyst to make a
    specialty of dissecting and challenging the financial reporting of
    public companies. The then lax accounting rules in franchising, leasing
    and revenue recognition provided me with easy targets. Many others
    later followed me into that specialty. I suspect that Enron heralds a
    revival of ``accounting analysis.'' There is nothing inappropriate
    about such scrutiny, indeed, it increases market efficiency. However,
    unless investors perceive that effective action is being taken to
    remedy these apparently widespread deficiencies and to reduce the
    frequency of accounting surprises, confidence in the existence of a
    ``fair game'' in the market may suffer.

    Outline of Proposed Actions
        In the following testimony I will suggest a series of actions to be
    taken which can be implemented through legislation or regulation. With
    the exception of those directly related to the proposed statutory self-
    regulatory organization (SRO) and the audit requirement for quarterly
    reports, they could also be implemented by existing private
    organizations: The Auditing Standards Board of the AICPA, the FASB, or
    the Public Oversight Board.

    Increase the Budget of the SEC
        However, allow me to first present a call to this Committee. The
    Securities and Exchange Commission, SEC, has been a critical and
    effective force for improvement in financial reporting and in the
    overall functioning of American capital markets. Notwithstanding
    impression created by the Enron debacle, the United States has the best
    and most comprehensive financial reporting in the world. Much, perhaps
    most, of the credit for our system must go to the effective work of the
    SEC. The proposals I am making will add even more to its
    responsibilities. The SEC's budget is miniscule, compared to the rest
    of the Federal budget and, more important, to the values in the capital
    markets it oversees. I urge the Committee to take action to
    significantly increase the SEC's budget to allow it to continue to
    protect our capital markets.
        My proposals are:

     Enact legislation establishing a statutory self-regulatory
        organization (SRO) with the NASD as a model and, under the
        direction of the SEC, responsible for financial reporting standards
        and regulation.
     Move the AICPA's standard setting and regulatory operations
        out of the Institute and into the new SRO.
     Make the Financial Accounting Standards Board an integral
        element of the Financial Reporting SRO.
     Replace the present peer reviews of accounting firms by
        accounting firms with examiners from the SRO staff.
     To reduce the potential corrupting influence of consulting
        fees, prohibit the performance of nontraditional consulting for
        audit clients of public companies.\5\
    ---------------------------------------------------------------------------
        \5\ For brevity the term ``public companies'' is used to denote
    those entities whose securities are publicly-traded.
    ---------------------------------------------------------------------------
     Require Forms 10-Q and published interim financial statements
        to be audited as part of a continuing audit process.
     Require audit committee approval to hire former auditors.
     Require auditors to evaluate the financial statements as a
        whole.
     Require ``preferable'' rather than ``acceptable'' to be the
        standard in the selection and application of accounting principles.
     Require companies to record all clearly correct adjusting
        entries proposed by auditors, regardless of materiality.

        The Commission also addressed significant deficiencies in the
    education and professional preparation of independent auditors. In
    retrospect, these recommendations, still not implemented, were among
    the most important made by the Commission for, as discussed below, in
    the quarter century since they were made the accounting profession has
    lost a great part of its professionalism. The recommendations are:

     Establish graduate professional schools of accounting.
     Reduce the schism between academic and practicing accountants.

    A Model for Self-Regulation of Financial Reporting
        The Cohen Commission studied then current efforts by individual
    firms and by professional organizations to establish quality control
    policies and procedures to encourage compliance with professional
    standards. It concluded:

              The Commission believes that the oversight of professional
            practice should remain within the profession and that the
            concept of individual firms' having responsibility for the
            quality of their own practice should be retained.\6\
    ---------------------------------------------------------------------------
        \6\ Report at 145.

        The Commission recommended a number of further steps, including
    peer review. The recommendation for public presentation of peer review
    results in a ``long form'' report has been mostly adopted.\7\ Reports
    of peer reviews and the related letters of comment are now available on
    the Internet but they provide little specific detail. For example, when
    deficiencies are noted, the letters do not indicate which offices were
    involved.
    ---------------------------------------------------------------------------
        \7\ Report at 146.
    ---------------------------------------------------------------------------
        The Commission's recommendation that disciplinary action not be
    postponed until all litigation was ended \8\ has been implemented to a
    limited extent. The Quality Control Inquiry Committee (QCIC) of the
    SEC's Practice Section of the AICPA (SECPS) now investigates
    substandard audits quickly but the results are reported only to the
    Public Oversight Board (POB) and the SEC; they are not made public. And
    of the Commission's most important recommendations, only those asking
    for greater auditor concern with detecting fraud have been adopted,
    albeit gradually.
    ---------------------------------------------------------------------------
        \8\ Report at 150.
    ---------------------------------------------------------------------------
        The Commission also studied the sanctions that could and were being
    imposed on individuals and firms for performance or conduct that
    violated professional standards. It is not unfair to say that the
    Commission was disappointed by the then current situation (which does
    not appear to have changed significantly). It noted:

              Failure to Address Significant Problems. With a few
            exceptions, individuals appear to be penalized only for
            infractions which involve advertising (no longer forbidden) or
            client solicitation and felony convictions related to the
            preparation of false tax returns. While not unimportant, those
            are not major problems facing the profession today. The major
            problem is substandard performance.\9\
    ---------------------------------------------------------------------------
        \9\ Report at 179.

        However, after suggesting a number of areas for improvement it was
    concluded, unfortunately incorrectly, that more progress would be made.
    ---------------------------------------------------------------------------
    With this optimistic outlook, the Commission noted:

              An organization could be established within the profession
            that would have the ability to penalize firms for substandard
            performance. Such organizations do exist in other areas, for
            example, the National Association of Securities Dealers. . . .
            We do not see any promise that the creation of a regulatory
            body as described above would be a significant improvement on
            the present mixture of private and public regulation.\10\
    ---------------------------------------------------------------------------
        \10\ Report at 181.

        I now believe that this conclusion, with which I agreed earlier,
    was wrong. Substandard performance does not appear to have been reduced
    or curtailed. Indeed, some recent cases are in many respects more
    egregious than any reviewed by the Cohen Commission.\11\ I do not like
    to rely excessively on evidence from one case, but the actions of a
    major firm, as disclosed in the recent SEC release on Arthur Andersen
    and Waste Management, strongly suggest that the problems are deeper
    than any of those contemplated by the Cohen Commission.
    ---------------------------------------------------------------------------
        \11\ It is important to note that we do not know the actual extent
    of substandard performance. Specific instances of substandard
    performance are disclosed only when revealed by some other event such
    as a restatement or bankruptcy. Most substandard audit performance, to
    the extent that it exists, probably will never be disclosed. I would
    like to believe that the vast majority of audits are completed
    conscientiously in accordance with the standards. However, in an
    ominous note, the Commission's research revealed that a majority of
    auditors had, at one time or another, signed off for audit work that
    they did not actually perform. (See Report at 179).
    ---------------------------------------------------------------------------
        The following excerpt from an SEC release on Arthur Andersen and
    Waste Management summarizes the essence of that case.

              As alleged in the Commission's complaint or found in its
            related administrative order: In each of the years 1992 through
            1996, the Andersen engagement team identified a variety of
            improper accounting practices that caused Waste Management's
            operating and income tax expenses to be understated and its net
            income to be overstated. While Andersen quantified some of
            these misstatements, other known and likely misstatements were
            not quantified and estimated, as required by GAAS. In
            connection with the audit of Waste Management's 1993 financial
            statements, Andersen proposed a series of ``Action Steps'' to
            change the company's improper accounting practices only in
            future periods and to write off its prior misstatements over a
            5 to 7 year period, rather than require immediate correction in
            accordance with GAAP. Andersen also allowed Waste Management
            to, in Andersen's own words, ``bury'' certain charges by
            improperly netting them against unrelated, one-time gains.
            Andersen told Waste Management that its use of netting was an
            ``area of SEC exposure'' but nonetheless allowed it to occur.
            Ultimately, when the misstatements were revealed, Waste
            Management announced the largest restatement in American
            corporate history. In issuing an unqualified audit report on
            the restated financial statements, Andersen acknowledged that
            the financial statements it had originally audited were
            materially misstated.\12\
    ---------------------------------------------------------------------------
        \12\ Securities Exchange Act of 1934, Release No. 44444 / June 19,
    2001. This writer was engaged by the SEC to serve as an expert witness
    in this matter. However, comments included here are based solely on the
    published releases by the SEC.

        The facts of this case are unique, not only in their magnitude, but
    in the actual accounting proposed. The notion that misstatements could
    be written off over some future period, rather than immediately
    corrected, is unsupported, indeed unheard of, anywhere in accounting
    practice or literature.
        Worse yet was the consultation process and the concurrence of those
    consulted:

              For example, in its 1993 audit, Andersen quantified current
            and prior-
            period misstatements of $128 million, the correction of which
            would have reduced net income before special items by 12
            percent. The engagement team also identified, but did not
            quantify or estimate, accounting practices that gave rise to
            other known and likely misstatements. Allgyer (the engagement
            partner) and Maier (then the risk management partner for
            Andersen's Chicago office and the concurring partner on the
            Waste Management engagement) consulted with the Practice
            Director and the Audit Division Head and informed them of the
            quantified misstatements and ``continuing audit issues,'' and
            Allgyer consulted with the Firm's Managing Partner and they
            provided him the same information. The partners determined that
            the misstatements were not material and that Andersen could
            issue an unqualified audit report on the Company's 1993
            financial statements.\13\
    ---------------------------------------------------------------------------
        \13\ Securities Exchange Act of 1934, Release No. 44444 / June 19,
    2001.

        Thus, this is not the case of an ignorant or ``renegade'' partner.
    Instead, this bizarre accounting was approved by a series of reviewers,
    all the way to the highest level in the firm.
        The Cohen Commission did not find any case exhibiting such
    pervasive concurrence with such bad accounting. And as I said earlier,
    most of the significant recommendations of the Cohen Commission, made
    24 years ago, for reducing substandard performance have not been
    adopted by the present private financial reporting establishment. I do
    not know if my other Commission members would concur, but I now believe
    that a stronger, statutorily directed oversight structure is called for
    if necessary improvements are to be made.

    The NASD Model
        A number of proposals for more stringent oversight of the
    accounting profession have been made in recent weeks, including that of
    the Chairman of the SEC and in legislation introduced in the House of
    Representatives.
        Both call for new organizations. I have learned that it is usually
    more efficient to look to and copy existing, successful models rather
    than invent new devices. And
    I believe:

     The NASD provides a model for a statutory self-regulatory
        organization (SRO) that could be applied to the accounting
        profession.
     Enacting legislation to transfer the AICPA's standard setting
        operations and the oversight responsibilities to the new self-
        regulatory organization for financial reporting would be the
        quickest and most efficient way of commencing operations of the
        SRO.

        I make this call for increased regulation of my profession with no
    small regret. I am a CPA, my father was a CPA. I started my career as
    an auditor. Such success as I have achieved is heavily due to what I
    learned as an accountant. I was privileged to work for or with some
    truly proud professionals and truly independent accountants such as
    Paul Grady, Philip Defliese, Joseph Cummings, Ray Groves, Robert
    Hampton and on the Cohen Commission, LeRoy Layton and Kenneth Stringer.
        I believe all of them would be truly outraged at many aspects of
    their profession today. Their firms, once managed by the leading
    technicians and theoreticians in the profession are now frequently led
    by ``rainmakers'' selected for their ability to generate new business,
    not for their accounting knowledge. Too many firms and practitioners in
    a profession dedicated to the public interest have become too dedicated
    to private gain.
        I make these comments not because of the Enron case. The gradual
    deterioration of the professional conscience of at least a sizable
    minority of public accountants has been continuing for the past several
    decades. Enron is merely a widely publicized symptom that may at least
    have the benefit of bringing about long delayed changes in the
    accounting profession. Ultimately, these changes must come not through
    regulation but by restoring the sense of professionalism that too many
    accountants seem to have lost. These are changes that Congress cannot
    enact, the SEC cannot promulgate. The management of accounting firms
    must be returned to accountants, not salesmen. Accountants must be
    educated as professionals in the same manner as the lawyers, doctors,
    and members of the other liberal professions.

    The NASD
        I assume there is no need to recount the history and functions of
    the National Association of Securities Dealers (NASD) for the Members
    of the Committee, but I will give a very brief summary for other
    readers.
        The precursor of the NASD was the Code Committee formed by the
    investment banking business under the National Recovery Act (NRA) in
    1933. When the NRA was declared unconstitutional, the members voted to
    continue the organization on a voluntary basis. That private voluntary
    organization grew and changed its name to the Investment Bankers
    Conference. In 1937, the governing committee of the Conference, working
    with the SEC, drafted legislation to create it as a self-regulatory
    organization. The legislation that came to be know as the Maloney Act
    was signed by President Roosevelt on June 25, 1938. In 1939, the
    organization was renamed the National Association of Securities
    Dealers.
        The relationship of the NASD and its subsidiaries to securities
    markets and to its participants is, in many ways, comparable to the
    functions of the AICPA and the Financial Accounting Standards Board
    (FASB), including development of qualifying examinations, registration
    of sales and supervisory personnel, regulation of individual ethics and
    business conduct, education and publications, and establishing rules of
    fair practice. Of course, it also has other operations, not comparable
    to the AICPA, such as the Nasdaq market and overseeing the American
    Stock Exchange.

    Create A National Financial Reporting Oversight Board
        There have been several proposals to create a new oversight body,
    some aimed at replacing or expanding the Public Oversight Board of the
    AICPA. With the evolutionary NASD model in mind, I see no reason to
    invest the enormous effort that would be involved in creating an
    entirely new organization.
        The AICPA's SEC Practice Section (SECPS), Auditing Standards Board
    (ASB), Accounting Standards Executive Committee (AcSEC) and
    Professional Ethics Division are already staffed and operational. The
    time and money saved by starting with these existing units of the
    AICPA, which appear to comprise about 30 percent of the Institute's
    total expenses, would be significant. The SEC's familiarity with these
    AICPA groups would conserve the SEC's scarce resources.
        I propose that legislation be developed through joint efforts of
    the AICPA, State CPA societies and boards, other accounting
    professional organizations and the SEC and enacted in the same manner
    as the Maloney Act to create a new National Financial Reporting Board
    (NFRB) based on a core of the appropriate elements of the AICPA.\14\
    Statutory direction would, hopefully, accelerate the past and the
    current torturously slow rate of improvement in the accounting
    profession.
    ---------------------------------------------------------------------------
        \14\ I have no pride of authorship related to the title National
    Financial Reporting Board (NFRB). Another descriptive title, hopefully
    with a more pronounceable acronym would be acceptable.
    ---------------------------------------------------------------------------
        The NFRB would fit into and amplify the present structure of
    professional regulation. CPA's are licensed by State boards of
    accountancy which system would be undisturbed. Note that individual
    securities brokers must be licensed by the States in which they deal.
    The NFRB could license or otherwise qualify firms that audit public
    corporations in much the same manner that broker-dealers are regulated
    under SEC Regulation M and by NASD Regulation, Inc. (NASDR, a
    subsidiary of NASD). The present Public Oversight Board (POB) and the
    SEC Practice Section of the AICPA would be the basis for an arm
    comparable to NASDR in the area of regulation of firms auditing public
    companies. The Quality Control Inquiry Committee (QCIC) of the SECPS
    already investigates substandard audits and likely would to do so, but
    having subpoena power and making its findings public. Financing of the
    NFRB would logically come from direct charges to public companies and
    accounting firms qualifying to audit public companies.

    Preserve State Societies and Regional Firms
        State societies and State boards of accountancy play a major role
    in licensing and maintenance of professional standards. For example,
    the New York State Society of Certified Public Accountants (NYSSCPA) is
    active at all levels of professional development. Its magazine, The CPA
    Journal, is one of the few forums available for the publication of
    debates and critical comment on issues in financial reporting by
    practitioners and educators. It is far superior intellectually to The
    Journal of Accountancy published by the AICPA. State societies are in
    some ways competitive with the AICPA--they have significant
    unduplicated memberships--and their continued contribution to
    professional development must be preserved.
        There are high quality local and regional accounting firms, some of
    which specialize in specific industries and whose practice includes
    auditing some public companies. Care must be taken to assure that the
    NFRB makes appropriate allowance for services rendered by CPA's who are
    not principally occupied with audits of public companies and for the
    private companies they audit. This care should not include different
    auditing standards, but would address, for example, different
    requirements for advice and consulting that private companies require
    from their accountants.
        Hopefully the creation of an NFRB that I am proposing will have the
    same effect as that suggested by Senator Francis T. Maloney, sponsor of
    the 1938 Maloney Act Amendment to the Securities Exchange Act of 1934:

              This Act is designed to effectuate a system of regulation . .
            . in which the members of the industry will themselves exercise
            as large a measure of authority as their natural genius will
            permit.

    Merge the FASB into the NFRB
        When the Financial Accounting Standards Board (FASB) was created,
    essentially by carving the accounting standards setting function out of
    the AICPA, I wrote an article titled ``Goldfish in a Bowl of Sharks.''
    \15\ I predicted that the new FASB (the goldfish), no longer enjoying
    the built in support and shield of the accounting profession and the
    large accounting firms and the membership of the AICPA, would be highly
    vulnerable to influence and pressures exerted by all the other parties
    (the sharks) affected by financial reporting. The AICPA, I suggested,
    having lost its most important professional function--standard
    setting--would be reduced greatly in professional status.
    ---------------------------------------------------------------------------
        \15\ The Accountants Magazine (Scotland) 1973.
    ---------------------------------------------------------------------------
        Unfortunately, these forecasts were mostly accurate. The FASB has
    been beset by enormous outside pressures. Returning to being part of
    the principal accounting professional organization will give it the
    strong support of the NFRB and a shield against attempts to unduly
    influence its decisions. In addition, the FASB, alone in bucolic
    Connecticut, has been somewhat isolated from the mainstream.
    Integration into the National Financial Reporting Board will provide
    better direction and focus for the FASB's efforts. With the AICPA's
    Auditing Standards Board and Accounting Standards Executive Committee
    also under its umbrella, the NFRB would have the standards setting
    responsibility for the accounting profession, as well as responsibility
    for overseeing the appropriate application of those standards, under
    the ultimate direction of the SEC.
        I might add that I have heard proposals that the directorship or
    board of an SRO created in this situation be ``independent'' of the
    accounting profession. That is, the membership would not include
    professional accountants. I disagree strongly with that notion. It is
    the equivalent of suggesting that the board of directors of a
    corporation exclude any member with extensive experience in the
    corporation's industry. To the contrary, the board of the SRO should
    include a reasonable number of members with strong public accounting
    backgrounds. Despite the decline in certain aspects of the accounting
    profession, there are still many highly qualified, independent
    accountants who can bring leadership talents to a financial reporting
    SRO.
        The FASB is principally funded by contributions from public
    accounting firms and public companies, as well as revenues generated by
    its publications. As part of the NFRB, its financing would come through
    the NFRB.

    Professional Auditors of Auditing Firms
        At present, the Public Oversight Board's (POB) peer reviews of
    members of the SECPS are performed by their ``peers,'' that is, other
    accounting firms. Major accounting firms are reviewed by other major
    accounting firms. Despite a series of SEC cases and private litigation
    which revealed clearly substandard auditing work, no major firm appears
    to have been publicly sanctioned as a result of a peer review.
        While the major accounting firms are willing to ``peer review''
    each other where the results of specific audits are not disclosed, they
    are not willing to testify against each other in open court. When the
    SEC brings charges against a firm of public accountants, other
    accounting firms will not serve as expert witnesses for the SEC,
    despite the fact that several firms have sections devoted to litigation
    support. Most financial accounting professors at universities,
    apparently unwilling to risk the wrath of the accounting firms who
    often support their work, also are unwilling to testify against
    accounting firms.
        This situation suggests that when the NFRB is established, it
    should develop its own auditors to examine public accounting firms and
    not depend on review by peers.

    The Influence of the Fees on Auditor Independence
        The relationship between independent auditor and client is unique
    in our society. In theory, the auditor works for and protects the
    shareholders. In practice, the management of the corporation pays the
    independent auditor to assure that management's financial reporting is
    accurate. A doctor cures his patients, a lawyer represents his clients
    but an independent auditor polices the management that pays him.
        For this unique relationship to work, the auditor must be truly
    independent, willing to tell the client what is wrong, to insist that
    what is wrong be corrected or to walk away from the client . . . and
    from a stream of future fees. The drafters of the Securities Laws
    understood the value to the capital markets of this independent control
    over the accuracy of financial statements. By requiring that all
    companies whose securities were publicly-traded have financial
    statements audited by independent accountants they virtually guaranteed
    a market for the services of American CPA's. The accounting profession,
    particularly the larger firms, grew and prospered under this mandate.
        Now, recent cases and the comments of many critics strongly suggest
    that this critical independence is being subverted by fear of losing
    the client and future fees. The following excerpt from the SEC's
    release on Arthur Andersen and Waste Management \16\ provides
    interesting insight into some of the ways in which an auditor's
    independence was compromised:
    ---------------------------------------------------------------------------
        \16\ Securities Exchange Act of 1934, Release No. 44444 / June 19,
    2001. This writer was engaged by the SEC to serve as an expert witness
    in this matter. However, comments included here are based solely on the
    published releases by the SEC.

     As noted in the order as to Andersen, this conduct took place
    ---------------------------------------------------------------------------
        against the following background:

       Andersen has served as Waste Management's auditors since
            before Waste Management became a public company in 1971.
       Andersen regarded Waste Management as a ``crown jewel''
            client.
       Until 1997, every chief financial officer (``CFO'') and
            chief accounting officer (``CAO'') in Waste Management's
            history as a public company had previously worked as an auditor
            at Andersen.
       During the 1990's, approximately 14 former Andersen
            employees worked for Waste Management, most often in key
            financial and accounting positions.
       Andersen regarded Allgyer as one of its top ``client
            service'' partners. Andersen selected Allgyer to become the
            Waste Management engagement partner because, among other
            things, Allgyer had demonstrated a ``devotion to client
            service'' and had a ``personal style that . . . fit well with
            the Waste Management officers.'' During this time (and
            continuing throughout his tenure as engagement partner for
            Waste Management), Allgyer held the title of ``Partner in
            Charge of Client Service'' for Andersen's Chicago office and
            served as ``Marketing Director.'' In this position, Allgyer
            coordinated the marketing efforts of Andersen's entire Chicago
            office including, among other things, cross-selling nonattest
            services to audit clients.
       Shortly after Allgyer's appointment as engagement partner,
            Waste Management capped Andersen's corporate audit fees at the
            prior year's level but allowed the Firm to earn additional fees
            for ``special work.''
       As reported to the audit committee, between 1991 and 1997,
            Andersen billed Waste Management corporate headquarters
            approximately $7.5 million in audit fees. Over this 7 year
            period, while Andersen's corporate audit fees remained capped,
            Andersen also billed Waste Management corporate headquarters
            $11.8 million in other fees.
       A related entity, Andersen Consulting, also billed Waste
            Management corporate headquarters approximately $6 million in
            additional nonaudit fees. Of the $6 million in Andersen
            Consulting fees, $3.7 million related to a Strategic Review
            that analyzed the overall business structure of the Company and
            ultimately made recommendations on implementing a new operating
            model designed to ``increase shareholder value.'' Allgyer was a
            member of the Steering Committee that oversaw the Strategic
            Review, and Andersen Consulting billed his time for these
            services to the Company.
       In setting Allgyer's compensation, Andersen took into
            account, among other things, the Firm's billings to the Company
            for audit and nonaudit services.

        This excerpt needs little elaboration. Allgyer is described as a
    marketing man, cross-selling other Andersen services. The audit fee was
    capped but other fees were not. Thus, if Allgyer were to take a strong
    stand against the client he would have risked losing not only future
    audit fees, but also the even larger consulting fees. In addition, one
    might also ask how objective Allgyer would be in auditing the results
    of actions taken in accord with his own strategic review.
        Given the strong pressures that fees of any sort exert on
    maintaining independence, it seems logical to eliminate, when possible,
    fees that bear no relation to the audit function.

    Prohibit the Performance of Certain Management Consulting for
    Audit Clients of Public Companies
        The Cohen Commission examined the question of whether performing
    management consulting impaired the independence of auditors. The
    Commission staff searched for cases where impairment of independence
    resulted from management consulting engagements. The Commission also
    solicited leading critics of the profession for specific cases. With
    the possible exception of Westec, no cases were found. The Commission
    analyzed the problems potentially associated with each of the nonaudit
    services then performed by independent auditors. Its conclusion:

              No prohibition of management services is warranted.\17\
    ---------------------------------------------------------------------------
        \17\ Report at 102.

        However, this conclusion, reached in 1978, should be viewed in the
    ---------------------------------------------------------------------------
    light of another comment in the Commission's report:

              Auditing dominates the practice of large public accounting
            firms, but it has never been the sole function performed by
            public accountants.\18\
    ---------------------------------------------------------------------------
        \18\ Report at 95.

        However, the business volume relationship between auditing and
    management consulting has changed since then. Twenty-two years later,
    the Panel on Audit
    Effectiveness (PAE) of the Public Oversight Board presented the
    following figures for the ``Big 5'' accounting firms in 1999:

                               Percent of Revenues
    ------------------------------------------------------------------------
                                           All Clients        SEC Clients
    ------------------------------------------------------------------------
    Auditing..........................      34 percent         48 percent
    Consulting........................      44 percent         32 percent
    ------------------------------------------------------------------------

        The growth in the last decade of the 20th Century was particularly
    rapid. The PAE reported that the ratio of auditing revenues to
    consulting revenues from SEC clients went from 6:1 in 1990 to 1.5:1 in
    1999.\19\
    ---------------------------------------------------------------------------
        \19\ Panel on Audit Effectiveness at 5.13.
    ---------------------------------------------------------------------------
        The Cohen Commission did recommend a series of safeguards to reduce
    the chance that independence would be impaired: Increased director and
    audit committee involvement and public disclosure of other services.
    These recommendations have been accepted in one form or another.
        The PAE examined the same issue of whether the performance of
    certain management services should be prohibited. The PAE members
    divided, with some members for exclusion of certain management services
    and others for no exclusion. The Panel therefore made no
    recommendation.

    It's the Fees, Stupid
        In arriving at their conclusions, both the Commission and the PAE
    took the same approach; search for examples where the performance of
    management services impaired the appropriate performance of the audit.
    That is, find instances where, because the auditor's consulting arm had
    provided services the auditor was compromised in examining or auditing
    the results of those services. Neither found any examples. In effect,
    the theory was not supported by empirical evidence. The PAE pointed out
    the difficulty of actually finding any such ``smoking gun.''
        I would suggest a different framework for viewing the issue: The
    impact of consulting fees, not consulting work, on the independence of
    the auditor. As discussed above, an auditor taking a strong stand
    against a client risks losing a future stream of audit fees from that
    client. Consider the excerpt above from the Andersen and Waste
    Management case. A truly independent audit partner would have faced
    losing a stream of consulting and other fees even greater than the
    audit fee.
        In addition, the audit partner, Allgyer, essentially was the
    salesman for the consulting services and was compensated for selling
    them. Recall the comment above that Allgyer had a ``personal style that
    . . . fit well with the Waste Management officers.'' Would the style of
    a strong independent auditor have fit as well?
        The Panel on Audit Effectiveness noted in its surveys that working
    auditors received the message that quality audit work was not
    important, that the audit has little value and that other services were
    more important.\20\ Some audit firm partners to whom I have spoken
    believe that audits are often offered as ``loss leaders,'' in other
    words, as entry for sales of consulting services. In my capacity as an
    Audit Committee Chairman soliciting proposals for new independent
    auditors I witnessed substantial price competition and the submission
    of bids that were clearly well below normal billing rates. Virtually
    every audit partner tries, at one time or another, to sell consulting
    services to audit clients.
    ---------------------------------------------------------------------------
        \20\ Panel on Audit Effectiveness at 4.3 and 4.4.
    ---------------------------------------------------------------------------
        I hold an economics degree and am not about to condemn price
    competition. However, in the auditing context, absent a high level of
    professional integrity and supervision, it can result in substandard
    work. For example, the Cohen Commission's extensive survey of working
    auditors found that fully 58 percent admitted to having signed off on a
    required audit step, not covered by another audit step, without
    completing the work or noting the omission of the procedures. ``Time
    budget pressure,'' the result of low fees, was by far the most common
    reason cited.\21\
    ---------------------------------------------------------------------------
        \21\ Report at 179-180.
    ---------------------------------------------------------------------------
        A second impact of ``loss leader'' pricing is a potential loss of
    independence. Professional ethics forbid an auditor to undertake an
    examination if the client has an unpaid balance from a prior audit.
    This is logical, since the debt may give the auditor a pecuniary
    interest in assuring the continuing business of the client. If an
    auditor has priced an audit so low that it will take 2 or 3 years for
    the original loss to be recovered--a period cited to me by several
    audit partners--is that not the same position as being unpaid for a
    prior examination?
        While one would not want to interfere with price competition, some
    steps can be taken to alleviate the problems described just above.
    First, the NFRB should extend the rule against commencing a subsequent
    audit when a prior year's fees remain unpaid to also apply when the
    prior year's costs are unrecovered.
        Audit committees generally now have the responsibility for engaging
    the independent auditor. Well before the current requirements for the
    audit committees of public companies were instituted, the Cohen
    Commission recommended that audit committees carefully consider the
    tradeoffs between price and quality in audit proposals.\22\ In doing
    so, audit committees should emphasize the quality and capability of
    different firms before considering price. When negotiating fees, audit
    committees, interested in assuring that they are receiving truly
    independent audits, should eschew arrangements that will tend to
    compromise independence, such as fixed fees for a period of years.
    ---------------------------------------------------------------------------
        \22\ Report at 107. Most public companies are required to follow
    the standards set in the Report and Recommendations of the Blue Ribbon
    Committee on Improving the Effectiveness of Corporate Audit Committees.
    ---------------------------------------------------------------------------
    Which Consulting Services to Permit? Which to Prohibit?
        This testimony is not the place to provide a detailed answer to
    these questions. However, some general concepts may be developed here
    which could be amplified by NFRB, SEC, or legislative action.
        First, we are considering only auditors of public companies with
    shareholders or creditors removed from direct contact with or control
    over management. The owners and creditors of private businesses are
    capable of making their own decisions as to what consulting is
    appropriate.
        Second, audit partners frequently are highly knowledgeable about
    the business and industries they audit. They should be encouraged to
    give management and the board of directors the full benefit of that
    knowledge as advice and counsel. For example, it may be decided to
    forbid management consultants associated with accounting firms to take
    M&A engagements similar to those undertaken by investment bankers, but
    nothing should prevent an audit partner from giving a board of
    directors advice about a proposed merger or acquisition.
        In short, those services that an audit partner (or senior audit
    staff ) can render themselves should not be prohibited. The Panel on
    Audit Effectiveness, noting the increasing complexity of business
    systems and the need for specialized knowledge to audit them, listed a
    series of ``audit support'' consulting services.\23\ Such services
    should be permitted.
    ---------------------------------------------------------------------------
        \23\ Panel on Audit Effectiveness at 5.10.
    ---------------------------------------------------------------------------
        There are ``traditional'' nonauditing services offered by
    accountants; the most significant of which is providing tax advice,
    planning and return preparation. There is no logical reason to forbid
    such services which have been offered without problems for decades.
    However, the structuring, by accounting firms often employing lawyers,
    of sophisticated, complex, sometimes marginally legal tax shelters (for
    high fees) recently has become an issue. This would be the type of
    ``nontraditional'' consulting, along with strategic planning, business
    reengineering, investment banking, executive placement, legal and
    actuarial services, that will warrant consideration as being prohibited
    for firms performing independent audits of public companies.
    Require Forms 10-Q and Interim Financial Statements to be
    Audited as Part of a Continuing Audit Process
        The Commission recommended:

              The audit should be considered a ``function'' to be performed
            during a period of time, rather than an audit of a particular
            set of financial statements. The annual financial statements
            should be only one, although the most important, of the
            elements audited. Eventually, the audit function should expand
            to include all important elements of the financial reporting
            process.\24\
    ---------------------------------------------------------------------------
        \24\ Report at 60.

        This call for a change in the nature of the audit was considered
    radical at the time. Although proposed again by Robert Elliott, a
    recent Chairman of the AICPA, the concept has not been embraced by the
    profession. However, in discussions following the Enron disclosures,
    there have been repeated calls for release of more current financial
    information.
        It will take time to develop standards for auditor association with
    ``current'' financial information. However, a first and significant
    step would be to require, by statute or regulation, that quarterly
    reports of public companies be ``audited.'' Such reports are currently
    ``reviewed'' on a timely basis under procedures set forth in SAS No. 71
    (1992). It should not be difficult to modify SAS No. 71 to integrate
    the procedures called for therein with the annual audit, as envisioned
    by the Commission.
        It will take a greater, but by no means an insurmountable effort,
    to develop a framework for the ``audit function'' envisioned by the
    Commission. With such a structure in place, rapid progress could be
    made to provide forms of assurance on more financial information that
    may be more current than quarterly reports.

    Former Auditors Working for Clients:
    Notify the Audit Committee
        The previously cited SEC release on Arthur Andersen and Waste
    Management noted that a significant number of former Andersen auditors
    occupied high level financial positions in Waste Management. The same
    appears to have been true in Enron. This migration from auditor to
    financial management is neither new nor unusual. The accounting
    profession has traditionally been a source of talent for companies,
    with individuals often moving to the same companies they audited.
        There are positive aspects to this flow. The company hires people
    already familiar with operations. If the auditor retains the
    professional sense of being a CPA, as well as being a corporate manager
    such employment is likely to be a positive force for integrity of the
    company's financial reporting.
        There are also negatives. In the worst case, the former auditor
    knows exactly how his or her former firm conducts the audit, and how to
    conceal information from them. In a less ominous sense, the former
    auditor knows how far former compatriots can be pushed to accept
    results preferred by management. In general, ``we are all friends,'' is
    not exactly the appropriate relationship between independent auditor
    and client. Recall that Allgyer, the Andersen audit partner had a
    ``personal style that . . . fit well with the Waste Management
    officers.''
        The Commission noted:

              It would be impractical to for us to recommend that companies
            be prevented from hiring individuals who were previously
            employed by a public accounting firm regardless of whether a
            client relationship existed.\25\
    ---------------------------------------------------------------------------
        \25\ Report at 101.

        The Commission said no more about this issue. However, there should
    be a safeguard against its getting out of control. Management should be
    required to notify and receive advance approval from the audit
    committee whenever a former auditor is engaged in a financial
    management position.

    Require Auditors to Evaluate the Financial Statements as a Whole
        The Commission recommended:

              Present standards require the auditor to use judgment to see
            that the selection and application of particular accounting
            principles do not produce a misleading result. He should
            exercise a similar judgment in evaluating the cumulative effect
            of the selection and application of accounting principles. This
            is the only position consistent with the views expressed by
            regulatory agencies and the courts that auditors have an
            obligation to go beyond
            determining technical compliance with specific accounting
            principles and to evaluate the overall presentation of earnings
            and financial position in the financial statements.\26\
    ---------------------------------------------------------------------------
        \26\ Report at 21.

        This recommendation, which has never been accepted, was called the
    ``Smell Test'' by Commission member LeRoy Layton.
        The profession's position is:

              The independent auditor's judgment concerning the
            ``fairness'' of the overall presentation of financial
            statements should be applied within the framework of Generally
            Accepted Accounting Principles. Without that framework, the
            auditor would have no uniform standard for judging the
            presentation of financial position, results of operations, and
            cash flows in financial statements.\27\
    ---------------------------------------------------------------------------
        \27\ AU 411.03.

        Professional standards do require the auditor to evaluate the
    aggregate effect of uncorrected misstatements on the financial
    statements as a whole.\28\ Layton's ``Smell Test'' calls for a broader
    look at the financial statements. It is possible for financial
    statements to be ``unfair,'' even if there are no misstatements and
    they are generally in conformity with GAAP. For example, it appears
    that Enron's accounting for certain energy contracts in accord with
    SFAS No. 133 (on derivatives) and other transactions greatly inflated
    the Company's apparent total size.\29\
    ---------------------------------------------------------------------------
        \28\ AU 312.34.
        \29\ In theory, an auditor might take an exception under Article
    203-1 of the AICPA Ethics Code saying that it was inappropriate to
    apply GAAP in a particular circumstance, but the ``Smell Test'' is a
    broader concept. The Enron example cited here probably does not qualify
    for Article 203 treatment since ``an unusual degree of materiality'' is
    specifically cited as not being a reason to apply Article 203.
    ---------------------------------------------------------------------------
        This recommendation was in accord with a general theme that runs
    through the Cohen Commission report; auditors must be made to exercise
    more independent judgment. As Enron has demonstrated, specific
    accounting rules cannot keep pace with the rapid evolution of business
    practices and the ingenuity of determined managements. The last line of
    defense of fair financial reporting is a well trained, informed auditor
    exercising independent judgment.
    Auditors Should Always be Required to Determine that Accounting
    Principles Selected by Companies are ``Preferable''
        When the Commission issued its report, and today, companies are
    only required to apply Generally Accepted Accounting Principles that
    are acceptable. If acceptable alternatives exist and a company is
    applying one of them, there is no requirement to determine whether one
    of the acceptable alternatives is better. It is only when a company
    changes accounting principles that a preferability test is required.
    The Commission noted:

              When management decides to change an accounting principle,
            use of an alternative must be justified on the basis that the
            new principle is preferable.\30\ If the required justification
            were not given, the auditor would be expected to qualify his
            opinion. However, the auditor's evaluation of management's
            choice among alternative principles should not be different
            simply because there has been a change. The auditor should have
            the same obligation to analyze the underlying facts and
            circumstances for accounting principles for which alternatives
            exist even in the absence of a change.\31\
    ---------------------------------------------------------------------------
        \30\ APB Opinion No. 20, para. 16. A similar requirement is found
    in the SEC's Accounting
    Series Release No. 177.
        \31\ Report at 20.

        This would appear to be a simple suggestion, not subject to a great
    deal of debate. When alternatives exist, the company must always use
    the preferable alternative. The Commission logically modified its
    recommendation to exclude those situations where authoritative bodies
    or extensive analysis had given full consideration to a particular set
    of alternatives and could not determine that one was preferable.
        Nevertheless, no action has been taken on this suggestion since the
    Report was issued in 1978.
        This issue relates also to the question of independent accountants
    giving advice on the structuring of certain transactions. It is
    legitimate and probably desirable for an auditor to give a client
    advice on structuring new transactions so that the accounting for the
    transaction will be acceptable. However, it is not desirable for that
    advice to produce accounting that is ``barely acceptable.'' A
    preferability standard should apply to advice as well.

    Require Companies to Record All Audit Adjusting Entrees
    Regardless of Materiality
        Materiality is the most powerful of all elements in GAAP. Every
    Statement issued by the FASB (and its predecessors) includes:

              The provisions of this Statement need not be applied to
            immaterial items.

        In effect, a materiality decision--or more precisely, a decision
    that a matter is not material--may outweigh the most authoritative
    accounting standard or the most egregious accounting. Recall the
    bizarre accounting in the quotes above from the SEC's Release on Arthur
    Andersen. The Andersen partners accepted it on the grounds that it was
    ``immaterial.'' Yet, there is no practical, clearly applicable
    definition of materiality. The standard definition is:

              The magnitude of an omission or misstatement of accounting
            information that, in the light of surrounding circumstances,
            makes it probable that the judgment of a reasonable person
            relying on the information would have been changed or
            influenced by the omission or misstatement.

        This definition was cited by the AICPA in SAS No. 47, by the FASB
    in Concepts 2 and by the Canadian Institute of Chartered Accountants.
    It does not provide an adequate basis for making practical accounting
    decisions; it is essentially a legal construct. In March 1975, the FASB
    issued a discussion memorandum ``An Analysis of Issues Related to
    Criteria for Determining Materiality.'' In 1978, the Cohen Commission
    said:

              The FASB has recently put on its agenda the topics of
            materiality and . . . We encourage prompt completion of the
            projects because of their importance to the development of more
            definitive statements of accounting principles and auditing
            standards.\32\
    ---------------------------------------------------------------------------
        \32\ Report at 16.

        The FASB has promulgated no additional work on materiality since
    1975.
        The better definition of materiality is critical to better auditing
    standards and stronger regulatory control. Almost every significant
    accounting action brought by the SEC hinges on whether the alleged
    misstatements were ``material.''
        I have little hope that my testimony here will result in any
    progress on the general issue of materiality, after more than a quarter
    century of inaction. However, there is one significant step in the area
    that can be taken by regulatory action, by the SEC or, if established,
    by the NFRB.
        Consider the following exchange:
        Auditor: We believe you should book this adjustment reducing
    revenue.
        Client: You are right theoretically, but I would rather not. The
    consolidation is almost finished.
        Auditor: We still think you should adjust.
        Client: No. Besides, your adjustment is only 2 percent of net
    income for the period. It is not material.
        Hypothetical? Uncommon? No. Most experienced auditors have
    encountered this situation. So has the SEC. On September 28, 1998 the
    Chairman of SEC gave a speech at New York University, noting:

              But some companies abuse the concept of materiality. They
            intentionally record errors within a defined percentage
            ceiling. Then they try to excuse the fib by arguing that the
            effect on the bottom line is too small to matter. When either
            management or the outside auditors are questioned about these
            clear violations of GAAP, they answer sheepishly. . . . ``It
            doesn't matter. It is immaterial.''

        Whether many auditors are quite as pliable as the Chairman implied
    is questionable. In practice, the outcome of such confrontations varies
    depending on many factors, not the least of which is the personalities
    and the character of the relationship between the auditor and the
    client. One fact is certain, however: The auditor gets little help in
    dealing with this problem from the profession's authoritative
    literature. The recently issued SAS No. 89 requires the audit committee
    be informed of uncorrected misstatements that are deemed immaterial,
    but not that they be corrected.
        I propose a simple, straightforward standard which I believe would
    provide guidance in many of the situations described above. The
    substance of the proposed rule is: Discovered misstatements must be
    corrected.
        The new standard could be promulgated as either an accounting or an
    auditing standard (or both). Its rationale is simple: Today, there is
    negligible incremental cost--in terms of time or money--associated with
    making an audit adjustment anytime before the financial statements are
    printed. In the digital age, worksheets and financial statements reside
    in computers. The $149 accounting program in my laptop computer will,
    when given an journal entry or other correction, instantly and
    completely revise all the resulting financial statements. The software
    used by corporations and auditors is certainly no less versatile.
        Thus, arguments that it is too difficult or too late to record
    audit adjustments have vanished in the computer age. It is time to
    promulgate a materiality standard that reflects this reality.
    Reinvigorate the Accounting Profession
        As I have said several times earlier in this testimony, the
    accounting profession has become less professional in the last several
    decades. Through the 1960's, the best and the brightest of the
    professional accountants led the accounting firms, filled the seats on
    the standard setting bodies and taught accounting students.
        Thereafter the accounting world began changing. Management of the
    accounting firms gradually passed to those who could bring in business.
    The technicians were eased out of management and essentially became
    consultants to the staff accountants who were themselves less able to
    deal with the increasingly complex accounting literature. Control of
    the standard setting function at the FASB became independent of the
    profession.
        New accounting professors were increasingly drawn from the ranks of
    Ph.D's who never practiced accounting and could, therefore, not become
    CPA's. Academic accountants grew increasingly apart from the
    profession, most occupied with research unrelated to problems and
    issues of the profession and financial reporting. Increasingly,
    accounting was taught in colleges and universities as support for
    management, rather than as a profession.

    Establish Graduate Professional Schools of Accounting
        The most obvious of these problems (in 1978) was:

              A student who graduates from a high-quality liberal arts
            undergraduate college cannot generally obtain an equally high-
            quality graduate professional degree in accounting.\33\
    ---------------------------------------------------------------------------
        \33\ Report at 89.

        It was clear to the Commission in 1978 that the lack of a graduate
    professional option was weakening the profession. In the past quarter
    century, the problem has grown worse as an increasing portion of
    students defer their career choice until they graduate college. They
    can then attend graduate schools in law, medicine, business,
    architecture, physical and social sciences, pharmacy and others, but
    not accounting.
        Without a graduate option, the accounting profession has cut itself
    off from a growing portion of the best brain power. It is in
    essentially the same position as single sex colleges, men or women
    only, who gradually realized that they were closed to 50 percent of the
    student pool. They opened their doors to the opposite sex.
        The Cohen Commission called for the establishment of graduate
    professional schools of accounting, following the law school model.
    However, it offered no suggestions on how such schools might be started
    or financed. This is not a problem that is susceptible to Federal
    legislation or regulatory action. However, after considering the issue,
    it might be useful to call for State boards of accountancy, which set
    entry requirements, to increase educational requirements or offer
    incentives to graduates of such accounting schools.
    Close the Gap Between Accounting Academics and the Profession
        As discussed above, most accounting professors have little interest
    in or ties to the profession. This gap has had an adverse impact on the
    profession. The Commission noted:

              One of the roles of the academic arm of a profession is to
            serve as the conscience of the profession. Academe provides
            opportunity for reflection and study not permitted to the
            practitioner; the professor need not fear the loss of a client
            when he makes a statement critical of current practices. During
            the hectic years of the 1960's . . . most members of the
            academic community remained silent. Only a few professors were
            openly critical of those accounting and reporting abuses that
            gave rise to much of the present criticism of the
            profession.\34\
    ---------------------------------------------------------------------------
        \34\ Report at 86. One of the few vocal critics during that period
    was Professor Briloff who is scheduled to testify before the Committee.

        The situation has not changed. The academic accounting community
    still remains almost mute about the current problems of the profession.
    Again, the establishment of graduate professional schools of
    accounting, with professionally oriented faculties, would appear to be
    the most likely solution.

                                   ----------

                   PREPARED STATEMENT OF ARTHUR R. WYATT, CPA

      Former Chairman, American Institute of Certified Public Accountants'
                    Accounting Standards Executive Committee
         Former Chairman, International Accounting Standards Committee
                     Former Partner, Arthur Andersen & Co.
           Professor of Accountancy Emeritus, University of Illinois
                                 March 6, 2002

        Chairman Sarbanes, Ranking Member Gramm, and Members of the
    Committee:
        I appreciate your invitation to testify before the Senate Committee
    on Banking, Housing, and Urban Affairs on Wednesday, March 6, 2002, and
    to submit in advance of that date my comments on the issues raised by
    recent failures in financial reporting by public companies,
    deficiencies in accounting standards, and inadequate oversight of the
    accounting profession.
        While I am mostly retired at the present time, I have served about
    25 years as a partner of Arthur Andersen & Co. and have been a member
    of the Financial Accounting Standards Board, a member and Chairman of
    the American Institute of Certified Public Accountants' Accounting
    Standards Executive Committee, and a member and Chairman of the
    International Accounting Standards Committee. My comments to follow are
    based upon my experiences with those entities, as well as my
    observations of the accounting profession as an academic and as a
    consultant to attorneys in litigation concerning accounting issues.
        I intend to address the following areas in my comments: The need
    for attitudinal changes within the major accounting firms, the need for
    a higher level of quality assurance, both within the accounting firms
    and by outside overseers, the need for certain restrictions on the
    range of services that public accounting firms should be permitted to
    provide to audit clients, the need for continued improvement of the
    Financial Accounting Standards Board, both in structure and in
    processes, the need for audit committees of boards of directors to
    become more proactive in the financial reporting process, and the need
    for reconsideration of existing accounting profession disciplinary
    structures.
        Before dealing with these issues, however, it may be helpful to
    provide some background on the evolution of the large public accounting
    firms over the past 35 years. My observation is that over this period
    the attitude of the leadership of the large accounting firms has
    gradually shifted from emphasis on the quality of accounting and
    auditing services provided to clients to emphasis on growing top-line
    revenues. While this change in emphasis has been a considered one by
    the firm leaders, the change has been an evolutionary one, more a
    gradual process than tied to any identifiable events. Competitive
    forces within the profession led firm managements to strive for growth,
    largely by increasing the range of services provided. The focus on
    growth in revenues altered attitudes within the firms as to the primacy
    of the quality of the accounting and audit services provided.
        I suspect that the various firm leaders would deny that such a
    change has, in fact, taken place. But the issue is not whether firm
    leaders intended to alter the emphasis on the quality of accounting and
    audit services. Rather, the issue is whether a heightened focus on
    expanding the range of services provided (in order to generate
    increased revenues) acted to diminish the focus of partners and
    managers on the quality of accounting and audit services provided. Firm
    leaders would likely argue that they have never purposefully
    deemphasized the primacy of quality of accounting and auditing
    services. The facts would show, however, that attitudinally a gradual
    change has occurred. Thirty-five years ago the leaders of most, if not
    all, the major accounting firms at that time were well-recognized
    technical experts, individuals for whom quality of service and
    outstanding professionalism in its delivery were paramount. That
    attitude was conveyed to younger partners and staff in a variety of
    ways, including educational and training programs. Furthermore, younger
    partners and staff could observe that advancement and salary increases
    went to those deemed to deliver best high-quality technical and
    professional services in the accounting and auditing arena.
        Today, the large firms continue to have a high level of technical
    expertise and continue to emphasize quality of services provided. Even
    so, the most technically competent individuals are no longer recognized
    as the principal leaders of the firms. Rather than being leaders of the
    various firms, these experts now are less visible within the accounting
    profession and, to some extent, even within their individual firms. The
    firm leadership roles have been assumed by individuals whose expertise
    lies in administration and/or marketing or promotional activities. By
    this observation I make no value judgment as to which type of
    background best prepares one to lead the complex accounting firms as
    they exist today. Rather, my point simply is that on a relative basis
    those with the greatest technical skills and a greater focus on high-
    level professionalism have a lesser role and a lesser visibility within
    the firms than was true 35 years ago. This relatively diminished role
    affects attitudes within the firms about the relative importance of
    quality of service provided and growth in firm revenues.
        I do not intend to imply that the leaderships of any of the
    accounting firms intended to trade off revenue growth for quality of
    service. I have no evidence that any such intent has existed, and, in
    fact, I would argue that such intent was not purposeful. Rather, firm
    leaders made a series of decisions over the years to grow their
    practices, a phenomenon clearly consistent with the direction taken by
    most commercial enterprises in the country. The result of these
    decisions, however, has been to create large commercially-oriented
    accounting firms when the franchise granted to these firms (through the
    State-monitored licensure of individuals permitted to attest to the
    fairness of presentations in financial statements) was more a
    professional service orientation than a commercial one.

    The Attitudinal Issue
        The impact of this attitudinal change within the firms has been
    significant in my view. No longer is technical expertise and leadership
    the obvious avenue to progress within the firms. Rather, expansion of
    clients served and expansion of client services are viewed as primary
    drivers. And, obviously, the loss of a client is a negative in one's
    career path. Since many decisions required of audit firm managers and
    partners are judgmental in nature, rather than clearly prescribed by
    extraneous forces, such judgments are, at the margin, sometimes
    influenced by perceptions of the attitudes of leaders of a given firm.
    If those perceptions by firm audit personnel are that loss of a client
    is damaging to one's career path, the judgments made may be more in the
    direction of keeping the client than to achieving fair presentation of
    financial statements.
        This change in attitude also has had a significant impact on the
    nature of new hires into the large accounting firms. Thirty-five years
    ago nearly all new hires by accounting firms for their professional
    staffs were college graduate accounting majors whose education not only
    encompassed technical accounting and auditing issues, but also
    emphasized professional and ethical responsibilities required of an
    accounting professional. As the firms grew and the range of services
    offered by auditing firms expanded, college accounting majors were no
    longer plentiful enough to serve the needs of firms, and they no longer
    possessed all of the skill sets needed to provide the expanded range of
    services. The major auditing firms turned increasingly to nonaccounting
    majors, bright students regardless of their field of study, for some of
    their new hires.
        While these new hires were talented in many respects, their
    understanding of the professional responsibilities of reporting
    auditors and the ethical constraints under which their work would be
    undertaken was limited, if not nonexistent. Individuals with such
    backgrounds might be more reactive to the attitudinal changes
    previously mentioned.
        Similarly, educational institutions struggled to modify their
    accounting-major programs to better fit the perceived needs of the
    major accounting firms. In fact, many of these academic modifications
    were urged upon the academic community by the large auditing firms.
    While exceptions could be cited, the emphasis on professionalism and
    ethical responsibilities diminished in a relative sense. Accounting
    programs employed as accounting professors some individuals with little
    or no educational backgrounds in accounting and were not particularly
    receptive to employing experienced professionals who might convey to
    students in an effective way professional and ethical responsibilities
    to be assumed by one entering the accounting profession.
        The effect of this relatively increasing emphasis on
    commercialization and relatively diminishing emphasis on
    professionalism tends to diminish efforts to maintain a strong
    professional focus that a professional firm may otherwise strive to
    promote. Recognizing that accounting and auditing services are more an
    art than a science, it should not be surprising at all that from time
    to time individual accounting practitioners, no matter how complete
    their training, would, for any number of reasons, fail to perform their
    professional duties at the level of competency their clients, the
    public, and the firm managements had a right to expect. For
    professional accountants to reach sound judgments in a professionally
    responsible way, their work environment, including the attitudes
    projected from the top of their firms, needs to be as unequivocally
    professional as possible.
        While my comments on the scope of services provided by public
    accounting firms will follow, I believe that the leadership in the
    various firms needs to evaluate how well their existing organizational
    structures and reward policies are serving what has to be their primary
    focus, the delivery of high-quality professional accounting and
    auditing services to clients. While these observations may not be very
    helpful in considering legislative initiatives, I believe they are
    crucial for the major accounting firms to address if the firms wish to
    survive in the private sector as respected reporters on the financial
    situation and results of operations of business enterprises.

    Improvement in Quality Assurance
        Large accounting firms have similar programs to try to assure audit
    quality control. Even so, the increased number of financial statement
    restatements in recent months suggests that existing quality control
    programs need to be strengthened. The emphasis on quality control needs
    to be heightened, and audit personnel need to gain a better
    appreciation for all aspects of a firm's quality assurance program.
    Renewed emphasis on the importance of audit quality control mechanisms
    would be an important part of shifting the attitude within accounting
    firms to a proper focus on the quality of financial reporting.
        As individual firm quality control experts evaluate the work of
    individual partners and managers in their numerous offices, special
    efforts need to be made to review high-risk clients and/or clients
    utilizing high-risk transaction forms. Likewise, quality control
    experts need to assess specifically the extent to which individual
    managers and partners address difficult client issues from the
    perspective of fairness of financial reporting. Specific challenges
    should be made of judgments by audit managers and partners that
    adjusting entries proposed by them and not recorded by the client are
    acceptable from the perspective of achieving fairness in the resulting
    financial statements. Quality control experts within the firms should
    seek out any evidence that suggests financial reporting by the client
    entity is not reflective of
    the transactions and events that occurred. Whenever such evidence is
    found, the appropriate resolution must be pursued even when the end
    result could be the loss of a client.
        Changes implemented in this area are in the best interests of the
    firms and, in the current environment, are likely to be instituted
    quickly on a voluntary basis. Recent news articles suggest some of the
    large firms have undertaken numerous initiatives on such matters. An
    independent oversight board, as discussed later, should monitor such
    changes to satisfy themselves that appropriate policies are in place to
    assure high-quality audit efforts.

    Expansion of Range of Services
        The evolution of the drift toward increased emphasis on
    commercialization and reduced emphasis on professionalism led the large
    accounting firms to expand the range of services provided to their
    audit clients. Importantly, however, we must acknowledge and emphasize
    that accounting firms have always provided their audit clients services
    that extend beyond the activities required in an audit to complete the
    formation of an opinion on the fairness of presentation in the
    financial statements. Many of these services are logically best
    provided by the audit firms--tax return preparation and tax planning,
    evaluation of accounting alternatives for planned transactions,
    assistance with financial statement preparation for regulatory
    purposes, audits or reviews of prospective acquirees in business
    combinations are examples. Indeed, any additional services that are
    directly related to assuring the fairness of presentation of client
    financial statements are proper activities for audit firms to
    undertake. Services of these types are often closely related to, and
    helpful in, the successful completion of financial statement audits.
    They supplement the knowledge base of audit personnel and do not
    conflict with the central mission of auditors--forming an opinion on
    the fairness of presentation of client financial statements.
    Restrictions imposed on these types of services would create
    inefficiencies for clients and would not be in the best interests of
    investors or the financial or business community.
        On the other hand, as the range of services provided broadened,
    some were clearly creating potential for conflicts with the basic audit
    services. While I am unaware of any evidence that consulting-type
    services have ever adversely influenced an auditor's audit judgments on
    decisions, the fact is that today existence of some services creates an
    appearance that can no longer be tolerated. For example, rendering
    internal audit services for audit clients was never a sound idea.
    Likewise, services related to the design of financial reporting systems
    place the auditor in an awkward position if the system does not
    function as anticipated. Actuarial services, executive searches, advice
    on specific investment decisions and many more services of this
    nature that evolved over the years to generate increased revenues but
    either have little relationship to the annual audit or may create
    conflicts of interest should no longer be permitted by audit firms for
    their audit clients.
        The range of services provided by audit firms to their audit
    clients grew for a variety of reasons. One was the leaning toward
    commercialization previously mentioned. Another was recognition by
    firms that their personnel possess skills that extend beyond those
    needed to complete audits successfully. Another was a desire, and
    ability, to fulfill requests by clients for additional assistance. As
    investment bankers and other financial advisers created increasingly
    complex business transactions (some designed to circumvent existing
    accounting standards), clients logically asked their auditors for
    assistance in evaluating the consequences of undertaking such
    transactions.
        Consistent with the reestablishment of professionalism as the
    primary focus of auditing firm services, restrictions need to be
    imposed on the range of related services that auditors should be
    authorized to provide their audit clients. Drawing lines in this area
    will not be an easy task, largely because words used are not always
    interpreted in the same manner by all those who have to interpret them.
    Given the current environment, it is certainly possible that some
    regulations or legislation will suggest scope of service restrictions
    that will damage the auditor's ability to develop the best possible
    basis for expressing an opinion on the fairness of presentation of the
    client's financial statements. Initiatives in this area need to be
    undertaken, but they must be undertaken with care so that they do not
    frustrate the auditor's ability to complete top quality audit services.
        Self-policing mechanisms have not worked well, and the Securities
    and Exchange Commission, audit committees or a newly created
    independent oversight body may have to play a significant role in this
    area. Regardless, attempts to regulate the range of acceptable services
    that audit firms may provide their audit clients likely will be
    frustrated without leadership in the several firms willingly agreeing
    to move away from their commercialization instincts and reemphasizing
    the primacy of meeting professional standards in all respects.

    Accounting Standard Setting
        The Financial Accounting Standards Board, FASB, is soundly
    conceived and has operated reasonably well given the difficult
    environment it faces. Two principal criticisms of the Board's standards
    are that they are not always conceptually sound and that they take too
    long to produce from inception of a project to release of a final
    standard.
        The Board has a conceptual framework that it utilizes in developing
    positions on an accounting issue under consideration. That framework is
    reasonably cohesive and has served the Board well. Even so, the Board
    needs to recognize that its conceptual framework is a living document
    that will require modifications from time to time as accounting and
    economic concepts evolve. Improvements in its conceptual framework
    should have a high priority for the Board.
        Too often the Board has departed in its final standard from the
    concepts that it has represented will guide its decisions, generally
    because interested parties have not only raised objections to
    conclusions tentatively expressed, but also have effectively lobbied
    against adoption of those decisions the Board has signaled. Such
    departures are not surprising given that the processes of the Board are
    open, with public meetings, public hearings, and Exposure Draft issued
    requesting comments from interested parties. While the comments
    received through these open processes are often helpful in the crafting
    of a final standard, too often the criticisms are not conceptually
    based, but rather are emotional in nature, reflecting a dislike for the
    direction the conclusions are taking. Thus, the Board often modifies,
    or softens, its tentative conclusions to reflect some of the concerns
    expressed in the due process procedures.
        The due process procedures are soundly conceived and essential for
    the Board to achieve a desirable level of credibility for its
    standards. What is needed is a greater discipline by those
    participating in the process to direct their comments to weaknesses in
    the Board's reasoning processes and to eliminate the emotional
    criticisms that have no logical basis. If the accounting standard
    setting process is to achieve its objectives of providing guidance on
    appropriate accounting for transactions and events of an entity, the
    process must be recognized by all participants as being primarily an
    intellectual process and not primarily a political process.
        As long as the Board is willing to depart from its underlying
    concepts in order to gain some measure of concurrence with the views of
    its constituents, it will issue standards that will not survive for
    long periods without being abused. The Board often receives negative
    comments from industry constituents, from auditing firm
    representatives, from Members of Congress, as well as others. When
    these comments become part of an organized campaign to undermine the
    direction a standard is taking and recommend alternative conclusions
    that are not conceptually sound, the mission of the Board is
    frustrated. This is particularly true when the intervenors are Senators
    and Representatives who, as part of their commentaries, threaten some
    type of legislation to frustrate the direction in which the Board is
    moving. While Senators and Representatives have a legitimate interest
    in the workings of the Board, they need to recognize that their
    interventions may well lead to Board decisions that are not in the best
    interests of investors and the broad business community. Being
    supportive of the views of constituents and contributors, without
    making conceptually sound alternative suggestions, too often creates
    opportunities for interpretations of the resulting standards that are
    not in the long-term best interests of any parties.
        The time interval required for the Board to promulgate a standard
    has long been a concern of the Board itself, as well as other
    interested parties. A great contributor to the lengthy process is the
    open due process procedures that the Board employs to assure that all
    interested parties have an opportunity to provide commentary. Such due
    process procedures are generally well conceived and serve the overall
    standard setting process well. On the other hand, those who dislike the
    direction a project is taking, whether Board members themselves or
    Board constituents, probably have too great an opportunity to effect
    delay by calling for additional research in order to buy time to lobby
    against the direction they perceive the process is moving. The Board
    may well need greater discipline in this area and the willingness to
    simply move forward at earlier points in the process than has been the
    case in the past.
        Even with improvements in recent years, the Financial Accounting
    Foundation trustee arrangement remains problematical. The trustee group
    would benefit from heavier reliance on individuals independent of the
    accounting firms and companies that provide a share of the Board's
    finances. The challenge is to identify public-minded individuals who
    are willing to devote the necessary time to meeting the trustees' two
    main areas of activity--identifying and appointing competent Board
    members and raising sufficient finances to permit the Board to operate
    effectively. While the current financing mechanism could be tinkered
    with, no individual entity currently contributes a significant portion
    of the Board's budget. I am unaware of any instance in which any Board
    member's vote on an issue was influenced by the position taken on the
    issue by a contributor. I believe with the proper composition of the
    trustee group the issue of independence of the trustees would be
    resolved. Alternative means for financing required by the Board may be
    considered, but I do not view the present mechanism to be troublesome
    as long as major contributing groups are not represented as trustees of
    the Financial Accounting Foundation.
        For the Board to be able to continue to improve the quality of its
    standards the Board needs to place increasing reliance on its
    underlying concepts, avoiding to the extent possible standards that
    compromise those concepts. Standards that are conceptually sound need
    not run hundreds of paragraphs to thwart those who would attempt to
    subvert the intent of the standards. Each standard issued by the Board
    should contain, in the clearest English possible, the objective, or
    intent, the Board intends to achieve by issuing the standard. Each
    standard issued by the Board should also contain a clear statement that
    anyone who is applying the standard should review carefully its
    application to satisfy himself or herself that the objective specified
    by the Board has, in fact, been best achieved through the application
    that has been adopted.
        I am convinced that the FASB process is soundly conceived, that the
    Board members over the years have been dedicated professionals of great
    integrity and independence, and that the quality of accounting
    standards today is better than it has ever been, even with the
    shortcomings that some standards contain.
        In summary, the financial standard setting process is an
    evolutionary one that has grown stronger over the years. Continued
    improvement in the areas outlined would strengthen the process further.
    Finally, if constituents would refrain from emotional criticisms during
    the due process period and if Senators and Representatives would
    refrain from interventions that are perceived by the Board as being
    heavy handed and politically, rather than intellectually, based, the
    accounting standard setting process will continue to improve and serve
    investors and the investment community better than any alternative
    structure.
        The relationship between the FASB and SEC over the years has been a
    positive one which benefits investors and creditors. While each
    organization has a different mission, each has the same end objective
    in mind. Continued cooperation between these two entities is in the
    best interests of investors and creditors.

    Audit Committees
        The requirement for public companies to have audit committees of
    the board of directors is a relatively recent phenomenon. Through
    interventions of numerous parties, most importantly the Securities and
    Exchange Commission, audit committee requirements and procedures have
    been modified, and upgraded, over the last several years. Even so, my
    experience (mostly as a consultant to attorneys in litigation matters
    involving issues of accounting) is that audit committees remain far
    less
    effective than they could be or ought to be. Audit committee members
    need to focus importantly on the various risks faced by their company,
    including accounting risks related to the possibility of improper
    accounting for new and/or complex business transactions.
        While financial statements can be misleading in a variety of ways,
    most deficient financial reporting matters fall into four areas: The
    timing of revenue recognition, the propriety of cost deferral, the
    omission from the balance sheet or related footnotes of any significant
    obligations, and the adequacy of disclosures, particularly any that may
    center or related party transactions. Audit committees need to question
    corporate financial accounting personnel in depth about such matters
    and the risk of possible financial misstatements. Likewise audit firm
    representatives need to be similarly questioned. In addition to routine
    agenda matters, each audit committee meeting should focus on a
    particular business risk area (including potential accounting risks)
    and any significant concerns emerging from such discussions need to be
    aired further with the full board of directors.
        At least the audit committee chairman, and preferably all audit
    committee members, should have experience in evaluating business risks
    and should be sufficiently conversant with accounting issues to raise
    appropriate questions with an ability to evaluate the responses
    received. Too often audit committee meetings are perfunctory in nature.
    Real opportunities to gain an understanding of business risk areas are
    missed. As a result the process in place is not as effective as it
    could be, nor as effective as those who accomplished the establishment
    of audit committees had a right to expect such committees would be.
        Audit committees should be especially curious about the so-called
    adjustments proposed by auditors but not made by company accounting
    personnel. Oftentimes the basis for the company not making the entry is
    that the amount involved is not material. Materiality is an elusive
    concept that is even more elusive in practice. Audit committees should
    pressure company accountants and the auditors to resolve any open
    proposed adjusting entries either by the company accepting the entry
    for recording or the auditor concluding that the proposed entry should
    be eliminated from its schedule of open proposed adjusting entries. In
    too many instances the materiality judgments made have masked what, in
    fact, was inappropriate accounting, accounting that fell outside
    Generally Accepted Accounting Principles.
        The audit committee concept is a sound one. Through efforts of the
    New York Stock Exchange and the SEC improvements in committee
    composition and mission should continue to evolve. Honest managements
    and responsible auditing firms should welcome audit committee
    involvement when such committees are constituted properly, with
    knowledgeable individuals willing to gain an understanding of the
    underlying business risk issues and raise questions on appropriate
    accounting and disclosure matters.

    Disciplinary Mechanisms
        My experience with this issue, as well as my knowledge base is
    sparse. The current mechanism, under the auspices of the American
    Institute of Certified Public Accountants, however, clearly is not
    working. Over the years the AICPA has become more and more a trade
    association and less and less a professional organization. The
    diversity of interests of its members, from sole practitioner to large-
    firm partner, to corporate executive makes it almost impossible for the
    AICPA to exercise leadership and articulate policies that one would
    expect of a professional organization. Its emphasis has been on
    expanding its breadth of membership rather than on providing leadership
    in professional practice areas or disciplinary policies that would be
    effective.
        Suggestions have been made recently for creation of a new
    independent oversight board comprised of leading individuals
    independent of the accounting profession. While the AICPA sponsored
    Public Oversight Board has been comprised of highly regarded
    individuals, its effectiveness has recently been questioned. Who should
    be the ``parent'' or ``owner'' of such a board is a difficult issue
    that I have no particular insights in resolving.
        Over the years the Securities and Exchange Commission has been a
    generally effective agency working toward improvements in financial
    reporting. Even so, its resources have probably been far too limited to
    achieve the optimum level of success in its diverse objectives. I would
    be inclined to provide increased funding to the SEC and have it assume
    the principal role in overseeing the effectiveness of the financial
    reporting process. Creation of a new agency to undertake this
    responsibility seems unnecessary in view of the record established by
    the SEC over the past 65 years.
        In summary, I feel that the leadership of the major accounting
    firms should see today that it is clearly in their best interests to
    refocus their objectives on quality professional performance and to
    refrain from growth through expansion of services rendered. New
    restrictions on scope of practice, possibly monitored by the SEC, are
    desirable and in the public interest. The FASB should place increased
    emphasis on conceptually sound standards and on more timely issuance of
    such standards. The Board should experiment with how better to craft
    its standards so that corporate accountants and auditors will be
    encouraged to apply the standards so as to best meet articulated
    objectives of the standards rather than to search out and expand
    possible loopholes that lead to applications that fail to reflect the
    economics of transactions undertaken. The Board should continue its
    efforts to rebuff initiatives of its constituents, including elected
    officials, when such initiatives are more emotionally than conceptually
    based. Audit committees should be encouraged, possibly by the New York
    Stock Exchange and the SEC, to be more diligent and effective in
    overseeing corporate risk exposures and accounting policies that accord
    fully with the intent of applicable accounting standards. Finally,
    improved disciplinary and oversight mechanisms on professional practice
    firms need to be instituted so that variant behavior is identified
    early and punished if not corrected.

                                   ----------
                    PREPARED STATEMENT OF ABRAHAM J. BRILOFF

                 Emanuel Saxe Distinguished Professor Emeritus
                        Bernard M. Baruch College, CUNY
                                 March 6, 2002

                Accountancy and Society / A Covenant Desecrated
        The Commission is fond of quoting Judge Friendly's statement: ``In
    our complex society the accountant's certificate and the lawyer's
    opinion can be instruments for inflicting pecuniary loss more potent
    than the chisel or the crowbar.'' U.S. Circuit Judge Henry Friendly,
    United States v. Benjamin 328 F2 85, 863 (1964).
        Chairman Sarbanes, Members of the Committee on Banking, Housing,
    and Urban Affairs of the U.S. Senate: I very much appreciate this
    opportunity of appearing before you this morning to share with you my
    views regarding the crisis in confidence which presently confronts my
    profession of certified public accountancy and then to suggest what I
    believe to be the essential critical path to resolve that crisis.
        After much reflection I have opted for the title theme for today's
    presentation, ``Accountancy and Society / A Covenant Desecrated.'' I
    recognize that I have thus opted for an awesome theme; I mean it to be
    just that, i.e., most certainly not a mere rhetorical conceit.
    The Covenant
        The covenant to which I am alluding involves on the one hand the
    mandate which is imposed on certified public accountants by the
    statutes which created that professional license; from the New York
    Statutes going back to the close of the 19th Century. Definition:

              The practice of the profession of public accountancy is
            defined as holding one's self out to the public, in
            consideration of compensation received or to be received,
            offering to perform or performing for other persons, services
            which involve signing, delivering or issuing or causing to be
            signed, delivered or issued any financial, accounting or
            related statement or any opinion on, report on, or certificate
            to such statement if, by reason of the signature, or the
            stationery or wording employed, or otherwise, it is indicated
            or is
            implied that the practitioner has acted or is acting, in
            relation to said financial, accounting or related statement, or
            reporting as an independent accountant or auditor or as an
            individual having or purporting to have expert knowledge in
            accounting or auditing.

        On the other hand there is the very special franchise granted to
    the accounting profession by a 3 to 2 vote of the Securities and
    Exchange Commission at its inception, that requiring all registrants to
    submit statements audited by accountants in the private sector rather
    than by employees of governmental agencies. That special franchise is
    generating revenues amounting to billions of dollars annually.
    Why the Covenant
        This covenant was undertaken between my profession and society for
    most compelling reasons--reasons which have been increasingly
    compelling with the passage of time and the corresponding expansion
    exponentially, it might appear, of our economic society and complexity
    of our corporate enterprises. It is to assure the effective functioning
    of capitalism powered by the corporate complex which demands an
    effective system of corporate governance and accountability--and it is
    to help drive such a process that the covenant was entered into by
    society with my profession.
        Let me back up a bit: I believe it to be self-evident that in the
    day-to-day existence of our citizenry the private sector of corporate
    complexes plays a far more
    direct role than the Government. Thus, the air we breathe, the
    recreation we enjoy our mode of mobility, our habitats, health, and
    economic well-being are all impacted by decisions by those who somehow,
    somewhere control the conduct of corporate
    enterprises.
        Here then is where we meet up with the Power without Property
    Syndrome, described early in the 20th Century by Gardner C. Means and
    later expanded by Adolf A. Berle. Thus, enormous pools of power have
    been delegated to managements by those who are the owners of the
    resources, that is, shareholders, creditors, Government, employees, et
    al.
        To assure those who have thus delegated their resources to
    managements we have conceptually, at least, built in a system of checks
    and balances, a system of corporate governance and accountability. I
    picture that system as a series of concentric rings, somewhat as
    follows.
    The Corporate Governance and Accountability System
        At the vortex of the constellation is management, the very center
    of power of the corporate complex. The first of the outer rings in this
    configuration is the board of directors whose authority is derived from
    the shareholders and presumed to be responsible for determining the
    policies of the corporate enterprises and then reviewing their
    operations to assure their constituencies that the policies are, in
    fact, being fully and fairly implemented.
        There then follows an especially critical sector, the independent
    audit committee of the board of directors. Here, too, those who have
    been elevated to this special role and responsibility should be
    continuously aware of the reasons why such a committee has become such
    a vital force in our corporate governance and accountability process.
    They should be continuously mindful of the terms ``independent'' and
    ``audit'' and make certain that they possess the temperament and
    healthy skepticism called for by the standards governing independent
    audit committees. Thus, those committees were mandated first by stock
    exchanges and then by the SEC in response to critical developments over
    the years; it is only if the members fulfill their roles
    conscientiously and professionally, determined to act as watchdogs
    rather than managements' lapdogs, that they will be fulfilling the very
    special mandate which has been bestowed on them and presumably accepted
    by them.
        This now brings me to what is for me the crucial ring in this
    constellation, that of the independent auditor, the one who has entered
    into the covenant with society; the one who is presumed to have
    undertaken the role and responsibility of probing the conduct of all
    aspects of the corporate enterprise as the surrogates on behalf of the
    world of third parties.
        In short, those are the qualities which our society had presumed of
    the independent auditors as an incident to the entering into the
    covenant. Absent those qualities, anything which compromises those
    expectations represent a breach, a desecration of the covenant.
        This brings us to the ring to representing the nexus of State and
    Federal agencies involved in the regulation of the corporate complex.
    At the outset, we have the States which bring the business enterprises
    into existence by the granting of corporate charters or licenses as
    appropriate.
        It is also the States which bestow the licenses for the various
    professional pursuits, accountancy, law, etc., which may be involved in
    the corporate governance and accountability process. But of special
    import for present purposes are the regulatory agencies, Trade,
    Utilities, Transportation and, especially for us here today, the
    Securities and Exchange Commission which is charged with the
    administration of the Securities Acts of 1933 and 1934, and the source
    of Regulation S-X providing the rules governing the registrant's
    accounting responsibilities and practices. It is undoubtedly the SEC
    which comes to mind regularly during these days of agonizing appraisal
    and reappraisal as to what went awry at Enron--and wherever else
    accounting irregularities are now surfacing with regrettably increasing
    frequency.
        The next succeeding ring is the Congress of the United States which
    over the scores of years since the Great Depression has, through its
    Investigative and Legislative actions critically, vitally, impacted the
    standards for corporate governance and accountability.
        We move outward then to the Judiciary, principally the Federal
    courts which through their determinations in civil and criminal
    proceedings further define the standards for conduct of all those
    involved in the corporate enterprise.
        This would complete the corporate governance and accountability
    configuration as I envisage it. But then too at each of the stages of
    the process we find the professions of the law, finance, journalism,
    academe, in addition to accountancy beyond that of independent
    auditing. All of these phases when functioning optimally consistent
    with their professed objectives should assure the effective functioning
    of our corporate enterprise system which, as I have emphasized, is the
    engine which propels modern capitalism system. If this system of
    interrelated responsibilities fails, we have the Enrons, et al.

    Some Footnotes to History
        In the hope that it might help to avoid repeating its mistakes,
    herewith some
    footnotes to history relating to past endeavors to overcome the
    recurring crises in corporate accountability.
        There was a flurry of activity during the second half of the
    1970's, including:

     Late 1976 a staff study dubbed The Accounting Establishment
        was prepared for the U.S. Senate Committee on Government
        Operations.
     The following year extensive hearings were held under the
        Chairmanship of Senator Lee Metcalf.

        To placate the extensive criticism leveled at the accounting
    profession its leadership, the AICPA, the Big 8, agreed to what they
    assured us would be an
    effective response to the crisis. This included the creation within the
    AICPA of a Division for Firms especially its SEC Practice Section and
    Public Oversight Boards; all that together with a system of peer review
    was going to lead us to Nirvana.
        Alas! As predicted, peer review became nought but mutual back
    scratching; the POB was soon co-opted by the AICPA so that the
    presumptive public protector became another layer of insulation to
    protect the Accounting Establishment.
        By way of a justification of the foregoing cynical observation, I
    have regularly challenged the POB and its parent body the AICPA to
    point me to any disciplinary sanctions meted out against those
    identified with the Accounting Establishment who have been prominently
    identified with serious audit failures after audit failures. That
    challenge continues to the present.

     We then have the Foreign Corrupt Practices Act of 1977 which
        explicitly directed the effective functioning of systems of
        Internal Control for all SEC registrants. The SEC proposed
        regulations to implement the provision's of the FCPA, that valiant
        endeavor was effectively resisted by the accounting profession and
        their constituencies--the proposal was withdrawn. (Included
        herewith as Exhibit A is a critical commentary on these
        developments which was included in my article ``The Private
        Securities Litigation Reform from a Critical Accountant's
        Perspective'' which appeared in the Critical Perspectives on
        Accounting (1999) 10, 267-282.
     This brings us to 1995 when, as part of the bargain leading to
        the passage of the Private Securities Litigation Reform Act of
        1995, Title 3 was enacted, so as to
        require auditors of SEC registrants to probe more aggressively for
        irregularities or fraud.

        As my aforementioned Critical Perspectives article also noted the
    Senate suggested that the new requirements be implemented with only
    most deliberate speed and so it has been. And as we know from the
    record of the so-called Independence Standards Board created by the
    AICPA the more deliberate the better insofar as the Accounting
    Establishment is concerned.

     And this takes us to the millennium year 2000 when the SEC
        under Chairman Arthur Levitt and Lynn Turner as its Chief
        Accountant sought to induce higher standards of independence from
        the independent auditors of its registrants.

        At hearings during the summer of 2000 we witnessed the AICPA and
    the Big 5 manifesting all of their arrogance of power unless it was
    their power of arrogance to thwart the SEC's proposals. At the end the
    SEC did salvage some changes; and
    especially gratifying as it now turns out is the added disclosure
    relating to the nonaudit fees.

    Quo Vadis?
        This brings me to the response to the question, ``Where should we
    go from here?'' which, I presume, is the reason for your inviting me to
    appear before you today.
        First, I want to repeat with added emphasis the cardinal
    recommendation that I made when I appeared before the SEC on September
    21, 2000, in connection with their hearings on Auditor Independence to
    wit:

          1. Absolute Divestiture, i.e., No ``Strategic'' or Other
    Entangling Alliances.
        Then demand that the profession of certified public accountancy
    rededicate itself to the independent audit as surrogates on behalf of
    all stakeholders. This is the covenant, which we are presumed to have
    undertaken with society--let us fulfill it.
        Such a rededication to the CPA as a professional should put an end
    to our quest for an XYZ license.
        Further, the renaissance of the independent audit as a vital social
    responsibility should prove salutary for relevant research and teaching
    of accountancy qua accountancy in the groves of academe.
        (I have submitted as an Exhibit B for the record a copy of my
    submission to the SEC as an incident to my testimony at the SEC
    hearings.)

        2. And now, going further I urge that the SEC develop a registry of
    firms which have fully committed themselves to the independent audit of
    SEC registrants, consistent with the standards set out above.
        By so doing the SEC would be in a position to proceed overtly to
    impose sanctions or even delisting of firms which have failed in the
    fulfillment of their undertakings.

        3. I would have the independent auditor as an incident to his
    rounds as such independent auditor apply his presumed ``healthy
    skepticism,'' corresponding to the way in which he would proceed if he
    were acting as a forensic auditor in the wake of an accounting
    disaster.
        For example, I recall the circumstances about 4 years ago when I
    had the occasion to analyze the report prepared by Arthur Andersen as
    the forensic auditor in the wake of the discovery of the fraud at CUC
    prior to its merger into Cendant in late 1997. In my analysis I
    congratulated AA on the ways in which it went about its probe to ferret
    out the perversity perpetrated by the financial people at CUC and
    spelled out the errors of omission and commission on the part of Ernst
    & Young, CUC's auditors.
        But then, just as I brought my analysis and commentary to a close,
    along came Sunbeam where AA as the independent auditor fouled its nest
    very much like E&Y at CUC. In short, the auditors know what they need
    to do to produce a product, which could be relied upon by the investor,
    et al. Let them apply their talents in all circumstances where they
    serve as the surrogates on behalf of the world of third parties.
        I am not here suggesting that the auditors become adversaries; but
    then, I insist that they refrain from the writing of the narrative as
    though they were writing an ``authorized biography.'' I am searching
    for a standard of Truth and Objectivity.

        4. I would then look for a sea change to conform the actual
    responsibility for the determination of the financial statements with
    that which is presently presumed by society generally, including even
    sophisticated investors. Thus, the community of users of the statements
    presume that they have been determined by the certifying independent
    auditor. The actuality is reflected by the following assertions
    typically found in the Audited reports submitted to shareholders and
    the other constituencies of the business enterprises.
        First, from the auditor's certificate:
    Report of Independent Accountants
              ``These financial statements are the responsibility of the
            company's management; our responsibility is to express an
            opinion on these financial statements based on our audits . .
            .''

        And then the corresponding assertion from the letter from
    management:
    Statement of Management Responsibility
              ``. . . management is responsible for the preparation,
            integrity and objectivity of the consolidated financial
            statements and other financial information presented in this
            report.''

        5. The resultant auditor's report in the form of words and numbers,
    characterized by clarity, logic, intrepidly, and integrity should
    convey a description of economic
    reality as closely as the states of the Arts of Communication,
    Economics, and Accountancy might allow.
    If We Should Fail . . .
        What if the required drastic, dramatic possibly draconian, as
    viewed by some, changes are not implemented promptly and effectively?
        All of the foregoing proposals for a response to the prevailing
    crisis could be seen to have evolved from my 1967 book entitled The
    Effectiveness of Accounting Communication. Justice William O. Douglas
    honored me by providing a Foreword to that work; some extracts from his
    essay:

              The author demands an understandably high price of the
            attesting accountant, who is preparing himself to fulfill this
            essential role. He expects him to undergo a ``ritualistic
            purging'' and to forego the rewards which may be derived from
            the rendering of a management services and the other
            ``peripheral services'' which he describes.
              The burdens which Mr. Briloff puts upon the profession are
            substantial; but, as he demonstrates, our economic society is
            in urgent need of this
            service. If the accounting profession does not respond
            effectively to the challenges presented, there may be little
            alternative but to have possibly a new profession fill the
            breach.

        (The Justice's Foreword is included in Exhibit B.)

        If we find ourselves deadlocked and our economic society continues
    to be vulnerable then despairingly I would proceed to the proposal
    advanced 2 years ago during my presentation to the FASB at their
    hearings on business ago during my presentation to the FASB at their
    hearings on business combinations. That proposal, as part of my ``An
    Accountancy Manifesto for the Third Millennium'' was published in
    Accounting Today and included in Exhibit B. Accountancy Today article:

              ``I would abort the present requirement that such financial
            statements carry the imprimatur from independent CPA's. This is
            because the major firms that are principally responsible for
            those audits are no longer firms of CPA's, nor are they as
            independent as they are perceived to be by the financial
            community.
              ``As a consequence of these proposals, the determination and
            implementation of the accounting precepts and practices, which
            would best reflect the financial condition and operations of
            the enterprise would become the sole responsibility of
            management. This is essentially the prevailing reality: The
            public's myth regarding the independent audit is just that, a
            myth.''

        I would then have the financial statements carry the legend caveat
    emptor. Coda:
        The February 28, 2002, New York Review of Books included an essay
    by Ambassador Felix Rohatyn captioned ``The Betrayal of Capitalism,''
    which concluded with the following foreboding:

              ``American popular capitalism is a highly sophisticated
            system that needs sophisticated regulation--whether in finance
            or in other fields. The Government itself does not seem to have
            acted illegally in the Enron case; it is the Government's
            failure to anticipate and prevent what happened that is the
            problem. Unless we take the regulatory and legislative steps
            required to prevent a recurrence of these events, American
            market capitalism will run increasing risks and be seen as
            defective here and abroad. That could have deeply serious
            consequences not only for our domestic economy but also for the
            world economy as well. Enron's failure was a failure of
            particular people and institutions but it was above all, part
            of a general failure to maintain the ethical standards that
            are, in my view, fundamental to the American economic system.
            Without respect for those standards, popular capitalism cannot
            survive.''

                     PREPARED STATEMENT OF BEVIS LONGSTRETH

                       Member of the O'Malley Commission
                           Former Commissioner of the
                  Securities & Exchange Commission, 1981-1984
                     Retired Partner, Debevoise & Plimpton
                                 March 6, 2002

                         Reforming the Audit Profession

        My name is Bevis Longstreth. I am a retired partner of the New York
    law firm, Debevoise & Plimpton, where I spent the bulk of my
    professional career. From 1981 to 1984, I served as a Commissioner of
    the SEC, a post to which I was appointed twice by President Reagan.
    Recently, I served as a member of the Panel on Audit Effectiveness,
    which released its final Report and Recommendations in August 2000. For
    5 years following retirement from law practice, I taught a course on
    the regulation of financial institutions at the Columbia Law School.
        I welcome this opportunity to address the Committee on the subject
    of reforming the audit profession. I am here because my professional
    experience and background give me some basis for contributing to your
    treatment of this urgent need for reform. I represent only myself, but
    in so doing, I hope to offer opinions that will resonate with other
    public investors in our Nation's securities markets.
        I want to speak about the audit profession, a once proud profession
    now embattled and greatly in need of reform.
        My thesis is simple. The profession needs reform in two major
    respects:

        1. An effective rule preventing the delivery of nonaudit services
    to audit clients.
        2. An effective system of self-regulation.

        Despite the SEC's adoption of Rule 2-01, the threat to an auditor's
    independence from performing nonaudit services allowed by the Rule
    remains palpable.
        Despite the enlarged charter of the Public Oversight Board, until
    recently the most promising vehicle for achieving some limited
    improvement in self-regulation, an effective system of self-regulation
    does not exist and cannot be achieved without legislative reform. No
    greater proof of this fact could be found than the POB's unanimous vote
    on January 20, 2002 to terminate its existence in reaction to the
    efforts of the profession's trade association and the CEO's of the Big
    5, in private meetings with the new Chairman of the SEC, to circumvent
    the POB by proposing still another voluntary oversight entity.
        While the reforms I advocate offer no guarantee against audit
    failures, they should sharply reduce the size and number of these
    occurrences without impairing the ability of firms to prosper. Indeed,
    I believe that, without these reforms, the profession, which has been
    its own worst enemy, will continue to spiral downwards until
    legislation denies it the exclusive economic franchise on which its
    success was built from the beginnings of the securities laws in 1933
    and 1934.
    The Need for an Exclusionary Rule for Nonaudit Services
        Arthur Levitt, with strong assistance from Lynn Turner, his Chief
    Accountant, showed boldness in their efforts to achieve a lasting
    solution to the vexing problem of independence. In the SEC's Proposing
    Release, they invited comment on a simple rule excluding an auditor
    from providing nonaudit services to audit clients. To many people away
    from the narrow corridor extending from the financial capital of the
    world that is still New York City to the separated powers of Government
    in Washington, the idea that boldness, and even personal courage, would
    be required for a governmental powerhouse such as the SEC to propose
    such an obvious, and widely supported, rule is strange. Yet, I am
    positive that it took both boldness and courage to issue the Proposing
    Release. That is because, by so doing, the SEC knowingly unleashed an
    unprecedented attack from those it was seeking to regulate, as it was
    charged by Congress to do, for the protection of the investing public
    and otherwise in the public interest. The ensuing battle, and it was
    clearly a battle, pitted a legally created monopoly, dominated by five
    global accounting firms, against the SEC. Three of the five,
    representing solely their private business interests, rejected any
    meaningful restrictions on the free play of those interests. Despite
    the profession's multipronged assault, the SEC, acting upon the need
    for greater independence, a need long recognized by virtually every
    group that is considered the issue (and there have been many), went
    ahead with its proposals, inviting comment and conducting 4 days of
    public hearings.
        There were almost 3,000 comment letters. One hundred witnesses
    testified for about 35 hours. The battle raged far beyond the
    frontlines at 450 5th Street, NW. Given the sharpness of the debate,
    and the transparency of the private versus the public interest, there
    was more at stake in the outcome than just the independence of
    auditors. The independence of the SEC, itself, was being challenged as
    the accounting firms did all they could, on Capitol Hill and throughout
    the business and legal communities, to bring political pressure to bear
    against a proposal, the exclusionary rule, that could not be defeated
    by argument on the merits. At an informal meeting during the pendency
    of the rule proposal, involving representatives of the SEC and the POB,
    I was told by a veteran Washington insider that there wasn't a
    significant law firm in DC that hadn't been lined up by the profession
    to assist in its battle.
        In the tumult of the moment, many leaders of the accounting
    profession--and here I must say I am not including leadership of the
    POB--forgot their profession's origins as one granted exclusive rights,
    and reciprocal duties, to perform a vital public service. Although
    affected by the public interest as much as, or more than, any public
    utility, these leaders were demanding freedom from serious oversight or
    constraint. From my vantage point as a member of the Panel on Audit
    Effectiveness who had a career of experience working closely with
    literally hundreds of responsible public accountants, I became
    increasingly convinced that the leadership of the profession was
    seriously, perhaps disastrously, disserving a worthy profession.
        A rule on independence was adopted on November 21, 2000, shortly
    before Arthur Levitt's term expired. The adopting release was 212 pages
    long. It was meticulously detailed. In that detail a careful reader can
    discern the parry and thrust of the battle that raged over each
    principle sought by the SEC and every word and sentence by which each
    surviving principle was to be expressed. I am sure if Lynn Turner bared
    his back and shoulders, we would find more wounds than we could count,
    inflicted by a profession in the hands of hostile and shortsighted
    people.
        The release acknowledges in several places that, in the SEC's view,
    the final rule struck a reasonable balance among the commenters'
    differing views. The release also claims the rule achieves the SEC's
    important public policy goals. I wish these statements were true. But
    it is my firm opinion they are not. There is a large gap between the
    sound policy goals sought by the SEC and the actual accomplishments
    that can realistically be anticipated by the rule. When the smoke had
    cleared, it was apparent to this observer that the profession had won
    the battle. Importantly, however, it was just one battle in a war the
    outcome of which, when it comes, sooner or later, will be different.
        About the rule, let me be clear. I am not saying that, on balance,
    we would be better off without the rule. It is useful, despite its
    breathtaking complexity, which has proven very costly for the best
    intentioned issuers. I speak here as Co-Chair of the Audit Committee of
    a large public company that is continually struggling to understand the
    rules and assure that both it and its auditor are in compliance.
        The rule is not even ``half a loaf;'' nonetheless, it is a step in
    the right direction. I say that for three reasons. First, because it
    was a bold and honorable battle hard fought by the SEC. In future
    battles this effort will count for a lot, despite the many compromises.
    Second, because the policy goals elaborated in both releases, and
    supported by abundant testimony and comment, provide a compelling
    foundation for carrying the battle forward in the halls of Congress,
    where, it has become clear, the fight must now be taken. And third,
    because the disclosure requirement is proving of particular use in
    focusing public attention, not to mention the attention of audit
    committees, on the amazing growth in nonaudit fees paid to their
    auditors.
        In thinking of the disclosure requirement, it is important to
    remember that the SEC in 1978, based on what it then saw as a growing
    amount of nonaudit services being performed for audit clients, adopted
    a very similar disclosure rule, ARS 250, which was swiftly repealed in
    1982 as the consequence of massive pressure from a profession that was
    beginning to be adversely impacted by disclosure. Since then, as we now
    know, nonaudit services have increased exponentially.
        So what is wrong with the rule? In many respects it can be
    criticized. I want only to address one big problem. The SEC adduced
    strong and abundant evidence in the rulemaking process, as summarized
    in III(c)(2)(a) of the Adopting Release, that providing to one's audit
    client nonaudit services of any kind or kinds, if large enough in terms
    of fees paid, may impair independence. Despite this powerful predicate
    for rulemaking, the rule adopted fails absolutely to address this
    concern.
        The SEC describes the rule as implementing a ``two-pronged''
    approach:

        1. Requiring separate disclosure of audit fees, financial
    information-related service fees, and other nonaudit fees.
        2. Prohibiting nine specific nonaudit services believed by the SEC
    to be, by their very nature, incompatible with independence.

        Economic incentives derived from nonaudit work, no matter what
    their magnitude, were not defined as being, by their very nature,
    incompatible with independence. In failing to address this matter, the
    SEC ignored a mountain of persuasive argument.
        This giant omission touches upon one of the two fictions I am going
    to address. Fiction Number One is the claim that payment by an audit
    client to its auditor for consulting and other nonaudit services, no
    matter how large, will never impair independence, that is, will never
    have an adverse effect on the quality of the audit or be seen to have
    such an effect in the eyes of the investing public.
        It defies common sense to claim that large payments for nonaudit
    services, which management could easily purchase, or threaten to
    purchase, from service providers other than its auditor, do not
    function as a powerful inducement to gain the auditor's cooperation on
    how the numbers are presented.
        Audit account partners are expected by their firms to establish
    close relationships with the managements they serve. They are expected
    to cross-market to management as full a range of nonaudit services as
    possible. And they are compensated by their firms on the basis, among
    others, of how much revenue they produce from their audit clients.
    Their stake in maximizing revenue from these clients through cross-
    marketing of nonaudit services is as natural and compelling as any
    financial reward could be. To claim these incentives have no adverse
    impact on both the fact and appearance of independence is a fiction,
    pure and simple.
        To be fair, I should point out that the rule contains a general
    standard, 2.01(b), that declares an accountant not independent if, in
    fact, or in the opinion of a fully informed, hypothetical ``reasonable
    investor,'' the accountant is not capable of exercising objective and
    impartial judgment. Absent a ``smoking gun,'' this ``capability'' test
    would seem to create a virtually insurmountable hurdle for the SEC.
        The disclosure requirements of the rule, which enjoy the truth-
    eliciting feature of proxy rule sanctions for misstatements, have
    already illuminated the seriousness of the economic incentive problem.
    On average, for every dollar of audit fee paid, clients paid their
    auditors $2.69 in fees for nonaudit services. In other words, nonaudit
    fees represent, on average, 73 percent of total fees paid to auditors.
    This percentage is astoundingly large, even when one discounts it for
    lumping together audit-related services such as work on financials in
    registration statements. Of course, this is just the average. As The
    Washington Post reported in a June 13, 2001 editorial: ``KPMG charged
    Motorola $39 million for auditing and $623 million for other services.
    Ernst & Young billed Sprint Corp. $2.5 million for auditing and $63.8
    million for other services.''
        If Rule 2-01 with all of its promise and detail, allows nonaudit
    service fees, as a percentage of total fees, to represent even a
    fraction of the 73 percent average that we now know prevailed on the
    eve of the rule's adoption, the rule must be counted a failure. Given
    the compromises reached in defining the ``terrible nine'' services that
    may not be provided, I am afraid the percentage will not be
    substantially lessened by these so-called ``bright line'' exclusions.
    Of course, there remains the often powerful effects of disclosure on
    corporate behavior and, in this case, on the behavior of the audit
    committees.
        Disclosure might encourage the growth of ``best practices,'' as
    exemplified by TIAA/CREF, for example, which denies its auditor any
    nonaudit business. Over some period of years, the rule's disclosure
    could cause a growing number of audit committees to back away from
    using their auditors for any significant amounts of nonaudit work.
        But I wouldn't bet on it. I fear Rule 2-01 will turn out to be the
    Maginot Line for Independence, crisscrossed with trenches, barbed wire
    and gun emplacements, all pointing in one direction only, capable at
    will of being thoroughly outflanked.
        One indication of the rule's failure in addressing the impact of
    large payments for nonaudit services can be found in the way the Big 5
    presented it to their audit clients. I have been exposed to only one
    sample, which I fear may be illustrative of what others did, at least
    in oral presentations. Overall the message of this firm's booklet on
    the rule, provided to audit committees and to management of its audit
    clients, is that the rule changes almost nothing. In the sweep of its
    misleading
    characterization of what the SEC was seeking to accomplish, it leaves
    an informed reader amazed at the firm's audacity. It carried Fiction
    Number One to a breathtaking extreme. I want you to hear only one
    statement taken from this document. It appears twice with only slight
    variations. Here's one version:

              ``The real issue for audit committees is the nature of the
            work performed, not its cost. The rules do not indicate that
            fees of any magnitude alone impair independence. Nor did the
            SEC cite specific ratios of audit to nonaudit fees as being
            `good' or `bad.'
              ``Historically, the size of nonaudit fees paid to an audit
            firm has been relevant to SEC independence considerations only
            to the extent that the total fees earned from one client
            represent a disproportionate percentage of the audit firm's
            total revenues. SEC guidance on this point has established 15
            percent of an audit firm's total fees as a threshold of
            concern.''

        In 2001, the smallest of the Big 5's total revenues was reported in
    The New York Times to have been more than $9 billion. Using the 15
    percent ``threshold of concern,'' a client could pay its Big 5 auditor
    at least $1.35 billion dollars per year in nonaudit fees before the
    audit committee, SEC, or anyone else need trouble itself over
    independence. In practical terms, there was no limit.
        How any professional firm, let alone a closely regulated firm of
    auditors, could so blatantly deceive its audit clients in this way
    defies common sense. For me, given the spirit of what the SEC was
    trying to accomplish by this rulemaking, and the take-no-prisoners
    approach of the profession, the only plausible answer is that it is a
    reflection of the contempt that a victor sometimes directs against the
    vanquished. For there was no question that the firms were victorious in
    beating back the SEC's efforts at reform.
        The Big 5 firm that authored this statement surely knew that the 15
    percent ``threshold'' came out of a 1994 no-action position taken by
    the Office of the Chief Accountant to address nonaudit fees proposed to
    be paid to a very small auditor to allow that auditor to take on as a
    client its first SEC registrant. They know as well that this ruling was
    limited to its special facts and contained no suggestion of being an
    authoritative statement with regard to independence generally.
        One basic problem with nonaudit fees, which exists regardless of
    their magnitude but grows more serious as the fees grow larger, is
    conflict of interest. This conflict derives from the fact that, in
    performing both audit and nonaudit services, the audit firm is serving
    two different sets of clients:

        1. Management, in the case of nonaudit services, which typically
    are commissioned by, and performed for, management.
        2. The audit committee, in the case of audit services, which now
    are by rule commissioned by the audit committee and performed for that
    committee, the shareholders and all those who rely on the audited
    financials and the firm's opinion in deciding whether to invest.

        The audit firm is a fiduciary in respect to each of these two very
    distinct client groups, duty-bound to serve each with undivided
    loyalty. It is obvious, and a matter of common experience, that in
    serving these different clients the firm will be regularly subject to
    conflicts of interest. These conflicts tear at the heart of
    independence. What is independence? It is the absolute freedom to
    exercise undivided loyalty to the audit committee and the investing
    public. When other loyalties tug for recognition, and especially when
    they come from those in a position to enlarge or shrink one's book of
    business, on which depends one's partnership share, the freedom
    necessary to meet one's professional responsibilities as an auditor is
    adversely affected.
        Paul Volcker, in testimony on the rule, given in New York City on
    September 13, 2000, made the same point:

              ``The extent to which the conflict has in practice actually
            distorted auditing practice is contested. And surely, instances
            of overt and flagrant violations of auditing standards in
            return for contractual favors--an auditing capital offense so
            to speak--must be rare. But more insidious, hard-to-pin down,
            not clearly articulated or even consciously realized,
            influences on audit practices are another matter.''

        To highlight the size of the hole in the rule, consider that, in
    addressing disqualifying financial and business relationships between
    an accountant and its audit client, the rule declares in absolute terms
    that an audit firm lacks independence if there exists (a) any
    investment in the client, however small, by the firm or personnel
    involved in the audit, or (b) any direct business relationship with
    that client, however insignificant. Explicitly excluded from the term
    ``business relationships,'' is the provision of nonaudit services by
    the audit firm to its audit clients. Thus, one faces the absurdity of a
    rule that is absolute in banning financial and business relationships
    that are utterly inconsequential while appearing to allow any level of
    nonaudit fees to be paid to the audit firm.
        My point is not to suggest that the finely textured concerns of the
    SEC over the independence-impairing effects of various financial and
    business relationships are misplaced. They reflect legitimate, albeit
    immeasurable, concerns. But the important point is that they pale in
    significance when compared to the potential for impairment that comes
    from the financial and business stake that an audit firm, despite the
    rule, is still free to develop in an audit client through provision of
    a very wide variety of permitted nonaudit services.
        To plug this big hole, I suggest a simple exclusionary rule
    covering virtually all nonaudit services, in place of the deeply
    complex, existing rule that I hope, by now, to have convinced you is
    ineffective.
        This rule would define the category of services to be barred as
    including everything other than the work involved in performing an
    audit and other work that is integral to the function of the audit. In
    general, the touchstone for deciding whether a service other than the
    straight-forward audit itself should be excluded from nonaudit services
    is whether the service is rendered principally to the client's audit
    committee, acting on behalf of investors, to facilitate, or improve the
    quality of, the audit and the financial reporting process or is
    rendered principally to provide assistance to management in the
    performance of its duties.
        This exclusionary rule could include a carefully circumscribed
    exception to permit certain types of nonaudit services to be rendered
    by the audit firm to its client where special circumstances justify so
    doing. Use of such an exception should require at least the following:

              (a) Before any such service is rendered, a finding by the
            client's audit committee that special circumstances make it
            obvious that the best interests of the company and its
            shareholders will be served by retaining its audit firm to
            render such service and that no other vendor of such service
            can serve those interests as well.
              (b) Forthwith upon the making of such finding, submission of
            a written copy thereof to the SEC and SRO having jurisdiction
            over the profession.
              (c) In the company's next proxy statement for election of
            directors, disclosure of such finding by the audit committee
            and the amount paid and expected to be paid to the auditor for
            such service.

        The rule would be refined, administered, and enforced by the
    legislatively empowered SRO that is the subject of my second
    recommendation for reform (discussed below).
        The fundamental argument for exclusion is the avoidance of what
    amounts to a professional conflict of interest in serving two clients
    within one corporation. Beyond that, however, there are a number of
    other points to be made. And I summarize them below:

        1. Given the conflict of interest, it is not realistic to expect
    the firm, itself, to decide convincingly on its own independence. Given
    its self-interest in the outcome, the credibility of this process is
    highly suspect.
        2. Nor is it feasible to expect independence to be assured by
    approval of the audit committee. It is impossible for that committee to
    identify when the problem exists. To challenge the auditor's judgment
    on the matter is to challenge its integrity, something audit committees
    are not likely to do. Independence is a state of mind, necessary to
    maintain the skepticism and objectivity that long have been the
    hallmarks of the accounting profession. Being subjective and invisible,
    independence is not something an audit committee can apply any known
    litmus test to determine.
        3. No one has suggested that the audit committee can be a
    substitute for clear rules where the problem of conflicts is most
    serious. Thus, for example, there is no suggestion that the audit
    committee be accorded discretion to assess independence despite the
    existence of financial or business interests between the audit firm and
    its client. Stock or other financial interests in one's audit client,
    for example, have long been viewed as creating too clear a conflict of
    interest to become the subject of discretion, even if exercised by an
    audit committee composed only of outside directors. The need for an
    exclusionary rule is rooted in the same ground: Prospective revenues
    from the provision of nonaudit services, extending into the future,
    create precisely the kind of financial stake that produces a conflict
    of interest capable of impairing independence.
        4. An exclusionary rule is easy to administer. It does not preclude
    an audit firm from engaging directly or through affiliates in nonaudit
    services of any kind. All business entities other than its audit
    clients are available for business. Since the rule would apply to all
    audit firms, for each audit client put out of bounds for nonaudit
    services, all the clients of other audit firms become available.
        5. An exclusionary rule should correct the current system of
    compensation, which was found by the Panel on Audit Effectiveness to
    fail in giving adequate weight to performing the audit function with
    high levels of skill and professionalism. This situation adversely
    affects audit effectiveness. Success in cross-marketing an audit firm's
    consulting services is a significant factor in the compensation system.
    The skills that make one successful in marketing nonaudit services to
    management are not generally consistent with the professional demands
    on an auditor to be persistently skeptical, cautious, and questioning
    in regard to management's financial representations. As long as the
    marketing of nonaudit services by auditors to their audit clients is
    encouraged, expected, and rewarded, there will exist a tension
    counterproductive to audit excellence. An exclusionary rule would
    eliminate both this tension and its harmful effects.
        6. An exclusionary rule would be effective in rewarding those audit
    firms most sensitive to the independence issue and most scrupulous in
    seeking to avoid a real problem or even the appearance of a problem.
    Toothless exhortation and disclosure are pale green lights to those
    willing to sail close to the line, or cross over it. This situation has
    the perverse impact of hurting the competitive position of the most
    sensitive and scrupulous audit firms, and in time encourages even those
    firms to drop their guard and exploit the laxness in standards as well.
        7. Independence is given important meaning in many analogous
    situations where potential conflicts, while not always certain to
    impair independence, nonetheless are prohibited in the interest of
    avoiding the problem. For example, consider the kind of independence
    necessary for a director to serve on an audit committee of a public
    corporation. The Blue Ribbon Committee on Improving the Effectiveness
    of Corporate Audit Committees determined that, for a director to be
    independent for that purpose, he or she must not accept compensation
    from the corporation for any
    service other than service as a director and committee member. The Blue
    Ribbon Committee noted that ``. . . common sense dictates that a
    director without any
    financial, family, or other material personal ties to management is
    more likely to be able to evaluate objectively the propriety of
    management's accounting, internal control, and reporting practices.''
    The common sense parallel to the auditor is both exact and compelling.
    Compensation for any service other than the audit threatens
    independence.
        8. An exclusionary rule is a low-cost premium on an important
    insurance policy for the whole profession, against governmental
    intervention to deny audit firms the right to do any nonaudit work. In
    the Panel's Report we wrote, as of August 31, 2000, that ``an
    exclusionary rule would go far toward eliminating the possibility of a
    major audit failure being linked to the influence of nonaudit service
    business on the audit firm's diligence and skepticism, an event that
    would provide a basis, and possibly the momentum, for some radical
    solution like a total ban.'' Enron could turn out to be the failure we
    were imagining.

    The Need for a Legislatively Empowered Self-Regulatory Organization
        The second fiction I wish to address is the profession's three-fold
    claim that (1) it has the ability and motivation to regulate itself
    voluntarily, (2) it has done so effectively over the past several
    decades, and (3) therefore, there is no need for a legislatively
    empowered regulatory body led by persons independent of the profession.
        The present form of self-regulation of the auditing profession
    reminds one of military music, or even, some might argue, corporate
    governance--a classic oxymoron. Having looked closely at the system of
    governance within the auditing profession, I am not prepared to be
    quite so simplistic. However, I am quite certain that the governance of
    this vitally important profession is in an entirely unsatisfactory
    state. Moreover, this is no trivial matter.

    Overview of Governance
        Today, governance is exercised from three sources:

        1. State boards of accountancy, which have licensing powers.
        2. The SEC, which exercises potentially broad powers over those who
    audit reporting issuers.
        3. Private organizations of the profession, of which there are at
    least seven important ones.

        The profession claims that, through its various organizations,
    effective self-regulation is achieved. Having looked closely at this
    claim, I believe it to be false. What one sees is a bewildering maze of
    overlapping committees, panels and boards piled one on top of the
    other. They are characterized by complexity and ineffectiveness in
    matters of central importance to any effective system of self-
    regulation.
        Among the short-comings of the present system are the following:

        1. Lack of real public representation.
        2. Lack of unified leadership over the seven organizations.
        3. Lack of transparency.
        4. Fuzzy and often overlapping areas of responsibility.
        5. Conflict between self-interest (as in the American Institute of
    Certified Public Accountants, AICPA, which is a trade organization
    parading as an SRO) and protection of the public interest.
        6. Lack of any credible system for imposing discipline, a sine qua
    non for effectiveness.
        7. Lack of assured funding.
        8. Overall, lack of accountability to anyone.

        Given its importance, a further word on discipline. Here's all
    there is. The Quality Control Inquiry Committee of the SEC Practice
    Section of the AICPA (QCIC) is charged with investigating alleged audit
    failures involving SEC clients arising from litigation or regulatory
    investigations. However, it is only looking to see if there are
    deficiencies in the firm's system of quality control. It is not
    involved in assessing guilt, innocence, or liability of the firm or any
    individual. And its report is only prospective in its impact.
        The Professional Ethics Executive Committee of the AICPA (PEEC) is
    charged with such responsibility for discipline as exists. It is
    supposed to pick up cases from the QCIC. However, out of alleged
    ``fairness,'' at the firm's request, the PEEC will automatically defer
    investigation until any litigation or regulatory proceeding has been
    completed, often many years later. This system results in long delays
    in investigation and, as a practical matter, renders the disciplinary
    function a nullity in
    almost all instances.
        It was the Panel's hope to recast the POB as the central overseer
    of self-regulation, with power and with responsibility to effect
    changes necessary to make self-regulation effective. With a new and
    energetic Chairman in Chuck Bowsher, this idea seemed achievable. As
    conceived by the Panel, the POB would have had these new elements:

        1. Public members, independent of both the profession and the SEC,
    would constitute a majority of the board.
        2. ``Strings attached'' funding would be provided by the profession
    in amounts sufficient to carry out the POB's mission.
        3. Absolute control over the nature of its work and the budget
    necessary to carry out that work.
        4. Power to oversee all of the profession's governance
    organizations.
        5. Power of approval over appointments to the various organizations
    and over
    hiring, compensation, evaluation, and promotion decisions by AICPA in
    respect of employees of key organizations.
        6. Term limits for board members.
        7. Nominating committee for selection of board members, composed of
    representatives of public and private institutions especially concerned
    with the quality of
    auditing and financial reporting.
        8. Advisory council, composed similarly to the nominating
    committee, responsible for annually reviewing the work agenda for the
    POB.

        The new charter for the POB was the result of heavy negotiation
    among the Big 5, the AICPA, and the SEC. It fell short of the Panel's
    recommendations in several important respects:

        1. No POB approval over membership of governance organizations.
    Concurrence rights over Chairs.
        2. No oversight over PEEC's standard setting activities.
        3. No nominating committee or transparency for POB board
    membership.
        4. No oversight of staff of key governance organizations.
        5. No power to change POB charter.

        The POB believed it could work around its charter limitations by
    the threat of going public with disagreements. A whistle-blower
    technique. At the time I thought this a slim possibility. Making the
    POB the central, responsible, and empowered regulator of the
    profession, which was the Panel's goal and similarly the goal of the
    SEC under Chairman Levitt, was powerfully and effectively resisted by
    the AICPA. Again, the battle was waged. Again, the AICPA and the big
    firms asserted their
    immense power on behalf of unchecked self-interest. And again, the
    profession's leaders came out on top.
        However well-intentioned Chuck Bowsher and his board might have
    been, and I know they were well-intentioned, there was no way they
    could have achieved effective self-regulation of this profession under
    the POB's charter as negotiated in 2000. Even if they had gotten all
    that the Panel advocated, it wouldn't have worked. The reason is quite
    simple. Like many other businesses, the profession, and particularly
    its current leaders, apart from the POB, do not want self-regulation.
    They want the shield of apparent self-regulation. But not anything
    close to the real thing.
        Now, as you know, the POB members have all resigned in protest over
    the actions taken by the Big 5 CEO's and the AICPA, in cooperation with
    the new SEC Chairman and in complete disregard of the Panel's
    recommendations and the modest efforts taken so recently to strengthen
    the POB. The five members of the POB did, indeed, become whistle-
    blowers, having no other choice even in the face of a palpable crisis
    to the profession.
        Whatever the explanation for the profession's nearly suicidal
    attempt to evade the POB, which was the only plausible entity capable
    of some self-regulation, and whatever the SEC Chairman's motives in
    lending support to this effort, it will not stand scrutiny. On the back
    of Enron, real reform must come at the legislative level. It must
    emerge from the lawmakers on Capitol Hill not only because the SEC
    appears unwilling to lead. In regard to an SRO, only legislation can
    arm an SRO with the necessary powers to do the job. A review of the
    essential elements common to all the existing SRO's will explain why
    this is so. Here they are:

        1. Creation by legislation or by governmental agency pursuant to
    legislation, with clear powers to write rules and conduct enforcement
    and disciplinary proceedings.
        2. Supervision by Government agency, including registration with
    that agency to operate as an SRO, agency approval of all rules adopted
    by the SRO and agency power to adopt rules for the SRO.
        3. Power in the supervising agency to sanction the SRO for failure
    to perform its responsibilities, as, for example, failure to comply
    with its self-governance rules or to enforce the rules it imposes on
    those it has the chartered duty to regulate.
        4. Requirement that all participants in the profession or industry
    being regulated (that is, brokers and dealers) become subject to the
    SRO's jurisdiction and powers.

        It will be useful to examine further the workings of the NASD's
    SRO, whose most important public duty is that of policing the rules of
    financial responsibility, professional conduct and technical
    proficiency. In carrying out this charge, the SRO is given essentially
    the same range of sanctions available to the SEC, which must be applied
    by the SRO in cases where a broker-dealer or its employees have
    violated the securities laws or SEC-enacted rules or the rules of the
    SRO. Of particular importance in achieving wide-spread compliance with
    the rules of professional conduct is the power of both the SEC and the
    SRO to discipline either or both the supervisory personnel and the firm
    for a failure to supervise employees who misbehave. To avoid sanction
    the firm must have in place procedures to deter and detect rule
    violations and a system for the effective implementation of those
    procedures. It is hard to exaggerate the importance of this ``duty to
    supervise'' in respect of its prophylactic effects.
        To facilitate speedy investigation by the SRO of alleged
    violations, and speedy judgment and imposition of sanctions where
    warranted, the SRO has one critically important tool that it uses to
    gain the cooperation of those it regulates, even those who are targets
    of an investigation. Its rules require each of its registered firms and
    individuals to turn over all requested documents and other information,
    and to appear and testify, in connection with an SRO investigation.
    Failure to cooperate in this way can result in expulsion from the
    industry. Courts have held the Fifth Amendment privilege against self-
    incrimination inapplicable to sanctions imposed by an SRO. Thus, as a
    practical matter, those regulated by the SRO, including the target of
    an investigation, must cooperate or lose their right to be in the
    industry.
        As a result of being vested with law enforcement powers in
    combination with close supervision from a governmental agency, an SRO
    possesses three significant protections that typically are only enjoyed
    by governmental agencies in the exercise of enforcement powers. They
    are:

        1. Immunity from suit.
        2. Privilege from discovery of investigative files. It is important
    to note here that this privilege is generally understood to operate
    only during the investigation. This limitation holds for the SEC too.
        3. Protection from antitrust violation for group boycott or other
    activity violative of antitrust principles.

        These protections proceed from the fact, as reflected in
    Congressional committee reports, that an SRO is delegated law
    enforcement powers subject to supervision by the governmental agency
    from whence those powers came. Effectiveness compels the delegation of
    these protections as well.
        From the foregoing brief summary of the common elements of an SRO,
    it can be seen that a private organization such as the POB, voluntarily
    organized by the accounting profession to self-regulate itself, cannot
    do the job, no matter how well-intentioned its leaders might be.
        To reiterate: The SRO's are effective because they are accountable
    to a governmental agency and derive from their relationship with that
    agency immunity from suit and important protections against discovery
    and antitrust laws, while at the same time preserving their private
    status enough to avoid the Fifth Amendment's protections for those it
    regulates.
        The inescapable conclusion from this analysis is that, unless and
    until a real, legislatively supported SRO is put in place to regulate
    the accounting profession, little, if any, progress toward an effective
    disciplinary system for accountants practicing before the SEC can be
    made, outside the SEC itself.
        The need for the two reforms outlined above is not a trivial
    matter. To the contrary. I will use an analogue from Congressional
    history to measure this need. In the wake of the Great Depression, with
    the failure of an immense number of banks, and the huge losses to
    depositors, the Congress recognized that the public's confidence in the
    country's banking system had been badly shaken. Through hearings before
    the House and Senate, it became clear that the public's earnings, when
    deposited in banks, had to be made safe, in fact, and the public had to
    be convinced of their safety. To meet this goal Congress passed the
    Banking Act of 1933, creating the Federal Deposit Insurance Corporation
    and the system of deposit insurance we still enjoy.
        Since 1933, as you all know, the public's earnings have gradually
    migrated from the banking system to the capital markets: From bank
    deposits to money market mutual funds and, increasingly, to equities.
        With this shift in how the public saves its earnings must come a
    shift by lawmakers in fashioning the kinds of protections these public
    investors need.
        The Congress should not, of course, create a safety net to protect
    public investors in equities against any loss. To do that would be to
    do more harm to our system of capital formation than good.
        But the Congress should act to insure that the system by which our
    corporations present their financial condition to the world is worthy
    of trust by the investing public. The auditors are the last line of
    defense against management's inclination to fudge the numbers and, in
    recent years, with disturbing frequency, to present misleading and even
    false numbers.
        Legislative action is needed now, because, with the growing number
    of audit failures in recent years, culminating (but not ending) with
    Enron, the public's trust and confidence has again been badly shaken,
    just as in the Depression. However, this time the loss of confidence is
    by the public in its capacity as investors, not depositors, and its
    loss of trust and of confidence is directed at the reliability of
    financial statements certified by auditors.
        I hope that the Enron hearings will convince Congress that the
    public's trust in the auditing system must be restored by prompt and
    forceful legislative intervention, just as the public's trust in the
    banking system was restored by forceful Congressional action in 1933.
        The two reforms I have summarized will do the job. Other measures
    addressed to: (1) matters of corporate governance, such as assuring
    punishment of officers and directors for dereliction of duty or
    conflict of interest; or (2) matters of conflict of interest involving
    securities analysts, may prove useful if carefully drafted after study
    and a weighing of costs against benefits. The time for reforming the
    auditing profession, however, is here and now.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                            THURSDAY, MARCH 14, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10 a.m. in room SD-538 of the Dirksen
    Senate Office Building, Senator Paul S. Sarbanes (Chairman of
    the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, the Committee on Banking, Housing, and Urban
    Affairs continues its hearings on auditing, accounting,
    financial reporting, and investor protection.
        Although much of what is happening in the Congress has been
    prompted by the collapse of one extremely large company, the
    interest here in the Committee has been in trying to fashion an
    effective response to what appears to be a structural and a
    systemic problem.
        In some respects, the problem perhaps can be summed up by
    the simple fact that, in addition to a well-publicized series
    of financial failures, public companies restated their earnings
    607 times in the past 3 years, more than in the entire previous
    decade. Against that background an objective must be to
    strengthen audit quality, auditor independence, financial
    reporting, all of which, of course, are highly relevant to
    investor protection. And, of course, investor protection is
    essential to sustain the integrity of the capital markets,
    which have been an important dimension of our economic
    strength.
        Each of the country's Federal securities laws--the 1933,
    1934, 1935, and 1940 Acts--requires comprehensive financial
    statements that must be prepared, in the words of the
    Securities Act of 1933, by ``an independent public or certified
    accountant.''
        Professor Benjamin Graham's seminal textbook for securities
    analysts gives the reason:

        Prior to the SEC legislation, it was by no means unusual to
    encounter semi-fraudulent distortions of corporate accounts,
    almost always for the purpose of making the results look better
    than they were, and it was generally associated with some
    scheme of stock market manipulation in which the management was
    participating.

        The statutory independent audit requirement which I
    referred to earlier, contained in the 1933 Act, has two sides
    to it. It grants a franchise to the Nation's public
    accountants, since their services, and only their services, and
    certification, must be secured before an issuer of securities
    can go to market, have the securities listed on the Nation's
    stock exchanges, or comply with the reporting requirements of
    the securities law. But the other side of this franchise comes
    in return for the CPA's performance, as the Supreme Court noted
    some years ago, of ``a `public watchdog' function that demands
    that the accountant maintain total independence from the client
    at all times and requires complete fidelity to the public
    trust.'' In other words, they cannot get to market without the
    certification. But obviously, that puts some obligations on the
    people that do the certification.
        The significance of that public trust was recognized from
    the beginning of the consideration of the Securities Act by
    this Committee almost 70 years ago. On April 1, 1933, Colonel
    A.H. Carter, the President of the New York State Society of
    Certified Public Accountants, and Senior Partner of the firm
    that was then named Deloitte, Haskins & Sells, testified before
    this Committee. He argued then, successfully, as it turned out,
    that requiring an opinion by an independent accountant as to
    the ``correctness'' of financial statements of registrants was
    preferable to creating a core of Government auditors at the
    Federal Trade Commission. He explained that independent
    auditors were in a different position than ``corporate
    comptrollers,'' and I quote him:

        We audit the corporate comptrollers. The corporate
    comptroller is in the employ of the company. He is subject to
    the orders of his superiors. He is not independent. CPA's
    should be empowered to check the accounts because it is
    generally regarded that an independent audit of any business is
    a good thing.

        When Senator Barkley, a Member of this Committee, asked
    Colonel Carter, ``Who audits you?'' He replied, ``Our
    conscience.''
        Senator Gramm. The best audit.
        Chairman Sarbanes. We have heard during these hearings from
    former chairmen and chief accountants of the Securities and
    Exchange Commission, former Federal Reserve Board Chairman
    Volcker, who testified as Chair of the Trustees of the
    International Accounting Standards Committee. We heard from the
    current Chair of the International Accounting Standards Board,
    David Tweedy, the Chair of the Financial Accounting Standards
    Board from 1991 to 1998, leaders of prior efforts to address
    accounting abuses and lagging standard setting, and experts in
    corporate governance. Virtually every witness has recommended
    basic changes in the regulation of auditing under the Federal
    securities law. It is appropriate, as we are doing today, that
    we hear from representatives of the accounting industry--not
    only appropriate, but also, obviously, quite important.
        The American Institute of Certified Public Accountants was
    established in 1887, and as I understand it, now has about
    350,000 members. Among its many activities, its committees
    promulgate auditing and ethical standards for accountants, and
    review claims of violation of professional ethics. The AICPA
    represents the interests of the accounting profession before
    the Congress and before the Nation's regulatory agencies.
        In fact, the AICPA has itself recognized a problem. It has
    now posted on its website the following:

        Investor confidence, already shaken by significant
    volatility in the capital markets, has been further unsettled
    by the highly publicized restatements of financial statements,
    which have generated questions about the quality of financial
    reporting, the effectiveness of the independent audit process,
    and the efficacy of corporate
    governance.

        We, therefore, look forward today to hearing the accounting
    industry's recommendations for addressing this situation. And
    subsequent to this panel, we will hear from two economists, one
    from Brookings and one from AEI, who have studied various
    aspects of current accounting issues.
        Before I introduce the witnesses for their statements this
    morning, I will yield to my colleagues.
        Senator Gramm.
        Senator Gramm. Mr. Chairman, Senator Bunning, I understand,
    has a conflict. So if it is okay with you, I would let him go
    first.
        Chairman Sarbanes. Yes, it is certainly okay with me.

                    COMMENTS OF SENATOR JIM BUNNING

        Senator Bunning. I would like to thank you, Mr. Chairman,
    for holding these very important hearings and I would like to
    thank our witnesses for being here to testify. I would
    especially like to thank Senator Gramm for letting me jump
    ahead of him.
        Unfortunately, today, I have to be in two places at once.
    In the Armed Services Committee, we have the Secretary of
    Energy before us today and I need to speak to him about some
    important issues, specifically about the uranium enrichment
    plant in Paducah, Kentucky. But I wanted to make sure that I
    came over to welcome our witnesses and thank all of you for
    testifying. I especially want to thank my fellow Kentuckian,
    Olivia Kirtley, for testifying today.
        Olivia Kirtley is one of the most outstanding Louisville
    business consultants and was Vice President and CFO of Vermont
    American Corporation from 1991 to 2000. Vermont American is one
    of the largest manufacturers of power tool accessories. We are
    very happy that their corporate headquarters are located in
    Louisville, Kentucky. And I go by it every time I go to
    Louisville.
        Olivia was also Chair of the AICPA board in 1998 and 1999.
    She currently serves as a member of the board of directors and
    chair of the audit committee of two public corporations.
        God bless you.
        [Laughter.]
        Thank you very much for coming today and I am sorry that I
    will not be able to stay any longer.
        Mr. Chairman, thank you for giving me the courtesy.
        Chairman Sarbanes. Certainly. Thank you, Senator Bunning.
        Senator Gramm.

                    STATEMENT OF SENATOR PHIL GRAMM

        Senator Gramm. Well, Mr. Chairman, first of all, I want to
    thank you for these hearings and for the tenor of these
    hearings. I do not think the Congress, in general, has covered
    itself in glory on this issue. But I believe that you have
    covered yourself and this Committee in glory by having hearings
    that are forward-looking, that are aimed at trying to determine
    what we need to do to be certain that we restore investor
    confidence.
        I look forward to working with you on the important
    legislation that will flow from this effort. I think it is
    imperative that the legislation be bipartisan. I think when we
    take a bill related to this general issue to the floor of the
    Senate, that we will have numerous amendments. I think there is
    a great danger that we could do very substantial harm to the
    American economy in the process.
        I believe if we are together on a bipartisan basis and we
    can unite our Committee, I think we have an opportunity to
    prevail with a reasoned approach that can benefit the American
    people and the American investor. If there has ever been an
    issue that should be a bipartisan issue that should not be a
    partisan issue, I think this is it.
        Let me say to our witnesses that we appreciate you coming.
    This is the era where we are bashing accountants. It does take
    the focus off bashing politicians and I guess we should be
    grateful for that.
        [Laughter.]
        But I just want to say to set the record straight, in
    repeating a comment I made in the first hearing we had, if I
    had to trust the safety and sanctity of my wife and children to
    a politician, a preacher, or an accountant, drawn at random
    from the American population, I would choose an accountant
    every time.
        I have a very high opinion of the men and women who
    practice accounting in America. I think it is very important
    that we not do anything that discourages the best and brightest
    from going into this profession. Because, ultimately, it is the
    quality of the person doing the job, not regulations, not laws.
    It ultimately comes down to the man or the woman who is making
    the judgment. And their judgment is absolutely critical.
        Let me say also that we need to be very careful about
    unintended consequences, unintended consequences where we do
    harm rather than good, or where we do more harm than we do
    good.
        There are two approaches to objectivity. And the one that I
    think is currently in fashion is let's find someone who just
    came in off a turnip truck that knows absolutely nothing about
    the subject, and let's give them responsibility because they
    are ignorant and they will be objective. But that creates its
    own series of problems. And I think in looking at structuring
    the governance of accounting, that these are issues that have
    to be discussed. I think it is imperative that we hear from
    people who are actually involved in the profession.
        There is this increasing tendency in Washington and in
    politics to say that people who know something about a subject
    are the last people we should ever talk to, that somehow,
    knowledge is corrupting, that the ability to petition the
    Government, which is guaranteed in the Constitution, that
    somehow, there is something wrong and corrupting about that.
        I would say the best information that I get in the
    legislative process comes from people who are directly involved
    in the industry that is going to be affected and, quite
    frankly, the people that represent them, the nefarious lobbyist
    who simply carries out a guaranteed constitutional right and
    performs great service to America in the process, in my
    opinion.
        My job is to try to figure out what is right and wrong,
    what is special interest and what is public interest.
        So these are very important hearings because this is a very
    important subject. We have had great hearings to this point,
    and I think they have enlightened us. We have heard many
    different opinions as to what needs to be done, much of it
    conflicting. But when you are dealing with important issues
    like this and you are dealing with people who have been
    involved in it a lifetime, they are going to have differences
    of opinion. And I see that as healthy. I do not see that as a
    bad thing.
        Mr. Chairman, again, thank you very much for these
    hearings. I look forward to hearing our witnesses.
        Chairman Sarbanes. Thank you very much.
        Senator Corzine.

                  STATEMENT OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman, and I thank all
    the witnesses for participating and taking the time to make
    these thoughtful presentations.
        I think this is the seventh hearing, if I have counted this
    right. This has been a remarkable set of presentations by
    people who I think really are searching for the best answer
    that we can come up with to--I do not think a perceived
    problem--a real problem in a lot of people's minds with regard
    to the presentation of financial information, which is so vital
    to the fundamental workings of our capital markets.
        I could not agree more with Senator Gramm about listening
    to practitioners. That is fundamental to make sure that we
    understand the nuances of what we are about. I also think this
    needs to be a bipartisan effort so we can get to an answer that
    works.
        I will disagree in the sense that unintended consequences
    sometimes do harm. But sometimes consequences of doing nothing
    also create harm. If we somehow undermine the value of one's
    ability to analyze how companies are actually performing and
    there is not a sense of confidence in that, then the risk
    premiums that will come into the valuation process I think can
    be dangerous for the economy and, in the long run, the
    formation of capital, which I think is what our objective is,
    is to try to get as even and level a playing field as we can in
    that proposition.
        I look forward to hearing all of your testimonies with it.
    I understand that Mr. Gerson is from Floren Park and I welcome
    him, a good part of New Jersey, very near to my home.
        I also would say that I have had personal experiences
    working with the accounting industry, diligent and fair-minded
    individuals who have worked very hard to make, I think, the
    presentation of numbers that I used to sign off on ones that I
    felt comfortable dealing with.
        So, I hope that we can look at this as a positive,
    integrated, and enhancing process as opposed to one that is
    confrontational.
        Thank you very much, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Corzine.
        Senator Enzi.

                  STATEMENT OF SENATOR MICHAEL B. ENZI

        Senator Enzi. Thank you, Mr. Chairman. I also appreciate
    your conducting these hearings and having as many hearings as
    we have had so that we can get as much information as possible
    before we leap off the ledge with legislation.
        I do hope that people understand that the main reason that
    accounting and accountants are our focus here is because that
    is the jurisdiction of the Committee. And it is also an easy
    target.
        It is a profession that has been respected and is respected
    and it occurred to me that maybe the reason that CEO's and
    CFO's and lawyers, stock analysts, and other people are not
    getting the same kind of scrutiny that accounting firms are
    getting is because there is not that same respect or
    expectation for those other groups.
        I was very disappointed in The Wall Street Journal this
    morning. It has an article that says: How Accounting Fell From
    the Heights of Respectability. I did not feel quite so bad when
    I found out the total length of it was about five columns and
    it starts in 1494.
        [Laughter.]
        So while there have been some bad things, you have to go
    back a long ways to get a lot of information.
        It has been one of those areas of stability and provides
    stability in an international market. It is very important that
    we do not destroy that ability as we undertake some of these
    operations that fall under one of the legislative principles
    that I noted a long time ago when I was in the legislature.
        That is, if it is worth publicity, it is worth reacting to.
    And if it is worth reacting to, it is worth over-reacting to.
        [Laughter.]
        And that is where a lot of legislation goes. We do need to
    be very careful with this so that we do not destroy an industry
    that only has about five columns of bad stuff on it since 1494.
        Enron and Global Crossing have raised the profile of
    accounting and auditing issues. The collapse of these two
    companies has caused a ripple of fear throughout the investing
    community. Investors are now asking, can I trust the officers
    of the company in which I invest? And can I believe the
    financial statements that I rely on to make my investing
    decisions?
        For decades, our investing structure has relied on
    integrity as one of the cornerstones of our financial markets.
    If we do not restore that integrity, investor confidence will
    remain low and will encounter the risk of completely
    undermining our capital-raising process.
        At this point, I think that we know a number of areas where
    legislation might be needed. A new board should handle the
    tough ethical and certain disciplinary actions dealing with bad
    actors. This oversight board needs the authority and manpower
    to catch people engaged in unethical or illegal behavior early.
        You have to have registration with the board. The oversight
    board would have a track record of an individual accountant's
    performance. Therefore, public accountants should register with
    the board. This will allow for better coordination between
    enforcement agencies.
        A new funding mechanism is badly needed. A board which sets
    our Nation's accounting principles has an enormous impact on
    our capital markets. The board should not have to spend time
    and resources looking for funding.
        New disclosure requirements for corporate officers. We
    should no longer let corporate insiders with detailed knowledge
    of the company's financial position sell blocks of stock while
    the rank-and-file employees lose their life savings.
        More accurate disclosure of companies' financial standing
    is also needed. Through our hearings we have learned a lot
    about off balance sheet partnerships. While I do think there is
    a useful purpose for these, if they have the ability of
    significantly affecting the standing of a company, they should
    be reported.
        The SEC needs to become more engaged in the oversight of
    how accountants are doing their job. Enron should have had
    their audits reviewed by the Commission on a more regular
    basis.
        I think the Commission is doing a fine job now. They seem
    to be doing a review of the audits of companies which use
    complicated accounting techniques. There is a higher
    sensitivity everywhere. However, where was the Commission over
    the past several years while the losses and hidden debt were
    building with each false report that have led to these
    different disclosures now?
        Last, and in the long term, this point may be the most
    important. We need to begin moving to a principle-based
    accounting system. Current accounting rules are too complicated
    and provide too much room for loopholes. Accounting rules and
    their explanation should not be 800 pages long. We have to make
    this a priority.
        I know that some of my colleagues have worked on
    legislation which addresses some of these concerns, but we have
    to be careful that the legislation doesn't go too far. We have
    to be careful that it goes far enough. We must remember that
    America's accounting system is still the best in the world and
    we cannot disrupt that with a knee-jerk at this point in time.
        Again, Mr. Chairman, I appreciate your holding the hearing.
    I look forward to working with you and all of my colleagues to
    find reasonable solutions. I hope we can come up with some
    bipartisan solutions that both protect investors and create
    effective oversight mechanism for accountants and all of the
    other people involved in the areas of business and finance.
        I do look forward to hearing from our witnesses. Thank you,
    Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Enzi.
        Senator Dodd.

                STATEMENT OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Mr. Chairman, thank you, and I thank our
    witnesses. It is good to see so many of you here. Some of you I
    know very, very well, and I am pleased that you are going to be
    with us to share some thoughts this morning.
        Mr. Chairman, it has been said by others, but it deserves
    repeating--these have been a very fine set of hearings, very
    well balanced, I think, over the last several weeks, as we have
    tried to take a look at this overall issue and its multiple
    parts. I think that is an important fact to remember here.
        We are dealing with a multifaceted set of issues, highly
    complex. And the point Senator Enzi just made deserves being
    repeated. There can be unintended consequences of even the best
    intentions of legislation and proposals. I am very mindful of
    that. That is why this hearing is very, very important, so that
    we can hear from the people within the industry itself as to
    how this could work.
        I would just say that Senators Corzine, Stabenow, Johnson,
    and I have worked on a proposal. I know many of you are aware
    of it and have seen it. I should tell you as well, and it won't
    come as a surprise, but actually, many of the ideas and
    suggestions came from the accounting industry itself as to what
    we might do here.
        So, I look forward to the testimony, Mr. Chairman.
        I want to add my voice to those who have already expressed
    this view. Senator Corzine, of course, brings a very special
    background and knowledge to this table. But his point made
    earlier and repeated by others is worthwhile.
        There is a lot of media attention obviously to what has
    happened, and maybe more so today, later today with news out of
    the Justice Department regarding Arthur Andersen.
        The accounting industry is a great industry. It has
    performed tremendously. We are very successful in this country
    economically for many reasons, not the least of which is
    because of the very strong accounting industry, historically.
        And so, while these are difficult days, obviously, when the
    headlines are not just on the business sections, but the front
    pages of every newspaper and leading news stories across the
    country, I know that there are people who work for all of you,
    who are involved in this industry, who wonder if they made the
    right career choices and what their futures may hold.
        We can't succeed economically and survive well without a
    strong accounting industry. That would be an illusion to think
    otherwise.
        I certainly am angered, as my constituents are, as my
    colleagues are, over what happened with Arthur Andersen, at
    least in the Houston office, and maybe beyond. We do not know
    that yet.
        I will also tell you that I am saddened somewhat to see an
    industry, or company, rather, with the name Arthur Andersen
    reach the depths it has. What an important industry or business
    Arthur Andersen has been. And so, for the some 90,000 people
    worldwide who work for Arthur Andersen, who had nothing to do
    with anything that happened in Houston, these are good people,
    hard-working people. My heart goes out to them this morning, to
    their families, what they had nothing to do with, and yet,
    their reputations and their careers have been seriously damaged
    by what obviously some people may have been engaged in.
        So, Mr. Chairman, these have been very worthwhile hearings
    and I thank you for it. But I wanted to make that particular
    point about my appreciation for what the industry has done.
        Chairman Sarbanes. Thank you, Senator Dodd.
        Senator Bayh.

                     COMMENTS OF SENATOR EVAN BAYH

        Senator Bayh. Thank you, Mr. Chairman.
        I am looking forward to hearing from our witnesses and
    getting the benefit of their insights about how we can strike
    the right balance here between transparency and reliability of
    information that our capital markets depend on, on the one
    hand, and on the other hand, not unduly or inadvertently
    raising the cost of accounting services to investors and
    businesses, the vast majority of whom are honest.
        So, I thank all of you for being here. I look forward to
    having the benefit of your thoughts. And Mr. Chairman, I
    express my appreciation to you.
        Chairman Sarbanes. Senator Stabenow.

                  STATEMENT OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Thank you, Mr. Chairman, and welcome to
    our witnesses.
        I want to first join my colleagues, Mr. Chairman, in
    thanking you for being a true leader on this issue and
    providing what I believe is the most thoughtful, comprehensive
    set of hearings and discussions on what has been happening and
    what needs to happen as it relates to the issues in front of
    us.
        I am pleased to be joining Senator Dodd, Senator Corzine,
    and Senator Johnson, in the introduction of the Investor
    Confidence in Public Accountability Act of 2002. I certainly
    want to hear the comments from those who are joining us today,
    each of you, regarding the issues and the provisions in the
    bill and how we might work together.
        As this Committee has investigated investor protections and
    the accounting industry in light of Enron and other troubled
    companies, time and time again, we have heard several things.
    We have heard about the need for an enhanced oversight
    mechanism for the auditing profession. We have also heard about
    the potential for conflicts of interest when accounting firms
    offer both auditing services and consulting services to the
    same companies. We have heard about the need for financial
    independence for an industry oversight board, and we have heard
    about the need for financial independence for the Financial
    Accounting Standards Board, FASB.
        In addition, I think few of us would argue that the SEC has
    enough resources or staff right now to be able to do its job.
    And I think all of us would agree that increased financial
    disclosures and additional information about stock sales by
    corporate leaders benefit American investors.
        These are some of the issues we address in the legislation.
    I am very much looking forward to hearing all of you today and
    clearly would join with my colleagues as well in saying that
    the accounting industry is an important industry in the United
    States and we need to address what are serious issues for many
    Americans right now, but we need to do it in a thoughtful,
    responsible way that recognizes that this is an important
    industry that has provided a great service to the country.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Stabenow.
        Senator Miller.

                    COMMENTS OF SENATOR ZELL MILLER

        Senator Miller. I have no opening statement, Mr. Chairman,
    but thank you for these hearings. They have been very useful.
    They have been extremely informative and I appreciate all of
    our witnesses being here, especially my fellow Georgian, Mr.
    Copeland.
        Chairman Sarbanes. Thank you.
        We will now turn to the panel. It is my intention to start
    with Mr. Castellano and then just move right across the panel,
    and I will introduce each witness just prior to their
    testifying.
        Mr. Castellano is the Chairman of the AICPA Board of
    Directors for 2001 and 2002, a Managing Partner of Rubin,
    Brown, Gornstein & Company in St. Louis. He has actually served
    in a number of positions in AICPA's private company's practices
    section, a member of the Financial Accounting Standards Board's
    small business advisory group.
        We are very pleased to have you here this morning, sir. We
    would be happy to hear from you.

                 STATEMENT OF JAMES G. CASTELLANO, CPA

                      CHAIRMAN, BOARD OF DIRECTORS

                 AMERICAN INSTITUTE OF CERTIFIED PUBLIC

                          ACCOUNTANTS (AICPA)

                            MANAGING PARTNER

                 RUBIN, BROWN, GORNSTEIN & COMPANY, LLP

        Mr. Castellano. Good morning, and thank you also, Chairman
    Sarbanes, Ranking Member Gramm, and other distinguished
    Committee Members, for permitting me to testify before you
    today on accounting and investor protection issues raised by
    the collapse of Enron.
        Chairman Sarbanes. I would say to each of the witnesses, we
    are going to include your full statements in the record. It
    would be helpful if you can summarize so that we will get to
    the question period in the morning.
        [Laughter.]
        Mr. Castellano. We will certainly do that. Thank you,
    again, Mr. Chairman.
        Let me say that the men and the women of the CPA profession
    provide a vital service to investors, analysts, and corporate
    stakeholders, and we have zero tolerance for those who break
    the rules.
        The AICPA has a long history of meaningful advocacy for
    maintaining the highest standard of financial reporting.
        CPA's are bound by a code of professional ethics that puts
    the public interest first. The AICPA gives the highest priority
    to issues where public reliance on CPA skills is most
    significant. Many CPA's inside companies prepare financial
    statements for the 17,000 or so U.S. public companies and many
    independent CPA's outside those companies audit those financial
    statements.
        In cities big and small--I am from St. Louis, Missouri, as
    the Chairman said--there are men and women preparing those
    financial statements and auditing them, and they do so with the
    utmost of integrity and fairness. Unfortunately, it is often
    the case that the significant role that those CPA's play in the
    U.S. capital markets only gets recognized when a business
    fails.
        Today, you will hear from a panel of professionals who
    represent a cross-section of the AICPA's members working for
    both small and large firms and in corporate governance.
        Today, we will address for you: Reforms for regulating the
    audit profession, including auditor independence. The likely
    impact of reforms on the profession's ability to recruit talent
    and other effects of reforms on smaller companies and on
    accounting firms. We will address corporate governance issues,
    including the role and responsibility of audit committees.
    Recent initiatives that we have undertaken to strengthen
    auditing standards.
        Each of the panelists and I have submitted written
    testimony and we do ask that it be included in the record of
    today's hearing.
        Enron and its aftermath have clearly shaken public
    confidence in the financial reporting system. It has brought us
    to the cusp of an historically significant moment when we need
    to give thoughtful and careful consideration to meaningful
    reform.
        As Chairman of the AICPA, I am here to assure you that the
    AICPA will support meaningful and appropriate reforms and will
    continue to be both an advocate and a catalyst for necessary
    change. We recognize the importance for elected leaders to act
    responsibly in order to do what they can to prevent a business
    failure on the scale of Enron from happening again.
        We believe the real value of any new public policy
    affecting our profession must be assessed by asking four basic
    questions. First, will it help investors make informed
    investment decisions? Second, will it enhance audit quality and
    the quality of financial reporting? Third, will it help restore
    confidence in the capital markets, our Nation's financial
    reporting system, and the accounting profession itself ? And
    fourth, will it be good for America's financial markets and
    economic growth?
        Using these four criteria as benchmarks, the AICPA will
    work with this Committee, the Congress, the SEC, and the FASB
    to continue to develop meaningful and appropriate reform.
        From our perspective, there are four initiatives that
    clearly pass the test, and strike an appropriate balance
    between the need for Government oversight and the efficiency of
    the private sector. We will firmly support the Congress and the
    SEC in enacting these proposals. They are:
        First, we support creating a new private sector regulatory
    body. We believe the time is right to create new systems for
    performing quality reviews of the practices of public company
    auditors and for disciplining those auditors. Accordingly, we
    support moving from public oversight to public participation,
    and from self-regulation to public regulation of those very
    important processes. And we further believe that these
    processes should be subject to SEC oversight.
        Second, we support reforming the financial reporting
    process. Economic change has moved more swiftly than accounting
    has adapted. The annual and quarterly reporting regime must
    keep pace with that change through more timely and broader
    reporting. Ultimately, we must move toward real-time
    disclosure.
        With intellectual capital as the greatest engine for
    corporate growth, financial reports should include a broader
    bandwidth of information. Investors should know more about
    company plans, risks and uncertainties, opportunities and the
    drivers of future success. Reforming the financial reporting
    process clearly passes the public interest test.
        Third, we support new rules for corporate governance. The
    SEC already has solid ground rules for audit committees. But we
    think the audit committee rules can be strengthened. Audit
    committee members should have auditing, accounting and
    financial expertise. Periodically, audit committees should hold
    separate executive sessions with management, the independent
    auditor, and the internal auditors. We also believe the audit
    committee should be involved in hiring and firing the
    independent auditor.
        And fourth, support for corporate truthfulness. We say,
    simply, make it a felony for anyone in a company, or anyone
    else involved in the financial reporting process, to lie to an
    auditor.
        Earlier, I identified four basic questions that we suggest
    be used to evaluate new public policies. In that vein, we are
    confident that reforms can be implemented, that will improve
    financial reporting, increase investor confidence, and
    strengthen our capital markets.
        We really appreciate the opportunity to be here today and
    we look forward to participating in this healthy debate in the
    days and weeks ahead.
        Chairman Sarbanes. Thank you very much, sir.
        Now, we will turn to James Copeland, who is the CEO of
    Deloitte & Touche. As I mentioned earlier, I quoted from
    Colonel Carter, who was one of the principals in this firm many
    years ago.
        Mr. Copeland has been with that firm or one of its
    predecessors since 1967. He is on the nominating committee of
    the International Accounting Standards Committee.
        Mr. Copeland, it has become a practice in this Committee
    now, with Senator Miller's addition here, to especially
    recognize graduates or products of the State university system
    of the State of Georgia.
        [Laughter.]
        So since you are a graduate of Georgia State University, I
    want to underscore that fact.
        Mr. Copeland. Thank you.
        Chairman Sarbanes. We would be happy to hear from you this
    morning.

                STATEMENT OF JAMES E. COPELAND, JR., CPA

            CHIEF EXECUTIVE OFFICER, DELOITTE & TOUCHE, LLP

        Mr. Copeland. Thank you very much, Mr. Chairman, and the
    other Senators.
        I am appearing here today not only in my capacity as the
    Chief Executive Officer of Deloitte & Touche, LLP, but also on
    behalf of the American Institute of CPA's. I am a member of the
    AICPA, and Deloitte & Touche is proud to be a member of the
    AICPA's SEC Practice Section.
        We at Deloitte have the same perspective as the AICPA and
    as our colleagues in the profession with respect to the many
    proposals currently under consideration. So, my remarks today
    are not solely intended to provide the Committee with
    Deloitte's perspective.
        People are suffering because of the recent events at Enron
    and Andersen. As Senator Dodd said, much has been lost in this
    process--tens of thousands of jobs, hundreds of millions of
    dollars in savings for retirement, tens of billions of dollars
    in shareholder value, and the reputation of Andersen, one of
    the icons of our profession. But as sad as all of this is,
    there is an even more important casualty, and that is the
    confidence of the American investing public. We need to find
    out exactly what did happen at Enron and we need to fix it.
        In the wake of Enron's collapse, public attention has
    focused on ways to improve the effectiveness and the
    independence of audits of public companies. And I want to make
    it clear that that attention is welcome.
        However, the current situation presents danger, as well as
    opportunity. The danger is this: In the rush to enact reforms
    in response to perceived flaws in the system, we risk losing
    sight of the fact that the proposed reforms come with real
    consequences--intended and unintended--some of which will
    diminish the stability and the certainty that characterize our
    markets, and that permit them to be the engines of economic
    growth for our country. That is why we must think through the
    consequences of the proposals currently under consideration
    before we begin implementing sweeping change.
        The SEC has proposed the creation of a new regulatory
    organization, under its oversight. We believe the time is right
    to create a new body, dominated by individuals from outside the
    accounting profession, that would be empowered to perform
    quality reviews of the practices of public company auditors and
    to discipline those auditors. Accordingly, we support moving
    from a system of self-regulation to one of public regulation
    for these important processes.
        While my colleagues and I support a number of proposals
    that have surfaced, I would like to offer a view on three
    proposals which at first glance may seem to address problems of
    perception, but will not improve the quality of audits, nor
    enhance investor protection.
        One proposal currently being debated is the periodic
    rotation of audit firms. The AICPA already requires that lead
    audit partners on every public audit be rotated at least once
    every 7 years, and this approach ensures a fresh look at a
    company's books at regular intervals. There is strong evidence
    that requiring the rotation of entire firms is a prescription
    for audit failure. It would result in the destruction of vast
    stores of institutional knowledge and guarantee that auditors
    would be climbing a steep learning curve on a regular basis. It
    would expose the public to a greater and more frequent risk of
    audit failure. It would increase the likelihood of undetected
    fraud by management. It would make it easier for reckless
    management to mislead the auditor. And finally, it would allow
    companies to disguise opinion shopping by enabling them to
    portray a voluntary change in auditors as obligatory.
        This is not just my opinion. Many groups have studied this
    issue over many years and all have concluded that audit firm
    rotation is a very bad idea. I have cited five of these studies
    in my written comments.
        A related proposal involves a ban on the so-called
    ``revolving door'' situations in which an auditor goes to work
    for an audit client. The SEC and the Independence Standards
    Board considered the wisdom of imposing a cooling-off period
    before an auditor could accept employment with an audit client,
    and both concluded that such a rule would impose unwarranted
    costs on the public, the client, and the profession. Indeed,
    limiting the career opportunities of accountants would make the
    profession less attractive and make it more difficult for firms
    to hire qualified people. Studies have shown, and our
    experience is that existing safeguards, including the mandatory
    rotation of audit partners, are effective in addressing the
    ``revolving door'' situations.
        That said, I do agree that the audit committee and our
    profession can enhance safeguards in this area to provide
    greater comfort to the investing public.
        Another proposal currently being debated involves placing
    increased limitations on the scope of services that firms may
    provide to their audit clients. Just last month, my firm
    announced that we will further separate our management
    consulting practice--a step we took very reluctantly, but one
    we deemed necessary to address the market's concerns about the
    perception of auditor independence and to help restore investor
    confidence in the profession. While we have adopted this
    business model, but it may not be right for all other firms.
        Further limiting the scope of services that firms may
    provide to their audit clients is a bad idea. It is a bad idea
    because it will not make an audit team any more independent,
    but it will make the team less competent.
        In conducting an audit of the financial statements of a
    company, you obviously need good accountants and auditors, but
    you also need specialized technical experts. For example, in
    auditing a company like Enron, you would need experts in market
    trading controls and information technology, among others. An
    audit team that does not bring with it the technical knowledge
    and skills necessary to understand the company's business will
    not be able to perform a competent audit.
        Why would additional limitations on the scope of services
    make it more difficult to bring specialists into the auditing
    process? Because these experts are not auditors. They do not
    devote their career to audit support work. And if we ask them
    to abandon their consulting work and do nothing but audit
    support work, we would not be able to retain them. The best and
    the brightest seek positions that will allow them to develop
    their expertise, to learn, to work and on cutting-edge issues
    and few will choose to remain in jobs that offer limited
    opportunities and seriously restrict their professional
    development and employment options.
        I would add that several recent studies have demonstrated
    that there is no correlation between the provision of nonaudit
    services and audit failures, and I have provided some examples
    of those in my written testimony.
        The current search for solutions for ways to prevent
    another Enron is fitting and proper. The failures of American
    businesses often teach us more than our successes. We should
    learn from what has happened and we should make changes that
    provide meaningful opportunity for improving the quality of
    audits.
        Thank you very much.
        Chairman Sarbanes. Thank you very much, sir.
        Now, we will turn to William Balhoff, Chairman of the
    Institute's Public Company Practice Section. Mr. Balhoff is a
    Senior Audit Director with Postlethwaite & Netterville, a Baton
    Rouge, Louisiana firm. Actually, I think the largest
    independent accounting consulting firm in Louisiana, as I am
    told.
        Mr. Balhoff. That is correct.
        Chairman Sarbanes. We are pleased to have you here, sir.

               STATEMENT OF WILLIAM E. BALHOFF, CPA, CFE

                     CHAIRMAN, EXECUTIVE COMMITTEE

                 AICPA PUBLIC COMPANY PRACTICE SECTION

                         SENIOR AUDIT DIRECTOR

                  POSTLETHWAITE & NETTERVILLE, A.P.A.C

        Mr. Balhoff. Thank you very much and good morning.
        In my role as Chair of the senior AICPA committee that
    represents the interests of smaller CPA firms, and also as a
    partner at a local firm in Louisiana, I am here today to
    represent the opinions of those small firms and the small
    business clients that they serve across the United States.
        I have two topics that I would like to discuss with you.
    The first is how restricting the performance of nonaudit
    services would impact small business owners and our ability to
    meet their diverse needs. And second, how any new legislation
    that would affect the accounting profession must take into
    account its effect on the ability of accounting firms to
    recruit new talent.
        My firm performs over 150 financial statement audits of
    which only three are public registrants. However, the majority
    of small- and medium-sized CPA firms do not audit any public
    companies at all. I believe that it would be a grave mistake
    for the Members of this Committee to believe that it is
    possible to impose restrictions only on the largest of firms.
        History shows that new legislation by Congress is highly
    likely to become a template for parallel legislative or rules
    changes at the Federal and State levels that would directly
    affect small CPA firms and the small business clients we serve.
    In particular, as auditors who provide services to small
    businesses, we are often subject to rules established by State
    accountancy boards, the U.S. Department of Labor, the General
    Accounting Office, and State and Federal bank regulators. These
    bodies traditionally follow the lead set by Congress and the
    SEC in adopting new laws and regulations for auditors of public
    companies.
        I will give you a specific example of this cascade effect.
        After the SEC issued new rules on auditor independence in
    late 2000, the GAO followed suit with its independent standards
    earlier this year. Its requirements not only duplicate, but
    also in some cases exceed, the new SEC restrictions on nonaudit
    services by broadening the scope of services prohibited and CPA
    firms affected.
        I recently received a letter from a sole practitioner in
    Denton, Maryland, a small rural community on the Eastern Shore.
    In his letter----
        Chairman Sarbanes. Eastern Shore of Maryland, yes.
        Mr. Balhoff. Thank you.
        [Laughter.]
        Of Maryland. Did I not mention Maryland?
        [Laughter.]
        Senator Gramm. It is one of the nicest places on the
    planet. That's why.
        [Laughter.]
        Chairman Sarbanes. It is a wonderful community.
        Mr. Balhoff. Do I get more time?
        [Laughter.]
        Senator Dodd. What a subtle touch here.
        [Laughter.]
        Mr. Balhoff. In his letter, the CPA explains that one of
    the new GAO restrictions that exceed the SEC's rules requires
    firms such as his to assign separate personnel to perform
    nonaudit work. Of course, as a sole practitioner, he has no
    other personnel to assign. He explains that the practical
    result will be that he will either have to give up his solo
    practice and associate with a larger firm, or tell his GAO
    clients that they will now need to hire a second firm to
    perform the nonaudit work, an alternative that for many such
    clients is not economically feasible nor justifiable.
        Small businesses have long depended on small accounting
    firms to provide much more than audit services. The CPA serves
    as the ``trusted advisor'' of the small business owner. For
    example, a CPA firm will often assist a small business in
    starting out, as well as providing guidance on setting up
    record-keeping systems, providing tax and estate planning and
    making suggestions to help make the business more successful.
    The CPA also helps the business as it grows. Allow me to give
    you an example.
        I have one client, and this is in Louisiana, that had
    decided to expand its business by adding a new location. After
    asking questions concerning its projected increase in sales,
    changes in gross margins, and expected competition, as well as
    the impact on their financial statements, I helped the client
    develop a financial model to address these issues. The bottom
    line was that the company decided that, if it had gone forward
    with its original plans, it would have risked the very
    financial stability that it took decades to build. This is just
    one example that displays the important role CPA's play in
    providing small businesses with the information necessary for
    them to maintain their financial strength.
        As I am sure you will agree, successful small businesses
    are the cornerstone of Main Street America. It is likely that,
    in many cases, if the CPA does not have the ability to act as
    the ``trusted advisor'' to his or her clients, many small
    businesses will simply not seek the input of a third-party
    professional. It is vital, both for the small business person
    and for the survival of the thousands of CPA firms, that
    current laws not be changed in a manner that is insensitive to
    these concerns.
        My second topic addresses how new legislation might affect
    the ability of our profession to retain personnel and attract
    new entrants into the profession. This is already an area of
    great concern for firms of all sizes, and research undertaken
    by the profession has uncovered alarming trends.
        Specifically, studies completed by my committee confirm
    that we are experiencing significant difficulty attracting
    students into accounting programs and into the profession.
        In a 5 year period from 1995 to 2000, we have experienced a
    33 percent decline in the number of students enrolled in
    accounting programs, as well as candidates sitting for the
    CPA's exam.
        Our surveys show that the major reason fewer qualified
    candidates are studying accounting is because the profession is
    perceived as narrow and focused too much on historical
    ``numbers,'' whereas other business careers seem much more
    rewarding and exciting. It is critical that we change this
    perception and continue to attract young, bright minds into the
    accounting profession. Any efforts to recruit students to the
    CPA profession could be severely undercut by any reforms that
    restrict services audit firms are able to provide for clients.
        There is much to do post-Enron to restore confidence in
    Corporate America and the accounting profession. As you have
    heard from my colleagues, the AICPA and its members, large and
    small, fully support many important reforms. But as Senator
    Gramm said, as Congress considers these issues, we urge you to
    consider the unintended consequences of short-term legislative
    solutions in your effort to respond to the Enron business
    failure.
        Thank you.
        Chairman Sarbanes. Thank you very much, sir.
        We will now hear from Olivia Kirtley. Ms. Kirtley was Chair
    of the AICPA Board of Directors in 1998 to 1999. Actually, I
    think she was the first woman to Chair that Board. She was Vice
    President and CFO of Vermont American Corporation from 1991 to
    2000. Vermont American is a manufacturer of power tool
    accessories and was listed on the American Stock Exchange until
    1990.
        Ms. Kirtley currently serves as a member of the board of
    directors and chair of the audit committees of two public
    corporations.
        We are very pleased to have you with us this morning.

                  STATEMENT OF OLIVIA F. KIRTLEY, CPA

                            FORMER CHAIRMAN

                 BOARD OF DIRECTORS, AICPA (1998 -1999)

                     RETIRED VICE PRESIDENT AND CFO

                      VERMONT AMERICAN CORPORATION

        Ms. Kirtley. Thank you very much, Mr. Chairman.
        Actually, I am a board member and chair of the audit
    committees of three public companies.
        Chairman Sarbanes. Well, I apologize.
        Ms. Kirtley. My remarks today will focus primarily on
    matters of corporate governance, including the roles and
    responsibilities of audit committees. I want to begin by
    discussing the importance of advice received from external
    auditors based on my experience as a former CFO, as well as an
    audit committee member.
        Some of the reforms being proposed would strive to strictly
    limit the use of this very important resource by companies and
    by their boards. There are a number of areas outside the scope
    of financial statement audit in which a company's independent
    CPA is in the best position to offer advice. This advice
    benefits the company and its shareholders rather than
    compromising the integrity of the audit. Not only will costs
    rise and efficiencies decline, but business decisions will
    suffer from the loss of expertise provided by the auditor's
    deep knowledge of the business.
        There are SEC rules in place to protect the public by
    requiring that the outside auditor disclose to the audit
    committee all relationships with the company that may impact
    independence and objectivity. After evaluating the report and
    discussing it with the auditor, the audit committee discloses
    this information to investors in its proxy statement. This rule
    has only been in effect a little over a year and we should
    allow it time to work. We need to be careful not to
    unnecessarily restrict a company and their board's ability to
    access the external auditor as a valuable resource.
        In the area of audit committee composition, we all know
    that the work of audit committees has become more difficult and
    demanding and it is certainly under more public scrutiny. In
    recent years, audit committees have been the subject of much
    study and attention. Just 2 years ago, new rules were issued by
    the SEC and the stock exchanges addressing the independence and
    the experience of audit committee members.
        One of the new rules is that corporate audit committee
    members must be financially literate, but only one member must
    have accounting or related financial sophistication or
    expertise.
        Presently, the definition of financial literacy is nebulous
    at best, with two different market regulators adopting
    different, yet vague, definitions that may not be sufficient to
    meet shareholders' increasing expectations.
        We recommend that the listing authorities consider
    requiring all audit committee members to have auditing,
    accounting or financial experience in order to minimize the
    reliance on one committee member. If a member lacks sufficient
    expertise, he or she may not understand the issues, know the
    questions to ask, or have a basis for considering the adequacy
    of the responses provided.
        Audit committee work, like public accounting work, requires
    significant judgment. It is not an exact science. Accounting
    and financial sophistication or expertise will not guarantee
    that mistakes in judgment will never be made, but it certainly
    should mitigate the risks.
        The final area I would like to discuss is audit committees
    communications. The Blue Ribbon Committee on the Effectiveness
    of Audit Committees cited a need for improved and more frequent
    communication between audit committees and independent auditors
    that would cover such important areas such as estimates and
    judgments, internal controls, significant risks, and the
    clarity of the company's disclosures. In response to these
    recommendations, new auditing standards and audit committee
    charters have created a framework for such enhanced
    communications to occur on a regular basis.
        In addition, a quarterly review is required to be performed
    by the independent auditor, and the auditing standards board
    recently implemented a requirement that the review results be
    discussed with the audit committee, or at least with the audit
    committee chair, prior to the quarterly filing with the SEC.
        Chairman Pitt has called for improved interaction between
    audit committee members and senior management and outside
    auditors.
        A step that would further strengthen open and candid
    communication would be to require audit committees to hold
    separate executive sessions on a periodic basis with financial
    management, with independent auditors, and with internal
    auditors. The use of executive sessions as a fact-finding tool
    is indispensable, providing an environment where committee
    members are able to probe more deeply to assure they are fully
    informed regarding risks, issues and judgments, and that the
    participants are given the opportunity to confidentially voice
    concerns they might not otherwise express.
        In closing, it is critical to note that many significant
    audit committee rules and regulations have taken effect over
    the last 2 years as a result of the Blue Ribbon Committee.
    During this period, the SEC and stock exchanges have
    implemented many new measures, including the requirement of the
    formal audit committee charters. These new requirements must be
    given time to work. In my experience, I have seen significant
    improvements in the effectiveness and communications of audit
    committees since the new requirements have been implemented. We
    must resist the temptation to layer on too many additional
    rules before giving recent audit committee requirements a
    chance to work.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you very much.
        Our concluding panelist is James Gerson, Chair of the
    Auditing Standards Board of the American Institute of Certified
    Public Accountants, and a partner in the national office of
    PricewaterhouseCoopers, where he is the assurance policy and
    communications leader. Mr. Gerson has been a member of the
    Auditing Standards Board since 1992, and he has also been a
    member of the Peer Review Committee of the Institute's SEC
    Practice Section.
        Mr. Gerson, we would be happy to hear from you.

                   STATEMENT OF JAMES S. GERSON, CPA

               CHAIRMAN, AUDITING STANDARDS BOARD, AICPA

                  PARTNER, PRICEWATERHOUSECOOPERS, LLP

        Mr. Gerson. Thank you, Mr. Chairman.
        The Auditing Standards Board is a senior committee of the
    AICPA authorized to set authoritative auditing standards that
    are commonly referred to as Generally Accepted Auditing
    Standards. These standards apply to all audits, both the public
    and nonpublic entities. The committee has 15 members appointed
    to achieve an appropriate representation among CPA firms of
    different sizes, as well as the public. At present, 2 of the 15
    seats are reserved for public members, currently filled by an
    academician and a Government auditor. We hold regular meetings
    that are open to the public and are attended by representatives
    from the SEC, the Public Oversight Board, and other
    constituents.
        Let me focus briefly on the role of the independent auditor
    in the financial reporting process. The management of a company
    prepares the financial statements in accordance with Generally
    Accepted Accounting Principles. The objective of an audit is to
    provide assurance on the credibility of these financial
    statements. An audit consists of a series of test procedures
    designed to gather evidence to enable the auditor to express an
    opinion as to whether financial statements are presented
    fairly, in all material respects, in accordance with these
    Generally Accepted Accounting Principles.
        The auditor's conclusions are reflected in the auditor's
    report. The goal of financial statements accompanied by an
    auditor's report is to provide information that is reliable and
    useful to investors, creditors, and other constituencies.
        I would like to tell you in the remaining time allotted
    what we are doing to improve the quality of the audit, and let
    me start with our fraud project.
        Let me assure this Committee that, as auditors, we
    recognize our responsibility to plan and perform every audit to
    obtain reasonable assurance, within the limitations inherent in
    the nature of an audit, as to whether the financial statements
    are free of material misstatements, whether caused by fraud or
    unintentional errors. Even a properly designed and executed
    audit, however, cannot provide a 100 percent guarantee that a
    material fraud will be detected. Nevertheless, we are working
    hard to continually improve auditor performance.
        In this regard, we issued an Exposure Draft just last month
    of a proposed revision to our standards on the Consideration of
    Fraud in a Financial Statement Audit. This proposal, in our
    opinion, will substantially enhance the ability of auditors to
    detect material misstatements arising from fraud.
        A major change in this new standard is the addition of
    required procedures that respond to the POB Panel on Audit
    Effectiveness's call for a forensic-type fieldwork phase by
    requiring, even when fraud is not suspected, and as part of
    every audit, including all public companies, the following:
    Discussions among engagement team members as to how and where
    fraud could occur, setting aside any prior beliefs they may
    have had about management's honesty and integrity. Specific
    inquiries as to fraud prevention programs and controls
    established by the company. A requirement to perform certain
    specific audit procedures to test for the intentional override
    of internal controls by management. And a continual evaluation
    of fraud risks throughout the audit, as well as a re-review at
    or near the end of the audit process.
        Also, last year, we formed a task force that is working
    together with international standard setters to improve the
    auditor's risk assessment process, to better understand where
    material errors are more likely to occur in the financial
    statements, and what auditing procedures are best suited to
    respond to those risks identified.
        We also expect to expose for comment this spring a new
    standard on auditing ``fair value'' measurements. We have
    previously issued detailed standards on auditing derivatives
    and similar financial instruments. Additionally, we are in the
    process of updating and improving our related audit guide and
    will be adding a new chapter that will provide guidance on
    auditing energy and other commodity contracts.
        This past December, in response to recent events and in
    time for this year's audits, we issued an auditor's ``tool
    kit'' to serve as a valuable reference guide when dealing with
    the complex topic of the potential abuse of related-party
    transactions.
        In addition, in response to growing demand for more
    frequent and timely reporting, we are actively involved in
    developing continuous auditing methodologies. Actual
    implementation will evolve, as the concept of more frequent
    reporting gains additional support and as appropriate,
    specialized software tools emerge.
        Investors depend on auditors to communicate the
    reasonableness of the company's financial information and to
    provide confidence in the numbers. When an investor reviews a
    company's financial statements, an independent audit should
    provide the investor with confidence that the company is
    playing by the rules.
        As a profession, we are committed to continually improving
    our auditing standards and the guidance we provide to auditors,
    so that investors and others who rely on an auditor's report
    can place full confidence in the audit process and the members
    of the profession who perform this valuable service.
        Thank you.
        Chairman Sarbanes. Thank you very much, sir.
        We thank all of the panelists.
        We will now go to our rounds of questioning.
        Let me say at the outset that I think we are very obviously
    mindful of the argument about unintended consequences. But we
    cannot for a moment permit the unintended consequences argument
    to swallow up the necessity, at least as I perceive it, of
    making systemic and structural changes. And with all due
    deference to the panel, I do not think there is a full
    appreciation of just how critical I think this situation is at
    the moment.
        I am not going to go through everything, chapter and verse,
    but even The Wall Street Journal yesterday in an editorial
    supporting Volcker's suggestions for Andersen, which they then
    thought would become a model for other accounting firms, the
    editorial says: ``As long as we have audits, investors should
    have confidence that the auditing signature means something. It
    is clear enough that as accounting firms have transformed
    themselves into full-service consultancies, the consultants
    have often wagged the auditors.'' And then they go on to
    describe that process.
        In the Journal this morning, their lead story is ``Did You
    Hear the One About the Accountant? It is Not Very Funny.'' And
    that is President Bush's joke. I won't put the joke out here.
    ``How A Decade of Greed Undid the Proud Respectability of a
    Very Old Profession.'' Then, of course, The New York Times also
    has a long story on Andersen: ``A Once Proud Company is
    Humiliated by the Enron Debacle.'' And they have some
    interesting quotes from Judy Spacek, who is the daughter of the
    other pioneering executive besides Andersen in establishing
    that old line firm.
        So, I think there are some real challenges here. And I do
    not think they are going to be corrected by half-way measures.
        Our search is to find out the measures and to make sure
    that they are sensible and that they will work. But it is my
    own perception that we need some substantial changes in the way
    the system and structure works if we are going to guard against
    this.
        Now having said that by way of opening, there are a couple
    of questions I want to ask before my time expires here.
        I want to address this issue of cascade, which the
    institute has already sent an alert out to its members,
    sounding the warning bells and the dangers and that small
    business will be done under and so forth and so on. Do you
    perceive that once you represent a listed company, that there
    are important additional obligations which go with playing that
    role?
        Mr. Balhoff, you said that you had only three clients that
    were listed companies.
        Mr. Balhoff. Right.
        Chairman Sarbanes. Now it may be that if you are going to
    play in the listed-company arena, you are going to have to
    recognize that there are going to be tougher demands on you
    than if you stay out of that arena. Our focus has been
    essentially in the listed-company arena because that is where
    we have most sharply put the investor protection issue and the
    confidence in the markets.
        Your argument is apparently that whatever has happened in
    the listed-company arena is going to cascade into the other
    arena and therefore, we are going to be impacted by that. But
    by the same logic, I do not know that I can accept a cascading
    up concept, which says, because of our problem in the nonlisted
    arena, you cannot do this, this, and this with respect to
    listed companies. Do you see a greater responsibility when you
    are dealing with a listed company?
        Mr. Balhoff. That question is for me?
        Chairman Sarbanes. Well, anyone on the panel.
        Mr. Balhoff. I will take that, initially at least. I
    believe that the responsibility, when you audit a company, is
    to see that the financial statements are fairly presented. And
    there, to whomever the readers in a listed company, obviously,
    you have more shareholders and more readers of the financial
    statements generally than in small businesses, most of the
    companies that we represent.
        I think that you have to be conscious of that when you are
    auditing. And addressing the issues of consulting services, my
    belief is consulting services are getting bad names right now.
    We are putting everything into the bucket of consulting
    services and I think we need to understand the types of
    consulting that happens with engagements.
        I can tell you, even for our public companies that we
    audit, which actually are SB's, they function in terms of their
    size and their needs are a lot like private companies. But to
    the extent that consulting services provide information to
    management, I think we are working in the public interest. We
    are helping those companies, whether they are listed or
    nonlisted companies, to better run their companies. I think
    that is a public interest.
        To the extent that any of our consulting services may put
    us in the position of management, then I absolutely believe
    there is a conflict and I believe that is for listed or
    nonlisted companies.
        Chairman Sarbanes. Does anyone else want to add to that?
        Mr. Castellano. I might add something to that, Mr.
    Chairman.
        I do think we should recognize that whatever is done here
    in terms of legislation Federally, is looked at by State boards
    of accountancy in setting independence rules in the States.
        Chairman Sarbanes. Well, they may have to sharpen up their
    ability to make the differentiation.
        Is it correct that about 95 percent of the listed companies
    are represented by the five major accounting firms?
        Mr. Castellano. I believe something in excess of 90 percent
    is the right answer, yes.
        But what we may want to look at is this new public
    regulatory body that we fully support, as I said, may eliminate
    the need for bright-line, prescriptive rules in matters such as
    what specific services should or should not auditors be allowed
    to provide for their audit clients.
        Because this new board will be, in fact, inside these firms
    that do these audits on a regular basis, a continuous basis,
    evaluating audit quality and making assessments as to whether
    firms are in fact independent rather than whether there is
    merely a perception of an independence impairment. So, I think
    the new regulatory board that we are fully in support of may
    compensate for the need to have bright-line prescriptions on
    certain services.
        Chairman Sarbanes. My time is expired. I will come back.
        Senator Gramm.
        Senator Gramm. Mr. Chairman, thank you very much. I want to
    thank each of you for very good testimony.
        I do think it is very important as we go through this
    process, despite all the public pressure that is going to be
    brought to bear in the debate, that people who understand your
    profession stand up and speak out on these issues.
        I am not taking exception to what the Chairman said, but I
    am taking exception to The Wall Street Journal. If this last
    decade was a decade of greed, may God give us many such
    decades, because the poverty rate among children fell by 20
    percent in the last decade. I think there are many people who
    are trying to take this Enron thing and use it to discredit
    capitalism itself. I just do not think the case can be made.
        I think a case can be made that we need to look at what
    happened as best we can determine. And I think the nature of
    the world we live in is that we are going to be forced to make
    a judgment before anybody really knows what happened at Enron.
    But we need to determine what happened and we need to find ways
    of trying to deal with it, both to make things better and to
    improve the system, and also to bolster public confidence. I
    think that is our challenge.
        I would like to raise a couple of issues. First of all, I
    think everybody agrees that part of the reform is greater
    independence for this oversight board and a secure financial
    base. This raises another question which may not concern many
    people, but it concerns me, and that is the whole
    accountability of the people who end up in these positions. A,
    are you concerned about that? And B, how would you deal with
    it?
        You do not have to ask anybody for money. You are giving
    people ability to subpoena. You are giving people power to set
    accounting standards. How would you deal with the whole
    question of checks and balances and accountability? Rapid
    turnover of the people?
        Let me just start with that. And if you all can be brief,
    this 5 minutes goes fast when you care about the subject.
        Mr. Castellano. I will start, Senator Gramm.
        We believe that there should be very careful consideration
    as to how members of the public body would be nominated and in
    terms of their terms and the background of the people that
    would serve on such an important body. I think there should be
    some checks and balances in terms of that body being subject to
    SEC oversight, as I said in my testimony.
        Mr. Copeland. Senator, I think you have asked a very
    important question. I have no problem with the concept of a
    board that basically would represent independent rather than
    self-regulatory processes, so long as there was some
    accountability for the people on those boards. Now how to
    provide that and still leave them largely independent is a real
    challenge.
        But I would just say that it is absolutely essential that
    whatever body is involved in our oversight in whatever way, has
    the absolute trust and confidence of the public, of the
    Congress, of the Commission, and of the people that they are
    overseeing.
        Somehow, coming to a point where we bring all of that
    together, I think any process that would assure that, I would
    vote for.
        Ms. Kirtley. I hope we would look to some of the
    improvements made in the corporate governance structure and
    apply some of those very same safeguards and checks and
    balances to a body such as this. I think it is very important,
    and Mr. Castellano's point about the nominating process is
    extremely important. And I hope that we would look to some of
    the things that we currently have in place and have put in
    place for corporate governance in that regard.
        Mr. Gerson. I think the issue of accountability and funding
    is an interesting one. I am not sure that anybody, including
    the Federal Government, operates in an environment of total
    discretion on spending, whatever it is, that you think you need
    to spend.
        Senator Gramm. Well, our whole system is based on
    preventing that from being the case.
        Mr. Gerson. Yes, right.
        [Laughter.]
        Senator Gramm. One final question in the time I have left.
        There is a real question about who ought to be on this
    board. I guess my own views are that if you are going to have
    an ethics subpanel, that perhaps there is some logic to having
    maybe even a majority of people who are non-CPA's.
        When we are setting accounting standards, I have to admit
    that it frightens me to have nonaccountants in the majority in
    setting such standards. And when we are setting those
    standards, maybe we ought to require a super-majority of the
    panel, no matter how it is made up. Does anybody have any
    thoughts on that they want to throw out?
        Mr. Castellano. Let me say first, Senator, that the public
    regulatory body that we support would take from public
    oversight to public participation two key aspects of what have
    been historically part of the self-regulatory regime of the
    accounting profession. This is unprecedented reform. That is
    discipline and peer review.
        We are not advocating that accounting standards, which are
    now set by the Financial Accounting Standards Board, be set by
    this new public regulatory body. We fully support the FASB as a
    private-sector standard setter for accounting standards.
        The auditing standards board has historically done an
    outstanding job of establishing auditing standards for our
    profession. I think there is no doubt that our auditing
    standards are the finest in the world and have contributed to
    our capital markets being the envy of the world.
        The public body that we recommend and fully support would
    again be unprecedented in taking over the discipline and peer
    review for public company auditors.
        So, to that extent, the composition of the board--I do not
    have strong feelings about it. I think people with financial
    acumen, some people from the profession. But we certainly
    support a publicly dominated board, would be appropriate.
        Chairman Sarbanes. Could you answer the super-majority
    question? That was imposed upon FASB and some people feel that
    is one of the reasons that FASB has had difficulty putting
    forward regulations. They used to operate just on a straight
    majority. Then a super-majority requirement was imposed upon
    them. I might also note that the Supreme Court decides very
    momentous issues affecting the whole structure of our
    constitutional system without a super-majority. Do you have a
    view on the super-majority issue?
        Mr. Castellano. It is hard to answer that one question in
    terms of how this would be structured, Mr. Chairman, unless we
    know the composition of the board. And that is, the background
    from which the members would come. Are they all public members?
    Are they a combination of public members and people who have
    previously been in the profession? Some people who are
    currently in the profession? I think it would be premature for
    me to express an opinion until we know the composition.
        Chairman Sarbanes. Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman.
        Let me just say that I think that one of the problems we
    have in this whole discussion is it is so Enron-focused, it
    gets off of the pertinent issue that we had 158 restatements
    last year, which gives, I think, investors and people who
    analyze statements real pause for cause. Three times the
    numbers in the 1990's. I think the paper said today there were
    three restatements in 1981. Something's going on that causes
    people to have major changes in how the earnings of companies
    have been reported and what actually happens.
        So, I hope that it is not just an Enron-derived issue that
    I think we are trying to talk about here. Sometimes I feel like
    we get so focused on that, that it is mistaken.
        I am pleased that you all are for this independent
    regulatory oversight crowd, group. But I am troubled when I
    hear the term, peer review. The reason I am troubled is, if I
    am not mistaken--and I ask whether this is, in fact, the case--
    but has the peer-review process ever resulted in any kind of
    disciplinary or dissenting view with regard to another one of
    the peer's auditing practices?
        Why wouldn't we want the oversight board to have the
    ability, as the SEC does, as the New York Stock Exchange does,
    as maybe Nasdaq does with security firms, or the Federal
    Reserve with regard to banks and other regulatory bodies, to
    actually go in and audit the auditors themselves?
        I think that is one of the major issues that I hope that we
    would be able to come through this process. I think that is the
    theme of one of the elements of the bill that Senator Dodd and
    I have suggested. I would love to hear your comments on it, but
    I would go back to the peer-review process. It certainly hasn't
    challenged these restatements. And it certainly hasn't led to a
    lot of dissent and challenge of breakdowns that might have
    occurred in different situations in a period of time, other
    than Enron.
        Mr. Copeland. Senator, maybe I could respond to that. First
    of all, I do think there are improvements that could be made in
    the peer-review process. Those were recommended in the Panel on
    Audit Effectiveness' Report. And my understanding is that those
    changes are being worked through the process.
        Senator Corzine. Is it true, by the way, that there have
    been no sanctions brought against a firm or dissent?
        Mr. Copeland. Yes. But it is not true, though, that there
    have been no comments and recommendations coming from those
    publicly issued comments and recommendations. Those are made in
    virtually every peer review. It is a little bit like an audit
    report. It is either adverse or unqualified. It basically would
    be a death sentence for a Big 5 firm to have an adverse opinion
    coming out of a peer review.
        Also, you should understand that because of the processes
    in place under the AICPA for the investigation of challenged
    audits, whether in the claims process or whatever, those audits
    and those engagements are reviewed through the QCIC process
    rather than through the peer-review process. For example, in
    the peer review of Andersen, the Enron engagement was excluded
    from that peer review and would be reviewed in the QCIC
    process.
        So there are two separate processes, one for troubled
    engagements and one for the practice at large.
        Senator Corzine. Okay. Could you comment further on whether
    peer review is what you think the independent regulatory body
    should do, or whether you could conceive and would be embracing
    of the kind of New York Stock Exchange, NASD, or SEC audit by
    the independent body?
        Mr. Copeland. I do think that there are--and for many
    reasons right now, I particularly would support the change from
    a peer-on-peer review process. I do believe that some
    significant changes in that process could enhance the public's
    confidence, whether it is the process you described--I am not
    familiar with that--but there are some excellent
    recommendations again from the Panel on Audit Effectiveness.
        Let me just add one other thing, though, that people have
    suggested because there have been no adverse opinions, that we
    should do away with the peer-review process.
        I think that would be a serious mistake. I can only assure
    you that when our firm is going through a peer review, we sweat
    bullets and we do pay attention to what we do, and the
    knowledge that another firm will be looking over our shoulder.
        I think that would be a little like saying that because
    traffic laws aren't successful in eliminating the 25,000
    fatalities we have every year, that we should do away with
    traffic laws.
        The peer-review process helps. If we can figure out ways to
    improve it, we absolutely should do that. But to throw that out
    I think would be a step backward. I think the peer-review
    process, as it was developed 15 years ago, was an excellent
    idea.
        Mr. Balhoff. If I could make a quick point. I think there
    have been adverse reports in peer review and there have been
    modified reports in peer review and there are follow-up actions
    that require education and sometimes oversight, preissuance
    reviews. So peer review, the process itself has resulted in a
    number of different monitoring actions on firms across the
    country. I know because I have seen some.
        Although some of the largest firms may not have had adverse
    or modified, I can assure you that the peer-review process has
    resulted in that, and in fact, I think that Mr. Copeland's
    correct. I think it has been a very positive process for the
    profession.
        Mr. Copeland. I stand corrected. I have, I admit, a Big 5
    focus.
        [Laughter.]
        Senator Corzine. Thank you.
        Chairman Sarbanes. Senator Enzi.
        Senator Enzi. Thank you, Mr. Chairman. This has been
    another very exciting day.
        [Laughter.]
        I just love it when we have accountants in here.
        [Laughter.]
        I would like to point out that this is the first panel that
    I can remember that stayed within their time limits.
        [Laughter.]
        Which shows what rule-followers accountants are.
        [Laughter.]
        I do hope that my colleagues will take a look at the
    testimony that was provided. It does address more specific
    questions that we have been having about the accounting
    profession than any of the voluminous texts that we have had in
    the past.
        I think they give us some answers that will help cover this
    range from small accountants to big accountants.
        There is quite a bit of variety in what was presented this
    morning. I appreciate Mr. Castellano and Ms. Kirtley talking
    about audit committee requirements and particularly Ms.
    Kirtley's comments about financial literacy, which she did not
    have time to go into a great deal in her testimony.
        If we have people on audit committees that had more
    financial literacy, and that fits in with the hearing that we
    had on financial literacy, I think the companies would be a lot
    better off and the investors will be a lot better off.
        Mr. Copeland, I really appreciate the information that you
    have on auditor rotation and the information on the separation
    of consultants from the auditing process. And I will get into
    that a little bit more here in a moment.
        But for Wyoming, Mr. Balhoff is the prime example because
    all we have are small accounting firms in Wyoming. And of
    course, they are auditing small firms. Those firms do expect
    that when they have that exit interview, that they not only
    find out the things they have been doing wrong, but also they
    can find out the things that they have been doing better.
        I know how disappointed they are going to be when it gets
    to that point and because of cascading, the auditor tells them,
    oh, I am sorry, that is consulting. You are going to have to
    pay another firm to come in and look at exactly the same
    information, do exactly the same work that we did, and pay them
    as much or more in order to get that other question answered.
        Every time I have seen something that affects the companies
    that audit the SEC filings, it does wind up coming down to the
    States and the States having less hearings and less
    information, but imposing the same rules on those small
    companies.
        We have to be very careful that what we do here does not
    wind up doing that same thing.
        Mr. Gerson, what I really like in your testimony is that
    you tell people what auditing is.
        [Laughter.]
        That is a very important piece that is missing from this
    whole process. We are assuming that everybody knows what
    auditing is. I have found that there is quite a bit of variety
    in what people are picturing as auditing and they are thinking
    more of the times that they have sat down with their IRS agent
    and answered questions, often for which they have been kind of
    bombarded and surprised.
        They do not recognize the continuity that is necessary in
    this, or the realm of information that is necessary in it
    because it is not supposed to be a gotcha situation. It is
    supposed to be assurance that the best accounting transparency
    is provided.
        And there are some different techniques that are involved
    in that, than what is involved with the IRS. But I guess I
    better get to the questions. I am running out of time and I am
    one of those rule-followers, too.
        [Laughter.]
        I would ask Mr. Copeland to comment--well, no, I am going
    to make some more comments.
        [Laughter.]
        We talked about forcing this rotation of auditors. I have
    to say that it was Congress that caused the problem to begin
    with. We have written all of our documents and questions and
    things to keep companies from shopping for auditors, to make
    sure that they are allowing full enough time for people to
    understand the business completely and to be sure that they are
    not applying pressure to the auditors with this threat of
    firing them.
        So everything that we have done has been toward saying, if
    you get rid of an auditor, take a look because there is
    something bad happening there. And now we are about to do a
    reaction, perhaps an overreaction, and say, unless you are
    changing auditors, you are doing something bad.
        We are going to have to reach some middle ground here, I
    suspect, where we recognize the errors that we are making and
    have made in the past and also rely on that financial literacy
    of an independent audit committee to be able to make the kinds
    of selections on when it is time to change auditors.
        I do have some questions which I will submit to you since I
    got carried away here.
        Chairman Sarbanes. Thank you very much, Senator Enzi.
        Senator Dodd.
        Senator Dodd. Thank you, Mr. Chairman.
        Thank you all for your testimony. It is very, very helpful.
    I want to make a couple of quick observations if I can.
        First of all, I want to underscore the point that Senator
    Sarbanes made. We have all acknowledged the unintended
    consequences and we are all very much aware of that. But I
    would also be very quick to add that there are more than just
    unintended consequences if we do not act.
        We are in a relatively brief session here with an election
    year coming upon us. We have a lot of work to do on
    appropriations bills and other things. These hearings have been
    very, very important, and while we are not going to act
    precipitously, it is going to be critically important that we
    act. So, I wanted to make that point to all of you.
        Chairman Sarbanes. Let me say, that is certainly the
    Chair's intention. We are trying to be thorough and careful.
    But it seems to me it is clear that changes are needed and we
    intend to do all we can to see that that happens.
        Senator Dodd. I appreciate the Chairman making that point
    again.
        And to my friend from Wyoming, I know that he is drafting
    legislation as well and will be submitting a bill on this
    matter. I am sure that there are no unintended consequences of
    what he is drafting here.
        [Laughter.]
        We are anxious to see what he proposes. Let me just make
    the point here, and I am preaching to the choir when I say
    this. I certainly know Mr. Copeland. I don't know the rest of
    you that well. But I have a lot of confidence in the integrity.
    I think the comment of Colonel Carter that the Chairman talked
    about and who audits the auditor, and he says, our conscience.
        I do not think he said that lightly or frivolously and I
    think over the years, there has been that strong sense. This is
    the difference, I suppose, when you understand the unique
    problems in smaller companies and so forth, not public
    companies that the Senator from Wyoming has pointed out. But
    there is a different set of circumstances in accounting and
    auditing.
        A consultant has one client. It is the client that has
    hired them. They do not have a responsibility beyond the client
    that has asked them to do the consulting.
        A lawyer has one client. He is an officer of the court. It
    is a bit beyond that. But, nonetheless, their primary
    responsibility--in fact, ethics say that their obligation is to
    the client.
        The auditor has a broader responsibility. It is not just
    the client that has hired you. There is a fiduciary
    responsibility that transcends just the person who pays the
    bills. It is that person out there is who's making investments
    and trying to decide how to make solid and intelligent
    decisions.
        Historically, we have relied on you, or at least the
    investor community has relied on you. We have no one else to
    really rely on in making these things. So the notion somehow
    that this is just an auditing function and a consulting
    function and a lawyer's function are all the same--I see you
    are agreeing. You are nodding your heads. It is different. Can
    you all agree with that? Am I overstating the case? It is very
    different. Is that not true? I am listening.
        Mr. Copeland. Yes, I agree.
        Senator Dodd. I just want to make that point. I think that
    is a very important point here.
        Also, I want to underscore the point that Senator Corzine
    made. This is not just about Enron, any more than the election
    of 2000 was about Florida. What Florida pointed up is a serious
    problem with election laws around the country, and Florida
    highlighted it for all of us. Enron has highlighted a set of
    issues that we need to address. But if we suggested that all we
    were doing is crafting legislation to respond to Enron, that
    would be foolish, in my view, at this juncture. We do not know
    a lot yet about that. There are a lot of things to be done. It
    has highlighted problems. But to suggest that it is just an
    Enron bill I think would be a mistake.
        Let me, if I can, get into this.
        First of all, I always believe in starting with where we
    can agree a little bit. I agree with the issue on the rotation
    question.
        I think in our bill, we ask for a study to look at this.
    You did not include in your testimony, but I have always
    thought a very worthwhile argument is that different accounting
    firms have different specialties, even among the Big 5.
        The idea that there is a cookie-cutter approach here that
    one accounting firm can do the job of any other accounting firm
    because you are mirror images of each other, is just
    fundamentally wrong. There are specialties and so forth.
        The idea of rotating accounting firms, in addition to the
    arguments you have made, Mr. Copeland, in your testimony, it
    may be more forcefully made by the idea that it is really an
    impractical suggestion as to how to deal with it. So, I agree
    with that.
        None of you commented on the issue of FASB's independence,
    about who pays FASB. Senator Corzine, Senator Stabenow, Senator
    Johnson, and I have suggested that we ought to come up with a
    different financing scheme for how FASB is financed. Other than
    maybe adopting a particular suggestion, do you agree that the
    suggestions we have made in our proposal make sense, I presume
    you would agree. I presume it is one less cost you have.
        [Laughter.]
        Mr. Copeland. Senator, from my perspective, I think if you
    can make them independent financially, that is great, as long
    as you have perhaps some kind of periodic sunset provision or
    something that allows Congress to look at the utility of the
    institution itself periodically to be sure it has a continuing
    utility. For example, if you decided you wanted to go to
    international accounting standards on a global basis, you would
    need some way to unwind that.
        But I certainly do not disagree, without knowing the
    details of your proposal, that an independent financing for
    FASB would be a great idea. It would make them even more
    independent.
        Senator Dodd. Do you all agree with that?
        Mr. Gerson. It might be worthwhile to note that the
    Financial Accounting Standards Board is not a part of the
    AICPA.
        Senator Dodd. I know that.
        Mr. Gerson. It is a separate organization.
        Senator Dodd. But because none of you really commented on
    it too specifically, in your testimony, I accepted the notion
    that maybe you agreed with what Senator Corzine and I have
    suggested here, without necessarily getting into the details of
    it, of that particular organization.
        Now let me come back to scope because that is a big issue
    and the independent auditor.
        I want to draw you out on this a bit. Before I do that, I
    have to ask you this one question. Obviously, I think there is
    a real possibility of Arthur Andersen going bankrupt. That is a
    suggestion I make. I am not suggesting you are endorsing that.
    But I wonder if you might just comment briefly on the
    implications of that to the markets. With some 2,200, I am
    told, clients, what would be the implications to the industry
    and to any market implications that that would be the case?
        Mr. Copeland. Senator, I would be happy to respond to that.
    I have been on record since the last spate of proposed mergers
    saying that I thought the further consolidation of our industry
    would not be in the public's interest. I continue to believe
    that. I actually think we went a bridge too far. So, obviously,
    I agree that losing Andersen or losing one of the Big 5 firms,
    depersonalize it from Andersen, would not be good for the
    capital markets. It would limit the number of choices. It would
    limit the amount of competition.
        However, if it is going to happen, by necessity, then I
    think it is important that that process be managed in a
    rational and comprehensive kind of way to avoid any sense of
    concern on the part of the public markets.
        We would certainly, as a firm, and I am sure our colleagues
    in the other firms would agree in the AICPA, that we would
    cooperate fully with the Securities and Exchange Commission in
    being sure that that consolidation was orderly, so that there
    was no chaotic result in the capital markets.
        Senator Dodd. Would you like to comment on that?
        Mr. Castellano. Senator, I would like to just follow up on
    Mr. Copeland's comments.
        I would reemphasize that we will be committed to work with
    the SEC to ensure the stability in the capital markets and
    whatever happens there.
        I would say that there are about 800 firms now that do
    audit public companies, all members of the SEC's Practice
    Section of the AICPA. So some of that capacity, depending on
    size and scope of the entities that need to be audited, can be
    absorbed by these other firms. It will be a challenge.
        I think it emphasizes the importance for all of us to be
    cautious in what we do because we do need a vibrant and viable
    accounting profession to serve these companies and the
    shareholders.
        Senator Dodd. Thank you, Mr. Chairman. I will come back to
    the scope questions in the second round.
        Chairman Sarbanes. Senator Stabenow.
        Senator Stabenow. Thank you, Mr. Chairman. And thank you
    all for your comments.
        I would like to go in a little different direction because
    it is clear from the reports on Enron that there were people in
    the company that knew there were problems, and that there were
    questionable procedures and standards, ethical business
    practices were undermined. My concern is whether or not there
    was a corporate culture that discouraged people to come forward
    or discouraged dissent.
        It appears there were well-meaning people that knew there
    were problems and if they had been able to raise a red flag
    earlier, they may have actually stopped a situation that has
    hurt thousands of people in an extremely serious way.
        So, I would like to ask you about the issue of whistle-
    blowing. I am wondering if auditors should have a confidential
    mechanism to allow employees at companies that they audit to
    draw attention to potential fraud or earnings manipulation.
    Should there be a way that employees could confidentially
    express their concerns to the SEC? How would you suggest having
    a mechanism to be able to allow information to be shared?
        Mr. Gerson. We considered this very significantly when we
    were doing our new proposed standard for auditing for fraud.
        The concept of having a separate hotline to the auditors is
    very difficult to manage. We have upward of, if you include all
    our clients, public and nonpublic, maybe 10,000 clients in a
    firm the size of PricewaterhouseCoopers. And to try to manage a
    hotline with that degree of volume would be very difficult.
        We have introduced some requirements in this new standard
    in response to some of these problems. Specifically, we have
    added a requirement that auditors get representations from
    management as to whether they are aware of any allegations of
    this type of activity because there have been, frankly, some
    situations where company management knew about it and did not
    tell the auditor. And we would like to know.
        So rather than setting up our own hotline, we are expanding
    the requirements on the auditor to find out what is going on
    inside the company, and also encouraging auditors to speak to
    people outside the financial organization because the more
    people you talk to and the more questions you ask, the more
    likely it is that you will come across some information that
    will start you down the trail.
        Chairman Sarbanes. What is the magnitude of that burden if
    the hotline applied only to public companies, not the nonpublic
    companies?
        Mr. Gerson. I think it is still significant. Companies have
    hotlines, and I think our experience--we have a hotline of our
    own, within our firm. And our experience has been that upward
    of 95 percent or more of the things that come in on the hotline
    are not related to fraud or fraudulent reporting.
        Most of the things, frankly, that come in on hotlines are
    human resource issues--complaints about working conditions,
    complaints about my boss, things of that nature. And to have
    all that kind of information filter through the accounting
    firm, I think, would be very difficult for us to manage. It is
    sometimes hard to separate those issues. But I do think that we
    should be paying more attention to those types of activities
    that are going on in companies and companies should have those
    kinds of processes in place.
        Senator Stabenow. Of course, the challenge is that it
    appears that there were managers that knew what was happening
    at Enron and did not share that information.
        Does anyone else want to comment?
        Ms. Kirtley. Senator, if I may. I think from a corporate
    governance perspective, if audit committees were required to
    hold private executive sessions and employees knew that they
    were required to hold those private executive sessions with
    financial management, with independent auditors, and with
    internal auditors, I think that could potentially provide some
    mechanism where they would know that their message could reach
    in confidentiality a body who would investigate.
        And when you have outside directors, independent directors
    who are now required to be on the audit committees, I think
    that there may be a mechanism within that structure to
    facilitate something that would go a long way in that regard.
        Senator Stabenow. Anyone else?
        Mr. Castellano. Senator.
        Senator Stabenow. Yes.
        Mr. Castellano. Thank you.
        I will say that we do support corporations having their own
    codes of ethics. I think your point is excellent.
        What this boils down to is corporations having the right
    culture, having processes within their organizations to
    evaluate the risks of fraud, and having processes within the
    company to provide oversight. Perhaps the company should have
    such a hotline. But at least they need to have the right tone
    at the top, the right culture, systems to evaluate the rest of
    these things happening and the right oversight.
        We do support, to make this new fraud standard that we are
    proposing effective, as I said, that it will be a felony for
    anyone in a company involved in the financial reporting
    process, to lie to the auditor, or to withhold material
    information.
        Senator Stabenow. Thank you. One other question, if I
    might.
        In previous testimony, we heard about the incredible growth
    in financial restatements by companies over the last few years.
    One witness stated that there were 464 revised statements
    between 1998 and the year 2000, nearly twice as many
    restatements as in the last 20 years.
        I know that several Members of the Committee have expressed
    concern about this and I know that Senator Corzine mentioned it
    this morning. But I am wondering if you have a theory on why we
    have seen this spike in earnings restatements. What would you
    recommend be done to stop this alarming trend in inaccurate
    information being given to the investing public, only to be
    revised at a later date? Should we consider charging companies
    a significant penalty when they misstate their earnings and
    have to restate it?
        Mr. Castellano. I have a comment for you about that,
    Senator.
        I think we have to look at the cause of the restatements. I
    think what you will find when we go back and look at what has
    happened since 1998, is that there have been some accounting
    series releases that have been published by the SEC dealing
    with specific accounting issues that have caused companies to
    have to go back and rethink the way certain transactions have
    been accounted for, things such as series releases on revenue
    recognition, materiality, accounting for in-process research
    and development.
        I believe when those releases came out, it caused
    registrants to have to go back and reconsider accounting
    treatments. I am sure that has not accounted for all the
    restatements, but that is an explanation for some of them.
        Senator Stabenow. Would you expect that there would be a
    dramatic decrease, then, in restatements? No? Yes?
        Mr. Copeland.
        Mr. Copeland. Maybe I could just speak to that.
        The Financial Executives Institute did an excellent
    analysis on this and I really urge your Committee to look at
    that analysis.
        Basically, the last 3 years, not including this just past
    year, are compared with the decade previous. When you adjust
    for market capital gains and losses--in other words, do not
    look at the number of restatements, but, rather, the market
    impact of the restatements, it basically boils down to 10
    restatements a year each year.
        In other words, if you took those 10 restatements out of
    each year, you would take out the majority of the impact on the
    capital markets of those restatements and it would look like
    the years prior. So that may be useful both to auditing firms
    and to policymakers in terms of where the concentration of
    effort should be.
        In terms of the number of restatements, that can be
    accounted for in two or three ways, I think. First is, of
    course, the enormous exponential growth in the body of
    knowledge within the profession. FASB 133 had over 800 pages,
    for example.
        The second thing is a single issue related to the dot com
    revolution, which was in process R&D. And that issue simply got
    ahead of the profession and I think got ahead of the Commission
    as well, and we had to react to that and that involved some
    restatements.
        The third thing was that one of the accounting series
    releases basically lowered the materiality factor that is used
    by auditors and by the Commission to determine whether or not a
    company needs to restate its financial statement.
        So, you are really looking at a population that was created
    by a different measurement when you look at the last 3 years
    and compare it to the prior decade.
        Senator Stabenow. Thank you, Mr. Chairman.
        Chairman Sarbanes. Good.
        Senator Carper.

                 STATEMENT OF SENATOR THOMAS R. CARPER

        Senator Carper. Thank you, Mr. Chairman. And to each of our
    witnesses, welcome. Thanks for taking time out of your lives to
    be here with us and to help us as we address these issues.
        Senator Dodd, I believe, earlier spoke of our election
    reform efforts and alluded to Florida. I just want to build on
    that in framing my question.
        It goes back to what Senator Stabenow stated in restating
    of earnings. A big part of what we are interested in doing here
    is making sure that when individuals or when pension funds or
    other entities invest their monies, that they know what they
    are investing in and that what they get is what they think they
    are getting.
        That is a primary concern of ours and focus of ours, and
    you are helping us to get there.
        If we had elections for the Senate, for the House, for
    governorships or mayoral positions, and we were not
    infrequently restating the results, so that someone we thought
    won, but later on we found out that they did not, in fairly
    short order, people would start to lose even more confidence in
    our electoral system and their ability to exercise their rights
    in a democracy.
        We want to make sure that we do not have those problems
    with respect to our democratic system and we want to make sure
    that the problems that are brought to our attention because of
    Enron and the restating of earnings, that we address that right
    away.
        I think there are three corrective courses that we can
    take. One of those is a legislative course, for us to take
    actions in certain areas. Another is to look to the regulators
    to take certain actions. And the third is for the industry
    itself to take corrective actions, in some cases, compelled or
    encouraged by the market and driven by market forces.
        I have been to two other hearings today, so, I have missed
    your testimony. First, I am going to ask each of you just to
    give me the benefit of where you agree--forget about where you
    disagree--but where do the five of you agree on what we ought
    to do legislatively, particularly with respect to the work that
    is done in your industry. Where do you agree, what should we do
    legislatively? Second, what falls within the purview of the
    regulators? What should they do? Where do you agree on what the
    regulators do? Last, where do you agree on what the industry
    should do?
        Mr. Copeland. Maybe I could just start with that.
        I have heard several times mentioned restatements in the
    context that means the accounting firms made an error. Just for
    the record, in a great many of those cases, the restatement was
    caused by the auditor identifying the problem and causing the
    statements to be restated.
        Senator Carper. I accept that.
        Mr. Copeland. In terms of where we could absolutely reach
    agreement, I believe that the issue of a more transparent
    governance process for our profession, oversight process for
    our profession, and disciplinary process for our profession,
    would be the most important thing that we could do from the
    standpoint of restoring the confidence of the investing public.
        I believe working together with the Commission, with the
    AICPA, with Congress, we can come up with an appropriate
    approach that would allow the investing public to understand
    that our profession is being properly overseen and, again,
    hopefully restore the confidence that we have enjoyed over the
    last many years.
        Senator Carper. Let me just make sure my question is clear.
    What I am asking is, as I sit here, there are three places that
    the corrective action can come from, at least three. One is
    from you, from the industry itself. Two, are the regulators.
    And three are those of us who are elected. I think you are
    suggesting that we essentially work together to come up with a
    corrective joint fix.
        Mr. Copeland. That is my suggestion, yes.
        Senator Carper. I am just asking the others on the panel,
    what out of those coordinated actions should come from the
    Congress?
        Mr. Castellano. I would like to comment on that, Senator.
        I agree, and I said this in my testimony, that we are
    committed to work with this Committee, the Congress, the SEC,
    and the FASB and all participants in the financial reporting
    process, to implement meaningful reforms.
        As to what role the Congress should play or what should be
    done through regulation or what should be done by the
    profession, I would just suggest that we carefully consider
    that whatever way the reform is enacted, be done in such a way
    that it can be responsive to evolving and changing market
    conditions because one of the challenges of a legislative
    solution is can that effectively change quick enough as market
    conditions evolve, or is a regulatory solution a better way
    with Congress working with the profession, working with the
    regulatory authorities, to come up with a solution that can be
    very responsive to evolving market changes?
        Senator Carper. Others, please?
        Ms. Kirtley. I have nothing to add.
        Mr. Gerson. No.
        Senator Carper. I don't think I framed that question very
    well. We are going to move on. But, Mr. Chairman, I am
    disappointed with what I just heard and I accept the
    responsibility. Obviously, I did not frame the question well. I
    will say it again, and I do not expect you to respond.
        There are some things that we need to do. I think they are
    probably rather limited, we, the Congress. There are a lot of
    things that you all need to do, and your industry, and there
    are probably a whole lot more, considerable, than what is
    appropriate for legislative action. There are clearly things
    that our regulators need to do. We can help them in that or we
    can discourage them, as we will. What I was looking for from
    each of you is where do you agree on what is the appropriate
    role for the Congress? Where do you agree on what is the
    appropriate thing for the regulators to do? Where do you agree
    on what is the appropriate thing for you within your industries
    to do?
        That was my question, and I did not ask it very well
    because I sure did not get the response that I was looking for.
        Thank you.
        Mr. Gerson. Is it possible to continue on this?
        Chairman Sarbanes. Pardon?
        Mr. Gerson. Is it possible to continue on this, on the
    question?
        Chairman Sarbanes. Why don't you take a moment or two. We
    have another panel that has been waiting.
        Mr. Gerson. Okay. I will be very brief.
        I think one of the things that we have laid out is a vision
    of where we need to end up. It is not always clear to some of
    us, at least some of us who aren't actively involved in the
    political process, which parts of it need to be constructed by
    whom. That is why I think it takes a collaborative effort.
        Let us use, for example, this new Public Oversight Board--
    or whatever its name is--some of its privileges and
    responsibilities may only be able to be established through
    legislation. There are some that the SEC could do through
    regulation and there are things that the profession can do to
    move it ahead.
        Personally, I am not sure how I know to pick which pieces
    of that each group needs to bring to the table. So, therefore,
    I do think it is important that we work together.
        I think there are some things that the profession itself
    clearly needs to take the lead on. Establishing a more
    effective business reporting framework is something that
    clearly I do not think would be done through legislation. The
    SEC would have a role in it, but it is something that is very
    important for us to take the lead on to make sure that the
    reporting that is done is effective.
        Improving the performance of auditors on the individual
    engagement level in terms of the standards that we put forward
    for our members to follow is something that we need to take the
    lead on.
        So there are things that each of the groups brings to the
    table. I think industry has a responsibility also with respect
    to their role in proper financial reporting.
        But most things require bits and pieces to be put together
    from the different groups and it is hard to establish that
    unless you have a very clear perspective on what is the goal
    and then how do you together make it happen.
        Senator Carper. Those comments are helpful. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. I would like to move to the next panel.
        Senator Gramm has a question.
        Senator Gramm. Yes, I want to raise an issue here and I
    will do it very quickly. I want to read you a quote:

        I have served on too many audit committees to know that
    even though I would consider myself independent, I would
    consider myself knowledgeable, I did not know what questions to
    ask the chief financial officer during meetings to find out
    what it is that conceivably is going wrong with the corporation
    and he wasn't about to tell me.

        Now, you might think this is some guy on the Enron board or
    this is some guy on Global Crossing, or this is some
    incompetent. This is the most respected financial person on the
    planet--Alan Greenspan.
        In listening to you, Ms. Kirtley, it seemed to me that you
    are acting as if somebody--and I raise this question because a
    year from now, I might very well be on an audit committee,
    since I am not going to be on this Committee.
        Ms. Kirtley. You are a brave person.
        [Laughter.]
        Senator Gramm. But I want to tell you, I am a lot less
    likely to do it today than I was a year ago.
        Ms. Kirtley. Right.
        Senator Gramm. If Coca-Cola asked me to be on their board
    and their audit committee and I cannot rely on the accountant,
    and we are meeting four times a year for a day and a half, and
    people are expecting me to go out and count Coke bottles, I am
    sure as hell not going to do it.
        I think we have to be very careful here or we are going to
    create a situation where people, competent people, are not
    going to be willing to serve on these boards.
        Somehow, if you do not accept the premise that people have
    a right to count on the outside auditor, that it is their job
    to go behind that auditor, then I think you basically write off
    people that are concerned about their assets from ever being on
    any aid committee or ever being outside members of a board.
        I would like to get your response to that.
        Ms. Kirtley. If I may comment. You are absolutely right on.
    The audit committee is not the auditor's auditor. The audit
    committee should be an oversight body. The audit committee
    should create an environment for open and candid and free
    communication, and they should do that by talking to various
    people throughout the organization that should know.
        You are absolutely right. If someone wants to hide
    something from you, or if you do not think to ask the right
    question and they are not forthcoming with the information, you
    do increase your chance of being able to see if there are
    concerns and risks or transactions that have nuances to it that
    you haven't been informed of, by discussing privately with
    these different groups. But there is no guarantee and you do
    have to trust someone.
        I think your point of regarding people willing to serve on
    audit committees is a very valid point. I know that the
    recruiting firms for boards of directors have said that they
    have had a lot more turn-downs----
        Senator Gramm. I am sure they have.
        Ms. Kirtley. --because people are not willing to put their
    personal wealth at risk or their reputations or anything else,
    if it is going to be a gotcha environment, if we cannot use the
    prudent-man rule, and if they perform their due-diligence, if
    we cannot rely on them to use their best business judgment.
        Senator Gramm. Thank you.
        Chairman Sarbanes. Senator Dodd.
        Senator Dodd. Just a comment because we have to get to the
    next panel.
        I did not get a chance to get back to the scope issue, and
    I am respecting the Chairman's desire to move along here. What
    I will do is ask you to make some comments about it. Again, we
    drafted this legislation and the scope issue.
        Mr. Copeland, looking at your own testimony, talking about
    the decision that Deloitte made, as the other firms did, the
    Big 5, and most recently, the recommendations of Mr. Volcker,
    regarding the consulting services and auditing decisions. The
    reluctant decision, using your language here----
        Mr. Copeland. Yes, sir.
        Senator Dodd. --to make those separations because of the
    perceptions and so forth.
        First of all, what we have done in our legislation, or the
    proposal we have made, anyway, is to go back to the original
    proposal the SEC made on auditor independence and we tried to
    be sensitive about some of the very legitimate points that need
    to be brought in the taxation question, which I think is a very
    legitimate point in terms of conducting an audit, to be able to
    advise where the taxation issues are involved.
        But I go back to the point, and I will ask all of you to
    comment
    on this if you want. When you are consulting, in a sense, in
    the contract or performing other functions within the
    consultative function, there is one client, in a sense. And
    that is, of course, the person who has hired you to do that
    service.
        When the same firm is performing that function and
    simultaneously performing the audit function, which has, in
    addition to the person that hired you, the shareholder interest
    and others who will depend upon that information, it seems to
    me we run the risk of having the kind of collision of interests
    between the consultative function and the audit function.
        And as we draft this one, we want to look at ways in which
    these nonauditing functions that are essential to performing
    the audit function are going to be included, or provide a
    mechanism for them to be included.
        So, I would invite your comments on how we might do that
    and our suggestions that we propose in the legislation.
        Mr. Chairman, I won't ask for a response to that at this
    particular moment, but I want to think that what the firms have
    done recently in response to this issue, and unilaterally
    voluntarily taking the decision to separate, is one based on a
    sound judgment and not just reacting because you think it is
    what the public wants you to do, but, rather, it makes sense to
    do.
        Obviously, incorporating that in a legislative proposal so
    it is not left to the vagaries to move back into it once this
    passes us by, the public attention on this question, and to be
    reinstated later on.
        So there is a need, I think, to codify in some way a
    decision on how we do make a distinction in those areas.
        Chairman Sarbanes. Why don't you submit to us any
    additional comments that you may have arising out of anything
    asked here at the hearing. We will continue to look to you to
    get your opinions on various issues that are being raised.
        I just want to close with this observation. I would just
    commend it to you to think about.
        As I said earlier, I think that we have a serious challenge
    on our hands. When the President of the United States is making
    jokes about the accounting profession, in a sense, even the
    implication is questioning whether it is a profession,
    essentially, is what it amounts to, that gives you some sense
    of where we are right now.
        Obviously, you are very concerned about where we are going.
    But I want to say this to you. If we do not go somewhere where
    the structure and the system that is in place and its
    requirements are perceived and in fact, really address these
    issues and give us a real prospect that these situations are
    not going to reoccur, or will be significantly diminished, I do
    not think this thing is going to come to rest.
        In the past when things have arisen, we had the Wheat
    Commission, the Cohen Commission, the Treadway Commission, and
    the O'Malley panel--we had some of those people in and of
    course, they were lamenting the fact that most of their
    recommendations never were implemented. Some did, but a lot of
    them did not.
        And so, I think that if there is any sense that, well, we
    will draw the steam of this thing and it will relapse back into
    memory and there will be some changes, but they will be
    relatively minimal, I do not think that is going to happen.
        This issue is going to continue to be an issue and will
    continue to ferment and to germinate until we reach a point
    where most people look at it and say, well, now, that is pretty
    sensible, what has now been put into place, and that ought to
    work.
        I think for accountants, it means really kind of a
    reference back to these really quite impressive stories about
    the establishment of these large accounting firms, what they
    represented institutionally, and the standards they set, which
    of course, they have now drifted away from. And that, I think,
    is one of the challenges that is before us as we try to deal
    with this matter.
        I would just leave that to you to think about as we try to
    move ahead and arrive at some resolution, which is obviously
    what we are focusing upon.
        Senator Dodd. Mr. Chairman, I was thinking as we were
    talking about these issues and the dual functions. You and I
    served with a Member of Congress whose name I won't reference
    who was elected years ago. He also had a law practice in his
    district. He had his district office as a Congressman----
        Chairman Sarbanes. Next door.
        Senator Dodd. Next door. And there were two doors. One
    says, Congressman X, Attorney At Law. And the other one said,
    Mr. X, Congressman X. When you opened up either door you got
    into the same room.
        [Laughter.]
        That doesn't happen any more, but it always struck me--
    maybe it has been reflected in my thinking back to those days
    of that very distinguished Member of the House.
        Chairman Sarbanes. You have been a very helpful panel and
    we appreciate your coming and giving us the benefit of your
    thinking.
        Mr. Castellano. Thank you very much.
        Mr. Copeland. Thank you.
        Mr. Gerson. Thank you.
        Chairman Sarbanes. We ask the next panel to come forward.
        [Pause.]
        We are very pleased to have you here and we appreciate your
    patience through a long morning.
        This panel consists of Peter Wallison, who is Resident
    Fellow and Co-Director of the Project on Financial Market
    Deregulation at the American Enterprise Institute.
        Peter was previously a partner at Gibson Dunn and Crutcher.
    He was General Counsel at the Treasury Department in the early
    1980's and then Counsel to President Reagan in 1986 and 1987.
    Sometime back, he was a Special Assistant to Governor Nelson
    Rockefeller and he was Counsel to Vice President Rockefeller
    during his tenure as Vice President.
        Our other panelist this morning is Robert Litan, Vice
    President and Director of the Economic Studies Program at
    Brookings, and was Associate Director of OMB in the mid-1990's,
    Deputy Assistant Attorney General in the Antitrust Division of
    the Department of Justice from 1993 to 1995, and previously a
    partner of Powell Goldstein Frasier and Murphy, and many years
    ago was a staff member of the President's Council of Economic
    Advisers.
        Gentlemen, we would be happy to hear from you. Mr.
    Wallison, we will go with you, and then Mr. Litan.
        Mr. Wallison. I thought we might start with Mr. Litan, if
    that is okay, Mr. Chairman.
        Chairman Sarbanes. Okay. That is fine.
        Mr. Litan.

                      STATEMENT OF ROBERT E. LITAN

                      VICE PRESIDENT AND DIRECTOR

                        ECONOMIC STUDIES PROGRAM

                       THE BROOKINGS INSTITUTION

        Mr. Litan. Okay. Our time constraints are what? I think
    staff told us somewhere between 5 and 10 minutes.
        Chairman Sarbanes. Yes. Can you do that?
        Mr. Litan. Yes.
        Chairman Sarbanes. Your full statement will be included in
    the record.
        Mr. Litan. I will stay south of 10 minutes.
        Chairman Sarbanes. All right.
        Mr. Litan. Thank you, Mr. Chairman, for inviting us. I
    would like to make several background points.
        Number one, markets and regulators already have engaged in
    a lot of self-correction in the wake of the Enron affair.
    Companies whose stocks were pummeled after Enron by investors
    are disclosing more, while the various gatekeepers who failed
    in Enron, the boards, the audit committees, the analysts, the
    rating agencies, and the auditors, have all tightened up.
        Number two, knowing exactly how to fix the problems exposed
    by Enron is hard. The issues are complex, the facts aren't all
    in, the experts do not all agree, probably including us, and
    there are pros and cons to every alternative that you consider.
        Number three, precisely for these reasons, it is important
    that any legislation that Congress enacts preserve a maximum
    degree of flexibility and leave the details to the SEC.
        With all of that in mind, I now turn to the four issues in
    my testimony. Number one is the improvement of accounting
    standards themselves. The accounting standard problem at Enron
    was basically the weak consolidation rule for all those
    special-purpose entities and you all know that FASB has
    basically since hopefully corrected that problem.
        So the remaining issue on the table is what, if anything,
    to do about FASB itself and two particular problems it raises.
    One, it is slow; and two, you have undue political influence on
    FASB.
        On the slowness issue, I have sympathy with those who have
    suggested that the SEC threaten as a backstop to step in by a
    date certain on a particular issue if FASB is not moving fast
    enough.
        The harder issue is what do you do about political
    influence?
        As I have talked to various people, some suggest nothing.
    They say, look, the FASB's rulemaking is like the EPA or OSHA
    or other kinds of rulemaking. It is inherently a political
    thing. So let politics intrude.
        Now the response to that, though, is that there really is
    in my view an unequal balance of political interests. You have
    the firms and the accounting firms that have very narrow, very
    specific interests in particular rules. And then you have a
    very diffuse investor class that may not care about a
    particular rule, especially because they can sell the stock and
    they do not have to exercise any voice.
        So, I think there is an undue political influence problem.
    The problem, though, is how to solve it. And I review all the
    options in my testimony and I say, ultimately, I do not think
    as long as the Congress oversees the SEC and the SEC oversees
    the FASB, that you are going to solve the problem at all.
        The only theoretical way to solve it is to move standard
    setting to the international arena, international accounting
    standards. You can either replace GAAP with IAS or you can have
    the two compete against each other.
        In my testimony, I come down on the side of competition. I
    suggest that we urge the FASB to narrow its differences on some
    key areas with IAS, and then quit. And then allow firms to
    choose one or the other.
        They do this in Germany and I do not see any reason why we
    could not do that in the United States. And that could reduce
    the role of political influence because one of the things we
    see is that the market would punish the standard that is not
    delivering investor protection.
        Chairman Sarbanes. What is it they do in Germany? I missed
    that.
        Mr. Litan. They give you a choice between international
    accounting standards or U.S. GAAP, or even, I believe, German
    GAAP.
        Chairman Sarbanes. Except the international accounting
    people told us that the EU has now made the decision that by
    2005----
        Mr. Litan. Correct.
        Chairman Sarbanes. --all countries will adopt the standards
    set by the International Accounting Standards Board.
        Mr. Litan. I am aware of that. And I am suggesting to you
    that in the United States, where we have had this war for many
    years, I think the only way to resolve it is to allow
    competition, but first, narrow the differences.
        Senator Dodd. What about the funding of FASB? It seems to
    me that is the politics of it. If you are going to be funded,
    20 percent of it by the accounting industry and 80 percent by
    buying reports and papers that the accounting industry buys, if
    you move their funding scheme, the $20 million they need, to a
    different source, to give them more independence on that, then
    you seem to at least take out that kind of political influence.
        Mr. Litan. Yes, you could. Hopefully, this is not all
    coming out of my time. But in any event----
        [Laughter.]
        --on the funding, Senator, I do not think that ultimately
    solves the problem, with all due respect, because we can change
    the funding and I agree with you that it is probably better to
    have it funded in maybe the way you suggested. But, look, on
    very specific issues like expensing stock options or whatever,
    if Congress wants to get involved, there is nothing to stop it.
        I think the big battles that we have seen over the last
    several years have not been funding issues. They have been
    because very specific interests have come to Congress, which
    then makes its views known, and there is no way to stop that,
    unless you basically take standard setting entirely out of the
    U.S. arena, or you allow competition and let the market punish
    the people that have the weaker standard.
        Senator Dodd. I will make sure this does not come out of
    your time.
        Mr. Litan. Sure.
        Senator Dodd. Just on that point. There have been efforts
    up here, for instance, in the debate over pooling and setting
    accounting standards, when there were threats made that
    Congress was going to legislate. Some of us up here bucked that
    very strongly and suggested, not that we necessarily agreed or
    disagreed with the accounting standard, but just the point that
    Congress somehow setting accounting standards was a bit
    frightening.
        Mr. Litan. Yes.
        Senator Dodd. We prevailed in that. That view that we
    should not bring these matters to a vote where, by a 51- 49
    vote, the Senate endorses a particular accounting standard. So
    where has the political influence produced a result? The stock
    option issue, is that the one you cite?
        Mr. Litan. I cite stock options.
        Senator Dodd. Okay.
        Mr. Litan. Yes. There is a survey article, actually, in the
    National Journal, that talks about Congressional involvement.
    The second issue is enforcement. Two ways to address
    enforcement--better monitoring and better incentives.
        Now on better monitoring, the proposal du jour is the
    public regulatory board. And what Congress appears to be doing
    and in fact, Senator Dodd, you are author of a proposal to
    basically tighten up Harvey Pitt's proposal. Make all the
    people independent, or most of them independent, and give it
    broader investigatory authority.
        What I say in my testimony is that before you rush to adopt
    that plan, just stop and think about one alternative, and that
    is, have the SEC do the enforcement itself.
        You can create the PRB and let them set the standards. But
    I survey the enforcement scene and I come from the Justice
    Department where I used to be and conclude that the Government
    does not contract out many enforcement jobs. This is inherently
    a Government function to enforce standards.
        And so, I just raise the question for you whether it might
    not be a better idea to go, for example, to Senator Gramm's
    question about accountability, to go ahead and have the
    Government do this because the Government is the one that is
    accountable and give it the money to do it. That is basically
    where I come out.
        Now what about incentives? We have the liability system,
    but that is a very blunt instrument, as we see. You drive a
    company out of business, it scares the hell out of everyone and
    sure, that is going to work. But you should want some more
    finely calibrated incentives.
        What I suggest in my testimony is that auditor rotation and
    banning audit firms from doing unaudit work are not necessarily
    going to solve the incentive problem. I will give you a perfect
    example.
        If you ban the nonaudit work and you only have an audit
    firm doing audit work, that is their only butter and they are
    working for management. They are at risk if they come down too
    hard at losing all their business on the only thing they are
    doing.
        The ultimate nub of the problem is who they are working
    for. They are working for management. And that same thing is
    true of rotation. If you do rotation, if you have beauty
    contests every 4 years, and people are going to wink--all
    right?--in order to get a job. And you have that risk.
        You have to change the people who are hiring them. I survey
    in my testimony all the kinds of people who can do this--the
    stock exchanges, the SEC, the PRB. I come down against each of
    them, because all of those options are just incredibly complex
    when you think about it.
        The only one that makes sense is have the audit committee,
    with all its warts, have the audit committee be the one that
    hires the audit firm. That is where I come down.
        Third point--competition in the wake of the decline of
    Arthur Andersen. If Arthur Andersen fails, we are going to have
    a less competitive auditing system. It is already highly
    concentrated. I have some data in my testimony on this. I can
    tell you from an antitrust point of view, this is not good.
    Audit services will go up, people have fewer choices. This is
    not a good outcome.
        Do I have a clear solution for you? No. All I can come up
    with is, asking the SEC basically to encourage the private
    sector to hire second-tier firms, the ones right below the Top
    5, and second, take a review of any of our regulations that may
    inhibit foreign firms from doing business in the United States,
    and maybe we can attract some foreign firms to try to get some
    more competition in this market. Those are the only two ideas I
    can come up with for a very difficult problem.
        My last issue, the cutting-edge issues beyond Enron. Now,
    Peter is going to talk in a minute about the need for more
    nonfinancial disclosure. I want to tell you about a couple of
    other cutting-edge issues.
        One of them is called XBRL. It is basically a project that
    the AICPA has started with a bunch of accounting firms and
    other real firms to put data tags on all the kind of
    information you see in financial statements, so that people who
    use the Internet will be able to manipulate data much more
    easily than they do now.
        They will be able to search, for example, and find a very
    specific category of firm. They cannot do that now with the way
    financial statements are currently done. And the way to advance
    XBRL, I suggest, is to have the Edgar filings, which are now
    done by every corporation, make them be in XBRL by a certain
    date, and you will vastly increase the ability of investors to
    play with analyzed data.
        I also like the Administration's proposal to require more
    significant intra-quarterly disclosures. I think that is a good
    idea. Also, I like the mandated disclosure of sales by insiders
    and so forth.
        But I leave you with the following observation. That in the
    age of the Internet, there is no reason why, ultimately, we
    cannot move to much more frequent reporting than quarterly.
    Monthly, even weekly.
        I know it sounds crazy. But I want to tell you, everyone
    here, or a lot of your witnesses, have complained about
    earnings management. Everybody's trying to hit those quarterly
    numbers. I haven't heard one credible idea to attack the
    problem, to reduce earnings management.
        I hold out one hope. If we had more frequent reporting,
    people would attach a hell of a lot less importance to the
    quarterly numbers. They'd be focusing on the weekly or the
    monthly numbers, and people would forget about the quarterly
    numbers. Frankly, you cannot predict----
        Senator Dodd. Quarterly numbers.
        Mr. Litan. Whatever. You cannot predict weekly or monthly
    numbers. The analysts will give up and, frankly, you will get
    so much information out there, that people will pay less
    attention to it and I predict there is a chance that the
    problem will go away.
        The final point is plain English. Everybody wants plain
    English in the financial statements. It is a great idea. But
    all I want to remind you is, you can have all the editors you
    want at the SEC and all the plain English in the front, which,
    by the way, I am for. I am all for plain English.
        I just want to tell you, it is not going to prevent future
    Enrons.
        That is the end of my testimony.
        Chairman Sarbanes. Very good. That was very helpful and
    very well done.
        I just might observe--we do hourly numbers and have the
    stock markets open 24 hours a day.
        Senator Dodd. Right.
        Chairman Sarbanes. We can keep everything in a total frenzy
    all the time.
        Mr. Litan. Exactly.
        [Laughter.]
        Chairman Sarbanes. Just feeding off of itself all the time.
        [Laughter.]
        Everyone will be absolutely hyperactive.
        Mr. Wallison.

                     STATEMENT OF PETER J. WALLISON

                    RESIDENT FELLOW AND CO-DIRECTOR

                PROJECT ON FINANCIAL MARKET DEREGULATION

                     AMERICAN ENTERPRISE INSTITUTE

        Mr. Wallison. This is the CNBC proposal, I suppose.
        Chairman Sarbanes. Yes.
        Mr. Wallison. Well, Mr. Chairman, and other Members of the
    Committee, it is a delight to be here, and to have the
    opportunity to present this testimony.
        Bob has covered really all of the issues that are currently
    in the press and are of interest to the Members of the
    Committee as you attempt to legislate in this environment. So,
    I won't cover any of those.
        I would like to say, though, that when you are asking
    questions of both of us, I would be happy to take questions,
    too, on these Enron-related issues. And you might find,
    surprisingly, that someone from Brookings and someone from AEI
    can agree on a lot of these things, although there are some
    areas where I have a different view from what Bob has
    expressed.
        My testimony today, however, will talk about the future, in
    large part because I believe much of the current debate about
    the quality of GAAP and how it was enforced--or whether it is
    sufficiently enforced--may be beside the point.
        The fact is that GAAP accounting is becoming increasingly
    irrelevant for financial disclosure and we must begin to work
    on supplements and alternatives. I will try to explain why this
    is so and
    discuss some of the ideas that are necessary to bring financial
    disclosure into the new economy that we are creating here in
    the United States. This could get just a little bit technical,
    but I will try to keep it as short as possible.
        The reason our financial disclosure system must change is
    that we have now entered the information or the knowledge
    economy, and intangible assets have become the primary means by
    which our economy creates value.
        According to some estimates, 80 percent of the value of
    companies listed in the S&P 500 is attributable to their
    intangible assets. Now what are intangible assets and what is
    the significance for
    financial disclosure of their coming to dominate the assets of
    American companies?
        Computer software and pharmaceuticals are two examples of
    goods that are, in one sense, manufactured, but in a much more
    important sense are the product of human knowledge and skill
    rather than machinery and equipment.
        In other words, most of the value created that is added to
    the plastic of a computer disk or the chemical in a pill is
    added by the knowledge of the employees who have the skills and
    the imagination to conceive and develop the computer software
    programs or the new drugs.
        The knowledge assets that conceive and produce these
    products are intangible because they cannot be touched or seen
    and they are assets because they are instrumental in generating
    cash flows for the companies that use them.
        Other intangible assets include such things as patents,
    trade secrets, computer programs, trademarks, brand names, and
    even, and this is quite interesting, customer loyalty or
    satisfaction.
        Here, then, is the difficulty.
        The vast majority of the value created in the United States
    today is produced by intangible assets. But these assets do not
    appear, and in many cases, cannot appear, on corporate balance
    sheets. It is important to note that this problem cannot be
    solved by changing GAAP accounting rules. GAAP relies on
    costs--of land, equipment, rolling stock--to establish values,
    and there is no known way to place value on knowledge assets.
        In fact, since in many cases they exist only in the heads
    of the employees of these companies, these assets are not even
    owned by the companies that make use of them for generating
    cash flow or profits.
        That is why, after the advent of the knowledge economy, the
    market value and balance sheet value of public companies began
    to diverge. So that, in the year 2000, the market values of
    public companies were six times greater than their balance
    sheet net worth. This was not true, incidentally, in the late
    1970's, when it was just about 1:1.
        Obviously, investors were seeing something in these
    companies other than what appears on their balance sheets and
    it seems reasonably clear that what they are valuing are the
    companies' intangible assets.
        Now it might be objected that balance sheet values do not
    really matter, that in the knowledge economy what investors are
    looking at are earnings, and that the price earnings ratios of
    public companies are what are important.
        Why is that not sufficient to give investors all the
    information they need about companies?
        The answer is that, once again, the inability to value
    intangible assets or determine whether a company is creating
    value in the form of intangible assets, or destroying it, can
    distort income statements, making price earnings ratios and
    other similar comparisons unreliable.
        A very good example is furnished by AOL. During the years
    1994 through 1996, AOL spent a huge amount of money on
    acquiring customers by sending out computer disks and extensive
    advertising. AOL treated these customer acquisition costs as an
    investment and capitalized on them. It argued that it was
    creating a valuable customer base, which would be, of course,
    an intangible asset.
        When a company capitalizes its costs, there is no immediate
    impact on earnings, of course, and the SEC claimed that this
    was misleading. The SEC's argument was that because AOL
    capitalized these costs, it was able to show profits in each of
    the years 1994 through 1996, but if it had treated them as
    expenses, it would have shown losses.
        In 1997, under pressure from the SEC, AOL changed its
    accounting treatment, and restated its 1994 through 1996
    financial statements, so that it expensed these customer
    acquisition costs. Was this the right treatment?
        The answer in the light of later developments is clearly
    no. AOL, as we all know, turned out to be a great success,
    largely because it accumulated a huge number of customers
    before anyone else. In other words, AOL's customer acquisition
    costs were investments since they produced a very large,
    profitable, and ultimately, market-dominating customer base,
    which is a huge intangible asset.
        This also means that investors who were sophisticated
    enough to recognize this were correct in giving AOL an enormous
    price earnings ratio during this period. The commentators who
    just looked at historic price earnings ratios and did not
    consider that AOL was building a huge intangible asset were
    wrong when they said that this company and a whole lot of other
    companies in the knowledge economy were ``overvalued.''
        We hear that even today.
        They failed to grasp the significance of an intangible
    asset that was not on AOL's balance sheet.
        It seems clear, then, that our economy, as it comes to rely
    increasingly on intangible assets as the source of company
    values, must have some way to assess the quality of these
    assets. We must recognize that GAAP accounting can never do
    this. As the AOL case shows, it may in fact distort perceptions
    of value.
        This is not a healthy situation. If financial statements do
    not allow investors to understand the real value of a company,
    this creates risk. And when risk is created, it raises the cost
    of capital, promotes volatility, and ultimately distorts
    capital allocation.
        The accounting profession has recognized this problem and
    has been working on it for years. Bob and I, neither of us
    accountants, wrote a book called ``The GAAP Gap,'' which covers
    what the accounting profession has been doing over the years on
    these issues.
        One answer that has achieved some currency is the
    development of metrics or indicators that would allow investors
    to get some sense of the value of the intangible assets that a
    company has created, and whether these assets are becoming more
    or less valuable.
        The organizations working on this include most of the major
    accounting firms, Financial Accounting Standards Board, and on
    an international level, the Organization of Economic
    Cooperation and Development. But up to now, progress has been
    slow.
        First, companies are concerned about proceeding down this
    road. They say it may provide information helpful to their
    competitors. They are afraid that it may result in legal
    liability. There is some merit in these concerns, but they may
    be somewhat exaggerated. Congress can do something about that.
        Also, companies do not see any direct financial benefit in
    incurring the costs necessary to develop the necessary
    indicators and the information that these indicators will
    disclose. But there are several areas where businesses are
    already cooperating in activities that are closely related to
    the development of these indicators and would be useful to
    investors.
        Benchmarking, supply chain standardization, and indicators
    developed for the internal use of management, which many
    companies now have, are examples of this.
        In addition, there is data, and this is extremely
    important, that indicates that increased disclosure can have
    the effect of lowering capital costs. This stands to reason
    since more information reduces uncertainty and, hence,
    volatility and risk.
        If companies can be convinced of this effect, it could
    produce a virtuous circle in which they offer higher quality
    disclosure to reduce their capital costs.
        The issue for policymakers is how to stimulate development
    in this direction. The solution, however, is not to mandate
    indicators, even if they already existed.
        Indeed, action of this kind by the SEC would be exactly the
    wrong way to get this process started. As we have seen in the
    past, mandated SEC requirements very quickly produce
    boilerplate disclosures and stifle innovation. On the other
    hand, the SEC could perform a valuable role without issuing
    mandates. It could convene experts, accountants, and business
    people, encourage voluntary action, deal with objections that
    are raised, seek solutions that attract support--emphasizing
    always that investors need information in order to make
    rational choices.
        I would hope that the Committee would include in any post-
    Enron legislation language that will encourage the SEC to move
    in this direction.
        Mr. Chairman, that concludes my testimony. Thanks very
    much.
        Chairman Sarbanes. Thank you very much.
        Who do you think should set the standards? The SEC? The
    professional group? Some independent body?
        Mr. Wallison. I am strongly of the view that the Government
    should have as little to do with setting accounting standards
    as possible. And I am somewhat concerned even about the idea
    that the Committee's proposal will result in an independent
    body that is supposed to set auditing standards, ultimately
    reporting to the SEC. This might give the SEC control over
    accounting standards.
        There is already too much opportunity for political
    involvement in setting accounting standards, and to the extent
    that this opportunity is increased in any way, I think we
    endanger the confidence of the investing public in the validity
    of accounting standards.
        Chairman Sarbanes. Well, who do you think should set the
    accounting standards?
        Mr. Wallison. An independent body, members of the
    accounting profession. How that is financed, I think can be
    worked out.
        Chairman Sarbanes. That is an important question. Do you
    think it should be financed in an automatic way?
        Mr. Wallison. Yes.
        Chairman Sarbanes. I do not know. You can think of
    different ways to do that, but where fees are levied and the
    people upon whom the fees are levied have no choice in the
    matter. They have to pay the fee, whether it is to be listed on
    an exchange, whether it is to be an accounting firm, whatever.
        Mr. Wallison. Yes. I think fees paid by the public
    companies, contributions by accounting firms. There could be a
    number of ways to provide for financing for this organization.
    But it has to be isolated, insulated insofar as possible, from
    politics.
        I should mention that I have done a little bit of work
    studying the Japanese economy. They have a terrible accounting
    system in Japan and it is one of the reasons why they have such
    serious banking and nonperforming loan problems.
        They cannot even tell when a loan is nonperforming. And one
    of the reasons their accounting system is so bad is that
    accounting principles have been set by legislation in some
    cases. You cannot legislate truth. How accounts are presented
    must be a judgment made by experts.
        Chairman Sarbanes. Do you have a view on the super-majority
    requirement at the FASB in order to put forward, to promulgate
    standards?
        Mr. Litan. Not a strong view. I think the most important
    thing, as I said in my testimony, is that we get competition.
    IF FASB were truly competing with IAS, you would see it act
    more quickly, and actually, I think it would reduce political
    influence for the reasons I talked about, because the market
    would punish the standard that is perceived as a weaker
    standard.
        Chairman Sarbanes. I take it, then, what is your view down
    the road of moving to one international accounting standard and
    one international accounting standard board?
        Mr. Litan. Okay. My view is that it is Utopian. Now, I
    know, even with the best of leadership, that is, with Paul
    Volcker and David Tweedy, they may come up with the world's
    best standard.
        But I think what is likely to happen is that because the
    international standards, as you know, are heavily
    discretionary, and our system is much more rules-based, I
    predict what would happen if we ever got to IAS as the single
    standard for the United States, is that because it is so
    discretionary, there would very quickly be a demand within the
    United States to have interpretive rulings, whether by FASB or
    whatever other body the SEC is talking about, on what does the
    IAS mean by Rule No. 214 and 215, and so forth.
        I think what would happen is that the international
    standard would fragment. You would end up with the U.S. version
    of the international standard, conceivably a European version,
    and we would be right back to where we are now. So, I do not
    think it is a stable equilibrium.
        By the way, there are people who disagree with me. There
    are people in the accounting profession who think that in a
    world of one single standard, we will see the demise of FASB
    and we won't get this fragmentation. But if we end up with that
    world, and only one single standard setter, all the problems
    you have with FASB being slow, not up with the times and so
    forth, seem to be multiplied in spades at the international
    level.
        Just look at the Basel Committee that sets capital
    standards. They are now in their either third or fourth version
    of a revision of a standard that now is, what, 3 or 4 years old
    and it will probably be another 3 or 4 years before they ever
    come out with one. That is what will happen if you go to an
    international standard.
        Chairman Sarbanes. Mr. Wallison.
        Mr. Wallison. It seems to me the most effective way for us
    to solve the problem of international accounting standards
    versus GAAP accounting is for the two systems to compete and
    compete in the same market. This would be a good market for
    them to compete in.
        I am very reluctant to have any set of standards set more
    or less bureaucratically for the entire world. The problem is
    that accounting is used for a number of purposes, not just for
    investors. It is also used for lenders and other people who
    interact with companies. And what we have to have is a system
    that permits change.
        One of the ways you bring about change and innovation is
    through competition.
        So, I would like to see two different sets of accounting
    standards competing here in the United States. I think the
    likelihood is that neither will ultimately triumph and we will
    continue to have two, one of which serves one set of purposes
    and one serves the other.
        Mr. Litan. By the way, there was a paper yesterday
    presented at a conference at AEI by a Wharton professor,
    Christian Leoz, who basically showed that in the never market
    in Germany, they have had the choice now for a number of years,
    and it is roughly 50/50, and it is been stable for the last
    several years, where issuers basically go right down the middle
    in terms of which they choose. And that is actually not a bad
    outcome.
        Mr. Wallison. Actually, the interesting thing about that,
    Mr. Chairman, if I could add to it, is that the bid asked
    spreads between companies in that market are no different for
    those that have chosen GAAP as opposed to those who are using
    IAS. And that suggests that the disclosure that is provided by
    both is equivalent from the standpoint of investors.
        Chairman Sarbanes. Mr. Litan, I want to be sure that you
    would leave enforcement with the SEC. Is that right?
        Mr. Litan. You mean the oversight function?
        Chairman Sarbanes. Yes.
        Mr. Litan. I think that the enforcement function is
    inherently a governmental function.
        Now, I know we have the NASD and we have examples of self-
    regulatory agencies, but they are the exception rather than the
    rule.
        Chairman Sarbanes. Do you think that the NASD is a good
    exception?
        Mr. Litan. It improved after we prosecuted it when I was at
    the Justice Department. Collusion--and by the way, this is a
    big problem in any private-sector solution because we have such
    a concentrated industry. You go too far in a private direction
    and you have a collusion problem. But I think, ultimately, we
    are talking about enforcement. That is a Government function,
    it sounds like to me. Who was it? Dick Darman says, ``If it
    walks like a duck, it is a duck.'' This enforcement thing is a
    duck. It belongs to the SEC.
        Chairman Sarbanes. Do you have a view on that, Mr.
    Wallison?
        Mr. Wallison. Yes. I agree with the enforcement point. I
    also think that it is necessary that there be a separate
    organization that regulates the auditing function and sets
    rules for it.
        I think accountants and nonaccountants can be members. That
    is an area that is suitable for some separate regulation by a
    nongovernmental or a quasi-governmental organization reporting,
    in that case, I think appropriately, to the SEC.
        Mr. Litan. And I agree with that. The rule setting is
    separate from the enforcement, and I think that is what we are
    both saying.
        Chairman Sarbanes. Well, you have been very helpful. It has
    been a long morning. We appreciate your patience in staying
    with us. I hope we can be back in touch with you to draw
    further on your expertise as we work through this problem.
        Mr. Wallison. Thank you.
        Mr. Litan. Thank you.
        Chairman Sarbanes. Thank you.
        This hearing stands adjourned.
        [Whereupon, at 12:48 p.m., the hearing was adjourned.]
        [Prepared statements supplied for the record follow:]
                 PREPARED STATEMENT OF SENATOR DEBBIE STABENOW
        Thank you, Mr. Chairman. I am glad to be back for another hearing
    on this very important topic.
        Last week, I joined with Senators Dodd and Corzine at the
    introduction of the Investor Confidence in Public Accountability Act of
    2002. I am proud to be an original co-sponsor of this bill because I
    think it offers some common sense solutions to the problems that we
    have discussed in the first six hearings on this topic and that we will
    continue to examine in this Committee up to the Spring recess.
        As this Committee has investigated investor protections and the
    accounting industry in light of Enron and other troubled companies,
    time and time again, we have heard about the need for an enhanced
    oversight mechanism for the auditing profession. We have also heard
    about the potential for conflicts of interest when accounting firms
    offer both auditing services and consulting services to the same
    companies. We have heard about the need for financial independence for
    an industry oversight board and we have heard about the need for
    financial independence for the Financial Accounting Standards Board
    (FASB).
        In addition, I suspect there are few who would argue that the SEC
    has enough staff and enough money to do its job. And I think that all
    of us would agree that increased financial disclosures and additional
    information about stock sales by corporate leaders benefit American
    investors.
        These are the issues that I have teamed up with Senators Dodd and
    Corzine, as well as with Senators Johnson and Boxer to address in our
    bill. I look forward to working with them and to working with the
    Chairman. The Chairman has been a true leader in the Senate on this
    issue, holding the most thorough examination of the topic at hand.
        As I have said before, our hearings don't necessarily make the
    headlines with subpoenas sent to Ken Lay and Andrew Fastow, but the
    work we do here is what is going to make the biggest difference at the
    end of the day. We are going to move important comprehensive reforms
    that will ensure best practices are followed in the accounting
    industry, reforms that will better insulate oversight and standard
    setting boards from industry and political pressure, and most
    importantly of all, reforms that will give investors more thorough and
    accurate information about the financial health of companies so they
    can make better investment decisions.
        That is the task before us and I look forward to working with all
    of my colleagues on both sides of the aisle to enact this bill this
    year.
        Again, I thank the Chairman and I look forward to hearing from our
    witnesses.

                                   ----------

                 PREPARED STATEMENT OF JAMES G. CASTELLANO, CPA

                          Chairman, Board of Directors
           American Institute of Certified Public Accountants (AICPA)
            Managing Partner, Rubin, Brown, Gornstein & Company, LLP
                                 March 14, 2002

        Thank you, Chairman Sarbanes, Ranking Member Gramm, and the other
    distinguished Members of the Committee for permitting me to testify
    before you today on accounting and investor protection issues raised by
    the collapse of Enron and other public companies. I am Jim Castellano,
    Chairman of the Board of the American Institute of Certified Public
    Accountants. Enron and its aftermath have clearly shaken public
    confidence in the accounting profession, in the quality of financial
    reporting, and in the reliability of our system of public company
    disclosure. It has brought us to the cusp of an historically
    significant moment when the need emerges to give thoughtful and careful
    consideration to systemic reform.
    Commitment to Reform
        The AICPA is deeply committed to maintaining and to improving the
    quality and reliability of financial disclosures. The public demands
    nothing less. In order for our capital markets to function effectively
    and for our economy to allocate resources efficiently, it is essential
    that business enterprises report accurately and fairly to investors and
    that investors perceive that they do so. Our economy needs both the
    fact and the appearance of credible financial reporting. To that end,
    our paramount concern is the restoration of public confidence in the
    quality of financial reporting and in the accounting profession.
        I am here to assure the Committee that the AICPA will support
    meaningful and appropriate reforms, and has been both an advocate and a
    catalyst for necessary change throughout its history. We recognize the
    importance for elected leaders to act responsibly in order to do what
    they can to prevent a business failure on the scale of Enron from
    happening again. In doing so, however, rapid action should not be a
    substitute for principled reform. We believe the real value of any new
    public policy affecting our profession must be assessed by asking four
    basic questions:

    1. Will it help investors make informed investment decisions?

    2. Will it enhance audit quality and the quality of financial
    reporting?

    3. Will it help restore the confidence in the capital markets, our
    Nation's financial
      reporting system, and the accounting profession?

    4. Will it be good for America's financial markets and economic growth?

        Using these four criteria as benchmarks, the AICPA will work with
    the Committee, the Congress, the SEC, and the FASB to continue to
    develop meaningful and appropriate reform.
    Context for the Accounting Profession
        Each year, many CPA's who are employed by public companies prepare
    the financial statements for the 17,000 companies that are registered
    with the SEC, and many CPA's audit those financial statements. In
    cities big and small, CPA's prepare and audit financial statements for
    tens of thousands of small, medium, and large companies to meet
    Federal, State, local, and other commercial requirements. The men and
    women preparing these filings and auditing these financial statements
    do so with the utmost integrity and fairness. Unfortunately, it is
    often the case that the significant role they play in the U.S. capital
    markets only gets recognized when a business fails.
        The AICPA and its members are committed to the goal of assuring
    that our markets remain the best in the world. Our paramount concern is
    the restoration of public confidence in the quality of financial
    reporting and the accounting profession. To that end, we believe the
    public interest requires a comprehensive approach designed to foster
    improvements in the quality of audits, the reliability of financial
    disclosure, and the efficiency of our capital markets.
    Modernizing the Financial Reporting Model
        To keep pace with today's fast moving economy, the system of
    financial reporting must be modernized. Economic change has outpaced
    the corresponding accounting for such change. Intellectual capital has
    become the greatest engine for corporate growth. Yet, accounting is
    still based on hard assets--physical plant and related items for
    producing goods. Even companies producing tangible goods have become
    highly dependent on intangible sources of revenues and competitive
    advantage. Knowledge work has become the key to corporate
    effectiveness.
        The accounting profession was first among those convinced that the
    accounting model needed to be modernized. From 1991-1994, a Special
    Committee of the AICPA studied the state of business reporting.\1\ The
    Special Committee's greatest achievement was its research on the needs
    of investors and creditors. The research showed that investors have
    many unmet informational needs. Figuratively speaking, because
    corporations seek capital from investors and creditors, investors and
    creditors are customers of the corporation's sale of securities.
    Monetary exchanges do not take place without information and, the
    better the information about a prospective purchase, the better the
    purchaser's chance to make a satisfactory pricing assessment. Putting
    the same point in terms of investors' purchases of securities, the
    better the information investors have, the lower the risk of poor
    investment or credit decisions.
    ---------------------------------------------------------------------------
        \1\ AICPA Special Committee on Financial Reporting, Improving
    Business Reporting--A Customer Focus, 1994.
    ---------------------------------------------------------------------------
        In the broadest sense, if we are going to modernize the accounting
    model, we must focus on the following areas:

     First, a broader ``bandwidth'' of information encompassed by
        the business reporting model.
     Second, different distribution channels, namely, the Internet.
     Third, increased reporting frequency, with an ultimate goal of
        on-line, real-time reporting.

        To achieve these fundamental improvements to our system of investor
    information, the accounting profession needs the best and brightest
    minds with a variety of interdisciplinary skills. As you will hear from
    my fellow panelist we must be careful to avoid quick fixes that would
    deprive the profession of this talent.
    Conclusion
        We will continue to work with the Committee, the Congress, and the
    regulators to develop meaningful and appropriate reforms. At the
    beginning of my remarks, I identified four basic questions that we
    suggest must be asked to assess any new public policy. In that vein, we
    all must consider whether any reform under consideration--while well-
    intentioned--will have unintended consequences that outweigh any
    benefits it may bring to the system.
        We look forward to participating in this healthy debate in the days
    and weeks ahead.

                                   ----------
               PREPARED STATEMENT OF JAMES E. COPELAND, JR., CPA

                Chief Executive Officer, Deloitte & Touche, LLP
                                 March 14, 2002

        I am the Chief Executive Officer of Deloitte & Touche, LLP, one of
    the five largest accounting firms in the country. I am appearing here
    today not only in that capacity, but also on behalf of the American
    Institute of Certified Public Accountants (AICPA). I am a member of the
    AICPA, as are many of Deloitte & Touche's partners and professionals,
    and Deloitte is proud to be a member of the AICPA's SEC Practice
    Section.
        We at Deloitte have the same perspective as our colleagues in the
    profession and the AICPA with respect to the many proposals currently
    under consideration, and so my remarks today are intended to provide
    the Committee with the perspective of large firms and the AICPA, not
    simply Deloitte.
        In the wake of Enron's collapse, public attention has focused on
    ways to improve the effectiveness and independence of financial
    statement audits of public companies. That attention is welcome.
    America has the most secure and reliable capital markets of any
    nation--an achievement that should not be ignored--and we should
    continue to try to strengthen a system that serves as a model for the
    world.
        But the current situation presents danger as well as opportunity.
    The danger is this: In the rush to enact reforms in response to
    perceived flaws in the system, we risk losing sight of the fact that
    the proposed reforms come with consequences--intended and unintended--
    some of which will diminish the stability and certainty that
    characterize our markets and that permit them to be the engines of
    economic growth. That is why we must think through the consequences of
    the proposals currently under consideration before implementing
    sweeping changes.
        SEC Chairman Harvey Pitt has proposed the creation of a new
    regulatory organization, under the SEC's oversight. The new
    organization would be dominated by individuals from outside the
    accounting profession and would be empowered to conduct disciplinary
    investigations and operate the program that ensures the quality control
    of firms that conduct audits of public companies. This regulatory model
    would effectively replace the profession's system of self-regulation in
    these areas with public regulation and should be fully explored.
        We believe the time is right to create new systems for performing
    quality reviews of the practices of public company auditors and for
    disciplining those auditors. Accordingly, we support moving from a
    system of self-regulation to one of public regulation for these
    important processes. We further believe that these processes should be
    subject to SEC oversight.
        Other proposals would effectively remove auditors from the audit
    standard setting process and burden the new regulatory organization
    with standard setting. Such a change would be a mistake. Audit
    standards should be set by professionals who understand auditing, not
    by lay people who have no practical experience in auditing.
        I would like to say a few words about several specific proposals
    that many regard as quick fixes to the problems they perceive with the
    profession.
        One proposal currently being debated is the periodic rotation of
    audit firms. The AICPA already requires that the lead audit partner on
    every public company financial statement audit be rotated at least once
    every 7 years,\1\ an approach that ensures a fresh look at a company's
    books at regular intervals. But requiring the rotation of entire firms
    is a prescription for audit failure. Rotation of audit firms would
    result in the destruction of vast stores of institutional knowledge and
    guarantee that auditors would be climbing a steep learning curve on a
    regular basis. It would result in increased ``start-up'' costs for the
    auditor, the company being audited, and the public, as every few years
    an entirely new group of auditors would have to be educated and brought
    up to speed on the intricacies, and legitimate accounting issues,
    presented by a given company's operation.
    ---------------------------------------------------------------------------
        \1\ This requirement does not apply to firms that have less than
    five SEC audit clients and less than 10 partners because the benefit of
    the rotation is greater for larger firms auditing large companies.
    ---------------------------------------------------------------------------
        And it would expose the public to a greater and more frequent risk
    of audit failure since studies show that audit failures are more likely
    to occur during the initial years a firm is auditing a new client. In
    fact, at least one study has identified a link between financial fraud
    and a change in auditors.\2\
    ---------------------------------------------------------------------------
        \2\ See Committee of Sponsoring Organizations of the Treadway
    Commission, Fraudulent Financial Reporting: 1987-1997: An Analysis of
    U.S. Public Companies (March 1999).
    ---------------------------------------------------------------------------
        Many groups have studied this very issue and concluded that audit
    firm rotation is a bad idea. The Commission on Auditors'
    Responsibilities, the SEC's Office of the Chief Accountant, the Public
    Oversight Board, the General Accounting Office, and the Committee on
    Sponsoring Organizations of the Treadway Commission have all determined
    that the costs of mandated firm rotation would exceed any of the
    possible benefits.\3\
    ---------------------------------------------------------------------------
        \3\ See The Commission on Auditor's Responsibility, Report,
    Conclusions, and Recommendations (AICPA 1978) at 108-09 (finding that
    the costs of mandatory audit firm rotation exceeds the benefits and
    suggesting that many of the benefits of audit firm rotation can be
    achieved through firm personnel rotation); SEC Office of Chief
    Accountant, Staff Report on Auditor Independence (March 1994)
    (indicating that a periodic change in engagement partners responsible
    for audits provides a good opportunity to bring ``a fresh viewpoint to
    the audit without creating the significant costs and risks associated
    with changing accounting firms''); Strengthening the Professionalism of
    the Independent Auditor, Pubic Oversight Board Advisory Panel on
    Auditor Independence (1994) (agreeing with the Cohen Commission's
    findings concluding that rules mandating audit firm rotation are
    impractical from a cost/benefit perspective); Committee of Sponsoring
    Organizations of the Treadway Commission, Fraudulent Financial
    Reporting: 1987-1997: An Analysis of U.S. Public Companies (March
    1999). It has been noted that countries that have legislated rotating
    audit firms, such as Spain, Greece, and Canada, have generally returned
    to a traditional market system, whereby companies are free to maintain
    or change audit firms as they see fit.
    ---------------------------------------------------------------------------
        Limiting an auditor's ability to become familiar with the client's
    business would also make it easier for reckless management to mislead
    the auditor. Regardless of how independent an auditor is, the
    likelihood of fraud will increase if the auditor lacks institutional
    knowledge and must, therefore, place undue reliance on the
    client's guidance and representations. Mandating audit firm rotation
    will also make it easier for companies to disguise opinion shopping by
    enabling companies to portray a voluntary change in auditors as
    obligatory.
        The Enron case illustrates the type of complex financial structures
    that auditors often confront. It would, therefore, be ironic were Enron
    used to justify any proposal, including audit firm rotation, that would
    result in auditors being less informed, less educated about the
    client's business and operations, and less equipped to conduct a
    thorough audit. Particularly in today's complex business environment,
    depth of knowledge is essential to performing an effective audit and
    making sound judgment calls regarding difficult accounting and
    reporting issues. Despite the superficial appeal of the idea, audit
    firm rotation likely would result in an increased number of audit
    failures.
        A related proposal involves a ban on the so-called ``revolving
    door''--situations in which an auditor goes to work for an audit
    client. The SEC and the Independence Standards Board considered the
    wisdom of imposing a ``cooling off '' period before an auditor could
    accept employment with a former client. Both concluded that such a rule
    would impose unwarranted costs on the public interest, on public
    companies, and on the profession. Indeed, limiting the career
    opportunities of accountants would make the profession less attractive
    and make it more difficult for firms to hire qualified people. Studies
    have shown and our experience is that existing safeguards, including
    the mandatory rotation of audit partners as well as the additional
    procedures that are put in place when a member of an audit team joins a
    client, are effective in addressing so-called ``revolving door''
    situations.\4\
    ---------------------------------------------------------------------------
        \4\ Current guidance on employment relationships requires, among
    other things, that the former practitioner cannot influence the firm's
    operations or financial policies; have a capital balance in the firm;
    or have a financial arrangement, other than one providing for regular
    payment of a fixed dollar amount, which is not dependent on the
    revenues, profits, or earnings of the firm. In addition: When an
    auditor is considering employment or approached by the client regarding
    employment, he or she must be removed from the audit engagement; if an
    auditor accepts employment, the firm needs to review the work of that
    auditor to assess whether the appropriate skepticism was exercised; if
    an auditor accepts employment, a determination needs to be made as to
    whether the audit plan should be revised to eliminate the risk of
    circumvention; in situations where a former practitioner joins the
    client and will have significant interaction with the audit team, the
    firm needs to take appropriate steps to ensure that the audit team has
    the stature and objectivity to effectively deal with the person and
    his/her work; and if the auditor joins the client within 1 year of
    disassociating from the firm, the audit must be reviewed separately by
    a professional who previously was not involved in the audit in order to
    make sure the audit team exercised the appropriate skepticism.
    ---------------------------------------------------------------------------
        Another proposal currently being debated involves placing increased
    limitations on the scope of services that firms may provide to their
    audit clients. Just last month, my firm announced that we will further
    separate our management consulting practice--a step we took
    reluctantly, but one we deemed necessary to address the market's
    concerns about the perception of auditor independence and help restore
    investor confidence in the profession. All of the other Big 5 firms, in
    one way or another, have taken a similar approach. But this is our
    model and it may not be right for other firms.
        Further limiting the scope of services firms may provide to their
    audit clients is a bad idea. It is a bad idea because it will not make
    an audit team any more independent, but it will make the team less
    competent.
        In conducting an audit of the financial statements of a company,
    you obviously need good accountants and auditors, but you also need
    technical experts. For example, in auditing the financial statements of
    a company like Enron, you would need experts in market trading controls
    and information technology. An audit team that does not bring with it
    the technical knowledge and skills necessary to understand the
    company's business will not be able to perform a competent audit.
        Why would additional limitations on the scope of services make it
    more difficult to bring specialists into the auditing process? Because
    these experts are not auditors. They do not devote their careers to
    audit support work. If we asked them to abandon their consulting work
    and do nothing but audit support work, we would not be able to retain
    them. The best and the brightest seek positions that will allow them to
    develop their expertise, to learn, to work on cutting-edge issues, and
    few will choose to remain in jobs that offer limited opportunities and
    seriously restrict their professional development and employment
    options.
        We do not believe that scope-of-services restrictions would have
    prevented Enron and will not prevent the next business failure. In
    fact, several recent studies have demonstrated that there is no
    correlation between the provision of nonaudit services and audit
    failures. In not one of the audits considered by the POB's Panel on
    Audit Effectiveness did the Panel identify any instances in which
    nonaudit services had a negative effect on audit effectiveness.\5\ To
    the contrary, the Panel's reviewers concluded that in about one-quarter
    of the audits studied, those services ``had a positive impact on the
    effectiveness of the audit.'' As to the remainder, ``the reviewers
    either were neutral regarding the effects of nonaudit services on audit
    effectiveness or concluded that the services had no impact on audit
    effectiveness.'' Investigators at the University of Southern California
    and Texas A&M International University, in their study, concluded that
    concerns that nonaudit services impair auditor independence are
    unfounded.
    ---------------------------------------------------------------------------
        \5\ See The Panel on Audit Effectiveness, Report and
    Recommendations, at 113 (August 2000). The Panel on Audit Effectiveness
    consisted of eight members appointed by the Public Oversight Board in
    October 1998 at the request of SEC Chairman Arthur Levitt. The Panel
    was charged with evaluating the performance of public company financial
    statement audits and assessing whether recent trends in audit practices
    served the public interest.
    ---------------------------------------------------------------------------
        The current search for fixes, for ways to prevent another Enron, is
    fitting and proper. The failures of American businesses often teach as
    much as their successes. We should learn from what has happened and
    make changes that provide meaningful opportunity for improving the
    quality of audits.
        Thank you very much.

               PREPARED STATEMENT OF WILLIAM E. BALHOFF, CPA, CFE

                         Chairman, Executive Committee
                     AICPA Public Company Practice Section
          Senior Audit Director, Postlethwaite & Netterville, A.P.A.C
                                 March 14, 2002

        In my role as Chair of PCPS, and as a partner in a local CPA firm,
    I am here today to represent the opinions of small firms located in
    towns and cities all across the United States. I have two main topics I
    would like to discuss with you: (1) how restricting the performance of
    nonaudit services would adversely impact small business owners and our
    ability to meet their very diverse needs and (2) how any new
    legislation that would affect the accounting profession must take into
    account the need for small accounting firms to recruit new talent.
        My firm performs over 150 financial statements audits of which only
    three companies are public registrants. However, the majority of our
    PCPS members do not audit public companies. Still, we believe any
    legislation that imposes new scope-of-service limitations on auditors
    will have unintended consequences that adversely
    affect small CPA firms, the small businesses we serve, and ultimately
    the public.
        History shows that new legislation by Congress is highly likely to
    become the ``template'' for parallel legislative or rule changes at the
    Federal and State levels that would directly affect small CPA firms and
    the small business clients we serve. In particular, as auditors who
    provide services to small businesses, we are often subject to rules
    established by State accountancy boards, the U.S. Department of Labor,
    the General Accounting Office, and State and Federal bank regulators.
    These bodies traditionally follow the lead set by Congress and the SEC
    in adopting new laws or regulations for auditors of public companies.
        Indeed, after the SEC issued new rules on auditor independence in
    late 2000, the GAO followed suit with its independence standards
    earlier this year. The GAO requirements not only duplicate, but in some
    cases exceed, the new SEC restrictions on nonaudit services. I have
    brought with me, and will submit to the Committee, a letter we received
    from one of our small CPA firm members, a sole practitioner located in
    Denton, Maryland, a small rural community on the Eastern Shore. In his
    letter, this CPA explains that, as a result of the new GAO
    restrictions, firms such as his that audit clients subject to GAO
    regulations are required to assign separate personnel to perform
    nonaudit work, such as the preparation of income tax returns. Of
    course, as a sole practitioner, he has no ``other personnel'' to
    assign. He explains that the practical result is that he will either
    have to give up his solo practice and associate with a larger firm, or
    tell his GAO clients that they will now need to hire a second firm to
    perform either their audit or tax work--an alternative that, for many
    such clients, is not economically feasible nor justifiable.
        Small businesses have long depended on small accounting firms to
    provide much more than auditing services. The CPA serves as the
    ``trusted advisor'' of the small business owner. For example, a CPA
    firm will often assist a small business as it is just starting out,
    providing guidance on setting up its record-keeping systems, providing
    tax and estate planning and making suggestions to help make its
    business more successful. The CPA also helps the business as it grows.
    I have one client that had decided to expand its business by adding
    another location in the local area. After asking questions concerning
    its projected increase in sales, changes in gross margin, and expected
    competition, as well as the impact on its financial statements, I
    helped the client develop a financial model to address these issues.
    The bottom line was that the company decided that, if it went forward
    with its plans, it would risk the very financial stability it had taken
    decades to build. This is just one example that displays the important
    role CPA's play in providing small businesses with information
    necessary for them to maintain their financial strength.
        As I am sure you will agree, successful small businesses are a
    cornerstone of Main Street America. It is likely that, in many cases,
    if the CPA does not have the ability to act as the ``trusted advisor''
    to his or her clients, many small businesses will simply not seek the
    input of other third-party professionals. It is vital, both for the
    small business person and for the survival of many thousands of small
    accounting firms, that current laws not be changed in a manner that is
    insensitive to these
    concerns.
        My second concern is the effect new legislation might have on the
    ability of our profession to retain personnel and attract new entrants
    into the profession. This is already an area of great concern for firms
    of all sizes, and research undertaken by the profession has uncovered
    alarming trends.
        Specifically, studies completed by my committee confirm that we are
    experiencing significant difficulty attracting students into accounting
    programs and the profession. For example:

     The number of accounting graduates in the United States has
        decreased from 60,000 to 45,000 from 1995 to 2000.
     The number of students enrolled in accounting programs has
        declined from 192,000 to 143,000 from 1995 to 2000.
     The number of candidates sitting for the CPA exam has declined
        by 33 percent from 1990 to 2001.

        Our surveys show that the major reason fewer qualified students are
    studying accounting is because the profession is perceived as narrow
    and focused too much on historical ``numbers,'' whereas other business
    careers are seen as much more rewarding and exciting. It is critical
    that we change this perception and continue to attract young, bright
    minds to the accounting profession. Any of our current efforts to
    recruit students to the CPA profession could be severely undercut by
    any reforms that restrict the services small audit firms perform for
    their clients.
        There is much to do post-Enron to restore confidence in Corporate
    America and the accounting profession. As you have heard from my
    colleagues, the AICPA and its members, large and small, fully support
    many important reforms. As Congress considers these issues, however, I
    urge you to consider the unintended consequences of short-term
    legislative solutions in your effort to respond to the Enron business
    failure.

                                   ----------
                  PREPARED STATEMENT OF OLIVIA F. KIRTLEY, CPA

            Former Chairman, Board of Directors, AICPA (1998 -1999)
               Retired Vice President and Chief Financial Officer
                          Vermont American Corporation
                                 March 14, 2002

        My name is Olivia Kirtley. I am a Board Member and Chair the Audit
    Committees for three publicly-traded companies, including ResCare, Inc.
    and Alderwoods Group, both Nasdaq companies, and Lancer Corporation,
    which is listed on the American Stock Exchange. I am also recently
    retired as the Chief Financial Officer of Vermont American Corporation
    in Louisville, Kentucky and past Chair of the Board of the AICPA. My
    remarks today will focus primarily on matters of corporate governance.
    However, I want to begin by discussing the importance of advice
    received from external auditors based on my experience as a CFO and an
    audit committee member.
        There are a number of areas outside the scope of the financial
    statement audit in which a company's independent CPA is in the best
    position to offer advice, which presents no conflict to the auditor's
    role. This advice benefits the company and its shareholders rather than
    compromising the integrity of the audit. In addition, a ban on the use
    of services of this nature can significantly inhibit small and mid-size
    growth companies that may not have this expertise in house. Banning
    auditors from performing nonaudit services for their audit clients will
    also have a negative impact on the larger economy. Costs will rise when
    businesses are required to contract and train multiple providers of
    services most efficiently provided by one firm. Efficiency will suffer
    as current practices are altered to adhere to new mandates and
    companies are prohibited from contracting with providers of their
    choice. Business decisions will suffer from the loss of expertise now
    provided by the auditor's deep knowledge of the businesses they audit.

    Executive Compensation
        With a significant amount of many executives' personal wealth that
    are based on short-term financial targets, the potential exists for
    some to sacrifice a company's long-term health and well-being for
    short-term gains. We believe two items in this area are worthy of
    further consideration: (1) requiring the disgorgement of executive
    bonuses paid on the basis of grossly inaccurate financial statements, a
    concept for which the President has expressed support, and (2)
    encouraging the compensation committee of the board to review the
    incentives driving executive compensation for balance between short-
    and long-term financial and nonfinancial goals.

    Audit Committees
    Audit Committee Composition
        We all know that the work of audit committees has become more
    difficult and demanding, and it certainly is under more public
    scrutiny. Moreover, the expanding complexity of issues that audit
    committees are called upon to address has caused the board to place
    greater reliance on the audit committee with respect to technical
    accounting, reporting and auditing oversight. In recent years, audit
    committees have been the subject of much study and attention; just 2
    years ago, new rules were issued by the SEC and the stock exchanges
    addressing the independence and experience of audit committee members.
        A primary focus has been the financial acumen of audit committee
    members. In this regard, the Blue Ribbon Committee on the Effectiveness
    of Corporate Audit Committees (Blue Ribbon Committee) recommended that
    corporate audit committee members be financially literate but only one
    member must have accounting or related financial sophistication or
    expertise. But what is ``financial literacy''? Presently, the
    definition is nebulous, at best, with two different market regulators
    adopting different, yet vague, definitions that may not be sufficient
    to meet shareholders' increasing expectations.\1\
    ---------------------------------------------------------------------------
        \1\ The Nasdaq's definition is as follows: ``All directors must be
    able to read and understand fundamental financial statements, including
    a company's balance sheet, income statement, and cash flow statement.
    At least one director must have past employment experience in finance
    or accounting, requisite professional certifications in accounting, or
    other comparable experience or background, including a current or past
    position as a chief executive or financial officer or other senior
    officer with financial oversight responsibilities.'' The NYSE's
    definition is as follows: ``The Board of Directors has determined that
    each audit committee member is financially literate, or will become so
    in a reasonable period of time, as such qualification is interpreted in
    the Board's business judgment.''
    ---------------------------------------------------------------------------
        Although it is not currently required, we recommend that the
    listing authorities consider requiring the majority of audit committee
    members to have accounting or related financial sophistication or
    expertise, in order to minimize the reliance on one committee member.
    If a member lacks sufficient expertise, he or she may not understand
    the issues, know the questions to ask, or have a basis for considering
    the adequacy of the response provided. In light of the increasing
    complexity of the tasks, we also believe that consideration should be
    given to requiring at least one CPA with appropriate technical or
    industry expertise to serve on the audit committee and, if this is not
    possible, then audit committees should be encouraged to seek outside
    assistance or input on a regular basis from someone other than the
    auditor or management.
        Audit committee work, like public accounting work, requires
    significant judgment. It is not an exact science. Accounting and
    financial sophistication or expertise will not guarantee that mistakes
    in judgment will never be made, but it certainly should mitigate the
    risks.

    Communications with the Audit Committees
        The Blue Ribbon Committee also cited a need for improved and more
    frequent communication between audit committees and the independent
    auditors that would cover such important areas as estimates and
    judgments, internal controls, significant risks, the clarity of the
    company's disclosures and the degree of aggressiveness or conservatism
    of the company's accounting principles. In addition, the Panel strongly
    supported more proactive audit committees and a stronger relationship
    between the board (and their audit committees) and the independent
    auditors. In response to these recommendations, new auditing standards
    and revisions to audit committee charters have created a framework for
    such enhanced communications to occur on a regular basis.
        Another reform that would further strengthen the effectiveness of
    the audit committee, however, would be to require audit committees to
    hold separate executive sessions, on a periodic basis, with financial
    management, independent auditors, and internal auditors. The use of
    executive sessions as a fact-finding tool is indispensable, providing
    an environment where: (1) committee members are able to probe more
    deeply to assure they are fully informed regarding risks, issues, and
    judgments, and (2) participants are given the opportunity to
    confidentially voice concerns they might not otherwise express.

    Quarterly Financial Reviews by Audit Committees
        Current standards place significant emphasis on the annual audit,
    but what about the rest of the year? Generally, a quarterly review is
    required to be performed by the independent auditor, and the market
    regulators recently implemented a requirement that the review results
    be discussed with the audit committee, or at least the chair of the
    committee, prior to the release of earnings. Much like the haziness of
    the ``financial literacy'' requirement, however, these limited interim
    review requirements are not universally understood by Board members,
    audit committee members or investors.
        Unlike the detailed work of an annual audit, a quarterly review
    primarily involves auditor inquiries of officers and others involved in
    the company's financial reporting function, a ``high-level'' review of
    significant transactions, and some analytical procedures. It is not an
    audit. One must ask if this is sufficient to meet the needs of
    investors in the fast-paced, ever-changing business environment in
    which companies operate, with numerous transactions and decisions
    occurring throughout each quarter. The requirements of quarterly
    reviews should be reviewed for sufficiency in meeting the need of
    investors for information on an ongoing basis.

    Audit Committee Interaction with the Internal Audit Function
        Increasing attention is being given by audit committees to the
    benefit and value that internal auditors can provide. Given the role
    internal audit departments play within a company, and their exposure to
    the many financial and nonfinancial areas in the company, we believe
    that internal auditors should have a direct reporting responsibility to
    the audit committee, and provide independent communications with the
    audit committee. If an internal audit function is in place, senior
    management should not be able to terminate the head of an internal
    audit department without audit committee approval.

    Recent Audit Committee Rulemaking
        It is critical to note that significant audit committee rules and
    regulations have taken effect over the last 2 years as the result of
    the Blue Ribbon Committee's recommendations. During that time period,
    the SEC and stock exchanges have implemented other measures including
    requiring formal audit committee charters and requiring audit
    committees to be composed of all members meeting the financial
    literacy requirements. These new requirements must be given time to
    work.
    In my experience, I have seen significant improvements in the
    effectiveness of audit committees since the new requirements have been
    implemented. Although we have outlined several suggestions for audit
    committee reform, we must resist the temptation to layer on too many
    additional rules for audit committees and the corporate governance
    process before allowing recent audit committee requirements to have an
    impact.
        Thank you for the opportunity to appear before this Committee.

                                   ----------

                   PREPARED STATEMENT OF JAMES S. GERSON, CPA

                   Chairman, Auditing Standards Board, AICPA
                      Partner, PricewaterhouseCoopers, LLP
                                 March 14, 2002

        My name is Jim Gerson, Chair of the AICPA's Auditing Standards
    Board. I am also a partner with PricewaterhouseCoopers. My objectives
    today are to briefly
    describe the auditing standards board, the role of the independent
    auditor and to highlight some significant changes in auditing standards
    that have just recently
    occurred, or will take effect shortly.

    The Auditing Standards Board
        The Auditing Standards Board is a senior committee of the AICPA
    authorized to set authoritative auditing standards commonly referred to
    as Generally Accepted Auditing Standards. Our committee is made up of
    15 members, appointed to achieve an appropriate representation among
    CPA firms, as well as the public. At present two of the 15 seats are
    reserved for public members, currently filled by an academician and a
    Government auditor. We hold regular meetings that are open to the
    public and attended by the SEC, the POB, and other constituents.

    Role of the Auditor
        Let me focus briefly on the role of the independent auditor in the
    financial reporting process. The objective of a financial statement
    audit is to provide assurance as to the credibility of management's
    financial statements. An audit consists of a series of test procedures,
    such as examining inventories, confirming accounts receivable and
    obtaining an understanding of a company's system of internal controls.
    Such tests are designed to gather evidence to enable the auditor to
    express an opinion as to whether a company's financial statements are
    presented fairly, in all material respects, in accordance with
    Generally Accepted Accounting Principles.
        The auditor's conclusions are reflected in the auditor's report.
    The report may notify financial statement readers about material
    departures from GAAP, changes in accounting principles, or a variety of
    other matters. The intended goal of financial statements accompanied by
    an auditor's report is to provide information that is reliable and
    useful to investors, creditors, and other constituencies.
        One question we are often asked is: ``What is the auditor's
    responsibility to detect fraud?'' Let me assure this Committee that, as
    auditors, we recognize our responsibility to plan and perform every
    audit to obtain reasonable assurance, within the limitations inherent
    in the nature of an audit, as to whether the financial statements are
    free of material misstatements, whether caused by fraud or
    unintentional errors. Even a properly designed and executed audit,
    however, cannot provide a 100 percent guarantee that a material fraud
    will be detected. We are working hard to continually improve both
    auditor performance and our fraud guidance.

    Recent Initiatives
        Let me briefly outline a few of our initiatives, many of which
    predate the issues surrounding Enron. First, we issued an exposure
    draft last month of a proposed standard entitled Consideration of Fraud
    in a Financial Statement Audit. This
    proposal supercedes prior guidance and will substantially enhance the
    ability of auditors to detect material misstatements arising from
    fraud. A major change in this new standard is the addition of required
    procedures that respond to the POB Panel's call for a forensic phase.
    Specifically, it responds to what they call a forensic phase by
    requiring, as part of every audit of an SEC registrant, even when fraud
    is not suspected:

     Discussions among engagement team members as to how and to
        where fraud could occur.
     A requirement to perform certain substantive audit procedures
        to test for the intentional override of internal controls by
        management.
     A continual evaluation of fraud risks throughout the audit, as
        well as at or near the end of the audit process.

        I will very briefly outline some initiatives in other areas.
        Last year, we formed a task force that is working to improve the
    auditor's risk assessment process. Through a more robust risk
    assessment process, auditors will be able to better understand where
    material errors are most likely to occur in the financial statements,
    and what auditing procedures are best suited to respond to those errors
    detected.
        We have undertaken a project to create a new standard on auditing
    ``fair value'' that we intend to expose for comment this spring. We
    previously issued detailed standards on auditing derivatives and
    similar financial instruments. Additionally, we are in the process of
    updating and improving our related audit guide and will be adding a new
    chapter that will provide guidance on auditing energy and other
    commodity contracts.
        In December 2001, in response to recent events and in time for this
    year's audits, we issued an auditor's ``toolkit'' to serve as a
    valuable reference guide when dealing with the complex topic of the
    potential abuse of related-party transactions. Through this toolkit, we
    are advising auditors to evaluate the possibility that related-party
    transactions may be motivated by a desire to improve reported earnings
    or by fraud.
        In response to growing demands for more timely reporting, we have
    actively participated in developing continuous auditing or assurance
    methodologies. This concept involves reporting on shorter time frames
    and can relate to either reporting on the effectiveness of a system
    that produces data or reporting more frequently on the data itself. We
    believe that the technologies, if not the tools, required to provide
    continuous assurance services are, for the most part, currently
    available. Their actual implementation will evolve, as the concept of
    more frequent reporting gains additional support and appropriate,
    specialized software tools emerge.

    Conclusion
        Investors depend on auditors to communicate the reasonableness of
    the company's financial information and to provide confidence in the
    numbers. When an investor reviews a company's financial statements, an
    independent audit should provide the investor with confidence that the
    company is playing by the rules.
        As a profession, we know that we can and must do a better job. I
    believe the entire auditing community would agree with me when I say
    that we are deeply concerned about recent events that have shaken the
    public's confidence in the financial reporting process. We are
    committed to continually improving auditing standards and the guidance
    we provide to auditors, so that investors and others who rely on an
    auditor's report can place full confidence in the audit process and the
    members of the profession who perform this valuable service.

                                   ----------

                   PREPARED STATEMENT OF ROBERT E. LITAN \1\
    ---------------------------------------------------------------------------
        \1\ Robert E. Litan is Vice President and Director of the Economic
    Studies Program and Cabot Family Chair in Economics at the Brookings
    Institution. He is also the Co-Director of the AEI-Brookings Joint
    Center on Regulatory Studies; Co-Chairman of the Shadow Financial
    Regulatory Committee; and Co-Editor of the Brookings-Wharton Papers on
    Financial Services. He
    formerly served as Associate Director of the Office of Management and
    Budget (1995-1996), Deputy Assistant Attorney General, Antitrust
    Division, Department of Justice (1993-1995) and as a consultant to the
    Treasury Department (1996-1997, 1999-2000). In the early 1990's, Dr.
    Litan was a Member of the Commission on the Causes of the Savings and
    Loan Crisis. The views he expresses here are his own and not
    necessarily those of the Brookings Institution, its trustees, officers,
    or staff, or those of the individuals with whom he is currently working
    on the study of disclosure mentioned in the text.
    ---------------------------------------------------------------------------
             Vice President and Director, Economic Studies Program
                           The Brookings Institution
                                 March 14, 2002

        Thank you, Mr. Chairman, for inviting me to appear today to discuss
    accounting and disclosure issues in the wake of the Enron failure.\2\
    ---------------------------------------------------------------------------
        \2\ The Enron failure raises numerous other public policy issues,
    including those relating to pensions (401(k) plans in particular),
    corporate governance, derivatives disclosures, which Congress, the
    Administration, and the regulatory agencies will be addressing this
    year and possibly beyond. I am confining my remarks here, however, to
    the issues itemized in the invitation letter from Chairman Sarbanes:
    ``financial reporting by public companies, accounting standards, and
    oversight of the accounting profession.''
    ---------------------------------------------------------------------------
        I come to you with a somewhat different background than many of
    those who have appeared before you so far--not as a professional
    accountant or securities regulator, but as an individual who has spent
    most of his career in a policy research setting and in Government
    working on a variety of issues, some of which have touched on Enron-
    related questions. In particular, much of my research has focused on
    the financial services industry, while in my years in Government, I
    have helped enforce the Nation's antitrust laws and overseen or worked
    with the budgets with a number of Federal agencies, including the SEC.
    Of perhaps greater relevance to the current hearing, I have co-authored
    a book with my colleague from AEI here today, Peter Wallison, on what
    we believe to be some of the cutting-edge issues in accounting and
    disclosure,\3\ and am in the process of co-authoring another book on
    disclosure policy in a world of increasingly global capital markets. I
    hope through these various experiences and endeavors I can provide the
    Committee with some fresh insight into the challenges it and the entire
    Congress now confront.
    ---------------------------------------------------------------------------
        \3\ The GAAP Gap: Corporate Disclosure in an Internet Age (AEI-
    Brookings Joint Center for Regulatory Studies, 2000).
    ---------------------------------------------------------------------------
    Overview
        The Enron failure poses some of the toughest policy challenges of
    any financial collapse in recent memory. The current situation is not
    comparable to the savings and loan or the banking disasters of the
    1980's, which were nearly a decade in the making before Congress
    finally took action. By comparison, the disclosure problems that have
    surfaced in Enron have been apparent only over the past several years,
    especially the growing numbers of earnings restatements and the rising
    concern about ``earnings management'' expressed by the SEC and others.
    More importantly, whereas in the S&L and banking cases there were clear
    ``solutions'' on the ``policy shelf,'' as it were, for Congress to
    implement (notably, the system of prompt corrective action for
    enforcing capital standards), only some ideas are on the shelf this
    time and there appears to be only a limited consensus on which ones
    ought to be adopted.\4\
    ---------------------------------------------------------------------------
        \4\ Similarly, during the Depression, Congress and the Roosevelt
    Administration took some ideas that had long been on the policy shelf
    and adopted them into law, notably deposit insurance and the Glass-
    Steagall Act's separation of commercial and investment banking
    (although 2 years later, Senator Glass expressed regret about its
    passage).
    ---------------------------------------------------------------------------
        This should not be alarming because improving the disclosure system
    is a complicated subject with few absolutely clear answers. As Paul
    Volcker pointed out in his testimony before this Committee on February
    14, the growing complexities of business--reflected in a dizzying array
    of new financial instruments and corporate organizations--pose
    increasingly difficult challenges for any system of disclosure. The
    fact is that for many kinds of transactions, there are no single
    ``right'' answers, which helps explain why the Financial Accounting
    Standards Board often takes so long before setting new standards or
    refining earlier ones (and why International Accounting Standards
    instead are framed in a more generic fashion, allowing accountants more
    discretion in deciding how to account for various transactions than is
    the case under Generally Accepted Accounting Principles in this
    country).
        The same is true for improvements to the system for overseeing
    auditing, or what I would call the ``enforcement problem.'' There is a
    compelling case for replacing or at least supplementing the current
    system of State supervision and self-regulation of auditors, as this
    Committee already has heard from previous witnesses. But there are
    arguments for and against each of the possible reform measures, as I
    will explain shortly.
        Meanwhile, Congress should be mindful that markets and regulators
    have already engaged in a lot of ``self-correction'' in the wake of the
    Enron affair and of the facts that this Committee and others have
    helped to uncover and publicize. Based on popular press accounts and
    conversations with knowledgeable observers, my impression is that a
    number of companies (including America's largest in terms of market
    capitalization, General Electric) already have delivered more
    disclosure; corporate boards, and their audit committees in particular,
    are paying closer attention to accounting issues and the choice of
    auditors; accounting firms have tightened up on their audits; financial
    analysts and credit rating agencies, chastened by their past
    performance, have become more discriminating; and the SEC is apparently
    doing the best it can with its limited resources to scrutinize
    corporate financial statements for possible problems.
        So what should Congress do at this point? This Committee and others
    are taking the right approach by first gathering facts and views from
    the experts. But you will inevitably find that at least so far there
    are many conflicting views. You should also be wary of all those who
    profess to know for certain about what reforms are most appropriate.
    The fact is that we--the Congress, the Administration, the experts, the
    investors, and the wider public--are all in the process of trying to
    figure out the best response. I am no exception in this regard: My own
    thinking continues to evolve as I gain more facts and learn of
    additional policy suggestions, and I ask you to bear that in mind as
    you hear the remainder of my testimony.
        Accordingly, my best advice at least on the disclosure-related
    issues, is that if Congress enacts legislation (rather than leaving the
    reform job solely to the SEC), it do so in a broad fashion allowing for
    significant flexibility. It can do this with broad, general
    instructions to the SEC, but leave the details to the Commission.
    Flexibility is important in this area precisely because it is complex,
    the answers to current problems are not obvious and often contentious,
    and the problems themselves may appear differently several months from
    now or even next year, than they do now.
        In the remainder of my testimony, I distinguish between issues
    relating to accounting standards, enforcement issues, one issue
    relating to the fate of the accounting industry post-Enron (possibly
    even greater concentration), and a set of cutting-edge disclosure
    issues that should be addressed at some point. Along the way I will
    briefly discuss certain of the Administration's proposals, as well as
    some of the
    reforms that I do not believe would solve any problems, or that
    conceivably might entail more costs than benefits.

    Accounting Standards
        The major immediate accounting problem exposed by Enron's failure
    was the weak consolidation rule prescribed for highly leveraged
    ``special purpose entities'' (SPE's). As this Committee and others in
    Congress have heard, Enron failed in part because of losses arising out
    of the many SPE's that it had created.
        In brief, the rule for some time has been that sponsors of an SPE
    need not consolidate it so long as outside investors contribute a
    majority of its capital and that investment constitutes at least 3
    percent of the SPE's assets. Putting aside the SPE's where Enron
    appears to have misled its auditor, Anderson, about the amount of
    outside investment (thus wrongfully avoiding consolidation), it is now
    clear that the 3 percent test was much too weak. FASB has since raised
    the 3 percent of assets threshold to 10 percent, clearly a move in the
    right direction.
        The more difficult, larger issue relates to FASB's standard setting
    process itself, however. As the Committee has heard from other
    witnesses, FASB is slow to set standards (the incredibly quick revision
    to the SPE rule being a notable exception) and when it does, it is
    often subject to political interference.
        Changing the funding of FASB from voluntary contributions from
    accounting firms and companies (the current practice) to some sort of
    mandatory assessment system, as some have suggested, would solve
    neither of these problems, although it might diminish any perception
    that FASB must tailor its views to those of its funders (a charge I
    suspect that FASB would vigorously deny).
        The slowness of FASB's standard setting could be addressed more
    directly by having the SEC impose deadlines on rule changes, with the
    threat that the SEC would take action by a date certain if FASB did not
    (as former SEC Chief Accountant, Lynn Turner, proposed before this
    Committee). I want to be clear: I am not enthusiastic about the SEC
    taking over the standards setting function altogether, which I fear
    could interfere with the other functions the Commissioners perform and
    could not guarantee any better outcomes. But I can see the value of
    having the threat of occasional SEC rulemaking as a way of keeping
    FASB's feet to the fire. The SEC could also become more proactive in
    reviewing, if not actually setting, FASB's rulemaking agenda on a
    regular basis, which could also help speed things up.
        The downside of more active SEC involvement, however, is that it
    could result in even greater political interference in FASB's
    activities than already exists--most recently, with respect to FASB's
    efforts to set standards relating to the expensing of stock options and
    the accounting treatment of derivatives. There is a respectable view
    that politics is inherent in any rulemaking process, especially one
    that is supposed to be in the public interest, and so we should simply
    live with the fact. Moreover, it can be reasonably claimed that setting
    accounting standards is not a science and we should stop pretending
    that it is something so pure that it should not be
    affected by the views of the profession that applies them nor of the
    firms that have to abide by them.
        At the same time, however, we should remember that the main purpose
    of accounting standards--at least for publicly-held companies--is to
    protect the interests of investors, not accountants and not the firms
    themselves. Accounting standards should help investors understand all
    relevant financial facts that will enable them, if they want, to make
    projections about future cash flows. Where the standards are changed or
    not implemented out of concern for affected firms rather than
    investors, who tend not to be organized and who in any event can always
    choose not to invest in the companies that may be lobbying the Congress
    or FASB on a particular rule, then the outcome may not be socially
    desirable.
        In short, it is not that politics should be kept out of the
    rulemaking process--it probably never can be--but that the current
    system, at times, can too heavily favor narrow interests over the
    interests of investors as a class (of course, this a problem that is
    not unique to accounting standards). In theory, putting more investor
    or public representatives on FASB could help rectify the imbalance. In
    practice, however, if Congress wants the rules to benefit narrow
    interests, then there is little that even a more balanced FASB can do.
        Similarly, moving the standards setting function to the SEC is not
    a panacea because Congress still exercises oversight of the SEC. The
    same would be true if FASB members were chosen directly by the
    Commission. As long as the SEC oversees FASB in some way and Congress
    oversees the SEC, I do not see how politics can be taken out of
    accounting standards setting.
        In principle, the only option I believe would have a chance of at
    least making some difference is to move standard setting to an
    international body like the International Accounting Standards Board
    and thus accept international accounting standards (IAS), which the
    United States thus far has refused to do--largely out of the belief
    that U.S. GAAP is superior to IAS.\5\ Of course, this is not the
    rationale for moving to international standards that is typically
    cited. Instead, the case for IAS rests largely on the view that a
    single set of accounting standards worldwide would eliminate
    discrepancies in accounting standards across countries, thereby
    facilitating cross-border movement of capital. In addition, removing
    sources of uncertainty generated by differences in national accounting
    conventions should reduce the cost of capital. In the wake of Enron,
    others also have argued that a system like the IAS that allows
    accountants more discretion is superior to the heavily rules-based
    system of U.S. GAAP which seemingly invites circumvention. (Precisely
    the opposite argument can be made, of course, against a system that
    allows more discretion, and thus potentially more freedom for
    managements to manage their earnings than already exists.) \6\
    ---------------------------------------------------------------------------
        \5\ The SEC allows foreign firms that want to list their shares
    here to use IAS, provided they also reconcile their financial
    statements to U.S. GAAP.
        \6\ A widely noted reason for the greater specificity of U.S. GAAP
    is that it is a response to the greater pressure of securities
    litigation in the United States than in other countries. If the United
    States adopted IAS, it is possible, if not likely, that our
    representatives would push the IASB to make IAS more specific over time
    for the same reason.
    ---------------------------------------------------------------------------
        Whatever the merits of all of these arguments, the simple point I
    want to make here is that another potential, and possibly unrecognized,
    advantage of replacing U.S. GAAP with IAS is that it would dilute the
    political power of American interests--whoever they are--to influence
    the outcome of the standard setting process. Take, for example, the
    fight over expensing stock options, which FASB was about to implement
    several years ago before it was stopped by a powerful lobbying campaign
    from the U.S. high-tech community. If standards were set solely by the
    IASB, our high-tech firms would make their views felt, but they could
    well run into significant opposition from standard setters from other
    countries. Indeed, it is just for this reason that moving away from
    U.S. GAAP to IAS, if it were ever seriously considered, almost
    certainly would arouse strong opposition in this country.\7\
    ---------------------------------------------------------------------------
        \7\ Those who fear a loss of ``financial sovereignty'' also
    presumably would weigh in against any move to a single world standard
    setter.
    ---------------------------------------------------------------------------
        Accordingly, I do not believe that replacing U.S. GAAP with IAS is
    a politically viable option, even if the IASB, under the strong
    leadership of Paul Volcker and David Tweedie, among others,
    convincingly updates IAS in a way that persuades many in this country
    that the international standards are superior to U.S. GAAP.\8\ I hold
    this belief for another reason: Even if U.S. GAAP were replaced, it is
    possible, if not likely, that FASB or something like it would continue
    to exist in order to issue interpretive rulings of the broader
    principles-based international standards. If this were the case, and I
    suspect there would be strong pressure to ensure that it would be if
    U.S. GAAP ever were replaced by IAS, then FASB's interpretive rulings
    would gradually lead to a U.S. version of IAS, as well as the
    ``international version.'' If other countries did the same thing, IAS
    could fragment over time back into multiple national standards.
    ---------------------------------------------------------------------------
        \8\ Volcker is Chairman of the Trustees of the International
    Accounting Standards Board and Tweedie is the Chairman of the IASB
    itself.
    ---------------------------------------------------------------------------
        It is possible, of course, that fragmentation would not occur--that
    national accounting bodies such as the FASB would simply fade away.
    Whichever view is right--fragmentation or monopoly--I lean toward a
    much different approach, one I would call ``constrained competition''
    in standard setting. Under this approach--which appears to be gathering
    greater support within the academic community--U.S. law (or regulation)
    would give firms listing their shares on our stock exchanges a choice
    between using U.S. GAAP or IAS, without having to undergo the expense
    of reconciling the differences between the two standards, once some of
    the key differences between the standards are substantially narrowed.
    The remaining differences of lesser magnitude would continue to exist,
    and the two standards would simply compete, but the discrepancies would
    not be so large as to produce widely divergent results for most
    companies. In that way, investors would get the benefits of both
    greater harmonization (but not complete identity) of the two standards
    and the benefits of competition.
        The benefits of competition in the standards setting arena are no
    different than in any other context. Like any monopoly, whether private
    or public, a single standard setting organization can stultify and be
    slow to adapt to market developments. Sound familiar? That is one of
    the main complaints about FASB. With competition, each standard setter
    would have a market-based incentive to keep up with the times and not
    drag its feet. Furthermore, if it really is true that any move to
    international standards would eventually break down into national
    versions of those standards (or at least a U.S. version), then some
    competition is inevitable. Why not simply
    recognize that to be the outcome, encourage the SEC and the FASB to set
    up a process for quickly narrowing some of the key differences between
    the standards--say, for example, with respect to revenue recognition,
    the handling of proforma statements, consolidation, and the expensing
    of stock options--and then let the competition begin?
        Wouldn't there be a ``race to the bottom'' if competition in
    standard setting is allowed? The post-Enron experience suggests the
    opposite would occur. Ask GE, IBM, Tyco, or any number of other
    companies whose stock prices were pummeled by investors after the Enron
    affair became public. Investors (prompted to some degree by the
    business media) looked at the financial statements of these companies
    and apparently found their disclosures inadequate. The market
    encouraged each to become more forthcoming in its disclosures. Based on
    this most recent experience, I believe it is reasonably likely
    (although I admit not certain) that if firms had a choice in reporting
    standards the market eventually would punish the standard that
    analysts, academics, and financial commentators would view as the
    weaker one from an investor protection point of view. For the same
    reason, I also believe there is also a reasonable chance that
    competition in standards could weaken (although not entirely eliminate)
    political influence on standard setting. At the very least, constrained
    competition is worth a real try, there being no other obvious solution
    to the problem of undue political influence.
        Finally, what if after a reasonable period of competition one of
    the standards was driven out of the market, much as has happened in the
    markets for computer operating systems (for Intel-based personal
    computers) or video cassette tapes? If that is the result, then so be
    it. But given the international movement away from U.S. GAAP and toward
    IAS, it is likely that the loser in any competition would be U.S. GAAP,
    leaving IAS. But if national standard setters nonetheless continued to
    issue interpretations of IAS, then the market would not have moved to a
    single standard.

    Enforcement
        However much accounting standards may be perfected, investors will
    not be protected if the standards are not properly enforced by
    auditors. In light of the rising numbers of auditing problems in recent
    years, culminating with Andersen's widely publicized failures with
    respect to its audit of Enron, attention has properly been focused on
    how best to improve the verification of financial statements. There are
    two basic approaches, which are not mutually inconsistent, but ideally
    should be reinforcing: Improved monitoring or oversight of the auditors
    themselves and better (and more finely calibrated) incentives for those
    who conduct audits to carry them out properly.

    Monitoring
        I agree with others who have testified before this Committee who
    have criticized the current system of overseeing the auditing
    profession--a combination of self-
    regulation (and audit standard setting) by the AICPA and supervision at
    the State level. There is too much self-interest at the AICPA and its
    penalties are not credible, while State efforts lack resources and
    expertise.
        As the Committee is well aware, the most discussed reform of the
    existing enforcement system is the creation of an independent body
    reporting to the SEC that would set and enforce auditing standards. SEC
    Chairman Harvey Pitt has outlined, and the Administration has basically
    endorsed, such a proposal for a new Public Regulatory Board (replacing
    the previous Public Oversight Board) that would have authority to set
    auditing standards and to investigate and punish wayward auditors (even
    while charges are pending). Most of the members of the PRB would be
    independent of the accounting industry, while the functions of the
    Board would be
    financed by assessments on accountants and the firms they audit. So
    far, to the
    extent the Pitt proposal has been criticized before this Committee and
    elsewhere, it is because it is said to not go far enough. A good case
    can be made that all of its members ought to be independent of
    accounting profession, and that its investigatory powers ought to be
    strengthened by at least giving it subpoena power.
        If Congress is inclined to create a new monitoring authority like
    the PRB, then I agree with the SEC's critics on these points. But
    before Congress rushes to do this, I urge it at least to consider
    whether the SEC itself should be performing the oversight of auditors
    directly, although as I will argue shortly, it might make sense to
    establish a slimmed-down PRB to set auditing standards. Indeed, as I
    understand it, the Commission already has the requisite enforcement
    authority, but to the extent it doesn't, then Congress can easily give
    it what it requires. I cannot think of many examples in the Federal
    Government where enforcement authority like this is effectively
    contracted out to an independent authority. I used to work at the
    Justice Department, and we certainly did not contract out the entire
    enforcement job (although the Antitrust Division where I worked has
    engaged private counsel in
    specific, high-profile cases).
        Why then create an independent auditing authority? Certainly, it
    cannot be credibly claimed that the job of overseeing auditors is more
    complex than overseeing the stock exchanges, investigating fraud or
    insider trading, or carrying out the rest of the Commission's statutory
    agenda. If nonetheless the reason for contracting out the supervision
    of auditors is that the SEC is short of staff and resources, as it
    clearly is, then there is an easy answer to that problem: Give it the
    necessary resources and finance it by an assessment--or what is more
    accurately a user fee--on any one of all of the following: Accounting
    firms, the firms they audit, or investors. Indeed, whether or not the
    SEC assumes the power of the PRB, it needs more resources, not just for
    more people but to raise salaries in order to stem its high rate of
    turnover, and if some kind of assessment is deemed necessary to finance
    the extra funding, then Congress should impose it.\9\
    ---------------------------------------------------------------------------
        \9\ Last week, the Committee heard testimony about the inadequate
    resources at the SEC from the U.S. Comptroller General David Walker.
    ---------------------------------------------------------------------------
        If the reason for creating an independent board is to shelter it
    from political interference, then that argument, too, shouldn't be
    decisive. The SEC has effectively
    contracted out the setting of accounting standards to the FASB, but
    that has not prevented affected interests from influencing what the
    FASB does. In fact, precisely because enforcement is an inherent
    Government function that is carried out elsewhere by other Federal
    agencies, Congress quite properly exercises its oversight
    responsibilities over those enforcement efforts. It would be no
    different if the SEC were to oversee the auditing profession directly.
        The only plausible argument I have heard for creating the PRB is
    the claim that the enforcement of auditing standards requires an
    understanding of the intent behind the standards and so the two
    functions should be lodged in the same place. And since the thought of
    having the SEC write audit standards seems to many like a nonstarter,
    better to have both jobs carried out by an entity like the PRB under
    the SEC's oversight.
        My response to this line of argument is two fold. First, many
    regulatory agencies write complex rules that they enforce, so in
    principle there is no reason why the SEC could not do both. If the SEC
    felt it did not have the requisite expertise to amend or rewrite the
    auditing standards that already exist--something that has not been
    demonstrated is necessary, by the way--it could look to an entity like
    the PRB to write the ``first draft'' and then formally amend or adopt
    the standards and any subsequent changes to them.\10\ Second, even if
    the SEC delegates the writing of audit standards to a new PRB, it would
    still retain oversight over the organization. In this capacity, I do
    not see why the Commission and its staff, in carrying out their
    enforcement functions, could not be in regular contact with the members
    and staff of the PRB to clarify any possible misunderstanding over the
    meaning of particular audit standards.
    ---------------------------------------------------------------------------
        \10\ I do not believe there would be a significant danger of
    political interference in the setting of auditing standards, wherever
    that function is lodged, because of the highly technical nature of
    those standards and because it is difficult to predict in advance the
    impact on individual firms and industries of any generic audit
    standard. This is not the case with accounting standards (such as the
    expensing of stock options) whose effects are much more easily
    anticipated and quantified in advance.
    ---------------------------------------------------------------------------
        So, at the end of the day, I favor lodging the investigation and
    the enforcement
    functions overseeing the auditing profession within the SEC, while
    leaving the preparation and refinement of audit standards to an
    organization like the PRB.
    Better Incentives
        Putting the equivalent of more and better ``cops on the beat'' is
    not the only way to improve auditing. Harnessing incentives is just as,
    if not more, important because it may be cheaper and more effective.
        A number of incentives for auditors to perform their jobs already
    exist, of course. Auditors care about their reputations. And they
    certainly care about their liability exposure. Just ask the partners of
    Andersen who face potentially huge liability costs over and above the
    amounts that their insurer may cover. Or ask the partners of any other
    Big 5 accounting firm who must fear that the same thing could happen to
    them.
        A problem with liability-based incentives, however, is that they
    can lead to overkill--to excessive caution as an understandable
    reaction to the threat of going out of business. Are there other more
    finely tuned incentives that might help?
        The Administration has suggested that the CEO's repay any earnings-
    based
    bonuses if companies have to restate their earnings. This seems like an
    eminently sensible idea.
        Another frequently mentioned proposal is to prohibit auditors from
    doing some or all types of nonaudit work for their audit clients.\11\
    Some have suggested going further and limiting auditing firms only to
    audit work for all their clients. The rationale for these various
    limitations, of course, is to remove any incentives that auditors may
    have to compromise their audits in the hope of holding onto lucrative
    nonaudit business. In fact, because this view is so widespread and out
    of a desire to preserve the reputations of their audits, all of the Big
    5 firms, already have taken steps
    either to sell off some of their nonaudit businesses entirely (notably,
    information technology consulting) and/or not to perform nonaudit work
    for their audit clients. One question that you may want answered is
    whether these market-driven developments should be enshrined in some
    kind of legal prohibition on the nonaudit activities of auditing firms.
    ---------------------------------------------------------------------------
        \11\ The Administration's proposed prohibition would apply where
    the nonaudit service ``compromises the independence of the audit,''
    presumably something the SEC would decide, presumably by generic rule.
    ---------------------------------------------------------------------------
        I am skeptical about the value of any permanent prohibition, but
    not because I agree with those in the accounting profession who in the
    past have argued that there are positive synergies to being in both the
    audit and nonaudit businesses. My skepticism instead is based on the
    fact that even if audit firms are limited only to audit work for
    clients, they still face the prospects of losing their audit business,
    which in a world of restrictions, would be the only business they have.
    As a result, audit firms could very well have the same incentives to
    compromise the quality of their work as they allegedly did before. (My
    skepticism does not extend, however, to a prohibition on an outside
    auditor doing internal audit functions for the same client, which also
    appears sensible.)
        For the same reason, I am also somewhat skeptical of the value of
    another widely discussed proposal: The mandatory rotation of auditors
    every several years. It is possible, of course, that some auditors who
    know they are going to be replaced and have their work scrutinized
    closely by a successor, will be more careful in carrying out their work
    every year. Another effect may work in the opposite direction: Once the
    rotation is over, auditors may tacitly promise good treatment in the
    ``beauty contests'' that firms would hold on a regular basis in
    choosing their next auditor.\12\
    ---------------------------------------------------------------------------
        \12\ In addition, a mandatory rotation system would eliminate the
    market signal that comes about when a company now voluntarily changes
    its auditor.
    ---------------------------------------------------------------------------
        In short, as long as management continues to choose the auditor,
    the potential will always exist for a conflict that could compromise
    the quality of the audit. One response to this is to intensify
    oversight of auditors for precisely this reason, as already discussed.
    The other response is to mandate that managers of publicly-held
    companies not be able to choose their auditors.
        Who could do this instead? One obvious candidate is the audit
    committee, as several witnesses before this Committee have suggested.
    To maximize the committee's distance from management, it could be
    further required that all members of the audit committee on boards of
    directors be independent. Of all the options available, this is the
    best one, although I would caution it is not perfect (probably nothing
    is). Management can still exert a subtle influence--directly or
    indirectly--over even independent board members (who tend to be chosen
    or recommended by management, after all). In addition, for this option
    to really work, audit committee assignments probably would have to
    become far more time-consuming than attending quarterly board meetings.
    To this add the post-Enron fear of many directors of even serving on an
    audit committee, and it is all but certain that if the hiring of
    auditors is moved to audit committees, directors will not serve on them
    unless they are given much greater compensation than is now the case.
        More radical alternatives would shift the hiring of auditors to
    third party entities--such as the stock exchanges, the SEC, or perhaps
    the PRB (if it is created), assuming that there is no appetite for
    having any of these organizations engage in the auditing itself (a
    massive undertaking that I clearly would not recommend). Having any one
    of these entities engage outside auditors would totally sever the link
    between the auditors and the firms they audit, and thus solve the
    conflicts problem. However, there are numerous practical problems
    associated with the
    assignment of auditors to the roughly 12,000 public companies that
    would require
    audits. In principle, the assignments could be made through bids or an
    auction, but a potentially very large bureaucracy would be required to
    administer that process. Also in principle, the cost and complexity
    could be reduced if the rights to audit numerous firms were lumped
    together. But in practice, how would the groupings be made, and on what
    basis? To what extent would firms found to have committed negligence in
    one or more cases be restricted from bidding for the rights to other
    audits? And then there is the problem of ensuring that no single
    auditing firm or a select grouping of firms smaller than the Big 5
    effectively corners the market for audit services. This could be solved
    by imposing market share limits, but I fear such a step would also
    invite political interference into the auditor selection process
    (perhaps resulting in set-aside programs that might not be in
    shareholders' interests).
        In short, because the practical difficulties of implementing any of
    the more radical measures appear too great, I believe an acceptable
    compromise is a rule requiring auditors to be hired by audit
    committees.
    The Accounting Industry Post-Enron
        One issue that has received relatively little public discussion in
    the wake of Enron's failure is what should be the attitude of public
    policymakers to the possible failure of the company's auditor. Clearly,
    this is a delicate matter, since Anderson is doing its best--at one
    time, with the apparent encouragement of the SEC--to settle the
    litigation against it. But what happens if the cases aren't settled,
    while audit clients continue to leave the firm? \13\ It is certainly
    conceivable then that at some point the ``Big 5'' accounting firms
    reduce to the ``Big 4,'' either through the migration of Anderson
    clients and/or partners to other firms or the outright failure of
    Anderson itself. Should policymakers be concerned about this
    possibility?
    ---------------------------------------------------------------------------
        \13\ See, e.g., Kirstin Downey Grimsley, ``Freddie Mac Drops
    Andersen; Delta May Follow Suit,'' The Washington Post, March 7, 2002
    [noting that Andersen has so far lost three of its six largest audit
    clients].
    ---------------------------------------------------------------------------
        My very short answer is ``yes'' because an industry that is already
    highly concentrated--the accounting profession--would become more so.
    The thousands of publicly-held companies, not only here but worldwide,
    would have even less choice than they do now in auditors. With less
    competition, the result could well be higher prices and lower quality
    of auditing services.\14\
    ---------------------------------------------------------------------------
        \14\ The Big 5 not only dominate the U.S. auditing market, but also
    as of 1999, accounted for 77 percent of the revenues of the 40 largest
    international accounting networks. Furthermore, as of the same year,
    the Big 5 audited 98 of the top 100 companies in the world, measured by
    market capitalization. See Lawrence J. White, Reducing the Barriers to
    International Trade in Accounting Services [AEI Studies on Services
    Trade Negotiations, 2002], p. 14.
    ---------------------------------------------------------------------------
        Since all this could happen without a merger, there is effectively
    no role for antitrust to play to ensure no diminution in competition.
    (Although Andersen now is reportedly in merger talks with one or more
    of the Big 5, any deal could easily be held up because of Andersen's
    liability exposure.) The only other way that competition would not
    diminish if Anderson failed or dwindled in size is if new entrants were
    attracted to the auditing business, existing second-tier accounting
    firms captured more audit clients, or the Big 5 (or Big 4, as the case
    may be) split up voluntarily (there being no way to force their split
    up absent any proof of an antitrust violation).
        I do not know what public policy measures are or even should be
    available to
    encourage the split up of existing firms. Nor do I know what public
    policy, and perhaps specifically the SEC, could do to facilitate the
    entry of brand new firms to compete head to head with the Big 5 or the
    Big 4, or to somehow promote more use of the second-tier accounting
    firms right below the Big 5. At the very least, policymakers should
    signal their openness to entry and the use of second-tier firms
    (although the widespread concern about mixing audit with nonaudit
    functions will make it difficult for the Commission to encourage entry
    by firms in related fields, such as management consulting or financial
    services).
        The only other way in which the policymakers might be able to make
    a real contribution is to remove any legal restrictions (regulatory,
    tax, or otherwise) that may now impede foreign accounting networks from
    gaining the requisite licenses and competing here in the United States.
    Accordingly, at a minimum, I would urge the Committee to make inquiry
    of the SEC to determine whether there are any such restrictions--formal
    or informal--that now exist, either or both at the Federal and State
    levels. If such impediments exist, I would then strongly encourage the
    Commission, and if necessary the Congress, to remove them--without
    waiting for any international agreement to gain reciprocal treatment
    from other countries (although that remains a worthy objective).

    Beyond Enron
        Finally, there are a range of issues relating to disclosure that
    have little to do with Enron, that may have received more attention had
    Enron not happened, and that should eventually get that attention once
    the preoccupation with fixing what apparently went wrong with Enron and
    other recent accounting affairs diminishes.
        Peter Wallison is addressing in greater detail in his testimony one
    of these issues--the need for more and better nonfinancial information
    about companies than is now routinely generated. Here I refer to
    measures of consumer or worker satisfaction, product or service
    quality, successful innovation, education and experience of the
    workforce and management, and a variety of other nonfinancial
    indicators. Individually or collectively, these nonfinancial measures
    may shed far more light for investors on the future ability of firms to
    generate earnings or cash flow, and thus on the long-run fundamental
    value of their stock, than the figures in financial statements that are
    based on historical costs that are inherently backward looking. In the
    GAAP Gap we urge the SEC to use its powers of persuasion in this area,
    perhaps by beginning to convene working groups of experts from
    different industries, to encourage firms to make more of these
    disclosures, and to do so consistently and repeatedly.
        A second cutting-edge issue is how best to harness the power of
    technology--computers and the Internet--to facilitate more complete and
    more rapid corporate disclosure. One large-scale and potentially
    revolutionary private sector initiative that already is under way is a
    collaboration by a growing number of companies, accounting firms and
    the AICPA to develop a common ``tagging'' system for various financial
    accounts, which goes under the acronym ``XBRL.'' Once these tags are
    fully developed and implemented by companies, a wide range of users--
    not just sophisticated users like financial analysts--will be able
    easily to take very detailed data from companies and reconfigure it in
    multiple ways, using widely available spreadsheet programs.\15\ Here,
    too, I would urge the SEC (and if necessary, urge the Committee to urge
    the SEC) to encourage this project and do what it can to publicize its
    importance and encourage companies to participate in the process of
    developing tags for information that may be industry-specific. The
    Commission may also want to consider ways in which it could encourage
    companies to use the tags at the earliest possible date. One
    possibility: Require EDGAR submissions to be in XBRL by a specific
    date.
    ---------------------------------------------------------------------------
        \15\ This is currently not possible because although company annual
    reports and financial reports filed with the SEC are available online,
    they are in a format (HTML) that cannot be manipulated by users, but
    simply read and copied as a text file. The major aim of the XBRL
    project is to enable users to accomplish these manipulations themselves
    (by using a related language, XML) and also to locate companies and
    information through computer-based search engines.
    ---------------------------------------------------------------------------
        A related project is for the SEC to encourage more frequent
    reporting. Chairman Pitt's proposal (which the Administration has
    endorsed) to increase the number of ``significant events'' that must be
    disclosed as they unfold--in as early as 48 hours after they occur--is
    a move in the right direction.\16\ So is the Administration's proposal
    to require disclosure within 2 days when corporate officials sell their
    company stock.
    ---------------------------------------------------------------------------
        \16\ Such additional events include the departure of top executives
    and the loss or gain of an important customer or contract. Under
    existing rules, companies must file ``8-K'' reports on key intra-
    quarter developments within 5 to 15 days.
    ---------------------------------------------------------------------------
        But policy should not stop there. With the Internet, many companies
    now or may soon have the ability to make available to the public their
    financial reports much more frequently than on a quarterly basis--
    weekly, if not daily. Indeed, financial institutions already typically
    balance their books every night. Why not then consider ways to have
    this financial information communicated in the same time frame?
        There will be objections to encouraging companies to make available
    unaudited financial information more quickly, but I believe these
    objections can be met. As it is now, quarterly financial data are
    unaudited and will remain that way unless the SEC or a new PRB come up
    with guidelines for more limited audits for more frequently reported
    data (in which case, liability thresholds would have to be adjusted to
    reflect any differences between the kinds of audits).\17\ In any event,
    the capital markets would become much more volatile if investors came
    to believe that all unaudited financial information were useless. Even
    in the wake of Enron, I believe that the financial data produced by the
    overwhelming preponderance of public companies still have use, and I
    further believe that market participants hold that view as well (if
    not, stock prices would be well below where they are now). Accordingly,
    if in an age of computers and the Internet companies have the ability
    to publish their financial statements more frequently than every
    quarter, why shouldn't public policy encourage that result?
    ---------------------------------------------------------------------------
        \17\ The Administration's proposal to require CEO certification of
    quarterly reports in addition to the annual reports may help, depending
    on the penalties and standard for invoking them. But the quarterly
    results still will be unaudited.
    ---------------------------------------------------------------------------
        Actually, there is an even more compelling case for more frequent
    financial disclosures. This Committee has heard complaints from many
    witnesses previously about the seemingly uncontrollable trend toward
    earnings management--or the manipulation of quarterly earnings reports
    to achieve or exceed market expectations. To his credit, former SEC
    Chairman Arthur Levitt was one of the first to sound the alarm about
    this practice, which is evidenced by the significant increase in
    earnings restatements over the past few years. The problem is that in
    reading through numerous descriptions of the problem, I have yet to see
    an effective solution for it.
        If, however, companies routinely reported their financial results
    much more frequently than every quarter, it is conceivable that
    investors and analysts would lose interest in the quarterly figures.
    Furthermore, it is highly doubtful that analysts would take the trouble
    to develop earnings forecasts more frequently than on a quarterly
    basis. Thus, there is a real chance that more frequent reporting could
    end incentives of managers--and their auditors--to engage in earnings
    management.
        At the same time, I would be the first to agree that mandating more
    frequent reporting at this point is premature. Many firms simply may
    not be able to comply with such a requirement, even over a period as
    long as a month. Or the cost of compliance may be prohibitive. The
    challenge is to find a way to provide incentives to the firms that are
    able to report more frequently than quarterly to do so. Here, too, the
    Committee could play a constructive role by asking the SEC to review
    the options, and at the very least, lead a visible campaign to
    encourage more rapid reporting more suitable to the Internet age.
        Finally, this Committee has commendably begun the process of
    exploring ways to improve financial literacy among the American public.
    Enron's failure has highlighted in the most dramatic way possible the
    need for diversification--especially in pension plans--which is one of
    the most basic financial lessons all Americans should know, as early as
    possible in life. In the same vein, I applaud the Administration's
    proposal to require companies to write their quarterly financial
    reports in ``plain English,'' which should improve information flow to
    those investors who invest in stocks directly (rather than through
    mutual funds). At the same time, however, I would caution that no
    amount of rule-writing or editing by the SEC relating to these plain
    English statements is likely to prevent the future Enrons that are
    intent on deceiving investors. Accomplishing that goal will require the
    implementation of the kinds of other measures I reviewed earlier in
    this testimony.

                                   ----------
                  PREPARED STATEMENT OF PETER J. WALLISON \1\
    ---------------------------------------------------------------------------
        \1\ Resident Fellow, American Enterprise Institute; Co-Director
    AEI's Project on Financial Market Deregulation.
    ---------------------------------------------------------------------------
                        Resident Fellow and Co-Director
                    Project on Financial Market Deregulation
                         American Enterprise Institute
                                 March 14, 2002

        Mr. Chairman and Members of the Committee: I very much appreciate
    the invitation to appear before you today to talk about the important
    accounting issues confronting this Committee--as well as investors,
    companies, accounting firms, and the Securities and Exchange
    Commission--in the wake of the collapse of Enron Corporation. Robert
    Litan has covered very comprehensively in his formal statement the
    various issues that are now the focus of public attention, and in
    general I can associate myself with the views he expressed.
        My testimony today, however, will look to the future, in large part
    because I believe that much of the current debate about the adequacy of
    Generally Accepted Accounting Principles--and whether they were
    properly applied or disregarded in the Enron case--may be beside the
    point. The fact is that GAAP accounting is becoming increasingly
    irrelevant for financial disclosure, and we must begin working on
    supplements and alternatives. I will attempt to explain why this is so,
    and discuss some of the ideas that seem necessary if we are to bring
    financial disclosure into alignment with where our economy is today.
    The accounting industry has foreseen this development, and has been
    working for years on how to address it. Much of what the industry has
    done, and much of what I will say today, is covered in a monograph, The
    GAAP Gap: Corporate Disclosure in the Age of the Internet, of which Bob
    Litan and I are the co-authors, published in 2000 by the AEI-Brookings
    Joint
    Center for Regulatory Studies.
        If there is any good that can be said to have come out of the Enron
    collapse it may be the sudden attention now being paid to the adequacy
    of GAAP accounting, and the possibility it creates that a better system
    of financial disclosure will emerge from this review. But if this is to
    happen, it is necessary that this Committee, policymakers generally,
    companies and investors, and especially the SEC, understand that in
    tinkering with GAAP they are in a real sense fighting the last war.
    Just as we are now realigning our military force structure to deal with
    terrorism instead of an attack by the Soviet Union in central Europe,
    there is a need to get started on the process of revising our financial
    disclosure system to deal with major changes in our economy.
        We are all very proud--and deservedly so--of the quality of our
    capital markets. The ease with which companies can obtain capital
    financing is one of the reasons we have the most powerful and
    successful economy in the world, and why ambitious and skilled people
    from all over the world want to come here to take advantage of the
    opportunities our economy offers.

    The Importance of Information
        But it is clear that our capital markets would not function nearly
    as well if investors did not have the information they need. Without
    information, investors are
    simply guessing, and when they do that they demand higher premiums or
    rewards to cover the additional risk they incur. This makes capital
    more expensive, and poor information reduces the efficiency with which
    capital is allocated among competing uses. Good information, on the
    other hand, reduces the uncertainty associated with making investments,
    and thus reduces one element of investment risk. Reduced investment
    risk in turn reduces the cost of capital. Lower capital costs generally
    means that more capital will be available for companies that need it,
    that capital will be allocated more efficiently, that we will have
    faster and broader-based economic growth, and that the welfare of all
    Americans will be enhanced.
        But despite the importance of the information, and the legal
    structure we have
    erected in the United States to assure its disclosure, recent changes
    in the economy have made it difficult for investors to get the
    information they need for evaluating companies. This is not because
    companies are withholding anything they are otherwise required to
    disclose, or that existing laws and regulations are not being
    vigorously enforced. It is because the nature of the assets on which
    most public companies now rely to generate cash flows and profits have
    changed so radically in the last quarter century that we literally do
    not have the skills or means to describe their value.

    Intangible Assets
        According to some estimates, about 80 percent of the value of
    companies listed in the S&P 500 is attributable to their intangible
    assets. This represents an important change in how our economic system
    creates value, but it requires a momentous change in how we account
    for, report on, and disclose the financial significance of that value.
        What are intangible assets, how do they differ from tangible
    assets, and what is the significance for financial disclosure of their
    coming to dominate the assets of American companies?
        We have all heard of the so-called ``post-Industrial economy,'' the
    ``information economy'' and the ``knowledge economy.'' These by now
    cliched terms refer to something real and undeniable--that the U.S.
    economy has moved from an industrial or manufacturing economy to one
    that creates value through services and the productive use of knowledge
    and information. Computer software and pharmaceuticals are two examples
    of products that are in one sense manufactured but in a more important
    sense are the products of human knowledge and skill rather than
    machinery or equipment. In other words, the value of these products is
    the knowledge and skill that went into creating them, not the few cents
    worth of plastic in each disk or the insignificant cost of the
    chemicals in each pill.
        The assets used to produce these disks and pills are classic
    intangible assets--they exist only as ideas and concepts in the brains
    of the scientists and technologists who conceived and developed them.
    They cannot be touched, and in many cases they cannot even be sold.
    Stranger still, because they consist of the skills, knowledge,
    education, and imagination of a company's employees, they are not even
    owned by the companies which receive the cash flows from the sale of
    the goods or services these knowledge assets have produced. For this
    reason, the assets that are responsible for the cash flows of many--
    perhaps most--U.S. public companies do not and cannot appear on their
    balance sheets.
        In addition, the productive assets of many companies include
    patents, trade secrets, formulas, computer programs, and other items
    that embody ideas or knowledge--and belong to the company--but were
    internally generated within the company and have values in terms of
    their revenue generation potential that far exceed their development
    costs. One of the unique characteristics of the knowledge economy is
    that companies develop their productive assets themselves, internally,
    rather than purchasing these assets the way industrial companies
    purchase machinery and equipment. Because there is no purchase
    involved, the cost as well as the value of internally developed
    knowledge assets is inherently uncertain.
        We can also go one step further: Most companies depend for their
    success on their reputation--the views that their customers and
    suppliers hold concerning the quality of their products or services and
    the honesty of their dealings. In other words, whether such a company
    is able to generate revenues may depend on the views of others about it
    and not on anything we can actually see or touch. Obviously, the views
    of others are not recorded on a company's balance sheet.
        eBay, the online auction system, is a good example of a knowledge
    economy company. It has a market value of about $14 billion and a book
    value of $1.4 billion. What is the driver of eBay's value? It has no
    inventory, warehouses or sales force. The only thing it has is the
    reputation it has built among the public, linked to a sophisticated and
    specially designed computer software system--neither of which can be
    valued fully by referring to their cost. That is why eBay's market
    value is so much larger than its balance sheet net worth.
        Even Enron can be analyzed in these terms. For all the financial
    and accounting chicanery that may have occurred in the Enron case, the
    company's collapse to virtually nothing was the result of a massive
    loss of confidence in the honesty of its management. As a trading
    company, the company relied on reputational assets to remain in
    business, and when this asset was dissipated there was virtually
    nothing of value left.
        Since both eBay today, and Enron when it functioned, consisted of
    little more than a collection of intangible assets, the question a
    prospective investor might ask about both of them is how one might be
    able to tell, at any point in time, whether its intangible assets are
    increasing or decreasing in value?
        Now, we are getting close to the issue. If you were an investor,
    and were considering the purchase or sale of a company's shares, you
    would want to know not just what the company had done in the past but
    what it was likely to do in the future. In fact, since your investment
    is all about the future, you would want to know as much as possible
    about what was producing the earnings or cash flows that are recorded
    in its financial statements, and whether those assets are likely to
    continue to produce those cash flows.

    The Effect of Intangible Assets on Balance Sheet Values
        To find this information, you certainly wouldn't look at the
    balance sheets of companies like eBay, because few of the assets that
    are generating its cash flows--the knowledge embedded in the software
    it uses, or the degree to which its services are valued by its
    customers, for two examples--are on its balance sheet. These intangible
    assets--the real source of its earnings and cash flows--are not
    captured by GAAP accounting, or for that matter by the International
    Accounting Standards that some regard as an alternative to GAAP. In
    Enron's case, the question would have been--as it is with all trading
    firms--whether they were building confidence and reputation in the
    market or depleting it.
        In other words, in an economy where the principal assets that
    generate revenues and cash flows for companies are intangible assets,
    GAAP financial statements are useless to provide the information that
    investors really need--information about the quality or value of the
    assets that will produce these revenues and cash flows in the future.
        It is important to understand that this is something new. When a
    company decides to build automobiles, it purchases the land, the
    factory and the equipment. These have a cost that can be readily
    ascertained and recorded on financial statements. This meant that the
    cost of the assets on a company's balance sheet were a reasonably good
    reflection of the company's actual value--since one could simply
    reproduce the same company by purchasing the same inputs. In theory, a
    company could be liquidated for the book value reflected on its balance
    sheet.
        That is not true of companies that rely on knowledge. One cannot
    simply reproduce Microsoft or Merck by buying their offices, research
    labs, and other facilities. They are collections of employees--
    biological scientists, computer specialists, and chemists--whose
    knowledge and skill create the values of these companies. And although
    research and development costs might appear on a corporate balance
    sheet, those costs do not include the actual value of the education,
    imagination or resourcefulness of their employees and management--all
    of which continue to belong to these individual employees.
        So when some sources estimate that 80 percent of the assets of the
    S&P 500 are intangible assets that is a fairly significant statement.
    It means that perhaps 80 percent of the assets that produce the cash
    flows and earnings of these companies will not appear--indeed can never
    appear--on their balance sheets.
        The reason for this is that conventional (GAAP) accounting
    establishes value with reference to costs; it has no effective means
    for recording the value of the intangible assets internally generated
    by companies. To be sure, these have a cost of some kind--salaries,
    laboratory equipment and the like--but these costs do not capture the
    real value of the assets that are being put to work. Before the advent
    of the knowledge economy, when goods rolled off factory assembly lines,
    it was possible to get a good sense of an industrial company's value by
    looking at its balance sheet. One would know, within certain
    limitations, that if the company ultimately became bankrupt because of
    mismanagement its assets still had value, since they could still be
    used to produce goods and could be sold to someone who would use them
    more effectively. Indeed, until the 1970's, the market values of
    companies did not depart significantly from their balance sheet values.
    But as the knowledge economy developed, the ratio of market value to
    book value of public companies began to grow, so that in 2000 it had
    reached 6 to 1. Obviously, investors were valuing something other than
    what appears on balance sheets, and it seems reasonably clear that they
    were placing a value on intangible assets of these companies, even
    though these did not for the most part appear on their balance sheets.

    The Effect of Intangible Assets on Income Statements and Price/Earnings
            Ratios
        Now it might be objected that balance sheet values do not really
    matter anyway--that in the knowledge economy what investors are looking
    at is earnings, and the price/earnings (P/E) ratios of public companies
    are what is important. Let's leave aside for the moment the question of
    how an investor can have confidence that a company will earn in the
    future what it has earned in the past--something that comes from an
    assets of its productive assets and of course cannot be determined from
    an income statement. Instead, let's focus on what the GAAP income
    statement reports. Why is that statement not sufficient to give
    investors the information they need about companies in the knowledge
    economy?
        The answer is that, once again, the inability to value intangible
    assets internally generated by companies creates distortions in income
    statements, making price/earnings ratios and other similar comparisons
    also unreliable.
        A very good example of this problem is furnished by AOL's
    settlement several years ago of an SEC charge that, in capitalizing its
    customer acquisition costs during the years 1994 through 1996, it
    adopted a misleading accounting treatment. Many of us saw evidence of
    the enormous amount AOL was spending on customer acquisition in those
    years, because we received unsolicited disks in the mail with which we
    could sign on to AOL and try its services. When a company capitalizes a
    cost like this, it means that it is treating the cost as though it were
    an investment rather than an expense. In GAAP accounting, of course,
    cash spent on an investment has no impact on earnings except through
    depreciation over a subsequent
    period of years. In capitalizing its customer acquisition costs, AOL
    claimed in effect that these costs were producing an intangible asset--
    customers who would use its services in the future--and that the proper
    accounting treatment would be to capitalize them when they occurred,
    and to amortize or depreciate them against the earnings from these
    customers in future years.
        The SEC disagreed. It argued that by capitalizing these very large
    costs AOL showed earnings in 1994 through 1996, when--if it had written
    off these costs as incurred--it would have shown losses for those
    years. In 1997, under pressure from the SEC, AOL changed its accounting
    treatment, so that it expensed its customer acquisition costs.
        Was this the right treatment? The answer--in light of later
    developments--is clearly no. AOL, as we all know, turned out to be a
    great success, largely because it accumulated a huge number of
    customers before anyone else. This is a network phenomenon, now well-
    known, in which each additional customer adds value to those already on
    the network and the network itself becomes more valuable as it acquires
    new subscribers. In other words, AOL's customer acquisition costs
    really were investments, since they produced a very large, profitable,
    and ultimately market-dominating customer base. But because these costs
    were--at the SEC's insistence--written off (expensed) as they were
    incurred, AOL's current earnings were in effect understated for the
    years in which this accounting treatment was required.
        Let's stop for a moment and consider what effect this had on the
    price/earnings ratio for AOL's shares. Before the write-down required
    by the SEC, let's say AOL had a P/E of 50--very high by historical
    standards. After the restatement of its earnings--because it now showed
    losses in each of the 3 years--it had a P/E for those years that was
    essentially infinite. Market commentators and analysts who looked at
    AOL's GAAP earnings (or lack thereof ) would conclude that it was
    vastly overvalued based on this enormous P/E.
        But as it turned out, AOL's original treatment was correct. It was
    making an investment when it spent so much to gain customers. We can
    see that now. But if an investor at the time recognized the value of
    what AOL was doing, he or she might have been willing to pay quite a
    lot for the company even though it was showing losses. In other words
    that perceptive investor would have realized that AOL was creating an
    intangible asset that had considerable value because it would generate
    enormous profits in the future. In fact, the cost of building this
    asset, because it was reducing current earnings, actually made the
    company look worse, probably lowering the market price at which our
    savvy investor could acquire shares.
        This example shows that in a knowledge economy seemingly
    sophisticated commentary about companies or a whole market being
    ``overvalued'' because price/earnings ratios are high by historic
    standards can be quite misplaced. Investors, as in the case of AOL, may
    be placing values on internally generated intangible assets the costs
    of which are being written off as incurred under prevailing GAAP
    accounting. This treatment both reduces earnings--thus increasing P/
    E's--and hides from investors with less sophistication the development
    of an asset that will be responsible for large cash flows in the
    future.
        It is important to mention here that there is no cure for this
    problem in GAAP accounting. If AOL had turned out to be a failure, the
    accounting treatment demanded by the SEC might have been seen as the
    right one. The asset that AOL thought it was building was not worth the
    cost. The losses from 1994 through 1996 were real losses, and to the
    extent that investors were warned off the company by these losses they
    would have been saved some losses of their own.
        How can investors tell the difference? They probably cannot in any
    precise way. They may be guessing, but overall--given the wide
    divergence between market values and book values, and the historically
    high P/E ratios in today's markets--they are seeing something in
    companies that conventional accounting is not recording.
        This situation is not the result of a deficiency in the skills or
    imagination of the accounting profession. There is simply no reliable
    way to place a value on internally generated intangible assets--to
    measure the value of the asset AOL was building through its customer
    acquisition costs. There is no market for most intangibles,
    especially those that are unique to the company that created them, so
    there is no known way to establish their value for balance sheet
    purposes.
        This is not a healthy situation. If financial statements do not
    allow investors to understand the real value of a company, if investors
    are left to guess, they are taking risks. Risk, as I noted above,
    raises the cost of capital, promotes volatility, and ultimately
    distorts the allocation of capital.
        In other words, the almost 60 year effort to create a more
    efficient market--in large part by making sure that investors have the
    information they need--has been at least partially defeated by the
    advent of changes in our economy. These changes have made intangible
    assets the real drivers of company value, but this has happened before
    we have had an opportunity to develop the means to assess and to
    communicate what these assets are actually worth. The result is an
    increasing discrepancy between what financial statements are telling us
    and what the market sees--and hence more uncertainty, more volatility,
    higher than necessary capital costs, and less efficiency in the
    allocation of capital in our economy.

    Data Elements and Real Time Financial Reporting
        There are also other inherent problems with financial statements
    that are worth noting. For one thing, they are inherently backward-
    looking. They tell us what happened to the company over the last
    quarter, or the last year, but not much about what will happen in the
    future. In fact, under some circumstances financial statements can be
    actively misleading about the future.
        Take the case of Xerox Corporation. While Xerox was exploiting its
    patent--from the mid-1950's through roughly the mid-1970's--it was a
    very profitable company. Unfortunately, however, the copiers that the
    company was producing, while in high demand because of their unique
    features, were highly unreliable and frequently needed repair. The
    company found that by selling the copiers instead of renting them it
    could make even more money--first on the sale, and then by charging for
    repair services. So until its patent expired, Xerox showed increasing
    earnings.
        However, as soon as competitors were able to use its technology,
    Xerox was nearly driven out of business. The poor quality of its
    copiers had infuriated customers, and as soon as they had a choice they
    changed brands. In other words, even though its financial statements
    were showing healthy and profitable growth, the company was hollowing
    out. Investors who relied on Xerox's financial statements, and did not
    know the degree of its customer dissatisfaction, were in for a shock.
        Here again, we encounter an intangible asset--customer
    satisfaction--that does not appear on a balance sheet and yet can be
    more important for predicting the
    future than what does. In other words, financial statements, because
    they are
    backward-looking, are inherently deficient in the information that
    investors want most to know about--the company's future. What is needed
    is information that supplements the financial statements--that provides
    some indication of the company's prospects.
        Finally, financial statements suffer from one other inherent
    deficiency. They are issued periodically--quarterly or annually.
    Between these reports, the market is full of speculation about what
    they will contain. This speculation adds to uncertainty and volatility,
    and therefore to risk. The way financial statements are prepared--
    involving decisions by management and the aggregation of many different
    items into a relatively few lines--this delay is probably unavoidable.
    But that should not necessarily mean that all data on a company's
    operations has to be issued at periodic intervals.
        In the past, when it took a while to assemble financial and other
    data, periodic releases were unavoidable. Today, however, when a good
    deal of information is available to management in real time, there is a
    question whether some of it could not be released more quickly. In
    fact, the delayed release of financial data may be leading to earnings
    management--where companies coach analysts to reach conclusions
    concerning the company's earnings, and then companies come forth with
    earnings that slightly beat these estimates. If this is happening, it
    further suggests that investors' lack of confidence in financial
    statements is well founded.
        The accounting profession has been developing ways for companies to
    make financial disclosures on a more timely basis--in some cases
    virtually in real time--and this subject is covered in The GAAP Gap and
    in the formal testimony of my colleague Bob Litan.
    Possible Solutions and the Obstacles They Face
        It seems clear then that our economy--as it comes to rely
    increasingly on intangible assets as the source of company values--must
    have some way to assess the quality of these assets. We must recognize
    that GAAP accounting can never do this, and may in fact distort
    perceptions of value.
        The inherent deficiencies in financial statements have drawn the
    attention of the accounting profession. As early as 1991, the Financial
    Accounting Standards Board (FASB) issued a report--now known as the
    Jenkins Report--concluding that the information furnished by companies
    should be forward-looking and user-driven.\2\ As the problems
    associated with intangible assets became more pronounced, accounting
    firms themselves began developing ideas for ways in which companies
    might communicate the value of their intangible assets and how they
    were meeting their goals.\3\
    ---------------------------------------------------------------------------
        \2\ American Institute of Certified Public Accountants, Improved
    Business Reporting--A Customer Focus, http://www.aicpa.org/members/div/
    accstd/ibr/appiv.htm, February 21, 2000.
        \3\ See, e.g., PricewaterhouseCoopers, ValueReporting Forecast
    2000, 1999.
    ---------------------------------------------------------------------------
        On an official level, the Organization for Economic Cooperation and
    Development (OECD), which is a program supported by many of the major
    industrialized nations, has begun an intensive effort to find and to
    develop nonfinancial indicators or measures that would permit investors
    to assess the prospects of companies or the value of their intangible
    assets. The indicators are nonfinancial in the sense that they involve
    information that does not appear in financial statements.\4\
    ---------------------------------------------------------------------------
        \4\ Organization for Economic Cooperation and Development,
    ``Public-Private Forum on Value Creation in the Knowledge Economy--
    Overview,'' 2000, http://www.oecd.org/daf/corporateaf
    fairs/disclosure/intangibles.htm.
    ---------------------------------------------------------------------------
        To take the AOL and Xerox examples, the hope would be that
    nonfinancial indicators or measures could be developed that would have
    allowed investors and analysts to get a better picture of whether AOL's
    customer acquisition costs were likely to pay off in the future, or
    that Xerox was incurring customer enmity rather than fostering customer
    satisfaction. In both cases, a great deal of uncertainty would have
    been eliminated, investors would have a better sense of how to value
    the intangible assets of both companies, and the securities markets
    would have functioned more efficiently.
        Thus, many groups see the need for making useful nonfinancial
    information available to investors. But up to now progress has been
    slow.
        First, there is really no comprehensive theoretical framework for
    the development of this information. There hasn't been any significant
    testing of the efficacy of various indicators, there are no universal
    indicators that could be applied to all businesses, and there are very
    few for specific industries or activities. In research for The GAAP
    Gap, I came across a few suggestions for indicators, and I have
    attached a list to this testimony, but as far as I know none of these
    indicators is now being used by a U.S. public company as part of its
    regular disclosures to investors.
        Second, there is concern among companies in proceeding down this
    road. Companies say that they are concerned that the information they
    will have to disclose will be helpful to their competitors, or that
    disclosures will result in legal liability. There is some merit in
    these concerns, but they may be somewhat exaggerated.
        Third, many companies see no value to them in taking the trouble to
    develop indicators, or the information that the indicators would
    require them to disclose.
        On the other hand, there are several areas where businesses are
    already cooperating in activities that are closely related to the
    development of indicators that would be useful for investors.
        First, many industries participate in a process called
    ``benchmarking,'' in which they seek to develop the best practices by
    exchanging information about the way they conduct certain kinds of
    operations, such as employee recruitment and training. Testing whether
    these practices are effective involves statistical comparison of
    indicators.
        Second, a number of industries are currently developing supply
    chain standardization, so that they can save procurement costs by
    creating accepted definitions for commonly used parts and services.
    This would enable a manufacturer, for example, to solicit bids for a
    particular part from a worldwide group of potential suppliers--all of
    whom would understand the specifications the manufacturer desires
    without having to meet and discuss them. The definitional problems
    associated with this activity is not far removed from what would be
    required to develop common measures or indicators.
        Finally, for a number of years businesses have been developing, for
    internal use, indicators that tell management whether and how well a
    company is achieving its goals. These indicators are not shared outside
    the company, but they could be. In fact, a few companies do make some
    of their internal indicators public. Skandia International Insurance
    Company, a large Swedish insurer with a worldwide financial services
    business, has for almost 10 years been making public, in time series,
    the indicators it uses to measure the success of some of its
    subsidiaries.
        To be sure, even if these internal indicators were made public they
    would still not permit the comparisons across competing companies that
    would be most useful to investors. Before this might be possible,
    certain indicators would have to gain industrywide acceptance.
    Nevertheless, making public the results of company-specific
    indicators, in time series, would be a good start. It is important to
    remember that Generally Accepted Accounting Principles--on which we
    rely today to make comparisons among companies--hardly existed as late
    as the 1950's. Financial accounting is hundreds of years old, and for
    most of that time individual firms, and then whole industries, had
    unique ways of accounting and reporting their results. Although we do
    not have hundreds of years--or even half a century--to develop the
    indicators that are necessary to supplement financial statements, a
    good place to start might be with companies making public the
    indicators they use themselves.
        Finally, and perhaps most important, there is data indicating that
    increased disclosure can have the effect of lowering capital costs.\5\
    This stands to reason--since more information reduces uncertainty and
    hence volatility and risk. If this can be demonstrated to the
    satisfaction of companies-- either through analytical work or by
    observing experience of others--a virtuous circle could result, in
    which successful companies disclose extensive amounts of nonfinancial
    information in order to achieve lower capital costs, and others must
    follow suit in order to remain competitive.\6\ A lot of value could
    accrue to the first mover.
    ---------------------------------------------------------------------------
        \5\ Botosan, Christine A., ``Disclosure Level and the Cost of
    Capital,'' Accounting Review 72(3) (July 1997): 323.
        \6\ In working on The GAAP Gap in 2000, I was unable to find any
    firm that was actively in the business of developing indicators that
    would help clients ascertain the value of their intangible assets and
    eventually disclose this information as a supplement to their regular
    financial reports. Since then, I have come across Booth Morgan
    Consulting, LLC, with offices in Virginia and Connecticut, which does
    this for financial services firms.
    ---------------------------------------------------------------------------
        Thus far, I have discussed indicators that are derived or
    interpreted from operating or other data of public companies. But there
    is also a class of information that might be called data elements.
    These are raw financial or nonfinancial facts that generally do not
    require any interpretation or compilation. As I suggested above, the
    number of patent citations would not be an example of such an
    indicator, since it requires the distillation of information from a
    number of sources. On the other hand, a data element might be a
    company's daily sales. This is the basic information a company uses to
    prepare its financial statements. Data elements can also be
    nonfinancial information, such as the number of employees--assuming
    that the term ``employees'' is suitably and precisely defined.
        This data can also be disclosed, some or all of it in real time.
    The development of the Internet makes instantaneous communication, at
    virtually no communication cost, entirely feasible. In part, this would
    address the problem of periodicity in
    financial statements. If the market were to have access to significant
    information in real time it would put to rest a lot of speculation
    between quarters.
        But developments involving the Internet enable us to go a step
    further with this kind of quantitative raw data. A new Internet
    language known as eXtensible Markup Language, or XML, is now coming
    into common use. Up to now, information on the Internet has been stated
    in a language known as Hyper Text Markup Language, or HTML. HTML is
    basically a set of instructions to a display mechanism--a monitor or a
    printer--on how to display the document as a whole. It does not
    generally permit individual items of data to be identified and
    extracted from a document. XML, on the other hand, permits the tagging
    of individual items of data with definitions and context, so that they
    can be extracted from the document in which they are imbedded. The word
    ``bank'' in a document, for example, would be tagged with a definition
    that would distinguish its meaning as a financial institution from its
    meaning as the side of a river, allowing documents on the Internet to
    be word-searched and data to be extracted for other uses. The
    accounting profession has begun to develop an accounting application of
    XML, known as XBRL. The details of this innovation are covered
    extensively in The GAAP Gap and in Bob Litan's formal testimony today.
        Clearly, the disclosure of data elements in real time is far
    different from the use of indicators. For one thing, companies would
    simply be disclosing factual information. Assuming it is accurate,
    there should be little if any legal liability associated with
    disclosures of this kind. Moreover, it is far less costly to develop
    this information than to develop the information used in indicators,
    since by and large it is
    information that 20 companies maintain anyway--either to prepare their
    financial statements or for other business purposes.
        There is still the issue of providing useful information to
    competitors, but the question would be whether any of this data would
    provide as much useful information to competitors as the many things
    companies have to do ``in the clear''--such as building plants, making
    acquisitions, or hiring skilled personnel. In any event, whether
    information will be of use to competitors is a matter to be worked out
    in considering specific information, not a reason to reject the whole
    idea out of hand.

    The Role of Policymakers
        The issue for policymakers is how to stimulate the development of
    indicators and more attention to the disclosure of information in real
    time. The SEC has thus far taken no serious steps in promoting
    alternative or supplemental forms of disclosure, although under its new
    chairman there appear to be slight stirrings of interest. Nevertheless,
    SEC humility in this area would be well-advised. Companies, accountants
    and analysts can take the lead, and should.
        Indeed, SEC mandates of any kind would be highly counterproductive.
    As we have seen in the past, SEC requirements quickly produce
    boilerplate disclosures and stifle innovation. There are sufficient
    potential benefits for companies in the form of lower capital costs to
    believe that once the best companies start disclosing additional
    information--and seeing these benefits--others will feel compelled to
    follow suit.
        On the other hand, the SEC could perform a valuable role without
    issuing mandates. It could encourage voluntary action--convening groups
    of companies, dealing with objections, seeking solutions that attract
    support, emphasizing that investors need information in order to make
    rational choices. In my experience, companies are highly responsive to
    requests from the Government for new thinking; what they do not want to
    do is waste the time of their executives.
        In summary, then, there is clearly a current and growing need for
    information that supplements conventional GAAP financial statements.
    Indeed, the continued
    efficiency of our economic system depends on developing this
    supplementary information. Through the Internet, there are now
    inexpensive ways that this information could be made available to
    investors, and a strong basis to believe that both companies and
    investors will be benefited by such disclosure. What is needed,
    however, is the will among policymakers and businesses to proceed. This
    Committee could do much to encourage more attention to this question by
    the SEC.
        Mr. Chairman, that concludes my testimony. Thank you for the
    opportunity to present these views.
    Indicators Source:
        Elliott, Robert K., ``The Third Wave Breaks on the Shores of
    Accounting,'' Accounting Horizons 6(2) (1992): 61- 85 and Elliott and
    Peter D. Jacobson, ``Costs and Benefits of Business Information
    Disclosure,'' Accounting Horizons 8(4): 81- 82.

    Percent of sales from products developed in last x months

    Average time to bring a new idea to market

    Market's perception of quality of product

    Market's perception of quality of service

    Percent (or number) of customers accounting for x percent of sales

    Customers industry concentration

    Percent (or number) of suppliers accounting for x percent of purchases

    Suppliers industry concentration

    Age of units being replaced

    Up-time ratios

    Mean-time to failure figures

    Customer reorder rates

    Percent of revenue from new products

    Elapsed time from raw materials to finished goods

    Break even time--time required to recover development costs

        Jenkins Report: The American Institute of Certified Public
    Accountants, Improved Business Reporting_A Customer Focus
    http://www.aicpa.org/members/div/accstd/ibr/ppiv.htm, February 21,
    2000.

    Reject rate for products

    Patents obtained annually

    Customer satisfaction

    Number of design and installation contracts received

    Ratio of contracts awarded to number of proposals

    Market share

    Average number of employees

    Average consumption of materials per employee

    Value of purchased components as a percentage of sales

    Product-development lead time

        PricewaterhouseCoopers, Value Reporting Forecast 2000, 1999.

    Six financial drivers: Sales growth rate, operating profit margin, cash
        tax rate, working capital to sales, capital expenditure to sales,
        and cost of capital

    Four nonfinancial drivers: Process, growth, and innovation, people, and
        customers

    Market share

    Share of customer spending

    Customer satisfaction

    Research and development productivity measured through number of
        patents per R&D dollar

    Size of its new product pipeline

    Time between development and marketing

    Time spent by employees on product innovation

    Relative strength of the company's brands in relation to competitors'

    Process costs per transaction

    Ranking in cross-industry benchmarking studies

    Efficient use of office space

    Outsourcing of nonvalue-adding activities to others who can perform
        more efficiently

        Kaplan, Robert S. and David P. Norton, The Balanced Scorecard,
    Harvard Business School Press, Boston, 1996.

    Revenue from new products

    Gross margins from new products and services

    Percentage of revenues from new customers, market segments or
        geographic regions

    Percentage growth of business with existing customers

    Number of responses to solicitations, or the conversion rate at which
        customers responding to solicitations actually purchase goods or
        services

    Solicitation cost per new customer acquired, or new customer revenues
        per dollar of solicitation cost

    Breakeven time, or BET, measures the time it takes for a new product to
        recover its development costs

    Gross margin from new products

    Number of employees qualified for specific functions that the company
        will need in the future

     RESPONSE TO WRITTEN QUESTION OF SENATOR MILLER FROM JAMES G.
                               CASTELLANO

    Q.1. On March 8, 2002, The New York Times ran a story entitled
    ``A Market Solution to the Accounting Crisis'' by Joshua Ronen.
    Mr. Ronen suggests, ``instead of appointing and paying
    auditors, corporations should be able to buy financial
    statement insurance.'' He says this would protect investors
    against losses suffered as a result of misrepresentations in
    financial statements.'' And he says it would ``redirect the
    auditor's loyalty to where it belongs: A corporation's
    employees, creditors, and shareholders.'' What do you think of
    this idea?

    A.1. We have a number of concerns regarding Mr. Ronen's
    proposal. His proposal would move the independent audit from
    one of assurance to one of insurance. In other words, it would
    shift the auditor's report from one that says to the public
    that in the auditor's opinion, the company's financial
    statements, in all material
    respects, present fairly the financial position and results of
    operations of the company in accordance with Generally Accepted
    Accounting Principles. An auditor's report under Mr. Ronen's
    proposal would say that if there is an error in the financial
    statements, there is insurance to cover the losses. It would
    not address the
    accuracy of the statements. Even if the public believe they
    would
    ultimately be paid for any losses suffered as a result of
    reliance on financial statements containing material error,
    this would not enhance investor confidence. Knowing that it
    might be years before any damages are paid is a disincentive.
    The public needs to feel that the financial statements are
    materially accurate.
        We do not have the insurance expertise to comment on Mr.
    Ronen's assertions that insurance companies would be happy to
    have this new business and that costs would not rise as a
    result of the new insurance product he is advocating. However,
    reflecting back on the banking and S&L crisis of the late
    1980's and early 1990's, when the FDIC sued many directors of
    failed banks, we note that D&O insurance became extremely hard
    to purchase and increased in cost exponentially at that time.
    We note that damages for audit failures can be massive and must
    therefore question both the appetite of insurance companies to
    take on such a huge underwriting risk, and the assertion that
    costs will not increase.
        The proposal would have the insurance carrier appoint and
    pay the auditor to assess the financial condition of the
    prospective client. Given the cost of an audit, we do not
    believe that an insurance company would be willing to pay the
    large audit fee for the assessment, knowing that it would have
    to swallow the cost if it decided not to insure the company.
    And a company would balk at paying for the assessment knowing
    that if the insurance company decided not to give it insurance
    coverage, it would have to pay for another assessment with
    another carrier. And if no carrier would insure the financial
    statements of a company, there would be no protection for the
    public because the financial statements would be unaudited.
        We also believe that insurance companies would base part of
    their underwriting on the condition of the company, and not the
    accuracy of the financial statements. If a company fails, or
    has losses that result in a reduction in its stock price, the
    probability of a lawsuit alleging accounting irregularities is
    high. Thus, companies in poor financial condition that have
    accurate financial statements would be unable to acquire the
    insurance, or would have to pay an exorbitant premium for the
    insurance. And the company would then not have an audit. This
    would deprive the public of having the assurance that the
    financial statements are audited.
        The interests of an insurance company and the interest of
    investors are quite different. The insurance company looks to
    minimize its risks for the protection of its shareholders. It
    would inject itself into the decisionmaking process that occurs
    during an audit. And it would do so without the expertise
    needed to make the appropriate decisions. One needs only look
    at the managed care field where insurance companies make
    decisions regarding medicines that can be prescribed, and
    medical tests and procedures that can be used based an cost
    considerations, and not on the informed medical judgment of the
    treating physician. This type of decisionmaking process
    regarding the conduct and findings of an audit would not
    protect the public interest.
        Mr. Ronen bases his idea on the erroneous theory that the
    auditor's loyalty is misplaced. That is not true. Seventy years
    ago the Congress determined that the auditor's independence
    would not be compromised if the auditor was hired and paid by
    the company. We continue to believe that the auditor's
    independence is not compromised because the auditor is hired
    and paid by the company.
        In fact, the success of the profession in protecting the
    public interest is impressive. Of the small number of instances
    where there has been an audit failure, many were caused by
    company fraud perpetrated on the auditor. The profession has
    been working to upgrade auditing procedures that will ferret
    out such fraud, and recently issued proposed audit standards
    that will help to uncover any such attempts.
        The balance of the failures are caused by human error--
    something that will unfortunately occur in every human
    endeavor. Such failures result in disciplinary action being
    taken against the auditor. The profession requires an extremely
    tough and comprehensive exam to become a CPA, and has extensive
    continuing education requirements and disciplinary deterrents
    to keep auditors an their toes and to keep the instances of
    human error at a minimum.
        To further ensure that the audit will be free from error,
    the profession has endorsed unprecedented and rigorous reforms
    in the discipline and quality monitoring of the accounting
    profession. While self-regulation has been a hallmark of our
    profession for nearly 110 years, we appreciate that the times
    call for such measures to restore investor confidence. This new
    disciplinary and quality monitoring body would look at
    independence, auditor performance, and firm quality control on
    a continuing basis and would help to ensure the highest
    standards of independence exist in every audit.

     RESPONSE TO WRITTEN QUESTION OF SENATOR GRAMM FROM ROBERT E.
                                 LITAN

    Q.1. Would you provide for the Committee your views as to why
    there is such heavy market concentration at the top of the
    accounting industry? In other words, the industry is divided
    into two groups, the Big 5, and everybody else, with a huge gap
    in market share between the two groups. Why is the industry so
    dominated by the Big 5, and why over the last several decades
    has the number of firms in the dominant group declined, with no
    new entrants from below?

    A.1. The answer to the questions about how we got to the Big 5
    is quite easy: Mergers. Of course, at the time of the various
    merger, there were those who worried about growing
    concentration in the industry, but under the conventional
    yardsticks used to judge mergers, the various transactions
    passed muster, and if they had been challenged in court, I
    suspect that Justice would have lost.
        As for the lack of new entrants into the upper tier, the
    explanation is probably two fold. For one thing, there
    certainly appear to be economies of scale in auditing, although
    it is not clear at what point they are exhausted. Second, there
    appears to be prestige value for listed companies to have one
    of the Big 5 do their audits--at least until Enron. Much the
    same effect is at work in investment banking, where it is
    difficult for lower tier firms to break into the top bracket.
    The open question now is whether in the wake of Enron, some of
    the prestige associated with a Big 5 audit will wear off and
    allow lower tier firms to move up. Only time will tell.

     RESPONSE TO WRITTEN QUESTION OF SENATOR MILLER FROM ROBERT E.
                                 LITAN

    Q.1. On March 8, 2002, The New York Times ran a story entitled
    ``A Market Solution to the Accounting Crisis'' by Joshua Ronen.
    Mr. Ronen suggests, ``instead of appointing and paying
    auditors, corporations should be able to buy financial
    statement insurance.'' He says this would protect investors
    against losses suffered as a result of misrepresentations in
    financial statements.'' And he says it would ``redirect the
    auditor's loyalty to where it belongs: A corporation's
    employees, creditors, and shareholders.'' What do you think of
    this idea?

    A.1. This is an interesting idea, with a very worthy objective:
    Having the auditors work for someone else other than
    management. Nonetheless, this proposal is likely to have the
    same practical problems I raised in my testimony with respect
    to other third parties: How to manage the selection of auditors
    for over 10,000 listed companies.
        There is nothing stopping the insurers from adopting the
    Ronen solution now; the real question is why no insurer has
    offered such coverage voluntarily. I suspect it is because of
    the daunting problems involved in picking the insurer, as well
    as because no corporation--or precisely, no management--yet
    sees it within its financial interest to let the insurer hire
    the auditor.
        It is possible that if, by law, listed firms were required
    to let their audit committees choose the auditor, the
    incentives might change. With the decision to hire the auditor
    lodged in some persons outside management, it is conceivable
    that insurers might develop the product Ronen advocates because
    there might be some demand for it.
        A more direct solution, of course, would be to prohibit
    companies from hiring their own auditor. This would require the
    invention of an insurance scheme of the type Ronen suggests.
    But there is no certainty at the outset that enough capacity
    would exist to cover all listed companies. Such a step,
    therefore, would run a significant risk of leaving some
    companies uncovered altogether.
        These are initial impressions, and it may well be that the
    Ronen idea could be implemented in a way that surmounts these
    and possibly other practical objections. I would encourage the
    Senator's staff to discuss the idea more directly with Ronen.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                            TUESDAY, MARCH 19, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 9:35 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, the Senate Banking, Housing, and Urban
    Affairs Committee conducts the eighth in a series of reviews of
    accounting reform and investor protection issues raised by the
    problems of Enron Corporation, and other public companies.
    Today's hearing will focus on issues raised by the oversight
    and regulation of the accounting profession, corporate
    governance, and stock analyst conflicts of interest.
        These issues predate Enron's collapse. We have other
    examples of the problem. Nearly 20 years ago, the Supreme Court
    observed:

        By certifying the public reports that collectively depict a
    corporation's financial status, the independent auditor assumes
    a public responsibility transcending any employment
    relationship with the client. The independent public accountant
    performing this special function owes ultimate allegiance to
    the corporation's creditors and stockholders, as well as to the
    investing public. This ``public watchdog'' function demands
    that the accountant maintain total independence from the client
    at all times and requires complete fidelity to the public
    trust.

        The charter of the Public Oversight Board provides the
    following:

        The Public Oversight Board shall oversee the audit and
    independent standard setting, peer review, quality control, and
    monitoring bodies relating to . . . [the SEC Practice Section],
    which is composed of accounting firms that audit the financial
    statements of some 17,000 public corporations that file reports
    with the SEC member firms, in order to represent the public
    interest on all matters that may affect public confidence in
    the integrity, reliability, and credibility of the audit
    process.

        There is a sobering comparison to be made between that
    charter statement and the Resolution of Dissolution that the
    Public Oversight Board approved unanimously on January 20,
    2002, after voting to disband.
        We look forward this morning to hearing about the
    experiences of the Public Oversight Board with the major
    accounting firms and the SEC, as well as to hearing the
    recommendations of the Public Oversight Board members regarding
    regulation of accountants.
        I will defer my comments on other matters this morning,
    corporate governance and stock analyst conflict of interest,
    until we go to our second panel, which will be directed toward
    that subject.
        Before I introduce our other witnesses on our first panel,
    I will turn to my colleagues for any opening statements.
        Senator Gramm.

                     COMMENTS OF SENATOR PHIL GRAMM

        Senator Gramm. Well, Mr. Chairman, I will be brief because
    we have two panels this morning, and we also have a lot going
    on in the Senate, which is why many of our colleagues are not
    here. I am going to be in and out myself as we deal with
    campaign finance reform and as we deal with the energy bill,
    and an amendment that I am directly involved in.
        Again, as I have on several occasions, I want to thank you
    for the forward-looking nature of these hearings. It is my
    opinion that Congress, especially the Senate, has not covered
    itself in glory during this process. I think this Committee has
    done an excellent job.
        I think we have focused on the problem and what we have the
    legislative responsibility to do to fix it. I continue to
    believe that our mission is to try to determine what we can do
    to improve the current process, what are the benefits of making
    legislative change, what are the costs of making legislative
    change. And I think we have to come to a delicate balance of
    the two.
        As I have said on many other occasions, I am a firm
    believer in the legislative equivalent of the Hippocratic oath:
    First, do no harm. I believe that there are changes that need
    to be made, and I think there is a consensus for us to act
    legislatively. I think that this Committee has a very important
    responsibility in that if we can put together a bipartisan
    bill, I think it will hold up on the floor of the Senate and
    will ultimately become law.
        We have heard from many good witnesses in trying to focus
    our thinking on this subject. We have two excellent panels
    today. I look forward to hearing from them, and I want to thank
    each of you for coming and sharing your views and your
    experience with us. We are long on theory, but we are short on
    practical experience.
        I took two accounting courses. I liked both of them. But
    when they assigned the practice set in the second course, that
    was the end of my career as a college student in accounting. It
    was too hard and too boring, and I did not have the personality
    for it. That is why I got into economics.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you.
        Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. I once again thank you for this hearing.
    After that comment on accounting versus economics, I have a
    hard time having any kind of rejoinder.
        I always thought accounting was exciting.
        [Laughter.]
        And particularly, I want you to know that I support you
    completely in that concept.
        I will tell you that there was nothing more important than
    the day that I sat down with our auditors and signed our
    audited financial statements as a CEO.
        So, it got your attention then. It has my attention now,
    and it is has the country's attention and we will work hard to
    try to get to a responsible, balanced, and bipartisan view on
    how we should move forward.
        I compliment the Chairman and the Ranking Member for their
    leadership in this effort.
        Chairman Sarbanes. Thank you very much, Senator Corzine.
        I might say to my colleagues, we have two nominees that, if
    we get a quorum, we will consider here. If not, we will try to
    do it off the floor, two members of the National Credit Union
    Administration Board, on whom hearings were held a week or so
    ago. We would like to move them along, with the objective of
    getting them into place before we break for the spring recess.
        Our first panel this morning consists of Charles Bowsher,
    who joined the Public Oversight Board in 1997, and has served
    as its Chairman since 1999.
        We all know Chuck Bowsher very well, of course, because he
    served as the Comptroller General of the United States--he was
    with the GAO from 1981 to 1996. He was also a partner at Arthur
    Andersen and worked with them from 1971 to 1981. He was
    Assistant Secretary of the Navy for Financial Management from
    1967 to 1971.
        Aulana Peters is a member of the Public Oversight Board,
    and a partner in Gibson, Dunn & Crutcher, a law firm that she
    has been with since 1973. From 1984 to 1988, Ms. Peters served
    as a Commissioner of the Securities and Exchange Commission.
    She served on the Financial Accounting Standards Advisory
    Council to the Financial Accounting Standards Board, and on the
    Board of Directors for the American Institute of Certified
    Public Accountants.
        They are joined at the table by Alan Levenson, Counsel to
    the Public Oversight Board and a Senior Partner at the firm of
    Fulbright & Jaworski. Alan Levenson is a former Director of the
    SEC's Division of Corporation Finance.
        We are very pleased to have this panel with us this
    morning. Mr. Bowsher, why don't you lead off and then we will
    go to Ms. Peters and we will proceed from there.
        I do not know whether Mr. Levenson will simply assist or
    have a statement to offer.
        Mr. Levenson. Supplement.
        Chairman Sarbanes. All right. Very good.

                    STATEMENT OF CHARLES A. BOWSHER

                    CHAIRMAN, PUBLIC OVERSIGHT BOARD

            FORMER COMPTROLLER GENERAL OF THE UNITED STATES

                    ACCOMPANIED BY: ALAN B. LEVENSON

                 COUNSEL TO THE PUBLIC OVERSIGHT BOARD

        Mr. Bowsher. Thank you very much, Mr. Chairman, Senator
    Gramm, Senator Corzine. It is a great pleasure to be here
    today.
        As you just pointed out, I am joined by Aulana Peters and
    Alan Levenson here at the table. Norm Augustine, one of our
    other board members, is out of the country and unfortunately
    could not be here. And you have heard from John Biggs before,
    at another one of your testimonies.
        I thought that it might be worthwhile to open with a little
    bit of history on the regulatory oversight of the accounting
    profession.
        The accountants really got started in this country when the
    British sent their accountants over from London and Scotland in
    the late 1890's. There was an organization formed, a
    predecessor to the American Institute of Certified Public
    Accountants--the AICPA.
        But there was really not that much oversight until we had
    the great stock market crash in 1929. Then we had Congressional
    hearings; we had the 1933-1934 Acts passed. In those, Congress
    mandated--on the advice of some accountants who testified--that
    there should be an annual audit and there should be accounting
    standards that the auditors could audit against.
        That authority was given to the SEC, but on a vote of 2 to
    1, with Joe Kennedy being the Chairman and Justice Douglas
    being the dissenting vote, they delegated that responsibility
    to the private sector. It went to the AICPA, which did it for
    many years.
        Actually, Congress did not look again at the accounting
    profession until the 1970's. What triggered that investigation
    was the bankruptcy of the Penn Central Railroad, which was the
    greatest bankruptcy in American corporate life up to that point
    in time, and the first big one that we had had, really, after
    World War II.
        We also had the ``sensitive payments'' problems, which
    meant that some foreign officials were being paid bribes by
    some of our American companies. The auditors were not told
    about it and, therefore, did not report it. That was a big
    issue.
        So, we had two hearings in the late 1970's, one by Chairman
    Metcalf in the Senate, and one by Congressman Moss in the
    House. Out of those hearings came some advice from Senator
    Metcalf, particularly to the accounting profession, that the
    accounting firms ought to go away and come up with what he
    thought they could devise--a self-regulatory program. That is
    when they set up the current self-regulatory program that we
    have, which is headed up by the SEC Practice Section. That is
    an independent group under the AICPA which the firms have to
    belong to. Prior to 1977, the firms never belonged to the
    AICPA, only individual CPA's.
        We also at that time started the peer review process to try
    to check to see how the auditing firms were doing as far as
    following good standards, good policies, good procedures.
        That was tested as a result of the Penn Central bankruptcy
    when Sandy Burton, the Chief Accountant of the SEC, thought
    that was something that could be done that would help improve
    auditing. The auditing firms resisted it, but once they went
    through it, found that it wasn't all that bad. And so, that was
    part of the new self-regulatory process.
        However, I do want to point out that the new self-
    regulatory programs, although innovative in their time, and I
    think really contributed to better auditing over the years here
    in this country and around the world, where many other features
    of it have been adopted, there were some doubts.
        Sandy Burton, the former distinguished Professor of
    Accounting at Columbia University, and at that time, the Chief
    Accountant of the SEC, warned in testimony before the House
    Interstate and Foreign Commerce Committee in 1978, that peer
    review ``is likely to be seen as a process of mutual back
    scratching.'' In other words, one firm doing the audit--the
    peer review--of another. He also warned that ``it is highly
    doubtful that a part-time POB can either in fact or in
    perception'' provide an effective substitute for statutory
    regulation.
        Harold Williams, Chairman of the SEC at that time, said
    that the ``effectiveness and credibility of the Public
    Oversight Board depends on its independence, including its
    willingness to be critical when called for and its ability to
    make public its conclusions, recommendations, and criticisms.''
    Chairman Williams also made the point that an effective POB
    could only be effective ``if it is not impeded in performing
    its functions and responsibilities.''
        Now a quarter century after those reforms, I believe events
    of the recent months here in the last 2 years demonstrate that
    the warnings of Dr. Burton and Chairman Williams have come to
    pass. I have come to the conclusion, as my fellow board members
    have, that the voluntary, self-regulatory program needs to be
    replaced
    because it has failed to keep pace with the challenges faced by
    the profession. More troubling is the resistance of the
    profession's trade association, the AICPA, and several of the
    Big 5 firms to really embrace major reform.
        Arthur Levitt, the former Chairman of the SEC, also
    described this problem in recent testimony before your
    Committee when he said that ``more than three decades ago,
    Leonard Spacek, a visionary accounting industry leader, stated
    that the profession could not `survive as a group, obtaining
    the confidence of the public . . . unless as a profession it
    had a workable plan of self-regulation.' Yet, all along the
    profession has resisted meaningful oversight.'' And he was
    really talking about the period from 1943 to 1973.
        In 1980, the SEC said in a report prepared for the Senate
    Committee on Governmental Affairs that the POB had an
    obligation to ``serve as the conscience and critic of the self-
    regulatory effort.'' The POB's charter, which was completed a
    year ago, provides that the POB is ``to represent the public
    interest on all matters that may affect public confidence in
    the integrity, reliability, and credibility of the audit
    process.''
        In the last 2 years, we have had several unfortunate
    situations. One was that in May of 2000, after the POB had been
    asked to do some special reviews of the major accounting firms,
    to see if there were independence problems at their firms. This
    request came after PricewaterhouseCoopers had had a special
    review and 8,000 infractions were reported. Some of those were
    technical, but there were at least 200 fairly serious ones that
    the chairman of their partnership acknowledged.
        We went forward with the request that the SEC asked us to
    do, to do a review of the other four big firms. Much to our
    surprise, we had our funding cut off, something that had never
    happened in over 20 years. And Mel Laird, who is a former
    Congressman, nine-term Congressman, former Secretary of
    Defense, and the longest-serving member on our POB, who was
    still on the POB at that time, said it was the ``worst incident
    in my 17 years'' on the POB.
        Following the decision to cut off the funding of the POB's
    special reviews, the SEC and the Big 5 did come into agreement
    on how to do the reviews by splitting them into two efforts.
        One, a look back where they asked each firm to hire a
    lawyer which the SEC would agree upon, to look back and see how
    many infractions there were. And then the look forward, which
    we were supposed to do, and look forward to see how well the
    new systems that the firms had implemented, were working along
    with the training, the leadership, and everything like that.
        Unfortunately, after 21 months, we have not been able to do
    those reviews and, again, we just ran into various delaying
    tactics.
        Then, of course, it took over a year to get our charter
    approved. Norm Augustine, one of our fellow Board members, said
    that after a while, one gets very discouraged that people
    cannot come into agreement faster on something like just a
    charter.
        But I think the precipitating event that caused us to
    terminate, as you pointed out Mr. Chairman, in January, was the
    proposed new regulatory structure that the Chairman of the SEC,
    Harvey Pitt, presented for the accounting profession. This plan
    was worked out in private talks between the SEC and the AICPA
    and the Big 5 accounting firms, with no input from the POB,
    which repeatedly had been assured that it would be consulted.
        This new proposal effectively rendered the POB a lame duck.
    The POB believed it could not oversee the activities of the
    accounting profession under the circumstances, and that it
    would mislead the public to appear to do so.
        Furthermore, the POB was concerned that if we were to
    continue in operation during an interim period before the new
    governance structure was in place, it would leave the
    impression that it approved of the new proposal that the SEC
    had put forward, which we did not approve.
        As the ``conscience and the critic,'' the POB felt it had
    no choice but to disband. We felt that only by so acting could
    we protect the public interest. What the POB did was really
    akin to what the auditor does when it believes it must resign
    from a client engagement because of a fundamental disagreement
    with the client.
        Now attached to my testimony, Mr. Chairman, are copies of
    the letters I sent as Chairman to Mr. Pitt on January 21 and
    January 31, detailing our decision to terminate. These letters
    are attached as Appendix A and Appendix B.
        Chairman Sarbanes. Your statement and the attachments will
    be included in full in the record.
        Mr. Bowsher. We appreciate that, Mr. Chairman.
        What we have proposed today in our White Paper is a new
    regulatory structure that we think the accounting profession
    needs and we believe that, to be effective, it must be totally
    independent of the accounting profession and it must be based
    on the foundation of Congressional action in creating a new,
    self-regulatory organization. If you look at the chart that we
    have--it is the last exhibit on the White Paper. It is also in
    the testimony. It shows the new format for this new oversight
    board that we would recommend.
        We recommend that the Congress create a new Independent
    Institute of Accountancy and center all regulation under its
    auspices. A seven-member board would run the institute totally
    independent of the AICPA, the Big 5, and other firms. The chair
    and the vice chair would be full-time employees of the
    institute. Five other members, or thereabouts, whichever mix
    they would like to make, would serve on a part-time basis. We
    suggest that they all be appointed by a panel composed of the
    Chair of the SEC, the Chair of the Federal Reserve, and the
    Secretary of the Treasury. Once named, the chair of the new
    board would also join the other three in naming the other
    members of the board. The members could only be removed by a
    vote of two-thirds of the board itself.
        The SEC, as we show on the chart, would have oversight of
    this new IIA Board, and the SEC's Office of Chief Accountant
    would have the liaison, we assume, to this new self-regulatory
    group in the private sector.
        If you look on the left-hand side, what we show is that all
    three of the standard setting bodies would be under this new
    board. In other words, we would bring the accounting
    principles--the Financial Accounting Standards Board or the
    FASB--under this board. We would also bring in the auditing
    standards and the independence standards. So that you would
    have all the standard setting under this new board.
        Then the new board would also have the ability to do
    reviews, both annual reviews, which would replace the 3 year
    peer review that we have historically had, as well as special
    reviews done by the professional people in this organization.
        The board would also have the enforcement and the
    discipline, the continuing professional education and the
    international liaison.
        We feel that it is very important to get all of the
    functions of the accounting world, you might say, under this
    one oversight board, which then could act as different problems
    come up.
        In other words, if there is a problem in accounting, the
    accounting principles would be within it. Sometimes you need
    the auditing standards to tell you what is the effect or the
    auditability of a new FASB standard. Right now, they have to do
    it on an informal basis.
        The independence group, of course, was established with the
    Independence Standards Board--the ISB--a couple of years ago,
    but then was disbanded. This proposal would bring it all back
    under one independent board.
        I might also say that we see the funding here being
    provided through fees imposed on public corporations in amounts
    sufficient to cover the costs of this institute. The POB
    strongly believes that the funding mechanism must be beyond the
    reach of the profession to prevent it from withholding
    necessary funds as it did in May 2000.
        Now beyond setting up the new institute, we are
    recommending certain other issues to be considered by the
    Congress.
        With regard to nonaudit services for audit clients, the POB
    recognizes that there has been disagreement on restricting
    scope of services and that various models have been suggested
    for what should be allowed and what should be excluded.
        The POB strongly agrees with a point made in President
    Bush's 10 point reform plan that ``Investors should have
    complete confidence in the independence and integrity of the
    companies' auditors.'' The specifics of the President's plan
    recognize the importance of prohibiting certain nonaudit
    services in order to safeguard auditor independence.
        We take note of a statement issued by the AICPA on February
    1, 2002, in which it affirmed that it ``will not oppose Federal
    legislation restricting the scope of services that accountants
    may provide their public audit clients, specifically in
    information technology and internal audit design and
    implementation.''
        Against this background, the POB proposes that the SEC
    regulations concerning independence be legislatively codified
    with appropriate revisions to update restrictions on scope of
    services involving information technology and internal audit
    services as noted above. At the same time, the POB believes
    such legislation should affirm that tax work not involving
    advocacy and attest work by the audit firms in connection with
    SEC registration and other SEC filings be allowed.
        Now, I know that other witnesses before your Committee have
    raised concerns--the AICPA especially--about cascading effects
    down to the smaller auditing firms and to the smaller
    businesses in this country.
        The POB believes that small public businesses, to be
    defined by the SEC, should not be subject to any restriction on
    nonaudit services for their audit clients. Further, with
    respect to the nonpublic corporations, it is the POB's position
    that such corporations and accounting firms that audit them
    should not be subject to any restriction on nonaudit services.
    We expressly emphasize this to avoid misunderstanding and any
    consequences to small business and small audit firms.
        We are also recommending that the auditors should be
    rotated every 7 years. Right now, there is a rule in the
    auditing world that the partner has to be rotated every 7
    years. We believe that the time has come now to consider
    rotating the firms themselves. John Biggs, one of our fellow
    members strongly believes in this.
        We think, as a corollary, public corporations would be
    prohibited from firing auditors during their term of service
    unless such action is determined by the audit committee to be
    in the best interest of shareholders, with prompt notice to the
    IIA and the SEC. Such action would be required to be publicly
    disclosed by corporations in current reports and proxy
    statements filed with the SEC.
        Another area that we want to make a recommendation on is
    the revolving door. We believe that engagement and other
    partners who are associated with an audit should be prohibited
    from taking employment with the affected firm until a 2 year
    cooling-off period has expired.
        I know, Senator Corzine, in your bill, you have 3 years,
    and that, too, would appear to be reasonable. But we do believe
    that we need a cooling-off period. For many years, all of us
    have tried to avoid that with some oversight by the auditing
    firm. But in recent alleged audit failures, there have just
    been too many incidents, it appears, of having too many people
    from the old auditing firm in the senior financial positions of
    the audit client.
        We would also recommend that the institute expand on the
    recommendations of the recent Blue Ribbon Committee. I know you
    are going to have Chairman Whitehead, who was Co-Chairman of
    our Blue Ribbon panel, on your next panel, Mr. Chairman. But we
    would recommend, too, as I believe he does in his statement,
    that it be made clear that the external auditors should be
    accountable to a firm's board of directors and its audit
    committees, and not to management. Specifically, the audit
    committee should take responsibility for hiring, evaluating,
    and, if necessary, terminating an audit firm.
        Another item that we would like to bring up is a proposal
    to discourage conflicts of interest involving public
    corporations, we think that Congress should amend the
    Securities Exchange Act of 1934 to require more meaningful and
    timely disclosure of related-party transactions among officers,
    directors, or other affiliated persons and the public
    corporation. Such disclosures should be made promptly in
    current reports as well as in proxy statements filed with the
    SEC.
        The last item that we highlight in our testimony today is
    that management of public corporations should be required to
    prepare an annual statement of compliance with internal
    controls to be filed with the SEC. This is a recommendation
    that was made in the General Accounting Office report in 1996,
    to improve the auditor's ability to provide more relevant and
    timely assurances on the quality of data beyond that contained
    in the traditional financial statements and disclosures. Both
    the POB and the AICPA at that time supported the recommendation
    that the GAO made, but so far, the SEC has not adopted it. I
    would hope they would at some point.
        Now, let me just say in closing that a decade ago this
    Banking Committee in the Senate was in the forefront of
    enacting major reforms for the banking industry, reforms that
    were really widely opposed by the banks and their lobbyists.
    Opponents then predicted gloom and doom for the industry should
    the proposed reforms be enacted. In reality, the reforms
    contained in the Federal Deposit Insurance Corporation
    Improvement Act of 1991 repaired flaws in regulation of the
    Nation's banking industry. More important, they significantly
    strengthened the industry.
        I am pleased that you have Bill Seidman here today as a
    witness because I think Bill's work during that period was
    outstanding for our country.
        Today, the Congress again is called upon, I think, to
    institute reform. In the wake of the Enron debacle, the POB,
    acting as the ``conscience and the critic'' of the profession,
    strongly believes that to protect investors and the public, the
    old system of voluntary self-regulation for the accounting
    industry must be replaced. While many will urge that the
    Congress act with caution and that the profession be again
    given the opportunity to fix the present system with marginal
    changes, the POB believes it is time to resist the continuation
    of the status quo and move ahead with fundamental change.
        Mr. Chairman, you recently made the point that recent
    events have had a critical impact on the national confidence in
    the financial markets, and that the time has come to focus on
    the protection of investors and the efficient functioning of
    our capital markets. I could not agree more. That is why I
    believe it is time to resist the continuation of the status quo
    and move ahead with fundamental change.
        Mr. Chairman, that concludes my prepared testimony. I would
    like Aulana to be able to give hers, and then we would be happy
    to answer any questions.
        Chairman Sarbanes. Thank you, that was extremely helpful.
        Ms. Peters, we would be happy to hear from you.

                     STATEMENT OF AULANA L. PETERS

                     MEMBER, PUBLIC OVERSIGHT BOARD

                          FORMER COMMISSIONER

                U.S. SECURITIES AND EXCHANGE COMMISSION

                RETIRED PARTNER, GIBSON, DUNN & CRUTCHER

        Ms. Peters. Good morning, Mr. Chairman, and Senator
    Corzine. Thank you very much for giving me this opportunity to
    speak to you today and share my views on what may be necessary
    as reforms to the self-regulatory structure of the accounting
    profession.
        I would like to emphasize that the views I am about to
    express are based on the observations I was able to make as a
    member of the Public Oversight Board.
        Indeed, as a part of our oversight responsibilities, I have
    begun to come to the conclusion that some changes were needed
    long before the Enron scandal was emblazoned across the press
    and the problems of Arthur Andersen started to surface. I
    emphasize that because, of course, I recognize Enron has
    created a circumstance or a situation where things have become
    more urgent and the perception of the need for change has
    become more urgent.
        I agree that instead of permitting change to evolve as it
    has in the past, this crisis suggests that the change should be
    radical and immediate.
        Again, before launching into the specifics of my testimony,
    I would like to further emphasize that I had an opportunity
    over the past year to observe the workings of certain aspects
    of the self-regulatory organization that currently exist, and I
    have concluded--my problems with the structure, with the
    system, lies in flaws that I perceive in the structure of the
    system and not necessarily in any competence of the individual
    professionals who are currently working within the system to
    set standards, impose discipline, examine audit failures for
    systemic changes.
        These people are dedicated. They are very bright and they
    work hard for the only reward given to them, which is to
    further the profession and its perception. It is just that
    times have changed and we have to move forward in a different
    process.
        Now, Chairman Bowsher has already indicated that members of
    the Public Oversight Board are in agreement that the change
    needs to be brought about by legislation.
        I would like to point out a couple of reasons why I
    personally believe that legislation is very necessary here, as
    opposed to letting it come about in some other way.
        First, legislation would provide the new entity, whatever
    that is called. We call it the institute, and with your
    patience and indulgence, I will refer to this entity that is
    yet to be created as the proposed institute. It would permit
    the institute to have a statutorily defined base of authority,
    which I think is critical. That would put it in a situation
    where it wouldn't have to continually renegotiate or discuss
    exactly the parameters and the scope of its authority.
        Second, legislation should, and will clarify the
    institute's ability to conduct operations by providing it with
    a permanent source of funding.
        Now, I fully realize that nothing is permanent on this
    earth or in our world. But it is a lot better than being
    subject, again, on an annual basis or any other periodic basis,
    to negotiating with those that you regulate or those who are
    affected by your regulation, for money to proceed with your
    processes and your operations.
        So, I think that that is also very key as well, and it is a
    point with which we differ with respect to what I understand
    the SEC proposal is.
        Finally, legislation I believe is the most effective way to
    streamline what former SEC Chairman Levitt and others have
    called the alphabet soup of governance that currently exists in
    the profession.
        Ladies and gentlemen, I do not think that you can look
    forward to any effective streamlining taking place as a result
    of negotiation with the parties involved. The Congress of the
    United States is going to have to take a position and bring, I
    hope, and I would recommend, all of the different elements that
    constitute the corporate governance or the governance structure
    applicable to the accounting profession under one umbrella, so
    that there is coordination and immediate flow-back and a single
    agenda within that organization, so that the profession can
    move forward effectively to do its job, and the self-regulatory
    entity can move forward effectively to do its job.
        Now with those comments about general legislative basis, I
    will just briefly comment on the benefits that I perceive would
    come from adopting the structure that the POB has proposed
    here.
        First, peer review, of course, has been a sacrosanct
    element in the structure for many years. I agree with Chairman
    Bowsher that it has served the profession well in many
    respects, particularly with encouraging the implementation of
    good quality control systems. However, I also believe that our
    recommendations which also stems from the recommendations of
    the POB panel on audit effectiveness, and I suppose fair and
    full disclosure would require me to remind the Committee and I
    was a member of that panel, and you may take my views in that
    context.
        It does replace the triennial review with an annual review
    by the firms with oversight by the regulatory entity and it
    expands and provides for the expansion of the nature of those
    reviews, as I understand it, to include more pointed and
    specific expertise being brought to bear on the systemic
    reviews, or the review of the systems. But most significantly,
    the oversight of those reviews would be conducted by the
    institute's personnel, thereby eliminating any perception of
    the fact that the peer reviews are done in a clubby atmosphere
    where individual firms may be unwilling to criticize their
    competitors because they do not want to set themselves up to be
    criticized in the future themselves.
        Another key difference would be that the POB's recommended
    process, would not exclude from this annual review audits that
    are known to have problems, audits that are already the subject
    of litigation or governmental investigation.
        That I believe is key for the process to have a diagnostic
    value, to help you understand what went wrong so that you may
    be in a position to adopt standards or take other steps to
    prevent the same thing happening in the future.
        Leaving peer review for a moment and going to the proposed
    changes that would relate directly to discipline, this is an
    area that really needs to be changed significantly. I think the
    processes that exist currently are divorced--the disciplinary
    processes are, in essence, divorced from the standard setting
    process.
        So although there is feedback and the current structure
    recognizes and the individuals operating the current structure
    recognize the need for feedback, that feedback takes a while
    for it to go through channels where what we know as the QCIC
    committee and the Peak Committee--QCIC is the Quality Control
    Inquiry Committee. And the Peak Committee is that committee
    that deals with regulation or discipline for individuals, as
    opposed to firms.
        If they were brought together, you would not have a
    separation between trying to determine what problems stem from
    systemic flaws and what problems are related to bad judgment.
    And a lot of the audit failures are related to bad judgment of
    individuals in the field, which is how you come to have good
    peer review reports and failed audits within the same timespan
    or time period.
        It is important to bring all of these elements, including
    standard setting. I want to emphasize that I think it is very
    important to bring standard setting into the same bailiwick to
    be conducted under the same umbrella as discipline.
        I think I will limit my comments to the structural changes
    that we have recommended to those that I have just made, and go
    on to add my 2 cents, so to speak, on the issue of why the POB
    decided to resign. It is a very important issue and I would
    like to share my views or add my views to those offered by
    Chairman Bowsher. And what he has stated, I completely accept,
    embrace, and endorse.
        I do not have a different take on it, but I would like to
    outline certain facts that are very important to me, and were
    important to me in coming to the conclusion that my colleagues
    and I were correct in voting to disband the Public Oversight
    Board, which, incidentally, was a post that I really looked
    forward to spending 7 years working at.
        The facts are that on December 4, we were all in Washington
    and the POB learned, after the fact, that the Chairman of the
    SEC had met with representatives of the accounting profession
    to discuss the implications of the Enron disclosures and the
    implications that those disclosures would have for the self-
    regulatory structure applicable to the accounting profession.
        Later, on January 4, Chairman Bowsher and I, along with our
    Executive Director, Jerry Sullivan, attended a meeting of the
    Executive Committee of the SEC Practice Section. That is that
    part of the AICPA responsible for regulating those auditors who
    audit publicly held accountants.
        During that meeting, we learned from an offhand comment
    that the committee was actually working on a proposal that they
    intended to submit to the SEC and that they thought would be--
    it was said that it would be made public within a couple of
    weeks, or a few weeks, in anticipation of hearings being held
    by the Senate, or other Congressional committees.
        Quite frankly, I was surprised. I looked at Chairman
    Bowsher and he was surprised, as was Jerry Sullivan.
        At that time, I personally asked the gathered professionals
    to make sure that the POB was brought into the loop on this
    issue. I emphasized that, while our role was one of oversight
    and I had perfect understanding of the limitations of
    oversight, that I thought that it was very, very important for
    us to have an opportunity to conduct that oversight because, as
    we well knew, ultimately, whatever was made public, whatever
    structure was proposed, the public and Congress would expect us
    to comment on it. And that we thought we should have an
    opportunity to understand it, to learn about it, and, if
    possible, to have some input into it before the fact.
        Well, on January 17, I learned through the staff of the POB
    that SEC Chairman Pitt was in the process of conducting a press
    conference, that was being televised. This was the first I had
    heard the public announcement of the proposal that was being
    made. Of course, Chairman Bowsher and our Executive Director
    learned about it an hour or two before.
        Now, for me, it is key that the Public Oversight Board,
    which currently is the only independent body being charged with
    overseeing the accounting profession and with its self-
    regulatory efforts, assigned with the duty to act in the public
    interest, that for that entity to be excluded from the process
    that is dealing with an issue of great moment for the
    profession, is really not tolerable.
        I personally am not particularly concerned about whether
    the fact of exclusion was intentional or whether it was the
    unintentional result of bad timing. I really do not think that
    that should be a focal point of our consideration or an issue
    for debate in the public or private arena.
        But it is without a doubt the fact that the exclusion
    occurred created a circumstance in which the entity that was
    charged with being the eyes and the ears of the public in the
    process lacked information, was in effect, in an informational
    vacuum. And without the information, without conducting the
    oversight, one can hardly advise or make any recommendations to
    either this body or be in a position to protect the public.
        With that, faced with those circumstances, my colleagues
    and I at the Public Oversight Board thought that we had no, and
    I believe did, have no alternative, if you were to remain
    principled and act with integrity, but to disband, because to
    continue to pretend to be in the role, we would find ourselves
    perhaps misleading those who were watching us and counting on
    us to be in the position to protect the interest of the public.
        Now protect the interest of the public, we must keep in
    mind, was to observe the process, draw our conclusions about
    the process, and then report on the process. If we cannot
    observe the process, we have no basis to draw conclusions and
    we cannot make any forthright, honest report.
        I have nothing further to add to the written statement that
    has already been submitted, and I am happy to try and answer
    any questions that you may have for me.
        I am sure that Chairman Bowsher is also.
        Chairman Sarbanes. Very helpful testimony. Did you want to
    add anything else, Mr. Levenson?
        Mr. Levenson. Not at this point, but thank you, Mr.
    Chairman.
        Chairman Sarbanes. Thank you all very much. We very much
    appreciate this panel. We particularly appreciate also the
    extensive White Paper that the Public Oversight Board has
    submitted to the Committee. That is going to be extremely
    helpful.
        I must say, Ms. Peters, it is hard for me to understand how
    it could have been expected that a proposal would have much
    credibility if there was a failure to consult or involve in the
    process of developing the proposal the Public Oversight Board,
    or, for that matter, a number of other interested parties as
    well. Obviously, that is exactly what happened.
        A very quick, in a sense, almost secret, consultation that
    then came forward with a proposal, did not get much traction.
    And obviously, one purpose of these hearings is to avoid that
    kind of situation and examine the basis for proposals.
        I want to ask some very specific questions because, as they
    frequently say, the devil is in the details.
        First of all, what do you see the relationship being
    between the SEC and the institute, as you have outlined it? I
    know you have the SEC in a box up above the institute.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. What does that mean? How would that
    work?
        Mr. Bowsher. Yes. Well, we definitely see the SEC of having
    the oversight over this self-regulatory group, very much like
    they do with the New York Stock Exchange and the NASD.
        Traditionally, within the SEC, the executive group that has
    done the liaison and oversight role has been the Office of the
    Chief Accountant. So, we would see that as being the way it
    would be organized. And the SEC would, as they always say, have
    the club in the closet. In other words, if the institute and
    its various components aren't doing the job to their
    satisfaction, they could certainly bring the club out
    occasionally and point that out.
        We definitely see Government here. But we do not bring the
    unit into Government. In other words, we keep it in the private
    sector, funded in the private sector for several reasons.
        Chairman Sarbanes. Is the club a public disclosure and
    criticism, or even private disclosure and criticism, or does it
    involve the power to actually do some of the substantive things
    that are the responsibility of----
        Mr. Bowsher. I think they have by law the power.
        As a former Commissioner, I think Aulana could testify that
    they have the power to make decisions if the private-sector
    oversight board is not making decisions in a certain area.
        Ms. Peters. I would wholeheartedly agree. The key is that
    this entity is being set up to, would be set up to regulate the
    accounting profession to the extent that for that portion of
    the profession that is involved in examining and reporting on
    the financial statements of publicly held corporations. And
    that is just a fraction of the entire profession and we must
    remember that.
        The SEC is the primary regulator and overseer of our
    markets and our financial reporting process and should remain
    so. The SEC will be always having the authority to bring
    lawsuits and administrative proceedings against accountants and
    accounting firms for violations of the law. This private
    entity, this institute, will have to also, to the extent that
    it is going to be making rules and setting some standards, but
    especially disciplinary rules, might want to pass those rules
    by the SEC.
        As well, there is a well-established precedent for self-
    regulatory organizations. I do not view the institute as the
    traditionally self-regulatory organization. But for these types
    of institutions to work under the aegis of the SEC and, in
    fact, that is what happens right now on an informal basis. It
    is just that the structure has not been formalized.
        Chairman Sarbanes. It could be argued that the SEC
    currently has the authority to do a great number of these
    things, but they just haven't done it.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. In the face of all kinds of pressures of
    one sort or another, which we are all very mindful of. I take
    it that is one of the reasons that you are recommending so
    strongly that there be a statutory basis for this regulatory
    organization. Is that correct?
        Mr. Bowsher. That is correct, Mr. Chairman.
        Chairman Sarbanes. Now, I want to address the cascading
    issue for a minute because it has been raised again and again
    by people in the profession. There are Members of this
    Committee that are sensitive to it.
        In my own mind, I had drawn a very sharp line at the public
    company and the nonpublic company, on the premise that once you
    go public and go into the markets and investors then can buy
    and sell your stock, you assume a different set of
    responsibilities. And that has been the premise of the
    securities law.
        You draw the line in a somewhat different place because you
    have a category in there of small public companies that are not
    going to be subject to the same limitations, whose auditors
    will not be subject to the same limitations as the auditors of
    the large public companies.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. Now that creates an opening that can be
    expanded, or, indeed, contracted. But, presumably, the pressure
    would be toward expanding it. Why do you create that additional
    category?
        Mr. Bowsher. We create it primarily because there is
    concern that some of the smaller private companies are out
    there being audited by some of the smaller CPA firms.
        Chairman Sarbanes. The smaller public companies.
        Mr. Bowsher. The smaller public companies. And when the SEC
    did their rule last year on the scope of service, they provided
    that kind of a group. We were saying that we would certainly
    be, as outside people, advising you, recognizing that that
    could be done here, too, in the same way as the SEC did it last
    year.
        I think they said anything under $200 million in sales,
    this would not apply. I think it could go the other way, too,
    and just draw the distinction, as you say, Mr. Chairman,
    between public companies and nonpublic companies.
        But we would not want this whole concept to not be
    considered by the Congress because people in the smaller
    communities and in the smaller businesses and in the smaller
    CPA firms think that they are going to get a cascading effect
    down on them because of what we are proposing here, which is
    primarily for the larger public companies. And when you think
    about it, it is a kind of unique situation.
        The Big 5, and I am seeing here possibly going to a Big 4
    of accounting firms, audit 85 to 90 percent, not only of the
    U.S. public companies, but also of the world's public
    companies. It is a very high percentage.
        These are very large auditing firms and these are very
    large corporations. And as I have said in some of my speeches,
    when one of these big business failures takes place, like
    Enron, there are great ramifications, great losses to many,
    many people. And we have to try to put an oversight function in
    here that reduces the number.
        We do not have a large number, actually. We have about 50
    accounting failures every year that are brought to our
    attention, out of over 10,000 audits. But when we have as many
    of the larger ones as we have had recently, that means a lot of
    people get hurt. And so, we have to try to reduce that.
        So the real emphasis here is to try to bring all the
    functions together under one accounting board that is
    independent, overseeing this, under the SEC, is to try to
    really strengthen the accounting and auditing. And we would be
    more than willing to see it broken strictly between public and
    nonpublic. That has been a really great tradition.
        We would not want this new effort to be turned down because
    some people would be concerned about how would that affect the
    smaller CPA firms.
        I have been in this profession for nearly 50 years now and
    I have seen a lot of reforms. Every time we go through a major
    reform--I can remember back in the 1960's when we were voting
    to not allow CPA's to take stock in their clients to make the
    profession more independent--everybody said, oh, that will be
    the end of the small CPA firm. I think it hasn't happened.
        In other words, we have had to make reforms. After the Penn
    Central bankruptcy, the New York City fiscal crisis, the
    banking crisis, and the S&L crisis, we have always had to come
    up with reforms and straighten out certain areas. And we have
    always raised the issue of what effect does this have on the
    small CPA firm in Taylorville, or my hometown of Elk Heart,
    Indiana. And we have to be concerned about that. No question
    about it.
        We are more than willing to take some kind of grouping in
    there if we can get the reforms for the large organizations.
    But you could easily do it the way you suggested, and that
    would be public companies versus private and nonpublic
    companies.
        Chairman Sarbanes. Yes. The logic for that is stronger
    because the logic is, once you go public, you assume certain
    responsibilities.
        Mr. Bowsher. Exactly.
        Chairman Sarbanes. I am going to yield to Senator Corzine.
    But let me ask one quick question--the independent funding.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. Could you just sketch out very quickly
    how you would expect that to be done?
        Mr. Bowsher. Again, there we believe that it would be much
    better if the corporations, the large public companies in this
    country, financed this self-regulatory process, rather than
    relying upon the auditing firms to do it.
        We have had the experience over the years with the FASB of
    trying to raise the money on a voluntary basis through the FAF,
    and their trustees. It has not been very successful.
        Chairman Sarbanes. I think it is clear that the voluntary
    does not work. You go around with a tin cup to the very
    people----
        Mr. Bowsher. Exactly.
        Chairman Sarbanes. Well, the very experience you had where
    they cut off your funding.
        Mr. Bowsher. Right.
        Chairman Sarbanes. The classic example. So let's assume we
    are looking for a mandatory source of funding.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. What should it be and how would it work?
        Mr. Bowsher. We think it would work here, as I say, with
    fees imposed on the public corporations and it would be a
    cascading arrangement with the biggest to the smallest and a
    percentage, sufficient to cover the cost to the institute. In
    other words, when they made registrations like the 10-K's with
    the SEC, there would be a fee and that fee would go to finance
    this oversight group.
        Chairman Sarbanes. Who would set the fee?
        Mr. Bowsher. Did we have that? It was the institute, I
    believe is the way we had it.
        Chairman Sarbanes. How do we then address the argument,
    which I am sure we are going to hear, that the institute
    setting its own fees, which are mandatory and automatic, is
    going to have a gold-plated budget and that you cannot allow
    the prospect of this incredible cost being imposed?
        Mr. Bowsher. We would definitely give the SEC oversight of
    that funding thing. We would like not to get it into the
    appropriations process of the Congress, Mr. Chairman.
        Chairman Sarbanes. All right.
        Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman.
        If you wondered where Taylorville was, that is a small town
    in central Illinois, of about 8,000 people, which Mr. Bowsher
    is appealing to my good instincts about.
        [Laughter.]
        Chairman Sarbanes. I appreciate that the Illinois caucus is
    at work here.
        [Laughter.]
        Mr. Bowsher. I went to the University of Illinois and that
    is why I know where Taylorville is.
        [Laughter.]
        Senator Corzine. I appreciate the testimony--a thoughtful
    view of both current circumstance and suggestions on going
    forward.
        This cascading issue that the Chairman talked about is
    certainly an important one. You have taken on another issue in
    your recommendations that is very challenging to sort through
    to the right answer, and it is the streamlining of the alphabet
    soup issues, the independence of the activity of FASB relative
    to SEC and putting it inside the institute.
        It is one that I must say I am torn with when I think about
    this issue, whether FASB, which is already, many would argue,
    slow-moving, with regard to dealing with accounting standards,
    whether this process would separate it from its fundamental
    relationship with the SEC, slow down that process further. Why
    is that coordination so important or not important? The pros
    and cons of that I would like to hear you discuss.
        Mr. Bowsher. Sure. I will give you two examples. One of the
    big issues that the auditors and the corporate financial
    reporting has faced here in the last year or two is the growing
    concern issue. In other words, will a dot com firm, for
    example, continue to be in business at the end of this year
    when the audit is done--you have to make that decision? When
    you look at the auditing standards, they have certain
    requirements, and when you look at the accounting principles,
    they have certain requirements in that kind of a decision. And
    what we have today is two very separate groups and they do not
    always coordinate.
        Another good example is when the new FASB ruling came out
    on derivatives, or on this doing away with pooling, you then
    have to go in and do different auditing. And the question was,
    did the auditing people get properly consulted as part of the
    accounting?
        I think maybe the most important area would be when you
    have a situation like the Enron situation, where it obviously,
    it looks like, at least, we do not have all the facts yet, but
    it looks like there are some accounting principles issues. It
    looks like there is some auditing standards. And it certainly
    looks like there is some independence standards issues.
        You would have one board that would be looking over and
    making sure that all three areas were looked at and properly
    looked at when we would have these kinds of situations.
        Now, literally, the chief accountant of the SEC has to get
    on the train or the plane and fly to different places and try
    to get everybody coordinated and that. So it is really the
    coordination and getting more oversight. See, the auditing
    standards has never really had any real oversight until we were
    given it in this last charter. And then, of course, when we go
    out of business, why, they no longer will have oversight.
        In Chairman Pitt's program, they wouldn't have oversight in
    the future. And the Independence Standard Board, when they went
    out of business, again, we no longer have oversight.
        What we are saying is, we think, as Aulana pointed out, you
    have to get this alphabet soup, which was a term of art that
    Chairman Levitt used, brought into some kind of coordinated
    function. And I really think with the FASB, we are not in any
    way trying to slow down the process and put more oversight over
    it.
        I think we are putting oversight over it, but I would think
    that they would try--one of the things that the board would ask
    them to do is to try--to get the process a little more
    efficient and a little more timely.
        Senator Corzine. Taking that one step further, do you have
    an opinion about principles versus rulemaking and FASB, which
    we are hearing much discussion about?
        Mr. Bowsher. Yes, you are hearing a lot about that.
        I have always thought that the rules were very complicated.
    In other words, I remember when I was Comptroller General, I
    issued a big report on derivatives and I recommended that FASB
    come with new accounting standards. I was astounded to see the
    document that came out.
        So, I think it would be good to go to more principles, but
    I am waiting to see the advocates of just how they are planning
    to do this because they talk about it, but I haven't quite seen
    how it is going to be done.
        Senator Corzine. Is the International Accounting Standards
    Board a program of principle delineation that you would
    embrace?
        Mr. Bowsher. I have always been kind of a big fan of that
    effort because I truly think we need international standards. I
    think most people do not realize how much American money is
    invested overseas, where they are investing in companies that
    do not have the best financial reporting.
        I really think we are in a global market. We are in a need
    for global standards. And the Europeans and people overseas
    really are kind of shocked to see how complicated and detailed
    our standards are. They tend to go the principle route.
        One of the things about Paul Volcker taking an interest in
    that whole area is that I was hoping that we would get some
    harmonization, and the Americans may be giving up some of the
    detail in some of the rule and getting a little bit closer to
    the principle. But, also, getting some of the Europeans to come
    a little closer to us on some of the issues, because they have
    some of the features in their accounting that is not very good.
        Senator Corzine. I have some more questions, but----
        Chairman Sarbanes. Go ahead.
        Mr. Bowsher. Aulana would like to add one thing, if she
    could.
        Ms. Peters. You raised the issue of independence. I know
    that there are different proposals.
        Senator Corzine. With regard to FASB.
        Ms. Peters. With regard to FASB, not with regard to the
    make-up of the institute's board.
        Senator Corzine. Right.
        Ms. Peters. As opposed to some other board.
        Senator Corzine. I think that is an interesting subject as
    well.
        Chairman Sarbanes. Why don't you address that?
        Senator Corzine. Go ahead.
        Ms. Peters. We believe that it is very important for the
    entity's board to be completely independent of the profession.
    I know that it may be viewed as logical to look at other self-
    regulatory organizations as an example of how this organization
    might operate. That is to say, with only, for example, a
    majority of the public, of the membership, being public
    members.
        However, I urge the Committee to understand the differences
    between a New York Stock Exchange and an accountability or an
    accounting board that is regulating the accounting profession.
        The institute that we are recommending that you adopt or
    the entity that we are recommending that you adopt, is going to
    be charged only with standard setting and discipline. They will
    not have a business to run.
        The New York Stock Exchange does have a governing board of
    directors that has some public members and some members from
    the profession that are currently actively involved in the
    profession. The New York Stock Exchange is, in addition to a
    disciplinary organization, a business. And it makes sense to
    have that input from the businesses that it regulates into the
    business aspects of its
    operations.
        Chairman Sarbanes. What do you mean by completely
    independent? Do you mean that they should not be accountants?
        Ms. Peters. No, not at all. You need the expertise in
    oversight of standard setting. What I mean is that they should
    not currently at the time be partners or affiliates of
    accounting organizations.
        I, for example, had a pretty close relationship to the
    accounting profession in my other life. Incidentally, Chairman
    Sarbanes, I am a Retired Partner of Gibson, Dunn & Crutcher.
        Chairman Sarbanes. We were trying to elevate Gibson, Dunn &
    Crutcher.
        [Laughter.]
        Ms. Peters. I am sure that my former partners are very
    pleased with that and I will remind them that I was trying to
    do them some good on this visit to the Hill.
        [Laughter.]
        But coincidental with my taking on responsibilities as a
    member of the POB, I retired and resigned my partnership at
    Gibson, Dunn & Crutcher so that there would not be any
    question, the less I brought with me, my background and
    experience as a defense lawyer who spent two decades or more
    representing the accounting profession.
        So there are many individuals--retired partners, retired
    leaders of the profession--that could bring to this institute a
    world of experience and a wealth of experience, without being
    the CEO, the current CEO, of the accounting firm.
        Senator Corzine. Let me take a slightly different tack and
    less user-friendly.
        The peer review process, we had a discussion with some
    folks from the industry who were arguing--I wasn't actually
    sure what their answer was--about whether there had been peer
    reviews that ever resulted in a negative review. I think we got
    into this cascading issue. I think there had been negative
    reviews for small firms, but not for large firms.
        Mr. Bowsher. Yes.
        Senator Corzine. But it wasn't perfectly clear what
    happened there. I understand that there are no disciplinary
    actions or other activities with regard to the Big 5 or with
    regard to publicly-traded companies. And it is a strange
    phenomenon when you have as many restatements of earnings and
    you said, I think Mr. Bowsher, 50 problems noted, major
    problems noted in audits during a given year, as the average.
        Why hasn't there been a larger hue and cry, until we have
    an Enron-like problem raised? And that doesn't mean that there
    have not been voices with regard to this. Certainly, Chairman
    Levitt has done that, and others as well.
        Why hasn't there been this move to rationalize the elements
    of the industry before? What lessons do we draw from that as we
    try to deal with the current situation? And is there a problem
    with POB itself for not raising some of these issues in a more
    visible manner to those of us who are responsible for public
    policy?
        Mr. Bowsher. The POB over the years had a series of reviews
    and reports that did raise many of these issues. One of the
    panels that we had was just in the last 2 years, the O'Malley
    panel, where they raised many of these issues, too.
        But in the peer review process, that is where they are
    really checking out to see whether the auditing firms are
    following the standards, the procedures, the policies that they
    are supposed to be following when they do an audit.
        It does not generally get to one of the problems that
    Aulana raised in her opening remarks that sometimes, at the end
    of an audit, you have to make some decisions. In other words,
    are you going to sign that certificate, even though there are
    certain problems facing you? Are you going to qualify that
    certificate, and things like that?
        And sometimes, decisions are made that ultimately turn out
    not to be the right decisions.
        We have another process called the QCIC process, the
    Quality Control Inquiry Committee, to look at that. And that
    would generally be where those 50 audits I mentioned earlier
    would be referred to us. We looked at those and we did raise
    various problems.
        I believe this, though, that one of the problems we had in
    this whole effort--and we were trying to work on it in the last
    year or so--was that there was not enough visibility to the
    reports at the end. In other words, you are exactly right.
    Every Big 5 always received a clean opinion in the peer review.
    But there were letters of comments.
        If you looked at those letters of comments, lots of times
    it was not as candid, it was not as plain English as to what
    some of the problems might be. We were trying to make progress
    there and we were not getting a lot of cooperation, to be very
    frank about it, and that was one of the things that discouraged
    the POB.
        So, I think you have every right to say, why wasn't the
    current process working better?
        One of the reasons why we are now recommending a new, much
    stronger oversight process is that we feel that the self-
    regulatory process set up in 1977 now needs to be significantly
    enhanced for the future.
        Senator Corzine. Thank you, Mr. Chairman.
        Chairman Sarbanes. Well, that does make an interesting
    point. It is very clear that there are tremendous pressure
    dynamics at work in this arena. Some of them come from the
    Congress, to be quite candid about it.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. Much of it comes from the industry.
    Levitt tries to do something about all these nonaudit functions
    and everyone jumps all over the SEC. It doesn't happen. Of
    course, you could have said, they should have bulled their way
    on through with that.
        Our challenge, I think, is to really try to get a system or
    a structure that, to the maximum extent possible--you cannot
    preclude it altogether--but that can check these kinds of
    pressures, so we get decisions made very much on the merits.
        In that regard, let me ask you, Mr. Bowsher, could you
    again lay out for us concisely how your proposal for regulatory
    oversight of the accounting profession differs from the one
    that was put forward by the SEC and some elements of the
    profession back at the beginning of the year?
        Mr. Bowsher. Yes. If you look at our chart here, what the
    SEC would do is they would create a new board over the
    enforcement and the discipline part. That new board would be
    what I call a mixed board. It would have representatives of all
    the major firms, is the way that it was explained to us. So
    that would be five seats for the major firms, one seat for the
    AICPA. Then maybe seven seats for public members and then the
    chairman of the SEC said that the seven members would dominate
    the board.
        Well, that is where we really differ because we think it
    would be very hard for those public members to dominate that
    kind of a mixed board. We had this experience with the ISB,
    which was put out of business at the end of 2 years. You really
    do need, I think, an independent board at the top of this.
        Our board would be totally independent, as Aulana pointed
    out. We would have experienced people--accountants, lawyers,
    former SEC people--serving on that board. But we would not have
    any current partners of any of the major firms serving on that
    board.
        Then what you literally have is we are bringing all the
    standard setting under the board, all the reviews, all the
    discipline, all the continuing education, whereas, his board
    would just only have a small fraction of these things, which
    would be the enforcement, the discipline, and whatever he's
    going to do with the annual review.
        Chairman Sarbanes. Let me ask this question because you
    move all the standard setting bodies under this new regulatory
    group that you propose. Is that essential? And in particular,
    does FASB need to be brought under? Or can FASB continue to
    operate in a somewhat separate status?
        Mr. Bowsher. You could leave FASB out to operate under
    their own board of trustees in that. But after giving it a lot
    of thought and consulting with a lot of people--former SEC
    chairmen, people who have served on the FAF, which I have
    myself, the trustees and others--we came to the conclusion that
    the fund-raising is not good, where you are passing that tin
    cup to people.
        Chairman Sarbanes. No, you would have to give them
    mandatory funding, I think.
        Mr. Bowsher. Okay. If you could do that, that would be
    good. But I think also the coordination with the other standard
    setting bodies is so important, that we would strongly
    recommend it come under this group.
        You could do it the other way.
        Chairman Sarbanes. Provided they had the mandatory funding.
        Mr. Bowsher. If they could be brought in with the mandatory
    funding, that is right.
        Chairman Sarbanes. Okay.
        Mr. Bowsher. But at that point you do not need 16 trustees
    to serve on the FAF.
        Chairman Sarbanes. Jon, did you have something? We have
    this other panel, but go ahead.
        Senator Corzine. One more question. On rotation of
    auditors, the 7 year recommendation.
        Mr. Bowsher. Yes.
        Senator Corzine. If you were able to have this structure,
    my presumption is that you would believe that the discipline
    and the oversight of the auditing process and the activities,
    enforcement, discipline, would be stronger, enhanced by some
    significant degree from where we are today.
        Mr. Bowsher. That is correct.
        Senator Corzine. Did you then think about the cost of
    rotating auditors and the expertise that might be necessary to
    deal with the complexity that is truly involved with a lot of
    these companies and the set-up process?
        Mr. Bowsher. Yes. This is a debate that has gone on for
    many years. And that is, if you rotate auditors, do you give up
    expertise and therefore, have a great degree maybe of audit
    failure in that first year when the new audit firm comes in?
        There has been some studies that kind of indicate maybe
    among the smaller audits that that is true. But when you look
    at the big audit failures of recent years, hardly any of them
    have ever been in the first year. In other words, if there is
    anything, it is that some corporations have been audited by the
    same firm for 15, 20, or 30 years. Some people say, maybe you
    need a fresh look every so many years.
        I can assure you that right now, when all of these big
    auditing firms are picking up a lot of Arthur Andersen's big
    clients, none of them are going in there and saying, we are
    going to have any trouble doing this audit the first year. They
    are all in there saying, boy, we can do it and we will bring
    the expertise to make sure we can.
        So, I have always thought that rotation brings the fresher
    look and the more independent look. Also, it forces the
    existing auditing firm to really want to do a good job here
    knowing that somebody else is going to take over.
        When I was the Comptroller General, I encouraged support
    for a 5 year rotation in the ``Yellow Book,'' which spells out
    auditing standards for Government. It has worked quite well. It
    works well up in Canada, too, where they have two auditing
    firms for the five big banks and they do some rotation up
    there.
        So, again, I am really thinking of the bigger companies.
    John Biggs, who is one of our board members, and he does it for
    the TIAA-CREF, and insists on it, he is a strong believer,
    having lived with it now for several turn arounds.
        Senator Corzine. So your view is that, no matter how strong
    we put the cop on the corner that would not be adequate, in
    your view.
        Mr. Bowsher. I think the rotation would do more to improve
    the auditing within the firms and the decisionmaking in the
    firms, and that, ultimately, is more important than even the
    cop on the street.
        Senator Corzine. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Corzine.
        I want to make one closing comment, looking into the
    future.
        I think that not enough thought is being given to how we
    are going to interrelate with the International Accounting
    Standards Board.
        If the European Union, as they have asserted, by 2005,
    adopts the standards of the International Accounting Standards
    Board, you will then have an economic entity as large as the
    United States, and potentially larger, as they add additional
    members and so forth. That is working off of one set of
    standards.
        Mr. Bowsher. Right.
        Chairman Sarbanes. I think that that will really sharpen
    the question in a global economy of how the U.S. interacts and
    integrates into that kind of environment.
        So, we may be moving toward a situation where the old
    premise that whatever U.S. accounting standards were, those
    would be the accounting standards for the world, may not apply
    as it has tended to apply in the past. But that is kind of an
    aside.
        Mr. Bowsher. No, I think it is a very important issue that
    you raise in there because we were always hoping that we could
    get harmonization. Some people thought that meant
    Americanization.
        We now know, especially after the Enron situation and a few
    other of our problem situations, that the overseas people are
    not going to automatically accept our principles.
        Chairman Sarbanes. We had Sir David Tweedie here from the
    International Accounting Standards as a witness at these
    hearings.
        Mr. Bowsher. Yes.
        Chairman Sarbanes. Thank you all very much. It has been
    extremely helpful and we look forward to consulting with you as
    we move ahead on this important issue.
        Mr. Bowsher. We would be pleased to do that, Mr. Chairman.
        Chairman Sarbanes. Thank you.
        Ms. Peters. Thank you, Mr. Chairman.
        Mr. Bowsher. Thank you.
        Chairman Sarbanes. If our next panel could come forward.
        [Pause.]
        Now, we will turn to our second panel. We are very pleased
    to have three able people here before us.
        In our previous hearings, the issue of corporate governance
    has come up and we need to focus on that. In 1999, the Blue
    Ribbon Committee on Improving the Effectiveness of Corporate
    Audit Committees, put forth 10 recommendations to strengthen
    the independence, improve operations, and enhance
    accountability of the audit committee.
        John Whitehead was the Co-Chairman of that Blue Ribbon
    Committee. We are very pleased that he is here with us today.
    Of course, we all know John very well. He was Deputy Secretary
    of State from 1985 to 1989. Before that, he was Co-Chairman and
    Senior Partner at Goldman Sachs, for many years. He is also a
    former Director and Chairman of the Securities Industry
    Association and a former Director of the New York Stock
    Exchange.
        We are also very pleased to have Bill Seidman with us. Bill
    served as Chairman of the Federal Deposit Insurance Corporation
    from 1985 to 1991, and as Chairman of the Resolution Trust
    Corporation. Previously, he was Chairman of the accounting firm
    of Seidman & Seidman.
        Bill, you might have been out of the room when Chuck
    Bowsher underscored the very significant contribution that you
    made to the FDIC reform bill in 1991. I think you had slipped
    out. And he underscored what a terrific contribution it was to
    the public interest. I wanted to particularly acknowledge that.
        Our third witness will be Michael Mayo, who is Managing
    Director of Prudential Securities and head of financial
    services research group. Previously, from 1997 to 2001, he
    directed the bank research group at Credit Suisse First Boston.
    And prior to that, he had a similar capacity with Lehman
    Brothers. He has been among the top three institutional
    investor all-star stock analysts for the past 5 years.
        We should get that on the record. And we are interested in
    his being with us this morning because one of the areas that
    has been raised is the potential for conflicts of interest in
    the advice that stock analysts give to investors. Some very
    interesting questions have arisen over that very subject.
        We are very pleased to have the panel here.
        John, why don't we hear from you and then we will go to
    Bill and end up with Michael Mayo.
        Senator Dodd, did you want to say anything?

                COMMENTS OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Thank you, Mr. Chairman. I apologize for
    missing the first panel. I want to be on record thanking them,
    Chuck Bowsher and others.
        There has been a lot of chatter recently about the
    effectiveness of the POB's and so forth. And whatever else we
    may decide on doing, I wouldn't want it to be any reflection of
    our lack of appreciation for the tremendous effort they have
    made.
        I think Senator Corzine and I both feel that way. He may
    have said so in my absence.
        Once again, it has been said here at almost every hearing,
    but these have been an excellent set of hearings. They are not
    as glitzy, I suppose, as some, where people are raising their
    right hand and walking out of the room. But if you want to
    really learn about what is going on and what are some of the
    best ideas and why other ideas may not be so great, these seven
    or eight hearings--I think this is the eighth hearing.
        Chairman Sarbanes. Eighth, yes.
        Senator Dodd. On this overall matter. It is about as
    thorough a discussion as has occurred here on the Hill. And
    that is all due to the Chairman, who has insisted that there be
    a deliberate, patient look at how we proceed.
        Having a panel as distinguished as this one, I just want to
    join in welcoming John and Mr. Seidman as well, who I have had
    the privilege over the years of working with. It seems like old
    times to see both of you sitting there again to testify in
    these matters.
        We thank you.
        And thank you, Mr. Chairman.
        Chairman Sarbanes. I appreciate your kind comments about
    the hearing. But the proof of the pudding is in the eating, and
    we have not gotten there yet.
        Senator Dodd. We haven't gotten there yet.
        Chairman Sarbanes. But we look forward to getting there.
        Senator Dodd. But I think it is a good product that is
    going to emerge out of all of this. Thank you.
        Chairman Sarbanes. Let me just say, Bowsher and company
    gave us a very carefully worked out White Paper here that I
    think is going to be extremely helpful to the Committee.
        Senator Dodd. Good.
        Chairman Sarbanes. John, we would be happy to hear from
    you.

                     STATEMENT OF JOHN C. WHITEHEAD

                FORMER CO-CHAIRMAN, GOLDMAN SACHS & CO.

                    FORMER DEPUTY SECRETARY OF STATE

        Mr. Whitehead. Thank you, Mr. Chairman, Senator Dodd, and
    Senator Corzine, nice to see you again.
        I am honored to appear before you this morning as I have
    done a number of times in the past: First back in the early
    1970's as Chairman of an SEC landmark study of the effect of
    institutional investors on securities markets, later as
    Chairman of the Securities Industry Association, and also as
    Co-Chairman of Goldman Sachs on various matters, and still
    later as Deputy Secretary of State and again on one occasion as
    Chairman of the Federal Reserve Bank of New York. I appear
    today, however, as a former nonmanagement director and former
    audit committee chairman of more than a dozen public companies,
    not all of them, I assure you, at the same time.
        I have always championed the importance of our securities
    markets and the competitive structure of the institutions that
    serve them. They are a national asset and an important part of
    our leadership position in the world economy. The confidence
    that investors have in the system must be protected at all
    costs. I have also championed the importance of diligent,
    independent, nonmanagement directors who represent the
    stockholders effectively and also represent the public
    interest.
        The Enron disaster is a severe blot on the generally good
    record that the system has had over the years.
        Indeed, it is an embarrassment to those of us who have been
    involved in that system. It is still hard for me to believe
    that what was coming to be considered one of America's great
    companies could collapse so rapidly in such an ignominious way,
    with such huge losses to employees, to lenders, to
    stockholders, and to the reputations of everyone involved: The
    management, the board, the audit committee, the auditors, the
    bankers, the security analysts, and the customers. It would
    seem to me that grounds for criticism exist in many places and
    that a thorough public review and investigation, including
    these hearings, Mr. Chairman, is absolutely desirable and
    necessary.
        I am knowledgeable enough about the system, however, to be
    quite confident that most companies act responsibly and that
    there are not a lot of Enrons out there.
        The only good result of the collapse is that it is causing
    companies now to look closely at their practices and at their
    disclosure policies, causing boards to review their attitudes,
    causing auditors to be more independent and more thorough,
    lenders to be more careful, security analysts to be more
    thorough, and so on.
        I can assure the Committee that there is now a self-
    cleansing process going on out there which is very healthy. It
    might be fruitful for the hearings to begin to focus not only
    on what actually happened to Enron, but on what the various
    institutions are doing now to keep it from happening again
    somewhere else. It may be wise to let this self-cleansing
    process go on for a while without being too precipitate with
    legislative action.
        It is clear to me that there were many signs that a more
    alert or even a more curious board might have recognized as
    fair grounds for questioning. Certainly, any request to the
    board to waive the board's ethics rules to exempt a transaction
    that otherwise would have violated them should have been enough
    to bring a lot of questions. However, the Committee should
    realize that it is very difficult these days to find and
    successfully recruit good board members. Many top experienced
    executives who would make excellent nonmanagement directors
    feel that their hands are full handling their present job, that
    their lives are already too full of other responsibilities and
    that the doubtful prestige and relatively unimportant extra
    compensation from taking on one or two outside directorships is
    not worth the increasing legal risk and the necessary time
    commitment.
        It would be a very unfortunate result of the Enron disaster
    if it became impossible now to recruit to board membership the
    kind of experienced, capable people that the system
    increasingly requires. The Committee should be careful about
    unnecessarily increasing the financial risks and the time
    commitments of nonmanagement corporate directors.
        Having said that, I do believe some things can and should
    be done now, and I have five points to make.
        Number one, having given the matter a lot of thought in
    recent years, particularly when I was Co-Chairman with Ira
    Millstein, who testified before you a few weeks ago, of the
    Blue Ribbon Committee on Improving the Effectiveness of
    Corporate Audit Committees, I have reached the conclusion that
    the accounting firm that does the audit should not do other
    advisory work for the company. Without that, the independence
    of the auditor's work will always be suspect. I reach that
    decision reluctantly, but I don't see that it is possible now
    to restore public confidence in the independence of the
    auditors without it.
        Now here is a point that is generally missed. The auditing
    firms should understand that this certainly does not require
    them to spin off or close down their advisory services. They
    would still be free to do advisory business with any company,
    excepting those they audit. Thus for any one firm what business
    they lose to others could be offset by business that others
    would lose to them, with no loss to the accounting advisory
    business as a whole.
        As an alternative way of accomplishing the same purpose, it
    might be worth considering whether the restriction might be
    placed on the company rather than on the auditors by requiring
    that a public company should not employ their auditing firms
    for services other than the audit. It would be preferable if
    this all could be accomplished by SEC action or action of the
    exchanges rather than by legislation. Of course, it might be
    appropriate to provide for a reasonable phase-out period.
        Number two, an unfortunate practice has developed in the
    relationships between management, auditors, and board audit
    committees on the setting of auditor's fees. Fees are set
    annually by negotiation between management and the auditor and
    then approved by the audit committee. Management's objective,
    as it is with all expenses, is to keep the fees as low as
    possible. The auditor, at that stage, has no idea of how much
    time it will take, or how much extra work might be required, to
    complete the audit, and is often pressured to accept a lower
    fee and agree to a shorter time schedule than might be
    necessary in case questions arose.
        Audit committees often agree to the fee and the time
    schedule, unwilling to question what seems reasonable in
    relation to last year's fee.
        If the auditor later does find questionable practices, he
    may have neither time nor money to pursue them under the terms
    of his agreement. A better practice would be to allow the
    auditor, at his option, to do work and charge fees up to a
    limit of, say, twice the originally agreed fee. This would tend
    to make management more aware of the authority of an
    independent author.
        Number three, over the years accounting rules, something
    like the income tax code, have become increasingly complex and
    arcane with the result that in combination they can often
    obfuscate the simple facts and obscure full disclosure.
        Rules that permit these results, such as hiding off balance
    sheet debt, transactions with related parties, alternative
    accounting for acquisitions, and so on, evade the principle of
    full disclosure and undermine the foundation stone of our free
    market system. The National Accounting Standards Board should
    be asked to review these matters promptly and recommend
    appropriate changes in the interest of full disclosure.
        Number four, rules now require that the chairman of a
    public company's audit committee have considerable financial
    background and experience. Those rules should be amended to
    require all members of the audit committee to have such
    backgrounds. This will encourage the recruitment to the board
    of more experienced and qualified people and recruitment to the
    audit committee those with the most financial experience.
        Finally, number five, since the principal purpose of audits
    is to provide public information to investors and the financial
    community, I believe the self-regulating authority of the SEC
    over the securities industry and the stock exchanges should be
    extended to the auditing firms. This would be an important
    addition to the present self-inspection system of the auditing
    companies. I know the earlier panel discussed that at some
    length. The authority of the SEC should also be extended to
    create a new self-regulatory
    entity charged with drafting a voluntary code of best corporate
    governance practices linked to an SEC disclosure requirement.
    Companies would then disclose whether they comply with the
    voluntary code, and if they do not, explain their areas of
    noncompliance and their reasons for not complying.
        I believe that these recommendations would be important
    moves forward.
        Thank you very much, Mr. Chairman.
        Chairman Sarbanes. Thank you. That was very, very helpful.
        Mr. Seidman.

                    STATEMENT OF L. WILLIAM SEIDMAN

                            FORMER CHAIRMAN

                 FEDERAL DEPOSIT INSURANCE CORPORATION

                            FORMER CHAIRMAN

                      RESOLUTION TRUST CORPORATION

        Mr. Seidman. Thank you very much, Mr. Chairman, and
    Senators. It is nice to be back again. It is a great honor to
    be on with John Whitehead, Mike Mayo, and to listen to Chuck
    Bowsher's excellent remarks.
        I have listed here a few reasons and my background why I
    might have some relevance to what went on in Enron, including
    the fact that I headed an accounting firm in troubled times, as
    a matter of fact, with the problems of equity funding.
        So, I have some feel for how an accounting firm----
        Chairman Sarbanes. We go looking for you every time there
    is trouble, Bill, to help us out of it.
        [Laughter.]
        Mr. Seidman. It looks like it. Anyway, I was also here when
    the banking problems went on. So, I will pass that over and get
    to my comments. My comments cover the range of the subjects
    that you have been discussing.
        One of the first things that I would note is that the Enron
    failure has caused tremendous losses. And we have heard a lot
    about it. But as far as I know, we have never heard exactly
    what happened. We do not really know what Arthur Andersen did,
    what it said, why it audited the way it did. They said they
    were studying that, but we are a long way from knowing what
    happened at Enron.
        So what I am saying after this is my surmise of what
    happened based on what we know now, knowing that Anderson has
    never testified. And my first comment is that this was
    essentially an accounting failure. Mr. Skilling made that very
    clear every time he was asked what happened. He said, I
    depended on my auditors, and that is usually a pretty good
    defense.
        I think that what we found, as far as what we know now, is
    that Enron held itself out to be a trading company. As Mr.
    Skilling said, if I bought on one side, I sold on the other
    side. So if somebody told me there was a big loss here, I
    wasn't worried because I had an offsetting thing.
        The first thing you look at when you audit a trading
    company is how much market risk they take. Most trading
    companies mark-to-market, as the Senator knows, every night, so
    they know exactly how much trading risk they are taking.
    Auditing such a company, that would normally be the first thing
    that you would look at.
        We now know that Enron really was not a trading company. It
    was a speculating company, speculating on volatile markets. And
    when the markets went against them, they failed. Why weren't
    they a trading company? Because they were hedging with their
    own related companies for which they were ultimately
    financially responsible. Once they used up the capital in those
    related companies, it came down to them to make up for the
    losses. So, in fact, they were not what they held themselves
    out to the world to be, and they were not, I guess, what most
    of the directors thought they were, which was a trading company
    in energy and the other new fields.
        And how Andersen arrived at the conclusions that they did,
    that they were fairly presenting the financial statements,
    given that, is something, as far as I know, we haven't heard
    from Andersen on. I cannot go further than just say, what we
    have so far, it seems to me, to say that this is an accounting
    failure based on a misperception of what the company was
    actually doing.
        I could be proved to be all wrong on that if they come in
    and explain it. But from what we know now, I think that is a
    reasonable explanation of what went on.
        As part of this, they mark-to-market contracts under the
    new hedging rules and derivatives rules where there really was
    no market. And therefore, Enron, as the prime market-maker,
    stated what the market was, maybe electricity prices over the
    next 10 years, marked-to-market, and then took a profit on the
    contracts because, in their view of the market, this was a
    profitable contract.
        There are some very important issues that I think have to
    be analyzed to have reasonable recommendations on what might be
    done here.
        Therefore, the first thing is how about the accountants and
    the auditing and accounting principles that were used at Enron?
        I heard Mr. Bowsher's testimony. I would generally
    subscribe to it, with a couple of exceptions which I will note.
    So, I will depart from what I had here because it might be more
    useful to you.
        I would say to begin with, CPA's are different. They are
    hired to audit a firm which pays them. They have a fundamental
    conflict of interest going in, like no other profession has,
    because they are examining a company which is, in effect,
    paying them to find out whether they are honest or not and also
    whether they are fairly presented.
        In that kind of a situation, I think that you have to have
    very substantial Government control. I do not believe that the
    kind of thing that we have had so far has worked. I did not
    think it worked when I was in the profession. Therefore, in
    looking at Mr. Bowsher's suggestions, the real question to me
    is, should that board be an independent board, appointed by the
    President, confirmed by the Senate, like we do for banking,
    like we do for other things that are fundamental to our
    economic system?
        I think accounting is clearly fundamental to a basic free
    market capitalistic system. So, I would raise that question.
    Then the second question that follows from that is, what is the
    relationship between that and the SEC?
        The only thing I have in my experience is what we did with
    the RTC. If you remember what the Senate did, we had one body
    that set policy and another body that carried it out with the
    individual companies involved. And there might be some guidance
    in that kind of a thing, where the SEC would deal totally with
    companies and reports and so forth, but the profession would
    handled by a separate body.
        Other than that, I subscribe to Mr. Bowsher's
    recommendations that the three units be put under one board so
    that they can be coordinated and that they be charged with
    accounting principles, auditing principles, and discipline and
    regulation.
        In that regard, I agree with that. The only thing I would
    say about the swinging door or the auditors that go to clients,
    I think that has been discussed for many years. Whether or not
    we ought to do that or not, the only concern I have about it is
    that it will make it much harder to hire young people to go
    into accounting
    because they find the swinging doors generally a large part of
    the attraction to accounting. But that can be weighed against
    the benefits that you see.
        I agree that, clearly, you have to have independent sources
    of funding for those things, so that we do not get into the
    kind of problems we had before. I would also say that we need
    to provide that board with the best possible protection we can
    against influences, both private and public.
        When I was at the FDIC, we had some very effective rules to
    protect us, to some extent, from both the private, and we even
    passed a rule which probably most of you do not remember, that
    if public officials came to influence us with respect to any
    particular client, that we had to publish that visit promptly
    after. And we did not have many visits after that.
        With respect to corporate governance, Enron raises some
    very interesting questions because, is the defense that I
    relied upon my accountant and my lawyer, to say that this was
    all appropriate, really all we can expect from directors?
        I subscribe to John's view that we have to be very careful
    not to put such burdens, unrealistic burdens, on directors that
    we won't get any competent directors. And I think that is
    doubly true with the audit committees.
        Very frankly, I am on a bunch of boards. I always try to
    keep off of the audit committee because, as a CPA, the standard
    for me will be so high, as to be very dangerous. And I haven't
    succeeded, incidentally.
        [Laughter.]
        But I think that that is an important point that has to be
    taken into consideration.
        So, in looking at this, was there a real failure on the
    part of the Enron board? Well, clearly, it was inappropriate to
    approve this conflict of interest between the related
    companies. Yet, if you look at what they did, they had a very
    detailed procedure for doing it. They had given different
    people that were supposed to sign off, and so on, and it was
    not done haphazardly.
        I really find it difficult at this point, not knowing more
    about what Andersen told them, to say that the board acted
    totally inappropriately, or can I think of any particular thing
    from Enron that might be suggested?
        I have two suggestions on that.
        First is that, in my experience on a lot of boards, having
    the chairman of the board and the CEO be the same person works
    many times. But when it doesn't work, it is a disaster. When
    you get real power like that in one person, and there is no
    real way to deal with it, it can be very expensive. This may
    have been true with regard to Enron. Mr. Lay was obviously the
    soul of the company. That is one thing.
        The second thing is, and I think it really goes along with
    your recommendations, that the committee that elects members to
    the board should be an independent committee, and that the CEO
    of the company should not be on that committee, because if you
    do not have that, then you really can get into the crony
    system.
        I will just close with two things regarding Government
    regulation, which I think is the third area that this raises.
    It raises the area of the auditors. It raises the area of the
    corporate governance and it raises the area of Government
    regulation.
        Clearly, Enron was operating in an area where they tried
    very hard to keep the Government from supervising it. They made
    no bones about the fact. And the argument and the idea was that
    the market will be much better if it is ruled by the discipline
    of the marketplace, therefore many of these new things that
    they were developing trading for should not have any market
    supervision.
        It seems to me that this experience does not support the
    idea that this is any different than other futures markets and
    so forth. And the question is, what kind of supervision or laws
    can you have, particularly in these very complicated areas?
        This, it seems to me, more than anything, would be an area
    where disclosure would be the best remedy to begin with, and
    full disclosure. For instance, one of the first things that
    ought to be disclosed, and this is now being discussed with
    Fannie and Freddie, is: ``Who is your counterpart on hedges? Is
    your counterpart viable under the kind of potential hedging
    liability, involved?''
        That, after all, everyone says, well, we have this nice
    market where they hedge. But if the hedge is not any good--ask
    the people who had Russian banks for hedges when they
    collapsed. That took several very good firms out of business.
        So who are they hedging with and what disclosure can we get
    as to the hedge capability of handling these things, and there
    may be other things.
        Obviously, that would be something that ought to be put
    into the hands of a commission. I do not think you can
    legislate in detail on that. But the responsibility ought to be
    put in the hands of the commission.
        I will finally say, and I am not even sure that this is in
    your area, but I think if you look at Enron and see that they
    paid no taxes in several years when they were reporting
    hundreds of millions of dollars of income, it indicates that we
    have a huge gap in our taxation system right now. From my
    personal experience, it is getting worse. My experience around
    the world is that when you do not collect taxes effectively, it
    jeopardizes the whole system of Government. I think that is an
    area that should be looked at and examine what Enron did with
    Camen Island things and all the rest. But I think that is a
    real threat to the operation of the system we all want.
        I will end just like John did, by saying the danger here
    may be in doing too much rather than too little. But there is
    certainly a danger if you do not do something.
        I appreciate your attention. Thank you.
        Chairman Sarbanes. Thank you very much. It is very helpful.
        Senator Dodd. Mr. Chairman.
        Chairman Sarbanes. Yes.
        Senator Dodd. I want to apologize to Mr. Mayo. I
    unfortunately cannot stay for the rest of the hearing. But I
    wanted to indicate my gratitude to all of you and tell you how
    important your testimony is.
        I am just curious. Again, reading newspaper stories about
    this, but I read one story where, allegedly, the audit
    committee at Enron never asked to meet with the accountants,
    even when these problems began to unfold.
        Like you said, this is an accounting story and I think it
    certainly is to a large extent based on what we know. It is
    also an Enron story here that we do not know much about.
        Mr. Seidman. Yes.
        Senator Dodd. We have relied on a couple of witnesses who
    have told their side of the story. But as more comes out, I
    think you are going to find that maybe passing the buck
    certainly has some legitimacy, but you cannot pass all the
    bucks over.
        Mr. Seidman. Those are the kinds of things we do not know
    at this point.
        Senator Dodd. Last, I would just mention this to the
    Chairman. I meant to bring it to him the other day. But there
    was a piece in The New York Times which indicated that where
    the IRS audits are occurring, there are stunning numbers about
    the massive increase in audits of people at the lower income
    levels in this country and the significant decline in audits of
    people at the upper income levels in the last 5 or 6 or 7
    years.
        Mr. Seidman. It has gotten so complicated--I would do, if I
    were there, what I did when I was at the FDIC. I would hire the
    big law firms and accounting firms to represent the Government
    in policing some of these very complicated and sophisticated
    areas.
        Senator Dodd. Thank you all.
        Senator Corzine and I have written a proposal for the
    Committee to consider. A lot of it deals with the very subject
    matters you have discussed and I presume that Mr. Mayo will
    discuss as well. We certainly invite your comments on what we
    have put down on paper and I will let Jon raise those issues
    with you.
        I apologize.
        Chairman Sarbanes. It is all right. No problem.
        Mr. Mayo, we would be happy to hear from you.

                       STATEMENT OF MICHAEL MAYO

             MANAGING DIRECTOR, PRUDENTIAL SECURITIES, INC.

        Mr. Mayo. Chairman Sarbanes, Senator Gramm, and Members of
    the Committee, thank you for inviting me to testify today about
    conflicts on Wall Street. I will cover conflicts among
    brokerage firms, corporations, and research analysts. I
    currently work for Prudential Securities, which values
    independent research, however, I am here today to give my own
    personal point of view.
        It is great to be back near my home in Maryland. I hope
    that the University of Maryland basketball team advances far in
    the NCAA basketball tournament. I can guess that the Chairman
    shares my hopes.
        Chairman Sarbanes. That is a fair guess.
        [Laughter.]
        Mr. Mayo. I am here to talk about what can be analogous to
    playing basketball with one hand behind your back. Objective
    analysts, those with negative opinions and/or critical remarks,
    may have trouble holding corporations accountable. The reason
    is that companies themselves and their managements are the best
    source of information, and bullish and conflicted analysts may
    have the best access to this information.
        It is still hard for an analyst to be objective and
    critical. When an analyst says ``sell,'' there can be backlash
    from investors who own the stock, from the company being
    scrutinized, and even from individuals inside the analyst's
    firm. While much attention in Washington is being paid to the
    pressures related to a firm's investment banking operations,
    other pressures can be as great or more. The main point: Some
    companies may intimidate analysts into being bullish. Those who
    stand up may face less access to company information and
    perhaps backlashes, too.
        I have a few perspectives to support my view--From personal
    experience: I have worked at 4 of the 10 largest brokerage
    firms. I understand how the brokerage industry works. From my
    research: I have covered the banking industry since the late
    1980's and head the financial research group at Prudential
    Securities. From my stock ratings: When the facts support it, I
    do not shy away from placing sell ratings on companies I cover.
    I have probably done so more than almost any other analyst. And
    from my current firm, Prudential Securities: A year ago,
    Prudential shed almost all of its investment banking
    activities.
        I will cover three areas in my testimony today: One, my
    personal experiences. Two, the conflict between serving
    investors versus corporations. And three, problems with access
    by research analysts to corporations.
        Number one, my personal experiences.
        As I prepared for my career, I had all the usual training--
    financial textbooks, MBA training, professional certification,
    and even training at the Federal Reserve here in Washington.
    But playing-by-the-book does not do it on Wall Street. Here are
    a few personal examples to illustrate my point.
        First, after publishing a report with a hold rating--not a
    sell but a hold rating--the CFO of the subject company had a
    shouting match with my boss and me. There was a threat of
    investment banking business getting withdrawn. Luckily, my
    senior management supported me.
        Second, I published a report criticizing a merger. One
    investment banker barked at me, ``How do we make money off this
    research?'' I stuck with my opinion.
        Third, a bank excluded me from an important dinner meeting
    at which all of the other banking analysts from major firms
    were in attendance.
        Fourth, a CEO called to complain. He did not like negative
    comments in a report. He said that he gave investment banking
    business to my firm due solely to me. He said we had ``let him
    down.'' I said simply that we are objective with our analysis.
        Fifth, I placed a sell rating on one bank. I was told that
    the bank's management, in turn, told large investors that we
    had not done our homework, effectively criticizing our research
    approach. Within 6 months, I was proven correct after the stock
    declined as a result of issues with earnings.
        Sixth, we asked to visit with the management of a company.
    The response was, ``No.'' I finally took a meeting with one
    company representative. They had said, ``Take it or leave it.''
    What choice did I have?
        So whether the time was the start of the last decade or the
    start of this decade, whether the firm was UBS, Lehman, Credit
    Suisse First Boston, or Prudential Securities, the backlash
    from corporations was similar. Little has changed to help me
    perform my job better. This pervasiveness suggests there are
    larger issues at work. We need to address these issues to
    ensure that investors get unbiased research.
        Number two is the conflicts at brokerage firms: between
    serving investors versus corporations.
        This statistic is critical: The brokerage industry earns
    four times as much from serving corporations, for example,
    through investment banking and related services, as from
    serving investors. Two decades ago, in 1982, this ratio was one
    to one. In addition, the same firms--the 10 largest brokerage
    firms--that get most of the trading business with investors
    gain an even greater percentage business of investment banking
    activities with corporations.
        So who is really the client? The degree of conflict between
    serving corporations and investors--based on where the money is
    made--is at its highest level in history. If nothing else, this
    creates an environment ripe for abuse.
        For brokerage firms, what does it mean to earn four times
    more from corporations? First, investment bankers have the
    leverage. They want research analysts to act as team players.
    To them, this may mean saying nice things about their major
    corporate client or potential future clients. Second, brokerage
    firms hire people who get along with investment bankers. One
    manager who hired me said that, in evaluating analysts, the
    firm placed a lot of weight on what the companies had to say to
    investment bankers. Can you imagine? This is like judging a
    food critic based on what the restaurants say.
        For analysts, what does it mean that their firms earn four
    times more from corporations? It means financial incentives,
    which can taint analysts' opinions, and keeping a job. It is
    not rocket science: 80 percent of traditional brokerage profits
    come from corporations. Help the firm, you do well. Hurt the
    firm, why get rewarded? Analysts are mainly bullish and
    conflicted, probably because they do not want to lose their
    jobs.
        My main point: People do what they are incented to do. For
    brokerage firms, the incentive to serve corporations over
    investors is stronger than at any point in history. For
    analysts, the main incentive is to stay employed.
        Number three is the problems with access by research
    analysts to corporations.
        It takes an objective and critical analyst many times more
    work to do the job than it does a bullish or conflicted
    analyst. The main reason: Backlash from corporations. Such
    backlash can take various forms. I have five examples:
        First, investment banking: The influence of investment
    banking on stock research is well documented after the Internet
    bubble. Per my other examples, sometimes companies pull
    business from a company after a critical report.
        Second, phone calls with the company: Phone contact is part
    of an analysts' day-to-day communication to get more color
    behind the numbers. Bullish and conflicted analysts can get
    their calls returned first, and even get senior executives on
    the line, including the CEO. As for objective and critical
    analysts, at times their calls are not even returned.
        Third, meetings with the management: Some firms reply to a
    meeting request, ``Why is it a good use of our management's
    time?'' In other words, ``Say something positive, we will let
    you in.''
        Fourth, conference calls: Companies hold conference calls
    for earnings, strategic moves, and other reasons. Conference
    call systems let you manipulate the order that questions are
    answered. Last year, on one call, the operator said that my
    call was in the queue. I then hear, ``No more questions.'' Do
    the more novice investors listening to the conference calls
    realize that the order of the questions can be manipulated?
        Fifth, managements participation in analyst events:
    Institutional investors--my main clients--pay a lot of
    commissions if you hold good conferences and bring managements
    in to see them. Guess who gets to do these tasks? Bullish and
    conflicted analysts, especially those whose firms have
    investment banking relationships.
        For the bullish or conflicted analyst, calls may be
    returned first, questions may be taken on conference calls,
    meetings with management may get scheduled earlier, managements
    help out to visit investors or participate in conferences, and
    investment banking fees may be better to boot.
        Reg FD has not fixed all of the problems. Companies simply
    make canned presentations on a webcast, but then may choose to
    turn off the webcast during the Q&A and the follow-on breakout
    sessions. Also, some firms do not webcast their presentations,
    which I find very discouraging.
        Perversely, this poor treatment has helped to make me and
    my team better analysts. We are forced to better scrutinize
    accounting footnotes, interact more with impartial third
    parties, and go out and ``kick the tires.''
        In other words, we are forced to hustle a lot more. To use
    the analogy, we are still doing the equivalent of playing
    basketball with one hand behind our back. The issue: I am not
    sure how many analysts are willing to accept this handicap,
    especially the newer ones trying to pay their New York City
    rents.
        To recap the problems: First, from my perspective, it is
    business as usual when it comes to conflicts between companies
    and their research analysts. Second, people do what they are
    incented to do. The financial incentives for brokerage firms to
    serve corporations has never been as high as they are today.
    Third, objective or critical analysts continue to face
    backlashes in many ways.
        So what is the solution--information and incentives. From
    my perspective, speaking solely as an independent analyst,
    there are a few steps that can be taken to improve the
    situation:
        First, information: Make sure that the access to the
    information is fair. One idea is have an avenue for those
    analysts who feel disadvantaged by the companies they cover to
    voice concerns and get corrective action. Maybe a clearinghouse
    whereby analysts have recourse to voice their concerns. Maybe
    someone at the SEC. Just give me someone whom I can call when I
    am treated unfairly. One caveat: Any solution needs to ensure
    that companies still are incented to maintain the highest level
    of information flow. I do not believe we need to regulate
    analysts. Analysts need to have equal access to information and
    appropriate incentives to provide objective research. Let's
    address the root of the problem.
        Second, incentives: Take actions to minimize the
    interference of investment bankers with the job of research
    analysts. Disclose investment banking relationships to
    investors. Does the retail investor know that the brokerage
    firm pitching shares is also earning investment banking fees
    from the company? A related solution is to eliminate deal-based
    incentive pay. Also, in terms of carrots and sticks, a lot of
    attention has focused on making the stick bigger to get the so-
    called ``bad'' analyst. The ``carrot'' needs more attention, to
    encourage good behavior. I know there is debate about
    separating research from investment banking. From my personal
    experience, I can tell you that this is an effective solution.
        My conclusion is that we have the best capital markets in
    the world. But let's not grade ourselves on the curve. They can
    be better. As analysts, we are at the intersection between the
    interests of corporations and the interests of investors. We
    provide institutional memory, act skeptically, challenge
    corporate authority, question assumptions, and speak up if
    something does not smell right. We are on the front lines of
    holding corporations accountable. Prudential Securities scaled
    back its investment banking a year ago. The result is a great
    environment for me. I have 100 percent support of my management
    when I am doing my research. Despite this, the pressures
    outside the firm are as strong as ever. The result: Impediments
    to conducting full, independent, unbiased investment research
    on corporations. Action that can help remove these impediments
    and reduce the remaining conflicts will help improve our
    ability to serve clients, and when I talk about clients, I am
    talking about investors.
        Chairman Sarbanes. Good. Thank you very much, sir. Very
    interesting testimony.
        John, in your statement, you say, and I am quoting you now:
    ``The authority of the SEC should be extended to create a new
    self-regulatory entity charged with drafting a voluntary code
    of best corporate governance practices linked to an SEC
    disclosure requirement. Companies would then disclose whether
    they comply with the voluntary code and explain areas of
    noncompliance.'' Could you develop that a little bit for us,
    please?
        Mr. Whitehead. Yes. I am a big fan of codes of conduct that
    are not legally required rules, but are considered by people in
    industry who have high standards to be rules that everybody
    should comply with. Let me think of an example.
        I believe the New York Stock Exchange rules require that a
    public company must have at least two outside directors. It
    would seem to me that that is appropriate when a company is
    first going public and let's say a family ownership company
    goes public and the public shares now represent 10 percent of
    the total shares.
        As that company goes public more and more, it seems to me
    it can be argued that the percentage of outside directors
    should increase as time goes on, and that if 90 percent of the
    company is owned by the public, there should then be very few
    inside directors or management directors.
        I think a code of conduct might say that the percentage of
    outside directors should be roughly proportionate to the
    percentage of stock owned by the public. But to make that into
    a law, or even an SEC rule, would be difficult. This would be
    an example of what might be part of a code of conduct. If the
    company still only had two outside directors and 90 percent of
    its stock was owned by the public, it would be required in its
    proxy statement each year to say, the company only has two
    outside directors. Yet, 90 percent of our stock is owned by the
    public. And the reasons that we have that is such and such.
        If the reasons looked weak and rather silly or self-
    serving, I think they would be under great pressure to change
    them because it would be pointed out that this is a ridiculous
    situation that they would have to disclose.
        That is an example. There could be many other examples,
    including some in the areas that the last witness was
    describing, which a code of conduct, a code of high standards,
    would help solve.
        Chairman Sarbanes. Thank you very much.
        Mr. Mayo, how much of this can we get at by just
    disclosure? Suppose the analysts had to lay out their
    companies' connections with the corporation that was being
    rated, their own personal connections--whether they hold the
    stock, et cetera. How much of a difference can that make?
        Mr. Mayo. I think disclosure makes a big difference.
    However, there is always the implied threat. If you are getting
    80 percent of your traditional brokerage profits from
    investment banking, then there is always the understanding by
    the analyst--again, it is not rocket science--that if you make
    money for the firm, you will do well. If you do not, then you
    might not do as well.
        And so, disclosure goes to a certain point. But from the
    analyst's perspective, I think there is still an issue about
    the implied threat by investment banking on an analyst's
    ability to have complete freedom and show unbiased research.
        Chairman Sarbanes. Well, I am struggling on how to deal
    with it. Bill Seidman did not read this paragraph and I am
    going to read it because I think it is quite a good paragraph.
        Mr. Seidman. Thank you.
        Chairman Sarbanes. He said, ``A good free market operates
    like a `prize fight,' plenty of chance to slug it out, but not
    below the waist and not with the second's stool. An
    unrestricted market is like a `ballroom brawl' where the fight
    results in widespread destruction of both people and the place,
    and the winner may be the dirtiest fighter on the scene.
        ``The trick, of course, is to have the right rules that
    promote fair competition without stopping the competition.''
        I think that is very well put. It doesn't give me an
    answer, but it is a nice frame of reference with which to go at
    this thing.
        Mr. Seidman. Thank you.
        Chairman Sarbanes. You then go on to talk about Enron being
    in an unregulated environment, at least for a good part of
    their activities, and the consequences of that, and I think
    that is a point well taken.
        We are trying hard to boost the budget of the SEC right
    now. I have for years felt that they were underfunded. Senator
    Corzine has taken a keen interest in that issue as well. We
    want to give them pay parity. In fact, we thought we had
    reached an understanding that they would get pay parity, and to
    our great surprise, the Administration did not deliver that in
    the budget, although they did move ahead and reduce the fees
    and that was all part of a package.
        Do you perceive the SEC as being significantly underfunded
    in terms of its ability to carry out its functions?
        I ask any one of you.
        Mr. Seidman. Yes, I do. I think it definitely is
    underfunded. I think Chairman Levitt made that point, the
    present Chairman. And all along here, as I suggested to the
    IRS, the ability of the Government to take on the astute
    private sector in these areas is falling behind, and I think it
    definitely needs more funding.
        Chairman Sarbanes. Well, you feel that, in a sense, we are
    slipping so much, that even the IRS lacks the expertise that it
    needs to handle some of its challenges and therefore, it should
    be thinking of contracting with the private sector to do it. Is
    that correct?
        Mr. Seidman. I think that is correct. That is what I did at
    the FDIC. When we were suing Mr. Milken, he had four huge law
    firms on his side and we had our GS-15's. I thought it was an
    unfair contest. So, we hired a major New York law firm to
    represent the FDIC. Now the Justice Department has done that in
    the Microsoft case. And I think it is very effective for the
    Government and it is in a way low cost because you just hire
    them for the job. I think it would be something that they
    should have a budget for.
        Chairman Sarbanes. Interesting suggestion.
        John.
        Mr. Whitehead. Yes, I agree with all of that. I think the
    SEC is underfunded and has been for some years. When you
    consider the seriousness of the system of just one Enron, it is
    dangerous to fool around with relatively small increases in
    budgets that the SEC asks for.
        Chairman Sarbanes. Right. Do you have any observations on
    that, Mr. Mayo?
        Mr. Mayo. I haven't studied it, but my one observation is
    to look at the SEC budget relative to the stock market
    capitalization. I believe that percentage has gone down for the
    past few decades.
        Chairman Sarbanes. My time has expired.
        Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman.
        Let me note that I have been sitting erect and firmly in my
    chair listening quite securely since I have one of my own
    former chairmen here who brought me through my training process
    at my old firm--I do not know whether he thinks successfully.
        Chairman Sarbanes. Well, we think successfully. We think
    you did a terrific job.
        [Laughter.]
        Senator Corzine. Let me give a great compliment to John
    Whitehead because, as a youngster growing up in the securities
    business, I was just constantly challenged with the elements of
    greed associated with the business, some of which you have
    heard Mr. Mayo talk about.
        John wrote a business principles issue which I think goes
    to the code of conduct that he probably is offering in the back
    of his mind. One of those codes was, our assets are people,
    capital and reputation, and if any of these is ever diminished,
    the last is the most difficult to restore.
        We had real leadership on this. And while I think there is
    room for regulatory and maybe even legislative response,
    ultimately, the leaders of corporations, leaders of business,
    need to establish standards that operate in the cultural milieu
    that we are all about.
        We heard some of that reflected in Mr. Mayo's comments. I
    can only say that John Whitehead is one who has practiced what
    he preaches in an extraordinary way throughout his career. It
    is always hard for me to ever disagree with him, although, on
    occasion, we have. And I do not in this particular instance.
    But I did want to make that comment with regard to his
    contributions.
        Let me turn to one of the specific questions, and I would
    be interested in any and all of you to comment on. But it gets
    at what Mr. Seidman had talked about in contracting out
    difficult assignments. I think it relates to one of the
    questions that is very hard for me to sort out. And this is the
    rotation of auditors on a 7 year basis, 5 year basis.
        The logic of it is it has merits. This is one of those
    tough pros and con balancing issues to me. But it strikes me,
    as we get more and more complicated, as you were just
    suggesting with regard to the nature of looking at these
    institutions, that we might gain greater security through the
    cop on the corner as opposed to the rotation device. And given
    your great wealth of experiences, I would love to hear your
    comments on it.
        Mr. Whitehead. Shall I start, or do you want to start?
        Mr. Seidman. Go ahead.
        Mr. Whitehead. I am not sure I am right on this thing. Some
    things I am sure I am right. I do thank you for your kind
    comments and the respect I have for you and your own career.
        I do not agree with many of your political views, but I do
    agree with you on this general subject of corporate
    responsibility and ethical conduct. And you carried on
    traditions at Goldman Sachs in your era that made me very
    proud.
        I guess I reached the conclusion that some kind of
    compulsory term for outside auditors is probably a good thing.
    There are pros and cons of it and the Chairman described those
    in earlier questions. It shouldn't be too short a term because
    there is advantage in somebody who knows the ropes, who knows
    the companies, who knows the problems, and has worked on the
    audit for some years. But then, if it goes on for 20 years and
    it is still the same people and they still have the same close
    relationships within the company, it is hard to think that that
    auditing firm might have the same courage to stand up and
    disagree with something that they disagreed with.
        I would say somewhere in the 8 to 10 year period might be
    striking, in my mind, about the right balance when the
    accounting firm should really change and when it is better to
    bring in a new firm, a new organization that would take a new
    look at the company.
        So that is about where I come out. I think that would be a
    good idea. I do not know what is necessary to institute that,
    whether the SEC has the authority or whether the stock
    exchanges have the authority to do that. I do not know. But it
    seems to me that would be a wise compromise between the two
    extremes.
        Mr. Seidman. Well, I thought John was going to say that the
    code of conduct would handle that by simply saying the
    preferred code would be, and if you do not change for so many
    years, you ought to explain why and so forth.
        I think this idea was first put forward by my former Senior
    Partner, Jack Seidman, when he was head of the AICPA. And it
    brought down a torrent of abuse on his head, particularly since
    he wasn't head of one of the largest accounting firms. So it
    was a very contentious issue and has continued to be.
        Looking at it, now that I have been out of accounting a
    long time and at the companies that I have been with, I think
    if we did have a code of conduct and it said that this was the
    preferred method, that might be as effective as anything.
        My fear, in changing the accountants, is that competition
    among accountants is terrific now. And if they know that every
    5 or 6 years, they have to go out and compete for new ones
    because they are going to lose the old ones, it is going to
    make it even worse than it is.
        So, I have some reservations about that kind of a mandatory
    thing because, again, the competition in a place where you are
    competing so that you can then go in and look at the company
    that has finally chosen you and see if there is anything wrong
    with them, is a very difficult situation. I would rely more on
    the regulatory structure, I think.
        Senator Corzine. I have one more question for Mr. Mayo, and
    then I have to leave.
        You outlined a number of the conflicts which I think
    investment banking firms and securities firms deal with on a
    day-to-day basis. I am sure Mr. Whitehead had many of the same
    experiences in trying to sort out relationships and
    independence of analysts that I know that I experienced in my
    career. Some of those yelling matches that you may have had
    with CEO's actually came to chairmen's offices and it is the
    responsibility of the chairmen to insulate and protect their
    analysts in those cases.
        One of the conflicts you did not talk about is the
    investment
    activity of the analysts themselves, whether they hold stocks,
    whether they trade stocks, whether they are involved in the
    companies themselves that they are involved in. I was curious
    why that was left out, or do you think it is not a problem?
        Mr. Mayo. If I had $100 to spend on a solution, I would
    spend $1 on the issue of stock ownership and the other $99 on
    the other issues. There has been some egregious cases reported
    in the press, aside from that. I did not know it was a big
    issue until the past few months, except for the real egregious
    cases.
        I think that misses the bigger issue of lack of equal
    access to information by analysts and the inappropriate
    incentives either on the upside, but especially on the
    downside, and I think that is the story that has been missed. I
    will spend $99 working on that solution relative to the stock
    ownership solution.
        Senator Corzine. All right. There are serious questions of
    incentives that I think can flow from involvement in these
    things. And disclosure may very well be one of those responses
    you have there, as well as compensation packages which are
    indirectly the kind of thing that I think reflects a stake-
    holding in the underlying company that is analyzed.
        But those are things that we need to talk about and the
    code of conduct I think is absolutely essential with regard to
    straightening out some of the public's lack of confidence in
    the industry's independence with regard to its analysis.
        It is really separate sometimes from the accounting issue,
    but one that can be handled with listing standards or the SEC
    or the whole set of different rules.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thanks, Jon.
        Senator Corzine. It is good to see you, and I thank the
    witnesses both for their presentation today, and for their
    public service throughout. It is an honor to be here and hear
    your remarks today.
        Chairman Sarbanes. I want to ask a question of Mr. Seidman.
    You have had a very distinguished both private and public
    career and have certainly fought for the public interest in
    your public jobs.
        We read about these so-called giants of the accounting
    industry or profession. I am not quite sure which term to use
    in the circumstance. We talked about high standards and
    financial rectitude and so forth. Has something really gone
    wrong? Is there some underlying thing that we are not
    identifying that has helped to create this problem? Or is it
    just in every barrel of apples, there is going to be some bad
    apples?
        Mr. Seidman. Thank you, Mr. Chairman. That is a hard
    question to answer. I think what has probably brought us to the
    kind of problems we are in now is the increasing complexity of
    the business world, the increasing concentration in the
    accounting profession until there are a very large mass of
    groups and the leadership is more a manager, maybe, than he is
    an accountant, or at least he's outstanding because he is a
    manager.
        So, I think my view is that human nature hasn't changed.
    There are still leaders around. But because of the complexity
    of the world that has developed and because of the
    concentration, it is much harder for them to emerge and provide
    that kind of leadership.
        Chairman Sarbanes. I take it, given that complexity from
    the close of your statement, we really need to have some
    Government role that provides at least the framework or the
    structure within which these activities take place and that can
    at least give us some assurance that the more egregious forms
    of conduct will be blocked out or ruled out.
        One perception I have is, unless you do that, you run the
    risk that the practices will go to the lowest common
    denominator because the people engaged in those practices, if
    they can do it without being called to account, may in fact
    gain what they perceive is a competitive advantage, or put
    others, what they would see as being at a competitive
    disadvantage.
        They may not want to do that practice. They may not think
    it is the right practice to do. But it is being done and those
    doing it are gaining advantage from it.
        It seems to me that we somehow have to get a structure here
    that--and the code of conduct I think becomes relevant to that
    consideration as well. Do you perceive it that way?
        Mr. Seidman. I do, Mr. Chairman. I think you read that
    little statement that I made about the fight.
        Chairman Sarbanes. Yes.
        Mr. Seidman. You need a structure and that structure,
    particularly in accounting because accounting, per se, is a
    conflict of interest. Therefore, you have to have a Government
    set-up structure within which they perform.
        I am sure that when I was heading an accounting firm, I
    would not have said that. But having been out of it a little
    while and looked at it from more of a business view, I think it
    is something that is going to be necessary.
        I think we have given the self-regulatory system all the
    chance in the world to operate and Enron proves that it is not
    effective.
        Chairman Sarbanes. John, let me ask you, it seems clear to
    me that we have to have a mandatory source of funding for
    whatever board we have, or boards, that set the standards, do
    the enforcement, and so forth.
        This going around with a tin cup and begging contributions
    from the very people that are being regulated obviously doesn't
    work. They would give the money to the Public Oversight Board,
    for example. What is the best way or place to get that source
    of funding?
        Mr. Whitehead. I am not one who generally supports
    increased Government funding. But I do in this case. I think
    those kinds of things should be financed from the SEC's budget
    or as part of the SEC's budget, with public funds. They are
    expended to help the public, to help the public investor. And
    it seems to me that it is not a bit unfair that the public
    should share in the cost of those basically regulatory policing
    organizations.
        Chairman Sarbanes. I agree with that, except that we then
    run into the perils of the appropriations process. We have been
    trying to think of putting a fee somewhere. Either the listed
    companies would pay some kind of fee or maybe the accounting
    firms would pay some kind of fee. Do you have any thought on
    that?
        Mr. Seidman. I would make it a fee for all the listed
    firms. In other words, it is a cost of being listed that they
    would pay a certain amount.
        Chairman Sarbanes. That would then fund these
    organizations.
        Mr. Seidman. And I would fund these organizations.
        Chairman Sarbanes. Do you have a problem with that, John?
        Mr. Whitehead. Well, there are a lot of others that benefit
    from them, too. All investors benefit. Maybe the large
    institutional investors should pay their share. The brokerage
    firms, investment bankers all benefit from the success of the
    system and the volume of investment that flows through them.
        So it seems to me that it gets back to being the whole
    public benefits from our wonderful capital markets and people's
    capitalism system. Actually, public financing doesn't disturb
    me.
        Mr. Seidman. What disturbs me is you are part of the
    appropriations process.
        Chairman Sarbanes. We just discussed the difficulty of
    getting the SEC an adequate budget to do what they are now
    charged with and are falling short of that. This would then
    require us to go even further.
        Now, you can get that budget, perhaps, we are trying hard
    now, in this particular climate right now. But how long that
    will last and whether it will survive subsequent budget rounds
    once you hopefully get the issue back in a more normal
    perspective, is an open question.
        Mr. Whitehead. I think the Enron disaster gives you a lot
    of ammunition that maybe you did not have a few months ago, and
    that there is nothing wrong with using that as a strong
    argument to not take away power from the SEC at this particular
    moment.
        Chairman Sarbanes. We have been joined by Senator Carper. I
    yield to Senator Carper.

                  COMMENTS OF SENATOR THOMAS R. CARPER

        Senator Carper. Thanks, Mr. Chairman. And to each of you
    welcome. It is great to see you all again and thank you for
    joining us.
        I have been at a couple of other hearings going on and I am
    just glad you are still here and I was able to join you for a
    couple of minutes.
        Can we stay with the issue of how to pay, how to raise the
    revenue to provide the services that most of us believe are
    needed?
        Mr. Whitehead, you started talking about the beneficiaries.
    It is not just a narrow group, but it is a more broadly defined
    group in our country. A lot of us benefit from it.
        I would ask of Mr. Mayo, Mr. Seidman, and Mr. Whitehead as
    well, if you were devising a way to raise the revenues, how
    would you suggest doing it? I think a lot of what needs to be
    done with respect to Enron should not be done legislatively. I
    am concluding a lot of it is going to be the market punishing
    or rewarding certain kinds of behavior.
        A fair amount can be done regulatorily and particularly if
    we provide the resources the SEC needs.
        But this particular area, coming up with the revenues to
    provide for these services, that seems to me an area where we
    are going to need to legislate. We are going to need to
    legislate with respect to the appropriations for the SEC so
    that they will have the resources that they will need to do
    their job.
        My hope is that, despite the concerns that the Chairman
    expressed about forgetting these lessons and a couple of years
    down the line, not providing those resources, I think we will
    remember this one for a while and I am hopeful that we will.
        But just help us devise a way of raising the revenues that
    makes sense, other than simply an appropriation. What comes to
    mind?
        Mr. Seidman. First, let me say that I think keeping it out
    of the appropriation process gives you a great deal more
    independence.
        The FDIC, we did not have an appropriation because we
    charged members and it gave us a considerable degree of
    independence that we would not have had under the appropriation
    process. I think independence is the key that we are looking
    for here.
        I would simply charge all public companies a certain
    percentage of the value of their stock at a given date. It will
    be so small to support this, that I think it will hardly be
    noticed. On the other hand, it will be automatic and it won't
    be subject to the problems that you have today with
    appropriation for the SEC.
        Senator Carper. Fine. Thank you.
        Mr. Whitehead. There is a long history for the SEC to
    charge fees of various sorts to raise parts of their budget, as
    I am sure you know. Those fees are applied on what are
    perceived to be the users of that particular service. There is
    still I believe a registration fee that a company registering
    with the SEC for a public offering of securities to raise money
    pays when they file the registration statement a fee. The check
    has to go along with the registration statement when it is
    filed.
        The collection of those fees as capital markets have grown
    in some years, all the fees in the aggregate exceeded all the
    costs of the SEC. But I believe the system is that those fees
    are turned over to the Treasury and not exactly credited
    against the SEC's budget. It seems to me that there have been
    years, and I do not know whether it is still true or not, but
    when the SEC, when looking at it that way, was a money-making
    organization for the U.S. Government because the fees that they
    charged for their regulatory services exceeded their expenses.
        Chairman Sarbanes. That is right, yes.
        Mr. Whitehead. Is that still true?
        Chairman Sarbanes. That is why we had this bill to cut the
    fees. But it was not a pass-through like the FDIC. The FDIC got
    the money for sure.
        We had these fees. That was the rationale. But the fees
    went into the general treasury and the appropriation had to
    come out of the general treasury, and it by no means matched.
    So it did not have an automatic nature to it.
        Mr. Whitehead. Maybe the Government audit system ought to
    be audited by auditors that would put it more on a cost-
    accounting basis.
        [Laughter.]
        Senator Carper. Mr. Mayo, want to add anything here?
        Mr. Mayo. I will pass. I agree conceptually with Mr.
    Seidman and I have quoted the statistic before. The SEC budget
    relative to the stock market capitalization and that ratio has
    declined over the past couple of decades. I think,
    conceptually, that is one way to think about the SEC. It is
    just part of the overhead cost of our stock market.
        Senator Carper. Give me just some quick idea of the
    magnitude of the decline.
        Mr. Mayo. I did this about 5 months ago. I am guessing from
    memory. It might be down by half or that type of magnitude. It
    is a significant decline.
        Senator Carper. Okay. Good. Thanks. Mr. Chairman, I think
    my time has expired.
        Since I have missed your testimony, can I just ask a favor.
    Is there anything as we walk out of here that you would
    especially want me to keep in mind from what you said in your
    testimony or what has come out in the questions? Just one germ
    of an idea that you think is just especially valuable. Not that
    there weren't many.
        Mr. Seidman. Well, I guess the one thing that I would say
    is, it is clear you are going to have to take action here. To
    me, this is primarily an accounting scandal and that is where
    the major focus of your action ought to be.
        Senator Carper. Thank you.
        Mr. Whitehead.
        Mr. Whitehead. I would say the point that I made that maybe
    I would have to pick as being the most important of all is to
    emphasize to you that there is a wonderful cleansing process
    going on out there in the private sector.
        Every company after Enron is looking at their own
    practices, their own accounting practices and changing them.
    Every board of directors is looking at its practices--is it
    tough enough on the management? Is it questioning things that
    should come up? Every audit committee is looking at what more
    should it be doing, because nobody wants to be another Enron or
    to be a director or an audit committee member of another Enron.
    Every investment banking firm, every security analyst is
    looking at what can be learned, how can we do a better job with
    Enron.
        So keep watching what is happening out there. Look at what
    other companies are doing. I hope these hearings continue into
    a new phase maybe, that you will call various people in and
    say, what have you done to change your practices as a result of
    Enron?
        You get a feel of what the private sector is doing out
    there before you jump in with too many new Government
    regulations.
        Senator Carper. Good. Thank you.
        Mr. Mayo.
        Mr. Mayo. Give the analysts equal access to information.
    Fix the disproportionate incentives. All the incentives are out
    there for
    securities analysts to say, bye. When you say bye, you get
    great
    access. You can get investment banking business. Management
    participates in every event that you have, and even if the
    stock goes down, you still get many of those benefits.
        If you are objective and critical, then you sometimes have
    less
    access. Sometimes you upset people at your own firm. Sometimes
    the company won't even talk to you.
        The incentives are all set. They need to be fixed and
    analysts need to be given the opportunity to do their job the
    way that it should be done.
        Senator Carper. Good points. Thank you. Good to see you.
        Chairman Sarbanes. We thank you all very much. You have
    been a very helpful panel.
        This hearing stands adjourned.
        [Whereupon, at 12:20 p.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]
                    PREPARED STATEMENT OF SENATOR PHIL GRAMM
        Mr. Chairman, I want to thank you for the forward-looking nature of
    these hearings. It is my opinion that Congress, especially the Senate,
    has not covered itself in glory during this process. However, I think
    the Banking Committee has done an excellent job.
        I think we have focused on the problem, and now we have the
    legislative responsibility to fix it. I continue to believe that our
    mission is to try to determine what we could do to improve the current
    process. As we go through the legislative process, we will need to keep
    in mind what the benefits and costs are in terms of legislative change.
    I think we need to come to a delicate balance of the two.
        As I have said on many other occasions, I am a firm believer in the
    legislative equivalent of the Hippocratic oath: First do no harm. I
    believe there are changes that need to be made, and I think there is a
    consensus for us to act legislatively. This Committee has a very
    important responsibility, and if we can put together a bipartisan bill,
    I believe that it will hold up on the Senate floor and will ultimately
    become law.
        We have heard from many good witnesses in trying to focus our
    thinking on this subject, and I think we have two excellent panels
    today. I look forward to hearing from them, and I want to thank each of
    you for coming and sharing your views and experiences with us. We are
    long on theory, but short on practical experience.
                                   ----------
                 PREPARED STATEMENT OF SENATOR DANIEL K. AKAKA
        Thank you, Mr. Chairman. The increasing number of inaccurate,
    incomplete, or misleading audits has led to an examination of the
    system of oversight for the accounting profession. The complex system
    of oversight currently in use includes seven private organizations, the
    Securities and Exchange Commission, and State boards of accountancy.
        Mr. David Walker, Comptroller General of the United States, told
    this Committee on March 5, 2002, that ``A continuing message is that
    the current self-regulatory system is fragmented, is not well
    coordinated, and has a discipline function that is not timely nor does
    it contain effective sanctions, all of which create a public image of
    ineffectiveness.''
        On January 17, 2002, Securities and Exchange Commission Chairman
    Harvey Pitt proposed a new oversight board to address disciplinary
    actions against auditors. The Public Oversight Board, a private sector
    organization which oversees peer reviews and audit quality inquiries,
    voted on January 22 to disband by March 31. I am pleased that two
    members of the Public Oversight Board are here to testify.
        The Committee has heard recommendations that a new self-regulatory
    organization be established for the accounting profession. Several
    witnesses have suggested that the new organization be given the ability
    to develop rules, handle disciplinary investigations and sanctions, and
    be provided with funding to ensure its independence. There is a clear
    need for an improved system of oversight. We must thoroughly examine
    the proposals.
        I look forward to your recommendations on how to improve the system
    for oversight of the accounting industry and on other accounting and
    investor protections.
        Thank you, Mr. Chairman.
                                   ----------
                    PREPARED STATEMENT OF CHARLES A. BOWSHER
                        Chairman, Public Oversight Board
                Former Comptroller General of the United States
                                 March 19, 2002
        Thank you, Mr. Chairman. My name is Charles Bowsher and since late
    1999, I have been Chairman of the Public Oversight Board, which was
    created in 1977 to oversee the voluntary self-regulatory program of the
    accounting profession. I am pleased to be here today to discuss our
    observations about recent problems in regulation of the accounting
    profession, to offer our recommendations for reform, and to discuss the
    decision of the POB in January to terminate its existence as of March
    31 of this year.
        I am joined today by Aulana L. Peters, a Member of the POB, a
    Retired Partner in the law firm of Gibson, Dunn & Crutcher and a former
    Commissioner of the Securities and Exchange Commission, and by Alan B.
    Levenson, a Senior Partner at Fulbright & Jaworski, who is Counsel to
    the POB and former Director of the SEC's Division of Corporation
    Finance.
        The accounting world as it exists today is the outgrowth of a long
    series of steps taken by Congress, the securities industry, and the
    major accounting firms over many years since the bleak days of the 1929
    stock market crash and the Great Depression that followed in the
    1930's.
        After the market crash in 1929, Congress enacted a series of
    reforms that laid the foundation for the system we know today. Chief
    among them was the enactment of the Securities Act of 1933 and the
    Securities Exchange Act of 1934, which included the creation of the
    Securities and Exchange Commission; the requirement that corporations
    that sell stock to the public register with the SEC; and that public
    companies undergo an annual independent audit of their financial
    statements. The system created in the early 1930's survived for more
    than 40 years with only minor adjustments.
        In the 1970's, however, it was revealed in hearings before the late
    Senator Frank Church's Subcommittee on Multinational Corporations that
    some companies had paid bribes to foreign officials to win business and
    that these payments had been kept secret from auditors and the public.
    In the aftermath of these revelations, the Congress--under the
    leadership of this Committee--passed the Foreign Corrupt Practices Act
    in 1977 to make clear that bribery of foreign officials by American
    firms is unacceptable.
        Another event affecting the accounting profession in the 1970's was
    the bankruptcy of the Penn Central Railroad--the largest bankruptcy
    since the 1930's and the Enron failure of its day.
        In the wake of the ``sensitive payments'' scandal, the Penn Central
    collapse, and audit failures, the late Senator Lee Metcalf of Montana
    in 1977 chaired a series of hearings to determine whether new Federal
    regulation of the accounting profession might be appropriate. In
    response to these hearings, and as an alternative to legislation, the
    American Institute of Certified Public Accountants (AICPA), in
    consultation with the SEC and with the support of the Nation's leading
    accounting firms, created a self-regulatory framework for the
    profession. To enhance the quality of
    audits of financial statements of public corporations, peer review was
    instituted as the cornerstone of the self-regulatory program.
        To run the new self-regulatory programs, including peer review, the
    AICPA created the SEC Practice Section (SECPS), composed of firms that
    audit the financial statements of public corporations. And to oversee
    the programs of the SECPS, the independent Public Oversight Board (POB)
    was created in 1977. Its function is to protect the public interest.
    Specifically, the POB was created to monitor and comment on matters
    that affect public confidence in the integrity of the audit process.
        I believe peer review--where one accounting firm hires another to
    review its operations and internal controls--resulted in major
    improvements. The recommendations that flowed from peer reviews in the
    early days led to substantive improvements in the quality controls at
    accounting firms, large and small.
        However, even though the new self-regulatory programs were
    innovative for their time, they were created with some concern and
    caution.
        John C. Burton, a distinguished Professor of Accounting at Columbia
    University and the Chief Accountant at the SEC when reforms were being
    made in 1977, warned in testimony before the House Interstate and
    Foreign Commerce Committee in 1978, that peer review ``is likely to be
    seen as a process of mutual back scratching.'' He also warned that ``it
    is highly doubtful that a part-time group [POB] can either in fact or
    perception'' provide an effective substitute for statutory regulation.
        Harold M. Williams, who was Chairman of the SEC at the time of the
    reforms in the late 1970's, warned in a speech in January 1978, that
    the ``effectiveness and credibility of the Public Oversight Board
    depends on its independence, including its willingness to be critical
    when called for and its ability to make public its conclusions,
    recommendations, and criticisms.'' Chairman Williams also made the
    point that an effective POB could only be effective ``if it is not
    impeded in performing its functions and responsibilities.''
        Now, a quarter century after the reforms of the late 1970's, I
    believe events of recent months demonstrate that the warnings of both
    Dr. Burton and Chairman Williams have come to pass. I have come to the
    conclusion that the voluntary self-regulatory program needs to be
    replaced because it has failed to keep pace with challenges faced by
    the profession. More troubling is the resistance of the profession's
    trade association, the AICPA, and several of the Big 5 firms to major
    reform.
        Arthur Levitt, the former SEC Chairman, also described this problem
    in recent testimony before the Senate Banking Committee. ``More than
    three decades ago,'' he said, ``Leonard Spacek, a visionary accounting
    industry leader, stated that the profession could not `survive as a
    group, obtaining the confidence of the public . . .
    unless as a profession we have a workable plan of self-regulation.'
    Yet, all along the profession has resisted meaningful oversight.''
        In 1980, the SEC said in a report prepared for the Senate Committee
    on Governmental Affairs that the POB has an obligation to ``serve as
    the conscience and critic of the self-regulatory effort.'' The POB's
    charter provides that the POB is ``to represent the public interest on
    all matters that may affect public confidence in the
    integrity, reliability, and credibility of the audit process.''
        Despite our attempts to serve the public interest and to be the
    ``conscience and critic,'' the POB has been impeded since I became
    Chairman in its ability to oversee the profession. Three events are
    noteworthy in how the POB has been frustrated in its ability for
    effectively carry out its responsibilities to serve the public
    interest:

     On May 3, 2000, SECPS took the unprecedented step of notifying
        the POB that it would refuse to pay for special reviews of public
        accounting firms. The special reviews in question had been sought
        by the SEC to determine whether the firms had complied with SEC and
        professional independence standards. The decision of the SECPS to
        deny funding to the POB was a serious blow to the notion of
        independent oversight of the accounting profession. Melvin Laird,
        the former Congressman and Secretary of Defense and the longest-
        serving member of the POB, said that this was ``the worst incident
        in my 17 years'' on the POB.

     Following the decision to cut off funding of the POB's special
        reviews requested by the SEC, the largest accounting firms--the Big
        5--agreed with the SEC that the POB should instead conduct more
        limited independence reviews of the large firms. Despite this
        agreement, the next 21 months were marked by a series of delaying
        tactics. Because of this lack of progress, the POB, in the end, was
        unable to conduct the reviews.

     For years, the POB had carried out its oversight
        responsibilities under a set of bylaws adopted after it was created
        in 1977. The POB felt that a formal charter would improve the
        independence of the Board, and a charter was one of the primary
        recommendations in August 2000 of the Panel on Audit Effectiveness,
        which was created by the POB at the request of the SEC. However,
        objections from the AICPA and the Big 5 caused negotiations to drag
        on for more than a year. Ultimately, a new charter took effect in
        February 2001.

        The recommendations of the Panel on Audit Effectiveness, including
    a formal charter for the POB, were designed to improve the existing
    voluntary self-regulatory system, not to create a new regulatory
    structure for the profession. At the time of the Panel's
    recommendations in August 2000, neither the POB nor members of the
    Panel thought it was likely that Congress would approve a statutory
    self-regulatory organization to govern the profession.
        These three events and the frustration they created were among the
    factors that led the POB to decide, on January 20 of this year, to
    terminate its existence. But the precipitating event was the
    announcement by the Chairman of the SEC, Harvey Pitt, of a proposed new
    regulatory structure for the accounting profession. This plan was
    worked out in private talks between the SEC and the AICPA and the Big 5
    accounting firms with no input from the POB, which had repeatedly been
    assured that it would be consulted.
        The new proposal effectively rendered the POB a ``lame duck.'' The
    POB believed it could not oversee the activities of the accounting
    profession under the circumstances and that it would mislead the public
    to appear to do so. Furthermore, the POB was concerned that were it to
    continue in operation during an interim
    period before a new governance structure was in place, it would leave
    the impression that it approved of the Pitt proposal, which it did not.
    As ``conscience and critic,'' the POB felt it had no choice but to
    disband. Only by so acting, we felt, could we protect the public
    interest. What the POB did was akin to what an auditor does when it
    believes it must resign from a client engagement because of a
    fundamental disagreement.
        Attached to my testimony, Mr. Chairman, are copies of the letters I
    sent as Chairman to Mr. Pitt on January 21 and January 31, 2002,
    detailing the POB's decision to terminate. These letters are attached
    as Appendices A and B. I would also ask that a letter to the SEC dated
    March 5, 2002, urging that an independent person be named to conduct
    the independence reviews which the POB was unable to complete, be made
    a part of the record.
        Mr. Chairman, the current system of self-regulation of the
    accounting profession has significant problems.
        First, the funding of the POB is subject to control by the firms
    through the SECPS. In the past--as noted above--the SECPS has cut off
    that funding in an
    effort to restrict POB activities. In addition, the AICPA and SECPS
    insisted on a cap on POB funding when the new charter was created.
        Second, the disciplinary system is not timely or effective.
    Disciplinary proceedings are deferred while litigation or regulatory
    proceedings are in process. This results in years of delay and
    sanctions have not been meaningful. The Professional Ethics Division of
    the AICPA, which handles disciplinary matters against individuals, does
    not have adequate public representation on its Board. Investigations by
    the Quality Control Inquiry Committee of the SECPS, which handles
    allegations of improprieties against member firms related to audits of
    SEC clients, do not normally include access to firm work papers and
    firm personnel involved in the engagements under investigation. The
    disciplinary system cannot issue subpoenas or compel testimony--it must
    rely on the cooperation of the individual being investigated--and
    cannot talk to the plaintiff or the client company involved.
    Furthermore, there is no privilege or confidentiality protection for
    investigations or disciplinary proceedings, and disciplinary actions
    are often not made public.
        Another problem is that monitoring of firms' accounting and
    auditing practices by the peer review process has come to be viewed as
    ineffective, and has been described as ``clubby'' and ``back-
    scratching.'' The peer review team does not examine the work of audits
    that are under investigation or in litigation, and public peer review
    reports are not informative.
        Other problems include the fact that the current governance
    structure does not have the weight of a Congressional mandate behind
    it. There is a perceived lack of candid and timely public reporting of
    why and how highly publicized audit failures and fraud occurred, and
    what actions have or will be taken to assure that such problems do not
    recur.
        Mr. Chairman, the Public Oversight Board strongly believes that a
    new regulatory structure for the accounting profession is essential.
    However, we believe that to be effective, it must be totally
    independent of the accounting profession and it must be based on the
    foundation of Congressional action creating a statutory self-regulatory
    organization.
        The Board recommends that Congress create a new Independent
    Institute of Accountancy--the IIA--and center all regulation under its
    auspices. A seven-member board would run the Institute totally
    independent of the AICPA, the Big 5, and other firms. The chair and
    vice chair would be full time employees of the Institute; five other
    members would serve on a part-time basis. All would be appointed by a
    panel composed of the Chair of the SEC, the Chair of the Federal
    Reserve Board, and the Secretary of the Treasury. Once named, the chair
    of the IIA would join these three in naming other members of the board.
    Members of the IIA board could be removed only by a two-thirds vote of
    the board itself.
        The SEC would have oversight of the IIA, and the SEC's Office of
    the Chief Accountant would be the liaison to the IIA. Attached as
    Appendix C is a chart showing the organization of the IIA.
        Important functions of the Institute would include:

     The IIA would exercise oversight for all standard setting for
        accounting, auditing, and independence, and their interpretation.
        Accounting standards are just as
        important as auditing and independence standards. For this reason,
        the POB believes the Financial Accounting Standards Board must be
        brought under the umbrella of the IIA, which would take
        responsibility for its oversight and funding.

     Firm-on-firm peer review would be discontinued for firms that
        audit more than 100 public corporations each year. In its place,
        IIA employees would conduct thorough and comprehensive yearly
        reviews of the annual internal inspections of such firms. Unlike
        peer review, no activities of a firm would be off limits to
        Institute reviewers and the process would produce detailed public
        reports. For firms that audit less than 100 public corporations
        yearly, reviews would be performed by other firms selected by the
        IIA. Their reports would be addressed to the IIA as the client of
        the reviewer. In addition to the reviews, IIA employees would
        conduct special reviews, when warranted. Similar to those the SEC
        originally asked the POB to undertake, these reviews could take a
        systemic, in-depth look at a firm's systems, policies, procedures,
        and operations. If necessary, such special reviews would delve into
        questions affecting the firm's compliance with applicable
        professional standards. As with the yearly reviews, reports of
        these special reviews would be public.

     An Office of Enforcement and Discipline within the IIA would
        have full authority to investigate allegations of wrongdoing by
        public accounting firms and their personnel. The POB recommends
        giving the IIA the privilege of confidentiality, as well as the
        power of subpoena to compel testimony and produce documents. Cases
        of alleged misconduct would be brought before IIA hearing
        examiners. When warranted, these examiners would recommend to the
        IIA board the imposition of sanctions, ranging from fines to
        expulsion from the profession. Cases could be referred to the
        Justice Department for possible prosecution, or to the SEC, State
        boards of accountancy, or other agencies, as appropriate.

     Funding would be provided through fees imposed on public
        corporations in amounts sufficient to cover the costs of the
        Institute. The POB strongly believes that the funding mechanism
        must be beyond the reach of the profession to prevent it from
        withholding necessary funds, as it did in May of 2000.

     The IIA would be charged with coordinating international
        liaison and overseeing continued professional education for those
        in the profession.

        Beyond these functions, the POB recommends that:

     With regard to nonaudit services for audit clients, the POB
        recognizes that there has been disagreement on restricting scope of
        services and that various models have been suggested for what
        should be allowed and what should be excluded.
        The POB strongly agrees with a point made in President Bush's 10-
        point reform plan that ``Investors should have complete confidence
        in the independence and integrity of companies' auditors.'' The
        specifics on the President's plan recognize the importance of
        prohibiting certain nonaudit services in order to safeguard auditor
        independence.
        The POB takes note of a statement issued by the AICPA on February
        1, 2002, in which it affirmed that it ``will not oppose Federal
        legislation restricting the scope of services that accountants may
        provide their public audit clients, specifically in information
        technology and internal audit design and implementation.''
        Against this background, the POB proposes that SEC regulations
        concerning independence be legislatively codified with appropriate
        revisions to update restrictions on scope of services involving
        information technology and internal audit services as noted above.
        At the same time, the POB believes such legislation should affirm
        that tax work not involving advocacy and attest work by audit firms
        in connection with SEC registration and other SEC filings be
        allowed. The POB also believes that small public businesses, to be
        defined by the SEC, should not be subject to any restriction on
        nonaudit services for audit clients. Further, with respect to
        nonpublic corporations, it is the POB's position that such
        corporations and the accounting firms that audit them should not be
        subject to any restriction on nonaudit services. We expressly
        emphasize this to avoid misunderstanding and any consequences to
        small business and small audit firms.
        The IIA Office of Standards should be empowered by legislation to
        promulgate appropriate rules affecting independence to cover
        changing circumstances.
        The POB believes there should be no prohibition against an audit
        firm offering nonaudit services to nonaudit clients.

     Auditors should be rotated every 7 years. As a corollary,
        public corporations would be prohibited from firing auditors during
        their term of service unless such action is determined by the audit
        committee to be in the best interest of shareholders, with prompt
        notice to the IIA and the SEC. Such action would be required to be
        publicly disclosed by corporations in current reports and proxy
        statements filed with the SEC.

     Engagement and other partners who are associated with an audit
        should be prohibited from taking employment with the affected firm
        until a 2 year ``cooling off '' period has expired.

     The Institute should expand on the recommendations of the
        recent Blue Ribbon Committee which made it clear that the external
        auditor should be accountable to a firm's board of directors and
        its audit committee and not to management. Specifically, the audit
        committee should take full responsibility for hiring, evaluating,
        and--if necessary--terminating an audit firm.

     To discourage conflicts of interest involving public
        corporations, Congress should amend the Securities Exchange Act of
        1934 to require more meaningful and more timely disclosure of
        related party transactions among officers, directors, or other
        affiliated persons and the public corporation. Such disclosures
        should be made promptly in current reports, as well as in proxy
        statements filed with the SEC.

     Management of public corporations should be required to
        prepare an annual statement of compliance with internal controls to
        be filed with the SEC. The corporation's chief financial officer
        and chief executive officer should sign this attestation and the
        auditor should review it. An auditor's review and report on the
        effectiveness of internal controls would--as the General Accounting
        Office (GAO) found in a 1996 report--improve ``the auditor's
        ability to provide more relevant and timely assurances on the
        quality of data beyond that contained in traditional financial
        statements and disclosures.'' Both the POB and the AICPA supported
        the recommendation when the GAO made it, but the SEC did not adopt
        it.

        The POB feels that these reforms are necessary if trust is to be
    restored in the accounting profession. The Board has presented what it
    believes is a sensible, workable plan for reform. It is premised on the
    firmly held belief that the fundamental purpose of regulation is to
    serve the public interest and that of investors. If this is to be
    accomplished, regulation must be totally independent of the profession,
    it must pull together all aspects of regulation from standards to
    discipline, it must be transparent, and it must provide for adequate
    funding and staff.
        A decade ago this Committee was in the forefront of enacting major
    reforms for the banking industry--reforms that were widely opposed by
    the banks and by their lobbyists. Opponents then predicted gloom and
    doom for the industry should the proposed reforms be enacted. In
    reality, the reforms contained in the Federal Deposit Insurance
    Corporation Improvement Act of 1991 repaired flaws in regulation of the
    Nation's banking industry. More important, they significantly
    strengthened the industry.
        Today, the Congress again is called upon to institute reform. In
    the wake of the Enron debacle, the POB, acting as the ``conscience and
    critic'' of the profession, strongly believes that to protect investors
    and the public, the old system of voluntary self-regulation for the
    accounting industry must be replaced. While many will urge that
    Congress act with caution and that the profession be again given the
    opportunity to fix the present system with marginal changes, the POB
    believes it is time to resist the continuation of the status quo and
    move ahead with fundamental change.
        Mr. Chairman, you recently made the point that recent events have
    had a ``critical impact on the national confidence in the financial
    markets'' and that the time has come to ``focus on the protection of
    investors and the efficient functioning of our
    capital markets.'' I could not agree more. That is why I believe it is
    time to resist continuation of the status quo and move ahead with
    fundamental change.
        Mr. Chairman, this concludes my prepared testimony. I would be
    happy to answer any questions you may have.

                     PREPARED STATEMENT OF AULANA L. PETERS
                         Member, Public Oversight Board
                    Retired Partner, Gibson, Dunn & Crutcher
          Former Commissioner, U.S. Securities and Exchange Commission
                                 March 19, 2002
        Good morning, Mr. Chairman. Thank you for giving me this
    opportunity to share my views on the issue of reform of the accounting
    profession's self-regulatory structure. In a conversation I had with
    the Robert Herdman, Chief Accountant of the SEC last January, he
    commented that there are times when reform can and should be
    evolutionary and times when it must be radical. Based on my oversight
    experiences as a member of the POB, I had begun to conclude that the
    profession's self-regulatory structure needed reform and was looking
    forward to working with the profession and within the structure of the
    POB to develop those reforms. But the crisis precipitated by the Enron
    scandal and other events have created an environment of urgency. So,
    here we are. The Chief Accountant did not tell me whether he thought
    the times called for evolutionary change or radical change. In my view,
    the current state of affairs requires the change to be radical and
    immediate.
        Before proceeding with my testimony, I wish to emphasize that the
    views I am about to express are based on my observations and
    conclusions about flaws in the current self-regulatory process. I
    believe these flaws are inherent in the structure itself and are not
    the result of any lack of competence of the professionals who serve as
    members of the Auditing Standards Board (ASB), the Quality Control
    Inquiry Committee (QCIC) or the Peer Review Committee of the SEC
    Practice Section of the American Institute of Certified Public
    Accountants (SECPS). During the past year, I have observed dozens of
    accounting and auditing professionals devote countless hours and
    enormous energy to setting standards, investigating alleged audit
    failures, and conducting peer reviews. The individuals involved in
    these processes are, without a doubt, highly intelligent, undeniably
    expert and extraordinarily dedicated. These men and women are not
    compensated for contributing their talents and skills to the work of
    the various committees of the American Institute of Public Certified
    Accounts (AICPA). Their reward is the satisfaction of knowing that
    their efforts are directed at improving the financial reporting
    process.

    General Structure
        Chairman Bowsher has summarized for you the most important points
    of the self-regulatory structure the POB believes is the most
    appropriate model for the accounting profession. It achieves the
    streamlining of what commentators like to call the ``alphabet soup'' of
    governance, by bringing all standard setting under one roof,
    eliminating overlapping and untimely disciplinary procedures, and by
    strengthening and adding transparency to what was the peer review
    process.
        Based on my observations and experiences, I have concluded that it
    is critical for the power of any new self-regulatory structure to be
    based in legislation. This is essential for the independence, certainty
    and long-term viability of whatever entity is created. For example,
    without a legislatively-based source of authority and funding, the new
    regulatory entity would be vulnerable to pressure from the persons it
    regulates or who are directly affected by its regulation.
        Furthermore, I believe that streamlining the current governance
    system is not likely to be accomplished through negotiation and
    compromise. For example, the SEC proposal is just such a negotiated
    compromise and I am advised that it leaves standard setting and the
    discipline of ``smaller'' firms with the AICPA. Furthermore, it does
    not deal with the Financial Accounting Standards Board. Consolidating
    all self-regulatory activities under one umbrella regardless of vested
    interests is important for efficiency, effectiveness, and cost savings.
        Most importantly, any new self-regulatory structure must be
    completely independent of the profession. In my opinion it is not
    enough to create an entity in which the public members ``predominate,''
    whether by a simple or super majority. No member of the new ``board''
    or ``institute'' or ``panel'' should be affiliated with or responsible
    to any accounting firm or the AICPA. That does not mean that the self-
    regulatory process should not tap the talent and expertise of the
    profession. There are other ways to achieve that end. For example,
    retired leaders from the accounting profession such as Michael Cook,
    Shaun O'Malley, or Robert Mednick, just to mention a few, could be
    called upon to serve. In addition, former chief executive
    officers, chief financial officers, and well-known and respected
    institutional money managers would contribute vital input to the
    process from the perspective of preparers and users of financial
    statements.

    The Structural Changes
        From the public's perspective, I think that one of the most
    important aspects of the new self-regulatory process will be that which
    is focused on discipline. To the extent the discipline can be
    structured to have a diagnostic element, as well as a punitive/remedial
    one, both the accounting profession and the public will benefit.

    Quality Control
        The objective of the peer review process is to evaluate the design
    of and test compliance with a firm's quality control system with a view
    to determining whether there are weaknesses, deficiencies or other
    problems within the system that would likely contribute to or result in
    substandard audits. However, I believe that peer review is not, as
    currently structured, a good diagnostic tool for reviewing the quality
    control system with a view to detecting and remedying flaws that result
    in a particular substandard audit. Furthermore, the peer review process
    is not predictive in that it has not been an effective tool for
    identifying how and why auditors in the field make bad judgment calls.
        I think the POB's recommendation that the triennial peer review be
    replaced by a retooled annual review conducted by the new regulatory
    agency will make the review process a more useful diagnostic tool even
    though it is unlikely that it can be more predictive. In my view,
    regardless of whether a review is triennial or annual, it will not
    prevent future audit failures although it can be enhanced to better
    serve its purpose of quality control. The POB proposal calls for the
    process to become:

     Independent of and from the firm being reviewed by
        transferring the activity to the self-regulator. This change may
        enhance scrutiny of quality control by avoiding potential biases in
        a system where competitors, having possible incentives to not
        burden the system with additional obligations or otherwise act to
        their own detriment, perform the review.
     Applicable to all engagements selected through the sampling
        process with no engagement being excluded from the review simply
        because it is, or possibly could be, the subject of litigation.
        Such engagements provide an opportunity to examine challenged
        audits to test compliance with quality controls and receive timely
        information on what went wrong with the quality control system and
        therefore could help avoid future audit failures.
     More transparent in that the reports issued include a
        description of (1) the limitations of the review and (2) the
        findings (whether ``best practices'' or ``deficiencies'') by the
        reviewing team.

    Discipline
        The current QCIC process is designed to review cases that are the
    subject of litigation to determine if there is a systemic problem at a
    firm whose audits become the subject of litigation. If during the
    course of this review the committee finds a problem with an
    individual's performance on the specific audit, it may refer the matter
    to the Professional Ethics Executive Committee (PEEC) and recommend
    action to be taken by the firm with respect to the specific individual.
    In my view, the QCIC and PEEC processes are flawed because they are
    segregated from one another and thus are not geared to react quickly to
    bad judgment calls that do not signal a breach of the quality control
    system; they are structured to have no impact on pending litigation
    which weakens the diagnostic or remedial benefits of their actions; and
    their ability to gather facts is limited.
        The POB recommendations address these issues by combining the QCIC
    and PEEC processes into a single disciplinary system for all auditors,
    so that issues of quality control are not divorced from those of
    individual performance. The new regulatory entity will be responsible
    for both identifying problems and remedying them. It will also conduct
    the annual reviews; consequently the information gleaned and lessons
    learned should naturally feed back into the standard setting process on
    a timely basis.
        The POB, as does the SEC, recommends that the new regulatory body
    have the power to compel the production of documents and take
    testimony, thus giving it authority to investigate fully allegations of
    audit failure or accountant malfeasance. Greater access to information
    should facilitate a deeper probing of the possible causes of alleged
    audit failures. However, the POB's proposal differs from that of the
    SEC in that it provides for no deferral process. This difference is
    important
    because the POB model goes farther in assuring the public that the
    disciplinary
    process is working and that errant accountants are being held
    accountable.

    POB Termination
        Finally, I would like to comment on the question of why the POB
    voted to disband and reiterate the particular facts that motivated me
    to vote with my colleagues. For me the key facts are:

        On December 4, 2001, the POB learned, after the fact, that the
    Chairman of the SEC had met with representatives of the AICPA and the
    ``Big 5'' to discuss the
    implications of the Enron disclosures for the profession and its self-
    regulatory
    structure.
        On January 4, 2002, the POB attended a meeting of the Executive
    Committee of the SEC Practice Section at which it learned from a
    committee member that the AICPA had formed a working group to formulate
    a proposal for a new self-regulatory structure to submit to the SEC.
    Comments were made to suggest that an announcement of the plan was
    anticipated within a few weeks. This was the first time that the POB
    was advised of the existence of this task force and its work. The POB
    immediately asked to be included in and advised of the progress of the
    working group's activities as part of its oversight duties.
        On January 17, 2002, the POB was informed for the first time that
    that morning the Chairman of the SEC would hold a press conference to
    announce his plans for changes to the accounting profession's self-
    regulatory system. Subsequently, but prior to finalizing its decision
    to disband, the POB learned that AICPA working group had submitted its
    proposal to the SEC a week prior to the January 17 press
    conference.
        Thus, the POB the independent body charged with oversight of the
    accounting profession and in that regard assigned the duty to act in
    the public interest was effectively excluded from a process of great
    moment for the profession and the public it serves. I for one am not
    concerned about whether the exclusion was intentional or the unintended
    result of bad timing. Regardless of ``why,'' circumstances were
    created in which the POB could not effectively perform its oversight
    duties. The POB cannot be the public's eyes and ears in an
    informational vacuum. Furthermore, the POB is a creature that exists at
    the sufferance of the SEC and the accounting profes
    sion. Consequently, whatever authority attaches to its activities and
    recommendations is based on a consensus of the SEC and profession. that
    the views of the POB are relevant and of significance. Thus, being
    excluded from a process which Chairman Pitt reportedly described as
    producing ``unprecedented'' change for the accounting profession
    clearly signaled the POB's perceived irrelevancy and emphatically
    undercut its authority and legitimacy.
        Thank you for your time and patience. I would be pleased to answer
    any questions you may have.

                                   ----------
                    PREPARED STATEMENT OF JOHN C. WHITEHEAD

                    Former Co-Chairman, Goldman Sachs & Co.
                        Former Deputy Secretary of State
                                 March 19, 2002

        I am honored to appear before you this morning as I have done a
    number of times in the past: First back in the early 1970's as Chairman
    of an SEC landmark study of the effect of institutional investors on
    securities markets, later as Chairman of the Securities Industry
    Association and also as Co-Chairman of Goldman Sachs on various
    matters, still later as Deputy Secretary of State and again on one
    occasion as Chairman of the Federal Reserve Bank of New York. I appear
    today, however, as a former nonmanagement director and audit committee
    chairman of more than a dozen public companies, not all of them, I
    assure you, at the same time.
        I have always championed the importance of our securities markets
    and the competitive structure of the institutions that serve them. They
    are a national asset and an important part of our leadership position
    in the world economy. The confidence that investors have in the system
    must be protected at all costs. I have also championed the importance
    of diligent independent nonmanagement directors who represent the
    stockholders effectively and the public interest.
        The Enron disaster is a severe blot on the generally good record
    that the system has had over the years. Indeed, it is an embarrassment
    to those of us who have been involved in that system. It is still hard
    for me to believe that what was coming to be considered one of
    America's great companies could collapse so rapidly in such an
    ignominious way, with such huge losses to employees, to lenders, to
    stockholders, and to the reputations of everyone involved: The
    management, the board, the audit committee, the auditors, the bankers,
    the security analysts, and the customers. It would seem to me that
    grounds for criticism exist in many places and that a thorough public
    review and investigation, including these hearings, is absolutely
    desirable and necessary. I am knowledgeable enough about the system,
    however, to be quite confident that most companies act responsibly and
    that there are not a lot of Enrons out there.
        The only good result of the collapse is that it is causing
    companies now to look closely at their practices and at their
    disclosure policies, causing boards to review their attitudes, causing
    auditors to be more independent and more thorough, lenders to be more
    careful, security analysts to be more thorough, etc. I can assure the
    Committee that there is now a self-cleansing process going on out there
    which is very healthy. It might be fruitful for the hearings to begin
    to focus not only on what actually happened to Enron but on what the
    various institutions are doing now to keep it from happening again
    somewhere else. It may be wise to let this self-cleansing process go on
    for a while without being too precipitate with legislative action.
        It is clear to me that there were many signs that a more alert or
    even a more curious board might have recognized as fair grounds for
    questioning. Certainly any request to the Board to waive the Board's
    ethics rules to exempt a transaction that otherwise would have violated
    them should have been enough to bring a lot of questions. However, the
    Committee should realize that it is very difficult these days to find
    and successfully recruit good board members. Many top experienced
    executives who would make excellent nonmanagement directors feel that
    their hands are full handling their present job, that their lives are
    already too full of other responsibilities and that the doubtful
    prestige and unimportant extra compensation from taking on one or two
    outside directorships is not worth the increasing legal risks and the
    necessary time commitments. It would be a very unfortunate result of
    the Enron disaster if it became impossible now to recruit to board
    membership the kind of experienced, capable people that the system
    increasingly requires. The Committee should be careful about
    unnecessarily increasing the financial risks and the time commitments
    of nonmanagement corporate directors.
        Having said that, I do believe some things can and should be done
    now.

        1. Having given the matter a lot of thought in recent years,
    particularly when I was Co-Chairman with Ira Millstein (who testified
    before you a few weeks ago) of the Blue Ribbon Committee on Improving
    the Effectiveness of Corporate Audit Committees, I have reached the
    conclusion that the accounting firm that does the audit should not do
    other advisory work for the company. Without that, the independence of
    the auditors work will always be suspect. I reach that decision
    reluctantly but I do not see that it is possible now to restore public
    confidence in the independence of the auditors without it. The auditing
    firms should understand that this certainly does not require them to
    spin off or close down their advisory services. They would still be
    free to do advisory business with any company, excepting those they
    audit. Thus for any one firm what business they lose to others could be
    offset by business that others would lose to them, with no loss to the
    industry as a whole. As an alternative way of accomplishing the same
    purpose, it might be worth considering whether the restriction might be
    placed on the company rather than on the auditors by requiring that a
    public company should not employ their auditing firms for services
    other than the audit. It would be preferable if this all could be
    accomplished by SEC action or action of the exchanges rather than by
    legislation. Of course, it might be appropriate to except from the rule
    fees for minimal advisory business and in any case a reasonable phase-
    out period should be allowed.
        2. An unfortunate practice has developed in the relationships
    between management, auditors, and board audit committees on the setting
    of auditor's fees. Fees are set annually by negotiation between
    management and the auditor and then approved by the audit committee.
    Managements objective, as it is with all expenses, is to keep the fees
    as low as possible. The auditor, at that stage, has no idea of how much
    time it will take, or how much extra work might be required to complete
    the audit and is often pressured to accept a lower fee and agree to a
    shorter time schedule than might be necessary in case questions arose.
    Audit committees often agree to the fee and the time schedule,
    unwilling to question what seems reasonable in relation to last year.
    If the auditor later does find questionable practices, he may have
    neither time nor money to pursue them under the terms of his agreement.
    A better practice would be to allow the auditor, at his option, to do
    work and charge fees up to a limit of, say, twice the original fee.
    This would tend to make management more aware of the authority of an
    independent auditor.
        3. Over the years accounting rules, something like the income tax
    code, have become increasingly complex and arcane with the result that
    in combination they can often obfuscate the simple facts and obscure
    full disclosure. Rules that permit these results, such as hiding off
    balance sheet debt, transactions with related parties, alternative
    accounting for acquisitions, etc., evade the principle of full
    disclosure and undermine the foundation stone of our free market
    system. The National Accounting Standards Board should be asked to
    review these matters promptly and recommend appropriate changes in the
    interest of full disclosure.
        4. Rules now require that the chairman of a public company's audit
    committee have considerable financial background and experience. Those
    rules should be amended to require all members of the audit committee
    to have such backgrounds. This will encourage the recruitment to the
    board of more experienced and qualified people and the recruitment to
    the audit committee those with the most financial
    experience.
        5. Since the principal purpose of audits is to provide public
    information to investors and the financial community, I believe the
    self-regulating authority of the SEC over the securities industry and
    the stock exchanges should be extended to the auditing firms. This
    would be an important addition to the present self-inspection system of
    the auditing companies. The authority of the SEC should also be
    extended to create a new self-regulatory entity charged with drafting a
    voluntary code of best corporate governance practices linked to an SEC
    disclosure requirement. Companies would then disclose whether they
    comply with the voluntary code, and explain areas of noncompliance.

                                   ----------
                    PREPARED STATEMENT OF L. WILLIAM SEIDMAN

             Former Chairman, Federal Deposit Insurance Corporation
                 Former Chairman, Resolution Trust Corporation
                                 March 19, 2002

        Mr. Chairman and Members of the Committee: I am pleased to be
    invited here to add my thoughts on Enron to the many outstanding
    presentations you have already received, including my distinguished
    friend Chuck Bowsher.
        My experience that may be relevant to the questions raised by
    Enron's disastrous failure include:

     Chairman of an international accounting firm in troubled
        times.
     Chief Financial Officer of a major international copper
        producer in troubled times.
     Dean of a major Business School in troubled times.
     Chairman of the FDIC and the RTC in very troubled times.
     Chief Business Commentator on CNBC 10 years in both good and
        troubled times.

        There is no doubt that Enron's failure has created troubled times
    for the accounting profession and securities markets looking for the
    causes of failure and its accompanying financial losses, as this
    Committee knows is not a simple task. The changes that are needed to
    try to avoid such costly events in the future will be numerous and
    unfortunately complicated.
        I believe we still have more to learn about Enron (and related
    activities), but it seems more clear each day, that Enron failed
    because it held itself out to be a trading company designed to hedge
    risk and make profits on trading, when, in fact, it turned out to be a
    company taking huge risks speculating in many volatile markets,
    including some that it was pioneering. When the market prices moved
    against the exposed underlying position, the company failed. Not as has
    been stated, because of a bank run, but because of huge losses that
    finally became visible. Enron's hedges proved to be ineffective because
    they were with Enron's ``other pocket'' related companies for which
    Enron was ultimately financially responsible. Further, the profits were
    reported on a market-to-market basis for future contracts for which
    there was no real market. Thus profit was dependent on future market
    prices determined by the company as the largest ``market maker'' in the
    field. Using optimistic forecasts, the company was anticipating earning
    profits based on estimates of future prices, when, in fact, these were
    not determinable. While accounting rules require market-to-market,
    there has to be a market for them to apply.
        The free market has now exercised its will and ``regulated'' Enron,
    as it always will, but the unrestricted free market is often a brutal
    and costly regulator. What can be done to avoid or minimize this kind
    of debacle in the future?
        I would suggest examination of three areas in need of some reform:

     Accounting policy and governance.
     Corporate governance.
     Government's regulatory, tax, and supervisory role.
    Accounting Matters
        From what we know at this stage, it seems that the CPA audit
    reports did not really ``fairly present'' the position of the company
    in a way that was understandable by investors, even sophisticated ones.
    Further, the accounting standards, though possibly technically
    followed, did not result in information adequate for markets to make
    decisions. Enron was a very complex large company and thus it was
    difficult to understand its operation, but the accountants did not make
    it easier.
        Both accounting standards and the firm applying them failed to
    provide the clear information necessary for free markets to perform
    effectively.
        What to do:
        1. The Government must provide and control the regulation of public
    accounting firms. Accountants start with a basic conflict of interest
    since they are paid by the enterprises they audit. Thus governmental
    control is necessary to insure compliance with the rules of operation.
    The alternative is for Government itself to audit, which is undesirable
    (though the Government does run the worlds largest ``audit firm'' (the
    IRS). Auditing is a highly competitive profession that needs structure
    for competition with compliance done by Government. This Government
    body should be appointed by the SEC Board. Its charge will be to insure
    that accountants follow the rules of practice as set by the SEC, FASB
    (or successor). The body should be bipartisan with terms of at least 4
    years.
        Many changes will follow from this, including, but not limited to,
    separating audit from consulting, control of the ``swinging door''
    between audit firm personnel and
    client accounting positions and possible rotation of auditors.
    Incidentally, I do not
    believe that tax return preparation and advice should be a part of the
    consulting practice separated.
        2. The accounting and auditing standards must be set by an
    independent body financed by independent sources--Government tax, user
    fee, etc. This organization must be protected from undue influence both
    of a public and private nature much like the FDIC and RTC was during my
    tenure as Chairman. The FASB seems to have performed reasonably well,
    except where outside pressures forced them to abandon necessary action.

    Corporate Governance
    The Board
        It is far from clear what the failure of corporate governance was
    at Enron. The Board relied upon reputable independent CPA's and legal
    counsel, and on a management perceived to be of the highest reputation.
    Even their doubtful approval of a conflict of interest regarding
    related parties transactions were set up with care. The audit
    committee's independence perhaps is in question, but there are already
    many independence rules in place on that issue. We must take care not
    to unfairly burden directors and particularly audit committee members
    or the result will be to reduce the availability of good directors to
    serve.
        If the directors failed in their fiduciary duties, the courts will
    hold them accountable. While insurance may cover their liabilities,
    they cannot be assured of this
    result if their conduct violates their fiduciary duties. I would
    suggest only two
    substantive changes be considered.
        First, my experience as a member of boards suggest that allowing
    one person to be the Board Chairman and CEO concentrates too much power
    in one place. While this is the way most U.S. boards of directors are
    organized, it can result in real abuse when the wrong person is CEO.
        Second, in this regard, it is important that the independent
    director (or some of them) constitute the committee to recommend new
    and retained directors to the board for approval. This suggestion will
    support board independence on which the governance system is based.

    The Corporate Offices
        Corporate officers performed poorly (to say the least) at Enron,
    but it is difficult to set performance standards legislatively. At the
    FDIC, we recommended, and the Congress passed, laws preventing golden
    parachutes when used shortly before a company failed. This was a
    difficult law to draft and enforce. Today, the golden parachute is
    offered in the form of options exercised while the officer knew or
    should have known the company was in trouble. Today's laws allow
    reclaiming profits, but this is not punitive. I guess most taxpayers
    would say, ``do something,'' but do not create more lawsuits so perhaps
    a penalty is justified.

    Government Regulation, Supervision, and Taxation
        In my view, free markets usually work better when Government has
    set the structure for them to perform. That is why we have an SEC,
    FDIC, Federal Reserve, OCC, EPA, CFTC, Anti-Trust Division, and many
    other agencies. Each came into being to remedy a market failure in the
    past.
        A good free market operates like a prizefight, plenty of chance to
    slug it out, but not below the waist and not with the second's stool.
    An unrestricted market is like a ballroom brawl where the fight results
    in wide spread destruction of both people and the place, and the winner
    may be the dirtiest fighter on the scene.
        The trick, of course, is to have the right rules that promote fair
    competition without stopping the competition.
        Enron tells us the structure for unregulated futures markets and
    derivatives failed and a market structure, while difficult to
    construct, is needed. Enron was a brawl because no regulators were
    empowered to deal with a good part of their market behavior. This
    supervision will be complicated to create, but only slightly more so
    than other supervision such as commodities futures, banking, antitrust,
    etc.
        Further, the tax system, which allowed Enron to avoid tax liability
    while reporting large profits, also must be fixed. The loss of revenue
    through Enron-type activities is growing rapidly. Tax results can be
    improved by enhancing IRS capabilities, including the use of private
    sector professionals and better tax laws.
        Above all, Enron's markets and activities needed transparency--a
    job that can only be done appropriately by the Government agency--the
    SEC.
        I have not tried, in this short period, to deal with all the many
    suggested actions in Congressional bills, testimonies, and the
    administrative proposals. I will be pleased to answer questions where I
    can on these and other matters.
        In summary, there is much to be done by the Congress, to reduce the
    chances of ``another Enron,'' but it must keep in mind that
    overreaction can do as much harm as no action at all.
        Thank you.

                                   ----------

                       PREPARED STATEMENT OF MICHAEL MAYO

                 Managing Director, Prudential Securities, Inc.
                                 March 19, 2002

        Chairman Sarbanes, Senator Gramm, Members of the Committee, thank
    you for inviting me to testify today about conflicts on Wall Street. I
    will cover conflicts among brokerage firms, corporations, and research
    analysts. I currently work for Prudential Securities, which values
    independent research, however, I am here today to give my own personal
    point of view.
        It is great to be back near my home in Maryland. I hope that the
    University of Maryland basketball team advances far in the NCAA
    basketball tournament. I can guess that the Chairman shares my hopes.
        I am here to talk about what can be analogous to playing basketball
    with one hand behind your back. Objective analysts, those with negative
    opinions and/or critical remarks, may have trouble holding corporations
    accountable. The reason is that companies themselves and their
    managements are the best source of information, and bullish and
    conflicted analysts may have the best access to this information.
        It is still hard for an analyst to be objective and critical. When
    an analyst says ``Sell,'' there can be backlash from investors who own
    the stock, from the company being scrutinized, and even from
    individuals inside the analyst's firm. While much attention in
    Washington is being paid to the pressures related to a firm's
    investment banking operations, other pressures can be as great or more.
    The main point: Some companies may intimidate analysts into being
    bullish. Those who stand up may face less access to company information
    and perhaps backlashes, too.
        I have a few perspectives to support my view:

     From personal experience: I have worked at 4 of the 10 largest
        brokerage firms. I understand how the brokerage industry works.

     From my research: I have covered the banking industry since
        the late 1980's and head the financial research group at Prudential
        Securities.

     From my stock ratings: When the facts support it, I do not shy
        away from placing Sell ratings on companies I cover. I have
        probably done so more than almost any other analyst.

     From my current firm Prudential Securities: A year ago,
        Prudential shed almost all of its investment banking activities.

        I will cover three areas in my testimony: (1) My personal
    experiences; (2) The conflict between serving investors versus
    corporations; (3) Problems with access by
    research analysts to corporations.

    My Experiences
        As I prepared for my career, I had all the usual training--
    financial textbooks, MBA training, professional certification, and even
    training at the Federal Reserve here in Washington. But playing-by-the-
    book does not do it on Wall Street. Here are a few personal examples to
    illustrate my point.

     After publishing a report with a Hold rating--not a Sell but a
        Hold rating--the CFO of the subject company had a shouting match
        with my boss and me. There was a threat of investment banking
        business getting withdrawn. Luckily, my senior management supported
        me.

     I published a report criticizing a merger. One investment
        banker barked at me, ``How do we make money off this research?'' I
        stuck with my opinion.

     A bank excluded me from an important dinner meeting at which
        all of the other banking analysts from major firms were in
        attendance.

     A CEO called to complain. He did not like negative comments in
        a report. He said that he gave investment banking business to my
        firm due solely to me. He said we had ``let him down.'' I said
        simply that we are objective with our analysis.

     I placed a Sell rating on one bank. I was told that the bank's
        management, in turn, told large investors that we had not done our
        homework, effectively criticizing our research approach. Within 6
        months, I was proven correct after the stock declined as a result
        of issues when earnings were publicized.

     We asked to visit with the management of a company. The
        response was ``No.'' I finally took a meeting with one company
        representative. They had said, ``Take it or leave it.'' What choice
        did I have?

        So whether the time was the start of last decade or the start of
    this decade, whether the firm was UBS, Lehman, Credit Suisse First
    Boston, or Prudential Securities, the backlash from corporations was
    similar. Little has changed to help me perform my job better. This
    pervasiveness suggests there are larger issues at work. We need to
    address these issues to ensure that investors get unbiased research.
    Conflicts At Brokerage Firms:
    Between Serving Investors Versus Corporations
        This statistic is critical: The brokerage industry earns four times
    as much from serving corporations (i.e., through investment banking and
    related services) as from serving investors. Two decades ago (1982),
    this ratio was one to one.\1\ In addition, the same firms (the 10
    largest brokerage firms) that get most of the trading business with
    investors gain an even greater percentage business of investment
    banking activities with corporations.
    ---------------------------------------------------------------------------
        \1\ Based on revenue data from the Securities Industry Association
    from 1999-2001 and assumed profit margins, earnings (pretax) in
    investor businesses were $35 billion versus $127 billion from
    investment banking. In comparison, these amounts in 1982 were $2.1
    billion and $2.6 billion, respectively.
    ---------------------------------------------------------------------------
        So who is really the client? The degree of conflict between serving
    corporations and investors--based on where the money is made--is at its
    highest level in history. If nothing else, this creates an environment
    ripe for abuse.
        For brokerage firms, what does it mean to earn four times more from
    corporations? First, investment bankers have the leverage. They want
    research analysts to act as team players. To them, this may mean saying
    nice things about their major corporate clients or potential future
    clients. Second, brokerage firms hire people who get along with
    investment bankers. One manager who hired me said that, in evaluating
    analysts, the firm placed a lot of weight on what the companies had to
    say to investment bankers. Can you imagine? This is like judging a food
    critic based on what the restaurants say!
        For analysts, what does it mean that their firms earn four times
    more from corporations? It means financial incentives, which can taint
    analysts' opinions, and keeping a job. Its not rocket science: Eighty
    percent of traditional brokerage profits come from corporations. Help
    the firm, you do well. Hurt the firm, why get rewarded? Analysts are
    mainly bullish and conflicted, probably because they do not want to
    lose their jobs.
        My main point: People do what they are incented to do. For
    brokerage firms, the incentive to serve corporations over investors is
    stronger than at any other point in history. For analysts, the main
    incentive is to stay employed.
    Problems With Access By Research Analysts To Corporations
        It takes an objective and critical analyst many times more work to
    do the job than it does a bullish or conflicted analyst. The main
    reason: Backlash from corporations. Such backlash can take various
    forms--I have five examples:
        (1) Investment Banking: The influence of investment banking on
    stock research is well documented after the Internet bubble. Per my
    other examples, sometimes companies pull business from a company after
    a critical report.
        (2) Phone Calls With The Company: Phone contact is part of
    analysts' day-to-day communication to get more color behind the
    numbers. Bullish and conflicted
    analysts can get their calls returned first, and even get senior
    executives on the line, including the CEO. As for objective and
    critical analysts, at times their calls are not even returned.
        (3) Meetings With Management: Some firms reply to a meeting
    request, ``Why is it a good use of our management's time?'' In other
    words, ``Say something positive, we will let you in.''
        (4) Conference Calls: Companies hold conference calls for earnings,
    strategic moves, and other reasons. Conference call systems let you
    manipulate the order that questions are answered. Last year, on one
    call, the operator said my call was in the queue. I then hear, ``No
    more questions.'' Do the more novice investors listening to the
    conference calls realize that the order of the questions can be
    manipulated?
        (5) Managements Participation In Analyst Events: Institutional
    investors--my main clients--pay a lot of commissions if you hold good
    conferences and bring managements in to see them. Guess who gets these
    tasks? Bullish and conflicted analysts, especially those whose firms
    have investment banking relationships.

        For the bullish or conflicted analyst, calls may be returned first,
    questions may be taken on conference calls, meetings with management
    may get scheduled earlier, managements help out to visit investors or
    participate in conferences, and investment banking fees may be better
    to boot.
        Reg FD has not fixed all of the problems. Companies simply make
    canned presentations on a webcast, but then may choose to turn off the
    webcast during the Q&A and the follow-on breakout sessions. (Also, some
    firms do not webcast their presentations, which I find very
    discouraging.)
        Perversely, this poor treatment has helped to make me and my team
    better analysts. We are forced to better scrutinize accounting
    footnotes, interact more with
    impartial third parties, and go out and ``kick the tires.''
        In other words, we are forced to hustle a lot more. To use the
    analogy, we are still doing the equivalent of playing basketball with
    one hand behind our back. The issue: I am not sure how many analysts
    are willing to accept this handicap, especially the newer ones trying
    to pay their New York City rents.
        To recap the problems: (1) From my perspective, it is business as
    usual when it comes to conflicts between companies and research
    analysts. (2) People do what they are incented to do. The financial
    incentives for brokerage firms to serve corporations has never been as
    high as they are today. (3) Objective or critical analysts continue to
    face backlashes in many ways.
    So What Is The Solution? Information And Incentives
        From my perspective, speaking solely as an independent analyst,
    there are a few steps that can be taken to improve the situation:

        (1) Information: Make sure that the access to the information is
    fair. One idea: Have an avenue for those analysts who feel
    disadvantaged by the companies they cover to voice concerns and get
    corrective action. Maybe a clearinghouse whereby analysts have recourse
    to voice their concerns? Maybe someone at the SEC? Just give me someone
    whom I can call when I am treated unfairly. One caveat: Any solution
    needs to insure that companies still are incented to maintain the
    highest level of information flow. I do not believe we need to regulate
    analysts. Analysts need to have equal access to information and
    appropriate incentives to provide objective
    research. Let's address the root of the problem.
        (2) Incentives: Take actions to minimize the interference of
    investment bankers with the job of research analysts. Disclose
    investment banking relationships to investors. Does the retail investor
    know that the brokerage firm pitching shares is also earning investment
    banking fees from the company? A related solution is to eliminate deal-
    based incentive pay. Also, in terms of carrots and sticks, a lot of
    attention has focused on making the stick bigger to get the so-called
    ``bad'' analyst. The ``carrot'' needs more attention, to encourage good
    behavior. I know there is debate about separating research from
    investment banking. From my personal experience, I can tell you that
    this is an effective solution.

    Conclusion
        We have the best capital markets in the world. But let's not grade
    ourselves on a curve. They can be better. As analysts, we are at the
    intersection between the
    interests of corporations and the interests of investors. We provide
    institutional memory, act skeptically, challenge corporate authority,
    question assumptions, and speak up if something does not smell right.
    We are on the front lines of holding corporations accountable.
    Prudential Securities scaled back its investment banking a year ago.
    The result is a great environment for me. I have 100 percent support of
    management when doing my research. Despite this, the pressures outside
    the firm are as strong as ever. The result: Impediments to conducting
    full, independent, unbiased investment research on corporations.
    Actions that can help remove these impediments and reduce the remaining
    conflicts will help improve our ability to serve
    clients . . . and when I talk about clients, I am talking about
    investors!
                               The Road to Reform

                               A White Paper From

                           The Public Oversight Board

                                       On

                   Legislation to Create a New Private Sector

               Regulatory Structure for the Accounting Profession

                                 March 19, 2002

                                  INTRODUCTION

        On January 20, 2002, the Public Oversight Board (POB)--created in
    1977 to oversee the voluntary self-regulatory structure for the
    accounting profession in the United States--voted to terminate its
    existence not later than March 31, 2002. For the POB, this action was
    taken as a matter of conscience and principle.
        In a report prepared for the Senate Committee on Governmental
    Affairs in August 1980, the Securities and Exchange Commission (SEC)
    pointed out that for a self-regulatory program for the accounting
    profession to be successful, strong leadership from the POB is
    essential. The POB, wrote the SEC, ``should serve as the conscience and
    critic of the self-regulatory effort.'' The POB's charter makes it
    clear that it is independent and the purpose of its oversight
    activities is ``to represent the public interest on all matters that
    may affect public confidence in the integrity, reliability, and
    credibility of the audit process.''
        At the time the POB was created, there were concerns that it might
    not be the right solution. John C. Burton, a distinguished Professor of
    Accounting at Columbia University and the Chief Accountant at the SEC
    in 1977, warned in Congressional testimony in 1978 that ``it is highly
    doubtful that a part-time group [POB] can
    either in fact or perception'' provide an effective substitute for
    statutory regulation.
        Meanwhile, Harold M. Williams, who was Chairman of the SEC at the
    time the current self-regulatory system was being created in the late
    1970's, warned in a speech in January 1978, that ``[t]he effectiveness
    and credibility of the Public Oversight Board depends on its
    independence, including its willingness to be critical when called for
    and its ability to make public its conclusions, recommendations, and
    criticisms.'' Chairman Williams also made the point that an effective
    POB could only be effective ``if it is not impeded in performing its
    functions and responsibilities.''
        Following its decision to terminate, the POB decided to prepare
    this paper to outline its proposals to create a new regulatory
    structure for the accounting profession. These proposals stem from the
    POB's extensive experience with the profession's voluntary self-
    regulatory system, its knowledge of problems that confront that system,
    and its insights on the need for change. The primary purpose of this
    paper is to present the case for legislative action creating an
    independent regulatory organization in the private sector.
        The POB felt it would be helpful to provide a brief history of how
    the current regulatory structure came into being; to discuss problems
    affecting the present regulatory structure; to provide the POB's views
    on enforcement, discipline, and several other issues facing the
    profession; and to discuss the POB's decision to terminate.

                               EXECUTIVE SUMMARY

        Over the past 2 years, the POB has faced increasing obstacles that
    have impeded its ability to carry out its oversight functions. As a
    consequence, the POB feels it must perform its role as ``conscience and
    critic'' because events of recent months have demonstrated that the
    warnings of Dr. Burton and Chairman Williams have come to pass.
        Three events are noteworthy in how the POB has been frustrated in
    its ability to effectively carry out its responsibilities.

     On May 3, 2000, the SEC Practice Section (SECPS)--an
        organization within the American Institute of Certified Public
        Accountants (AICPA)--took the unprecedented step of notifying the
        POB that it would refuse to pay for special reviews of public
        accounting firms. The special reviews in question had been sought
        by the SEC to determine whether the firms had complied with SEC and
        professional independence standards. The decision of the SECPS to
        deny funding to the POB was a serious blow to independent oversight
        of the accounting profession. Melvin Laird, the former Congressman
        and Secretary of Defense, who served on the POB longer than any
        other member, said that this was ``the worst incident in my 17
        years'' on the POB.

     Following the decision to cut off funding of the POB's special
        reviews requested by the SEC, the largest accounting firms--the Big
        5--agreed with the SEC that the POB should instead conduct more
        limited independence reviews of the large firms. Despite this
        agreement, the next 21 months were marked by delay and lack of
        progress. The POB, in the end, was unable to conduct the reviews.

     For years, the POB had carried out its oversight
        responsibilities under a set of bylaws adopted after it was created
        in 1977. The POB felt that a formal charter would improve the
        independence of the Board, and a charter was one of the primary
        recommendations in 2000 of the Panel on Audit Effectiveness,
        created by the POB at the request of the SEC. However, objections
        from the AICPA and the Big 5 caused negotiations to drag on for
        more than a year. Ultimately, a new charter took effect in February
        2001.

        When the POB voted to terminate its existence, the lack of progress
    in connection with the independence reviews and the frustrations that
    stemmed from the funding cut off and slow negotiations over the new
    charter all played a role. But the precipitating factor was the
    decision of the SEC to develop a new regulatory structure in private
    talks with the AICPA and the Big 5 firms, with no consultation with the
    POB. The SEC did not consult with the POB even though the POB had been
    established by the AICPA, in consultation with the SEC, to protect the
    public interest.
        When the POB initially learned of these talks, it asked to be
    included in the process and was promised that it would be consulted.
    That consultation never took place. In the end, the POB was simply
    informed--on the day of the announcement of the proposed new structure
    that there was no continued role for the POB in this structure,
    rendering it a ``lame duck.'' The POB determined that it could not
    effectively oversee the activities of the accounting profession under
    the circumstances, and that it would mislead the public to appear to do
    so. Furthermore, the POB was concerned that if it were to continue
    during an interim period before a new governance structure was in
    place, it would leave the impression that the POB approved of the SEC
    proposal, which it did not. Thus, as a matter if principle, it voted to
    terminate its existence.
        The Public Oversight Board strongly believes that a new regulatory
    structure for the accounting profession is essential and that, to be
    effective, it must be based on the foundation of Federal legislation.
        The Board recommends that Congress create a new Independent
    Institute of Accountancy--the IIA--and center all regulation under its
    auspices. A seven-member board would run the Institute totally
    independent of the AICPA, the Big 5, and other firms. The chair and
    vice chair would be full-time employees of the Institute; five other
    members would serve on a part-time basis. All would be appointed by a
    panel composed of the Chair of the SEC, the Chair of the Federal
    Reserve Board and the Secretary of the Treasury. Once named, the chair
    of the IIA would join these three in naming other members of the board.
    Members of the IIA board could be removed only by a two-thirds vote of
    the board itself.
        The SEC would have oversight of the IIA, and the SEC's Office of
    the Chief Accountant would be the liaison to the IIA.
        Important functions of the Institute would include:

     The IIA would exercise oversight for all standard setting for
        accounting, auditing, and independence, and their interpretation.
        Accounting standards are just as
        important as auditing and independence standards. For this reason,
        the POB believes the Financial Accounting Standards Board (FASB)
        should be brought under the umbrella of the IIA, which would take
        responsibility for its oversight and funding.

     Firm-on-firm peer review would be discontinued for firms that
        audit more than 100 public corporations each year. In its place,
        IIA employees would conduct comprehensive and thorough yearly
        reviews of the annual internal inspections of such firms. Unlike
        peer review, no activities of a firm would be off limits to
        Institute reviewers and the process would produce informative
        public reports. Substantial staff resources to conduct these
        reviews will be needed.
        In addition to the reviews, IIA employees would conduct special
        reviews, when warranted. Similar to those the SEC originally asked
        the POB to undertake, these reviews would take a systemic, in-depth
        look at a firm's systems, policies, procedures, and operations. If
        necessary, such special reviews would delve into questions
        affecting the firm's compliance with applicable professional
        standards. As with the yearly reviews, reports of these special
        reviews would be public.
     An Office of Enforcement and Discipline within the IIA would
        have full authority to investigate allegations of wrongdoing by
        public accounting firms and their personnel. The POB recommends
        giving the IIA the privilege of confidentiality, as well as the
        power of subpoena to compel testimony and produce documents. Cases
        of alleged misconduct could be brought before hearing examiners.
        When warranted, these examiners could recommend to the IIA board
        the imposition of sanctions, ranging from fines to expulsion from
        the profession. Cases could be referred to the Justice Department
        for possible prosecution, or to the SEC, State boards of
        accountancy, or other agencies, as appropriate.
     Funding would be provided through fees imposed on public
        corporations in amounts sufficient to cover the costs of the
        Institute. The POB strongly believes that the funding mechanism
        must be beyond the reach of the profession to prevent it from
        withholding necessary funds, as it did in May 2000.
     The IIA would be charged with coordinating international
        liaison and overseeing continued professional education for those
        in the profession.

        Beyond these functions, the POB recommends that:

     With regard to nonaudit services for audit clients, the POB
        recognizes that there has been disagreement on restricting scope of
        services and that various models have been suggested for what
        should be allowed and what should be excluded.
        The POB strongly agrees with a point made in President Bush's 10-
        point reform plan that ``Investors should have complete confidence
        in the independence and integrity of companies' auditors.'' The
        specifics on the President's plan recognize the importance of
        prohibiting certain nonaudit services in order to safeguard auditor
        independence.
        The POB takes note of a statement issued by the AICPA on February
        1, 2002, in which it affirmed that it ``will not oppose Federal
        legislation restricting the scope of services that accountants may
        provide their public audit clients, specifically in information
        technology and internal audit design and implementation.''
        Against this background, the POB proposes that SEC regulations
        concerning independence be legislatively codified with appropriate
        revisions to update restrictions on scope of services involving
        information technology and internal audit services as noted above.
        At the same time, the POB believes such legislation should affirm
        that tax work not involving advocacy and attest work by audit firms
        in connection with SEC registration and other SEC filings be
        allowed. The POB also believes that small public businesses, to be
        defined by the SEC, should not be subject to any restriction on
        nonaudit services for audit clients. Further, with respect to
        nonpublic corporations, it is the POB's position that such
        corporations and the accounting firms that audit them should not be
        subject to any restriction on nonaudit services. We expressly
        emphasize this to avoid misunderstanding and any consequences to
        small business and small audit firms.
        The IIA Office of Standards should be empowered by legislation to
        promulgate appropriate rules affecting independence to cover
        changing circumstances.
        The POB believes there should be no prohibition against an audit
        firm offering nonaudit services to nonaudit clients.

     Auditors should be rotated every 7 years. As a corollary,
        public corporations would be prohibited from firing auditors during
        their term of service unless such action is determined by the audit
        committee to be in the best interest of shareholders, with prompt
        notice to the IIA and the SEC. Such action would be required to be
        publicly disclosed by corporations in current reports and proxy
        statements filed with the SEC.

     Engagement and other partners who are associated with an audit
        should be prohibited from taking employment with the affected firm
        until a 2 year ``cooling off '' period has expired.

     The Institute should expand on the recommendations of the
        recent Blue Ribbon Committee which made it clear that the external
        auditor should be accountable to a firm's board of directors and
        its audit committee and not to management. Specifically, the audit
        committee should take full responsibility for hiring, evaluating,
        and--if necessary--terminating an audit firm.

     To discourage conflicts of interest involving public
        corporations, Congress should amend the Securities Exchange Act of
        1934 to require more meaningful and more timely disclosure of
        related party transactions among officers, directors, or other
        affiliated persons and the public corporation. Such disclosures
        should be made promptly in current reports, as well as in proxy
        statements filed with the SEC.

     Management of public corporations should be required to
        prepare an annual statement of compliance with internal controls to
        be filed with the SEC. The corporation's chief financial officer
        and chief executive officer should sign this attestation and the
        auditor should review it. An auditor's review and report on the
        effectiveness of internal controls would--as the General Accounting
        Office (GAO) found in a 1996 report--improve ``the auditor's
        ability to provide more relevant and timely assurances on the
        quality of data beyond that contained in traditional financial
        statements and disclosures.'' Both the POB and the AICPA supported
        the recommendation when the GAO made it, but the SEC did not adopt
        it.

                       A BRIEF HISTORY OF SELF-REGULATION

    The Stock Market Crash of 1929 and Its Aftermath
        The 1929 crash revealed a general absence of accounting and
    auditing standards, thereby permitting public companies to report
    financial position and results of operations that sometimes bore little
    relation to economic reality. The crash and ensuing depression led to
    Congressional hearings, which in turn led to several pieces of
    reform legislation, beginning with the Securities Act of 1933 and the
    Securities
    Exchange Act of 1934. The Public Utility Holding Company Act of 1935,
    the Trust Indenture Act of 1939, and the Investment Company Act and
    Investment Advisers Act of 1940 followed. These Acts require, or permit
    the SEC to require, as the SEC summarized in 1994, ``that financial
    statements filed with the Commission by public companies, investment
    companies, broker/dealers, public utilities, investment advisors, and
    others, be certified (or audited) by independent accountants.''
        Although audits of public corporations were common before the
    Federal Securities Acts of 1933 and 1934, they had not been required by
    statute. Beginning in April 1932, the New York Stock Exchange (NYSE)
    requested corporations applying for listing to agree to have their
    annual financial statements audited by independent accountants.
        The 1929 market crash revealed improper accounting practices at
    large public companies that had become bankrupt. In 1939, the AICPA's
    Committee on Accounting Procedure issued the first Accounting Research
    Bulletin and the AICPA's Committee on Auditing Procedure issued the
    first Statement on Auditing Procedure. At present, accounting standards
    are issued by FASB, auditing standards are issued by the AICPA's
    Auditing Standards Board (ASB), and interpretations of the Code of
    Professional Conduct are issued by the AICPA's Professional Ethics
    Executive Committee--all of which are private sector bodies.

    The 1970's--Expansion of the Regulatory Structure
        The major reforms of the 1930's and the regulatory system they
    created survived for more than 40 years with only minor modifications.
    That the regulation of the accounting profession remained unchanged for
    so long may be attributed in part to the relatively few allegations of
    audit failures during most of that period, at least in comparison with
    later years.
        To this day, the responsibility for promulgating auditing and
    ethical standards resides within the AICPA. The AICPA also was
    responsible for promulgating accounting standards until mid-1973
    through its Committee on Accounting Procedure and its successor body,
    the Accounting Principles Board. Both of those committees were
    comprised principally of practicing auditors, often those who were
    responsible for their firms' accounting policies. In 1973,
    responsibility for promulgating accounting standards passed to FASB in
    the belief that the setting of accounting standards by an independent
    body with no ties to either auditors or preparers of financial
    statements would enhance the public's confidence in the financial
    reporting process. At the same time, the Financial Accounting
    Foundation was created to raise funds for FASB, among other tasks, and
    a Financial Accounting Standards Advisory Council was created to advise
    FASB on its agenda and deliberations. That structure remains largely
    unchanged today.
        A series of cases involving alleged audit failures in the 1970's
    led the AICPA to create the Commission on Auditors' Responsibilities,
    Chaired by Manuel F. Cohen, a former Chairman of the SEC. Those cases
    involved fraudulent financial reporting and illegal or questionable
    corporate acts, such as bribes, political payoffs, and kickbacks. The
    Cohen Commission's Report, Conclusions, and Recommendations issued in
    1978 made numerous recommendations to improve audit practice in several
    areas. Those recommendations led to the promulgation of Statements on
    Auditing Standards (SAS) that increased the auditor's responsibility to
    detect and report fraudulent financial reporting and illegal acts by
    corporate management. Several other auditing standards can be traced
    either to the Cohen Commission recommendations or to specific audit
    failures and the litigation that they spawned.
        The same cases that spawned the Cohen Commission also led to
    hearings by both the Senate and House of Representatives in 1977 and
    1978. In particular, the Senate's Subcommittee on Reports, Accounting,
    and Management of the Committee on Government Operations (the Metcalf
    subcommittee) held hearings to determine whether additional
    governmental regulation of the accounting profession was necessary or a
    system of professional self-regulation was sufficient.
        In response to these hearings, the AICPA, in consultation with the
    SEC, created a voluntary self-regulatory framework consisting of the
    SEC Practice Section (SECPS) of the Division for CPA Firms, with an
    independent POB to oversee the activities of the Practice Section and
    to monitor and comment on matters that affect the public interest in
    the integrity of the audit process--a structure that exists to this
    day. While no additional governmental regulation was imposed once the
    voluntary self-regulatory system was created in the 1970's, the
    Congress did pass the Foreign Corrupt Practices Act (FCPA) in 1977,
    following Senate hearings which revealed the payment of bribes by
    American corporations to foreign officials. The FCPA made it clear that
    bribery of foreign officials by American companies is an unacceptable
    and illegal practice. The Act required SEC registrants to maintain a
    system of internal accounting controls to provide reasonable assurance
    that certain objectives would be achieved. For example, transactions
    must be executed consistent with management authorization and be
    recorded to permit preparation of financial statements in conformity
    with Generally Accepted Accounting Principles and to maintain
    accountability for assets. In addition, the FCPA required public
    corporations to make and keep books and records which, in reasonable
    detail, accurately and fairly reflect underlying transactions.

    The 1980's and 1990's -- Congressional Hearings and Legislation
        As noted in a September 1996 report of the GAO, The Accounting
    Profession--Major Issues: Progress and Concerns, ``In the 1980's,
    continued business failures, particularly those involving financial
    institutions, led to a series of Congressional hearings on auditing and
    financial reporting under the Federal securities laws.'' Two major
    pieces of legislation resulted from those hearings: The Federal Deposit
    Insurance Corporation Improvement Act of 1991 (FDICIA) and the Private
    Securities Litigation Reform Act of 1995. While those laws increased
    responsibilities for auditors, they did not address the regulatory
    structure of the accounting profession.
        FDICIA added Section 36 to the Federal Deposit Insurance Act to
    provide early identification of needed improvement in financial
    management at banks and savings and loan institutions. Management's
    responsibilities under regulations implement- ing Section 36, which
    apply to institutions with total assets of $500 million or more,
    include reporting on management's responsibility for and assessment of
    the effectiveness of the institution's internal controls over financial
    reporting. Each institution is required to have an audit committee
    composed of outside directors independent of management. Audit
    committees of institutions with $3 billion or more in assets must
    include members with relevant banking or financial expertise, have
    access to their own outside counsel, and exclude large customers. Under
    Section 36, the independent accountant must examine and report on
    management's assertions about the institution's internal controls over
    financial reporting, using the AICPA attestation standards. This
    requirement constitutes one of the very few statutory or regulatory
    requirements that independent auditors report publicly on client
    internal controls.
        The Private Securities Litigation Reform Act of 1995 addressed the
    concerns of Congress and regulators about auditors' responsibilities
    with respect to their clients' compliance with laws and regulations and
    about how instances of noncompliance were reported. Those concerns led
    to inclusion in the Act of a requirement that auditors of public
    companies notify the SEC of material illegal acts when an entity's
    management and board of directors have failed to take timely and
    appropriate remedial action.
        The 1996 GAO report, which was commissioned by Representative John
    Dingell (D-Mich.), the Ranking Minority Member of the House Committee
    on Energy and Commerce, identified five major issues discussed in the
    various studies concerning the accounting profession from 1972 through
    1995: (1) auditor independence, (2) auditor responsibilities for fraud
    and internal controls, (3) audit quality, (4) the accounting and
    auditing standard setting processes and the effectiveness of financial
    reporting, and (5) the role of the auditor in the further enhancement
    of financial reporting. The report summarized the results of these
    reviews as follows:

              GAO's analysis of the actions taken by the accounting
            profession in response to the major issues raised by the many
            studies from 1972 through 1995 shows that the profession has
            been responsive in making changes to improve financial
            reporting and auditing of public companies. Further, GAO's
            analysis of statistical data on the results of peer reviews of
            accounting firms that audit public companies registered with
            the SEC shows that most firms now have effective quality
            control programs to ensure adherence with professional
            standards. However, GAO's review of the studies' findings shows
            that the actions of the accounting profession have not been
            totally effective in resolving several major issues. Issues
            remain about auditor independence, auditor responsibility for
            detecting fraud and reporting on internal controls, public
            participation in standard setting, the timeliness and relevancy
            of accounting standards, and maintaining the independence of
            FASB.

        While the profession and the SEC subsequently have addressed
    several of the issues that the GAO review identified as being
    unresolved in 1996, a number of them, such as reporting on internal
    controls, remain unresolved in 2002.
    Changes in the Practice and Culture of Accounting Firms
        The business model that describes the practice of the large
    accounting firms--a wide array of financial services performed both
    domestically and internationally for both audit clients and others--has
    existed for many years.
        Each of the large public accounting firms provide accounting and
    auditing services, tax services, and management consulting services,
    and the largest firms provide those services globally through overseas
    offices and foreign affiliates. These characteristics have existed for
    decades. As the Cohen Commission noted in 1978:

              Before independent audits became widespread in the United
            States, public accountants were already performing a variety of
            other services. Public accountants in the early 1900's offered
            advice on accounting systems, kept accounting records, prepared
            financial statements and tax returns, and performed a variety
            of consulting services, including appraisals.

        The Cohen Commission also noted that ``large corporations typically
    operate at a number of different locations. A public accounting firm
    must provide services at many places throughout the country and the
    world.'' The Panel on Audit Effectiveness, citing SEC data, noted in
    its 2000 report that:

              The number of foreign companies that have registered
            securities in the United States has almost tripled since 1990.
            . . . The securities of many U.S. companies registered with the
            SEC are traded outside of the United States, and the financial
            statements of those companies may be filed with non-U.S.
            regulators. The financial statements of many U.S. companies and
            foreign companies are available to investors or creditors in
            numerous countries, irrespective of the jurisdiction that
            regulates such companies.

        While multifaceted practices of the international accounting firms
    described above have existed for many years, the extent to which
    nonaudit services are provided to audit clients and the globalization
    of the profession have changed over the years. Superimposed on the
    growth of nonaudit services and globalization is the high level of
    competition among the firms for audit clients in recent years that many
    believe has changed the culture of auditing practice.
        Certain nonaudit services provided to audit clients--particularly
    the design and implementation of large integrated information systems
    and internal audit and valuation services--have long raised concerns
    about both the fact and the appearance of auditor independence, and
    thus about the quality of audits. The size of the fees from those
    services in many cases and their relationship to the amount of audit
    fees from the same client has added to those concerns. Similar concerns
    about audit quality are a natural result of a firm's international
    practice in countries that do not have the same level of accounting,
    auditing, and quality control standards as the United States. Last,
    some fear that excessive competition for audit clients has driven audit
    fees down to a level that cannot support a quality audit but that
    serves primarily to provide the firm with ``a foot in the door'' for
    marketing other services.
        Some have suggested that an increasing appetite for growth and
    profits is now driving the ``culture'' and ``tone'' of most accounting
    firms. Accounting firms sometimes seem to view their clients--even
    their audit clients--as ``business partners.'' There are also those who
    contend that audits are sometimes used as ``loss leaders'' to build a
    relationship with a client for the marketing of the accounting firm's
    nonaudit services.
        One can question whether, together with the natural reluctance to
    lose the audit fee, a diminished professionalism makes it more
    difficult for a firm to reject a client's proposed accounting
    treatment. There seems to be little doubt that the forces described in
    this section as presenting challenges to audit quality were present in
    several of the widely publicized recent business and audit failures.
    And that, in turn, suggests the need for additional regulation of the
    profession and a degree of oversight that significantly exceeds what
    exists at present.

    The SEC's 1998 and 2000 Initiatives
        In a September 1998 speech at the New York University (NYU) Center
    for Law and Business, SEC Chairman Arthur Levitt noted that
    ``qualified, committed, independent, and tough-minded audit committees
    represent the most reliable guardians of the public interest.'' He
    announced that the NYSE and the National Association of Securities
    Dealers had agreed to sponsor a ``blue-ribbon'' panel to develop
    recommendations ``to empower audit committees and function as the
    ultimate guardian of investor interests and corporate accountability.''
    The committee's report was issued in February 1999.
        The SEC responded with new disclosure rules in December 1999. Among
    them is the requirement that a report by the audit committee be
    included in the company's proxy statement, indicating whether the audit
    committee has, among other things:

     Reviewed and discussed the audited financial statements with
        management.

     Discussed with the independent auditors the matters required
        to be discussed by auditing standards (which includes the quality
        of the accounting principles and underlying estimates reflected in
        the financial statements).

     Discussed with the auditors their independence.

        In addition, the SEC adopted a rule requiring that the independent
    accountants
    review a company's interim financial information before the company's
    quarterly report is filed.
        The major stock exchanges also responded to the committee's
    recommendations by enacting rules covering the independence,
    qualifications, and composition of audit committees, including a
    requirement that committee members be financially literate. The
    exchanges further required that the audit committee adopt a formal
    written charter approved by the board of directors; the exchanges also
    specified that the charter should contain minimum audit committee
    responsibilities.
        Also in 1999, the Independence Standards Board (ISB) adopted
    Independence Standard No. 1, Independence Discussions with Audit
    Committees. The standard requires that, at least annually, an auditor
    intending to be considered an independent accountant with respect to a
    specific entity under the Federal Securities Acts shall:

     Disclose to the audit committee of the company (or the board
        of directors if there is no audit committee), in writing, all
        relationships between the auditor and its related entities and the
        company and its related entities that in the auditor's professional
        judgment may reasonably be thought to bear on independence.

     Confirm in the letter that, in its professional judgment, it
        is independent of the company within the meaning of the Acts.

     Discuss the auditor's independence with the audit committee.

        In his 1998 NYU remarks, Chairman Arthur Levitt also proposed that
    ``the Public Oversight Board form a group of all the major
    constituencies to review the way audits are performed and assess the
    impact of recent trends on the public interest.'' In response, the POB
    formed the Panel on Audit Effectiveness. Its report and
    recommendations, issued in August 2000, are discussed below.
        In November 2000, the SEC adopted amendments to its auditor
    independence rules. These amendments to the independence requirements
    placed limits on certain services, particularly the information
    technology and internal audit services, that
    accounting firms may provide to their audit clients without impairing
    their independence. In those two areas in particular, the final
    independence rule was not as restrictive as the rule originally
    proposed--it did not completely prohibit auditors from providing them
    to their audit clients. In early 2002, in apparent response to concerns
    emanating from the Enron collapse, the five largest accounting firms
    announced their intent to no longer provide any internal audit or
    certain information technology services to their audit clients.
        The release containing the SEC's revised independence rules noted
    the risk of compromised independence when a former partner, principal,
    stockholder, or professional employee of an accounting firm is hired by
    an audit client of the firm. Accordingly, under the Commission's final
    rule, as under the then existing requirements, an auditor's
    independence is impaired when such an individual is employed in an
    accounting or financial oversight role at an audit client, unless
    certain conditions are met. Both the SEC and ISB considered the notion
    of a mandatory ``cooling off '' period before accounting firm personnel
    join an audit client. Neither body adopted it because of concerns it
    would unnecessarily restrict the employment opportunities of former
    firm professionals.

    The Public Oversight Board's Role in the Voluntary Regulatory Structure
        As previously noted, the POB is a private sector body--independent
    of the accounting firms, the AICPA, and the SEC--that was created in
    1977 by the AICPA in consultation with the SEC for the purpose of
    overseeing and reporting on the self-regulatory programs of the SECPS.
        In addition to its ongoing monitoring and oversight
    responsibilities, the POB has undertaken or commissioned special
    studies and reviews over the years. The reports emanating from them
    have had a significant effect on regulation of the accounting
    profession and the quality of audits. The following are examples of
    these reports:

     In the Public Interest: Issues Confronting the Accounting
        Profession, which contained recommendations designed to enhance the
        usefulness and reliability of financial statements, strengthen the
        performance and professionalism of auditors, and improve self-
        regulation (1993).

     Strengthening the Professionalism of the Independent Auditor,
        which contained recommendations in the areas of auditor
        independence, involvement of audit committees and boards of
        directors with independent auditors, litigation reform, and the
        relationships among the accounting profession, standard setting
        bodies, and the SEC (1994).

     Report and Recommendations of the Panel on Audit
        Effectiveness, which is discussed below (2000).

        In addition to its ongoing oversight of the peer review and quality
    control inquiry processes, the POB's principal activities in 2001 and
    2002 centered around monitoring the implementation of the
    recommendations of the Panel on Audit Effectiveness, overseeing the
    ASB, and preparing for the reviews of the firms' systems, procedures,
    and internal controls relating to independence, as discussed below.
    Over the past year, the POB has made significant additions to its full-
    time and part-time staff to carry out expanded oversight and monitoring
    responsibilities called for in the new charter.
        The POB's charter affirms that it is independent and specifies that
    the purpose of the POB's oversight activities is, as noted above, ``to
    represent the public interest on all matters that may affect public
    confidence in the integrity, reliability, and credibility of the audit
    process.'' The public interest is represented by the quality, breadth,
    integrity, and stature of the members of the POB, which the Board
    believes should serve as a model for the future membership of any
    successor oversight body. The POB's first Chairman was John J. McCloy,
    former High Commissioner for Germany who also served his country in
    many other capacities over a long and distinguished career. He was
    followed by Arthur Wood, former CEO and Chairman of Sears, Roebuck &
    Co., and then by another distinguished public servant, A. A. Sommer, a
    former SEC Commissioner and securities lawyer. Other former board
    members included Melvin R. Laird, former Member of Congress and
    Secretary of Defense, who served on the POB for 17 years, and Paul H.
    O'Neill, who resigned from the board to become Secretary of the
    Treasury. The current Board consists of Charles A. Bowsher, former
    Comptroller General of the United States, who was
    appointed to the Board in 1999 to serve as its Chairman; Norman R.
    Augustine, former Chairman and CEO of Lockheed Martin; Aulana L.
    Peters, former SEC Commissioner; and John H. Biggs, Chairman and CEO of
    TIAA-CREF. Donald J. Kirk, former Chairman of FASB, resigned as Vice
    Chairman on January 18, 2002.

    The Panel on Audit Effectiveness
        As previously indicated, in October 1998, at the request of SEC
    Chairman Arthur Levitt, the POB appointed the Panel on Audit
    Effectiveness to examine the way independent audits are performed and
    to assess the effects of recent trends in auditing on the public
    interest. The Panel issued its report and recommendations on
    August 31, 2000. Its recommendations were addressed to many
    constituencies--standard setters, accounting firms, the SECPS, audit
    committees, the SEC, and others--and covered a wide range of matters,
    including:

     Conduct of audits, including the auditor's responsibility for
        the detection of fraud (including earnings management when it
        constitutes fraud).

     Leadership and practices of audit firms.

     Effects on auditor independence of nonaudit services provided
        to audit clients.

     Governance of the auditing profession.

     Strengthening the auditing profession internationally.

        The Panel's report received widespread endorsement. SEC Chairman
    Levitt, for example, stated that ``[i]mplementation of the specific
    recommendations made by the [p]anel to improve the audit process
    through more comprehensive and vigorous audit methodologies and
    standards will engender greater confidence among investors that they
    are receiving high-quality audits.'' He also commended the members of
    the Panel ``for their proposals to improve the self-regulatory
    framework of the profession.'' POB Chairman Bowsher predicted that the
    report would play an important part in setting a future course for the
    accounting profession.
        No conclusions can yet be drawn about the extent to which the
    actions taken to date to implement the Panel's recommendations have
    enhanced audit effectiveness. The Panel's report was published less
    than 2 years ago, and the process of responding to the Panel's
    recommendations is incomplete.

                        EXPERIENCE WITH SELF-REGULATION

        The POB experience with self-regulation of the accounting
    profession has varied throughout the period of its existence. For
    years, the profession and the AICPA were responsive to the POB and the
    need to improve audits to enhance investor confidence in financial
    statements of public corporations.
        The environment changed in recent years as accounting firms
    expanded greatly the scope of their services which, in turn, led to a
    reexamination of the concept of independence by the SEC. During the
    late 1990's, the relationship between the
    accounting profession and the SEC became very strained, with division
    among the Big 5 on whether to support or oppose the SEC.
        During the same period, the relationship between the accounting
    profession and the POB also became strained over the adoption of a
    charter for the POB, particularly with respect to the section in the
    charter dealing with funding. In effect, the proposed POB charter
    became hostage to the dispute among the accounting profession and the
    SEC over resolution of proposed revisions to the independence
    requirements and rules. But, even during this period, several of the
    Big 5 supported the POB.
        The relationship between the accounting profession and the POB was
    further strained when the POB, at the SEC's request, attempted to
    conduct reviews of the Big 5 firms' policies, procedures and internal
    controls related to independence. The SEC and the firms had agreed to
    these reviews, and requested the POB to conduct such reviews and issue
    written reports on them. Some of the firms, unfortunately, adopted an
    approach that resulted in delay and a lack of progress. This did not
    permit the POB to conduct the reviews.
        In the final analysis, the experience with voluntary self-
    regulation has been mixed in recent years. The AICPA and several of the
    Big 5 firms, in the view of some, saw the POB's role as one of a
    ``shield'' for the profession rather than as an independent overseer.
        Mr. Levitt, the former SEC Chairman, also described this problem in
    testimony before the Senate Banking Committee in February 2002. ``More
    than three decades ago,'' he said, ``Leonard Spacek, a visionary
    accounting industry leader, stated that the profession could not
    `survive as a group, obtaining the confidence of the public . . .
    unless as a profession we have a workable plan of self-regulation.'
    Yet, all along the profession has resisted meaningful oversight.''

              PROBLEMS WITH THE CURRENT SYSTEM OF SELF-REGULATION

        The current system of self-regulation of the accounting profession
    has significant problems.
        First, the funding of the POB is subject to control by the firms
    through the SECPS, which in the past has cut off that funding in an
    effort to restrict the POB's activities.
        Second, the disciplinary system is not timely or effective.
    Disciplinary proceedings are deferred while litigation or regulatory
    proceedings are in process. This results in years of delay and
    sanctions have not been meaningful. The Professional Ethics Division of
    the AICPA, which handles disciplinary matters against individuals, does
    not have adequate public representation on its Board. Investigations by
    the Quality Control Inquiry Committee of the SECPS, which handles
    allegations of improprieties in litigation against member firms arising
    out of audits of SEC clients, do not normally include access to firm
    personnel and work papers. The disciplinary system does not include the
    power to issue subpoenas or compel testimony. Thus, investigators must
    rely on the cooperation of the individual being investigated. The QCIC
    has no access to the complaining party or the client involved.
    Furthermore, there is no privilege or confidentiality protection for
    investigations or disciplinary proceedings, and disciplinary actions
    are often not made public.
        Another problem is that monitoring of firms' accounting and
    auditing practices by the peer review process has come to be viewed as
    ineffective, as either a diagnostic or remedial tool. More important,
    the process has lost credibility because it is perceived as being
    ``clubby'' and not sufficiently rigorous. Finally, the peer review team
    does not examine the work of an audit that is under investigation or in
    litigation.
        Other problems include the fact that the current governance
    structure does not have the weight of a Congressional mandate behind
    it. There is also a perceived lack of candid and timely public
    reporting of why and how highly publicized audit failures and fraud
    occurred and what actions have or will be taken to ensure that such
    problems do not recur.
    Auditing Standards and Termination of the ISB
        The Auditing Standards Board (ASB) was not subject to oversight by
    an independent entity until it was put under the oversight of the POB
    in February 2001. In contrast, under the SEC's proposed governance
    structure for the accounting profession announced in January by the SEC
    Chairman Harvey Pitt, there will be no oversight of the ASB other than
    by the profession's trade association, the AICPA. Most of the members
    of the ASB are associated with the eight largest public accounting
    firms.
        The auditing standards promulgated by the ASB have not provided
    sufficiently specific and definitive guidance, a weakness noted in the
    Panel on Audit Effectiveness Report and Recommendations issued on
    August 31, 2000.
        During a speech in January 1978, then-SEC Chairman Harold Williams
    stated, ``The issue of independence is the key one'' for the accounting
    profession. The Independence Standards Board (ISB), which was
    established in 1997, was terminated in July 2001 because both the AICPA
    and SEC, for different reasons, did not agree with what the ISB had
    done. The ISB was established to create, codify, and interpret
    independence standards for auditors of public companies. Its
    termination has left a significant void.
    The Public Oversight Board Charter
        For more than two decades, the POB operated under a set of bylaws,
    but without the benefit of a charter. Creation of a charter to provide
    expanded and greater assurances of POB independence became a priority
    of the Board in December 1999, and was one of the key recommendations
    of the Panel on Audit Effectiveness, which issued its draft report in
    May of 2000 and its final report in August of the same year. Yet it
    took over a year--from December 1999 to February 2001--to negotiate a
    new charter.
        The primary reason for this delay was the resistance of the AICPA
    and the large firms to various points. For example, the AICPA and
    accounting profession, contrary to the recommendation of the Panel on
    Audit Effectiveness, wanted limitations on POB funding. In addition,
    for many months they opposed giving the POB authority to approve
    nominations for the chairs of the SECPS executive committee and the
    ASB, even though they acknowledged that in the past, the POB, in
    effect, had approved those nominations informally.
        In the end, the POB adopted a pragmatic attitude in order to
    further the public interest. A charter was approved which gave the POB
    expanded oversight and an enlarged budget and staff. It took effect in
    February 2001.
        The recommendations of the Panel on Audit Effectiveness, including
    a formal charter for the POB, were designed to improve the existing
    voluntary self-regulatory system, not to create a new regulatory
    structure for the profession. At the time of the Panel's
    recommendations in August 2000, neither the POB nor members of the
    Panel thought it was likely that Congress would approve a statutory
    regulatory
    organization to govern the profession.

    Independence Reviews
        In a letter to the POB dated December 9, 1999, then SEC Chief
    Accountant Lynn Turner expressed concern that public accounting firms
    possibly lacked adequate quality controls for independence. As a step
    to ``safeguard the public interest,'' he ``strongly recommend[ed]''
    that the POB undertake ``a special review of SECPS member firms'
    current compliance'' with independence requirements. On December 21,
    1999, the POB agreed to do so. Two weeks later, on January 6, 2000, the
    SEC announced that an internal investigation at PricewaterhouseCoopers
    LLP (PwC) had disclosed more than 8,000 independence violations there.
    At this time, there were publicly expressed concerns that the
    widespread independence violations at PwC might also be found at other
    large accounting firms if they were subject to a similar compliance
    review. Against this background, the POB commenced preliminary work on
    the special reviews in January 2000, and had meetings with the firms to
    discuss the reviews.
        Then, in early May 2000, the POB's work on the special reviews was
    stopped by a decision of the SECPS to cut off funding for them. Mr.
    Levitt, the Chairman of the SEC, stated that this was ``a significant
    setback to self-regulation and independent oversight'' and raised
    ``serious questions as to the profession's commitment to self-
    regulation.'' Melvin Laird, former Congressman and Secretary of Defense
    and the longest-serving member of the POB, said that this was ``the
    worst incident in my 17 years'' on the POB.
        The special reviews did not go forward, but shortly afterward, in
    June 2000, the SEC and the Big 5 firms entered into a ``Term Sheet for
    Independence Look-Back Testing Program'' (term sheet), which called for
    the POB to conduct more limited independence reviews.
        Subsequently, on October 10, 2000, the POB received a letter from
    Mr. Turner asking that the POB do the independence reviews called for
    by the term sheet ``in lieu of '' the special reviews previously
    requested in his December 1999 letter to the POB. The POB agreed to do
    so, and commenced preliminary work on these reviews in November 2000.
    Between then and January 2002, a period of more than a year, the POB
    did a substantial amount of work preparing to conduct the independence
    reviews. This work included a request for documents sent to the firms
    and the SEC staff in July 2001, as well as comprehensive work programs
    for both phase I (evaluation of design and implementation
    effectiveness) and phase II (testing and evaluation of operating
    effectiveness) of the reviews, sent to the firms and SEC staff in
    October 2001 and January 2002, respectively. In addition, the POB was
    involved in working with the firms on a confidentiality agreement for
    the independence reviews. The POB's efforts to enter into a
    confidentiality agreement with the firms, going back to July 2001, met
    with no success. In addition, by the middle of January 2002, the POB
    still had not been able to obtain from the firms documents it had
    requested for the independence reviews in July 2001. This lack of
    progress in conducting the independence reviews was one of the factors
    that led to the POB voting to terminate its existence.
        In a letter to the SEC and the firms dated March 5, 2002, the POB
    set forth its position on the transfer of its responsibility for
    conducting the independence reviews to an independent person and
    discussed the background of the independence reviews. This letter can
    be found on the POB's website at www.publicoversight
    board.org.
    The Public Oversight Board Decision to Terminate
        As noted above, although the POB commenced preliminary work on the
    independence reviews in November 2000, by January 2002, it still had
    not been able to obtain information and documents it had requested from
    the firms in July 2001. The POB was concerned that the lack of progress
    on the independence reviews would continue. This lack of progress was
    one of the considerations that caused the POB to vote its intention to
    terminate its existence no later than March 31, 2002.
        However, the precipitating factor in the POB's decision to
    terminate was the announcement of a proposed new self-regulatory
    structure by SEC Chairman Pitt. The POB was not consulted on this new
    proposed governance structure for the accounting profession, announced
    by Mr. Pitt at a press conference on January 17, 2002, even though the
    POB had requested and been assured that it would have the opportunity
    to provide input as the proposals were being developed and prior to any
    public announcement. Instead, without including the POB in the process,
    the SEC worked privately with representatives of the AICPA and the Big
    5 firms and developed the new SEC proposal. Thus, the private sector
    entity which was charged with oversight of the profession's self-
    regulatory activities and with representing the
    public interest had no input into what may well be the most significant
    change in regulating the accounting profession in the last 30 years.
        A January 23, 2002 article in The Wall Street Journal reported that
    a spokesman for PwC confirmed that chief executives of the Big 5 firms,
    including PwC, had held a series of private meetings with the SEC
    Chairman in Washington between December 4, 2001, and January 17, 2002,
    on this matter, and that the gatherings ``took place at Mr. Pitt's
    invitation.''
        On the same day that one of these meetings was being held, December
    4, 2001, Charles Bowsher, Chairman of the POB, had a discussion with
    Barry Melancon, President and CEO of the AICPA, at the John J. McCloy
    dinner hosted by the POB. During this discussion, which also included
    James Castellano, Chairman of the AICPA, Mr. Melancon told Mr. Bowsher
    that the profession and the SEC were working on proposed changes to the
    governance structure of the accounting profession. Mr. Bowsher
    specifically asked that the POB be included in any such discussions so
    that it would be able to provide input before any public announcement
    of a proposed new structure. Mr. Melancon assured Mr. Bowsher that this
    would be done.
        At a meeting of the SECPS executive committee on January 4, 2002,
    Mr. Charles Bowsher, Aulana Peters, a POB member, and Jerry Sullivan,
    the POB Executive Director, were told that a proposed governance
    structure for the profession would be announced within a month. Messrs.
    Bowsher and Sullivan and Ms. Peters asked that the POB be ``brought in
    the loop'' and be given an opportunity to participate. They were told
    the POB would be consulted.
        The SEC did not seek input from the POB on the new regulatory
    structure. While Chairman Pitt had left a voice message for Mr. Bowsher
    on January 10, 2002, and Mr. Bowsher had called back twice, in the end
    Mr. Bowsher did not receive a return call and the two men did not speak
    before the press conference.
        On January 17, 2002, Mr. Bowsher received a call from Mr. Melancon
    and Robert Kueppers, Chairman of the SECPS executive committee, a few
    hours before Mr. Pitt announced the new SEC proposal at a press
    conference. In this call, Mr. Bowsher asked specifically if there would
    be a place for the POB in the new structure. Mr. Melancon replied that
    there was no place for the POB in the new regulatory structure to be
    announced by Mr. Pitt and that the POB would be a redundancy.
    Subsequently, the POB was advised by the Chairman of the SECPS that the
    SECPS working group had provided the SEC with an outline of a proposal
    a week before the January 17, 2002 press conference.
        The POB believes that one of its primary functions is to facilitate
    communication. The Panel on Audit Effectiveness found that ``The POB
    should serve as the oversight body to whom the SEC, the State boards of
    accountancy, the auditing profession and the public should look for
    leadership. This leadership position is intended to enhance
    communications among the profession's self-regulatory bodies in order
    to facilitate the profession's continuous improvement efforts and
    identify and resolve important issues on a timely basis.'' The Panel
    recommended that the SEC should ``[s]upport the POB's authority as
    enumerated in its charter to enable the POB to serve as an independent,
    effective, unifying leader of the profession's voluntary self-
    regulatory process.''
        During Chairman Pitt's press conference on January 17, he was
    specifically asked whether there would be a role for the POB in the new
    SEC proposal. He did not answer the question.
        John Coffee, the distinguished Columbia Law School Professor who
    has written extensively about securities regulation, faulted the SEC
    chair for the way in which the new regulatory structure was created.
    Professor Coffee said that ``It is not the high watermark of public
    accountability when the industry to be regulated designs its own
    regulatory structure in negotiations with its former lawyer.''
        The foregoing was the context in which the POB voted unanimously on
    January 20, 2002, its intention to terminate its existence pursuant to
    Section IX of the POB's charter no later than March 31, 2002. The
    reason for this action was that the new SEC proposal had been worked
    out by the SEC, in collaboration with the AICPA, SECPS executive
    committee and representatives of the Big 5 firms, without any
    consultation with the POB, which is charged with representing the
    public interest. The new proposal rendered the POB a ``lame duck.'' In
    making its decision, the POB was also cognizant of the experience of
    negotiating its new charter, the fact that the SECPS had cut off funds
    for the special reviews, and that there had not been progress in
    connection with the reviews to which they had agreed. The POB believed
    it could not effectively oversee the activities of the accounting
    profession under the circumstances and that it would mislead the public
    to appear to do so. Furthermore, if the POB were to continue during an
    interim period before a new governance structure were in place, it
    believed it would leave the impression that it approved of the Pitt
    proposal. As the ``conscience and critic'' of the profession, the POB
    felt it had no choice but to terminate its existence to protect the
    public interest. What the POB did was akin to what an auditor does when
    it believes it must resign from a client engagement because of a
    fundamental disagreement.
                 THE PUBLIC OVERSIGHT BOARD PROPOSAL FOR REFORM
        The Public Oversight Board is mindful that there are many suitable
    models that could be adopted as part of a reform program for regulation
    of the accounting profession. Congress will undoubtedly consider many
    of the available options in coming weeks as decisions are made on
    regulatory changes in the aftermath of the Enron debacle. Whatever the
    details of reform, the POB strongly believes that a legislative
    foundation for any future regulatory structure is crucial.
        Because it has had oversight responsibility for a good portion of
    the voluntary self-regulatory structure of the accounting profession
    for the past 25 years, the POB has first-hand knowledge of the
    strengths and weaknesses of the existing system and, thus, a unique
    perspective on regulatory reform. The POB considered a number of
    options for reform based on the present system, but ultimately came to
    the conclusion that a complete overhaul is essential. The Board
    believes that the existing system has become ineffective.
        Dating back to the 1970's, when bribery of foreign officials by
    American corporations was first uncovered, followed by the audit
    failures associated with the bankruptcy of the Penn Central railroad--
    the Enron failure of its day--reforms have been largely incremental and
    piecemeal. The creation of the POB and other early reforms grew out of
    hearings in the House and Senate that followed the Penn Central
    bankruptcy and the ``sensitive payments'' scandal. While the POB
    believes that many of these early reforms served a useful purpose and
    strengthened the profession, it is also clear that in recent years,
    regulatory oversight and attempts at further reforms have been met with
    resistance or outright rejection by the profession. As noted earlier in
    this paper, the profession over the past 2 years has acted to preserve
    the status quo and has resisted major reform efforts.
        Faced with this opposition, the Public Oversight Board believes the
    time for legislative action has come. The current system needs to be
    replaced. To accomplish this, the POB believes it is essential that all
    critical elements of regulation--including all standard setting,
    inspections and reviews of accounting firms, enforcement and
    discipline, and other functions--be placed under the aegis of a single
    regulator operating under statutory authority. This new entity--an
    Independent Institute of Accountancy (IIA)--would employ a professional
    staff of individuals unaffiliated with the profession or any of the Big
    5 accounting firms and would be run by a seven-member Board, which
    itself would be totally independent of the profession.
        The SEC would have oversight of the IIA, and the SEC's Office of
    the Chief
    Accountant would be the liaison to the IIA. A chart showing the
    organizational structure of the IIA is attached as Appendix A.
    The Board
        Under the POB's model, the chair and vice chair of the IIA Board
    would be employed on a full-time basis. Five other members would serve
    on a part-time basis. Each member, including the chair and vice chair,
    would serve a 5 year term and no member could serve more than two
    consecutive terms. To assure future continuity, it is anticipated that
    the initial membership of the Board would have staggered terms. While
    qualified persons with accounting experience, such as retired
    accounting professionals, would be allowed to serve on the Board, the
    majority of members would have no ties whatever to the profession.
        The importance of independence cannot be stressed enough.
    Independence removes any conflict of interest--real and apparent--on
    the part of Board members. Independence enhances the likelihood that
    when the narrow needs of the profession conflict with the broader
    public interest, it is the public interest that will be served.
    Independence will also serve the interests of the accounting profession
    itself. Because the accounting profession depends on the trust of
    investors and the public, that trust will wither and die if the
    profession is seen to be self-serving in its actions. The best way to
    keep that trust is to place regulatory decisions at arms-length in an
    independent, legislatively mandated oversight structure within the
    private sector.
        The chair of the Board would be selected by a committee composed of
    the chair of the SEC, the chair of the Federal Reserve Board and the
    Secretary of the Treasury. Once named, the IIA chair would become a
    member of the selection committee and would join in selecting the vice
    chairman and the other members. To assure independence, members could
    be removed only by a two-thirds vote of the IIA Board itself. Having a
    selection committee of these individuals would enhance the credibility
    of the Institute.

    Standards and Interpretation
        The POB charter gave it authority to oversee the issuance and
    interpretation of auditing and independence standards for the
    profession by the ASB and the ISB. Accounting standards have been set
    for nearly three decades by FASB.
        The POB believes it is time to consolidate all standard setting
    bodies under one roof. Thus, a basic and critical function of the new
    Institute would be oversight of the issuance and interpretation of
    accounting, auditing and independence standards for the profession. To
    accomplish this end, an Office of Standards would be created by the IIA
    Board and would report to it. Within the Office of Standards, separate
    bodies would be created to issue accounting standards, auditing
    standards, and independence standards. While the POB envisions a system
    in which the IIA Board would have overall authority to create the
    structure under which standard setting would take place and to make
    appropriate rules for the standard setting process, the standard
    setting bodies within the Office of Standards would be given
    considerable autonomy in carrying out their work. A well-staffed and
    funded research arm within the Office of Standards would support the
    standard setting entities. The Office of Standards would also be
    charged with issuing interpretations of standards and be subject to
    monitoring by the IIA Board.
        With respect to FASB, the POB is cognizant of its hard work in
    setting accounting standards for nearly three decades, but believes it
    should be integrated along with all standard setting bodies into one
    unified and coordinated structure under the aegis of the IIA. Placing
    the responsibilities of FASB under the new IIA would
    lessen the chances of it being influenced by those whose its standards
    affect and could likely help alleviate what some--including the current
    SEC Chairman--have said is a slow process for promulgating standards.
    As Lee Seidler, Deputy Chairman of the 1978 AICPA Commission on
    Auditor's Responsibilities, testified before the Senate Banking
    Committee in March 2002, ``FASB has been beset by enormous outside
    pressures.'' Also, former SEC Chairman David Ruder expressed similar
    concerns before the same committee in February 2002, noting that ``FASB
    continually faces difficulties in financing its operations.''
        These problems would be alleviated because FASB's independent
    funding would be guaranteed by the IIA. Further, one of the major
    advantages to placing the activities of FASB under the new IIA would,
    as Mr. Turner testified before that committee in February 2002, be
    ``the accounting standard setting, and enforcement of those standards,
    residing within a single organization. In turn, when the disciplinary
    process identifies shortcomings in the standards, they could then be
    promptly referred to the standard setter for timely action.''
        With respect to auditing standards, the POB believes that standards
    promulgated by the current ASB have not provided guidance that is
    sufficiently specific and definitive, a problem noted in the
    recommendations of the Panel on Audit Effectiveness. The ASB is
    controlled by the AICPA, and eight of its 15 members are partners of
    the eight largest accounting firms. As with other standard setting
    entities, it should be placed under the aegis of the newly created
    Institute.
        As was discussed earlier, the termination of the ISB-- established
    to create, codify, and interpret independence standards for auditors of
    public corporations--has left a significant void. The POB believes this
    void should be filled by creating a new entity independent of the
    profession and operating under the aegis of the Institute, with
    sufficient resources and staff to issue clear, unambiguous standards of
    independence.
        As to the membership of the separate bodies that would be created
    under the
    Office of Standards of the IIA, the POB believes a majority of their
    members should be independent of the profession. The new Office of
    Standards with separate bodies would help alleviate the concerns
    expressed by former SEC Chief Accountant
    Michael Sutton, who testified in February 2002 before the Senate
    Banking Committee that ``standard setters too often pull their punches,
    backing down from solutions they believe are best--perhaps because of a
    perceived threat to the viability of private sector standards setting--
    perhaps because of the sometimes withering strains of managing
    controversial, but needed change--perhaps because of a loss of focus on
    mission and concepts that are supposed to guide their actions.'' Public

    representation would assure that, at the least, the public had a voice
    and a vote in the process.

    Annual and Special Reviews
        Since 1977, peer review of one accounting firm by another has been
    the backbone of the voluntary self-regulatory system in the United
    States, and the POB has been charged with overseeing this process. The
    POB believes that peer review resulted in major improvements in the
    profession. The recommendations that flowed from peer reviews in the
    early days led to substantive improvements in the quality
    controls at accounting firms, large and small. At the same time, as
    former SEC Chairman Williams testified on February 12, 2002, before the
    Senate Banking Committee, peer review ``in its present form [has
    become] too incestuous. A system needs to be established which is
    independent of the accounting profession.''
        Because it is not a transparent system (details of peer reviews are
    not made
    public) and is limited in scope (audits subject to investigation or
    litigation are not looked at as part of a peer review), peer review has
    come under considerable criticism from Members of Congress, the media,
    and others. ``You scratch my back, I will scratch yours'' is the
    prevailing cynical opinion of peer review raised by many.
        The Public Oversight Board is of the opinion that peer review, as
    it has been conducted, should be discontinued in favor of a more
    thorough, independent, and transparent system. Each accounting firm now
    carries out an internal inspection each year. The POB would mandate
    that, for firms that audit more than 100 public corporations each year,
    these inspections would be subject to a comprehensive and thorough
    review, carried out by an independent professional staff hired by the
    Institute. While these reviews would usually look at a representative
    sample of a firm's work, IIA reviewers would have the authority, unlike
    current peer reviewers, to look at any aspect of a firm's operations it
    might find appropriate. Details would be compiled in reports that would
    be made available to the public. Reviews of smaller audit firms would
    be performed by other firms selected and paid by the IIA. Their reports
    would be addressed to the IIA as the client of the reviewer.
        Professor Joel Seligman, who testified before the Senate Banking
    Committee in March 2002 stated that ``the most significant issue may
    prove to be who conducts periodic examinations and inspections. To
    paraphrase the classical adage: Who will audit the auditors? I would
    urge serious consideration be devoted to replacing peer review with a
    professional examination staff in the new SRO. Peer review has been, to
    some degree, unfairly maligned. But even at its best it involves
    competitors
    reviewing competitors. The temptation to go easy on the firm you review
    lest it be too critical of you is an unavoidable one.''
        But these reviews are only one piece of an updated oversight
    structure. To supplement them, the POB believes that special reviews
    should be carried out, when warranted, on a case-by-case basis. These
    special reviews, similar to those the SEC originally asked the POB to
    undertake of the Big 5 firms, could take a more systemic and in-depth
    look at a firm's systems, policies, procedures and operations. If
    necessary, they would delve deeply into questions affecting a firm's
    compliance with SEC rules and applicable professional standards. As
    with annual reviews, an independent professional staff hired by the
    Institute would carry out any special reviews and results would be
    public.

    Enforcement and Discipline
        One of the most pervasive complaints about the current voluntary
    system is that firms and their personnel are rarely disciplined by the
    profession for infractions in carrying out audits or other work.
        Dave Cotton, a member of the AICPA's Professional Ethics
    Committee's Technical Standards Subcommittee, wrote in a January 2002
    Washington Post article that, while the Ethics Committee expels someone
    from the AICPA 5 to 10 times a year, ``[m]ore typically, when [that]
    committee finds that a CPA has violated professional standards, it
    orders continuing professional education classes. A CPA found to have
    violated an accounting standard in connection with a multibillion-
    dollar corporate collapse, causing massive damage to investors and the
    public, might receive this minimal sanction.''
        When discipline is imposed by the present system, it almost always
    comes years after the fact because of procedures which delay the
    process, including sanctions, until after the outcome of litigation.
    Mr. Cotton noted in The Washington Post article cited above that, as a
    result of delays in the disciplinary system, ``accountants who have
    committed the most egregious ethical lapses--the ones resulting in SEC
    investigations, bankruptcy and litigation--can often continue to
    practice for 10 years or more after the alleged violation until all the
    cases are resolved.'' Bevis Longstreth, a former SEC Commissioner and
    member of the POB's Panel on Audit Effectiveness, stated in his
    Congressional testimony in February 2002 that the present system
    ``results in long delays in investigation and, as a practical matter,
    renders the disciplinary function a nullity in almost all instances.''
        The POB believes that these concerns about the present system have
    validity and that an effective mechanism for timely and effective
    discipline is essential to any reform effort.
        One reason for the delay in the current system stems from the fact
    that those charged with administering the system lack privilege to
    ascertain facts. Privilege would give the investigative entity the
    authority to protect information it uncovers from outside demands until
    any enforcement action is concluded. At present, firms will not
    disclose documents or other information that is likely to wind up in
    the hands of litigants in legal proceedings. As Shaun O'Malley,
    Chairman of the POB's Panel on Audit Effectiveness and former Chairman
    of Price Waterhouse, pointed out in his testimony in March 2002 before
    the Senate Banking Committee, the present system has been ``hampered by
    distrust and by concerns that the materials developed were not
    protected. Providing confidentiality will expedite and vastly improve
    the review, investigatory, and disciplinary processes.''
        Further hampering those charged with discipline in today's system
    is the lack of subpoena power. Because of this, the system may not be
    able to obtain important information from auditors or audit clients.
    Also, sanctions are limited; the most that can be done is expel someone
    from membership in the AICPA. Further, the disciplinary process is not
    transparent, so the public is often unable to determine what, if any,
    action has been taken, even with respect to major audit failures.
        The POB suggests that an Office of Enforcement and Discipline be
    formed within the new IIA to have full legal authority to investigate
    allegations of wrongdoing by public accounting firms and their
    personnel, including subpoena power. The Office would be staffed by
    accounting and other professionals, as well as investigators. Cases of
    alleged improper professional conduct would be brought before IIA
    hearing officers, who would be charged with recommending, where
    warranted--after public notice and opportunity for public hearing--that
    the IIA Board impose sanctions that would range from fines to
    suspension or expulsion from the profession. Cases could be referred to
    the Justice Department for possible prosecution, or to the SEC, State
    boards of accountancy, or other agencies, as appropriate.
        The allegations brought before the Office of Enforcement and
    Discipline would go forward to investigation regardless of any pending
    litigation, unlike the present system. Disciplinary hearings and
    decisions would be public.

    Funding and Staff
        If the Institute is to be successful in all that it is charged with
    overseeing and regulating, it must be appropriately funded and it must
    have an adequate, well-trained staff. It is clear that to attract a
    talented staff, competitive salaries must be available. Further, the
    Institute must be assured that the funds will be there when needed.
        Former SEC Chairman Williams testified before the Senate Banking
    Committee in February 2002 that the POB ``is not adequately funded and
    is beholden for its funding to the very people it is supposed to
    oversee. I suggest that the SEC consider a requirement that a
    percentage of the audit fees of public companies be assessed to pay for
    independent oversight, whether it is the Public Oversight Board or a
    successor body, so that its funding is assured.''
        Another former Chairman of the SEC, David Ruder, said in testimony
    the same day that: ``Independent and adequate funding is crucial. An
    independent body that depends upon sporadic voluntary contributions
    from industry or the financial community may risk loss of financial
    support if it takes positions seen as contrary to the best interest of
    those it regulates.''
        The POB recommends that funding be provided through fees imposed on
    public corporations in an amount that would be sufficient to cover the
    costs of the Institute. The fees would vary according to the total
    revenues of the corporation. The POB strongly believes that the funding
    mechanism must be beyond the reach of the profession to prevent it from
    withholding necessary funds, as it did in May 2000.
    International Liaison
        Convergence of international accounting and auditing standards is
    one of the most pressing issues facing the profession. In an era when
    major firms either own or are affiliated with large accounting entities
    throughout the world and major corporations engage in global trade,
    common accounting and auditing standards are fast becoming a critical
    need. The Public Oversight Board believes that international
    liaison should be a primary function of the Institute.
        Paul Volcker, the former Federal Reserve Chairman and Chairman of
    the Trustees of the International Accounting Standards Board (IASB),
    told the Senate Banking Committee in February 2002 that FASB and IASB
    were working together on a number of issues and that the ``result
    should be convergence and significant improvement in both bodies of
    standards.'' Since the IIA would oversee accounting standard setting as
    well as auditing and independence standard setting, the Institute would
    be in the best position to act as international liaison to promote
    convergence and significant improvement to United States and
    international standards. This is a POB function under its charter and
    should be transitioned to a new regulatory body.
    Continuing Professional Education
        Education has always been a hallmark of the accounting profession,
    and accountants and auditors are required to accumulate 80 hours of
    continuing professional education credits every 2 years. As important
    as education has been in the past, however, it will become even more
    crucial in years to come. The ability of auditors to deal with audits
    of companies involved in cross border offerings and derivatives and
    other new financial instruments that are constantly being invented is
    largely dependent upon their ability to understand them--and that is a
    function of education. Similarly, convergence of standards across
    international boundaries will present new and unprecedented challenges
    to accountants and auditors and only continuing education will make it
    possible for the profession to remain on top of new developments. For
    these reasons, continuing education should be a primary focus of the
    new Institute.
    Other Matters Affecting the Profession
        Beyond the regulatory structure of a new system, the POB believes
    there are a number of other issues that should be addressed as part of
    legislation creating a charter for the new Institute.
    Auditor Independence
        The POB recognizes that there are several models available to deal
    with the matter of auditor independence and that there continue to be
    disagreements on this matter.
        The Panel on Audit Effectiveness, for example, was split on the
    issue of scope of services for audit clients. Some Panel members wanted
    to essentially ban nonaudit services for audit clients. But these
    members would have allowed a ``carefully circumscribed exception'' if
    the client's audit committee (composed only of independent directors)
    found that the best interests of the company and its shareholders would
    be served by retaining its auditor to render such nonaudit services in
    cases where ``no other vendor of such service can serve those interests
    as well.'' This proposal would also have required submission of such a
    finding to the SEC and POB and disclosure in the corporation's proxy
    statement of the finding and the amount paid for the nonaudit services.
        On the other hand, those on the Panel who opposed restricting
    nonaudit services--a majority--held that ``audit firms can provide both
    audit and nonaudit services to the same public audit client, and with
    proper safeguards and disclosures, can maintain independence and
    objectivity.'' Those taking this view believed that ``nothing in the
    long history of the profession's providing nonaudit services has
    indicated otherwise.''
        Mr. Volcker said during the September 2000 public hearings on the
    SEC's proposed independence rules that:

              The extent to which the conflict has in practice actually
            distorted auditing practice is contested. And surely, instances
            of overt and flagrant violations of auditing standards in
            return for contractual favors--an auditing capital offense so
            to speak--must be rare. But more insidious, hard-to-pin down,
            not clearly articulated or even consciously realized,
            influences on audit practices are another matter.

        Importantly, President Bush's 10-point plan ``to improve corporate
    responsibility and protect America's shareholders,'' announced in March
    2002, provides that ``Investors should have complete confidence in the
    independence and integrity of companies' auditors.'' The specifics on
    this plan recognize the importance of prohibiting certain nonaudit
    services in order to safeguard auditor independence.
        On February 1, 2002, the AICPA issued a statement, which said it
    ``will not
    oppose Federal legislation restricting the scope of services that
    accountants may provide their public audit clients, specifically in
    information technology and internal audit design and implementation.''
        In considering this matter, the POB started from the premise that
    the accountant's audit and report add significant credibility and
    reliability to a corporation's
    financial statements in the process of capital formation and that the
    foundation of that credibility is auditor independence.
        To effectively assure independence, the POB believes legislation
    governing nonaudit services to audit clients is necessary. The POB
    proposes that SEC regulations concerning independence be legislatively
    codified with appropriate revisions to update restrictions on scope of
    services involving information technology and internal audit services
    as noted above.
        The POB believes such legislation should also affirm that tax work
    not involving advocacy and attest work in connection with SEC
    registration and other SEC filings be allowed, and that small public
    businesses, to be defined by the SEC, should not be subject to any
    restriction on nonaudit services. Further, with respect to nonpublic
    corporations, it is the POB's position that such corporations and the
    accounting firms that audit them should not be subject to any
    restriction on nonaudit services. We expressly emphasize this to avoid
    misunderstanding and any consequences to small business and small audit
    firms.
        The IIA Office of Standards should be empowered to promulgate
    appropriate rules affecting independence to cover changing
    circumstances. The POB also believes that nonrestricted, nonaudit
    services should require approval by the audit committee if it finds
    such services to be compatible with maintaining independence. Also
    required would be prompt notification to the IIA Office of Standards
    and public disclosure in current reports and proxy statements filed
    with the SEC.
        The POB believes there should be no prohibition against an audit
    firm offering nonaudit services to nonaudit clients.
    Auditor Rotation and Retention
        The POB believes that the time has come to require the rotation of
    auditors every 7 years. The one effective way to prevent the emergence
    of too close a relationship between a corporation and its auditor is to
    make certain that auditors are rotated periodically. While there is
    merit to the argument that a long-term relationship helps the auditor
    do a better job, it is also true that a new auditor every 7 years would
    provide the corporation with the benefit of a fresh perspective.
        The POB agrees with its member, John Biggs, who testified in
    February 2002 before the Senate Banking Committee that auditor rotation
    is a ``powerful antidote'' to auditor conflicts of interest, which
    ``reduces dramatically the financial incentives for the audit firms to
    placate management.'' In addition, as Mr. Biggs stated, ``rotation
    reduces the problem of cross-selling other services and is likely to
    eliminate the revolving door that allows former auditors to become the
    top financial officers of the audited company.'' The POB also supports
    Mr. Biggs' idea, described in his testimony, that the new auditor at
    the time of rotation should do ``an exhaustive review of the former
    audit work papers'' that would assure ``transactions and documentation
    were fully transparent.'' In addition, the new auditor could do ``a
    brief, signed peer review report'' on its predecessor.
        As a corollary to auditor rotation, the POB recommends that public
    corporations be prohibited from firing auditors during their term of
    service. As former SEC Chairman Williams stated in his testimony before
    the Senate Banking Committee, the benefit of such a retention
    requirement is that ``the auditor would be assured of the assignment
    and, therefore, would not be threatened with the loss of the client and
    could exercise truly independent judgment.''
        The POB recommends allowing an exception to this retention
    requirement if the audit committee determines that an exception is in
    the best interest of shareholders, with prompt notice to the IIA and
    the SEC. Such action would be required to be publicly disclosed by
    corporations in current reports and proxy statements filed with the
    SEC. The POB also believes that audit committees, in engaging the
    auditor, should give primary consideration to the quality of the audit
    firm and its audit plan, and not to the lowest price.
        The POB is cognizant that if an auditor rotation regulation is
    included in legislation, action will have to be taken to phase in the
    new system. The POB recommends giving the IIA authority to promulgate
    new rules governing the transition to an auditor rotation system.
    Actual rotation of auditors would begin only after those rules are in
    place.
    Cooling Off Period
        For many years, Members of Congress and senior Federal Government
    officials have been required to enter a ``cooling off '' period during
    which they are prohibited from taking certain actions, such as
    lobbying, on behalf of their new employer. The objective is obvious: To
    guard against undue influence by former colleagues and friends when it
    comes to making Government decisions that could benefit the new
    employer of the former official.
        The POB believes such a cooling off period is sound policy and
    feels a variant of it should be applied to the accounting profession
    when senior partners leave their firms. Specifically, the POB
    recommends that engagement and other partners who are associated with
    an audit be prohibited from taking employment with the affected firm
    until a 2 year period has expired. This would end the current situation
    in which there is at least the appearance of impropriety in audit firms
    being unduly influenced by former colleagues who have taken senior
    positions with existing audit clients.
        As Mr. Seidler said in his testimony this February, ``the former
    auditor knows
    exactly how his or her former firm conducts the audit,'' and also
    ``knows how far former compatriots can be pushed to accept results
    preferred by management.'' Mr. Seidler added that `` `we are all
    friends,' is not exactly the appropriate relationship between
    independent auditor and client.''
        It is also important to recognize that in the cases of Lincoln
    Savings and Loan, Waste Management and, most recently, Enron and Global
    Crossing, senior financial officers at the company came from the
    outside audit firm.
        Under the POB proposal, the IIA Board would have the authority to
    adopt specific rules affecting this proposed cooling off period.
    Audit Committees
        The POB believes that the Institute should expand on the
    recommendations of the Report and Recommendations of the Blue Ribbon
    Committee on Improving the Effectiveness of Corporate Audit Committees,
    which made it clear that the external auditor should be accountable to
    a firm's board of directors and its audit committee and not to
    management. Specifically, the POB believes audit committees should take
    full responsibility for hiring, evaluating, and--if necessary--
    terminating an audit firm.
    Conflicts of Interest
        To discourage conflicts of interest involving public corporations,
    Congress should amend the Securities Exchange Act of 1934 to require
    more meaningful and timely disclosure of related party transactions
    among officers, directors, or other affiliated persons and the public
    corporation. Such disclosures should be made promptly in current
    reports as well as in proxy statements filed with the SEC.
    Internal Controls
        In the 1980's, a series of major business failures, particularly
    those involving financial institutions, led to Congressional hearings
    on auditing and financial reporting matters. Out of those hearings, the
    FDICIA became law. This Act required among other things, that
    management report on internal controls and, further, that the
    independent auditors examine and report on those management assertions.
        The Special Report by the POB dated March 5, 1993 on ``Issues
    Confronting the Accounting Profession'' recommended that the SEC
    require public companies to include with their annual financial
    statements ``(a) a report by management on the effectiveness of the
    entity's internal control system relating to financial reporting; and
    (b) a report by the [entity's] independent accountant on the entity's
    internal control system relating to financial reporting.'' The POB, in
    support of this recommendation, stated: ``The Board believes that
    requiring auditors to assess management's reports on the quality of
    internal controls will benefit the public. First, the auditing
    profession's evaluation of internal control systems will lead to
    improvements in those systems. Second, as long as companies' boards and
    top management demand conformity with those systems, the improved
    systems will make management fraud and manipulation of financial
    reporting more difficult.''
        Just a few months later, in a June 1993 position statement, the
    AICPA Board of Directors stated:

              To provide further assurance to the investing public, we join
            the POB in calling for a statement by management, to be
            included in the annual report, on the effectiveness of the
            company's internal controls over financial reporting,
            accompanied by an auditor's report on management's assertions.
            An
            assessment by the independent auditor will provide greater
            assurance to investors as to management's statement. The
            internal control system is the main line of defense against
            fraudulent financial reporting. The investing public deserves
            an independent assessment of that line of defense, and
            management should benefit from the auditor's perspective and
            insights. We urge the SEC to establish this requirement.

        The General Accounting Office discussed this issue of reporting on
    internal controls in its 1996 report, ``The Accounting Profession.''
    The GAO pointed out that the POB had said ``it was disappointed by the
    failure of the SEC to take action to mandate issuer and auditor
    reporting on internal controls. The POB agreed with us that such action
    would add immeasurably to the ability to prevent and detect fraud and
    would in general enhance the quality of finance reporting.'' The GAO
    stated that the SEC was ``the key player'' here and, further, that the
    SEC should move forward on this important issue. So far, the SEC has
    not done so.
        Management of public corporations should be required to prepare an
    annual statement of compliance with internal controls to be filed with
    the SEC. The corporation's chief financial officer and chief executive
    officer should sign this attestation and the auditor should review it.
    An auditor's review and report on the effectiveness of internal
    controls would--as the GAO found in its report--improve ``the auditor's
    ability to provide more relevant and timely assurances on the quality
    of data beyond that contained in traditional financial statements and
    disclosures.''
        In addition, strengthened internal controls over financial
    reporting should improve quarterly statements, interim disclosures and
    earnings estimates that are the basis for many market price changes
    during the year. They should also be helpful in avoiding restatements
    that are now seen so frequently.
                                   CONCLUSION
        The Public Oversight Board has not come lightly to its
    recommendations for reform. For many months, members of the POB hoped
    that patient negotiation and discussion would prevail. In the end,
    however, it became very apparent to the POB that real reform will take
    place only when the Congress requires it through legislative action.
        A decade ago Congress acted in the public interest when it voted
    major reforms in the banking industry--reforms that were widely opposed
    by the banks and their lobbyists. Opponents then predicted gloom and
    doom for the industry should the proposed reforms be enacted. In
    reality, the reforms contained in the FDICIA repaired flaws in
    regulation of the Nation's banking industry. More important, they
    significantly strengthened the industry.
        Today, the Congress again is called upon to institute reform. In
    the wake of the Enron debacle, the POB, acting as the ``conscience and
    critic'' of the profession, strongly believes that to protect investors
    and the public, the old system of voluntary self-regulation for the
    accounting industry must be replaced. While many will urge that
    Congress act with caution and that the profession be again given the
    opportunity to fix the present system with marginal changes, the POB
    believes it is time to resist the continuation of the status quo and
    move ahead with fundamental change.
        In short, the POB believes it is time for Congress to enact the
    kind of reform that will make a real difference.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                           WEDNESDAY, MARCH 20, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:20 a.m. in room SD-538 of the
    Dirksen Senate Office Building, Senator Paul S. Sarbanes
    (Chairman of the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        This morning, we continue in our series of oversight
    hearings on the systemic issues surrounding the issues of
    accounting practices and investor protection.
        Last week, actually, we had an interesting panel with
    representatives from the accounting industry. This morning, we
    are very pleased that we are going to hear from a variety of
    interested parties, including the Consumer Federation of
    America, the Council of Institutional Investors, the
    Association of Investment Management and Research, and the AFL-
    CIO.
        We have been reviewing in the Banking Committee a number of
    important issues--auditor independence, the setting of auditing
    standards, disclosures, conflicts of interest, SEC authority
    and funding, corporate loans to executives and insider abuse,
    corporate governance, self-regulatory structure for
    accountants.
        Each of the groups represented here today have held in some

    instances pronounced views on these issues that we have under
    consideration and we very much welcome this panel being with
    us.
        I will introduce each person as we go. We will hear from
    all four before we do any questioning.
        First, we will hear from our former colleague, the very
    able and distinguished Senator from Ohio, Howard Metzenbaum,
    who served here with us in the Senate for 19 years, and is now
    the Chairman for the Consumer Federation of America, a pro bono
    assignment, as I understand it.
        We wouldn't expect anything less from Howard Metzenbaum.
        CFA is a nonprofit educational and consumer advocacy
    organization. Its membership consists of more than 285
    organizations throughout the country, with an estimated
    membership in excess of 50 million people.
        Howard, we are delighted to have you with us and we would
    be happy to hear from you.

            STATEMENT OF SENATOR HOWARD M. METZENBAUM (RET.)

                CHAIRMAN, CONSUMER FEDERATION OF AMERICA

        Senator Metzenbaum. Mr. Chairman, I am delighted to appear
    before your Committee. When I was here, I always enjoyed
    working with you and considered you a friend. We made trips
    together and it would not feel proper or appropriate if I did
    not, on behalf of
    myself and my wife, send our best regards to your wife,
    Christine.
        Chairman Sarbanes. Thank you.
        Senator Metzenbaum. It is truly a privilege to be here with
    you today speaking for the Consumer Federation of America.
        Chairman Sarbanes. Howard, would you just suspend your
    statement for a moment.
        I am sorry, Senator Akaka. Did you have an opening
    statement?
        Senator Akaka. Yes, Mr. Chairman. Thank you very much.
        Chairman Sarbanes. You are recognized.

                  STATEMENT OF SENATOR DANIEL K. AKAKA

        Senator Akaka. I want to add my welcome to our former
    colleague, Howard Metzenbaum, and to all of you here.
        I just want to tell you as a Member of this Committee, I
    have a different perspective. I see things from the side.
        [Laughter.]
        Chairman Sarbanes. It is known as covering all your bases.
        [Laughter.]
        Senator Akaka. Thank you so much for being here.
        Without question, your being here and your statements will
    be useful to the Committee.
        Investors planning for retirement are faced with a
    complicated set of financial decisions that will significantly
    impact their future financial security. The shift from defined
    pension benefit plans to 401(k) contribution plans has placed
    additional financial decisionmaking responsibilities onto the
    employee.
        The 401(k) plans have the potential for greater returns and
    more money during retirement. But they come with additional
    risks that need to be managed properly. False or misleading
    information provided by companies, auditors, or stock analysts
    has the potential to result in losses which will destroy
    retirement savings.
        You might wish to comment on the possibility that the
    Administration may be dipping into our Thrift Savings Plan,
    TSP, funds.
        Enron has demonstrated the need for additional accounting
    and investor protections to ensure that investors have the
    necessary information that they need to make sound financial
    decisions.
        Mr. Chairman, we must also secure the funding level
    necessary for the Securities and Exchange Commission, to
    enforce the regulations intended to protect investors.
        According to the General Accounting Office, GAO,
    approximately 250 positions were vacant last year because the
    Commission was unable to attract qualified candidates.
    Additional funding will be necessary to attract and retain
    employees.
        I just held a hearing yesterday on human capital. At the
    hearing, we discussed personnel shortages that the Federal
    Government will be facing. If the Congress does not address
    this issue, the Federal Government may soon face a national
    emergency. We have to plan for that and recruit and retain
    people. There has to be enough recruitment incentives to get
    them to come and work for the Federal Government.
        Mr. Chairman, I look forward to hearing your
    recommendations for reform and to the recommendations of our
    witnesses.
        Thank you very much.
        Chairman Sarbanes. Thank you, Senator Akaka.
        Senator Metzenbaum.
        Senator Metzenbaum. Thank you very much, Mr. Chairman,
    Senator Akaka. It is good to see you again and I am so pleased
    to see you here this morning.
        Chairman Sarbanes. Thank you.
        Senator Metzenbaum. I enjoyed serving with you when we
    worked together in the Senate.
        As a matter of fact, I spent my career in the U.S. Senate
    working to prevent corporations from running roughshod over the
    rights of consumers and workers. I have to tell you that I have
    never seen a more appalling example of heartless, unfettered
    corporate greed than in the Enron debacle. This company lied to
    their investors, lied to their employees, hid crucial
    information about their finances, and tried to improperly
    influence Government officials. And in criminally indicting
    Enron's auditing firm, Arthur Andersen, the Department of
    Justice has said that it believes that Andersen was a party to
    this massive deception.
        What kind of response to this wrong-doing have we gotten
    from the accounting industry? Is the industry going to support
    meaningful reforms so that investors and the public will regain
    confidence in corporate financial statements and in
    participating in stock market investments?
        As they say in the rental car commercials, not exactly.
        Last week, the accounting industry kicked off a multi-
    million dollar advertising campaign opposing significant
    reform. For shame. Of course, they try not to come right out
    and say so.
        In essence, what their representative told the House last
    week is that they are 100 percent behind efforts to increase
    investor confidence in financial disclosures, just as long as
    they do not have to make any real changes in the way they audit
    public companies. That is not good enough. The American people
    are demanding that the accounting industry face up to their
    responsibility, not run slick advertising campaigns designed to
    stop real reform.
        To understand why real reform is absolutely necessary, you
    have to understand the extent of the failure that occurred. The
    disturbing fact is that as in the case of many other blown
    audits that cost investors billions, all the safeguards
    designed to protect investors failed and failed miserably.
        Most importantly, the auditors failed. They signed off on
    financial statements that did not present an accurate picture
    of Enron's finances, signed off on statements that were
    inaccurate. The Financial Accounting Standards Board failed.
    They did not require that companies divulge information that
    would present a complete financial portrait. The Enron
    corporate board failed to ask management tough questions,
    challenge questionable practices, and require more transparent
    disclosure. The credit-rating agencies and the security
    analysts who are supposedly the outside experts that investors
    can rely on failed to provide any advanced warning of possible
    trouble.
        The ultimate failure, however, was two-fold: Congress and
    the Security and Exchange Commission.
        The real story out of the Enron disaster is not that its
    corporate managers went to great lengths to hide the company's
    indebtedness and artificially inflate its earnings. Our system
    was designed with just that behavior in mind. The real story is
    that Congress and the SEC stood on the sidelines and watched as
    laws and regulations designed to keep auditors independent and
    corporate managers honest were eroded and undermined. They were
    snookered by an accounting industry that claimed that oversight
    and self-regulation would protect investors, employees and the
    public.
        In 1995, for example, Congress passed the Private
    Securities Litigation Reform Act. Sounds good. But
    significantly undermine the ability of investors to go to court
    to deter wrong-doing by companies and their auditors. I am
    happy to say that I did not vote for that law. I left the
    Senate 1 year too soon to oppose it.
        Clearly, the system is broken and it is Congress' job to
    fix it. In my written testimony, I propose a comprehensive
    package of reforms to do the job. What I would like to do today
    is to highlight the single most important step that Congress
    can take--restore integrity to the independent audit. To
    accomplish this, it must enhance auditor independence, provide
    effective regulatory oversight of accountants, and restore the
    threat of private litigation as a strong deterrent to wrong-
    doing.
        The whole point of requiring public companies to obtain an
    independent audit is to ensure that outside experts have
    reviewed the company's books and determined that they not only
    comply with the letter of accounting rules, but also present a
    fair and accurate picture of the company's finances. Auditors
    have profited handsomely over the years from performing this
    important public watchdog function. Unless the auditor is free
    of bias, brings an appropriate level of professional skepticism
    to the task, and feels free to challenge management decisions,
    you might as well let the company certify its own books.
        The independent audit is arguably more important today than
    it has been at any time since the requirement was first imposed
    in the 1930's. More than half of all American households today
    invest in public companies, either directly or through mutual
    funds. They do so primarily to save for retirement.
        As a result, their financial well-being later in life is
    dependent on the integrity of our financial markets.
        At the same time, corporations today are under great
    pressure to keep their stock prices on a smooth upward
    trajectory. This gives corporate managers a strong incentive to
    manage their earnings in order to present the picture of a
    steadily rising profitability that Wall Street enjoys. To do
    that, they need an auditor who is willing to turn a blind eye
    to their overly aggressive accounting. The less independent the
    auditor, the more compliant they are likely to be.
        Many factors have undermined auditor independence. First,
    most of the big firms have dramatically increased their sales
    of consulting and other nonaudit services to their audit
    clients, despite the clear conflict of interest that this
    creates.
        I might say, parenthetically, Mr. Chairman, that before I
    came to the Senate, I was active in the business world. I was
    on a substantial number of corporate boards, some of which were
    on the New York and American stock exchanges and over the
    counter.
        I do not remember any instances in which consultants were
    brought in. There may have been some minor instances in which
    consultants were brought in by the auditors. But in the main,
    auditors were used for auditing purposes, to relate the facts
    and details as to the profit and loss of the company and what
    its financial stability was and what its capital structure was.
        But this development, I think, mostly in the last 10 years,
    of bringing in consultants, has really made the consulting part
    of the accounting industry become the major factor as far as
    producing income is concerned. And as a consequence, I think it
    has been a bane as far as getting the proper kind of accounting
    that the public are entitled to.
        Today, virtually all of the big companies receive both
    audit and nonaudit services from their accountants and they
    typically pay between two and three times as much for the
    nonaudit services as they do for the audit itself.
        So if an auditor's tough questioning of the management were
    to threaten its more profitable consulting arrangement, that
    auditor might very well expect to face tough questioning of his
    own from higher-ups at his own firm, or her own firm.
        Lack of independence involves more than just consulting,
    however. It starts with the fact that auditors are hired, paid,
    and fired by the audit client. This basic conflict is
    exacerbated by the general lack of client turnover. Auditors
    may reasonably expect to keep the same client for 20, 30, even
    50 years.
        Also undermining auditor independence is the revolving door
    that all too often exists between auditors and their audit
    clients. This was true at Enron. It was true at Waste
    Management, and it is a common feature in many failed audits. A
    constant flow of personnel from the auditor to the audit client
    helps to create an environment in which external auditors are
    viewed as just another part of the corporate family. Such
    intimacy is not conducive to true independence.
        Congress has an interest and an obligation to put a halt to
    this all-too-close relationship. Half-measures and phony
    reforms will actually harm investors and the public by creating
    the illusion of independence where none exists.
        If Congress only does one thing this year to prevent more
    Enron-like catastrophes from occurring, it must be to guarantee
    that audits are truly independent. The first step in
    guaranteeing a completely independent outside audit is to ban
    accounting firms from providing auditing and consulting
    services to the same client. And I want to emphasize that. I
    think it is imperative that Congress act to ban accounting
    firms from providing auditing consulting services to the same
    client.
        Accounting firms got along very well for many years without
    the consulting function. It is only within the last 10 years,
    as I previously mentioned, that this whole consulting facet has
    developed.
        Certainly narrowly defined services could be exempted by
    the SEC on a case-by-case basis, but only if it shows that
    these services enhance audit quality and benefit investors and
    only if they are
    directly and separately approved by the audit committee or by
    the board.
        A ban on nonaudit services should be accompanied by the
    periodic rotation of auditors, an idea that has gained some
    highly credible backers. An audit firm that knows it has a
    limited term of engagement has significantly less to lose by
    challenging management than one that expects to retain the
    client indefinitely.
        Because such an approach would significantly enhance
    auditor independence, we believe the benefits far outweigh the
    costs. One proposal that deals with this issue is the
    legislation proposed by Senators Dodd and Corzine, which
    requires a study of mandatory rotation. The Dodd-Corzine bill
    has a number of positive features, but we think a strong case
    can be made for requiring mandatory rotation, not just studying
    it.
        Finally, to close the revolving door between audit firms
    and their audit clients, there should be a 2 to 3 year cooling
    off period after their involvement and the audit has ended,
    during which members of the audit team and their supervisors
    would be prohibited from seeking or accepting employment with a
    former audit client.
        We also believe that Congress must provide effective
    regulatory oversight of accountants. If auditors face numerous
    pressures to sign off on questionable accounting practices,
    they face relatively little fear of sanctions if they do.
        The current regulatory system is underfunded, inefficient,
    and a captive of the industry. A complete overhaul is
    definitely needed. Whether the SEC is given enhanced oversight
    responsibility or a new regulatory body is created, that
    regulator must be independent of the accounting industry. It
    must be adequately funded and have strong rulemaking, standard
    setting, investigative, and enforcement authority.
        The private litigation laws also must be reformed to
    provide a real deterrent to wrong-doing. Private litigation has
    long been viewed as an important supplement to regulation,
    since the threat of having to pay significant financial damages
    provides an incentive to comply with even poorly enforced laws.
        In 1995, however, Congress passed the Private Securities
    Litigation Reform Act, which significantly reduced auditor's
    liability in cases of securities fraud. It did so both by
    making it more difficult to bring a case against accountants
    and by reducing their financial exposure where they are found
    to have contributed to fraud.
        The result is that the threats of private lawsuits now
    poses a
    diminished deterrent to accounting fraud. Restoring reasonable
    liability for culpable accountants should be part of any
    overall reform plan. At a minimum, this should include
    provisions: To enable plaintiffs to gain access to documents
    through discovery before having to meet the heightened pleading
    standards regarding state of mind; to restore joint and several
    liability where the defendant recklessly violated security laws
    and the primary wrongdoer is bankrupt; to restore aiding and
    abetting liability for those who contribute to fraud but are
    not the primary culprit; and to extend the statute of
    limitations for securities fraud lawsuits.
        In conclusion, let me say that the collapse of Enron has
    provided a clarion call for reform. It has exposed gaping holes
    in the investor protections we rely on to keep corporate
    managers honest. Enron is not unique and only a comprehensive
    set of reforms will prevent future Enrons from happening.
        As I said at the beginning of my comments, such a far-
    reaching approach must focus on enhancing the independence of
    the audit, providing effective oversight of the accounting
    industry, and ensuring that, when all else fails, the threat of
    private litigation will deter wrong-doers.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Metzenbaum, for a
    very comprehensive and helpful statement.
        Next, we will hear from Sarah Teslik, the Executive
    Director of the Council of Institutional Investors.
        The Council of Institutional Investors is an organization
    of over 100 public and private pension funds that seek to
    address investment issues affecting the security of its
    members' $1.3 trillion in assets. Prior to the formation of the
    Council, and becoming its Executive Director, Ms. Teslik was a
    corporate and securities attorney with the law firm of Wilke,
    Farr & Gallagher here in Washington.
        Ms. Teslik, we would be very happy to hear from you.

                       STATEMENT OF SARAH TESLIK

                           EXECUTIVE DIRECTOR

                   COUNCIL OF INSTITUTIONAL INVESTORS

        Ms. Teslik. Thank you. I know you are Enron-exhausted, so I
    will start with the bottom line.
        The very bad things that we have seen happening at Enron
    and everywhere else happened because we let them. Even honest
    people begin behaving badly when they realize there are no
    consequences. And there are essentially no consequences for
    corporate crime and essentially no consequences when boards,
    CEO's, auditors, analysts, and others merely behave badly.
        When the upside is a few hundred million dollars to keep,
    people will behave badly when there are no consequences.
        Why are we seeing more frauds today than we used to? For a
    reason that I think is largely missed in the press, and that is
    that ever since the laws were passed 65 years ago to protect
    investors, special interests have been eating away at them,
    quietly but gradually, so that now the laws in place, which, in
    theory, are there to protect investors, in fact, protect the
    other side.
        I will give you some examples in a minute.
        Typically, over time, great civilizations have crumbled
    when special interests have been able to get a hold of the
    government machinery. And I know of no better example than what
    has gone on in our investment sector over the last 65 years. If
    history is any guide, you are all being pressured right now to
    give in, keep the system the way it is. Also if history is any
    guide, you will give in. I am here to beg you not to.
        What must be done? Let's start with the auditors, even
    though I think they are a sideshow, and let's start with what
    is wrong.
        Right now, auditors are picked by the managers whose books
    they have to review. If fifth graders picked their teachers,
    fifth graders would get A's. Not only that. Auditors, and the
    people who have to produce financial statements, write the
    standards they have to follow to make those statements. If
    fifth graders wrote grading standards, all fifth graders would
    pass. Not only that. We allow auditors to oversee and police
    their own profession. You know better than that. No profession
    ever self-polices effectively.
        What should you pass? I have a list of suggestions in my
    written testimony. You have heard them in a variety of
    permutations and have seen them in just about every bill
    imaginable. But, in essence, you need to focus on legislation
    that aligns the financial interest of auditors with investors.
    Many people invariably act in their self-interest. You cannot
    rely on honor or professionalism. Chinese walls never work.
    Independent bodies never remain independent. Unless you harness
    self-interest, you will keep getting misleading financials.
        I know I am unusual in the people testifying in front of
    you to say that auditors are a sideshow. They are very
    important. But they are a sideshow. Auditors review the books.
    It is not the auditor's job to run the company. It is not the
    auditor's job to have put in place the ethics policies. It is
    not the auditor's job to make money, to produce secure jobs, to
    say no to CEO's who want loans of $341 million when they are
    already rich. That job belongs to the managers and it belongs
    to the board. It is their job to prevent fraud in the first
    place and you need to focus on them.
        Why is it that boards turn a blind eye? There is an easy
    answer here. What if Senate staffers picked Senators? Would you
    stop your staff if they were stealing? I doubt you would.
        Currently, boards of directors are picked by managers, not
    by shareholders. Therefore, they protect managers rather than
    protecting shareholders. As long as that system is in place,
    that result will be in place.
        I know that the Council is known to be a shareholder
    advocate and it is sometimes assumed that we are out in left
    field when we make suggestions that the system is broken. I
    would like to give you a few examples of existing laws that
    protect managers and boards rather than shareholders, so you
    can decide whether I am the crazy one or whether the system is
    broken. Eight quick ones.
        One, if a shareholder buys a mere 5 percent of a company,
    he or she has to file forms as if the Government were tracking
    a pedophile, not an owner. Why don't shareholders file these
    forms? Instead, they take the second option, which is, if you
    promise the Government that you will be inert, you can file a
    simpler form.
        Two, the Government also tells us what issues we can
    discuss with managers. I am not making this up. The SEC decides
    what issues we can raise for a shareholder vote and what issues
    we
    cannot. Have any of you read those rules? They pretty much take
    everything off the table. We cannot ask about anything that is
    ``ordinary business''--which covers anything that we ought to
    ask about.
        We also cannot ask about anything that is extraordinary
    business if it only affects a small part of the company. We
    cannot ask anything about the current board of directors, the
    single thing to which we should pay the most attention. Many of
    the issues raised by Enron we cannot ask about through
    shareholder vote because the SEC won't let us.
        Three, if we get through the SEC hoop and we figured out an
    issue that they will let us raise with our own employees,
    corporate managers, and it gets on the ballot, the SEC requires
    us physically to go to the meeting. Even though most companies
    do not require their directors to go to the meeting and most
    shareholders do not go to the meeting. So if you do not have a
    lot of money, if you actually have to go to work in the
    morning, if you are disabled or cannot travel, forget it.
        Four, not only that--if the company knows you are coming
    and they know you are going to ask a question they do not want
    to hear about, they can move the meeting to a place you cannot
    get to. U.S. companies have held their annual meetings in
    Russia. They have held them in towns in Alabama, without
    airports, on Friday afternoon at 5:30, before a holiday
    weekend. They move meetings when they know we are coming. They
    are allowed to.
        Five, if the managers who are counting the ballots realize
    they are going to lose, they can call off the vote on the
    meeting day, and they have done so.
        Six, if a shareholder actually wins, if we have gotten
    through the first five things and we actually win the majority
    of the votes cast, the managers can ignore it as if it did not
    happen. And virtually all of them do, some of them, year after
    year after year.
        Seven, shareholders used to get to vote on boards of
    directors every year, once a year. Now if you look at the
    Comcast and AT&T merger, they have packaged into the merger a
    provision that says that we cannot vote on the directors again
    until 2005, even if, presumably, Enron-like facts emerge. We
    are out of luck.
        Finally, shareholder elections in many cases are rigged. If
    shareholders do not vote, unbeknownst to them, their brokers
    can vote for them for management. There are studies documenting
    that this throws elections.
        With rules like that in place which protect managers and
    boards rather than shareholders, it is no surprise that we are
    unable to do anything about the Enrons of the world on our own.
        So what legislation do you pass if you want to risk your
    reelection funding and fix the problem?
        First, we need better and immediate information about
    executive compensation packages and about CEO's buying,
    selling, hedging, and lending habits. This does not sound like
    the kind of recommendation you have been getting from a lot of
    people who have been testifying here, but it is actually
    critical to the process.
        Why? Because unless CEO's and boards can have stock option
    packages which allow them to get hundreds of millions of
    dollars out of the companies, they cannot turn companies into
    Ponzi schemes. Unless they can get the money in, fake the
    financials, take enough out quickly enough before the company
    crashes, the money's not in it for them. You have to get at the
    money.
        Second, Senator Nelson's bill has a number of issues that
    we think are worthy of addressing. We have had a rulemaking
    pending at the SEC for about 4 years, asking that directors'
    conflicts of
    interest be disclosed. We find it a significant pattern at
    companies with major accounting fraud, that directors have
    undisclosed conflicts of interest. There is no excuse for
    failure to disclose every significant or nontrivial conflict of
    interest a board member has. It is an easy thing to implement.
    We have not even received a little postcard back from the SEC
    to say, ``got rulemaking.'' We are out of stock.
        Third, Senator Nelson's bill also gets at the independence
    board issue very well. And unlike many bills, it uses a
    definition of an independent director that makes sense. It is
    one that essentially provides that a director is independent
    only if his or her board seat is their connection to the
    company.
        At our meeting next week, we will be discussing legislative
    language to submit to you which would allow shareholders, if a
    large percentage agreed, to submit board candidates that the
    company would have to run on the company's proxy. Ultimately,
    if we cannot select directors, we cannot fix these problems.
        Corporate governance, in short, should be at the center of
    your legislative debates, not at the periphery. Structures that
    stop fraud in the first place, rather than structures that deal
    with it once it has gotten on the auditor's desk, are the way
    to deal with fraud. We need both, but we need you to not
    neglect the governance.
        A final word on enforcement. There is too little
    enforcement in general and there is way too little enforcement
    that targets individuals. When the hubbub of Enron dies down,
    it is 5 years from now and you are an auditor and you are
    sitting at a conference table privately with the CEO who is
    going to pay your fee. And the CEO wants you to do something
    that makes you uncomfortable. Which will deter you more? The
    notion that your employer may eventually pay a fine? Or the
    notion that you may go to jail?
        There is no comparison. Fines victimize the victims. We the
    shareholders pay them. You need to go after the individuals. We
    applaud the Leahy-Daschle bill in that regard and any other
    efforts to focus on the people who you can, in fact, deter. One
    CEO or one director, not a mid-level scapegoat, that goes to
    jail would be a corporate governance shot heard around the
    world.
        Thank you.
        Chairman Sarbanes. Thank you very much.
        We will now turn to Thomas Bowman, who is President and CEO
    of the Association for Investment Management and Research. He
    has been the President since 1994.
        The Association for Investment Management and Research is
    an international nonprofit organization of more than 50,000
    investment practitioners and educators that educate and examine
    investment managers and analysts. They run the chartered
    financial analyst program.
        Before joining AIMR, Mr. Bowman was President and CEO of DP
    Asset Management in Wilmington, Delaware, and previously Vice
    President and Chief Investment Officer at Frank Russell
    Investment Company in Tacoma, Washington.
        Mr. Bowman, we are pleased to have you here this morning.

                   STATEMENT OF THOMAS A. BOWMAN, CFA

                 PRESIDENT AND CHIEF EXECUTIVE OFFICER

                 ASSOCIATION FOR INVESTMENT MANAGEMENT

                              AND RESEARCH

        Mr. Bowman. Thank you, Chairman Sarbanes, Senator Akaka,
    and other Members of the Committee, for the opportunity to
    speak on behalf of the 150,000 investment professionals
    worldwide who are AIMR members or candidates for the CFA
    designation.
        Most AIMR members are not subject to the majority of
    conflicts of interest facing research analysts working for Wall
    Street brokerages and similar firms worldwide. But all
    investors, not just investment professionals, are disadvantaged
    by lack of transparency and
    of disclosure in corporate financial statements, unreliable
    audit
    reports, and deficiencies in corporate governance.
        In today's written testimony, we address a number of
    investor protection issues: The adequacy of accounting
    standards. The effectiveness of the SEC oversight. The
    importance of a high-quality corporate governance framework and
    the role that institutional investors should play to protect
    their clients' interests.
        In my oral remarks, however, I wish to focus on the issues
    of independence of two respected professions: Auditors and
    analysts. In particular, allegations that analysts lack
    independence, issue
    biased reports, and make recommendations without a reasonable
    basis are important to us because they cut to the heart of our
    ethical principles and taint a proud profession and its
    practitioners. We want to share with you our recommendations
    for reform.
        AIMR has been quite vocal in advocating changes in
    regulations and oversight of auditors so that they can regain
    their lost independence and become more vigilant watchdogs. We
    believe these changes are needed if investors are to regain
    confidence in the audit process, and ultimately, in the
    information provided in corporate financial statements.
        Audit firms are not obligated to provide business advisory
    and other nonaudit services to their audit clients. They choose
    to do so because there are strong economic incentives. As a
    result, accounting professionals face conflicts of interest and
    are often put in the position of auditing their own firm's
    work. We recommend that audit firms stop providing those
    nonaudit services that present
    insurmountable conflicts, and retain only those that may
    improve the effectiveness of the audit, such as tax
    preparation.
        If audit firms are permitted to provide nonaudit services
    to audit clients, they must manage the resulting conflicts more
    effectively, and ensure that they never lose sight of their
    primary purpose--to attest to the fairness of the financial
    statements, providing
    needed assurance to shareholders and investors.
        In our written testimony, we make several recommendations
    for managing auditor conflicts. The only one I will mention
    here is our proposal that full disclosure of these conflicts be
    required in the clients' financial statements, including the
    types of nonaudit services provided and the related fees.
        It would be inappropriate of us to discuss auditor
    conflicts of interest without acknowledging that some
    investment professionals, specifically Wall Street research
    analysts, also face conflicts in conducting research and making
    investment recommendations.
        At the start, it is important for me to tell you that
    analysts, like auditors, work in conditions of uncertainty.
    They gather and analyze corporate financial and other
    information of varying degrees of transparency and use that
    information to forecast a company's future prospects. And even
    when analysts have the benefit of full and fair disclosure,
    financial analysis remains more art than science. No analyst,
    no matter how independent and objective, has a magic formula
    that accurately and consistently predicts stock prices.
        To do the best job they can, analysts need an environment
    that fosters their objectivity. To create that environment, we
    must recognize and address all sources of pressure and
    implement effective processes to manage each of them. The
    existing pressures create an environment that challenges the
    integrity of those who work within it, undermining the ethical
    principles upon which AIMR and its CFA program are based.
        Two conflicts, investment banking collaboration and
    personal investments, are fully within the capacity of firms to
    manage. I will address these conflicts today. Others--arising
    from issuers, from institutional clients, and from human
    nature--are not. But they must also be addressed, if analysts
    are to be truly free from coercion or enticement to bias their
    reports and recommendations.
        Regarding investment banking: We do not dispute that any
    collaboration between research and investment banking is
    fraught with ethical conflicts. However, we understand that, in
    the current structure, collaboration is critical to a firm's
    due diligence in evaluating investment banking clients and may
    provide synergies within the firm.
        The question then becomes how analysts should be rewarded--
    according to what criteria? We strongly believe that firms can,
    and must, reward analysts first and foremost for the quality of
    their analysis and the reliability and success of their
    recommendations, and not their contributions to investment
    banking or other corporate finance activities. We must align
    analysts with investor interests, not with investment banking
    interests.
        With respect to personal investments and to trading, we do
    not
    believe that permitting analysts to invest in the companies
    they
    follow is inherently unethical as long as strict rules are in
    place to ensure that client interests come first. Indeed, some
    would argue that such investments better align analysts and
    investing client interests. To manage these two conflicts more
    effectively, we make the following recommendations:
        First, compensation is key. Firms must not link analyst
    compensation directly to the success of investment banking
    activities, but rather, directly link, and heavily weight,
    compensation to the quality of the research and
    recommendations. Firms must have
    explicit quantitative measures for the performance of stock
    recommendations and the accuracy of earnings forecasts.
        Second, firms must foster a corporate culture that protects
    analysts from undue pressure from, and retaliations by, issuers
    or
    others. Firms cannot control the behavior of others, but they
    can have an impact on how their employees react to that
    behavior.
        Third, firms must constantly communicate to clients and the
    investing public the measures in place that ensure analysts are
    independent and their reports and recommendations have
    reasonable and adequate bases.
        Fourth, firms must have reporting structures that prevent
    investment banking or corporate finance from reviewing,
    approving, modifying, or rejecting reports or recommendations.
        Fifth, firms must have clear, strict, and enforced policies
    and procedures for personal investment and trading that ensure
    investors' interests come first, prevent analysis from either
    the front running clients or their firms, and from trading
    against their recommendations.
        Sixth, firms must require analysts to provide full
    disclosure of conflicts in reports and media appearances. The
    disclosures must be prominent, specific, and in ``plain
    English,'' not marginal and boilerplate.
        At a minimum, analysts and their firms should disclose:
    Personal and firm investment holdings. Directorships on company
    boards. Compensation received by the firm from the subject
    company and the nature of the relationship. And material gifts
    received by the analyst from the subject company or the firms'
    investment banking or corporate finance departments.
        Seventh, firms must require timely, regular updates or
    reconfirmations of recommendations under normal circumstances,
    and more frequently in periods of high market volatility.
        Eighth, firms must not quietly and unobtrusively
    discontinue coverage or move a security to a ``not-rated''
    category--such action does not serve investor interests--but
    must promptly issue a final report with a reason for
    discontinuance.
        Finally, an overhaul of securities' rating systems is
    needed. Although firms may believe their proprietary rating
    systems are a competitive advantage, the market is better
    served when ratings are concise, clear, and easily understood
    by the average investor and provide reasonable comparability
    across firms.
        Therefore, we recommend that all ratings have three
    elements: One, the recommendation itself. Two, a risk measure.
    Three, a time horizon. We believe that a rating that
    incorporates these three elements will help address the current
    tendency to overemphasize short-term price performance.
        As you know, today, investment analysts and fund managers
    are prime-time news. Their recommendations, primarily likes
    rather than dislikes, are delivered in 30-second sound-bites.
    The message this communicates is that the serious business of
    investing is a sport, like horse racing, where investors should
    always be looking for hot tips.
        Ideally, we would prefer that investors could always
    purchase and read the full research report to understand the
    risks and rewards of a particular investment before investing,
    we know that this is not realistic. We hope that by expanding
    the rating and communicating all three elements in media
    appearances as well as reports, investors will have better
    information by which to judge the suitability of the investment
    to their own unique circumstances and constraints.
        In closing, I would like to impress upon the Committee that
    we appreciate not only the seriousness, but also the complexity
    of the problems facing Wall Street analysts. A precipitous
    solution that addresses only one aspect of the problem is not
    the answer. However, we believe that the profession itself can
    address these issues, and recommend effective solutions that
    can be implemented by the affected firms. Let me assure you
    that AIMR is already working diligently toward these ends.
        I will be happy to answer any questions later. Thank you.
        Chairman Sarbanes. Thank you very much, sir.
        Our concluding panelist this morning is Damon Silvers,
    Associate General Counsel of the AFL-CIO. Mr. Silvers was
    previously the Assistant Director of the Office of Corporate
    and Financial Affairs for the Amalgamated Clothing and Textile
    Workers Union, and has been the Research Director for the
    Harvard Union of Clerical and Technical Workers.
        Mr. Silvers, we are pleased to have you here this morning.
    We would be happy to hear from you.

                     STATEMENT OF DAMON A. SILVERS

                       ASSOCIATE GENERAL COUNSEL

                    AMERICAN FEDERATION OF LABOR AND

                  CONGRESS OF INDUSTRIAL ORGANIZATIONS

        Mr. Silvers. Thank you very much, Senator.
        I am, as you said, the Associate General Counsel of the
    American Federation of Labor and Congress of Industrial
    Organizations. On behalf of the AFL-CIO's 13 million members,
    our 62 member unions, we wish to thank you, Senator Sarbanes,
    and this Committee, for taking up this vital issue on the heels
    of the collapse of Enron and the similar problems that have
    arisen at companies like Waste Management and Global Crossing.
        Corporate governance is a web of relationships. These
    relationships should work toward getting companies to make
    smart, long-term, focused decisions that lead to sustainable
    benefits for all who participate in the company. Unfortunately,
    Enron is a window into a set of pervasive conflicts of interest
    that defeat the purposes of corporate governance and that
    threaten the retirement security of America's working families,
    as Senator Akaka alluded to in his opening remarks.
        At Enron, the management, the board of directors, the
    outside auditors and the Wall Street analysts all failed to
    protect investors. And similar events have both preceded and
    accompanied Enron's collapse at companies like Global Crossing,
    Cendant, Waste Management, McKesson, and many, many more. The
    source of these failures lie in the unregulated conflicts of
    interest that permeate the relationships between the management
    of these companies and the people who were supposed to be
    protecting investors.
        I will just note here that the AFL-CIO, which is a member
    of the Council of Institutional Investors, fully shares the
    analysis that you have heard about the board-focused problems
    that Sarah Teslik just spoke about.
        The AFL-CIO's member unions and their members urge that
    this Committee take up the task of crafting comprehensive
    legislation to take on the conflicts of interest in the capital
    markets and the board rooms of America's public companies. You
    have heard in prior hearings from those who have benefited from
    and continue to benefit from these conflicts as to why they
    must be allowed to continue, from those who would lull you to
    sleep with the lullaby that everything will be all right if you
    just do nothing. Now that may be the view from the lobbyists'
    offices on K Street that do the heavy lifting for the
    accounting industry here on the Hill, but it is not how things
    look from the homes of thousands of working families in
    Houston, Texas, Portland, Oregon, and Rochester, New York, who
    have lost their retirement savings and, in some cases, their
    jobs and their health care because they believed what they were
    told, told by the experts, told by the people who had duties to
    them, told by the people they trust, by their employers, by
    their employers' accountants, and the analysts that interpreted
    the accountants' numbers.
        I will also add that although not everyone suffers so
    acutely as these people that I have referred to, that literally
    tens of millions of working families have had money taken out
    of their retirement savings by the events at Enron and other
    companies that we have been discussing today.
        Let me address what a comprehensive reform package
    requires.
        Corporate governance, as Sarah Teslik said, starts with
    boards of directors. Public company boards need strong
    independent directors who are accountable to investors. Key to
    what happened at Enron was that Enron touted directors as
    independent who really had significant ties to Enron's
    management, ties that in many cases were not disclosed.
        Investors first need complete disclosure of all ties
    between board members, the company, and company management. And
    by the way, the AFL-CIO put a rulemaking petition into the SEC
    in December asking for this, and although we haven't been
    waiting as long as the Council has been waiting, we are still
    waiting to hear back from them.
        Then this Committee should encourage the NASD and the New
    York Stock Exchange, who have the authority to do this, to
    require that this higher standard of independence be the
    relevant standard for measuring the independence of members of
    audit and compensation committees.
        With genuine independence from management must come genuine
    accountability to shareholders. Shareholders should have access
    to management's proxy, not just for shareholder proposals on
    the very narrow range of subjects that are currently allowed,
    but for director candidates that a substantial number of
    shareholders want to see on the board of the company they
    invest in. Investors also deserve the right to bring before the
    annual meeting through management's proxy, which is generally
    the only economically viable way of doing so, any proposal that
    is legal and can be shown to enjoy significant shareholder
    support. Shareholders themselves should be the determinants of
    what is ordinary business and what merits a discussion with the
    management they hire.
        The second area in need of reform is the practice of public
    accounting. There are three issues here. And I will treat them
    in a little detail. I do not mean by doing so to suggest that
    they are necessarily the most important issues. I think, as
    Sarah was alluding to, there are many very important components
    here.
        The three issues, though, in the accounting area are:
    Independence, oversight, and the process by which the rules are
    made. In regard to independence, the simple fact is that you
    cannot be a public auditor with an obligation to get the
    numbers right for a public audience and also be a consultant
    whose aim is to advise executives on how to optimize the
    numbers. The tension between those goals is too severe and the
    rewards for compromising the audit responsibility are too
    great. It is just too easy for an auditor to blend those rules
    and end up like Arthur Andersen at Enron, structuring SPE's--
    Special Purpose Entities--as a consultant and auditing those
    same structures as an auditor.
        The Big 5 firms now seem to be arguing that if they cannot
    earn the big money as consultants that they won't be able to
    attract top people. I believe that argument was made before
    this Committee recently. From an investor perspective, we would
    say that the opposite is true--that unless audit and consulting
    functions are separated, the Big 5 will not be able to attract
    anyone with any integrity to their audit practices, and
    integrity is what worker funds want in the auditors their firms
    hire.
        The next issue after independence is oversight. Former SEC
    Chairman Arthur Levitt has outlined what we believe are the key
    characteristics of a much needed public auditor oversight
    body--members independent of the accounting industry, full
    investigative and disciplinary powers, and independent funding,
    optimally through the small fees assessed on public companies
    as the current SEC is partially funded.
        Finally, there is the rulemaking process. Anyone familiar
    with the political pressures brought to bear on FASB around
    accounting for executive stock options in the mid-1990's, not
    to mention the decade long paralysis on special purpose entity
    accounting knows that FASB is too open to pressures from
    issuers and those beholden to issuers currently to adequately
    address the needs of investors and the public. Here there are a
    variety of options available for dealing with that. I think we
    are open to looking at any number of them. But there really
    must be change in the way that FASB is governed and makes
    decisions.
        Then there are the Wall Street analysts. The witness who
    preceded me I think did a really impressive job at outlining
    the issues there and what some of the solutions should be. I
    will say from the perspective of the consumers of the analysts,
    that they play a vital role because they interpret the numbers.
    Most work with their 401(k) plans, most anybody, even those
    with the expertise, do not have the time to do the analysis
    that analysts.
        But, tragically, analysts in recent years have become
    captive to the investment banking side of their firms--Wall
    Street analysts, that is, and I recognize that they are not all
    analysts by any means. That is why part of a comprehensive
    package of reforms would be a provision banning basing
    analysts' compensation, not just banning it basing it on
    specific transactions, as Harvey Pitt and the NASD would have
    it, but barring any analyst tie, any compensation for analysts
    that is tied to investment banking performance specifically in
    general.
        Finally, I want to address the ultimate accountability
    measures available to shareholders--recourse to the courts. The
    AFL-CIO and worker funds view litigation as part of a continuum
    of tactics for holding the management of the companies we
    invest in accountable, and for obviously recovering money
    fraudulently taken from worker retirement funds. As such, we
    strongly believe that the current immunity from civil suits in
    the law for those who aid and abet securities fraud is
    outrageous--and directly connected to the rise in accounting
    restatements and in accounting fraud since the
    Supreme Court's wrongly decided the Central Bank of Denver case
    in 1994.
        In addition to a legislative fix, the Central Bank of
    Denver, we support a number of other reforms in the area of
    securities litigation relating to the partial repeal of the
    Private Securities Litigation Reform Act. Specifically, the
    restoration of joint and several liability in private
    securities cases, so that we do not have what we are seeing now
    in the Enron case, where everyone is chasing a few dollars, and
    the extension of the statute of limitations in securities cases
    beyond its current 3 years.
        There are hundreds of millions of dollars in losses in
    Enron that cannot be pursued in the courts by worker funds,
    particularly by public employee funds, because of the current
    short statute of limitations.
        Finally, I want to add that the AFL-CIO strongly supports
    increases in the SEC budget and full funding for pay parity. It
    is really an astounding fact that the monies realized by
    Enron's insiders in the last year before Enron went bankrupt
    are several times the size of the SEC's entire budget. And that
    should tell us something about where we have landed and where
    we need to go.
        Together, these measures constitute a comprehensive
    approach to the problems presented by Enron and similar
    companies. This approach is in great measure embodied in the
    House bills introduced by Representatives LaFalce and Dingell.
    Here in the Senate, Senator Leahy and Majority Leader Daschle
    have introduced a very positive bill on litigation issues.
    Senators Corzine's and Dodd's bill on accounting issues and
    Senator Nelson's bill on board conflicts also, each in their
    areas, are quite positive steps. But there is a desperate need,
    we believe, for a comprehensive approach here in the Senate,
    one which we are confident this Committee can and will provide.
        In closing, I wish to strongly emphasize the labor movement
    does not view what happened at Enron as simply the product of a
    few bad people. While those individuals who have been given the
    responsibility to manage workers' and the public's money need
    to be held to a single high standard, we believe at the heart
    of what happened at Enron are systemic problems that need
    systemic solutions. These solutions will offend powerful
    interests and they will fight them as hard as they can, but
    they will protect America's working families, and that is what
    we need today.
        The AFL-CIO welcomes the opportunity to continue to work
    with the Banking Committee as you take up this very important
    and profound challenge.
        Thank you very much, Senator.
        Chairman Sarbanes. Thank you very much, Mr. Silvers.
        Let me ask you very quickly a couple of very specific
    questions. You talk about independence and oversight. What do
    you mean by independence?
        Mr. Silvers. With respect to the auditing profession, I am
    really talking about here the conflict of interest--there are
    several layers here. First, you have the conflict of interest
    that occurs when the auditor is also a consultant. That
    situation puts----
        Chairman Sarbanes. I am talking about whatever oversight
    board you have. When you say the members of that board should
    be independent, what do you mean by independent?
        Mr. Silvers. There is a history in this area of self-
    regulation by the industry.
        Chairman Sarbanes. Right.
        Mr. Silvers. We do not believe that practitioners in the
    public accounting field should have a significant role in the
    governance of the oversight board. Now it may make sense to
    have a member or two. But the majority of any public oversight
    board needs to be representatives of the investing public, not
    of the accounting industry.
        Chairman Sarbanes. Does that mean that they should not be
    accountants?
        Mr. Silvers. I think that there is a difference between
    accountants in general and practitioners, people involved in
    the auditing of public firms.
        However, I would still say that I believe the majority of
    this board should not be accountants. I think that it may be
    appropriate that more of them be accountants who are not
    involved in the auditing of public companies. But I believe
    that it is important that this board not be in any sense a
    self-regulatory body of the kind that we have seen in that
    industry.
        Chairman Sarbanes. We have had some people at the witness
    table who are accountants. In fact, they have been partners in
    some of the major accounting firms.
        Mr. Silvers. Right.
        Chairman Sarbanes. They are not there now. They have done
    other things.
        Mr. Silvers. Right.
        Chairman Sarbanes. And some of the strongest testimony we
    have gotten for better oversight has come from those very
    people.
        Mr. Silvers. Sure.
        Chairman Sarbanes. Should they be eligible to be on this
    board or do they contradict your desire for independence?
        Mr. Silvers. No, I believe that they should be eligible to
    be on the board. What I was saying, Senator, about this, is
    that the majority of this board should be representatives of
    investors and the public. But I believe it is quite important,
    in fact, to have some individuals of the kind that you are
    referring to making up part of the board.
        Chairman Sarbanes. Does anyone else have any thoughts on
    that particular subject?
        Ms. Teslik. If I could add to that. I think that most
    investors care particularly about who appoints these people,
    not what their credentials are, because, obviously, if they do
    not know what they are talking about, they are not going to be
    any good. But an accountant who we appoint is different than an
    accountant that the AICPA appoints. So, I think you need to
    focus on where they come from because that is who they will
    report to.
        Chairman Sarbanes. Mr. Silvers, I wanted to ask you, what
    do you think the statute of limitations in securities cases
    ought to be?
        Mr. Silvers. Senator, there have been different suggestions
    in this area. My feeling is that it ought to be something in
    the range of 5 to 7 years for recoveries. This is not the time
    to bring the claim, but how far can you look back to price the
    recovery?
        I also believe that there ought to be some latitude given
    to judges in this area because there are circumstances in which
    you have a continuing fraud that an iron-clad cut-off may not
    properly address.
        Chairman Sarbanes. Now, Mr. Bowman, you had, I thought, an
    impressive listing of what firms ought to do, so we had greater
    assurance about analyst independence. But how do we make sure
    that firms do that?
        This is kind of an appeal to the firm to do right. But what
    structure or framework do we have within which the firm
    operates that will place pressure upon them to do right?
        Mr. Bowman. Senator, we have seen over the years that
    market forces and competitive forces are very powerful. For
    example, about 12 years, AIMR introduced performance
    presentation standards to make uniform the way that investors
    and managers presented their returns on their portfolios
    because up until that time, there was a lot of abuse going on
    with regard to how performance numbers were reported. And when
    AIMR first came up with these standards, they were met with a
    great deal of resistance and it took several years, basically,
    for them to begin being accepted.
        However, once one major firm began accepting these
    standards and using these standards and disclosed that they
    were in conformance with AIMR presentation standards, it was
    amazing how quickly other investment management firms fell into
    line and now it has become an integral part of the RFP process
    when people look for managers, whether they are in compliance
    with the performance presentation standards or not.
        So, I would hope that if Wall Street firms that have these
    conflicts, if they were to adopt the recommendations that we
    have put forward, disclose them prominently and continue to
    disclose them to clients and the investing public, my suspicion
    is that competitive forces would cause most of the other, if
    not all of the others, to adopt them as well.
        Chairman Sarbanes. Why shouldn't they be required to do it?
        Mr. Bowman. I think they probably should be. We are an
    organization of individual investment professionals. We are not
    an organization of institutions. But, certainly, we are all for
    anything that would restore investor confidence in the markets
    and in security analysts because, like I say, a very small
    percentage of our membership are analysts that have these
    conflicts. But it is tainting the entire profession.
        It has also, as my fellow panelists have indicated, damaged
    individual investors and their confidence in the markets. And
    anything that could be done to restore the confidence, I am
    sure that AIMR would strongly support.
        Chairman Sarbanes. Any observations on this issue?
        Mr. Silvers. Senator, there has been, I think, a back and
    forth about this that you rightly point out about whether this
    can be dealt with voluntarily or not. The problem fundamentally
    comes down to one word, and that word is transactions.
        It is in the Security Industry Association, which is the
    Wall Street folks that we have been focusing on here, their
    voluntary guidelines say that you cannot tie analyst
    compensation to a single investment banking transaction. But
    you are still free to tie it to the overall performance of
    investment banking. That distinction that they draw guts their
    voluntary code.
        The AFL-CIO, we have been involved in this issue more than
    a year now and testified on the House side last summer. We were
    profoundly disappointed to see that when the NASD, with the
    blessing of Chairman Pitt, came forward with their ideas on
    analyst independence, they left that word transactions in
    there. And until somebody, whether it is the Commission or the
    Congress, mandates that you cannot tie analyst compensation to
    investment banking performance, the problems that we have in
    this area are going to continue.
        Chairman Sarbanes. I would like to address the audit
    committees for a minute.
        We had former Chairman of the SEC, Rod Hills, testify in
    the lead-off hearing that we had. He said:

        The audit committees of too many boards are not exercising
    the authority given them or the responsibility expected of
    them.
        Audit committees should be protecting their auditors. But
    board members are too often chosen by the CEO, who also decides
    who will sit on the audit committee and who will chair it.
        The members seldom ask the auditor if there is a fair or
    better way to present the financial position of the company.
    They seldom play any significant role in choosing the audit
    firm or in choosing the new partner from the audit firm. And
    they seldom establish themselves, in short, as the party in
    charge of the audit and they do not establish themselves as the
    party in charge of retaining the auditor.

        Now how important is the role of the audit committee and
    what can we do, if it is important, to strengthen or enhance
    it?
        Senator Metzenbaum. I would just say that we think the
    audit committee is particularly important. But we are concerned
    about the independence of the audit committee. Too often, the
    audit committee is too intertwined with management and, as you
    say, chosen by management. As a consequence, you get this kind
    of fealty to the management that an audit committee shouldn't
    have. An audit committee ought to have almost a wall of
    independence between it and the corporate leadership.
        The way it is at the moment, that is not the reality. And
    perhaps some procedure can be developed where audit committees
    are selected not just by the corporate executives, but by
    turning to some outside sources for recommendations as to who
    can serve on the audit committee.
        Ms. Teslik. If I can add to that?
        Chairman Sarbanes. Ms. Teslik.
        Ms. Teslik. I alluded in my testimony that I did not read
    to you that the perhaps single first step you should take to
    increase auditor independence is to require a listing standard
    that the audit committee of the board hire and fire the
    auditors.
        After all, it is usually managers rather than auditors who
    start the frauds, and while audit committees may not be as
    independent as we would like, they are a lot more independent
    than the managers whose books are being reviewed. And that is a
    relatively easy, relatively costless step to have a listing
    standard saying the audit committee hires the auditors. They
    report to the auditors.
        It is probably a little bit more complicated to say that at
    least once a year, the audit committee has to meet with the
    auditors without management present. But that matters because
    so often, boards have independent committees. At every single
    meeting of that committee, management sits in unofficially.
        I think that is a relatively low-cost, relatively easy, and
    relatively legal simple fix. The audit committee hires, the
    audit committee fires. It is in a listing standard.
        In addition, as silly as it sounds, the suggestions you
    have heard elsewhere that the audit committee, as well as the
    CEO, sign the financials, makes a difference. When you sign
    your tax returns, you probably think a little bit. Again, it is
    very cheap. It takes 2 minutes. But signing the document gives
    you a completely different feel than not signing the document.
    That can also be done in a listing standard.
        So, you have two ways, relatively inexpensive, relatively
    simple, with a clear legal route to funnel this, that would
    help get the audit committee involved.
        I suspect Enron's directors would not have liked to be in
    the position they are in now. And if Arthur Andersen had come
    to them and said, fraud is occurring on your watch, however
    much they were appointed by management, I suspect they would
    have said, I do not want this to happen.
        You at least increase the change that some boards will do
    something with two easy, relatively inexpensive legal changes.
        Chairman Sarbanes. As you note, the exchanges could require
    that as part of the listing standards. Is that correct?
        Ms. Teslik. It could. But they won't unless you make them.
        Chairman Sarbanes. That is where I am going now.
        [Laughter.]
        They have not done it. Presumably, the SEC could require
    it. Is that right, under current authorities?
        Ms. Teslik. It could. There is some debate over the SEC's
    ability to oversee the New York Stock Exchange. This is a most
    bizarre debate.
        Whenever we contact the SEC about something the New York
    Stock Exchange has failed to do, the SEC's response is, we
    cannot help it. I say, well, do they regulate you or do you
    regulate them? And they say, because of the lawsuit over one
    share/one vote, the Business Roundtable lawsuit, it is not
    clear to them how well they can oversee the New York Stock
    Exchange.
        I think it is clear. I think they can do it. You certainly
    can do it. The New York Stock Exchange won't do it on its own.
    It is paid by corporate executives to list their companies on
    the exchange.
        It will not regulate those executives for our benefit. You
    can certainly mandate it. I think the SEC can. You could
    further this by making clear in your legislation that the
    impediment raised by the Business Roundtable lawsuit is not
    there.
        Mr. Silvers. Senator.
        Chairman Sarbanes. Yes.
        Mr. Silvers. Sarah's first suggestion, that the audit
    committee do the hiring and monitoring directly of the
    auditors, is in a rulemaking petition that the AFL-CIO
    submitted to the SEC in December, which, again, we have not
    heard back from them on.
        Chairman Sarbanes. Chairman Breeden, when he was before us,
    raised strong concerns about the practice of corporations
    making large loans to their executives. First of all, do you
    share that concern? Presumably, you do. But what do you think
    should be done about it? The amounts are staggering.
        Ms. Teslik. The amounts are staggering.
        Chairman Sarbanes. In some of these instances, on February
    16, the Houston Chronicle reported that last year, Ken Lay
    borrowed about $70 million from a line of credit provided by
    Enron Corporation and repaid it with stock, a $15 million loan
    at Global Crossing.
        On March 13, The New York Times reported that the SEC is
    looking into hundreds of millions of dollars of loans WorldCom
    made and arranged for its Chief Executive, Bernard J. Ebbers.
        So what is your view on this issue?
        Ms. Teslik. It is always significant Sherlock Holmes taught
    you, that when there are facts that do not make sense, there
    are other facts you need to know. When CEO's, the wealthiest
    people in the United States, get loans, not from banks, get
    loans at all, but get loans from companies, you have to ask
    yourself, what is going on?
        There are a couple of things that are going on that are of
    concern to you. One is that loans are used to cover CEOs'
    dumping stock before a company crashes. This is what happened
    in Enron. This has happened other places.
        Because our disclosure regulations are written in such a
    way that a CEO can combine the fact that he/she has a loan, the
    fact that he/she has stock options, to use the stock to repay
    the loan. And what it does is it dumps the stock. It gives the
    CEO cash, but our regulations allow disclosure of that
    transaction to be delayed sometimes for more than a year.
        So, we average investors, who watch carefully when CEO's
    dump stock, do not know for more than a year that the CEO has
    dumped the stock. And that is, I think, the first place that
    you should focus and that is an easy place to focus.
        Chairman Sarbanes. By dumping it back to the company in
    repayment of his loan.
        Ms. Teslik. In repayment of the loan. So, they walk away
    with the cash.
        Chairman Sarbanes. You would make them report that
    immediately, I take it.
        Ms. Teslik. Report that immediately.
        Chairman Sarbanes. Or 24 hours, or whatever it is.
        Ms. Teslik. Right. It is very tricky to get involved with
    whether companies can lend money to their employees. That is
    messy. It is not messy to require instant disclosure to cover
    these loans, as well as stock sales, because it is merely a way
    to cover up stock sales.
        Senator Metzenbaum. Mr. Chairman.
        Chairman Sarbanes. Yes.
        Senator Metzenbaum. I do not see any corporate purpose in
    the corporation lending money to its executives. And I think
    that it very properly, appropriately, might call for
    legislation to bar the practice.
        I do not see any reason why the chief executive of a
    company, or some lower-level figure, should be able to borrow
    hundreds of thousands or millions of dollars from his or her
    corporation. I cannot see any normal business purpose that
    would be gained for the corporation. And I think it is totally
    inappropriate--more than inappropriate. I think it should be
    illegal.
        Mr. Silvers. Senator.
        Chairman Sarbanes. Yes.
        Mr. Silvers. One point about this. I think Sarah's
    explanation points out a larger issue here that the loans are
    one piece of, which is that, in the current complex financial
    markets, it is possible for CEO's to do all kinds of things
    that are not currently forced to be disclosed.
        Loans are one. Hedging their stock is another. There are
    all sorts of ways in which you can get hidden compensation and
    change the nature of the compensation, so that what appears on
    the surface to be a compensation measure that aligns CEO
    interest with shareholders, even if it is excessive and
    indefensible in its size, may turn out, if you understand all
    the loans or options or other hedging contracts, derivatives
    contracts associated with it, to not even provide the incentive
    effect.
        For example, if you buy the stock with a loan, it looks a
    lot more like an option than stock, which is less favorable
    from a shareholder perspective for an executive to hold. If you
    take a stock and hedge it, you can turn it into essentially a
    Treasury bill, which has no shareholder alignment whatsoever.
        Our disclosure regulations are just simply not up to where
    the markets are right now and what they allow CEO's to do.
        Chairman Sarbanes. Mr. Bowman talked about a lot of issues
    which could involve disclosure. But how much of it can
    disclosure do as opposed to actually mandating standards and
    prohibit certain conduct?
        Mr. Silvers. I think that disclosure only works when people
    have the power to act on it, and act on it effectively. The
    increased disclosure needs to be tied up with some of the
    measures that we have talked about today, such as giving
    shareholders wider access to the proxy, facilitating the
    economics of running independent
    directors for boards, ensuring that the compensation committee,

    for example, is really independent directors and not people in
    the pocket of the CEO in some fashion.
        Those measures start moving to the point where shareholders
    and other investors have the ability to act on the disclosure.
        I think if you look at the history of executive pay in the
    1990's, you will see that, although there has been some
    incremental improvements in disclosure, the ability of
    shareholders to really monitor that pay and the willingness of
    boards to do their job in that area, has not really improved
    that much.
        Maybe Sarah will add to that. I do not know.
        Senator Metzenbaum. Simply stated, I do not believe
    disclosure adds very much. You learn that the chief officer,
    principal officer, borrowed $2 million. I am a stockholder.
    What can I do about it? I cannot say that there is anything
    wrong about it. And yet, he may not be able to repay it. The
    fact is there may be no business reason to be doing it.
        So, I do not think disclosure solves the problem at all. I
    think there just ought to be a firm bar against it, and the
    shareholders would be much better represented if that were the
    case.
        Ms. Teslik. I have to say I would follow Damon on this one.
    The loans are a good example. Corporate loans to CEO's
    originated from corporate moving fees, when they would move an
    executive from one place to another, which I think is a
    perfectly legitimate thing for a company to do. And it gets
    very messy when you in Congress say, you cannot ever lend money
    to an employee.
        As much as I agree with the Senator that these CEO loans
    tend to stink, I think it is probably a better solution to let
    shareholders take care of the problem. They are employees,
    after all, and do as Damon said, which is you give us a
    disclosure and then take off a couple of the handcuffs that
    prevent us from acting, and we will take care of the rest.
        If there was any real threat that when a company gave $340
    million in loans to its CEO, that the board might not get
    reelected, that loan wouldn't be made. And I think it is
    probably a more appropriate solution for our private sector.
    You give us the disclosure, and then just remove a couple of
    the things that prevent us from acting, and let's see how that
    works.
        Chairman Sarbanes. What are some of the things?
        Ms. Teslik. As Damon said, give us some ability, you can
    tinker with the rules, but give us some ability to select
    directors.
        For example, if 25 percent of the shareholders say to the
    company, we would like you to run someone, that that person
    gets put on the ballot. He doesn't get elected. He just gets
    put on the ballot. That alone would make a huge difference.
        Chairman Sarbanes. And the others?
        Ms. Teslik. Is that if a shareholder proposal is backed by
    a large percentage of shareholders and passes, it needs to be
    implemented, because right now, we cannot submit a shareholder
    proposal on a loan. That would be considered ordinary business
    unless there are certain circumstances. But if 85 percent of
    the shareholders at WorldCom said that we do not want you to
    lend the CEO money, then they could not lend the CEO money.
    Right now, they still can.
        Those two things, with disclosure, I think you would see a
    lot of change.
        Chairman Sarbanes. Mr. Bowman, do you want to add anything?
        Mr. Bowman. Yes. I find it very troubling, and I agree with
    my panelists here, why a chief executive officer or other high-
    paid individual within a firm would need to borrow money from
    his or her own firm, especially in the amounts that we are
    talking about. That doesn't seem to pass the smell test to me
    at all. And as far as the inadequacy of disclosing it, I do not
    think that it ought to be occurring anyway.
        Where I was going with disclosure is that there are many
    other ways that executives are paid, for example, stock
    options, and there are other ways that firms can avoid putting
    what we consider to be the expenses on the income statement and
    shown on the balance sheet, that really does mislead investors.
        We believe that requiring disclosure of those kinds of
    things is very helpful, not necessarily a solution in many
    cases, but very helpful because to disclose generally drives
    behavior. And if management knows that they are going to need
    to disclose the stock
    options that were given or disclose how they deal with special
    purpose entities or disclose whatever, their actions could be
    affected in ways that are more positive for investors.
        But certainly, disclosure--I agree with Senator
    Metzenbaum--it is not necessarily the solution.
        Chairman Sarbanes. Do you think the stock options ought to
    be reflected on the balance sheet as an employee expense?
        Mr. Bowman. Absolutely. We have been advocating that for
    probably 10 years. And we are on record as having pleaded with
    the SEC and the FASB to have options shown as an income
    statement expense. Yet, corporate influence and other outside
    influences have outweighed our recommendations. But we
    certainly are strongly in favor of showing those kinds of
    things as expenses on the income statement.
        Chairman Sarbanes. They are out there beating the drum now
    that it will mean the demise of an important economic sector.
    It is interesting to watch. Did you want to add to that?
        Mr. Silvers. I just have an anecdote for you, Senator.
        The AFL-CIO at one time brought a shareholder proposal to a
    major insurance company with a significant financial services
    business, and asked that they change their stock options so
    that the CEO would not be compensated based on the generic rise
    of the market, but would only be compensated if his company
    outperformed his sector.
        In the meeting we had with them, they said to us, we would
    like to do that, but we do not know how to really price these
    options. We do not know what they are worth. We wouldn't know
    how to do what you are asking us to do.
        This is a company which I know for a fact had a trading
    floor full of hundreds of people who did nothing all day long
    but price options. And I think that, frankly, they try to pull
    that same nonsense here too often.
        Chairman Sarbanes. I think, Howard, you think the SEC
    should do it directly and not have a board over the accounting
    people. Is that correct?
        Senator Metzenbaum. That is correct.
        Chairman Sarbanes. What do the others think about that?
        Mr. Bowman. Senator, I believe that the SEC, if given
    proper funding and resources, and given the independence that
    it really needs, could do an effective job of overseeing the
    FASB and the accounting. I do not know enough about the
    proposals to create an independent oversight, but I do know
    that the SEC has been hampered by the fact that they haven't
    had proper resources.
        Chairman Sarbanes. Some have argued that if we can
    structure the board well enough, it might actually have more
    independence from political influence than the SEC would have.
    That is an interesting question. Do people have a view on that?
        Ms. Teslik. I personally, I suppose, am a little bit
    cynical, having done this job almost 20 years, about the long-
    term independence of any private-sector company with Government
    authority. Obviously, I have had to work with FASB and we have
    had to work with the stock exchanges. And my experience is that
    these entities tend to have the worst of both worlds rather
    than the best.
        They are not accountable to anyone. We do not elect them.
    They do not disclose anything. Do you know what Dick Grasso
    makes? We know what you make. We do not know what CEO's make.
    They tend to be funded by parties they are supposed to
    regulate. Even if it doesn't start out that way in the
    beginning, it becomes that way. And our ability to either
    police them, oversee them, or even give them input, tends to be
    less than the Government entities that we deal with.
        I am not always happy with the SEC. They have been sitting
    on a lot of things that could have helped Enron. By and large,
    we get better responses, more quickly in the sunshine, with
    better regulation from Government bodies.
        I do agree with you, if a private-sector entity is set up
    in the accounting area, who appoints the people matters most.
        Chairman Sarbanes. Is it important that they have a
    guaranteed mandatory source of funding, or does that carry the
    risk that it will make them so removed and so independent, that
    no one can talk to them, so to speak? Do you have a view on
    that?
        Ms. Teslik. I think the mandatory funding matters. You do
    have the accountability problem. Who can speed up FASB?
        On the one hand, FASB is too dependent on other entities
    that give it money, and so that influences it----
        Chairman Sarbanes. They go around with a tin cup begging
    for money.
        Ms. Teslik. Yes, they do. And that is not a good thing. But
    let's suppose that we now mandate the money and FASB has the
    money. We still have the problem that it is too slow, which is
    one of my problems with private-sector companies with
    Government authority.
        How do you speed up FASB? Obviously, with specific issues,
    the SEC can say, get the darn SPE rule out by the end of the
    year, and they have done that. But that is something you have
    to deal with when you have a private-sector entity with
    governmental authority. I think, by and large, mandated funding
    is better than the influence that the absence of funding
    creates. But then you have an accountability problem.
        Chairman Sarbanes. Of course, FASB is subjected to all
    kinds of pressures. I have seen it at work. There is no
    question about it.
        Ms. Teslik. Yes, more than we have.
        Chairman Sarbanes. So that part of their slow-up is that it
    may not be internal to FASB, but may be external in terms of
    the pressures that are being directed at them.
        Mr. Silvers. Senator, there is no question that on a number
    of the issues we are discussing here today, FASB in particular
    has been hamstrung by outside pressures. And the question is--
    --
        Chairman Sarbanes. The Public Oversight Board, Bowsher was
    just here on Tuesday. They were going to do these special exams
    and the companies told them, we are not going to give you any
    money. Your budget's gone if you go and do that. Well, that is
    a pretty powerful weapon to bring you to a halt.
        Mr. Silvers. Sir, I think the problem here is trying to
    figure out how to balance this out because, for example, the
    SEC is subject to similar pressures.
        Chairman Sarbanes. Right.
        Mr. Silvers. As we saw during Arthur Levitt's efforts on
    behalf of auditor independence.
        One thing we believe would be important here is to look at
    the extent to which in dealing with the SRO's and with FASB,
    the Commission itself feels handcuffed to move them along
    sufficiently.
        I think our view would be, although we are open to discuss
    it, to think about it, because it is not a simple problem,
    that, in general, a stable, secured source of financing that
    doesn't give the ultimate source of the funds much power--I
    assume we are talking about private-sector sources now. I
    wouldn't want to suggest that that would be true of this body--
    is probably the best way to go.
        Senator Metzenbaum. Mr. Chairman, I think one of the things
    that we, the Consumer Federation of America, are concerned
    about is that Congress will look at this problem and has really
    had any number of committees--I think I was told that there are
    three committees conducting hearings on this subject today.
        What concerns us is that after all the hearings, there will
    be a lot of noise and a lot of hearings, but there won't be any
    effective legislation, tough legislation to correct some of the
    problems.
        I think that the accounting industry is gearing up for a
    public relations program. And I would just say the sooner the
    better. Tougher will serve the American economy that much
    better and will serve the American people that much better.
        I hope that you, as the Chairman of the Banking Committee,
    will see that there is some movement in this area before all
    the excitement dies down and people say, well, they made the
    indictments, they did this and that. We can go back to the way
    it has been and the world won't come to an end.
        Chairman Sarbanes. Well, I am sure that we can count on the
    Consumer Federation and the others that are at the table to
    keep our eye focused on the important objectives here.
        Mr. Bowman. Senator Sarbanes.
        Chairman Sarbanes. Go ahead.
        Mr. Bowman. I just wanted to comment with regard to the
    oversight bodies, the SEC and the FASB.
        We agree that there ought to be mandatory funding there.
    But in addition to that, I think, one of the major problems has
    been, is the lack, the dearth of investor input and influence
    at the FASB.
        I have witnessed over the years that FASB is very, very
    highly influenced by corporate interests, by issuers of
    financial statements rather than users of financial statements,
    such as investors and money managers. And I think that real
    improvement could be made if there was more a mandate for more
    investor interest
    personnel at the FASB and the SEC, rather than accountants and
    corporate interests.
        Chairman Sarbanes. Well, if the funding source is
    guaranteed as a levy, automatically, and if the appointments to
    the board are made by appropriate public interest people, the
    combination of those two things might provide a dynamic that
    brings a very important change in the operation of a particular
    body.
        I do not know. That is one of the things we are trying to
    puzzle through right now. But it seems to me that offers some
    opportunity if you go down that path, to get a better system
    and structure into place.
        I think it is clear that the existing structure and system
    has not worked and the challenge, really, is determining what
    changes can we bring about in it that will significantly
    diminish the likelihood of any of these things occurring again.
        I do not know that you can guarantee that they won't
    because, as Ms. Teslik kept pointing out, humans are humans as
    you move through. But you have to get a structure that tries to
    limit and restrain and control that as best we can.
        That is one of the challenges we face and it is one of the
    reasons we have tried to do a very careful and comprehensive
    set of hearings, so we establish an appropriate basis on which
    then to act.
        This panel has been enormously helpful. Is there anything
    that anyone wants to add before we adjourn?
        Mr. Silvers. Senator, if I could just make one comment
    about something you asked about earlier, which is the
    distinction about disclosure and substantive regulation.
        Chairman Sarbanes. Yes.
        Mr. Silvers. I would hope that, as you move forward on the
    task of crafting legislation here, that you consider that,
    traditionally, the securities laws have had a disclosure-only
    sort of perspective. And the pension laws have had a more
    substantive regulation to them. ERISA tends to look more at
    barring things and that kind of thing.
        However, in recent years, the securities laws I think have
    become more relevant to the set of retirement issues and
    retirement securities issues that ERISA historically dealt
    with. And there are areas in which the determined bright-line
    rules and bars on certain kinds of conduct that, say, the
    prohibited transactions rule in ERISA has, make more sense in
    the securities area.
        One example of that is with the conflicts involving
    analysts and investment banking practices. I think another
    example has to do with the auditors and the conflicts there,
    that there simply is not an ability in the system to have mere
    disclosure regulate effectively the conflicts at work in those
    areas.
        I think it is worth noting that and knowing what is
    involved there and thinking about in those areas in which
    disclosure works and those areas where it really won't because
    there is not the power to act on it.
        Chairman Sarbanes. That prompts me to ask a question before
    I let the panel go.
        We are getting this argument now that if you--I am a small
    business. I have a small accountant. And we interrelate here
    and we work together. If you separate these things out or put
    these additional requirements, it is going to become an onerous
    burden on me to carry out my activities.
        Now, first of all, it would seem to me that we would draw a
    sharp line between public companies and nonpublic companies. I
    think most of our discussion has focused and should focus on
    public companies.
        Once you list on an exchange, it seems to me that you are
    moving into a different arena. Then there are obligations that
    go with that because you have a very different investor
    protection issue.
        Do you all agree with that, that we are essentially
    focusing in the arena of the public companies?
        Mr. Silvers. Absolutely.
        Senator Metzenbaum. Yes.
        Ms. Teslik. Yes.
        Chairman Sarbanes. What do you say to the argument where
    they say, well, if you establish these requirements in that
    arena, State accounting boards will simply adopt them and apply
    them to everybody, and then we won't be able to do the sort of
    business that doesn't raise any of these problems and it needs
    to be done. What is your response to that?
        Ms. Teslik. The State accounting boards are not known for
    their activism.
        [Laughter.]
        I don't think that is a fear you have to lose a lot of
    sleep over.
        Mr. Bowman. I think that is a spurious argument.
        Mr. Silvers. You know, Senator, when the securities laws
    were adopted, States had securities regulation. States have
    corporate law. By that argument, one might have feared that the
    entire body of securities regulation would have been imposed on
    every restaurant and taco stand and newsstand in the country.
    States are more sensible than that.
        Chairman Sarbanes. Okay. Thank you all very much. This has
    been an extremely helpful panel.
        Senator Metzenbaum. Thank you, Mr. Chairman.
        Mr. Silvers. Thank you.
        Mr. Bowman. Thank you.
        Ms. Teslik. Thank you, Mr. Chairman.
        Chairman Sarbanes. The hearing stands adjourned.
        [Whereupon, at 11:59 a.m., the hearing was adjourned.]
        [Prepared statements and response to written questions
    follow:]

                             PREPARED STATEMENT OF

                      SENATOR HOWARD M. METZENBAUM (RET.)
                    Chairman, Consumer Federation of America
                                 March 20, 2002

        Good morning, Mr. Chairman, Senator Gramm, and Members of the
    Committee. My name is Howard M. Metzenbaum and I now serve as Chairman
    of the Consumer Federation of America (CFA). CFA is a nonprofit
    association of some 300 pro-consumer organizations, with a combined
    membership of over 50 million Americans. I appreciate your invitation
    to offer my comments on this very important issue. I am especially
    pleased to appear before my old friend and colleague, Chairman
    Sarbanes.
        I spent my career in the U.S. Senate working to prevent
    corporations from running roughshod over the rights of consumers and
    workers. I have to tell you that I have never seen a more appalling
    example of heartless, unfettered corporate greed than in the Enron
    debacle. This company lied to their investors, lied to their employees,
    hid crucial information about their finances and tried to improperly
    influence Government officials. And in criminally indicting Enron's
    auditing firm, Arthur Andersen, the Department of Justice has said that
    it believes that Andersen was a party to this massive deception.
        How could this energy giant have gone from number seven on the
    Fortune 500 to bankruptcy court almost overnight? The answer, of
    course, is that it did not. The problems that ultimately brought Enron
    down were a long time in the making. They were simply hidden from
    investors' eyes. That revelation has prompted an even more pressing
    question, since it has broader implications for investors in all
    publicly-traded companies: Given all the safeguards in our system
    designed to ensure investors receive full and fair disclosure, how
    could Enron have succeeded for so long in presenting a false picture of
    financial health? The disturbing answer is that, in this case as in
    others, all the safeguards designed to protect investors failed, and
    failed miserably.

     The rules that dictate what information companies have to
        disclose and how they have to disclose it failed to produce an
        accurate picture of Enron's finances, even where the company
        complied with the rules.
     The corporate board that is supposed to supervise management
        failed to ask the tough questions, challenge questionable
        practices, or require more transparent disclosure.
     The auditors, whose job it is to certify that financial
        disclosures are not only prepared according to the rules but also
        present an accurate picture of company
        finances, signed off on financial statements that clearly failed
        that test.
     The Securities and Exchange Commission, which also has the
        responsibility for reviewing corporate disclosures, had not
        reviewed the energy giants complex financial statements since 1997.
     The credit ratings agencies and securities analysts--outside
        experts that investors rely on to analyze all of the available
        information and provide an independent assessment of the company's
        credit- or invest-worthiness--did not provide any advance warning
        of possible trouble.

        In short, the real story out of the Enron disaster, at least for
    policymakers, is not that its corporate managers went to great lengths
    to hide the company's indebtedness and artificially inflate its
    earnings. Our system was designed with just that behavior in mind. The
    real story is that all the safeguards that we rely on to keep corporate
    executives honest failed. Clearly, key parts of the system are broken,
    and it is Congress's job to fix them. Only a comprehensive package of
    strong reforms will do the job.

    Restore Value and Integrity to the Independent Audit
        The most important thing Congress can do is restore value to the
    independent audit. To accomplish this, it must enhance auditor
    independence, provide effective regulatory oversight of accountants,
    and restore the threat of private litigation as a strong deterrent to
    wrongdoing.

    Make the ``Independent '' Audit Truly Independent
    The Independent Audit Has Never Been More Important
        The whole point of requiring public companies to obtain an
    independent audit is to ensure that outside experts have reviewed the
    company books and determined that they not only comply with the letter
    of accounting rules but also present a fair and accurate picture of the
    company's finances. Auditors have profited handsomely over the years
    from performing this important public watchdog function. Unless the
    auditor is free of bias, brings an appropriate level of professional
    skepticism to the task, and feels free to challenge management
    decisions, however, the audit has no more value than if the company
    were allowed to certify its own books.
        The independent audit is arguably more important today than it has
    been at any time since the requirement was first imposed in the 1930's.
    More than half of all American households today invest in public
    companies, either directly or through mutual funds. They do so
    primarily to save for retirement. As a result, their financial well-
    being later in life is dependent on the integrity of our financial
    markets.
        At the same time, corporations today are under great pressure to
    keep their stock prices on a smooth upward trajectory. As one writer
    has noted:

              No longer is a higher stock price simply desirable, it is
            often essential, because stocks have become a vital way for
            companies to run their businesses. The growing use of stock to
            make acquisitions and to guarantee the debt of off-the-books
            partnerships means, as with Enron, that the entire partnership
            edifice can come crashing down with the fall of the underlying
            stock that props up the system. And the growing use of the
            stock market as a place for companies to raise capital means a
            high stock price can be the difference between failure and
            success.\1\
    ---------------------------------------------------------------------------
        \1\ ``Deciphering the Black Box: Many Accounting Practices, Not
    Just Enron's, Are Hard to Penetrate,'' by Steve Liesman, The Wall
    Street Journal, January 23, 2002, p. C1+.

        Corporate managers have a strong incentive to manage their earnings
    in order to present the picture of steadily rising profitability that
    Wall Street rewards. And, as the Enron case clearly illustrates, murky
    accounting rules that rely on numerous subjective judgments make it
    easier than it should be to construct a false picture of financial
    health. The Enron case also makes it abundantly clear that an auditor
    whose independence is compromised may be all too willing to sign off on
    financial statements that conceal, rather than reveal, the company's
    true financial state.
        Finally, Enron's dramatic collapse, and Arthur Andersen's obvious
    complicity, have shaken public confidence in the reliability of
    companies' financial statements. That adds an unhealthy element of
    uncertainty to financial markets. As the SEC noted when it proposed its
    auditor independence rules in 2000: ``Investors are more likely to
    invest, and pricing is more likely to be efficient, the greater the
    assurance that the financial information disclosed by issuers is
    reliable. Independent auditors play a key role in providing that
    assurance.''

    Many Factors Undermine Auditor Independence
        Because of the central importance of the outside audit in upholding
    the integrity of our system of financial disclosure, the Supreme Court
    has stated that this ``public watchdog function demands that the
    accountant maintain total independence from the client at all times.''
    Unfortunately, accountants have shown virtually no real willingness to
    accept the responsibility for maintaining their independence that goes
    with the privilege of performing audits.
        Since the mid-1990's, most of the big firms have dramatically
    increased their sales of consulting and other nonaudit services to
    their audit clients, despite the clear conflict of interest that this
    creates. Today, virtually all big companies receive both audit and
    nonaudit services from their accountants, and they typically pay
    between two and three times as much for the nonaudit services as they
    do for the audit itself. In some cases, the disparity between audit and
    nonaudit fees is far greater. Furthermore, consulting services
    increasingly drive the profitability of accounting firms. If an
    auditor's tough questioning of management were to threaten its more
    profitable consulting arrangement, that auditor might expect to face
    tough questioning of his own from higher ups at the firm.
        Other factors also undermine auditor independence. The lack of
    independence starts with the fact that auditors are hired, paid, and
    fired by the audit client. This basic conflict is exacerbated by the
    general lack of client turnover. Auditors may reasonably expect to keep
    the same client for 20, 30, even 50 years. These long relationships
    make it that much harder for the auditor to challenge management
    aggressively, not only because of the friendships that are likely to
    develop between auditors and company management, but also because they
    risk losing this seemingly endless stream of future audit revenues if
    their tough questioning causes them to lose the client.
        Another problem that clearly needs to be addressed is the revolving
    door that all too often exists between auditors and their audit
    clients. This was true at Enron, it was true at Waste Management, and
    it is a common feature in many failed audits. A constant flow of
    personnel from the auditor to the audit client helps to create an
    environment in which external auditors are viewed as just another part
    of the corporate family. Such intimacy is not conducive to true
    independence.

    Comprehensive Reforms Will Be Needed to Restore Auditor Independence
        The only way to provide complete independence to the outside audit
    is to take it out of the private sector. Representative Kucinich has
    introduced legislation (H.R. 3795) that would create a Federal Bureau
    of Auditing in the SEC, and CFA has endorsed that legislation. But
    other less radical approaches could significantly enhance auditor
    independence while leaving it in the private sector. Some have
    suggested, for example, making the exchanges responsible for hiring
    accounting firms to audit the companies that trade there. The idea
    behind this approach is that it would minimize the company's financial
    leverage over the auditor, and that auditors would as a result be more
    likely to perceive themselves as working for investors, rather than for
    the audited company. This is an intriguing suggestion that we believe
    deserves further exploration.
        Another idea that has gained some high-powered and highly credible
    backers is the idea of requiring periodic mandatory rotation of
    auditors. An audit firm that knows it has a limited term of engagement
    has significantly less to lose by challenging management than one that
    expects to retain the client indefinitely. This approach has costs as
    well, in the form of the learning curve at the start of an audit
    rotation. However, such costs can be minimized by setting a
    sufficiently long rotation period of 5 to 7 years. Because such an
    approach would significantly enhance auditor independence, we believe
    the benefits far outweigh the costs.
        This mandatory rotation of auditors should be combined with a broad
    ban on provision of nonaudit services to audit clients. Certain
    services could be exempt, on a case-by-case basis, if it is shown that
    these services are closely related to the audit, directly enhance the
    quality of the audit, benefit investors, and create negligible
    conflicts of interest for the audit firm. If any such nonaudit services
    are permitted, they should have to be directly and separately approved
    by the audit committee of the board. Finally, to close the revolving
    door between audit firms and their audit clients, there should be a 2
    to 3 year cooling off period after their involvement in the audit has
    ended during which members of the audit team would be prohibited from
    seeking or accepting employment with a former audit client.
        A strong package of reforms along this line would restore real
    integrity and value to the independent audit. That, in turn, should go
    a long way toward restoring investor confidence in the reliability of
    corporate disclosures.

    Provide Effective Regulatory Oversight of Accountants
        If auditors face numerous pressures to sign off on questionable
    accounting practices, they face relatively little fear of sanctions if
    they do. Although a variety of groups including the SEC, State
    accountancy boards, and the AICPA all have power to discipline auditing
    firms and their employees for ethical and legal infractions, even
    serious violations typically receive little more than a hand slap.
    The Current ``Regulatory'' System is Under-Funded, Ineffective, and
    Captive of the Industry
        In theory, the real authority over auditors lies with the SEC. It
    has the power to bar individuals and firms from auditing publicly-
    traded companies. It also has authority to impose potentially
    substantial fines. In reality, however, the agency does not routinely
    review how auditors perform their audits, and instead delegates that
    responsibility to the AICPA and its Public Oversight Board.
    Furthermore, according to past agency officials, the SEC only has the
    resources to tackle the very worst cases of alleged accounting abuse,
    and it typically settles even those cases without an admission of
    wrongdoing. It took no action, for example, against a former Arthur
    Andersen managing partner whom the SEC said had allowed persistent
    misstatements on Waste Management's financial reports to go
    uncorrected.\2\ Similarly, a PricewaterhouseCoopers' partner ordered by
    the SEC in 1999 to cease and desist violating securities laws did not
    even lose his position as lead partner on the audit in question.\3\
    ---------------------------------------------------------------------------
        \2\ Ibid.
        \3\ Ibid.
    ---------------------------------------------------------------------------
        The AICPA sets audit standards, oversees through its affiliated
    Public Oversight Board a peer review system to determine compliance
    with those standards, and has disciplinary authority over its members
    for violations. According to former SEC Chief Accountant Lynn Turner,
    however, the audit standards adopted by AICPA are ``so general that, as
    a practical matter, it is difficult to hold anyone accountable for not
    following them.'' \4\ The POB,\5\ which is responsible for overseeing
    the industry's peer review system and other ethics investigations, is
    notable for having never sanctioned a major accounting firm in its 25
    years of existence, even when peer reviews have uncovered serious
    shortcomings in a firm's audit procedures.\6\ Furthermore, the POB
    cannot act against a firm without the AICPA's cooperation. In one case
    where, at the SEC's prompting, the POB did attempt to investigate
    possible stock-ownership violations at the major firms, the AICPA
    refused funding for and cooperation with the investigation, which as a
    result went nowhere.\7\
    ---------------------------------------------------------------------------
        \4\ ``After Enron, New Doubts About Auditors,'' by David
    Hilzenrath, The Washington Post, December 5, 2001, p. A01.
        \5\ The POB recently voted itself out of existence in protest over
    SEC Chairman Harvey Pitt's proposal to create a new self-regulatory
    body for the accounting industry.
        \6\ ``Peer Pressure: SEC Saw Accounting Flaw,'' by Jonathan Weil
    and Scot J. Paltrow, The Wall Street Journal, January 25, 2002, p. C1.
        \7\ The case is described both in a May 12, 2000 letter from Rep.
    John Dingell (D-MI) to the SEC Chairman Arthur Levitt and in a May 22,
    2000 Business Week editorial, ``Why the Auditors Need Auditing.''
    ---------------------------------------------------------------------------
        Even if they had the will to act, the AICPA and POB are also
    hampered by a severe lack of investigative authority. They cannot
    subpoena evidence, for example, and as a result are forced to rely on
    the public record in building a case. If the SEC settles a case
    confidentially, with neither a public ruling nor an admission of guilt,
    there is no public record the AICPA or POB can rely on in bringing its
    own enforcement actions. Where the AICPA does act, its maximum sanction
    is expulsion from the organization, which can have serious
    consequences, but does not prevent the individual from continuing to
    practice.
        In reality, however, AICPA has shown itself to be a reluctant
    regulator. According to a Washington Post investigation, the AICPA took
    disciplinary action in fewer than a fifth of the cases in which the SEC
    imposed sanctions over the past decade. Even when AICPA determined that
    SEC-sanctioned accountants had committed violations, they closed the
    vast majority of ethics cases without disciplinary action or public
    disclosure.\8\ The disciplinary action AICPA was most likely to take,
    according to the Post investigation, was issuing a confidential letter
    directing the offender to undergo additional training. Ethics committee
    member Dave Cotton has reported seeing ``ethical lapses that resulted
    in millions of dollars of losses get punished with as little as 16
    hours of continuing education.'' \9\
    ---------------------------------------------------------------------------
        \8\ Ibid.
        \9\ ``CPA's (and I am One) Can Reverse Their Losses,'' by Dave
    Cotton, The Washington Post, January 27, 2002, Op Ed.
    ---------------------------------------------------------------------------
    A Complete Overhaul of the System is Needed
        Some policymakers, including SEC Chairman Harvey Pitt and several
    Members of Congress, have recommended creation of an independent
    regulatory organization for accountants. Others have argued that the
    SEC should be given enhanced responsibilities in this area. Regardless
    of which approach is adopted, it is clear that improved oversight is
    needed. The following are some principles that must be incorporated in
    any such plan.
        A. It Must Be Independent of the Accounting Industry
        As one former SEC official observed to Business Week, ``The
    accounting profession is very creative at taking over every group that
    has ever tried to rein it in.'' \10\ For a self-regulatory organization
    to have any credibility, therefore, its independence must be
    unassailable. At a minimum, a super majority of board members must have
    no ties whatsoever to the accounting industry, and they must be subject
    to conflict of interest rules that prohibit ties to the industry for a
    significant period after they leave the board. Just as important,
    funding for the organization must be totally free from threat by
    industry members. The AICPA and the Big 5 firms have shown their
    willingness to use strong arm tactics to head off potentially
    embarrassing investigations in the past. They must have no such hold
    over any SRO that is created to provide enhanced oversight in the wake
    of the Enron-Andersen disaster.
    ---------------------------------------------------------------------------
        \10\ ``Accounting in Crisis,'' by Nanette Byrnes with Mike McNamee,
    Diane Brady, Louis Lavelle, Christopher Palmeri, and bureau reports,
    Business Week, January 28, 2002, pp. 44-48.
    ---------------------------------------------------------------------------
        Because of the tendency of self-regulatory organizations to
    identify with the
    industries they regulate, rather than the public, CFA has generally
    favored direct Government oversight over the SRO approach. In this
    case, that would take the form of direct SEC regulatory oversight of
    accountants. However, such an approach does not offer a perfect
    solution. The accounting industry has shown itself to be more than
    capable of influencing SEC actions, the most recent example being the
    industry's ability to force the agency to back off the toughest
    components of its proposed auditor independence rules by lining up
    Members of Congress to intervene.
        B. It Must Be Adequately Funded
        Whether the SEC or an SRO assumes responsibility for rulemaking,
    inspections, investigations, and disciplinary actions against auditors,
    the effort must be generously funded. Because the SEC's budget has for
    two decades failed to keep pace with the growth in its workload, the
    SEC today is severely under-funded. By passing SEC fee-reduction
    legislation last year without first raising the agency's budget to an
    appropriate level, Congress increased the likelihood that the agency
    will continue to be hampered by a shortage of funds in the future. The
    President's proposed fiscal year 2003 budget for the agency includes no
    significant increase in funding, not even enough to fund the pay parity
    provisions enacted last year. This raises serious concerns about the
    willingness of Congress and the Administration to adequately fund
    enhanced SEC oversight of auditors without robbing other high priority
    agency activities. One of the most favorable aspects of a proposal to
    create an independent regulatory body (provided it is unassailably
    independent) is that it offers the opportunity to ensure both adequate
    funding and the higher pay scales that make it
    easier to attract top investigation and enforcement staff.
        C. It Must Have Rulemaking Authority
        Chairman Pitt's SRO proposal appears to anticipate leaving
    authority for developing auditing standards with the AICPA. This is
    unacceptable. Rules on how to conduct audits clearly need to be
    strengthened and clarified. That is the job of an independent
    regulator, not an industry trade association. Either the SEC or an SRO
    operating under SEC supervision must be given authority to set both
    auditing and quality control standards. The AICPA, as a trade
    association, should have no Government recognized role in the
    regulatory process.
        D. It Must Have Strong Investigative and Enforcement Authority
        If oversight of accountants is delegated to an SRO, that SRO must
    have the ability to conduct routine, thorough inspections of audit
    firms to determine their compliance with auditing standards. It also
    must have extensive powers to conduct timely investigations of
    suspected abuses, including the power to subpoena witnesses and records
    from both auditors and the public companies they audit. And it must
    have the ability to impose meaningful penalties for violations.
        It has also been suggested that, in cases where companies are
    forced to restate their earnings, a team of forensic accountants be
    dispatched immediately to investigate.\11\ At the end of their
    investigation, they would issue a public report on what went wrong and
    what is being done to correct the problem. Possible recommendations
    might include revisions to accounting rules, revisions to auditing
    standards, changes in audit practices at the firm under investigation,
    etc. The SRO would then have authority to ensure that those changes
    were made. We believe this offers a good model for appropriate
    corrective action where problems are exposed either at a particular
    firm or in the system more generally.
    ---------------------------------------------------------------------------
        \11\ ``Auditors Face Scant Discipline, Review Process Lacks
    Resources, Coordination, Will,'' by David S. Hilzenrath, The Washington
    Post, December 6, 2001, p. A01.
    ---------------------------------------------------------------------------
    Reform Private Litigation Laws to Provide a Real Deterrent
    to Wrongdoing
        Private litigation has long been viewed as an important supplement
    to regulation, since the threat of having to pay significant financial
    damages provides an incentive to comply with even poorly enforced laws.
    In 1995, however, Congress passed the Private Securities Litigation
    Reform Act, which significantly reduced auditors' liability in cases of
    securities fraud.\12\ It did so, both by making it more difficult to
    bring a case against accountants and by reducing their financial
    exposure where they are found to have contributed to fraud.
    ---------------------------------------------------------------------------
        \12\ PSLRA also all but guaranteed that Enron's victims will
    receive mere pennies on the dollar in any recovery.
    ---------------------------------------------------------------------------
        It is not enough, in a securities fraud lawsuit, to show that an
    auditor made a materially false statement. You must also show that the
    auditor acted with an intent to defraud or a reckless disregard for the
    truth or accuracy of the statement. PSLRA set pleading standards with
    regard to state of mind that create a Catch 22 for plaintiffs'
    attorneys. They must present detailed facts showing the defendant acted
    with requisite state of mind, and they must do this before they gain
    access through discovery to the documents they need to establish state
    of mind. If plaintiffs cannot meet the pleading standards, the case is
    dismissed.
        In addition to making it more difficult for securities fraud
    victims to bring private lawsuits against accountants, PSLRA reduced
    accountants' liability when they are found to have contributed to
    fraud. The primary way it accomplished this was by replacing joint and
    several liability with a system of proportionate liability. Thus,
    accountants who are found to have contributed to securities fraud no
    longer have to fear being forced to pay the full amount of any damages
    awarded should the primary perpetrator be bankrupt. Under proportionate
    liability, the culpable accountant cannot be forced to pay more than
    their proportionate share of damages. As a result, according to noted
    securities law expert Professor John C. Coffee, Jr., accountants will
    rarely be forced to may more than 25 percent of the losses.\13\
    ---------------------------------------------------------------------------
        \13\ ``The Enron Debacle and Gatekeeper Liability: Why Would the
    Gatekeepers Remain Silent?'' Professor John C. Coffee, Jr., Adolf Berle
    Professor of Law, Columbia University Law School, testimony before the
    Senate Committee on Commerce, Science and Transportation, December 18,
    2001.
    ---------------------------------------------------------------------------
        PSLRA was also notable for what it did not do. It failed to extend
    the Federal law's very short statute of limitations for securities
    fraud of no more than 3 years from the time of the wrongdoing. This
    rewards those who are able to cover up their fraud for the relatively
    short period of 3 years and guarantees, for example, that some claims
    against Enron and Andersen will be time-barred. PSLRA also failed to
    restore aiding and abetting liability under securities fraud laws,
    which the Supreme Court's 1994 Central Bank of Denver decision
    eliminated as a potential cause of action. Thus, accountants can only
    be sued as primary perpetrators of securities fraud, not for their role
    in aiding and abetting that fraud.
        The result is that the threat of private lawsuits now poses a
    diminished deterrent to accounting fraud. Restoring reasonable
    liability for culpable accountants should be part of any overall reform
    plan. This should include provisions: To enable plaintiffs to gain
    access to documents through discovery before having to meet the
    heightened pleading standards regarding state of mind; to restore joint
    and several liability where the defendant recklessly violated
    securities laws and the primary wrong-doer is bankrupt; to restore
    aiding and abetting liability for those who contribute to fraud but are
    not the primary culprit; and to extend the statute of limitations for
    securities fraud lawsuits.
    The Independent Audit Must Be Backed Up By An Aggressive,
    Fully Funded SEC
        In the wake of Enron's collapse, many have asked, ``where was the
    SEC?'' Given the SEC's responsibility for reviewing public company's
    financial disclosures, why had the agency not detected the company's
    problematic accounting earlier? One
    answer is that the SEC had not reviewed Enron's financial disclosures
    since 1997. The reason is that the agency is so understaffed it is only
    able to review a small percentage of filings each year.
        This Committee recently heard testimony from the head of the
    General Accounting Office on the devastating effect that under-funding
    is having on the SEC's ability to perform its assigned tasks. The
    recent GAO report that formed the basis for that testimony looks at the
    growth in workload at the agency since the start of the 1990's, and
    documents the degree to which funding has failed to keep pace. It tells
    only half the story. The real damage to SEC funding occurred before the
    period
    covered by the report, in the 1980's, when staffing stayed virtually
    flat while the industry experienced dramatic growth.
        In 1980, for example, there were just over 8,000 publicly-traded
    companies filing annual reports, according to a report commissioned in
    1988 by the Securities Subcommittee of this Committee,\14\ and there
    were 710 new registration statements filed. Excluding the staff for
    electronic filing and information services, 420 staff years were
    devoted to disclosure matters. As a result, the agency was able to
    review all transactional filings.
    ---------------------------------------------------------------------------
        \14\ Self-Funding Study, prepared by the Office of the Executive
    Director of the U.S. Securities and Exchange Committee, submitted in
    partial response to the request of the Securities Subcommittee of the
    Senate Committee on Banking, Housing, and Urban Affairs (S. Rpt. 100-
    105), December 20, 1988.
    ---------------------------------------------------------------------------
        In 2000, the number of staff years devoted to full disclosure
    (again excluding the staff for electronic filing and information
    services), had dropped to 356, according to the SEC's analysis of the
    President's proposed fiscal year 2002 budget. As a result of diminished
    staffing, dramatic growth in the number of publicly-traded companies,
    and increased workload associated with review of initial offerings,
    ``the percentage of all corporate filings that received a full review,
    a full financial review, or were just monitored for specific disclosure
    items'' decreased to about 8 percent in 2000, according to the GAO
    report. Because of a dramatic drop-off in the number of IPO's in 2001,
    the SEC was able to complete ``full or full financial reviews of about
    16 percent, or 2,280 of 14,060 annual reports filed'' last year, the
    GAO report found.
        Among the financial statements that was passed over for review
    because of this staffing shortfall were the financial statements for
    Enron from 1998, 1999, and 2000. Although it is impossible to know
    whether more regular, more thorough reviews would have nipped the
    accounting problems at Enron in the bud, it is reasonable to think they
    might have. Certainly, it is irresponsible to so grossly under-fund the
    Federal regulators that they cannot hope to fulfill the important
    responsibilities assigned to them.
        Last year, Congress had a historic opportunity to fix this problem.
    A decision was made not to use SEC-generated fees to fund other areas
    of the Government. As a result, the agency no longer had to compete
    with other Federal priorities in justifying its budget. Instead of
    taking that opportunity to dramatically boost agency funding, Congress
    approved a budget that required additional staffing cuts and passed
    legislation to reduce agency imposed fees to reflect that inadequate
    budget. The Members of this Committee fought to provide a funding
    boost, but those efforts were ultimately unsuccessful.
        The collapse of Enron has focused new attention on the issue of SEC
    funding. Because of Enron, most of that attention is focused on
    staffing issues related to full disclosure and enforcement. These are
    important priorities that certainly need a funding boost, but similar
    trends have affected all areas of SEC responsibility. Think of what has
    happened in that time in the area of mutual funds or financial planning
    since the beginning of the 1980's. Think of how many more households
    are now participants in the markets and thus vulnerable to wrongdoing.
    The GAO report commissioned by this Committee has helped to make the
    case for across-the-board significant funding increases for the SEC.
    That case is even more powerful when the numbers from the 1980's are
    taken into account. The Members of this Committee must make a priority
    of undoing the damage of last year's fee reduction legislation and
    providing a budget for the SEC that is commensurate with its
    responsibilities.
    Study Credit Ratings Agencies to Determine Why They Failed to
    Provide an Earlier Warning of Problems
        Another troubling aspect of the Enron collapse is the failure of
    credit rating agencies to provide an early warning of trouble. In fact,
    both Moody's and Standard & Poor's still had Enron at investment grade
    until just 5 days before it filed for bankruptcy. According to a
    Bloomberg News account, Moody's had decided to downgrade Enron to junk
    in early November, but backed down in response to lobbying from Dynegy,
    which was then negotiating a takeover of Enron, and its bankers.\15\
    Although this raises serious questions about the objectivity of the
    ratings, it is unclear that an earlier downgrade would have changed
    things for investors. A credit rating is not just an isolated measure
    of a company's financial health. A downgrade may not just reflect the
    company's worsening financial status, it can trigger further
    financial woes, as it did for Enron.
    ---------------------------------------------------------------------------
        \15\ ``Moody's Enron Rating Shows Lack of Independence,'' Mark
    Gilbert, Bloomberg News,
    November 15, 2001.
    ---------------------------------------------------------------------------
        We strongly encourage this Committee to conduct a further study of
    this issue to assess whether the operations of credit ratings agencies
    are adequate to ensure
    accurate ratings and, if not, what should be done to enhance the
    quality of ratings. That study should examine the extent to which
    recently announced changes by the ratings agencies are likely to
    provide the desired improvement. It should also examine whether lack of
    competition in the industry is contributing to the problem. We expect
    that a thorough review will identify areas in need of additional
    reform.
    Study Measures to Address Securities Analyst Conflicts of Interest to
    Determine Whether Additional Protections are Needed
        Credit ratings agencies were not alone in missing the warning
    signs. In early November, after the SEC had already announced it was
    looking into Enron's partnership transactions, ten of fifteen analysts
    who followed Enron still rated it as a ``buy'' or ``strong buy.'' One
    reason, as the analysts are quick to point out, is that they were not
    getting good information from Enron's financial statements. Another is
    that Enron was apparently actively and intentionally misleading
    analysts about activity on its trading floor, for example.
        However, this offers only a limited explanation. Red flags were
    there for those who were looking. And many now looking back--albeit
    with the benefit of 20-20 hindsight--have been able to point out
    obvious danger signs. These included wide discrepancies between the
    company's reported earnings and its retained earnings, negative
    cashflow of $2.56 billion in 2000 once proceeds from asset sales and
    other one-time activities not part of its core business were deducted,
    and actual revenues on energy trading that were a mere fraction of
    those that accounting rules let the company claim.\16\ Surely it is
    analysts' job to look for just such clues and to probe deeper than the
    surface of company disclosures.
    ---------------------------------------------------------------------------
        \16\ ``How 287 Turned Into 7: Lessons in Fuzzy Math,'' by Gretchen
    Morgenson, The New York Times, January 20, 2002, Section 3, page 1.
    ---------------------------------------------------------------------------
        Another reason analysts may have missed these signs is that they
    simply weren't looking. After all, negative reports do not attract
    investment banking business, and Enron was clearly seen as a huge
    potential source of such deals. Since investment banking business is
    far more profitable than the retail sales business for large Wall
    Street firms, it is hardly surprising that those firms use their
    research arms to support their investment banking business. In the
    process, their research has become so compromised by conflicts of
    interest that it has no real credibility.
        Recently, new rules have been proposed to address analyst conflicts
    of interest. They do so by attempting to limit the investment banking
    department's influence over research, limit analysts' investments in
    pre-IPO shares of companies in the
    industry they cover, limiting their purchase or sale of securities
    during a window of time around the release of a new research report,
    and prohibiting trades against their own recommendations, and requiring
    better disclosure of conflicts. We view this as a very positive step in
    the right direction, and will be commenting on the rules as they move
    through the approval process. However, we believe more should be done
    in several areas, including banning compensation for analysts that is
    tied in any way to investment banking profits, improving the clarity
    and relevance of required disclosures, and extending disclosure to
    recommendations by sales representatives to retail clients based on the
    company's research. We encourage this Committee to further study this
    issue to determine whether additional steps to enhance analyst
    independence may be necessary.
    Protect FASB's Independence
        In the wake of Enron's collapse, Arthur Andersen has tried to blame
    inadequate accounting rules--rather than its own poor performance as
    auditor--for Enron's less-than-transparent financial disclosures. This
    ignores the fact that Enron's financial statements have been shown to
    contain several violations of existing rules.\17\ It also ignores
    Andersen's responsibility as auditor to ensure not just that Enron's
    disclosures complied with the letter of existing rules, but also that
    they presented an accurate picture of Enron's overall financial status.
    However, this is not an either-or proposition. It is, in fact, the case
    that Andersen failed in its responsibility as auditor and existing
    accounting rules are inadequate.
    ---------------------------------------------------------------------------
        \17\ In his January 24, 2002 testimony before the Senate Committee
    on Governmental Affairs, former SEC Chief Accountant Lynn Turner
    outlined four areas of noncompliance with existing rules.
    ---------------------------------------------------------------------------
        One reason is the inability of the Financial Accounting Standards
    Board to produce strong rules in a timely fashion when faced with
    entrenched opposition from large corporations and accounting firms. It
    is difficult to criticize FASB for moving too slowly on improved
    accounting rules governing special purpose entities, for example, when
    their past efforts to pass similarly controversial rules--regarding
    pooling of interest accounting for mergers, derivatives disclosures,
    and accounting for stock options--have met strong resistance, not just
    from business, but also from Members of Congress.
        Something needs to be done to enhance FASB's independence. This is
    a difficult issue to tackle, since FASB is a private entity not subject
    to Government oversight. We applaud Senators Dodd and Corzine for
    tackling this issue in their recently
    introduced legislation. We believe the approach they have outlined--by
    giving the SEC greater say in FASB's agenda and by guaranteeing an
    independent funding source for FASB--offers the possibility of real
    progress. In addition, certain Members of Congress must recognize that
    they have played a key role in undermining FASB's independence in the
    past and should refrain from interfering inappropriately in the future.
    Improve Corporate Governance Standards
        Enron's independent board members, and particularly the board audit
    committee, have come in for considerable criticism for authorizing some
    of the company's more controversial partnership deals and for failing
    to ensure clear, accurate financial disclosures. While it may be
    unrealistic to suppose that board audit committees will ever be
    equipped to closely scrutinize and challenge the outside auditor's
    work, steps can and should be taken to enhance the independence and
    expertise of independent board members. This Committee could play a
    valuable role by examining what additional steps are needed to improve
    corporate governance practices.
        As a first step, exchanges must be pressed to adopt tough standards
    for determining the independence of board members and to require that a
    majority of board members for listed companies meet these
    standards.\18\ A starting point should be the 1999 recommendations of
    an SEC-appointed blue ribbon commission. Among other things, that
    commission recommended that all audit committee members be financially
    sophisticated independent board members, and that at least one member
    have expertise in accounting or financial management.\19\
    Unfortunately, those standards have never been fully embraced by the
    major exchanges. Under its listing rules, for example, the New York
    Stock Exchange permits directors on the company payroll to serve on the
    audit committee, along with former employees and their families after a
    3 year cooling off period, and board members with significant business
    relationships with the company, if the board determines those ties
    won't interfere with the board member's judgment.\20\ If the exchanges
    fail to act voluntarily to
    improve board member independence standards, Congress and the SEC
    should call them to account.
    ---------------------------------------------------------------------------
        \18\ In his January 24, 2002 testimony before the Committee on
    Governmental Affairs of the U.S. Senate, former SEC Chairman Arthur
    Levitt said independent board members should be precluded from
    receiving consulting fees, using corporate aircraft without
    reimbursement,
    accepting support of director-connected philanthropies, ``or other
    seductions.''
        \19\ ``Accounting in Crisis,'' by Nanette Byrnes with Mike McNamee,
    Diane Brady, Louis Lavell, Christopher Palmeri, and bureau reports,
    Business Week, January 28, 2002, pp. 44-48.
        \20\ Ibid.
    ---------------------------------------------------------------------------
    Conclusion
        The collapse of Enron has provided a clarion call for reform. It
    has exposed gaping holes in the investor protections we rely on to keep
    corporate managers honest. Enron is not unique. These same shortcomings
    apply to all publicly-traded companies. We are fortunate that so many
    company managers have remained committed to providing clear, accurate
    disclosures to investors. But we cannot rely exclusively on their
    integrity. We need a system that works even when company managers are
    greedy and overly aggressive. Congress can repair the gaps in the
    current system. It is of paramount importance that you do so.

                                   ----------

                       PREPARED STATEMENT OF SARAH TESLIK
             Executive Director, Council of Institutional Investors
                                 March 20, 2002

        We are all Enron exhausted, so I will start with the bottom line.
        Accountants sign off on financials that trick investors because we
    let them. CEO's pay themselves hundreds of millions of dollars, even
    when they bankrupt their companies, because we let them. Boards look
    the other way because we let them.
        There are almost no consequences for individuals who commit
    corporate crimes. There are almost no consequences for board members,
    CEO's, auditors, analysts, rating agencies, and Government employees
    who fail to do their jobs. Even honest people start behaving badly when
    there are no consequences. Especially when the reward is hundreds of
    millions of dollars.
        This is not an Enron issue. Enron is already old news--questions
    about Global Crossing, PNC, WorldCom, and A.C.L.N. all post-date it.
        People will behave badly to get great wealth if the stock exchanges
    do not stop them. If the SEC doesn't deter them. If the FASB and the
    AICPA enable them. If prosecutors rarely go after them. And if you
    legislate loopholes.
        The causes of this problem are not recent. Frauds are bigger and
    more frequent because the laws that were passed 65 years ago to protect
    shareholders have been steadily worn down by special interests. Indeed,
    our laws now protect executives, accountants, and financial wheeler/
    dealers at the shareholders' expense instead of the other way around.
    We are reaping the harvest of this multi-decade legal hijacking now.
        Great civilizations in history crumble when special interests take
    control of Government machinery and use it for their benefit. I am well
    aware that these special interests are applying heavy pressure to each
    of you right now. If history is any guide, you will give in. I am
    begging you not to. The fact that we have had a good run of it the past
    200 years doesn't mean we will in the future unless you reverse this
    erosion of average Americans' protections.
        What most urgently has to be done? Let's start with the auditors.
        Right now we allow managers to pick and pay people to bless their
    work. If fifth graders picked their teachers, fifth graders would get
    A's. People invariably act in their self-interest.
        Not only that. We allow auditors and managers to write accounting
    and auditing standards. If fifth graders wrote grading standards, all
    fifth graders would pass. People invariably act in their self-interest.
    So who can be surprised that we have loophole-ridden, outdated
    standards that permit amazing things--what is permissible under current
    standards is more amazing than what is not.
        Not only that. We allow auditors to fund and run their own
    professional oversight. You all know better than that. No profession
    self-polices effectively. People invariably act in their self interest.
        What should you pass? Legislation that aligns auditors' interests
    with shareholders' and that stops aligning auditors' interests with the
    managers whose numbers they review. Unless it is in auditors' financial
    interest to protect shareholders, it won't happen reliably enough. You
    also need legislation that keeps oversight and enforcement power free
    of undue influence by auditors and issuers. Specifically:
        One: Require the board audit committee, not the managers, to hire
    the auditors. This is critical. Two: Fix the FASB's and the AICPA's
    accounting and audit standard setting systems with guaranteed funding
    and better accountability to investors--current accounting principles
    gave Enron crater-size loopholes. In other words fix the system for
    setting accounting and auditing standards, not just a couple of the
    worst products of the current systems. Three: Require CEO's, audit
    committee members and outside auditors to sign the financials as true
    and accurate--just like you and I sign our tax returns. (You think
    twice, don't you, when you sign?) Four: Remove nontrivial conflicts of
    interest--conflicts affect behavior. And five: Come down hard on
    individuals--not just companies--who break the law. If you merely fine
    audit companies for fraud, you simply increase a company's cost of
    doing business. Andersen settled case after case, wrote checks and
    moved on.
        Relying on peoples' honor or professionalism will not work. Chinese
    walls never work. Independent bodies do not remain independent long.
    Unless you harness self-interest as the legislative motivator, you will
    keep getting misleading financials.
        But auditors are only partly to blame for this mess. If your
    legislation focuses mostly on audit reform, it will be ineffective.
        It is not the auditor's job to oversee the company. It is not the
    auditor's job to detect fraud, absent certain red flags. It is not the
    auditor's job to prevent self-dealing or make business decisions. It is
    not the auditor's job to set the tone at the top and say it is wrong to
    lend a rich CEO $341 million. It is not the auditor's job to create
    secure jobs and shareholder value. These are jobs for managers and
    boards.
        Why have so many boards allowed terrible things to happen? Let me
    ask you this: If your staffers had absolute power to remove you from
    office, would you discipline them if they were stealing? Our system
    allows executives to pick the boards who are supposed to police them.
    So, although boards are supposed to represent shareholders, they do
    not. You participate in real elections so you care about your
    constituency. We shareholders should be so lucky.
        Fixing this fundamental misalignment is more important to fraud
    prevention than auditor independence because a board's responsibilities
    are more critical to a company's health. Yet current laws, rather than
    helping shareholders keep companies accountable, do the opposite. I
    will give you a few examples.

     If a shareholder buys a mere 5 percent of a company's stock,
        he/she has to file forms as if the Government is tracking a
        pedophile rather than an owner. The only way a shareholder can
        avoid this is to file a form promising to be passive. I am not
        making this up. So, shareholders without expensive form-filing
        lawyers have to promise to remain inert. Large pension funds that
        might otherwise be willing to pressure a troubled company, and who
        do not seek control, remain inert rather than filing burdensome
        forms that bring litigation risks with them. These requirements
        should be reworked.

     The Government tells us what issues we can and cannot bring up
        with our own employees--company executives. The SEC decides what
        issues shareholders can raise for a shareholder vote. Have any of
        you read these rules? They take almost every issue a shareholder
        ought to want to raise off the table:

      --We cannot ask about anything that is ``ordinary business''--which
            covers almost everything we should care about.
      --We cannot ask about anything that is extraordinary business either
            if an issue affects only a small part of the company.
      --We cannot ask about the thing we should most want to ask about--the
            election of the company's actual board. I am still not kidding.

        Many of the problems at Enron would be off limits for shareholders
        to raise under current rules. Worse, the SEC is free to, and often
        does, change its interpretations of these rules, without warning or
        recourse, so we do not know from 1 year to the next what we can
        ask.

     When the SEC does allow a shareholder to raise an issue for a
        vote, it requires the shareholder to send someone to the annual
        meeting, even though few companies require their own directors to
        attend and most shareholders vote by proxy and not in person. If
        the shareholder's representative is not there, the company can
        cancel the vote. So if you are disabled, have a job, are not rich
        or cannot
        travel, forget it.

     As if this is not enough, companies can, and do, move their
        annual meetings to hard-to-reach places, even foreign countries, so
        shareholders cannot get there. Annual meetings of major United
        States companies have been held in Russia-- or in towns without
        airports in Alabama on Friday afternoons before holidays. I am not
        kidding.

     Managers can call off a shareholder vote on election day if
        they see they are losing. (Though a Council member sued a company
        over this recently and more or less won.) Can you imagine if a U.S.
        Senator could do this--people would howl.

     If a shareholder wins a majority of votes cast for its
        proposal, companies can, with few exceptions, ignore the vote. Most
        do. Some companies ignore the majority shareholder votes even when
        an issue passes year after year. This makes the shareholder
        franchise a joke.

     Shareholders used to get to vote once a year on directors. But
        this year AT&T and Comcast have agreed to bar shareholders from
        voting again on the board of the new company until 2005.

     Some shareholder ballot items are rigged. The New York Stock
        Exchange allows brokers to stuff ballot boxes and vote for
        management when shareholders with broker accounts do not vote. Most
        shareholders do not know this. Studies show this throws important
        votes. The SEC and NYSE ignore our pleas to fix this.

        On this subject, I would caution you not to put the New York Stock
    Exchange in charge of any investor protections. The NYSE is a private
    sector corporation. It gets money from corporate executives--listing
    fees. Never expect private-sector bodies to act against those who fund
    them--they won't do it. Not surprisingly, the NYSE has, in my opinion,
    consistently used its Government powers to harm investors and protect
    managers, not the other way round. In my opinion, anyone who assigns
    investor protections to the NYSE doesn't want to protect investors.
    Democracies were designed to avoid precisely the problems we see over
    and over in this guild-like, Government-protected, reportedly highly
    profitable franchise.
        So if you do want to make a real difference, what legislation do
    you pass?
        We need better and immediate information about companies' executive
    compensation practices and directors' and CEOs' buying, selling,
    borrowing, and hedging
    activities. And we need better ways to control this compensation--votes
    on all stock option plans and an ability to put up board candidates if
    existing boards are giving away the shop. Fraudulently calculated pay
    needs to be returned.
        Why is all this so important? Because if we cannot control our
    employees' compensation, even honest people will gradually pay
    themselves more and more. It is happening all over. Power corrupts. In
    extreme cases companies become Ponzi schemes. Executives siphon money
    out in mega option grants and companies crash.
        There is a reason that nearly a quarter of major-company CEO's get
    their companies to give them huge loans--loans as high as a third of a
    billion dollars to one person. There is a reason these loans are often
    forgiven, subsidized, and/or used to hide CEO stock dumping. When
    shareholders' hands are tied behind their backs and key information
    stays secret, or stays secret until it is useless, executives get more
    and more generous with themselves. They do it because they can.
        If you curb executive compensation abuse, frauds become less
    profitable to fraudsters. Money is the main motivator. Focus on it.
        Neither the SEC nor the NYSE has used the powers they already have
    to address this problem adequately; if it doesn't come from you, it
    won't happen.
        What else? Senator Nelson's bill gets at many of the issues I have
    raised today. It requires that companies disclose directors' conflicts
    better--something we asked the SEC to do years ago but which just sits
    over there. In fraud after fraud we
    discover undisclosed director conflicts. There is no excuse for hiding
    this critical
    information. Nelson's bill also gets at board independence effectively
    because it uses a real-world definition of independence, not a weak
    definition, like those used by the NYSE and some companies.
        At our meeting next week Council members will be discussing
    legislative language that would make it easier for shareholders to put
    director candidates on the company's proxy and get issues on company
    ballots. Why do you let companies ignore our majority votes? Why does
    the NYSE throw shareholder votes by letting brokers, who are not
    shareholders, vote? Shareholders will keep markets clean, at no
    Government expense, if only you would let us by removing our handcuffs.
        Corporate governance should be at the heart of this debate, not at
    the periphery. Structures to stop frauds in the first place, rather
    than efforts to catch them when they arrive in auditors' hands, should
    be the starting point. Better information is useless without ways to
    act on it. We need both.
        Finally, enforcement. There is too little enforcement and too much
    of it targets companies and not human wrongdoers. Five years from now
    when this hubbub is history and you are an auditor or a director being
    pressed privately by management to go along with a fraud, will you be
    more deterred by the thought that your company may be fined or by the
    thought you may go to jail?
        When you punish companies, you punish innocent shareholders, the
    victims. I am therefore very pleased by the enforcement proposals in
    the Leahy-Daschle bill. Fraudsters will do anything you let them.
    Please stop letting them. And please do not go for mid-level
    scapegoats. Those who get the big bucks need to shoulder the
    responsibility. A CEO or a director going to jail would be a corporate
    governance shot heard round the world.
                                    *  *  *
        The Council is a not-for-profit association of large institutional
    shareholders. It
    includes corporate pension funds, Government pension funds, labor
    funds, endowments, international pension funds, entities such as the
    World Bank and TIAA-CREF, money managers and financial institutions.
    Its members manage over $2 trillion and represent millions of
    beneficiaries, employees, and voters. The Council is funded solely by
    members' dues. It is nonpartisan. It addresses investment issues
    exclusively.

                                   ----------
                  PREPARED STATEMENT OF THOMAS A. BOWMAN, CFA

                     President and Chief Executive Officer
               Association for Investment Management and Research
                                 March 20, 2002

    Introduction
        Good morning, I am Thomas A. Bowman, President and Chief Executive
    Officer of the Association for Investment Management and Research
     (AIMR ) and a holder of the Chartered Financial
    Analyst  (CFA ) designation. I would like to thank
    Chairman Sarbanes and other Members of the Committee for the
    opportunity to speak on behalf of the more than 150,000 investment
    professionals worldwide who are members of AIMR or are candidates for
    the CFA designation.
        AIMR is a nonprofit professional membership organization with a
    mission of advancing the interests of the global investment community
    by establishing and maintaining the highest standards of professional
    excellence and integrity. AIMR is most widely recognized as the
    organization that conducts qualifying examinations and awards the CFA
    designation. In 2002, over 100,000 candidates from 143 countries have
    registered to take the CFA exam, which is administered annually in more
    than 70 countries worldwide.
        Although not a license to practice financial analysis or investment
    management, the CFA charter is the only globally recognized standard
    for measuring the competence and the integrity of financial analysts.
    The CFA Program consists of three levels of rigorous examinations,
    which measure a candidate's ability to apply the fundamental knowledge
    of investment principles at a professional level.
        To be awarded the CFA charter, a candidate must pass sequentially
    all three levels of the examinations, totaling 18 hours of testing.
    They must have at least 3 years of relevant professional experience
    working in the investment decisionmaking process and fulfill other
    requirements for AIMR membership. All AIMR members, CFA charterholders,
    and candidates must sign and submit an annual Professional Conduct
    Statement that attests to their adherence to The Code of Ethics and
    Standards of Professional Conduct (AIMR Code and Standards). A
    violation of the AIMR Codes and Standards, including failure to file
    the Professional Conduct Statement, can result in disciplinary
    sanctions, including suspension or revocation of the right to use the
    CFA designation.
        The AIMR Code of Ethics requires AIMR members to always:

     Act with integrity, competence, dignity, and in an ethical
        manner when dealing with the public, clients, prospects, employers,
        employees, and fellow members.
     Practice and encourage others to practice in a professional
        and ethical manner that will reflect credit on members and their
        profession.
     Strive to maintain and improve their competence and the
        competence of others in the profession.
     Use reasonable care and exercise independent professional
        judgment.
    General Remarks
        The issues this Committee is addressing--corporate governance;
    integrity and adequacy of the U.S. financial reporting and disclosure
    system; the effectiveness of certified financial audits and regulatory
    oversight; insider trading and conflicts of interest among securities
    underwriters and financial analysts--are all extremely important to
    AIMR constituents. Although most AIMR members are not subject to the
    conflicts of interest that financial analysts working for Wall Street
    and similar ``sell-side'' firms face, all investment professionals are
    disadvantaged in their ability to conduct research, make investment
    recommendations to, or take investment action for, their investing
    clients by some companies' exploitation or disregard of financial
    accounting standards and the important principle of disclosure, and by
    any failure of regulatory oversight to enforce those standards.
        Enron's alleged exploitation of financial reporting rules is
    remarkable only for its egregiousness and its scale. We believe Enron
    is not an isolated case of accounting abuse. The current environment
    allows any company to play games with their financial reports to a
    greater or lesser degree. Research commissioned by the Financial
    Executives Institute (FEI), a private, nonprofit organization of
    company executives, supports our belief. This research shows that, from
    1998 to 2000, 460 companies
    restated various financial statement items, including many that were
    material. However, with the amount of flexibility that financial
    reporting standards allow, we are surprised that any company would
    resort to fraud to mislead even the most
    sophisticated investors.

    Adequacy of Financial Accounting Standards and the
    Regulatory Oversight System
        We believe that the Financial Accounting Standards Board (FASB) has
    the will to provide appropriate accounting and disclosure for the
    benefit of investors, but external pressures have prevented it from
    doing so. The existing standard on accounting for share-based
    compensation is a perfect case in point. However, there are several key
    areas with deficient rules that must be addressed immediately if
    investor needs are to be met. Such rules are an engraved invitation to
    the kind of abuses alleged at Enron. We offer the following examples:
    Consolidations and Off Balance Sheet Assets or Liabilities
        For the past 20 years, AIMR has advocated that all off balance
    sheet activities be reported in the parent company's financial
    statements. This includes activities such as leasing transactions as
    well as consolidation of subsidiaries, special purpose entities, joint
    ventures, and partnerships. Current accounting rules are inadequate
    because they have ``bright lines'' that allow companies to tailor their
    transactions to be on or off balance sheet. For example, subsidiaries
    are not consolidated unless the company owns more than 50 percent.
    Consolidation on an SPE requires more than 97 percent ownership.
    Partnerships and joint ventures can escape consolidation altogether.
    Rules for recognition of liabilities under leasing arrangements allow
    companies to keep significant assets and liabilities off the balance
    sheet and can distort the reporting of operating cashflows and
    earnings.

    Financial Assets and Liabilities
        As the market in derivatives and other complex financial
    instruments has grown, we have argued for reporting of financial assets
    and liabilities at fair value, rather than historic cost. Given the
    volatility of these instruments, we believe that reporting these assets
    or liabilities at their fair value is the only way to understand their
    risks and rewards. Corporate objection to this change has been fierce.
    The resulting standards require some instruments to be recorded at fair
    value but others not; some changes in value are recorded in earnings
    but others not. Even when fair value changes are recorded in earnings,
    companies need not disclose in what income statement item they appear.
    This situation turns financial analysis into an impossible game of
    hide-and-seek.
        Investors also need more informative disclosures regarding
    financial assets and
    liabilities. In response to rule proposals by the Securities and
    Exchange Commission (SEC), the AIMR argued for disclosure of
    sensitivity analysis to allow investors to understand fully the
    potential risks of these instruments to changing market conditions.
    Companies lobbied heavily against improved disclosures. The Senate
    Committee on Banking, Housing, and Urban Affairs held hearings at which
    the FASB, SEC, and AIMR testified in support of the SEC rule proposal,
    but corporate issuers opposed the improved disclosures. The regulations
    that were implemented give companies too much flexibility in the type
    of disclosure. They are generally so simplistic as to be all but
    useless to investors.

    Share-Based Compensation
        Stock options and other equity-based compensation have become an
    important part of executive compensation in the United States,
    particularly in new and growing industries. Such compensation should be
    a way to align management and shareowner interest, but unfortunately
    has led to earnings manipulation to improve share price. Contrary to
    what managements would have investors believe, stock options are not
    ``free'' or of ``little or no value.'' If so, why would management
    accept them in lieu of cash? In fact, exercise of executive stock
    options reduces external shareholder interest and increases
    management's interest, generally on unfavorable terms to shareholders.
    Nor do these options better align management and shareholder interests,
    since research shows that managers are more apt to sell the shares they
    receive when options are exercised.
        In 1994, to its credit, the FASB was prepared to issue a new rule
    to require recognition of compensation expense for stock options. Heavy
    corporate lobbying and legislative intervention, however, led the FASB
    to allow footnote disclosure rather than recognition. Disclosure is no
    substitute for recognition and measurement. A recent AIMR survey shows
    that 83 percent of responding fund managers and analysts support
    recognition and believe that current disclosures are inadequate and
    difficult to use.

    Pro Forma Earnings
        Another creative way in which managements mislead investors and
    manipulate investor expectations is by communication of ``pro forma
    earnings,'' company-specific variations of earnings, or ``earnings
    before the bad stuff.'' With all its deficiencies, we believe that
    earnings data based on Generally Accepted Accounting Principles (GAAP)
    are still the most useful starting point for analysis of a company's
    performance. Analysts and other investors at least know how GAAP
    earnings are computed and, hence, there is some comparability across
    companies. We believe GAAP earnings should always be displayed more
    prominently than non-GAAP earnings data.
        Unfortunately, just the opposite seems to be the norm, particularly
    in press releases where pro forma earnings get the most emphasis and
    GAAP earnings may not be mentioned at all. GAAP earnings and associated
    balance sheet may only become available to investors in SEC filings 1
    to 2 weeks after pro forma earnings are announced. While pro forma
    earnings can be helpful supplemental information for analysts, the
    practice of providing pro forma earnings is widely abused. Companies
    selectively exclude all sorts of financial reporting items, including
    depreciation, amortization, payroll taxes on exercises of options,
    investment gains and losses, stock compensation expenses, acquisition-
    related and restructuring costs. Mr. John Bogle, the respected
    investment professional, recently noted in a speech to the New York
    Society of Securities Analysts, ``In 2001, 1,500 companies reported pro
    forma earnings--what their earnings would have been if bad things
    hadn't happened.'' We recommend that either the FASB or SEC curtail
    this practice or ensure that pro forma earnings data never have more
    prominence than GAAP earnings in company communications.
        Inappropriate legislative intervention in the standard setting and
    the regulatory processes has resulted in less transparency for
    investors in preference to corporate interests. We hope that such
    intervention will cease. The FASB must be allowed to be independent in
    its decisionmaking and be supported with adequate funding to proceed
    quickly and expeditiously to address both longstanding and emerging
    issues. The FASB cannot only be reactive to financial reporting
    failures; it must be proactive and continuously review and update its
    standards. We are concerned that its current rush to ``fix'' the
    existing standard for Special Purpose Entities (SPE) will be only a
    ``Band-Aid'' for SPE's rather than a solution to the larger, underlying
    problem of off balance sheet liabilities.
        We do not believe that the SEC's regulatory oversight and
    enforcement of FASB's standards and its own regulatory rules are
    consistent or adequate. We also observe that its attitude toward
    corporate/issuer versus investor/user interests changes when the SEC's
    leadership and membership changes. Even when the SEC has been concerned
    with investor needs, it has severely lacked the economic and human
    resources to address all the issues, including those for which here
    there are no
    accounting or disclosure standards.
        For example, in 1996, SEC staff approached AIMR about a project on
    disclosure requirements for asset-backed securities. Considerably less
    disclosure is mandated for these securities than for equity securities,
    either in securities offering documents or in subsequent continuous
    disclosure filings. To respond to the SEC's request, we convened a task
    force of interested and knowledgeable AIMR members who expressed
    concerns about their ability to fulfill their fiduciary
    responsibilities in the current environment and were excited that
    better disclosure might be forthcoming. They were anxious to
    communicate the investor needs to the SEC. The task force drafted a
    formal response to the request, outlining the information that
    investors need to make good initial and on-going decisions about these
    securities; why the information was needed; and how it would be used.
    That is the last that we have heard from the SEC about this project. In
    answer to our subsequent inquiries about the project's status, we were
    told that the staff members assigned to the project had left the SEC
    and the project would be resumed when new staff was assigned. We have
    heard nothing since. We still consider this to be an important project
    and an important area where critical investor needs for information are
    not being met.

    Audits and Auditors
        Financial statements should be the single best source of
    information about a company, its financial health and its prospects for
    the future. The Investors use the information they contain as an
    analytical tool, as a ``report card'' of management's performance and
    accountability and as an early indicator of the company's future
    success or potential failure. Financial statements are an indispensable
    source of information for shareholders and investors, employees,
    lenders and suppliers, customers, governments, and regulatory agencies.
    But these users of financial statements must have assurance that the
    information is reliable and credible.
        Such assurance begins with management, which must establish a
    strong internal control system to facilitate reliable financial
    reporting and assist the company in complying with applicable laws and
    regulations. But high quality internal controls will not guarantee a
    company's success, reliable financial reporting, or compliance with
    laws and regulations. Decisionmaking can still be faulty and simple
    errors and mistakes can creep in. Controls can be circumvented by
    collusion of two or more people and management generally has the
    ability to override the system. The chief executive officer, therefore,
    must accept ``ownership'' of the system and set a tone that strengthens
    the integrity and ethics of the control environment. Of particular
    importance to the process are the financial officers and their staffs.
        Although financial statements are the product and responsibility of
    management and a high quality internal control system is critical, no
    external party plays as
    important a role in the achievement of reliable financial reporting
    than the independent certified public accountants. They must bring an
    independent and objective view to management and the board of
    directors. Auditors bring assurance about the reliability and
    credibility of financial statements to a higher level, and attest to
    their fairness in conformity with Generally Accepted Accounting
    Principles.
        Unfortunately, although internal controls are the first line of
    defense against fraudulent or misleading financial statements, the
    auditor does not generally focus on their adequacy. Therefore, one of
    our recommendations is that auditors be required to test and report on
    the effectiveness of internal controls as part of their audit
    responsibilities. An assurance about internal controls should be
    reported publicly as part of the audit opinion. We also believe that
    required audit procedures must be improved to ensure the auditor has a
    greater ability to detect fraud.
        Independence is an essential element in an auditor's ability to
    perform effective audits, disclose improper accounting choices, whether
    in accordance with GAAP or not, and enhance the credibility of
    financial statements. Arthur Andersen, Enron's auditor, has come under
    such intense pressure that it may not survive. But at some time, all of
    the major international, ``Big 5,'' accounting firms have been charged
    with a lack of independence, similar in kind if not severity.
    Investment professionals have understood these conflicts for some time
    and have viewed auditors as advocates for their corporate clients
    rather than for shareholders and for investors. One only has to read
    audit firm advertisements or a description of their business to
    understand that auditors support their clients' interests. The
    following descriptions have been copied from the websites of two of the
    Big 5 audit firms, but are indicative of all:

     ``A global leader in professional services, Ernst & Young
        helps companies in businesses across all industries--from emerging
        growth companies to global powerhouses--identify and capitalize on
        business opportunities. Our 84,000 people in more than 130
        countries worldwide can implement a broad array of solutions in
        audit, tax, corporate finance, transactions, online security,
        enterprise risk management, the valuation of intangibles, and other
        critical business-performance issues. We audit 113 of the Fortune
        500 companies and are one of the largest providers of tax services
        in the world. Our worldwide revenues for the fiscal year ended June
        30 were $9.9 billion.''

     ``Deregulation, privatization, emerging markets, and quantum
        improvements in telecommunications and information technology have
        radically altered the business landscape creating complex problems
        that are challenging chief executives. To help you meet these
        demands, . . . [PricewaterhouseCoopers'] Assurance and Business
        Advisory Services (ABAS) practice in the United States offer you a
        broad range of innovative and cost-effective solutions, drawing on
        our worldwide resources we provide Assurance on the financial
        performance and operations of your business. Through our Global
        Risk Management Solutions, we help you manage the totality of
        risks--financial, operational and systems, and strategic--and
        thereby improve your financial and business performance. We provide
        Transactions Services as a core part of mergers, acquisitions,
        divestitures, joint ventures, spinoffs, and strategic alliances. We
        provide Services such as Middle Market Advisory Services that
        utilize sophisticated business solutions to help clients maximize
        their growth potential and remain competitive.''

        AIMR members are concerned about the effectiveness of audits and
    the independence of auditors. A subcommittee of the AIMR U.S. Advocacy
    Committee has dedicated itself to responding to initiatives of the
    Independence Standards Board and others on audit issues. In September
    2000, we testified before the SEC on this important issue. We believe
    that independent auditors, by helping to maintain the credibility of
    financial information, also help to maintain the overall stability and
    strength of financial markets. Reliable and credible information
    ensures that capital is allocated to those investments that create the
    highest returns commensurate with the risks and uncertainties of the
    investment.
        To facilitate our responses to proposed changes to auditor
    independence requirements, AIMR conducted three separate surveys of
    AIMR members and CFA candidates who work as either financial analysts
    or portfolio managers. Each survey addressed one of the following
    issues: Financial ownership and interests in audit clients held by
    audit firms, partners or other audit professional staff; nonaudit
    services provided to audit clients; and employment relationships
    involving personnel with the audit firms and clients. A total of 2,273
    individual responded to the three surveys sent to AIMR members working
    in the United States.
        There were 875 respondents to the survey on financial ownership and
    interests. Over 85 percent of the respondents indicated that audit
    firms and audit partners should be prohibited from owning shares in
    their audit clients, and over 77 percent indicated that holdings in the
    audit client should also be prohibited for professional staff on the
    audit. There was less concern about other partners or professional
    staff.
        Over 50 percent of respondents to the survey on nonaudit services
    indicated that providing the following services impairs independence:

        (1) Asset valuation and appraisal (65 percent).
        (2) Accounting, payroll, and other outsourced activities (62
    percent).
        (3) Legal services (62 percent).
        (4) Executive compensation consulting and training (61 percent).
        (5) Treasury management (60 percent).
        (6) Risk management (59 percent).
        (7) Other management consulting (53 percent).

        We believe that prohibiting all nonaudit services would be too
    severe and that some, such as tax planning and compliance or
    information systems design, may provide beneficial synergies to the
    audit.
        Our primary concern is actually with the basic concept of audit
    firms marketing nonaudit services, even to nonaudit clients. The
    evolution of the audit firm into a multi-service business advisory
    firm, providing consulting and management advisory services in addition
    to tax and audit services, has shifted the emphasis of the firm's
    practice from the original purpose of the audit and formation of a
    professional opinion on the financial statements. This is entirely
    understandable; audit services are extremely price sensitive and
    nonaudit services are far more profitable. The audit is viewed within
    the firm as a commodity or ``loss leader'' and nonaudit partners and
    activities have more value and prestige.
        We recommend the following enhancements to existing rules regarding
    auditor independence:

     An audit firm should be prohibited from having any ownership
        interest in an audit client unless this interest is held in trust
        by an independent trustee, such as a pension plan managed by a
        third party or mutual fund. This prohibition should also apply to
        audit clients having a financial interest in the audit firm.

     Certain nonaudit services, that is, legal services or
        appraisal/valuation services, should be prohibited or severely
        limited in scope, and adequate safeguards must be in place to
        segregate the audit practice from nonaudit services.

     Full and fair disclosure of all conflicts of interest between
        a client and its auditors must be required. Such disclosures would
        include information about fees for nonaudit services, the nature of
        nonaudit services provided, and post-audit employment of audit firm
        professionals by the audit client.
    Corporate Governance
        Corporate governance and the influence of investors in the
    governing process are issues of growing importance in the global
    capital markets. Good corporate governance protects the interests of
    shareholders and investors. It is critical not only to the development
    and integrity of financial markets, but also to investor confidence in
    these markets, giving investors an incentive to risk their capital.
    Given the magnitude of investment in the United States, the potential
    power and influence that institutional investors, representing millions
    of individuals, can wield over the companies in which they hold
    interests is staggering.
        Corporate governance should foster transparency: Full disclosure of
    the conditions--risks and opportunities--to which investors in a
    particular market, or a particular company, are subject. At the macro
    level, these conditions encompass a market's various legal, financial
    reporting and disclosure, regulatory and supervisory standards and
    regimes. At the micro level, these conditions include an individual
    company's financial performance and outlook, as well as full disclosure
    of how a company is governed, and the qualifications, responsibilities
    and compensation of its board of directors. Even more importantly, a
    good corporate governance framework provides evidence to shareholders
    and potential investors of the independence of the board of directors.
    Only when companies exhibit good corporate governance will investors
    have the confidence to provide them with the capital they seek.
        A framework for corporate governance must encompass the duties,
    responsibilities and powers of the board of directors, the procedures
    for selecting members of the board, and the process for making those
    decisions that materially impact a company's value. Such decisions
    include whether to merge with a competitor, to divest certain assets,
    or to repurchase equity. Essentially, frameworks or codes for corporate
    governance are designed to help boards fulfill their fiduciary duty--
    doing the right thing, even when no one is looking--thereby earning the
    trust, confidence, and capital of investors, especially outside
    investors.
        Best practice frameworks exist and can be applied. Even markets
    that already recognize the need for good corporate governance can
    benefit from improvement to their frameworks. To that end, we recommend
    the following best practices in corporate governance:

     At least half of the directors should be independent,
        nonexecutive officers of the corporation, even if one group owns
        the majority of outstanding equity shares.
     Shareholder voting rights and meeting rights should ensure
        that one share has one vote, and decisions are not made by a show
        of hands.
     The following three independent committees should be appointed
        by the Board, and not management:

      --Audit
      --Nominations
      --Compensation

        Standard setting bodies increasingly recognize that, to govern
    effectively, board members need to have a relatively high level of
    knowledge of the corporation's business activities, in addition to its
    financial condition. For example, the National Association of Corporate
    Directors has issued a set of new guidelines for enhancing the
    professionalism of board members. We support the following
    qualifications and responsibilities for directors and recommend their
    adoption:

     Directors should be active participants and decisionmakers in
        the boardroom, not merely passive advisers or ``rubber stamps'' for
        management proposals.

     Directors should limit their number of board memberships.

     Directors should limit their length of service on a board to
        10 to 15 years so that new directors with fresh insights and a
        renewed independence can be elected.

     Directors should immerse themselves in both the company's
        business and its industry while staying in touch with senior
        management.

     Directors should know how to read a balance sheet and an
        income statement and understand the use of financial ratios so they
        can do their own analysis of the company's performance and detect
        early warning signs of emerging problems.

     Directors should own a significant equity position in the
        company.

        We also recommend that institutional investors play a greater role
    in corporate governance. The fiduciary duty of pension fund sponsors
    and trustees and mutual fund managers entails duties of care and
    loyalty to their investors and clients. It entails an obligation to add
    value to clients' investments and protect their interests in the long-
    term health of the companies in which they invest. This is particularly
    important for passive or index fund managers who may have significant
    positions in a company's securities but do not have the flexibility to
    influence corporate management by simply selling shares. As the founder
    of Deutsche Bank, Mr. George
    Siemens once said, ``If one cannot sell, one must care.''
        We recommend that institutional investors assume a role that
    ensures that corporate policies serve the best interest of a
    corporation's investor-owners. Although we would not expect that
    institutional investors would seek involvement in the day-to-day
    operations of the companies in which they invest, we believe that
    institutional investors should recognize the need for conscientious
    oversight of and input into management decisions that may affect a
    company's value. Although institutional investors should follow clear
    and transparent general voting guidelines, available to all investor-
    clients, in voting their proxies, they must also recognize the need to
    review all votes individually and not permit minority shareholders to
    be treated unfairly.
        Ideally, we would like to see a private-public partnership of
    investors, financial industry participants, and Government regulators
    that would unite to help eliminate market barriers by establishing,
    implementing and maintaining corporate governance standards that
    mandate transparency, timeliness and accuracy of corporate financial
    reporting. For these standards to work and offer real investor
    protection, there must also be enforcement of fiduciary laws and
    standards through effective market monitoring and surveillance by
    regulators as well as self-regulatory organizations. The standards and
    their enforcement work together to create a level playing field for all
    market participants--foreign and domestic--and to encourage competition
    in the market. The end result is better protection for investors,
    instilling them with confidence, and giving them more and better
    investment choices and increased access to opportunities.
    Analyst Independence
        To reiterate, the AIMR mission is to advance the interests of the
    global investment community by establishing and maintaining the highest
    standards of professional excellence and integrity. Clearly, the
    erosion of investor confidence in the independence and objectivity of
    ``Wall Street'' research reports and recommendations does not enhance
    those interests and could seriously harm the reputation of the entire
    investment profession. We believe that all market participants have a
    mutual responsibility to create and maintain an environment that
    enables ``Wall Street''
    research analysts to fulfill their responsibilities with independence
    and objectivity. Only if the investing public believes that the
    information available to them is fair, accurate, and transparent can
    they have confidence in the integrity of the financial markets and the
    investment professionals who serve them.
        Investment professionals expect the companies they research,
    recommend, or whose securities they hold to provide full and fair
    disclosure. They should expect no less of themselves. But just as
    investment professionals would not make an investment recommendation or
    take investment action based on earnings information alone, so too
    investors should not make investment decisions based on a simple, one-
    dimensional rating.
        AIMR is committed to the principle that the best interests of the
    investing client must always take precedence over the needs of the
    research analyst, investment manager, and his or her employer. With
    respect to relationships with clients and prospective clients, The Code
    of Ethics and The Standards of Professional Conduct of our organization
    specifically require AIMR members to:

     Exercise diligence and thoroughness in making investment
        recommendations.

     Have a reasonable and adequate basis, supported by appropriate
        research and investigation, for such recommendations or actions.

     Use reasonable care and judgment to achieve and maintain
        independence and
        objectivity in making investment recommendations or taking
        investment action.

     Act for the benefit of their clients and always place their
        clients' interests before their own.

     Distinguish between the facts and the opinions in the
        presentation of investment recommendations.
     Consider the appropriateness and suitability of investment
        recommendations or actions for each client.

        AIMR members are individual investment professionals, not firms.
    They work in various capacities in the global investment industry.
    Approximately 9,000 (18 percent) of our members work for ``Wall
    Street'' or similar firms worldwide, known as the ``sell-side'' (for
    example, broker-dealers and investment banks). Those who work as
    research analysts for these firms, whose independence and objectivity
    have been questioned, are an even smaller percentage of AIMR members.
    In contrast, more than 65 percent of AIMR members work as investment
    advisors or fund managers for the ``buy-side,'' the traditional, and
    still the primary, purchasers of ``sell-side'' or ``Wall Street''
    research. They are not subject to most of the conflicts of interest
    faced by sell-side analysts.
        Based on our experience in setting ethical standards for AIMR
    members, I can tell you that ethical standards are most effective when
    developed by the profession and voluntarily embraced rather than
    externally and unilaterally imposed. In making your determination about
    whether to trust the private sector to manage analyst conflicts of
    interest effectively, I ask that you consider AIMR's commitment to
    developing and recommending practical, long-term solutions for the
    conflicts of interest and ethical dilemmas that Wall Street analysts
    face.
        It is important to recognize that the conflicts that Wall Street
    analysts face are not new. They have, however, been magnified in an
    environment that emphasizes short-term performance and where profits
    from research and brokerage are minuscule compared to profits from
    investment banking and other corporate finance
    activities. In this environment, penny changes in earnings-per-share
    forecasts have dramatic effects on share prices. And in this
    environment, individual investors rely on analyst ratings or on
    recommendations without even reading their research
    reports--in contrast to institutional investors, who learn what they
    can from the report, judge the validity of the methodology and
    analysis, and ignore the ratings. It is more than unfortunate--it is
    untenable--that the serious business of investing one's assets for
    retirement has become a ``sport,'' like horse racing where investors
    are always looking for ``hot tips.'' Unfortunately, investments are not
    ``sure things.'' Many, in fact, are ``long shots.'' Investors must be
    cautioned about making investment decisions based on ratings alone.
        The analysts' responsibility is to conduct thorough and
    comprehensive research and then to form an opinion about the future
    prospects for a security. This opinion is communicated by a
    recommendation or rating based on their firm's rating system. The
    resulting report is then ``sold'' to investing clients, primarily
    institutional investors, who direct brokerage to the firm.
    Unfortunately, this responsibility must be carried out despite
    sometimes opaque and misleading financial information, designed to hide
    the ``bad news'' while promoting the ``good news.'' Unless analysts'
    clearly see through companies' bending of accounting rules, the
    positive bias in financial statements can influence analysis.
        Besides this bias, are Wall Street analysts sometimes pressured to
    be positive about the prospects of the companies they follow? Yes. But
    these pressures come from many sources, and not all from their
    employers. Effective solutions to these pressures can only be developed
    when all the pressures and those who contribute to them are identified
    and addressed.
        In the wake of Enron, the particular conflict posed by Wall Street
    analysts' involvement in their firms' investmentbanking activities
    continues to be the focus of media attention. However, even if Wall
    Street investment banks were prohibited from selling research to
    investing clients or if in-house research analysts were prohibited from
    collaborating with investment banking, the problem of analyst
    objectivity would not be solved. As long as securing corporate clients
    for investment banking is in part dependent upon keeping management
    ``happy'' with analyst ``buy'' recommendations, investment banking will
    inevitably seek out those research analysts, independent or not, who
    are favorable toward the client company.
        Collaboration between research and investment banking is by no
    means the only conflict that must be addressed if we are to provide an
    environment that neither coerces nor entices analysts to bias their
    reports and recommendations. For example, strong pressure to prepare
    ``positive'' reports and make ``buy'' recommendations comes directly
    from corporate issuers, who retaliate in both subtle, and not so
    subtle, ways against analysts they perceive as ``negative'' or not
    ``understanding'' their company. Issuers complain to Wall Street firms'
    management about ``negative'' or uncooperative analysts. They bring
    lawsuits against firms--and analysts personally--for negative coverage.
    But more insidiously, they ``blackball'' analysts by not taking their
    questions on conference calls or not returning their individual calls
    to investor relations or other company management. This puts the
    ``negative'' analyst at a distinct competitive disadvantage, increases
    the amount of uncertainty an
    analyst must deal with in doing valuation and making a recommendation,
    and
    disadvantages the firm's clients, who pay for that research. Such
    actions create a climate of fear and intimidation that fosters neither
    independence nor objectivity. Analysts walk a tightrope when dealing
    with company managements. A false step may cost them an important
    source of information and ultimately their jobs.
        Institutional clients, the ``buy-side,'' have their own vested
    interests in maintaining or inflating stock prices and, thus
    indirectly, recommendations and ratings. Fund managers do not want to
    be ``blind-sided'' by a change in recommendation that might adversely
    affect their portfolio performance, and hence their compensation. When
    they find out about a negative analyst, the ``buy-side'' has been known
    to ``turn in'' that analyst to the subject company.
        An investment professional's personal investments and trading pose
    another conflict, one that AIMR addressed extensively in a 1995 topical
    study that now forms an important component of the AIMR Code and
    Standards. We do not believe that it is in clients' best interests to
    prohibit Wall Street analysts, or other investment professionals for
    that matter, from owning the securities of the companies they follow or
    in which they invest their clients' money. Rather, permitting personal
    investments better aligns analyst and investor interests as long as
    strict, and enforced, safeguards are in place that prevent analysts
    from front running their clients' or their firms' investment actions,
    and that prohibit analysts from trading against their recommendations.
        The content and quality of research reports and investment
    recommendation is also affected by this simple fact: Analysts are
    human. No matter how experienced, expert, or independent, Wall Street
    analysts do not have crystal balls; they are not infallible. Even in
    the absence of fraud, the more opaque a company's disclosures and the
    more reticent company management, the more difficult it is for the
    analyst to predict changes in the company's fortunes. Much has been
    made about some Wall Street analysts' failures to change their
    recommendations as the price of Enron began and continued to fall. But
    I wish to remind the Committee that many ``buy-side'' investment
    managers with major positions in Enron, who do not suffer from the
    alleged investment banking conflicts of Wall Street analysts, have
    admitted that they too could not predict soon enough the downturn in
    Enron's fortunes or the speed with which it would spiral into
    bankruptcy. These failures were not due to a lack of independence,
    skill, or due diligence, but to the lies allegedly told them by a
    company that apparently betrayed their trust.
        I have recommended improvements to accounting standards, regulatory
    enforcements, auditor independence, and corporate governance. I can do
    no less for analyst independence. In recommending specific measures to
    increase the likelihood that investors will receive unbiased
    recommendations from Wall Street, I am seeking to inform as well as
    protect those investors who may not be aware of the pressures on Wall
    Street analysts from the sources I cited and the limitations in
    analysts' ability to make foolproof recommendations. This is especially
    true for those investors who receive shorthand information through
    various media outlets rather than by purchasing and reading the full
    research report directly from the Wall Street firm. Surely, no one
    would recommend that individuals make important decisions, such as
    taking medication or buying a home, solely on what they read in the
    press or hear on television. How much more critical then are the
    investment decisions that can adversely affect their own and their
    families' financial welfare?
        We do not dispute that some Wall Street firms may pressure their
    analysts to issue favorable research on current or prospective
    investment banking clients, or that this practice must stop. These and
    the other forces I mentioned create an environment replete with
    conflicts of interest, one that undermines the ethical principles upon
    which the AIMR and the CFA Program are based. We condemn all who foster
    or sustain it.
        However, the relationship between research and investment banking
    is symbiotic and an important part of the firm's due diligence when
    evaluating whether or not to accept a company as an investment banking
    client. Although we do not believe that this collaborative relationship
    is inherently unethical, it poses conflicts that can lead to serious
    ethical problems for analysts, especially when a large portion of the
    firm's profitability comes from investment banking. If such
    collaborations are allowed, investment banking firms must take
    particular care to have policies and procedures that minimize and
    manage all real and potential conflicts, and that fully and fairly
    disclose them to investors.
        To effectively manage these conflicts, AIMR is currently developing
    proposed standards to improve research objectivity. These standards
    include the following recommendations:

     Firms must foster a corporate culture that fully supports
        independence and objectivity and protects analysts from undue
        pressure from issuers and investment banking colleagues.

     Firms must establish or reinforce separate and distinct
        reporting structures for their research and investment banking
        activities so that investment banking never has the ability or the
        authority to review, approve, modify, or reject a research report
        or investment recommendation.

     Firms must establish clear policies for personal investment
        and trading to ensure that the interests of investors are always
        placed before analysts' own.

     Firms must implement compensation arrangements that do not
        link analysts' compensation directly to their work on investment
        banking assignments or to the success of investment banking
        activities, but rather directly link, and heavily weight, analysts'
        compensation to the quality and the comprehensiveness of their
        research and the accuracy of their recommendations.\1\ (Only when
        compensation arrangements explicitly include quantitative
        measurable attributes, such as performance of stock recommendations
        and accuracy of earnings forecasts, as well as qualitative
        characteristics, that reference the quality and comprehensiveness
        of the research on which recommendations are based, will analysts
        have the proper incentives to do truly independent, objective, and
        high quality research.)
    ---------------------------------------------------------------------------
        \1\ We believe that it would be interesting and informative to see
    the pattern of Wall Street analysts' compensation vis-a-vis their
    recommendations and vis-a-vis the success of their firm's investment
    banking activities for their industry and in total.

     Firms must make prominent and specific, rather than marginal
        and ``boilerplate,'' disclosures of conflicts of interest. Such
        disclosures must be written in ``plain English'' so that they are
        accessible and that they are understood by the average reader or
    ---------------------------------------------------------------------------
        listener.

        Enhanced disclosures are a key part of the AIMR proposal. At a
    minimum, we believe that Wall Street analysts must disclose--and their
    firms must require them to disclose--the following information
    prominently on the front of the research report and, even more
    importantly, in all media interviews and appearances:

     Investment holdings of Wall Street analysts, their immediate
        families, the Wall Street firm's management and the firms
        themselves.

     Directorships on the subject company's board by the analyst, a
        member of their immediate family, or other members of the Wall
        Street firm.

     Compensation that was received by the Wall Street firm from
        the subject company and the nature of the relationship or services
        provided.

     Where and how to obtain information about the firm's rating
        system, and its policies to protect and promote independence and
        objectivity.

     Material gifts received by the analyst from either the subject
        company or the Wall Street firm's investment banking or corporate
        finance department.

        We caution, however, that effective disclosure in media interviews
    and appearances will only be accomplished with the full cooperation and
    active support of the media itself. Neither Wall Street analysts nor
    their firms should be held accountable for what the media won't publish
    or broadcast. We call upon the media to ensure that these disclosures
    reach their intended audience.
        We also think that rating systems need to be overhauled so that
    investors can better understand how ratings are determined and compare
    ratings across firms. Ratings must be concise, clear, and easily
    understood by the average investor. We would also suggest that, in
    addition to the recommendation itself (``buy-hold-sell'' or market
    ``outperform-neutral-underperform''), the rating should also include a
    risk element, to provide a measure of expected price volatility or
    other risks, and a time horizon, to provide an estimated time period
    for the stock price to reach the price target or which the analyst
    expects the current rating to hold. We believe that adding a risk
    measure and time horizon to the rating, and always communicating all
    three elements, will provide investors who do not read or have access
    to the full research report with better information by which to judge
    the suitability of the investment to their own unique circumstances and
    constraints.
        Finally, under normal circumstances, Wall Street analysts and their
    firms should also be required to update or reconfirm their
    recommendations on a timely and regular basis, and more frequently in
    periods of high market volatility. They should be required to issue a
    ``final'' report when coverage is being discontinued and provide a
    reason for discontinuance. Quietly and unobtrusively discontinuing
    coverage or moving to a ``not rated'' category, for example, a
    ``closet'' sell, does not serve investors' interests.
    Closing Remarks
        In closing, I would like to impress upon the Committee that the
    AIMR and its members appreciate the seriousness of the problems facing
    our financial markets at this time. We believe that only with the
    cooperation and involvement of all market participants will effective
    long-term solutions be developed and implemented. Specifically, we are
    convinced that:

     Until the Financial Accounting Standard Board and the
        Securities and Exchange Commission are truly free of undue external
        influences, and thereby able to establish and enforce financial
        reporting and disclosure standards that command full transparency,
        investors will be disadvantaged.

     Until financial reporting standards are developed for the
        benefit of investors, the primary users of financial statements,
        instead of for the benefit of issuers, enabling them to manipulate
        earnings and hide liabilities and losses, investors will be
        disadvantaged.

     Until auditors renounce their advocacy of corporate interests,
        regain their lost independence, and become vigilant watchdogs for
        truth and fairness in financial reporting, investors will be
        disadvantaged.

     Until corporate management understands and embraces the need
        to put their companies' long-term business targets and shareholder
        interests first, rather than managing earnings to maximize their
        own personal compensation--and publicly acknowledge their
        commitment to this end--investors will be disadvantaged.

     Until corporate management recognizes that good companies are
        not always good investments and desists in retaliating against
        analysts and their firms for issuing negative opinions on the
        company's securities, investors will be disadvantaged.

     Until Wall Street and similar firms worldwide recognize that
        it is in their best interest, including their financial interest,
        to reward high quality, independent research and require their
        analysts to express objective views on their assigned companies
        without recrimination or financial disincentives, investors will be
        disadvantaged.

     And finally, until all Wall Street analysts:

      --Demand quality financial reporting so that they are confident in
            the reasonableness and in the adequacy of the information that
            forms the basis for their
            recommendations.
      --Ferret out information not contained in the primary financial
            statements, but obscured in footnotes and other disclosure
            documents.
      --Embrace personally and cling tenaciously to a strict code of ethics
            and standards of professional conduct that require them always
            to place the interests of their investing clients before their
            own--or their firm's--investors will be disadvantaged.

        Finally, I believe that if we put even a fraction of the creativity
    and energy into strengthening the integrity of our financial markets
    that has gone into undermining it--and I mean strengthening each and
    every one of its disparate elements that I have discussed today--we
    will be rewarded with renewed investor confidence in those markets,
    greater reliance on financial reporting information and the research
    and recommendations that flow from analysis of that information, and
    with the kind of transparency that will be a long-term benefit for
    investors in those markets and the envy of investors in every other
    financial market in the world.
        Thank you. I will be happy to answer any questions that you might
    have.

                                   ----------

                     PREPARED STATEMENT OF DAMON A. SILVERS

                           Associate General Counsel
     American Federation of Labor and Congress of Industrial Organizations
                                 March 20, 2002

        Good morning, Mr. Chairman, my name is Damon Silvers, and I am an
    Associate General Counsel of the American Federation of Labor and
    Congress of Industrial Organizations. The AFL-CIO believes today's
    hearing on corporate governance in the aftermath of the collapse of
    Enron and similar events at companies like Waste Management and Global
    Crossing is an essential part of a much needed effort at comprehensive
    reform of the capital markets.
        Corporate governance is a web of relationships. These relationships
    should work toward getting companies to make smart, long-term focused
    decisions that lead to sustainable benefits to all who participate in
    the company. Unfortunately, Enron is 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. At Enron the management, the board of directors, the
    outside auditors, and the Wall Street analysts all failed to protect
    investors. And similar events have both preceded and accompanied
    Enron's collapse at Global Crossing, Cendant, Waste Management,
    McKesson and more. The source of these failures lie in the
    unregulated conflicts of interest that permeate the relationships
    between the management of these companies and the people who were
    supposed to be protecting
    investors.
        The AFL-CIO's 62 member unions and their 13 million members urge
    that this Committee take up the task of crafting comprehensive
    legislation to take on the conflicts of interest in the capital markets
    and in the board rooms of America's public companies. You have heard in
    prior hearings from those who have benefited and continue to benefit
    from these conflicts as to why they must be allowed to continue, from
    those who would lull you to sleep with the lullaby that everything will
    be alright if you just do nothing. That may be the view from K Street,
    but it is not how things look for thousands of working families in
    Houston and Portland, Oregon and Rochester, New York who have lost
    their retirement savings and in some cases their jobs and their health
    care because they believed what they were told--by their
    employers, their employers' accountants, and the analysts that
    interpreted the accountants' numbers.
        Let me then address what a comprehensive reform package requires.
        Corporate governance starts with boards of directors. Public
    company boards need strong independent directors who are accountable to
    investors. Part of the problem at Enron was that Enron touted directors
    as independent who really had significant ties to Enron management,
    ties that Enron did not have to disclose. So investors first need
    complete disclosure of all ties between board members, the company, and
    company management. Then this Committee should encourage the NASD and
    the New York Stock Exchange to require that this higher standard of
    independence be the relevant standard for measuring the independence of
    auditor and compensation committees.
        With genuine independence from management must come genuine
    accountability to shareholders. Shareholders should have access to
    management's proxy, not just for shareholder proposals on a handful of
    subjects, but for director candidates that a substantial number of
    shareholders want to see on the board of the company they invest in.
    Investors also deserve the right to bring before the annual meeting
    through management's proxy any proposal that is legal and can be shown
    to enjoy significant shareholder support.
        The second area in need of reform is the practice of public
    accounting. There are three issues here--independence, oversight, and
    the process by which the accounting rules are made. On independence,
    the simple fact is that you cannot be a public auditor with an
    obligation to get the numbers right for a public audience and also be a
    consultant whose aim is to advise executives on how to optimize the
    numbers. The tension between those goals is too severe and the rewards
    for compromising the public audit responsibility are too great. It is
    just too easy for an auditor seeking to blend those roles to end up
    like Arthur Andersen at Enron, structuring SPE's as a consultant and
    auditing those same structures as an auditor.
        The Big 5 firms now seem to be arguing that if they cannot earn the
    big money as consultants they won't be able to attract top people. From
    an investor perspective, we would say the opposite is true--that unless
    audit and consulting functions are separated, the Big 5 will not be
    able to attract anyone with any integrity to their audit practices, and
    integrity is what worker funds want in an auditor.
        The next issue after independence is oversight. Former SEC Chair
    Arthur Levitt has outlined what we believe are the key characteristics
    of a much needed auditor oversight body--members independent of the Big
    5, full investigative and disciplinary powers, and independent funding.
        Finally, there is the rulemaking process. Anyone familiar with the
    political pressures brought to bear on the FASB around accounting for
    executive stock options in the mid-1990's, not to mention the decade
    long paralysis on SPE accounting knows that the FASB is too open to
    pressures from issuers and those beholden to issuers. Here there are a
    variety of options available for how to make FASB more independent--
    ranging from merging with a public auditor oversight body to closer
    ties with the SEC.
        Then there are the Wall Street analysts. These people play a vital
    role in our markets--they interpret the numbers. But analysts have
    become captive to the investment banking side of their firms. That is
    why part of a comprehensive package of reforms would be a provision
    banning basing analyst compensation not just on specific investment
    banking transactions, but also barring tying analyst compensation to
    investment banking performance generally.
        Finally, I want to address the ultimate accountability measures
    available to shareholders--recourse to the courts. The AFL-CIO and
    worker funds view litigation as part of a continuum of tactics for
    holding the management of the companies we invest in accountable and
    for recovering money fraudently taken from us. As such, we strongly
    believe that the current immunity from civil suits in the law for those
    who aid and abet securities fraud is outrageous--and directly connected
    to the rise in accounting restatements and accounting fraud since the
    Central Bank of Denver case in 1994. We also support a number of other
    reforms in the area of securities litigation, such as a restoration of
    the doctrine of joint and several liability in private securities cases
    and the extension of the statute of limitations in securities cases
    beyond its current 3 years.
        Together, these measures constitute a comprehensive approach to the
    problems presented by Enron and similar companies. This approach is in
    great measure embodied in the House bills introduced by Representatives
    LaFalce and Dingell. Here in the Senate Senator Leahy and Majority
    Leader Daschle have introduced a positive bill on litigation, as has
    Senators Dodd and Corzine on accountants. But there is a need for a
    comprehensive approach here in the Senate, one we hope this Committee
    will provide.
        In closing, I wish to strongly emphasize the labor movement does
    not view what happened at Enron as the product of a few bad people at
    Enron or at any other company, for that matter. While those individuals
    who have been given the responsibility to manage workers' and the
    public's money need to be held to a single high standard, we believe at
    the heart of what happened at Enron are systemic problems that need
    systemic solutions. These solutions will offend powerful interests, but
    they will protect America's working families. The AFL-CIO welcomes the
    opportunity to continue to work with the Banking Committee as you take
    up this challenge.
        Thank you.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR AKAKA FROM SARAH
                                 TESLIK

    Q.1. The Committee heard recommendations that corporate board
    members become more actively involved to protect investors. Are
    current board members prepared for this increase in
    responsibility?

    A.1. Probably some are but most are not. I do not think too
    many directors have seen it as their duty to protect investors.
    Traditionally, many of them saw their duty largely as confined
    to hiring, firing, ``overseeing,'' and approving the
    compensation of the CEO, whose leadership they generally
    followed and whose decisions they pretty much rubber-stamped.
    Their ``education'' consisted of being briefed by the general
    counsel and corporate secretary on the statutory duties of care
    and loyalty, director liability, and what would go on at the
    annual meeting.
        In the last 15 or 20 years, increased shareholder activism
    and media coverage on the failings of some boards have sparked
    improvements in corporate governance at many companies. Many of
    the board members now attend seminars sponsored by such
    organizations as the National Association of Corporate
    Directors, the Wharton School and Stanford University. They
    also receive publications such as Directors & Boards,
    Directorship and Director's Monthly, which contain articles
    advising directors on how to deal with governance issues. New
    venues have sprung up recently offering more intensive
    instruction in certain areas, such as the Delaware Audit and
    Financial Reporting Institute for Corporate Directors at the
    University of Delaware and the Directors' Summit at the
    University of Wisconsin. But much more is probably needed.

    Q.2. If not, what can be done to better prepare board members
    for taking a more active role?

    A.2. If the goal is to get directors more actively involved in
    order to protect investors, the biggest thing that is needed is
    a change of mindset. Directors must understand that they are
    elected to represent and protect the shareholders, not the
    management. They are there to oversee management, not maintain
    a cozy relationship with it. They should not only meet the most
    stringent definitions of independent, with no ties to
    management or the company, but they should think and act
    independently.
        The shareholders--the owners of the company--would elect
    only directors who accept and live by these basic premises if
    they could, but they typically have no voice in the selection
    of directors. In most cases, the only way they have of holding
    their elected representatives accountable for governance or
    performance failures is to apply pressure via shareholder
    resolutions and other forms of activism or withhold their votes
    from the directors when they stand for reelection, which has no
    practical effect. The time may come when shareholders can have
    access to corporate proxy materials to nominate directors, but
    until then, costly proxy fights are the only avenue open to
    them to replace directors.
        Education and appeals to the pride of incumbent boards and
    CEO's have resulted in some improvements, such as CEO,
    director, board evaluations, and the weeding out of some weak
    or nonperforming directors, but this is hardly sufficient to
    produce a whole new culture of directors dedicated to
    protecting investor interests.
        What is needed is, first, strong, independent boards.
    Congress and the Securities and Exchange Commission should
    press the stock exchanges to adopt tough standards for
    determining the independence of board members and to require
    that a substantial majority of board members for listed
    companies meet those standards. The Council of Institutional
    Investors recommends that at least two-thirds of a board's
    members be independent, according to its stringent definition,
    and that all members of the audit, nominating, and compensation
    committees be independent.
        In addition, to strengthen the position of the independent
    directors, the Council believes that if the CEO is also board
    chairman, there should be a lead, or contact, director for
    directors wishing to discuss issues or add agenda items that
    are not appropriately or best directed to the CEO. The board,
    not the CEO, should appoint its own committees and committee
    chairs. Boards and committees should meet in executive session
    on a regular basis, and should be able to hire their own
    experts or other service providers as needed. Directors should
    attend the annual shareholders' meeting and be available to
    answer shareholder questions; they should also respond to
    communications from shareholders and seek shareholder views on
    important governance, management, and performance matters.
    There is no reason for directors to be shielded from the views
    of the shareholders who elect them. All of these things, and
    more, are found in the Council's corporate governance policies,
    which can be accessed at www.cii.org.
        Also essential to getting strong, independent boards
    dedicated to protecting investors is to have all directors
    stand for election every year, and to have boards evaluate
    themselves and their individual members on a regular basis.
    Board evaluation should include an assessment of whether the
    board has the necessary diversity of skills, backgrounds,
    experiences, ages, races, and genders appropriate to the
    company's ongoing needs. Directors with poor attendance records
    should not be renominated, and boards should review the
    performance and qualifications of any director from whom 10
    percent or more of the votes cast are withheld. Directors need
    to understand that election to a board is not a lifetime
    appointment and that they will be held accountable.
        The Council believes directors should receive training from
    independent sources on their fiduciary responsibilities and
    liabilities. Directors have an affirmative obligation to become
    and remain independently familiar with company operations; they
    should not rely exclusively on information provided to them by
    the CEO to do their jobs. Audit committee members in particular
    need to be financially knowledgeable and have some expertise in
    accounting or in financial management.
        The Council also believes that the directors will protect
    investors' interests best if their own compensation is designed
    to align their interests with those of the shareholders.
    Directors should be compensated only in cash or stock, with the
    majority of compensation in common stock. Absent unusual and
    compelling circumstances, all directors should own a meaningful
    position in company stock, appropriate to their personal
    circumstances, in addition to any options and unvested shares
    granted by the company.

                             ACCOUNTING REFORM AND

                              INVESTOR PROTECTION

                                  ----------

                            THURSDAY, MARCH 21, 2002

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:25 a.m. in room SH-216 of the Hart
    Senate Office Building, Senator Paul S. Sarbanes (Chairman of
    the Committee) presiding.

             OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

        Chairman Sarbanes. Let me call this hearing to order.
        We were delayed, obviously, because of the vote. I hope we
    will be able to proceed now without any interruptions.
        This morning, the Committee on Banking, Housing, and Urban
    Affairs conducts the tenth in a series of hearings on
    accounting and investor protection. We have heard from some
    very distinguished witnesses in the course of these 10 hearings
    and they have brought some valuable perspectives to the work
    that is ahead of us.
        Today, we are very pleased to have the Chairman of the
    Securities and Exchange Commission, Harvey Pitt, with us.
    Chairman Pitt is the Commission's 26th Chairman. The SEC, of
    course, is known as an agency which has traditionally attracted
    very accomplished and dedicated professionals. It has been
    described by some as a jewel among Government agencies, and I
    think that is, by and large, deserved.
        Mr. Pitt actually began his career at the SEC and was the
    youngest general counsel in its history. But he has enormous
    burdens and responsibilities at the present time, as we examine
    carefully the system and the structure. I think it is clear
    that we need to make changes. You always have human failings,
    but you should have a system in place that minimizes the
    likelihood of that either occurring or going undetected and
    unpunished, and provides the
    investor protection and the integrity of the markets which we
    constantly reiterate are so important to our economic success,
    both historically and currently, and as we project into the
    future.
        Of course, there is a serious erosion of investor
    confidence right now that is very visible and, obviously, we
    have to take major steps to restore that.
        We are very pleased to have Harvey Pitt with us. I think we
    will move right ahead here because we may be interrupted for
    further votes on the floor.
        Yesterday, an objection was raised to committees meeting
    after 2 hours. I hope that does not happen to us today, but we
    will just proceed apace.
        Senator Dodd.

                STATEMENT OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Mr. Chairman, thank you, the point is well
    taken.
        We are delighted to have the Chairman here. I was saying to
    him earlier, does private practice look better to you now?
        [Laughter.]
        He has had a difficult set of circumstances to deal with.
    But while there may be some disagreements from time to time, I
    think a lot of us feel very reassured because he knows these
    issues very, very well.
        As the Chairman pointed out, you began your career at the
    SEC and have been engaged in a strong private practice
    involving the securities area for a good part of your adult
    life. You bring a good deal of information to this whole
    debate.
        For the record, I wanted to say again what all of us have
    said here. This is the tenth hearing this Committee has held on
    this subject matter. By my calculation, Mr. Chairman, you have
    had 38 witnesses from both the public and private sectors
    before all of us here who have been interested in this.
        These witnesses include five former chairmen of the SEC,
    the chairman of the International Accounting Standards Board,
    as well as the chairman of its trustees, a panel of SEC chief
    accountants, a former chairman of the Financial Accounting
    Standards Board, the CEO of a preeminent pension fund,
    authorities on corporate governance, preeminent securities law
    professors, members of commissions that study accounting
    reforms, Comptroller General of the United States, the CEO of
    securities self-regulatory organization, leaders in the
    accounting industry, institutional investors, scholars,
    consumers, labor and investment practitioners, and educators.
        Whatever else one may think, this has been a very
    comprehensive examination of this issue, and this in my view,
    Mr. Chairman, is how the Senate of the United States ought to
    operate. And it is a tribute to the Chairman's leadership of
    this Committee that we have examined this issue about as
    thoroughly as you could do in extensive hearings.
        So it is very appropriate and proper that we conclude with
    you, Chairman Pitt, to hear your views on the subject matter,
    and I am anxious that we get to it.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Bunning.

                    STATEMENT OF SENATOR JIM BUNNING

        Senator Bunning. Thank you, Mr. Chairman, for holding this
    very important hearing. And I would like to thank Chairman Pitt
    for testifying today.
        As you all know, a number of committees on both sides of
    the House and Senate have had many hearings on this issue.
    While some of these committees' hearings have been very
    partisan and will not go down as the finest hearings in the
    history of the Senate or the House, I would like to commend
    you, Mr. Chairman, for your leadership in making sure that
    these hearings did not end up like that. Your hearings have
    been focused on how to ensure that the Global Crossing,
    Andersen, and Enron messes never happen again, not trying to
    score political points. You have done a very good job.
        Chairman Pitt, it was not so long ago that you were in New
    York choosing what securities cases you wanted to take. Would
    you like to go back?
        [Laughter.]
        Chairman Pitt. No.
        [Laughter.]
        Senator Bunning. Now, after taking a pay cut, you are in
    the middle of this debacle, coming on the heels of September
    11, when you had to work very hard just to make sure that you
    could open the markets. I am starting to wonder if you are
    jinxed.
        [Laughter.]
        All kidding aside, I know that there were calls for you to
    recuse yourself from the Enron matter, but so far, the SEC has
    acted swiftly and decisively to fix the problems that have
    arisen. But obviously, there is much more to do and I look
    forward to working with you.
        Personally, I think that the two areas we must concentrate
    on are auditor independence and analysis issues. I was one of
    those who urged your predecessor to slow down a little on the
    auditor independence issue. I thought he was trying to ram a
    major rule through and taking side in an industry fight without
    the proper vetting.
        Though I still think that we were moving just a little too
    fast at the time, I think that we must have a true auditor
    independence. Although the firms have split off their
    consulting arms, we should codify that split into law. If you
    audit someone, you should not be able to do their business
    consulting.
        I am also very concerned about the Chinese walls between
    analysts and their firms. In another committee, we had some
    analysts from three major credit-rating agencies. It is still
    beyond me that despite all the information they are supposed to
    have that the public does not get to see, that they did not
    lower Enron's credit rating until 4 days-- 4 days--before it
    filed for bankruptcy.
        I spent 25 years in the securities business. We had Chinese
    walls at the firms that I worked at. But believe me, I and the
    rest of the people that worked in that firm knew what was going
    on.
        We must make sure analysts protect the investor they are
    advising, not the position of the firms they represent. I am
    happy to see that you are going to hold an inquiry into the
    SEC's regulation of the credit-rating agencies.
        Chairman Pitt, once again, I want to thank you for
    testifying today. I look forward to hearing from you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you very much.
        Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman. Let me echo the
    comments of my colleagues that I think you have run an
    outstanding series of hearings that I think you could almost
    categorize as a seminar on the issues of financial reporting
    and accounting.
        I am not sure any of us will get passing grades, but we are
    going to try when we get around to dealing with suggestions on
    reform.
        I truly appreciate it. It has been enlightening. I have
    learned a lot and it has been very helpful. I thank Senator
    Dodd for his help with trying to start working on those final
    papers that we are putting forward with regard to some of these
    issues.
        I think there is much to be derived from these hearings in
    trying to make sure we come up with a balanced and sensible
    approach, one that doesn't overreach, but builds the investor
    confidence that I think we need to have strong working,
    functional capital markets.
        I also want to say thank you to our witness, Chairman Pitt,
    for his service. I hope that sometimes when disagreements
    occur, it is not in any way interpreted as anything other than
    the challenges that one has with intellectual arguments about
    how we best get to an end goal that I think we all agree on.
        Your intellect and integrity, in my mind, is unquestioned.
    The efforts of the SEC and its response, particularly through
    enforcement activities, I think has been strong and one that is
    of due process. And I congratulate both you and the SEC for
    those efforts.
        I hope that we can all certainly win on one issue together
    in a very bipartisan manner, making sure you have the resources
    that allow the SEC to do the job that it needs.
        I know this is important to the Chairman and to all of us
    on the Committee, to make sure the SEC, which provides
    oversight to a $10 trillion economy, is not going to war with
    BB guns and slingshots in a world that is extraordinarily
    complicated today.
        So, I look forward to the Chairman's comments and moving on
    to some of the work on the final papers.
        Chairman Sarbanes. Thank you very much, Senator Corzine.
        Senator Enzi.

                  STATEMENT OF SENATOR MICHAEL B. ENZI

        Senator Enzi. Thank you, Mr. Chairman, and thanks again for
    holding another in this series of hearings that is helping to
    educate all of us on a number of situations, particularly
    accounting.
        Chairman Sarbanes. We have brought joy to Senator Enzi's
    life.
        [Laughter.]
        He is the only accountant in the Senate. Maybe in the
    Congress. I am not sure.
        Senator Enzi. No, there are five in the House. So there is
    kind of a limit of one of us per hundred.
        [Laughter.]
        Senator Gramm. You don't want to enliven the party too
    much.
        [Laughter.]
        Senator Enzi. This is the next best thing to March Madness.
        [Laughter.]
        I am very much looking forward to hearing Chairman Pitt's
    comments. I know this is another appearance before us and I
    want to thank him for the meetings and the phone calls that he
    has also had with me, and in addition, the participation of
    your head accountant, Mr. Herdman.
        It has been very helpful in giving me a better
    understanding of what is going on, and I cannot think of many
    other chairmen of agencies who have had the workload that you
    have had and the issues of importance placed on them in such a
    short timeframe.
        I think you have performed remarkably well and I want to
    commend you for that.
        Mr. Chairman, what has happened to the confidence in our
    markets and in our financial reporting system is alarming.
    Without the confidence of the individual investor, our markets
    cannot work. The small investors have the important role of
    providing needed liquidity in our markets and allowing
    companies to raise the capital required to grow the economy and
    increase the number of jobs in our country.
        The characteristics inherent in our capital formation
    process are why we are the envy of the world. We are considered
    to be the best at what we do. Recently, probably partly because
    of the efforts of Congress, a little bit of the gleam has been
    taken off, but, hopefully, we can restore that without damaging
    the system we have.
        I am encouraged to see that there is a new focus on the
    role of accountants. I am really very excited about this. I am
    told that in classrooms across the country, kids are saying,
    what is this accounting stuff that is so powerful that it
    destroys companies like Enron?
        Now that they see it as a really sexy profession again,
    there are a lot more inquiries and a lot more people going into
    it.
        But mostly what it is, is an opportunity for the companies
    themselves to get people across the country to understand what
    auditing is. Normally that is kind of a glaze-the-eyes-over
    situation.
        The only way we have been able to get around that is to
    throw in this consulting thing because consulting has more
    appeal than auditing. I think a lot of people think of auditing
    as storm troopers from the IRS descending on your home to check
    your taxes, doing it in a few minutes, assessing some penalties
    and leaving. Instead of the very lengthy and detailed process
    that accountants actually have to go through, particularly when
    they are exploring a company as big as Enron or any other of
    the big companies, or even some of the smaller ones that file
    with you.
        I do have a lot of small businessmen across the country who
    are contacting me and saying, please do not make us pay for two
    audits. When I ask what they are saying, they say, well, the
    auditor goes through all of my books and everything and he sits
    down with me and I say, what did we do wrong? He tells me. Then
    I say, what should we do better? He says, whoa, that is
    consulting. You will have to hire somebody else, to look
    through the same set of books, pay them the same money, but I
    just do not want any liability at this point for answering
    those questions.
        It has been a traditional role that accountants have
    played. In the bigger companies, if we draw the lines too
    closely, then we have the problem of them not being able to get
    the kind of expertise they need to be able to understand the
    company that they are auditing.
        I do appreciate all your patience and the way that you have
    looked at this and would love to know how some of the
    investigations are going, but know that that is not territory
    that we can get into yet, although it is probably territory
    that we ought to look at before we make massive decisions on
    behalf of the very successful business community across the
    country.
        I do hope that we will be careful when crafting
    legislation. What has happened with Enron is a terrible thing.
    We cannot overreact with legislation as a response to Enron,
    particularly before we know some of the details on what
    happened with Enron and Global Crossing and the other companies
    that have come to light recently.
        It is important to remember that what happened at Enron
    was, in all likelihood, already illegal and the persons
    responsible I trust will be punished. But what we are going to
    do will have far-reaching ramifications.
        So, I do urge all Members to take the time to completely
    understand the impact of the actions and I thank you for being
    willing to testify here today and I thank the Chairman for
    making all of this possible. I look forward to working on the
    issue.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you very much, Senator Enzi.
        Senator Gramm.

                    STATEMENT OF SENATOR PHIL GRAMM

        Senator Gramm. Well, Mr. Chairman, first of all, every time
    we have one of these hearings, I say something good about you.
    I know that at some point in this process, when something bad
    needs to be said, that you are going to remind me of all the
    good that I have said. So, I want to be careful.
        But I do want to say that I have been proud of this
    Committee on many occasions. And I am very grateful that the
    most important decisions we are going to make in the wake of
    the problems that we have had in the last year will be made in
    this Committee.
        I think that the Congress and the country will be blessed
    by that being the case.
        First of all, we know more about these issues than anybody
    else because we deal with them all the time. Second, we have a
    lot of people who want to do something on a bipartisan basis.
    It is very important that we try to achieve that because if we
    do, I think that our product will stand the test of going to
    the floor and will ultimately become law.
        I would like to also say that I am very proud of how you
    have conducted these hearings on a forward-looking basis. So
    much of what has been done in Congress has been finger-pointing
    for the media, which I think has not reflected glory on the
    Congress.
        I think everything you have done forward-looking about what
    is the problem and how can we fix it and what contribution can
    we make, I think that is what, at least when we were
    schoolboys, we read about in these textbooks that Congress was
    supposed to do.
        So, I want to congratulate you.
        I am very glad to be here with the Chairman of the SEC,
    Harvey Pitt. I cannot imagine anybody with a better background
    to deal with these problems than Harvey Pitt.
        I know there are some people who think that, well, if you
    have had association with accounting firms, whether you brought
    actions against them at the SEC or whether you have defended
    them, and Harvey Pitt has done both, that somehow, you are
    corrupted.
        In fact, as some of you know, I have a son who is a rock
    star. He took Latin and Greek in college, so he has no
    production skills.
        [Laughter.]
        After much prayer and help from God, he is now in business
    school. So, as he was off to business school in New York, the
    first course he had to take was in accounting. He said, ``Pop,
    what exactly is accounting?'' And I did not realize it at the
    time, but he is qualified to be on this accounting standards
    board because, obviously, he knows nothing and therefore, he
    cannot be corrupted.
        [Laughter.]
        I have a very strong feeling about experience and
    knowledge. I do not believe in guilt by association. And I
    think that your broad experience and your knowledge and
    understanding is a great asset.
        I would like to say, Mr. Chairman, that we are going to
    give you the tools you need. I do not believe we are going to
    write accounting standards in this Committee. I hope we do not
    in the Congress.
        Ultimately, you are going to be the person that puts the
    program into effect. And I would just like to say that, given
    your background, given your experience, and given your proven
    integrity in everything you have done, I could not be more
    confident in anybody than I am you. I think we are very blessed
    to have somebody with your background at the SEC at exactly
    this moment.
        Finally, clearly, I saw a front page Business Week article
    about you--I have always thought of Business Week as being a
    corporate socialist magazine. I hope they are listening.
        [Laughter.]
        I hope you will exercise your good judgment and your
    experience. And you are not standing for election anywhere. It
    is very important, given the parameters of the law, that you
    exercise positive judgments in looking at benefits and costs
    and that you do what is right. I have confidence you will. So,
    I want to thank you and I am glad you are here today.
        Chairman Pitt. Thank you.
        Chairman Sarbanes. We want you to do what is right without
    any reluctance, if I can refer back to the article that Senator
    Gramm talked about.
        Chairman Pitt, we are pleased to have you here. We would be
    happy to hear from you.

                      STATEMENT OF HARVEY L. PITT

           CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

        Chairman Pitt. Thank you, Mr. Chairman, Senator Gramm, and
    Members of the Committee.
        I am pleased to appear here on behalf of the Securities and
    Exchange Commission. Before I discuss some of the critical
    issues before this Committee, I do want to take a second to
    thank each of you for the kind words and for your support.
        Senator Bunning, I do want to assure you that I think I
    have the greatest job in this country, and I am not interested
    in returning to private practice, either now or potentially,
    ever. This is a great job. Not that I will stay here forever,
    but this is a wonderful job and I wouldn't change it for
    anything right now.
        Chairman Sarbanes. Actually, you are not even yet into the
    5 year term. You are still doing the excess over the 5 year
    term, if I am correct.
        Chairman Pitt. Yes, that is correct. I did take a 99
    percent pay cut, however.
        [Laughter.]
        I have followed with enormous interest and admiration the
    issues this Committee has explored the past 2 months. I commend
    the thoughtful and deliberative approach the Committee has
    taken under Chairman Sarbanes' leadership. In the face of
    crises and their concomitant turmoil, it takes patience and
    restraint to develop a full legislative record.
        Chairman Sarbanes, I congratulate you on this approach. I
    also want to thank you, Mr. Chairman, as well as Senator Gramm
    and the Full Committee, for the strong bipartisan support that
    this Committee has expressed for funding pay parity and our
    need for additional resources.
        My tenure at the SEC is still relatively brief, although
    some days, it seems as if I have been here much longer.
        Three crises occurring at the outset of my tenure--
    September 11, Enron's bankruptcy, and last week's indictment of
    Arthur Andersen--focused national attention on the need for
    meaningful reforms of the laws and rules we administer.
        Both Congress and the Commission must act: The Commission,
    through regulation and enforcement, which has the benefit of
    immediacy and flexibility; and the Congress, through
    legislation, which has the advantage of extending our reach and
    authority where appropriate.
        We cannot act independently of one another. We must act in
    concert if we are to restore public confidence in our markets
    and make the world's best capital markets even better. You have
    my commitment that we will continue to do precisely that.
        At my confirmation hearing, Senator Dodd gave me some sage
    advice. He said: ``Your job is not to become the most popular
    guy in town. It is to be the guy that actually will look at us
    and tell us, no matter how unpopular it may be, that you have
    an obligation to do what is really right on behalf of investors
    in this
    country.''
        I am positive I have satisfied the first prong of Senator
    Dodd's advice. I am not the most popular guy in town. Today, I
    hope to satisfy the second prong of Senator Dodd's counsel. I
    will tell you in unvarnished tones what we think must be done
    to restore public confidence and to repair the critical aspects
    of our system that have remained broken for far too many years.
        In response to recent events, I believe that we need to
    address three overarching reform needs.
        First, disclosure by public companies must be truly
    informative and timely. Of course, it has to be honest.
        Second, oversight of accountants and the accounting
    profession must be strengthened and the accounting principles
    that underlie financial disclosures must be made more relevant
    and more comprehensible.
        Third, the governance of American companies must be
    upgraded.
        We have already taken or announced a large number of
    significant initiatives.
        In cautionary advice issued on December 4 of last year, we
    provided guidance on the appropriate use of and limits on pro
    forma financials and we followed that with an enforcement
    action to back up our statements.
        We issued further cautionary advice on December 12, setting
    forth the initial requirements and guidance on the obligations
    of public companies to disclose critical accounting principles.
        On December 21, we announced our staff would monitor annual
    reports submitted by all Fortune 500 companies in 2002. This
    initiative significantly refocuses and improves our review
    program for financial and nonfinancial disclosures by public
    companies.
        On January 17, we announced our preliminary--and I stress
    preliminary--concept for 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 with our guidance, announced proposed rules
    to create more transparency for analyst recommendations.
        On February 13, we announced proposals to address aspects
    of corporate disclosure needing immediate improvement. Also on
    February 13, we called upon the New York Stock Exchange and the
    Nasdaq to look at specific components of corporate governance,
    and they have responded remarkably.
        This past Monday, we released orders and temporary rules in
    order to assure a continuing and orderly flow of information to
    investors and the U.S. capital markets in light of Arthur
    Andersen's indictment.
        On Tuesday of this week, the Commission commenced a formal,
    quasi-legislative investigation into the activities and effects
    of rating agencies on our capital markets.
        On March 13, we brought an action against the former CEO of
    a public company seeking to recoup bonuses, options, and
    salaries paid for financial performance that was a sham. This
    was a landmark effort by the Commission's Enforcement Division.
        Before turning to the three-pronged approach we believe
    that you and we should take together, I want to add a word
    about the need for legislation and additional regulation.
        I have said many times already that I do not believe that
    new legislation or new regulations are the key to solving every
    problem. I do believe, however, that we must respond to a
    unique crisis of confidence created in our capital markets and
    I want to assist this Committee in developing a sound
    legislative proposal and to work with you to tailor our
    concepts of necessary regulations.
        In short, I support your efforts, Mr. Chairman, and those
    of the Committee to take prompt and appropriate steps. Whether
    or not we always agree on the solutions, this Commission will
    always agree to assist you in achieving your objectives and
    implementing your legislative directives.
        We have begun enhancing our corporate disclosure system.
    The reforms we contemplate are aimed at improving the quality
    and timeliness of financial disclosure. The Management's
    Discussion and Analysis (MD&A) Section of disclosure documents
    is meant to be for investors a narrative explanation of, and
    provide the context for, companies' financial statements, so
    that investors can see the companies in which they invest
    through the eyes of management and understand the risks to a
    company's earnings and cashflow. MD&A is the cornerstone of our
    system of corporate disclosure and it must be improved.
        The rule reforms to Management's Discussion and Analysis
    that we contemplate include: Codifying principles that we
    suggested companies adopt voluntarily in December to identify
    their most critical accounting policies; mandating specific
    disclosures concerning relationships with entities that have a
    great impact on a company's financial condition, such as off
    balance sheet financing arrangements; and improving disclosures
    relating to key trend information without converting our
    disclosure system into an attractive nuisance for increased
    litigation.
        In addition to these planned MD&A disclosure reforms, we
    have in mind two very different initiatives, both of which are
    still in the conceptual stage, to improve the quality and
    utility of our corporate disclosure system.
        First, we believe investors would benefit if companies
    produce clear and concise financial statements that allow
    readers to explore whatever layer of detail they wish. This
    would not be an initiative to ``dumb-down'' financial
    statements, but an effort to give companies the flexibility to
    produce and to disclose financial information in layers.
        Second, we can improve the corporate disclosure system by
    increasing the CEO's individual accountability for his or for
    her
    company's disclosure. We intend to implement the President's
    directive to us to require CEO's to certify their company's
    annual and quarterly filings in a meaningful way. We are also
    considering rulemaking to require corporations to adopt
    procedures designed to bring important information to the CEO's
    attention.
        Third, we intend to impose obligations on companies to
    report immediately any transactions by corporate insiders,
    including transactions with the company. This would quickly
    address an issue that is circumscribed by existing statutes and
    rules. Corporate insiders need not file reports of their
    activities in their company's stock for as long as 40 days
    after the transaction. And a few years ago, the Commission
    adopted a rule that permits insiders to delay filing trading
    reports for up to a year if, as in Enron's case, the trades are
    directly with the company. While we seek to require faster and
    better disclosure by rule, a legislative solution here would be
    very helpful.
        Fourth, we intend to expand significantly the list of items
    to be disclosed by companies between their quarterly and annual
    reports. At present, only five events require intra-period
    disclosure. We propose to add about a dozen new significant
    events to that list. Over the longer term, we also will
    implement amendments to the basic framework of the reporting
    system to require public companies to disclose vital
    information on a current basis. Our present laws only provide
    investors with a still life picture of a company. We want to
    provide them with a moving picture.
        We also believe there are a number of ways that corporate
    governance standards can be improved to strengthen the resolve
    of honest managers which may have eroded in recent years, due
    in part to the increasing pressures to meet elevated
    expectations. We do not, however, contemplate changing the
    basic division of labors between State governments which
    regulate corporate behavior and the Federal Government, which
    regulates securities transactions.
        To this end, last month we asked the NYSE and the Nasdaq to
    review their listing standards on a number of important issues,
    including officer and director qualifications, continuing legal
    education, and codes of conduct for public companies. And we
    separately asked Financial Executives International to review
    its code of ethics in light of recent developments. The private
    sector and the self-regulatory bodies have been responding in a
    way that is quite gratifying.
        Perhaps the most pressing need is the reform of our
    accounting system. We see the need for reform in two areas--the
    regulation of accountants who audit financial statements of
    public companies and regulated entities, and the process of
    setting substantive accounting standards.
        The number of sudden and dramatic reversals of public
    companies' financial conditions calls into question the
    regulatory system currently used to oversee the quality of the
    audits of public company financial statements.
        Therefore, we propose a new private-sector regulatory body,
    the Public Accountability Board, to direct periodic reviews of
    accounting firms' quality controls for their accounting and
    auditing practice, as well as discipline auditors for
    incompetent and unethical behavior. This PAB would replace the
    system of self-regulation, to which the accounting profession
    is currently subject, such as the current system of firm-on-
    firm peer reviews overseen by the POB, under the aegis of the
    AICPA.
        There is substantial consensus on this point. Indeed, the
    AICPA and the major accounting firms have embraced the need for
    this change to restore public confidence. The PAB would
    supplement our own enforcement efforts by adding a tier of
    ethical and competence requirements beyond legal prohibitions
    and requirements.
        Such two-tier regulation has been successful in the
    securities
    industry. While the SEC is well suited to bring actions for
    fraud and such, private regulation can govern conduct that may
    not be unlawful, but that should be deemed unethical or
    incompetent.
        We believe the PAB should be comprised predominantly of
    members currently unaffiliated with the accounting profession.
    But we do, however, believe that the public will benefit if the
    PAB includes some members, a minority, from the accounting
    profession who would bring necessary expertise to the process.
        To assure the quality and independence of the members, the
    selection of the initial group of PAB members should be made by
    the Securities and Exchange Commission and future selections
    subject to SEC approval.
        In addition to independent membership, we believe the PAB
    should have a secure and independent funding source. We propose
    a system of involuntary fees to be imposed on all who benefit
    from financial audits, including, but not limited to, the
    accounting profession. It is also important that we take steps
    to ensure that auditors are perceived as being, independent of
    their audit clients.
        The Commission adopted rules on auditor independence less
    than 18 months ago, after considerable study and discussion. A
    number of those rules have not even become effective yet. The
    Commission's new requirements provide a framework to be applied
    to any proposed nonaudit service to determine whether it is
    inconsistent with independence. We believe this is the correct
    approach.
        Therefore, we believe these rules should be tested, but
    reformed if problems are shown to exist.
        It is useful to recall in this context that there were
    large audit failures long before accounting firms had any
    significant consulting business. Merely mandating the
    separation of consulting from auditing to create an audit-only
    firm, as some have suggested, does not guarantee an audit
    failure-free future.
        For one thing, an audit-only firm also would be more
    dependent, not less, on their audit clients, and a single large
    audit client could exert far more influence on such a firm than
    is the case with firms that have multiple sources of revenues.
    Moreover, information that can be gained through consulting
    engagements often is useful in performing audits.
        Auditor independence is a complex subject. It cannot be
    resolved by simplistic solutions. We are opposed to those who
    say that accounting firms as a whole should be restricted to
    providing only audit services. That is not the same as saying
    they should be able to provide both auditing and consulting
    services for the same client. But even there, we urge you to
    decline to adopt legislation that forecloses our flexibility.
        Auditor independence is a dual-faceted problem. But most
    importantly, those who perform the actual audits must be
    completely free of any pressures to waiver from absolute and
    meticulous application of accounting principles. When
    engagement partners are given additional compensation for
    cross-selling consulting services to the same client, they are
    exposed to the potential of divided loyalties. We believe those
    practices need to be banned.
        At the firm level, the critical goal should be to both
    require and incentivize firms to supervise and oversee the
    audit team to make sure they perform audits not solely within
    the letter of auditing principles, but at the highest level of
    integrity. One of the best ways to do this is to have a
    vigorous auditing quality control review process, something the
    PAB could do. Each major firm should be reviewed by the PAB
    every year, not every 3 years as the POB does it, and be at
    risk to lose valued clients if their audits aren't deemed to be
    of top quality, whether or not they comply with minimal
    standards.
        While we have statutory authority to establish accounting
    standards for public companies, for over 60 years we have
    looked to the private sector to provide the initiative in
    establishing accounting principles. We continue to support
    private-sector standard setting.
        But the SEC has historically abdicated far too much of its
    obligation to ensure that accounting standards meet the
    objectives of the Federal securities laws. Consequently, we
    plan to take a more active role to ensure that standards are
    implemented that benefit markets and investors.
        Going forward, we plan to use our existing authority to
    oversee the standard setting process to ensure that it
    functions in the best interest of investors by broadening
    funding sources and making the funding fees involuntary,
    meaningfully participating in the selection of the members of
    the FASB and setting the FASB's agenda, exercising our
    authority to review standards actually adopted, and ensuring
    that the FASB promulgates principle-based standards which adopt
    faster to changing business environment and emphasize overall
    accuracy and completeness.
        There are additional areas where we need the assistance of
    Congress to implement our initiatives and to take other
    important steps in improving the integrity, quality, and
    timeliness of the corporate disclosure system.
        The present securities laws authorize us to petition a
    court if we want to bar officers and directors who break our
    laws. We could use this tool more effectively and protect
    investors far more efficiently if we could impose this sanction
    administratively.
        This would be akin to our authority to bar individuals from
    the brokerage industry and also akin to the authority of the
    banking regulators to bar future service by banking officers
    and directors.
        A related tool is statutory flexibility to seek civil
    contempt penalties for those who violate prior judicial or
    administrative sanctions and restrictions. We now have to ask
    the Department of Justice to pursue those cases for us. Also,
    under existing law, penalties are capped at $120,000, or the
    gross amount of pecuniary gain for each violation, even for
    fraudulent disclosure violations.
        We would like to increase this amount so it is a more
    meaningful deterrent and we also would like the authority to
    impose penalties directly rather than seeking them through the
    courts.
        The last area I wanted to address briefly is the Private
    Securities Litigation Reform Act (PSLRA) of 1995. Some have
    urged its repeal. We think it appropriate to express the
    Commission's position. Private litigation, when properly
    formulated, is a very necessary supplement to the SEC's
    mission. The data to date, however, demonstrates no erosion of
    investor rights in the PSLRA's wake. We strongly urge you to
    refrain from making any changes in that legislation in the
    absence of compelling empirical support.
        We look forward to continuing to work with you to make sure
    that we discharge our obligations prudently, generously, and in
    the spirit with which the Federal securities laws were
    adopted--to protect investors and maintain the integrity of the
    securities markets.
        I thank you for the opportunity to testify today. I ask
    that my written testimony, which, unbelievably, is even longer
    than my oral statement, be made a part of the record, and I am
    pleased to attempt to respond to any questions the Committee
    may have.
        Chairman Sarbanes. Thank you very much, Chairman Pitt. The
    full statement will be included in the record and we appreciate
    the obvious time and effort that went into its preparation.
        Let me start right off. There is a headline in the morning
    paper on the basis of your testimony yesterday on the House
    side that says: ``Ease Up On Accounting Curbs, Pitt Says.'' So
    now what accounting curbs are there that you think should be
    eased up on, because most of the testimony we have been hearing
    has been suggesting that we ought to have additional curbs of
    one sort or another. They vary in the extent.
        Chairman Pitt. I think even the reporters who write stories
    for various newspapers will tell you that they have no control
    over the headlines. But any resemblance between that headline
    and what I testified to yesterday is purely coincidental.
        I do not believe that accounting principles or curbs should
    be eased up. What I do believe, Mr. Chairman, is consistent
    with the approach you have taken, that we should progress in a
    measured, thoughtful way, that to the extent that we believe
    there are conflicts created by firms providing more than one
    service to a firm, we should have the power to outlaw those, to
    ban them.
        But to write in stone the notion that no one can provide,
    say, both accounting and consulting services in a firm, or even
    to say no consulting services can be provided to any audit
    client, would put us back in a situation that this Congress
    faced just a few years ago with the Glass-Steagall Act. It was
    adopted in 1933 and it took nearly 70 years to undo some of the
    iron-clad restrictions in that legislation.
        All I am saying is that we hope that you will proceed with
    a flexible approach, not one that assumes an absolute position
    on these services.
        Chairman Sarbanes. Let me try to parse that out because I
    need to get the benefit of where you draw the lines. Do you
    think an accounting firm should be able to provide consulting
    services to an audit client?
        Chairman Pitt. It depends on what the definition of
    consulting services is.
        Chairman Sarbanes. Okay. If I can just pursue it.
        Chairman Pitt. Sure.
        Chairman Sarbanes. In other words, you entertain the notion
    that there should be some consulting services that an
    accounting firm should not provide to an audit client.
        Chairman Pitt. Absolutely.
        Chairman Sarbanes. In fact, the big accounting firms have
    themselves now, as I understand it, identified at least two
    such services. Is that correct?
        Chairman Pitt. They have.
        Chairman Sarbanes. Internal audit, and I think IT work. Is
    that correct?
        Chairman Pitt. Yes. But I think they have gone further.
    Most of them are now just severing all consulting work from
    their operations. That is a matter of choice. But I think they
    do not believe they have any choice.
        Chairman Sarbanes. Now, you say in your statement that the
    Commission has now put in a framework applied to any proposed
    nonaudit service to determine whether it is inconsistent with
    independence. And you note that Arthur Levitt, the former
    Chairman, endorsed the existing rules as they had been revised.
        I think it is important to note, because we had Levitt
    before us, and he said:

        Two years ago, the SEC proposed significant limits on the
    types of consulting work an accounting firm could perform for
    an audit client. An extraordinary amount of political pressure
    was brought to bear on the Commission. We ended up with the
    best possible solution given the realities of the time. I would
    now urge, at a minimum, that we go back and reconsider some of
    the limits originally proposed. While I commend the firms for
    voluntarily agreeing not to engage in certain services, such as
    IT work and internal audit outsourcing, I am disappointed the
    firms have remained silent about consulting on tax shelters or
    transactions, such as the kinds of special purpose entities
    that Enron engaged in. This type of management consulting only
    serves to help management get around the rules.

        So that is his current posture.
        Chairman Pitt. At the time that the changes in the rules
    were adopted, and I think we have attached the quotes for the
    record, he said that the rules that he was announcing were
    better than an absolute ban. And that was his precise word--
    ``better'' than an absolute ban.
        He has a perfect right to change his position. My
    difficulty is that some of the things that were put in at that
    time have not even gone into effect yet.
        All I am saying is that before we write in legislation in a
    way that curtails our ability to be flexible, I urge that this
    Committee write with a much more flexible stroke. That is my
    only point.
        I do believe that there are potential conflicts, as I have
    said, but I do not believe, for example, that doing tax work
    where you are trying to figure out what the consequences are of
    certain transactions, is necessarily detrimental, particularly
    if the firms would lose their tax competence if they had to
    sever all of those tax efforts. Those are the types of things
    that I would like us together to have the flexibility to deal
    with.
        Chairman Sarbanes. Well, my recollection of his testimony,
    and I see my time has expired, was that he did not take that
    position on the tax work and in fact, left that open, at least
    certain important aspects of it, to be engaged in.
        I think it is very important that we focus very directly on
    these different questions because you may not be out to ban all
    consulting services, but you may make the judgment that there
    are certain services that just ought not to be done.
        We had the Superior Bank failure--that is not under your
    jurisdiction. And the accounting firm that did the audit was
    the accounting firm that structured the process by which the
    residual
    interests would be valued.
        So then they set up this process for the valuation of the
    residual interests and then they came along as the auditor and
    of course they accepted the valuation of the residual interests
    that had emerged from their process.
        One wouldn't expect anything less, presumably. But of
    course, that was the whole genesis of the ultimate collapse of
    that banking institution and a hit to the fund which we now
    estimate is--well, we are not sure--probably $350 to $400
    million.
        Chairman Pitt. I am with you 100 percent on the notion that
    providing auditing and consulting services for the same client
    can, and in a number of situations, clearly does, create
    conflicts that we ought to eliminate.
        What I am saying is that, as I think former Chairman
    Levitt's testimony here and his statements to the press when he
    adopted the rules show, people change their minds.
        At the time the Commission adopted those rules, I received
    a call from Chairman Levitt asking me to talk to Members of
    Congress to urge them not to draft legislation establishing
    what the rules would be. And that is all I am saying today I
    believe the case should be. I think you should tell us what
    standards you want us to adhere to, but trust us to have the
    flexibility to understand whether a particular service helps or
    hurts.
        Chairman Sarbanes. Fine. I am going to yield. Let me just
    be clear. We are talking here about public companies, as I
    discuss this issue, because that is where the investor
    protection issue comes in.
        Chairman Pitt. And regulated entities.
        Chairman Sarbanes. Yes. So that the nonpublic company--none
    of the limitations we are talking about would apply in that
    circumstance.
        Chairman Pitt. They wouldn't, sir, but the problem you
    would have is that you could not hire anyone competent if they
    could not provide services for certain types of firms. That
    doesn't get to the question of whether they should be allowed
    to perform these services for their audit clients. But unless
    you have a scope of practice that is broad-ranging, the best
    people will go some place else.
        Chairman Sarbanes. I just want to address the cascading-
    down argument that we are hearing that says, I am a small
    accounting firm in a small town and I represent small
    businesses, none of which are publicly listed. They view this
    with some sense of horror because they think, what is going to
    happen with respect to the publicly-listed companies is going
    to reach them.
        Now the counter to the cascading-down is you get a
    deterioration to the lowest denominator. Obviously, it is clear
    all companies and those who audit them, once they list, have
    different responsibilities because you are drawing in the
    public markets and the investors.
        So it is a different arena in which we are dealing. Because
    we heard from the accountants and they are concerned about that
    and I can understand they would be concerned about that. I
    think most of us are sensitive to that concern, but I think it
    can be dealt with.
        Well, I have gone beyond my time here.
        Senator Gramm. Mr. Chairman----
        Senator Bunning. I yield to the Ranking Member.
        Chairman Sarbanes. All right. Senator Gramm.
        Senator Gramm. Mr. Chairman, I think you put your finger on
    a very important part of what we have to deal with. I think it
    is important to note that not every public company is listed on
    the New York Stock Exchange, that in most little towns, a lot
    of the companies are public and they have over-the-counter
    traded stock.
        Chairman Sarbanes. On the Nasdaq.
        Senator Gramm. On the Nasdaq or just simply locally traded.
        I am just saying it is important to define what is a public
    company, and as I would define it, it is any company where you
    have stock that is owned by a group of people and you have a
    set of corporate governance. And I am just saying that that
    would not be uncommon for a fairly good-size local plumbing
    operation.
        Chairman Pitt. Your point, Senator, is more articulately
    made than what I was trying to say to Chairman Sarbanes. I
    believe that if you have a one-size-fits-all rule, you can
    stifle competition, you can hurt smaller companies. Even small
    public companies may need different treatment.
        I am not prepared to say today that that is necessarily the
    right thing. I am prepared to say that we should have the
    flexibility to tailor whatever standards are raised based on
    further information in light of different circumstances.
        Senator Gramm. Well, let me go with my questions and my
    point.
        I guess I have two concerns about just mandating that if
    you are in the audit business, you are only in the audit
    business. The one is that you mentioned, and that is the
    isolation from expertise in areas that are critical to
    auditing. I think the art of this thing is deciding what areas
    provide the expertise and attract the real talent into
    accounting we want, and that minimize a conflict.
        Conflict of interest exists, and there is no way it can be
    eliminated. You are being paid by the company, for one thing.
        Chairman Pitt. Exactly.
        Senator Gramm. The question is finding that point at which
    you haven't narrowed down the knowledge of the auditor so much
    that they really have to rely on the company for so much
    information that they are doing a nominal audit rather than a
    real look at the company. So that is what I would call the
    isolation problem.
        The second problem has to do with a smaller company that
    cannot hire two accountants, where you have the practical
    problem. And many of those companies are public in the sense
    that they have over-the-counter traded stock, not necessarily
    on Nasdaq, but that might just be traded locally in Maya,
    Texas, and over some regional exchange.
        I want to thank you for the comment about security
    litigation. I would have to say that I think that bill was a
    very important contribution. There was a real abuse. I think we
    took important steps to close that loophole. I know there are a
    lot of people who would like to open it up again and that would
    like to take advantage of the situation we are in. But is it
    not true that more money has gone to people who filed lawsuits
    since that litigation reform than was going to them before?
        Chairman Pitt. The statistics I have seen are that there
    has been no diminution in the number of actual class actions
    filed, but the settlement levels have increased remarkably
    since the legislation has been in effect. That could well be
    attributed to the notion that there are better suits being
    brought now, so they get higher settlements.
        Senator Gramm. Let me touch real quickly before my clock
    runs out on a couple of other things.
        I am a little bit concerned about nonaccountant majorities
    on these oversight boards. And I sense maybe my view is a
    minority view, which is not uncommon. But it seems to me that
    there are two functions here. One is discipline and the other
    is setting standards. And maybe one of the ways we can bring
    people together is on the overall board that disciplines
    accounting and that we might give some strengthened ability to
    gather information and to make judgments. Maybe on that you
    would want a majority of nonaccountants. But where you are
    setting accounting standards, I think you clearly want a great
    preponderance of people who are
    accountants.
        I am wondering what you would think of trying to separate
    those two things out.
        Chairman Pitt. Senator, in our written statement, we make
    the observation that discipline or quality control judgments
    have to be made by a group that has no incentive to pull their
    punches.
        Senator Gramm. I agree with you.
        Chairman Pitt. I think that is consistent with what you are
    suggesting. All of the members should have been in or be very
    familiar with the accounting profession. The only issue is, do
    you have anyone who is in practice now?
        My view is, and I have seen this, the difference--some of
    my best friends are academics in law school. I like academics.
    But they do not have the same perspective that somebody who is
    out in the field every single day obtains by seeing problems in
    their theory. That is why you get a rule like Regulation FD,
    which has a great fundamental premise, but reflected a rule
    that was created by people who had no practical experience
    applying it.
        Chairman Sarbanes. But two issues are getting mixed up
    here. You can have expertise on the board because people have
    been trained as accountants and worked as accountants, but are
    not now practicing accountants, which of course raises then the
    difficult conflict problem.
        Chairman Pitt. Right.
        Chairman Sarbanes. We did not allow you to continue to be a
    lawyer doing SEC practice when you became Chairman of the SEC.
        Chairman Pitt. That is correct.
        Chairman Sarbanes. So the question becomes, as we deal with
    this board that is obviously coming along, how do we structure
    it?
        Now, I think it is a reasonable point to say, well, you
    cannot put people on there who do not know anything. And
    especially in complicated matters like this. But on the other
    hand, the notion that you are going to take people that are
    right in the industry, who will continue to be in the industry,
    and put them on the board to do these functions, I find----
        Senator Gramm. I think once you are on the board, you are
    on the board.
        I see it as two different functions of the board, one
    discipline and the other setting accounting standards.
        Can I just ask one short question now?
        Chairman Sarbanes. Sure.
        Senator Gramm. Another concern I have, and maybe I am the
    only person concerned about it, but I am a little nervous--I
    understand a dedicated funding source and I think that is
    important because the power to fund and not fund is the power
    to influence. And I do not want influence coming directly from
    Congress, not that Members of Congress--I had no objection to
    people standing up and saying they disagreed with Arthur
    Levitt. What I objected to was when there was a suggestion that
    we were going to legislate to override what he did.
        Chairman Pitt. Exactly.
        Senator Gramm. That I was opposed to. But I am nervous
    about having this dedicated funding source and making these
    people so insulated from their own profession and from the
    whole world around them. Do you have any thoughts as to how we
    could do the dedicated funding source, but yet, not put these
    people in a position where they never have to meet with
    anybody, never have to listen to anybody, and there is no
    vehicle whereby anybody can get their attention? That kind of
    makes me nervous.
        Chairman Pitt. Let me start by saying that the critical
    nature of having a dedicated funding source would deal with
    some of the problems that the POB experienced over time, which
    is somebody comes in and says, if I am doing this voluntarily
    and I do not like what you are doing, I am taking my money and
    my marbles and I am going home. That is unacceptable to us.
    That is one of the reasons why we felt the POB was incorrectly
    structured and why we felt we had to move beyond that.
        You have to have what I call involuntary, you call
    dedicated--we are talking about the same thing. That doesn't
    mean that these boards should be insulated. The real problem
    has been, in my view, that in the past, the SEC has not been
    sufficiently involved in overseeing the activities of these
    private-sector bodies.
        Again, let me just say, and I have told this to the FASB in
    private meetings, I have said, as long as whatever rule that
    you come up with does not hurt investors and is not absolutely
    bizarre, even though we may not like it, we will support your
    decision and we will not try to get you to undo a decision you
    have made.
        We will respect that independence. To me that is critical.
    But if the FASB doesn't go out to the private sector in setting
    standards, then you lose all of the benefits of having a
    private-sector body.
        So, I feel very strongly that they have to be in touch with
    people and know what is going on.
        Senator Gramm. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Dodd.
        Senator Dodd. Thank you very much, Mr. Chairman.
        This is a very interesting discussion. Let me jump to
    another area. This is one that I would like to pursue because
    it is a very important area. Senator Corzine and myself and a
    couple of others have crafted a draft bill proposal that we
    hope will become at least a starting point to look at some of
    these ideas, and they touch on many of the things that you have
    testified to today. It is very much a work in progress and the
    hearings have been tremendously helpful as we go back and
    review some of the ideas and suggestions.
        In the area of consulting and auditing, we have tried in
    our proposal to separate out, following the SEC original
    proposal, so the taxation issue, for instance, would be
    outside, the IT issue, and the internal auditing outsourcing,
    for instance, would be different.
        And then we leave it up to the audit committee, if there
    are other matters which the firm would not quite fit into the
    auditing definition, it would bleed over a bit into the
    consultative section where you could accommodate that, so as
    not to have such a stark line drawn.
        But you have already kind of discussed this and I do not
    know how much further you want to pursue it. But we are trying
    to think creatively on how to get around this issue where you
    want to have a distinction between consultative and auditing
    functions, but you do not want to eliminate those,
    ``consultative functions that are critical for performing the
    audit function.'' And how you do that is a challenge and we
    have tried to come up with one idea. It appears there may be
    many. So if you want to comment on that, fine.
        The other thing is the rotation issue.
        Contrary to some press accounts today, in our proposal, we
    say we have to study this and look at it. I gather you are
    troubled, and I am a little troubled as well. I understand what
    is behind the idea of rotating the firms. But it strikes me, as
    practically, not terribly sophisticated--I understand what
    underlies the concern about not having developing too close a
    relationship over too many years.
        We do this with ambassadors. We limit ambassadorial service
    to 3 or 4 years. Part of the idea was that, after a period of
    time, even people who are the best can forget who they
    represent in time.
        Senator Gramm. They get client-itis.
        Senator Dodd. You end up discovering that you represent the
    country you are working in rather than the country that sent
    you.
        Chairman Sarbanes. There is a wonderful story. Can I
    intrude?
        Senator Dodd. Absolutely. I know the story. It is a great
    story.
        Chairman Sarbanes. Well, you tell it.
        Senator Dodd. No, you tell it.
        [Laughter.]
        Tell him the story because it is a good one.
        Senator Gramm. Good story.
        [Laughter.]
        Chairman Sarbanes. George Schultz, when he was Secretary of
    State, before every ambassador would go abroad, he would invite
    them up to his office to have a discussion with them. He would
    go over to the globe that he had there and he says, ``Point out
    your country to me.'' And if they did not point out the United
    States, then they received a lecture from him.
        [Laughter.]
        Senator Dodd. Invariably, in their enthusiasm, they would
    be pointing out the country they were being sent to. And the
    point was, no, no, that is where you are going to work. You are
    from the United States and you are going to represent us.
        Well, that is sort of what is underlying this a bit, I
    think the motivation, that after a while, you can forget that
    the letter P in CPA was put there for a purpose, that this is
    not just a lawyer-client, doctor-patient relationship.
        You have a responsibility beyond the one that is paying
    you, to the person who is looking over your analysis and
    deciding whether or not to invest in that company. And we rely
    on that individual, although we did not pay them, in a sense,
    to perform a service which we are relying on to a great extent
    to make our financial
    decisions.
        So the notion of having someone who is spending too long a
    time with someone can end up distorting their vision to some
    degree.
        The problem, the reason we did not write anything in our
    bill is because when Senator Corzine and I were talking about
    it, I do not know how you do this with four or five terms. You
    are dealing with complicated companies where, in the space of 3
    or 4 years, you may just really begin to understand a highly
    complex company. Therefore, when you start to pull someone out
    and put someone else in, you run into a problem there.
        Second, the accounting firms, as I understand it, and you
    are far more familiar with this, are not cookie cutters of each
    other. They are not mere images of each other, different firms
    bring a different expertise to the table. Some do energy
    particularly well. Others may do financial services well. And
    so, by taking one firm and applying it, in a sense, assigning
    it, if you will, to some other company when they do not really
    have the expertise, can pose real problems for the P in CPA,
    for us, the public, who may be relying on it.
        But those are our concerns about it.
        Chairman Pitt. I share those concerns, Senator, and I would
    say to you, because I agree with everything you have said,
    there is a tension.
        Senator Dodd. Yes.
        Chairman Pitt. But on the one hand, as my dear mother used
    to say, familiarity can breed contempt, and it also can breed
    more familiarity.
        Senator Dodd. Yes.
        Chairman Pitt. And so, you have to be careful about just
    how people are performing.
        By the same token, empirical data suggests that in the
    first couple of years of a relationship, and particularly as
    companies grow more complex, those are the years when auditors
    are at their most vulnerable.
        So if you think about it this way, let's say I am an
    auditor and I am going to assume the worst about auditors now,
    even though I do not as a practical proposition.
        In my first 2 years, I am not smart enough to know where
    all the problems are. And in my last year or two, I know I am
    losing this client, so I do not really care, even if I am now
    smart.
        Now if you have a 5 year rotation, you have knocked off
    four-fifths of the period. That doesn't answer your concern,
    however. And your concern is the one that bothers me because of
    the public interest.
        I believe the answer to that is to establish standards for
    the audit committee to interview the auditors, to talk to the
    national partners of the audit firm, find out what steps they
    are taking to review the quality, and then on top of that, to
    have every year the PAB come in and do a quality control.
        This would not be a for-cause thing. It would be a quality
    control. And if they find that audits are not being done at the
    highest standards, if they think there is sloppiness or
    slovenliness, give them the power to take away the client. That
    to me is the incentive. So that an auditor will know, if I want
    to keep this client, I have to be tougher, not weaker.
        Senator Dodd. Let me ask you quickly. My time is up,
    although the story may have taken some of my time.
        On the individual case where--what did we call it? The
    cooling-off period--people can all of a sudden find themselves
    moving from having done the audit, moving into the company they
    are auditing.
        There is a logic or an illogic to that that I do not like
    in the sense of depriving people of the opportunity to have
    careers and so forth. But there is also a legitimacy to the
    concern that someone is job-hunting and that dangling out there
    while you are doing this.
        Even, again, the most honest individual can all of a sudden
    start shading their conclusions here if someone is dangling a
    pretty significant position.
        What are your thoughts on that?
        Chairman Pitt. Well, I am troubled by the so-called
    revolving door for exactly the reasons that you have indicated.
    I think it can give rise to potential problems.
        I think, again, however, that it is impossible for any of
    us to write a rule that will deal with every set of
    circumstances if we try to decide it is 2 years, no matter
    what.
        My view is, first of all, there may be circumstances where
    a company is too small and the ability to get somebody from its
    auditor may provide it with immediate expertise.
        Second, there may be circumstances where because somebody
    has been at the firm, and has some knowledge about the company,
    they can help clean up a mess that has existed.
        So, again, what I would do is say, to me, this is not an
    area for Federal determination. What I would say to the audit
    committee is that, in cases of the so-called revolving door,
    the audit committee should examine the hiring process and
    decide for itself whether it has assurances that the person
    will operate independently of the accounting firm.
        In that case, it may well be that they take the individual
    and maybe they get a different accounting firm or it may be
    that they can do both, or it may be that they look for another
    individual. But because there are so many possibilities, my
    concern comes with trying to dictate it.
        I have to say, if I were leaning in either direction, the
    larger companies, which I think have the ability to get more
    people, this argument doesn't move me as much. And so if you
    had a rule like this and it applied to the larger companies,
    perhaps that would make sense.
        But I think the best rule would be to put the onus, if you
    will, on the audit committee. When I say onus, I mean the
    judgment. Give them the ability to exercise their judgment on
    behalf of the shareholders so that they can deal with special
    circumstances.
        Senator Dodd. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Bunning.
        Senator Bunning. Thank you, Mr. Chairman.
        In listening to my Ranking Member, Senator Gramm, talking
    about funding sources, it brought to mind the Federal Reserve
    and their independence and their funding source. We have
    absolutely no control over what they do.
        Chairman Pitt. I have noticed.
        Senator Bunning. None. That worries me, too. Believe me.
        I want to ask you this question because my basic tendency
    is to separate auditing from the other functions that auditors
    are now doing, and separate them with a dark, black line and
    make sure that they do not get into the financial consulting
    business with the same firm that they are auditing.
        That is the easy way out. But it also is a way that we get
    public confidence back in the markets. Is there any way you can
    see that we can build true firewalls between the auditors, the
    analysts, and the firms they represent? Is there any way we can
    keep them from knowing what their firms' positions are on other
    issues? I do not think there is.
        Chairman Pitt. Let me say this. Firewalls require a lot of
    effort and, to some extent, a leap of faith. Whether it is a
    large leap or a small leap I guess depends on your perspective.
    But they can work. The difficulty is in how you define it.
        Suppose I gave you the hypothetical of Company A that wants
    to buy Company B and merge them, and A is public. They retain
    their auditors to review the companies to give them a sense of
    what the auditors think the combined company might look like,
    and how to value it in that sense. Not a valuation, but just
    what accounting principles might apply. Technically, that is
    not an audit. So, somebody might say, well, that is a
    consulting service, and it probably is. But I think it is a
    very valuable one.
        Senator Bunning. Let me ask you the question, though.
        Chairman Pitt. Yes.
        Senator Bunning. Does Company A and Company B have the same
    auditor? And if they do, then I really have a conflict.
        Chairman Pitt. There I think Company A would be well
    advised to get somebody else to look at the situation.
        Senator Bunning. Outside.
        Chairman Pitt. Not because the accountants may or may not
    do a good job, but because the shareholders that you report to
    should be confident that they got a fair deal before the bid is
    made.
        So, yes, that could be a very different factor. And it only
    proves, my point, which is you might say in a lot of cases it
    is okay, but in some cases, it wouldn't be okay.
        To me, this is why you need a principled basis for saying
    what the criteria should be, as opposed to trying to write a
    prescriptive statute that says, well, you can do some internal
    audit work, but not others, or you cannot do any internal audit
    work. You cannot do any of this.
        The difficulty will always come up, somebody's going to sit
    there and they are going to have a problem where we will all
    potentially agree, it makes sense to have the skills brought to
    bear.
        And so, I want to work with this Committee to prevent
    conflicts and to improve independence. But I think the best way
    to do that is by coming up with standards as opposed to coming
    up with a per se ban.
        Senator Bunning. I was in a hearing yesterday where the
    three credit-rating people were. What kind of things are you
    going to look into, are you going to inquire into regulations
    other than the current ones for credit-rating bureaus?
        Chairman Pitt. I have to start with a fundamental concern.
        We have a couple of rules which establish a category of
    entities called National Securities Rating Organizations, and
    give them, in effect, some form of a governmental imprimatur.
    But to my knowledge, we neither do nor probably could do any
    kind of due diligence. What happens is somebody comes in and
    they say, we rate one third of all of the public companies in
    this country and now they are okay.
        We want to look at the application of existing rules. We
    want to look at practices by rating agencies that may affect
    their ratings because rating agencies provide more than one
    service, and they too are paid by their clients.
        So if you had a circumstance, hypothetically, and I am not
    suggesting this has happened, where a rating agency was paid
    for other services and somehow, it took a more benign view of a
    company's credit situation. You have an immediate conflict of
    interest and the public never knows that.
        There is an analogue in the securities laws. Back in 1933,
    the Congress, in its wisdom, passed Section 17-B of the 1933
    Act, and it says, if you want to make a recommendation about a
    security and you are getting paid to make that recommendation,
    then you have to tell people that you were paid before you make
    your recommendation.
        Senator Bunning. They usually put that in the footnote that
    this firm may or may not have an equity interest in this firm.
        Chairman Pitt. Yes. That is what we would I guess refer to
    as boilerplate. And we moved away from that in the analyst area
    and I think, to the great credit of the securities industry.
        I have no idea whether that is warranted in the rating
    agency circumstance at all. But I think that this is a business
    that we need to know a lot more about and decide whether there
    are any practices in which investors can get a better shake.
        Senator Bunning. My time is expired. Let me just ask you
    one thing. We only have three recognized agencies in the
    credit-rating business. It would seem to be more healthy for
    the SEC and for the public to have more than just three.
        Chairman Pitt. I agree with you. There are other rating
    agencies that actually meet what we think are the standards of
    our rules and some of them have even been invited to come in
    and apply and they have declined.
        At the same time that I agree with your point, I also note
    that we only have five accounting firms, in a sense, five major
    accounting firms.
        Senator Bunning. Major.
        Chairman Pitt. Maybe.
        Senator Bunning. Thank you, Mr. Chairman.
        Chairman Sarbanes. Thank you, Senator Bunning.
        Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman, and once again,
    welcome, Chairman Pitt.
        A quick point with regard to the revolving door issue. You
    addressed it as an issue with the accountant working inside the
    company and the audit committee can make those judgments.
        I think the real concern of a lot of us that look at this
    issue is the set-up of the individual, potentially--put your
    cynical hat on--that someone compromises how they may interpret
    a rule while they are the accountant.
        Chairman Pitt. I agree.
        Senator Corzine. As opposed to what happens after the fact,
    once they are working inside the company. I think it is a
    concern that may not even be an active Commission. It may be
    something that one is really allowing themselves to ingratiate
    themselves to access it. I think it is a much harder problem to
    have an audit committee resolve after the fact.
        Chairman Pitt. I agree with the first part. I think it is a
    much harder problem. And I think it is a real problem. I am not
    certain that it is not susceptible to review. You have to do
    due diligence.
        But if you had a presumption against it for larger
    companies, except where it is shown that there is a bona fide
    need and there is no reason to believe that independence is
    impaired, and then there are strictures put in place, you may
    be able to do that.
        All I am saying is I think it is worth looking at instead
    of having an iron-clad rule. But I do not have a problem with
    the iron-clad rule for larger public companies.
        Senator Corzine. It appears to me and I suspect Chairman
    Sarbanes asked these questions because he has asked it
    regularly, but we have this cascading problem, and you have
    potential for a set of rules on listed companies. Some would
    argue that you need to subdivide that, versus small business
    arrangements. And I think this is a hard sort-out, no matter
    what kind of initiatives you take.
        Chairman Pitt. I agree.
        Senator Corzine. But do-able in the context of other
    regulatory schemes.
        I want to make sure that I am hearing what you are saying.
    You do believe that auditing and consulting should be separated
    with the same client. Did I hear that? Or am I over-reading?
        Chairman Pitt. No, you are not over-reading. I believe that
    the provision of auditing and many consulting services can give
    rise to a conflict, and therefore, ought not to be permitted.
        I do believe that there are some types of things that may
    be characterized as consulting as to which not only isn't there
    a conflict, but also there may be a public benefit.
        I do not think that it can be written in stone that way.
    But the basic presumption is, if you are doing one thing for a
    client, that is what you should do, unless it is clear that the
    client benefits and the shareholders benefit. There are a lot
    of concerns in this area and I think public confidence has to
    be buoyed by creating that kind of distinction.
        Senator Corzine. In your PAB concept, you use quality
    control as opposed to auditing of the auditors. Can I get you
    to be a little more expansive about what quality control
    reviews?
        I am trying to think about whether this is an SEC review of
    a securities firm. I only think in analogies where I have
    actually gone through some of these life experiences. And NASD
    review, maybe pre-1995 and post-1995. But how are you
    perceiving what a quality control review is?
        Chairman Pitt. I think there are a lot of elements that go
    into quality control.
        First of all, you want to find out how the audits are
    structured. What type of decisions are being made, what
    educational level and ethical training do the people who are on
    the frontline have?
        What types of restrictions has the firm imposed to make
    sure that the people on the line get the best quality?
        To what extent are the engagement partners and the rest of
    the audit team supervised by national partners who are far more
    expert in the more complicated nuances of accounting?
        How was a particular audit actually conducted?
        This is, in effect, a not-for-cause inspection as in the
    securities industry, if somebody comes in just to see how you
    maintain your files, how you handle a customer account and so
    on. The larger firms need to be reviewed, in my view, on a
    yearly basis.
        Senator Corzine. Do you anticipate that being that you look
    at a specific client audit, or are you saying, we are going to
    go look at Arthur Andersen's laying out of what the framework
    of the audit will be about?
        Chairman Pitt. Both. I think it is both.
        Senator Corzine. So, you really are talking about an audit
    of the auditors.
        Chairman Pitt. Yes. And if we have that, if we have that
    system, it would be my belief that our Office of Compliance,
    Inspections and Examination would have to audit the PAB. That
    is to say, we would see what kind of a job they were doing,
    which of course, right now, we do not do. The Commission has
    never looked at the POB.
        Senator Corzine. Are you basically suggesting that the peer
    review process is not hacking it with respect to making sure
    that the audit of the auditors brings the confidence that I
    think that the public, or at least I believe the public, should
    reasonably expect?
        Chairman Pitt. Also to assure that the particular firm, as
    you look at an audit or two, is applying the highest standards
    in the profession, not applying bare bones standards.
        If that evaluation were made, the PAB could say, listen,
    you may not have done anything illegal. You may not have even
    done anything unethical. But given the way you have handled
    this client, it is our view that either you are too cozy with
    it or you were too sloppy with it, and we are telling the
    client it has to find a new auditor.
        It seems to me that would be one of the punishments. To me
    that is the way that you deal with rotation. You have it as a
    meaningful stick, so that firms are afraid that if they do not
    do the best possible job, they will lose their clients.
        Senator Corzine. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Senator Bennett.

                 STATEMENT OF SENATOR ROBERT F. BENNETT

        Senator Bennett. Thank you, Mr. Chairman.
        Thank you, Chairman Pitt. I am sure you have anticipated my
    comments and reactions to your last statement made to Senator
    Corzine.
        I am very nervous about rotation. The reason you have given
    being perhaps the most cogent, that when you know you are going
    to lose the client, but you know you have him for the full 5
    years, you take him for granted and, okay, I won it. It is an
    old story we have heard.
        We have told stories around here before about the real
    estate
    developer who died and had his choice of going to heaven or
    hell. When Satan showed him around hell, it looked really,
    really wonderful, to the point that he actually decided, I am
    more at home here. I have more friends here. I feel more
    comfortable here. I am going to choose hell. And the next day,
    after he had made his choice, things were not wonderful. He
    checked into the head office and said, wait a minute. You
    promised me this, this and this, and you haven't done any of
    it. What's the story? And Satan said, you are a developer in
    the real estate business. You should understand this perfectly.
    Yesterday, you were a prospect. Today, you are a tenant.
        [Laughter.]
        I think that may very well arise if you get into this
    rotation. Okay. I have you locked in for 5 years. I will give
    you perfunctory service and spend my time trying to woo the
    next one that I am going to go after when this 5 years is up.
        A variation on the theme you just described for your
    consideration and maybe comment. As long as we are using
    analogies, let's take it out of the sports world, where you
    sign up a star player for X-number of years and at the end of
    that contract, he is a free agent. You do not want to lose him.
    You go to every extreme you can, within your financial limits,
    to hang onto him. But other teams are bidding for him.
        So that there is an understanding that after 5 years, to
    pick the date that has been picked, the company has to put this
    out for bid.
        Now the incumbent auditor can bid on it and has a chance of
    hanging onto it. But he knows that if he does not serve the
    needs of the client properly during the 5 years, at the end of
    the 5 year period, when the bidding time comes up, one of the
    others will be more attractive. This is a variation on the
    theme that you have
    described, and maybe the two can be merged together. Can you
    comment on that?
        Chairman Pitt. Yes. I think that something like that could
    have very positive benefits. First of all, I would move the
    decision as to who hires the auditor from management to the
    audit committee. The same thing, I would move the decision as
    to whether you replace the auditor with another audit firm to
    the audit committee.
        I am not saying that management won't make recommendations
    and present them. I am just saying I would like the audit
    committee to be able to review that and understand what is
    going on.
        Senator Bennett. If I could interject, when I was a CEO of
    a publicly-traded company, that was de facto the case. If the
    audit committee of the board and the CFO came to me in tandem
    and said, we are not getting what we need out of this auditor,
    I did not try to second-guess them.
        Chairman Pitt. Many companies do that today. However, I
    think the proposition you are suggesting has a great deal of
    attraction. There is one concern I have and I do not think that
    your proposal either exacerbates it or eliminates it. I think
    your proposal is neutral to this.
        One of the concerns I have had about the way auditing
    services have been marketed to date, and it is not something
    that is talked about very much, is that public companies may
    say to an auditor, you are proposing to charge me $20 million
    for my audit. I am not going to pay $20 million. I will pay $10
    million, and I will give you four or five other projects that
    will give us value and you value.
        Obviously, it is none of the Government's business what
    people charge, and I wouldn't ever want to get into that
    business. But what does concern me is, I do not want to create
    a situation in which, basically, what you wind up with is, in
    the free agent market, you have people who basically make a
    decision and can move away. And here, it is a buyer's market.
        The one problem you have with the analogy to the sports
    world is that an Elvis Grbac can be bid on by a lot of firms
    and Grbac makes the decision. Here, what is happening is that
    the Washington Redskins are making the decision and therefore,
    they could push the price in a lower direction.
        Senator Bennett. Well, you stimulate so many things that I
    could say in response that I will have to be very careful and
    try to be quick.
        Two observations. Number one, there is an assumption in
    most of this conversation--I know that you are sophisticated
    enough that you do not share it, but it is certainly there with
    most editorial writers--that accounting is a commodity.
        Chairman Pitt. Right.
        Senator Bennett. That an accountant is an accountant is an
    accountant. One accounting firm is just as good as another, and
    we can switch these things. It is just like switching one
    bushel of wheat for another bushel of wheat. It is a commodity.
        My own experience makes it very clear that is not the case.
        Chairman Pitt. Absolutely right.
        Senator Bennett. Many, many times, the decision to move
    from Accounting Firm A to Accounting Firm B has nothing
    whatever to do with conflicts of interest or transparency or
    anything else.
        In my case, we fired, at that point, a Big Six accounting
    firm, and I am very disturbed to see that now it is toward a
    Big Four, and if we can figure out some way to get it back up
    to the Big Eight, I would be very grateful.
        We fired a Big Six accounting firm because the partner in
    Salt Lake City who was handling our affairs got transferred. He
    was promoted and his replacement was, in our view, incompetent.
    And we went to another Big Six accounting firm for that
    purpose.
        Chairman Pitt. You have put your finger on something, and I
    completely agree with everything you have said. Accounting is
    not a commodity.
        But, again, if the CEO hypothetically is the one that is
    making this decision, and the CEO's compensation depends on the
    profit numbers, and he has two auditing firms, one of whom is
    coming in at twice the price of another and he realizes if he
    can save several millions of dollars, it may affect his
    business, he has his own built-in conflict.
        That is why I want to move this to the audit committee.
    Once you do that, you then tell the audit committee, you are
    not required to make this decision on the basis of any
    particular factor. You should use your business judgment. You
    do what you think is in the best interests of the company and
    its shareholders. But the guy who is getting paid for producing
    a short-term number may treat it as if it were a commodity.
        Senator Bennett. Well, one last comment. The audit
    committees of the boards with which I served would have taken
    into account the economist cost.
        Chairman Pitt. I think they should take it into account.
        Senator Bennett. Just as much. But, as you say, it would
    not be the driving force.
        Chairman Pitt. Exactly.
        Senator Bennett. I had an audit committee that said, we are
    going with this firm rather than this firm because, frankly,
    this firm is over-auditing us, demanding to see papers they
    really do not need to see just so they can run up the bill. And
    this firm, which is equally as competent, knows that they can
    produce an audited statement for, that meets all standards
    without their taking advantage of a CFO who wasn't confident
    enough of his numbers.
        Frankly, I changed auditors. I changed CFO's at the same
    time.
        Chairman Pitt. Exactly.
        Senator Bennett. Thank you.
        Chairman Sarbanes. Thank you, Senator Bennett.
        Senator Schumer.

                 COMMENTS OF SENATOR CHARLES E. SCHUMER

        Senator Schumer. Thank you, Mr. Chairman.
        Thank you, Chairman Pitt. I have a few questions.
        First, I know my colleague, Senator Corzine, asked a little
    bit about something I have been very interested in, this uber-
    auditor.
        I think that having the SEC occasionally do audits or
    investigations might really have a prophylactic effect in a
    whole lot of places, the way people fear an IRS audit. You
    could not do it that often, but doing it every so often,
    particularly when maybe you would smell a rat, would be very
    worthwhile.
        My questions are: What currently actually triggers an SEC
    investigation into accounting practices? Is it ever done
    randomly the way IRS audits are? And how successful have they
    been, not just in the particular area you have looked into, but
    as a prophylactic?
        Chairman Pitt. Actually, I think that question is worth a
    lot of reflection because it goes to some very core issues.
        The Commission commences an investigation when it believes
    there is a reason to think that somebody has done something
    wrong. You can get a confidential informant. You can get a
    restatement. You can get short-sellers who make statements,
    forensic accountants who raise problems.
        We have an Office of Inspection, Compliance and
    Examination. They do not review audit firms. They do not review
    corporations. They do not review law firms. If we had a
    private-sector regulatory body like the PAB that we have
    proposed, my view would be that we would have to do inspections
    of the PAB and through that, look at some of their inspections
    or quality-control reviews of firms.
        Senator Schumer. So, you would need a lot more staff to do
    that, I imagine.
        Chairman Pitt. We would need more staff, or at least we
    would have to find people who were both competent and not doing
    something else that was critical. I do not know yet how much
    staff we would need. But this is not going to be a simple
    process, and we would want people to be trained before they
    went out into the world and raised problems.
        Senator Schumer. What would be the difference between
    having the SEC directly do its own auditing, a separate unit,
    looking here, looking there, and having it be done as looking
    over the shoulder of this PAB? Why would you prefer that
    proposal, that approach, to the one that I have mentioned here?
        Chairman Pitt. The reason, and this is something that I
    actually--it is hard to say this about auditing issues, but it
    is something that I feel passionately about.
        Chairman Sarbanes. I am sorry Senator Enzi's not here to
    hear the comment.
        [Laughter.]
        Chairman Sarbanes. We will certainly communicate that to
    him.
        [Laughter.]
        Chairman Pitt. I waited until he left.
        [Laughter.]
        But the difference is this. What you want are people who
    are professional enough and have enough experience and who are
    properly compensated to do this kind of a job. I do not think
    that the Government is capable of doing this job directly by
    itself, and if it did do it, I do not think it would do it
    well.
        Beyond that, even if it could do it and even if it could do
    it well, because Government will never pay for the talent that
    is really needed, you are not likely to get the best people.
    And if it did pay for the talent, we are talking about hundreds
    of millions of dollars, which I could not justify. I think the
    private sector can pick this up quite well.
        Senator Schumer. The next question is about stock options.
        Chairman Greenspan has said publicly--I know he said it to
    me and I think he has now said it publicly--that if he could do
    one thing to learn from what has happened with Enron, the
    auditing and everything else, he would expense stock options
    because it has created a climate where too much of top
    management is interested in the stock price, unrelated to the
    performance of the company. Do you agree with him?
        Chairman Pitt. Well, first of all, I am always reluctant to
    disagree with Chairman Greenspan. But I would say this. I think
    the short-term mentality and the short-term profit incentives
    that are placed on CEO's is very detrimental.
        As far as I am concerned, the FASB spent an inordinate
    amount of time looking at the stock options question. The
    result they came up with requires companies to show what the
    impact would be. They can either expense it or they can
    disclose what the impact would have been had they expensed it,
    so that shareholders who want that information can get it.
        Whether that decision is right or wrong, I think is open to
    very serious debate on both sides of the issue.
        Senator Schumer. What is the argument against expensing.
        Chairman Pitt. I am sorry?
        Senator Schumer. It is an expense.
        Chairman Pitt. Yes.
        Senator Schumer. What is the argument against expensing?
    You could decide to expense it at different points.
        Chairman Pitt. It may well be an expense, depending upon
    what happens with the options and how they are exercised. But
    my view is this.
        Senator Schumer. Once they are exercised, how are they not
    an expense?
        Chairman Pitt. If they are exercised, then, obviously, you
    are in a different posture. But the point I was making is that
    having gone through this exercise, I would be exceedingly
    reluctant to reopen the issue.
        There are a lot of arguments on both sides of this question
    and my reaction is, we have so many other things to do, the
    FASB in 27 years has not yet given us revenue recognition
    policies. To me, that is critical. This is, in my view, not an
    issue.
        I guess the one place where I would take exception with
    Chairman Greenspan is, I do not think that the nonexpensing of
    options caused what happened in Enron. I do not think any one
    thing caused what happened in Enron. But I certainly do not
    think the nonexpensing of options created that problem.
        Chairman Sarbanes. Senator Carper.

                  COMMENTS OF SENATOR THOMAS R. CARPER

        Senator Carper. Thanks, Mr. Chairman.
        Chairman Pitt, welcome. Thank you for joining us today and
    for your testimony.
        I would like to have us focus a little bit on the audit
    committee and the role of the audit committee. What I have
    tried to do over the last month or so is to talk to a lot of
    people in my State who are involved in corporations and
    corporate boards and those who in some cases oversee them.
        We have met with folks from a number of auditing firms and
    accounting firms to try to understand different aspects of the
    issues that are either going to get some kind of Congressional
    attention or not.
        One of the things I have tried to learn about is to better
    understand the role of the audit committee and who should end
    up on the audit committee, the kinds of expertise they need to
    have, and to the extent that they do not have the level of
    expertise that is needed to enable them to play their
    appropriate role, how might they get it.
        Chairman Pitt. Senator, before I give you what I hope is a
    direct response to your question, I do want to make one
    observation which may be helpful.
        I believe that the audit committee process is incredibly
    valuable. It is good to have outside people, wholly
    independent, looking at something.
        Much of my corporate practice when I was a lawyer was
    advising audit committees. But I will also tell you that, no
    matter what the expertise is, at the end of the day, if
    management is going to play games, no matter how determined,
    how smart, and how experienced the audit committee is, they are
    not going to find it.
        The best you can hope for is to have a process. And to have
    that process, you need people with expertise.
        You want people, first of all, who have some knowledge of
    accounting. You want people who have some knowledge of
    corporate internal controls and record-keeping. You also want
    people who are sufficiently intelligent, that they are not
    going to just sit in a room for 25 minutes, get a presentation,
    and then leave. They are going to ask a lot of questions.
        We held a roundtable on the whole issue and Warren Buffett
    was at our roundtable in New York on March 4. He came out with
    a list of questions that he thought people had to ask.
        Senator Carper. People on the audit committee had to ask?
        Chairman Pitt. The audit committee had to ask. And the
    questions were actually--it is the test of a really brilliant
    idea. When you hear it, you say, that is so simple. Why didn't
    I think of it?
        His approach to that I think was right on. What I used to
    do when I represented audit committees was to help them focus
    on the questions. And then when they got the answers, help them
    focus on follow-up questions so that they did not just accept
    what they heard.
        It is not an easy job. It is one of the reasons why I worry
    about putting too much pressure on audit committees, or even
    potentially, depriving them of a reasonable standard of
    liability.
        Senator Carper. When you have a board assembled and you
    look at the board and you do not have people with the kind of
    expertise, maybe they are bright, but they do not have the kind
    of expertise that you have alluded to, what can be done to help
    them gain that level of expertise?
        Chairman Pitt. Well, I think there are a number of things
    that can be done.
        The audit committee has to have the independent authority
    to hire whatever expertise they think they need.
        Senator Carper. Should the audit committee be hiring the
    independent auditor and should the independent auditor be
    reporting to the audit committee, as opposed to the CEO of the
    company?
        Chairman Pitt. That is correct. That is something that I
    believe quite strongly, that the audit committee should do the
    hiring. But I also believe, if the audit committee is hearing
    something and they are not certain they understand it, that
    there are really two issues.
        First, do you understand what is going on? And sometimes
    people are embarrassed to admit, I do not understand this. They
    need assistance, expertise, lawyers, accountants, who will help
    them say, I do not get it. I need to understand this.
        In addition, I think there ought to be training programs.
    We organized raining programs for the audit committees we
    represented. We would have people from various accounting
    firms, various MBA's and others, come in and talk to them.
        A second area of expertise that I think people need, and it
    is one that we want to bring into the Commission, frankly, is
    risk management.
        I think if an audit committee, and many companies do not do
    this. The securities industry has made great use of risk
    management. But I think if the audit committee can tap into
    risk management expertise and say, tell me, with companies that
    are in this kind of business, where should I be looking for the
    problems?
        That would be a very, very useful effort on the part of an
    audit committee.
        Senator Carper. I know my colleagues have participated in a
    number of sessions outside of these hearings to get input. We
    had a real good session in Delaware earlier this week, talking
    about the motivation of the board to really engage in spirited
    oversight.
        One of the very bright people with whom we were meeting
    suggested that maybe we consider requiring directors to have a
    meaningful, long-term equity position that they could not sell,
    or should not be able to sell, except under some very unusual
    circumstances while they are on the board, and suggested that
    that kind of requirement might provide directors with the
    incentive that they need to engage in aggressive oversight.
    Would you just react to that?
        Chairman Pitt. Yes. Let me just say, on the substance of
    that, I could not agree more. That is one of the reasons why we
    have made it a policy, and it was directed from the President,
    that where people are getting compensated on a short-term
    basis, but it is really a sham, they have to give it back.
        The better way to do it would be to basically say, you
    cannot have the compensation unless it has been evolved over
    the long-term. So, as a policy matter, I think that is what a
    lot of corporations should consider doing.
        Where I start to have a problem is who makes them do it?
    And part of my problem is, I do not think that the SEC should
    be taking over the governance of corporations. I think what we
    should do is use our bully pulpit to say to people and
    investors, this would be a best practice. This is the kind of
    thing that people should do.
        I am not at the point where I would be in favor of adopting
    a rule or recommending that you legislate the area.
        Senator Carper. Thank you.
        Mr. Chairman, thank you.
        Chairman Sarbanes. Yes, thank you, Senator Carper.
        I have a few questions that I want to add, and I am sure my
    colleagues may as well.
        First of all, I think Senator Schumer probably covered
    this, but I was going to ask you this question. You are the
    Chairman of the Securities and Exchange Commission. Why
    shouldn't the Securities and Exchange Commission do these
    things directly, the things that you are going to put into this
    statutory, regulatory organization?
        I take it that your answer to that is we cannot get the
    good people to pay them enough money to do the job. Is that it,
    essentially?
        Chairman Pitt. That's an answer. I think that we won't do
    it as well, but I think there is a more fundamental,
    substantive reason.
        I see what we want from the audit profession as having
    three levels. We want them to obey the law and not do anything
    fraudulent or illegal. We want them to have the highest set of
    ethics. And we want them to be the most competent they can be.
        The SEC is terrific at the first of those. We can make
    people abide by the law. But I think it has been shown that if
    you have an effective system of private regulation, the setting
    of ethical standards and the setting of competent standards can
    be better done through that vehicle than the Government is able
    to do it. That was the whole philosophy of the securities
    industry. And what it gives investors is a three-fold
    protection instead of a one-part protection.
        Chairman Sarbanes. Do you think we have achieved a pretty
    good situation with respect to the securities dealers through
    the workings of the NASD in terms of setting appropriate
    standards, monitoring them, disciplining them, policing, and so
    forth?
        Chairman Pitt. I think that the level of industry policing,
    both by the NASD and by the NYSE has been improving constantly.
    My view is, as with everything, it is not perfect. There are
    places where improvements can occur. But I think it is a system
    that is now serving the public interest exactly as Congress has
    intended it to do.
        Chairman Sarbanes. Do you think that is, if not a model, at
    least something we should look at as we try to formulate how we
    are going to handle the problems that have arisen in the
    accounting field?
        Chairman Pitt. I believe we should look at that model. The
    accounting profession is different from the securities
    industry. But I have spent a number of hours with people from
    the NASD. We had people from the New York Stock Exchange
    participate in our roundtables and we are consulting with them
    to get their input on it. There are some areas where I think
    there is a direct correlation, but others where there may not
    be.
        Chairman Sarbanes. We had Bob Glauber, Chairman and CEO of
    the NASD, as a witness at one of our panels. It is very
    interesting what they are doing. Of course, they have a very
    full-fledged operation. They have a staff of 2,000 employees, a
    budget of $400 million, and they really investigate
    infractions, discipline people, including significant fines, or
    even expulsion from the industry.
        Chairman Pitt. Absolutely. That is what we want in the
    accounting profession. That type of discipline is very good and
    that is why I have spent a fair amount of time with Bob
    Glauber. I am very impressed with what he is doing there.
        Chairman Sarbanes. I wanted to ask a question about
    consultation, in a friendly way.
        Aulana Peters testified about the Public Oversight Board
    and what, amongst other things, prompted them to step down, and
    made the point that, while you had consulted with the
    accounting firms, there had really not been a consultation with
    them. In fact, she went so far as to say that the POB, the
    independent body charged with oversight of the accounting
    profession, and in that regard, assigned the duty to act in the
    public interest, was effectively excluded from a process of
    great moment for the profession and the public it serves. And
    the fact that you had been in discussion with the Big 5.
        That really raises an issue that also we have been hearing
    from others about how broad and extensive the consultation the
    SEC is engaging in.
        Now, we did these hearings. We tried to cover the
    waterfront, so to speak, and to make sure that everyone had an
    opportunity. And I have found in the past that sometimes you
    may have very sharp exchanges with people and you do not really
    agree with them. Later, when you reflect about what they have
    said and what the discussion was, out of that comes some
    important perception.
        We had a panel yesterday, the Council of Institutional
    Investors, the Consumer Federation of America, the AFL-CIO, and
    the Association of Investment Management and Research on that
    panel.
        I am just kind of curious, has the SEC been, in a sense, in
    consultation with them or been having direct opportunity to
    hear from them as you wrestle with these problems? To what
    extent are they folded in to your consultation process?
        I think one of the reasons your initial proposal met the
    kind of, some of the negative comment on it, was that it was
    perceived as having been a proposal that emanated from a
    discussion between the SEC and the five accounting firms and
    not extended beyond that. And, of course, you did have the
    Public Oversight Board on the scene.
        So, I am just curious what your approach is to this
    consultation question and how extensively it has been done to
    this point. And if not done extensively, whether that could be
    addressed as we move ahead.
        Chairman Pitt. Actually, I am pleased you asked the
    question. I do not take it as an unfriendly question. I think
    you have a perfect right to ask it and you deserve a clear
    answer.
        First, let me say that I understand what Mr. Bowsher and
    Aulana Peters said about the reason why some of the POB members
    voted to disband. And I am really not going to get down in the
    muck with some of the accusations that some people have made.
    But let me answer your question more directly.
        We consulted on accounting regulation with the POB long
    before we consulted with the CEO's of the companies. Mr.
    Bowsher had been to my office. His lawyer, Alan Levenson, had
    been in repeated conversations and phone calls with me. And
    long before we ever met with any of the CEO's, I had a specific
    conversation with Mr. Levenson in which I said, when we finally
    come up with a proposal, we want the POB to be a part of this.
        The first point I will make is that, I like to talk to
    everybody. I do not have a lock on what the right answers are.
    And I find that by listening to others, I learn a great deal.
    Mr. Bowsher had a lot of experience, which is why he was in my
    office and we met.
        Now when we announced the structure of what we were
    thinking about, I went to great pains to make it clear that
    this was something for people to start to think about and we
    would then meet with people about what we had in mind.
        So when the POB voted to terminate its existence, I wrote
    them a letter. I noticed that when Mr. Bowsher testified, he
    gave you the letters that he wrote. But he did not give you the
    responsive letters that he got from me.
        Chairman Sarbanes. Well, we have all the letters, so that
    is not a problem for us.
        Chairman Pitt. I hope so.
        Chairman Sarbanes. Yes.
        Chairman Pitt. I first wrote him a letter and said that I
    thought their action was unfortunate. My view was that I wanted
    them to have a role to play and to learn from their expertise.
    But what I was not going to do is keep the POB unchanged
    because I believed it was flawed: Its funding came from the
    AICPA; it has no disciplinary power whatsoever; and its peer
    review was viewed as, you scratch my back, I will scratch
    another. And it was unsatisfactory to me to continue with the
    POB, and I think Mr. Bowsher knew that because I told it to
    him.
        Nonetheless, I told him that I wanted to understand their
    views. I then spoke with every single member of the POB, met
    personally with Mr. Bowsher in San Diego, and then attended a
    meeting with the POB where I made all the statements I have
    already made to you. I said, we need your expertise; we would
    like your assistance. It is in the public interest for you to
    help us, and that is what we would like you to do.
        But having just said that, let me now talk about the CEO's
    of the accounting firms because I take this as a point of great
    concern to me.
        I represented a lot of people when I was in private
    practice. And I do not believe in guilt by occupation.
        When I came here and took an oath of office, and you had me
    under oath at my confirmation hearings, I told you that I had
    only one client now, and that was the public investor. I meant
    it, and anybody who knows how I have performed will tell you
    that is exactly what happened.
        When I saw things deteriorating in the accounting
    profession, I asked the CEO's of the major firms and the AICPA
    to come to a meeting. And at that meeting, it was very simple.
    Nobody negotiated. Nobody talked about what kind of a deal we
    could make.
        I basically laid down the law to them. I said, there are
    problems here and either the profession is going to step up to
    the plate and take responsibility for cleaning up the public
    perception, or it is going to be done to it. It may be done by
    us. It may be done by Congress. It may be done by the courts or
    it may be done by all of the above. And I then said, there are
    all sorts of things that you are going to have to deal with and
    you are going to have to deal with popular perception.
        So knowing what I think is required, you come back with
    something. And if you do not, then I will come up with
    something.
        Those were my negotiations.
        I said at a press conference, and I will say it here, I do
    not negotiate about the public interest. I did not negotiate
    with any members of the accounting profession or the AICPA.
        What I think we have come up with--and we have laid it out
    as strongly as we can in this very lengthy statement--is
    something that this Congress should be proud of. I know we
    would be. And that is why we have a unanimous view on the
    Commission vis-a-vis our testimony.
        Chairman Sarbanes. Have you consulted with these groups
    that we heard from yesterday that I asked you about? What is
    the nature of that consultation?
        Chairman Pitt. Yes. I have consulted with investor groups:
    The Consumer Federation of America, Barbara Roper will tell
    you. I have had Mel Minnow in. I have had people from Calpers
    in. For example, with the Consumer Federation of America, I
    reached out to them. I did not wait for them to call me.
        I will say that there are clearly differences in the way
    some people behave. Some people pick up the phone and call you
    first, some people wait for you to call. But there is no group
    that I will not talk to and, indeed, I talk to every group.
        You may recall, and this is off the point, one of the
    questions you asked me at my confirmation hearing was about the
    union. One of the first things I did when I took office was to
    invite the union representatives to my office to tell me what
    their problems were. And the fellow who is the local union
    leader, said: I have been at the SEC for 11 years. This is the
    first time I have ever seen the Chairman's office.
        There is no one that I won't listen to.
        With respect to some of the other things, I do want you to
    know that we have had roundtables and Barbara Roper, again of
    the Consumer Federation, is scheduled to appear at our Chicago
    roundtable, which is set for April 4. Sarah Teslik of the CII
    is scheduled to meet with the SEC on March 26. And I spoke at
    the annual meeting of the Consumer Federation of America where
    I announced that we would hold an investor summit.
        I am very committed to investor protection and I take my
    oath of office very, very seriously.
        Chairman Sarbanes. Senator Gramm.
        Senator Gramm. Thank you, Mr. Chairman.
        I first want to say that--and I know the Chairman did not
    imply this in any way, so I am not responding to what he said--
    but I think talking to the accounting firms is vitally
    important.
        One of the things that disturbs me about this process we
    have been going through in the last year is this feeling that
    there is somehow something corrupting about talking to people.
        You know that there has been this effort to pin Enron on
    the Administration. Things that are held out as potential proof
    is that somebody listened to what somebody said.
        I cannot imagine a country in which the president of one of
    the largest companies in America calls to talk to a Government
    official and cannot talk to him. I think setting down how
    things are going to be with the Big 5 accounting firms is
    important, but I also think listening to them is important. And
    I want to share a little story.
        When I first came to Congress, we had a bill on the floor
    about hazardous waste. And it had to do with small generators
    of hazardous waste. As you can imagine, nobody in Congress knew
    anything about the subject and therefore, we were legislating
    on it.
        [Laughter.]
        I received a letter from a little garage in my district.
    This is in essence what the letter said. I read the letter on
    the floor of the House of Representatives. He said: I am pretty
    responsible. When I get crankcase oil or solvents, I collect
    them and I put them in a barrel. And then when the barrel is
    full, I call the guy from the waste disposal company and he
    comes by and gets them.
        But let me tell you something, he said. If you make me
    assume liability for what he does after he puts that barrel on
    his truck, if you make me keep a long list of paperwork, you
    know what I am going to do? I am going to take those hazardous
    wastes and I am going to flush them down the toilet and I am
    going to let the City of Bron worry about it.
        Now, somebody could say, well, my God, you were corrupted
    by talking to potential polluters.
        The point is, when I read that letter on the floor of the
    House of Representatives, we changed the bill and took into
    account these small people who were generating relatively small
    amounts of hazardous waste, and I think came up with a
    procedure whereby this guy won't be flushing the stuff down the
    toilet.
        I am probably overstating the case, but I am really
    concerned about this idea that listening to people and talking
    to people is corrupting. The Constitution guarantees the right
    of people to petition the Government. I just think it is
    vitally important that we never get defensive about talking to
    people or listening to people, especially people that are
    involved.
        Quite frankly, I have regard for every self-appointed group
    in the world, many of them who have no constituencies
    whatsoever. I represent more consumers than any group in
    America. I have 21 million consumers. I am an embodiment of
    consumer interest in this country.
        [Laughter.]
        I think it is important that you listen to them. But I do
    not think it is important that you listen to them as it is that
    you listen to the people who actually are involved in the
    business.
        So, I just wanted to make that pitch. I think it is very
    important to listen to everybody. And from what you have said,
    it is clear to me that you are willing to meet with and listen
    to anybody, and I think that is commendable.
        I am not trying to set differential levels, but I do
    believe if you are going to impose a rule on the accounting
    profession, or if you are going to set hazardous waste
    standards for garages and filling stations, the most important
    visit, the most important person to listen to is somebody who
    is in the accounting business or somebody who is running a
    garage or somebody who is running a filling station. And if we
    ever get to the point where you are tainted by talking to
    people, then the whole system is going to break down.
        Chairman Pitt. I just want to say, I could not agree more
    with everything you have said. I do want to make one other
    observation.
        My first crisis was not Enron. It was 9/11. And the first
    thing I did was get together the heads of all of the major
    brokerage firms and the major marketplaces, and we started to
    talk about what the public interest required.
        We received great acclaim for doing that. People said, that
    was a great approach. You listened to people. The way it worked
    was terrific.
        When Enron hit, I did exactly the same thing. But now
    people were saying, let's look at all the people this fellow
    has represented in his lifetime because, after all, this is a
    political mess, they think, and therefore, nobody's bona fides
    are above reproach.
        Senator Gramm. If I could just say in conclusion on that,
    their tactic is an old tactic that was used in Nazi Germany.
    Their tactic is guilt by association and trying to exclude
    people from having an opportunity to have their say.
        Chairman Sarbanes. Well, now, I think this thing is getting
    carried away here.
        [Laughter.]
        Let me just try to get it back into a little focus. The
    test of your stewardship will be the substance of what is done.
        Chairman Pitt. Exactly.
        Chairman Sarbanes. We recognized at the time that you were
    nominated what you had done over your career and the premise,
    at least on my part, in carrying forward that nomination was
    the belief that you could drop at the door, in effect, the
    clients of your private practice when you went into the public
    office, and that, in effect, what would renew itself would be
    the commitment you had when you were at the SEC, when you
    became its youngest general counsel in its history, and the
    commitment to the public interest that marked your private
    career as well, and of course, you represented clients within
    that context, which is what lawyers do under our system and we
    recognize that.
        Obviously, questions were raised at the time. Presumably,
    questions will continue to be raised. So there is an extra
    burden, in a sense, given the history to produce the substance,
    and of course, that is what we are searching to do here.
        Now, I think you have an affirmative obligation to reach
    out for consultation. I do not think it is enough to say, well,
    if they get in touch with us or they communicate with us, why,
    we will try to be responsive.
        I think there is an obligation on the Commission to make
    sure that it is reached out and heard from everyone, so we do
    not have people saying, well, you know, we represent investors
    and we have a long history of doing that, and we have a concern
    here, and we do not feel that our concerns are getting through.
    Obviously, we shouldn't run into that.
        But the test here for all of us is going to be what we can
    produce on substance because you can review the records of
    Members of the Congress and find one thing or another that
    would raise a question as to with what frame of mind do they
    come to the issue?
        That is the thing, obviously, we have to work on in the
    weeks ahead, to put together a structure here that will work.
        This structure has not worked. No one has come to us and
    said that the existing structure was working okay and we just
    essentially ought to leave it alone. No one has said that.
    Therefore, the question now is what do we do about it and how
    do we remedy this situation, and that is what we are focused
    on.
        In that regard, I just want to leave one thought with you.
        You are a very nuanced thinker and I respect that. But it
    seems to me that we are now working in an area where we are
    going to have to draw some bright lines. I am not out to draw
    anything but bright lines, and it seems to me we have reached
    that point.
        I think in a sense, if you look at something and you say,
    well, that will work for 99 percent of the times, but there is
    this 1 percent when it may not work. And therefore, we have to
    leave it open to take care of that 1 percent, that is a way of
    thinking that I am used to, but not when you are under this
    kind of, what I regard as something of a crisis situation.
        So, I think as we move to try to deal with this, we cannot
    have it all so loose and flexible that it is open again to
    sliding down the slippery slope and having a renewal of many of
    these problems.
        That is one of the things we have to work at. That is why I
    went through that questioning earlier, because I was trying to
    take a scalpel in order to see if we cannot draw the lines. Not
    a meat axe. We understand the problems that are associated with
    that.
        Chairman Pitt. May I just say one thing on that? I
    apologize,
    because I agree completely with what you have said.
        Part of the reason I was so successful in private practice
    was because I was pragmatic. When people did something or came
    to me with something that I thought was a problem, I was not
    afraid to tell them that it was a problem. And when people
    asked me to find a solution, I wasn't afraid to find a
    solution, provided it was in the public interest. And so, I
    could not agree with you more. I am not interested in defeating
    something here. I am interested in working with you.
        I think you have shown great concern for the small
    investor. I have enormous admiration, as well as respect, for
    what you are doing and I want to be a helper, a participant,
    even perhaps a partner, in working with you and the rest of the
    Committee to come up with the very best structure we know how.
        The other thing I do want to say is, I do reach out to
    people. I have reached out to everyone. And in particular, I
    can assure you that the CEO's and the AICPA did not reach out
    to me for that meeting. They would have been just as happy if
    they never had it. But I reached out to them.
        Chairman Sarbanes. Senator Corzine.
        Senator Corzine. Thank you, Mr. Chairman.
        I do not really have anything to add on this outreach
    issue. But being someone who tries to formulate policy or
    previously, responses to business situations, both the timing
    of when you see people and the amount of time that you spend in
    delving into how ideas are generated, was also an important
    ingredient.
        Some of the kinds of conflicts that sometimes come after
    the fact reflect the chronology and the timing of the
    proposals.
        If the horse is out of the barn with regard to a proposal,
    then some people can feel like, well, they may have been
    consulted for changes, not really in the formative stage.
        More important, I would like to go back to FASB and its
    role in a new structure.
        I am a little troubled. I look at your testimony on page 36
    which has to do with FASB's agenda and you talk about revenue
    recognition, taking 27 years to get to a proposal. Then I read
    on page 35 of your discussion about accounting standard setting
    and making an eloquent case why Federalization would be such a
    horrible idea because it is so laborious and subject to
    political interference and lacking in flexibility.
        Then I turn around to the discussion that goes on about
    FASB's agenda over the last 27 years, when we have had
    Republicans and Democrats and it is not a matter of
    partisanship. It is a matter of this doesn't seem to have
    worked in a lot of ways in getting to the right kinds of
    answers.
        Some of it may be the SEC. I think one of the questions we
    have to ask ourselves while we are going through this process
    of how we put this structure together, your PAB or somebody
    else's independent regulatory board, should FASB be a part? I
    think we all agree that it needs independent funding so that it
    doesn't have to use the tin cup to go to those that it is
    proposing rules to come up with the resources to be able to
    come up with it.
        You could also have a strong case that the information that
    you gain from auditing the auditors and understanding the
    practical applications of what you do, relates to how FASB
    might want to set principles or maybe get completely out of the
    rulemaking business. I doubt it.
        But if that were the case, how do you feel about making all
    of those elements responsive through a coordinated chain of
    command, if you would, as opposed to having them separate and
    independent in different formats?
        Chairman Pitt. Well, I am usually never in doubt about
    things, although I am seldom right. But on this, I will tell
    you, my instinct says that if you have had a stand-alone
    organization and you now try to squeeze it into some other
    organization, you have to be certain that you are not going to
    diminish what you already have, and I think there are real
    problems with it.
        I am also going to tell you that I do not think there is
    absolute truth on that issue.
        What I think has to be coordinated is the fund-raising. I
    do not think you can have an FAF that goes out and seeks
    voluntary contributions for FASB and then have a PAB over here
    that has involuntary contributions.
        At least as to fund-raising--not fund-raising as to fees
    and revenues--I think they need to come from the same source.
    You cannot keep going back to people more than once and so on.
        As to whether they are stand-alone or not, my instinct is
    that setting accounting standards is sufficiently discrete that
    it could be separate. And if you said to me, you wanted it to
    be together, I would say great. If you want me to help you
    draft it, I will.
        Senator Corzine. Two observations. One, the NASD and the
    New York Stock Exchange models tend to combine those because
    they use the information that is available, I think, and people
    think is a reasonable model. And two, I really would like to
    hear your observation on how you think FASB actually has
    worked.
        Senator Gramm. Jon, would you talk into the microphone, I
    cannot hear you.
        Senator Corzine. I am trying. Good Lord, I am trying.
        Senator Gramm. I want to know what you are saying.
        [Laughter.]
        Senator Corzine. I would love to hear your comments with
    regard to the NASD and the New York Stock Exchange as its
    relative model, which I think we have talked about. Then I
    would like to hear your observations on the functioning of
    FASB, why it has not worked or has worked, or whether you feel
    good about that process.
        Chairman Pitt. I think the NASD and the New York Stock
    Exchange have one thing in common--they reflect a Congressional
    notion of self-regulation and the idea that self-regulation can
    work.
        I think the NASD now reflects the notion that when you have
    a proprietary activity--namely, running a marketplace--and
    where capital becomes very important to that proprietary
    activity, maybe it is easier to regulate that market if you
    separate regulation from proprietary activity.
        The New York Stock Exchange has gone in a different way and
    we stand in review of both of them to make sure that the
    quality of regulation is the same, notwithstanding that.
        But when I thought about the PAB, the model I looked at was
    the NASD and the New York Stock Exchange, and it is why I spent
    time with Glauber. I have had several meetings with him. Why I
    have spent time with Dick Grasso. And why I have tried to build
    in what I think is acceptable in those areas, recognizing that
    accounting is a profession and it does have a different
    predicate.
        I think the models that those two self-regulatory bodies
    have provided are excellent with one exception--I think given
    the lack of public confidence that has arisen, and some of it
    is incredibly well deserved. Some of it is just hype. But there
    is a lack of confidence. We cannot have self-regulation of the
    accounting profession.
        So the place where I have moved the model is to say, I
    think you have to have private-sector regulation, but not self-
    regulation. I do not think self-regulation will produce the
    confidence that I want.
        As to how FASB has worked, it is very easy for me to tell
    you that FASB has not worked as well as I think it was intended
    to work. I think that the accounting standards that we have in
    this country, as of this moment, are the best in the world. And
    FASB has produced a lot of those accounting standards. The
    people there have been very thoughtful. They are very smart.
    They are very bright, and they are very well-intended. And so,
    to that extent, I do not want to move away from FASB.
        What has not worked is that they have had difficulty
    raising funds. They have been subject to political pressure.
    And they have approached the issue of dealing with setting out
    accounting principles as if they were writing a trust
    indenture. And to my way of thinking, the world has moved away
    from that. Whether it was always that way or not is really of
    little relevance to me.
        If FASB continues the way it is now, we will have big
    problems. But I think it has done a very credible and fine job
    in a number of areas. I think it can be materially improved and
    the views that we have talked to them about, which they have
    been quite accepting of--they are reducing the size of the
    Board. It is now going to be five and they are going to adopt
    rules by a majority. I have told them I want them to shoot for
    a 60 to 90 day turn-around period on proposals, and that we
    will respect what they come up with, but they have to come up
    with something.
        They won't do 60 to 90 days, but they will do better than 5
    years or 10 years. They won't give us 800-paragraph principles
    any more. They will give us much broader principles that will
    be the kind of appropriate approach that we need and won't
    allow people to use check-the-box mentality to justify having
    billions of dollars in off-the-financial-statement liabilities
    that nobody knows about.
        I said early on when Enron hit, and I am not commenting
    about what happened there because, frankly, I don't even know.
    I am not part of the investigation. I am not participating in
    it. But I said there were two problems there. One is that they
    got the accounting wrong. And they must have gotten some of it
    wrong because they took a huge restatement. But the worst
    problem is they may have gotten some of it right.
        That to me is why the system has to be fixed.
        My big concern is that the problems that we see in FASB did
    not arise with Enron. They have been around for the last 5 to
    10 years, and nothing was done to fix it. We intend to fix it.
    If it is done by legislation, we are going to work with you and
    we will do what you want. But we cannot wait to fix FASB. We
    have to fix it immediately. It is broken and it has been broken
    for too long.
        Senator Corzine. Thank you.
        Thank you, Mr. Chairman.
        Chairman Sarbanes. Mr. Chairman, thank you very much for
    coming. As you know, we are trying to get you a budget increase
    so you can address the pay parity issue, which I think is
    extremely important, particularly having promised people they
    were going to get pay parity, and now, not to deliver on that
    promise, it seems to me, is just going to significantly
    compound your morale problem at the SEC. You have enough
    challenges without starting to lose--or continuing to lose, I
    should more accurately say--extremely able and competent
    people.
        We very much appreciate your being with us today.
        Chairman Pitt. Thank you.
        Chairman Sarbanes. The hearing is adjourned.
        [Whereupon, at 1:10 p.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]

                   PREPARED STATEMENT OF SENATOR TIM JOHNSON

        Chairman Sarbanes, thank you for holding today's hearing to discuss
    issues related to the oversight of the accounting profession, audit
    quality, and the formulation of accounting standards. Also, I thank
    Chairman Pitt for agreeing to speak with us today. I am sure that these
    are challenging times at the SEC, and I particularly appreciate your
    efforts to prepare for and attend today's hearing.
        Today's hearing is the culmination of a series of 10 hearings that
    have enabled us to gain a thorough understanding of the pertinent
    issues. Mr. Chairman, I want to commend you for the constructive tenor
    of these hearings, and for allowing us to accomplish a great deal in a
    relatively short period of time.
        As I have noted previously, the Enron Corporation debacle and other
    recent high-profile corporate bankruptcies represent a serious national
    scandal, one with terrible human and financial cost. Concern about
    audit and accounting practices have dogged many of these business
    failures. Furthermore, these accounting woes appear to be widespread,
    as is evidenced by the recent increase in the number of earnings
    restatements precipitated by accounting problems.
        These developments have shaken the financial markets and left
    lingering doubts in the minds of investors about the integrity of the
    individuals and firms responsible for providing honest and unbiased
    financial information. We in Congress need to make sure that regulators
    and industry participants implement changes to address these issues.
        The most obvious way to make progress is to give the SEC the
    personnel and the financial resources it needs to take strong
    enforcement measures against illegal accounting practices. I was
    disappointed that President Bush failed to provide these resources,
    even though the Congress spoke with one voice last year in passing H.R.
    1088. As a member of the Senate Appropriations Committee, I will fight
    for these resources so we can have a strong and effective SEC to
    protect our capital markets.
        Another important avenue for accomplishing this goal is through
    constructive and targeted legislative reforms.
        I am very proud to join with Senators Dodd, Corzine, Stabenow, and
    others in cosponsoring a bill to address the problems that have become
    evident in audit and accounting practices at publicly-traded firms. S.
    2004, the Investor Confidence in Public Accounting Act of 2002, tackles
    these problems by creating a framework to give investors access to
    transparent, accurate, and unbiased financial information crucial
    ingredients for the proper functioning of our free market economy.
        The bill provides improved oversight of the auditing profession by
    establishing an independent regulatory organization that would be
    responsible for establishing audit standards, maintaining proper
    quality control oversight, and ensuring proper enforcement of
    violations. S. 2004 would also designate a fully independent
    organization to set generally accepted accounting principles. In
    addition, the bill clarifies auditor independence standards and
    provides for greater transparency in financial disclosures.
        I would note, however, that these provisions should not materially
    affect small accounting firms or businesses that rely small accounting
    firms. Since the bill pertains primarily to accounting firms that
    conduct work for publicly-traded businesses, small businesses will be
    largely unaffected. I continue to be very concerned about the effect
    that any piece of legislation would have on small, Main Street
    businesses. I will continue to work to ensure that any legislation of
    this type protects the ability of small firms to compete in the
    marketplace.
        I thank Chairman Pitt for his extensive and thoughtful written
    testimony, and I once again thank you, Mr. Chairman, for scheduling
    this hearing.

                      PREPARED STATEMENT OF HARVEY L. PITT

               Chairman, U.S. Securities and Exchange Commission
                                 March 21, 2002

        Chairman Sarbanes, Senator Gramm, Members of the Committee: I am
    pleased to appear before the Senate Banking Committee on behalf of the
    Securities and Exchange Commission. As the final witness in the series
    of hearings you have held over the past 2 months, I have followed with
    great interest the many issues this Committee has explored surrounding
    high profile business failures in recent years, including, most
    recently, the collapse of the Enron Corporation. At the outset, Mr.
    Chairman, I would like to express how much my fellow Commissioners, our
    staff, and I appreciate the thoughtful and deliberative approach you
    have taken in these hearings. The record these hearings have developed
    will help us all advance our thinking on improvements to our current
    regulatory system and surely will be a landmark example for future
    Congresses to follow. Undoubtedly, the record compiled will provide a
    thorough foundation for making our Nation's Federal securities laws
    more responsive to the current-day needs of investors, whether by
    legislation, regulation, or some combination of the two.
        On a related note, we want to thank you, Mr. Chairman, Senator
    Gramm, and all the Members of this Committee for your strong,
    bipartisan support of our agency. This Committee, of course, has had a
    long tradition of supporting the SEC; but over the last several months,
    as we have witnessed not one but three separate crises affecting our
    capital markets, you have provided leadership and strong support for
    our efforts, and I am personally grateful for your wisdom, support, and
    encouragement. In addition, we deeply appreciate the support of the
    entire Committee for funding pay parity for our staff and your concern
    for our agency's resources at this especially critical time. I will
    address resources later on in my testimony, but I wanted to begin a
    substantive discussion by both commending and thanking you, Chairman
    Sarbanes, Senator Gramm, and the Members of the Committee, for your
    extraordinary support.

                                  INTRODUCTION

        The past 7 months have tested the mettle and resiliency of our
    country, our markets, and the investing public's confidence. With the
    events of September 11, the bankruptcy of Enron and, just last week,
    the indictment of Arthur Andersen, we have witnessed how critical our
    appropriately vaunted capital markets are to the strength, security,
    and spirit of our country and our economy. All Americans have felt, and
    continue to feel, the consequences of these events. These hearings
    appropriately address the crisis created by the implosion of Enron
    Corporation. But before we turn to Enron's impact, it is important to
    keep in mind that, from the perspective of the Federal securities laws,
    all three crises have much in common. In each, the continuity and
    integrity of our capital markets was, or is, put in play. The response
    to the tragic loss of lives, and the sudden shutdown of our capital
    markets after the terrorist attacks of September 11, presented a model
    for all of us, and the rest of the world, on how to address and respond
    to a crisis. From the President's unstinting and fearless leadership,
    to bipartisan cooperation in the Congress, we
    responded quickly and forcefully to an unthinkable crisis. With the
    implosion of Enron, and the indictment of Arthur Andersen, my hope is
    that we will follow the model set last September, and work
    constructively together to restore vital confidence in our capital
    markets.
        With Enron's disintegration, innocent investors, employees, and
    retirees, who made life-altering decisions based upon a stock's
    perceived value, found themselves locked-in to a rapidly sinking
    investment that ate up the fruits of years of their hard work. It is
    these Americans, whose faith fuels our markets, whose interests are,
    and must be, paramount. America's investors are entitled to the best
    regulatory system possible. The Commission as an institution, and I
    both as its Chairman and personally, are committed to doing everything
    in our power not only to prevent other abuses of our system, but also
    to improve and modernize our existing system.
        In the aftermath of Enron's meltdown, our agency currently is
    conducting an enforcement investigation to identify violations of the
    Federal securities laws that may have occurred, and those who
    perpetrated them. Until the investigation is complete, the Commission
    cannot address the specific conduct of Enron Corporation and those
    involved with it, or the activities currently under investigation. The
    public can have full confidence, however, that our Division of
    Enforcement is conducting a thorough investigation and that the
    Commission will redress any and all wrongdoing and wrongdoers swiftly
    and completely.
        Nothing that has occurred in recent months should undermine, or be
    allowed to undermine, investor confidence that our markets, or the
    regulatory system governing them, are still the best in the world. Our
    capital markets are still the world's most honest and efficient. Our
    current disclosure, financial reporting and regulatory systems also are
    still the best developed, the most transparent, and the best monitored
    by market participants and regulators. No other system yet matches the
    depth, breadth, and honesty of our markets, and it is important that we
    not lose sight of that critical fact. While some foreign regulators
    have publicly claimed that Enron would not have collapsed under other
    systems, I tell you unequivocally that any such claim is unsupportable.
        But even though our system is the best at present, we can, and
    must, do better. As more and more individuals become direct
    participants in our markets, and face increasingly difficult investment
    decisions that affect their lives, savings goals and retirement
    security, we need to maximize the utility of our existing system for
    individual investors. At the same time, we must find a way to
    facilitate and promote the ability of American businesses to raise
    capital efficiently and expeditiously.
        At my confirmation hearing before this Committee last July, I noted
    that our core securities laws are nearly 70 years old and reflect a
    time and state of technology long past. I promised to lead a review of
    the requirements the SEC administers to be certain they are sound,
    reasonable, cost-effective, and promote competition. At that hearing,
    many Members of this Committee, including Chairman Sarbanes and Senator
    Gramm, discussed with me the need for reform in the areas of corporate
    disclosure, accounting, analysts, and even crisis management. The
    events that have occurred since then have focused national attention
    and scrutiny on these needs. But as you are all well aware, the need
    for comprehensive reform in these areas did not arise overnight. In
    fact, this Committee had identified many of the issues with which we
    are now grappling even before I was confirmed. It is important to keep
    in focus the fact that our system has long needed regulatory attention,
    especially as we evaluate competing claims for solutions to currently
    perceived problems.
        At my confirmation hearing, Senator Dodd gave me wonderful and sage
    advice. He said:

              [Y]our job is not to become the most popular guy in town. It
            is to be the guy that actually will look at us and tell us,
            when we may be calling on behalf of constituent interests, no
            matter how popular it may be, that you have an obligation to do
            what is really right on behalf of investors in this country,
            the consuming public that depends upon the integrity of these
            markets. . . . [A]t the end of the day, you have to decide--the
            Commission does--what is really in the best interest of
            maintaining those basic pillars and standards that have . . .
            sustained this country and its markets and their integrity for
            so long.

        I am reasonably confident that I have already satisfied and
    surpassed Senator Dodd's first standard--clearly, I am not ``the most
    popular guy in town!'' Today, I address Senator Dodd's second guiding
    principle--I will tell you what we think in unvarnished fashion.

                              OPERATIVE PRINCIPLES

        In dissecting the weaknesses Enron has highlighted, and exploring
    appropriate solutions, we should start by recognizing the substantial
    agreement and consensus that exists. We all know there are problems.
    Enron will stand in history as the symbol of the excesses of the
    1990's, when our markets lived on a culture of speculation, with too
    many market participants believing the market could only go up. Enron
    is the poster child for something that has been evident for a long
    time--our financial disclosure and reporting system has not kept pace
    with changes in our markets, and as a result, it does not work as well
    as it should. Enron is tragic, and we grieve for the losses investors
    and employees suffered. Enron also must be a catalyst for lasting
    reform.
        In analyzing the aftermath of Enron, there are two discrete issues
    we must address, and concomitantly, two discrete attributes the
    solution to both issues must possess. First and foremost, it is no
    secret that the public's confidence in our capital markets and
    disclosure system has been shaken over the past 7 months. Therefore,
    whatever it is that we do, we must do it quickly. Second, our system of
    financial disclosure and reporting, corporate governance and accounting
    regulation are in need of significant improvements and updating.
    Therefore, as we act quickly, we must also act wisely and
    comprehensively.
        As we work together, we need to identify the problems requiring
    solution, discuss the range of proposed solutions, consider
    alternatives to, and criticisms of, those alternative solutions, and
    accept the timeless truth that, in matters of this nature, there are no
    perfect answers, there is no absolute truth. Indeed, to paraphrase both
    Voltaire and von Clausewitz, the worst enemy of a good solution is a
    perfect one.\1\ Both Congress and the Commission must act--at the
    Commission, through regulation, which has the benefit of greater
    immediacy, pursuant to our existing and ample available authority; in
    the Congress, through legislation, which has the benefit of extending
    the reach of our available authority where necessary. The fact that we
    have ample authority to pursue most of our reform objectives does not
    lessen our obligation to consult and work with Congress. But it does
    mean that Congress should be cautious in passing legislation unless it
    is clear that our authority simply cannot get us to the finish line.
    Together, I am confident that we can solve these problems in the best
    interest of the public.
    ---------------------------------------------------------------------------
        \1\ Francois Marie Arouet Voltaire, Dictionnaire Philosophique,
    ``Le mieux est l'ennemi de bien'' (``Perfection is the enemy of the
    good''). Compare also Carl von Clausewitz, On War (``The greatest enemy
    of a good plan is the dream of a perfect plan.'').
    ---------------------------------------------------------------------------
        Regardless of the reforms we discuss or adopt, one point must be
    absolutely clear. The Commission and our Division of Enforcement are
    vigorously engaged in enforcing the current securities laws. Make no
    mistake, the SEC is the markets' top cop and--with additional resources
    this Committee has sought for us--we will carry out our mission with
    even greater vigor.

                           OVERVIEW OF NEEDED REFORMS

        Our system requires that corporate leaders be faithful to the
    interests of investors and to act with both ability and integrity.
    Complete and accurate disclosure and
    financial reporting to investors and markets are important parts of
    this duty. The most important challenge to corporate governance today
    is to restore the preeminence of this duty. This is as much a moral
    imperative as a legal one.
        In recent years, corporate leaders have been under increasing
    pressure from the investment community, including individual investors,
    to meet elevated expectations. They also have been operating under a
    system that can misalign the incentives of investors and those of
    management. Our culture over the past decade has fostered a short-term
    perspective of corporate performance. Corporate leaders and directors
    have been rewarded for short-term performance, sometimes at the expense
    of long-term fundamental value. Investors have purchased stock not
    because they believed in the business or its strategy as an investment
    over the long-term, but simply under the assumption that stock prices
    would only go up.
        But after a most incredible bull market, we have had to witness the
    truth of the timeless axiom that whatever goes up can also come down,
    and not only because of a reversal in business outlook or fundamentals.
    Corporate leaders, under pressure to meet elevated expectations in the
    bull market, in too many instances were drawn to accounting devices
    whose principal effect was to obscure potentially adverse results.
    Moreover, the effectiveness of a number of the checks and balances
    intended to ensure that we achieve appropriate corporate governance and
    financial reporting and disclosure also declined. These include reviews
    of financial reporting by outside auditors and the activities of audit
    committees. The moral imperative on those intended to provide the
    checks and balances has eroded and must be restored. Out of the ashes
    of the Enron debacle, corporate reputation is reemerging as a
    significant economic value. Corporate governance appears to be
    improving as a result of this greater market discipline in the wake of
    the Enron debacle. But much more needs to be done.
        Confidence in our capital markets begins with the quality of the
    financial information available to help investors decide whether, when
    and where to invest their hard-earned dollars. Comprehensible
    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 full and
    fair disclosure of this information. Companies choosing to access the
    public capital markets must provide material information about their
    financial results and condition, businesses, securities, and risks
    associated with investment in those securities.
        This Committee and its distinguished predecessors wisely permeated
    the Federal securities laws with the philosophy that full disclosure is
    the best way to permit markets to allocate capital. Congress rejected a
    ``merit-based'' system of regulation, which could have been construed
    as Government's approval or guarantee of securities issued by public
    companies and that could unduly interfere with efficient market
    allocation of capital. Optimal capital allocation requires that there
    not be limits on entrepreneurship or companies failing, or on
    permitting people to invest in companies that will fail. There must,
    however, be complete, clear, and timely disclosure to support the
    market's allocation decisions. We believe it is important to maintain a
    disclosure-based regulatory system that relies on capital allocation
    decisions made by market participants.
        The success of our markets has not been due just to their depth and
    breadth, but also to their quality and integrity. In the wake of the
    Great Depression, when world economic forces caused precipitous and
    calamitous declines in equity market values, this Country learned that
    investors are willing to commit their capital to markets only if they
    have confidence that those markets are fairly and honestly run, are
    fully transparent, and affirmatively minimize the risk of loss from
    fraud and manipulation. Existing statutory and regulatory provisions
    require that the public statements by or on behalf of publicly-traded
    companies in the United States contain no misstatements of material
    fact and no omissions that make the statements that are made materially
    misleading. These protections are supported by a detailed structure of
    accounting and disclosure requirements intended to ensure that
    financial reporting and other disclosures meet the mandated standards
    of accuracy, completeness, and comparability. Current law prohibits
    wrongful activity including, but very definitely not limited to, fraud
    in making materially defective or incomplete disclosure.
        As the complexity of our financial markets continues to grow
    unabated, and the number of Americans who participate in them increases
    steadily, the Commission must ensure that our system's traditional high
    standards are not compromised. The goal of the SEC is to ensure that
    our financial markets are transparent and fair to all investors, and to
    do so, we must make certain that the public is adequately informed
    about investing and that corporate America provides the disclosure
    investors need to make fully informed decisions based on sound and
    reliable information. In addition to our extensive investor education
    programs, an integral part of our
    investor protection efforts is the SEC's aggressive law enforcement
    program, which protects investors from fraudulent and unfair practices.
        Of course, no one should believe that we could create a foolproof
    system; those with intent and creativity can override any system of
    checks or restraints. Fraud aside, however, both the quality and
    timeliness of financial reporting and other disclosures can, and must,
    be enhanced. Financial reporting and disclosure standards can and
    should be amended to address the evident deficiencies, and the standard
    setting process can and should be made more responsive to changing
    circumstances. As I discuss in more detail below, we believe 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 very timely. Companies must be subject to an
        affirmative obligation to provide reliable information that is
        informative, relevant, comprehensible, and timely. Investors should
        have all the information they need to make valuation and investment
        decisions. We want investors to have an accurate and current view
        of the posture of their company, as seen ``through the eyes of
        management.'' This has long been the SEC's disclosure standard, but
        ``through the eyes of management'' must be viewed by all of us, and
        most importantly by companies' top officials, as a broad and fluid
        obligation, not merely an obligation to disclose specified
        categories of information at specified times. And meaningful
        disclosure is more than a single number. There has been far too
        heavy an emphasis by all market participants on quarterly and on
        year-end earnings per share, and too little emphasis on a concise,
        yet lucid, presentation of financial information. We recommend
        additional substantive disclosure requirements that permit fuller
        understanding of financial statements and thereby improve overall
        financial disclosure. We also recommend improving other disclosure
        requirements to provide disclosure of higher quality, while
        avoiding greater quantity for quantity's sake. Finally, we are
        seeking to modernize our disclosure system to seek more timely
        disclosure of the most significant information, while protecting
        companies from premature disclosure, disclosure of sensitive
        information and second-guessing over when and how disclosures were
        made.

     Second, oversight of accountants and the accounting profession
        must be strengthened and accounting principles that underlie
        financial disclosure must be made more relevant. Outside auditors
        have an important role in ensuring that the companies they audit
        present an accurate, complete, and current picture of their
        financial condition. Critical regulatory functions, including
        quality control and discipline, should be moved from the profession
        to an independent regulatory body that is completely or
        substantially free from influence or funding by the profession, and
        is subject to comprehensive and vigorous SEC oversight. Standards
        of independence should be revisited and strengthened to prevent
        conflicts of interest that might cause auditors to compromise the
        performance of their auditing functions. The standard setting
        process for accounting and financial disclosure must be more timely
        and responsive to market changes and independent from undue
        influence. Present-day accounting standards are cumbersome and
        offer far too detailed prescriptive requirements for companies and
        their accountants to follow. That approach encourages accountants
        to ``check the boxes''--to ascertain whether there is technical
        compliance with applicable accounting principles. We seek to move
        toward a principles-based set of accounting standards, where mere
        compliance with technical prescriptions is neither sufficient nor
        the objective. We support the wisdom of having accounting standards
        set by the private sector, but subject to our vigorous oversight.
        That standard setting authority today resides in the Financial
        Accounting Standards Board, whose pronouncements govern financial
        statements because, but only because, the Commission has chosen to
        accept those standards as authoritative. The SEC should exercise
        its authority to ensure that FASB's agenda is responsive to issues
        facing investors and accountants and is completed on a timely
        basis.

     Third, corporate governance needs to be improved. Recent
        events also underscore the need to craft responsible guidance for
        directors and senior officers to follow. There are a number of ways
        current corporate governance standards can be improved to
        strengthen the resolve of honest managers and the directors who
        oversee management's actions and make them more responsive to the
        public's expectations and interests. We think the best way to do
        that is a two-fold approach: First, make certain that officers and
        directors have a clear understanding of what their roles are, and
        second, apply serious consequences to those who do not live up to
        their fiduciary obligations. The role of audit committees and
        outside directors also must be strengthened.

        In his State of the Union Address in January, the President
    appropriately demanded ``stricter accounting standards and tougher
    disclosure requirements.'' He called for corporate America to ``be made
    more accountable to employees and shareholders and held to the highest
    standard of conduct.'' \2\ And just 2 weeks ago, the President outlined
    a substantive, serious, and thoughtful program to move toward
    implementation of these goals.\3\ The SEC shares and embraces these
    principles, and is firmly committed to making them a reality.
    ---------------------------------------------------------------------------
        \2\ President George W. Bush, State of the Union Address (January
    29, 2002).
        \3\ President George W. Bush, Remarks During 2002 Malcolm Baldridge
    National Quality Awards Ceremony (March 7, 2002); President's Plan to
    Improve Corporate Responsibility and Protect American Shareholders,
    available at www.WhiteHouse.gov/infocus/corporate responsibility.
    ---------------------------------------------------------------------------
                              OUR WORKING PROPOSAL

        Even before Enron Corporation failed, we had been working to
    improve and modernize our corporate disclosure and financial reporting
    system to make disclosures and financial reports more meaningful and
    intelligible to average investors. As I pointed out in an opinion piece
    in The Wall Street Journal last December, the public and the private
    sectors must work hard, together, to produce sensible and workable
    solutions.\4\ Effective and transparent private sector regulation of
    accounting and
    accountants, subject to both SEC oversight and rigorous review by
    Congress, is an
    essential component. In addition, it is critical to improve corporate
    disclosure with financial statements that are clear and informative,
    with a system of ``current'' disclosure of unquestionably significant
    information and with better identification and discussion of critical
    accounting principles and other financial information and their impact
    on a company's results.
    ---------------------------------------------------------------------------
        \4\ ``How to Prevent Future Enrons'' The Wall Street Journal, A18
    (December 11, 2001), annexed as Attachment A.
    ---------------------------------------------------------------------------
        The Commission has endeavored to move forward as quickly as it
    responsibly can on these issues. First, in cautionary advice on
    December 4, 2001, we gave guidance on the appropriate use of, and
    limits on, pro forma financials.\5\ In further cautionary guidance
    issued on December 12, 2001, we set forth initial requirements and
    guidance on the obligation of public companies to disclose critical
    accounting principles.\6\ On December 21, 2001, we announced that our
    Division of Corporation Finance would monitor the annual reports
    submitted by all Fortune 500 companies that file periodic reports with
    the Commission in 2002.\7\ This new initiative significantly expands
    the Division's review of financial and nonfinancial disclosures made by
    public companies. On January 17, 2002, we announced our preliminary
    plan for a Public Accountability Board, a private sector regulatory
    body for the accounting profession.\8\ On January 22, we identified
    issues in Management's Discussion and Analysis to be addressed in 2001
    fiscal year reports regarding off balance sheet financing
    arrangements.\9\ On February 4, the securities industry and its self-
    regulators announced proposed rules to create more transparency for
    analyst recommendations--in response to a directive from the House
    Financial Services Committee and guidance from the SEC. We are in the
    process of obtaining public comments on these proposed rules and will
    proceed expeditiously to review and finalize them.\10\ On February 13,
    we announced plans to propose rules to address aspects of corporate
    disclosure needing immediate improvement, and on the same day we called
    upon the New York Stock Exchange and Nasdaq to look at specific
    components of corporate governance.\11\
    ---------------------------------------------------------------------------
        \5\ Cautionary Advice Regarding the Use of ``Pro Forma'' Financial
    Information in Earnings Releases, Securities Act Release No. 8039
    (December 4, 2001).
        \6\ Cautionary Advice Regarding Disclosure About Critical
    Accounting Policies, Exchange Act Release No. 45149 (December 12,
    2001).
        \7\ ``Program to Monitor Annual Reports of Fortune 500 Companies,''
    SEC News Digest, Issue 2001-245 (December 21, 2001).
        \8\ Public Statement by SEC Chairman Harvey L. Pitt: Regulation of
    the Accounting Profession (January 17, 2002), available at www.sec.gov/
    news/speech.
        \9\ Statement About Management's Discussion and Analysis of
    Financial Condition and Results of Operations (January 22, 2002),
    available at www.sec.gov/rules/other.
        \10\ See Notice of Filing of Proposed Rule Changes by the National
    Association of Securities Dealers, Inc. and the New York Stock
    Exchange, Inc. Relating to Research Analyst Conflicts of Interest,
    Exchange Act Release No. 45526, File Nos. SR-NASD-2002-21; SR-NYSE-
    2002-09 (March 8, 2002).
        \11\ The Securities and Exchange Commission's Press Releases
    regarding these actions are annexed as Attachments B-H.
    ---------------------------------------------------------------------------
        Just this Monday, we released orders and temporary rules in order
    to assure a continuing and orderly flow of information to investors and
    the U.S. capital markets in light of the indictment of Arthur Andersen
    LLP.\12\ Immediately upon the announcement by the Department of Justice
    that Andersen had been indicted, we announced that we requested and
    received assurances from Andersen that it will continue to audit
    financial statements in accordance with generally accepted auditing
    standards and applicable professional and firm auditing standards,
    including quality control standards. Andersen has also told the
    Commission that if it becomes
    unable to continue to provide those assurances, it will advise the
    Commission immediately. The Commission will continue to accept
    financial statements audited by Andersen in filings as long as
    Andersen's assurances remain in full force and effect. The orders and
    rules we released also establish a framework for Andersen clients that
    are unable to obtain from Andersen, or that elect not to obtain from
    Andersen, a signed report on audits that are currently in process. As
    to those issuers, the Commission will require adherence to existing
    filing deadlines, but will accept filings that include unaudited
    financial statements from any issuer unable to provide
    audited financial statements in a timely manner. Issuers electing this
    alternative generally will be required to amend their filings within 60
    days to include audited financial statements. This alternative
    framework is procedural in nature, is of finite duration, and is
    intended solely to address timing constraints and temporary disruptions
    that the affected issuers may face.\13\
    ---------------------------------------------------------------------------
        \12\ Requirement for Arthur Andersen LLP Auditing Clients,
    Securities Act Release No. 8070 (March 18, 2002).
        \13\ The Commission's Press Release regarding reporting
    requirements for companies audited by Andersen LLP is annexed as
    Attachment I.
    ---------------------------------------------------------------------------
        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 4 in New York
    City and March 6 in Washington, DC, with distinguished business
    executives, lawyers, accountants, academics, regulators, and public
    interest representatives, who discussed various proposals and helped
    advance our understanding and insight into these issues. We have
    scheduled our next Roundtable for April 4, 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.
        This Committee has acted in a similar manner, seeking input from a
    wide variety of experts, and today both the Commission and this
    Committee are much better informed as a result of our respective
    information-gathering processes. For example, the ``Investor Confidence
    in Public Accounting Act'' recently introduced by Senators Dodd and
    Corzine has substantially advanced the discussion of issues in the area
    of regulation of public accounting in this country. Other related
    initiatives contain a number of suggestions that would be beneficial to
    the overall improvement of our system and its controls in the wake of
    Enron.
        In testimony today, we seek to offer this Committee the most detail
    we can on our thoughts and plans for reform. But we do not yet have
    final answers. We are still soliciting and gathering additional broad
    input. We are receiving e-mails, phone calls, and letters daily from a
    wide variety of our constituents. We are continuing to work with this
    Committee, the Congress, the Justice Department, the Labor Department,
    and the President's Working Group on Financial Markets. Of course, we
    will invite additional public comments in the formal rulemaking
    process. Therefore, I respectfully submit this testimony today as our
    informed commentary on a number of important and complex subjects, but
    caution that it is truly a work in progress--we are ready to learn
    more, to explore further, and we will not foreclose any valuable
    alternatives and suggestions. The SEC does not have a monopoly on
    wisdom. What we do have is an undeniable obligation to think about the
    issues, search for answers, lead constructive debate, and move quickly
    on behalf of investors.

    1. Corporate Governance and Disclosure Reforms
        One of the most important challenges facing our capital markets
    today is to improve the quality of available corporate information.
    While technology enables investors to acquire information more rapidly
    than ever, our capital markets cannot reach a higher level of
    efficiency and investor confidence unless companies provide higher-
    quality, more insightful information as well.
        As we engage in rulemaking efforts to strengthen the corporate
    disclosure system, the Commission also is assessing how our staff can
    further protect investors through our review of that disclosure. In
    recognition of the limits of our resources, we are working to further
    the application of risk management techniques to our review process.
    For example, in the screening of periodic reports by the Fortune 500
    companies that we have begun, we are using revised criteria which focus
    on areas we believe require in-depth scrutiny. Some of our additional
    personnel resource requests are intended to enable us to build an
    improved risk management competence for many facets of our agency's
    activities, not the least of which is corporate disclosure.

    1.1 Improved Quality of Financial Disclosure

    1.1.1. Management's Discussion and Analysis
        Among other reforms, we believe it is necessary to improve the
    Management's Discussion and Analysis section of disclosure documents.
    MD&A has three related objectives:

     To provide a narrative explanation of companies' financial
        statements to enable investors to see the company ``through the
        eyes of management.''
     To improve overall financial disclosure and provide the
        context within which financial statements should be analyzed.
     To provide information about the quality of, and risks to, a
        company's earnings and cashflow.

        As such, MD&A is the backbone of a company's disclosures. Its goal
    is to wrap GAAP financial statements in a clear, understandable
    discussion of their context. Recognizing the importance of MD&A
    information to investors, the Commission is working to improve the
    quality of that disclosure in three key ways.

     Critical Accounting Policies

        First, we intend to propose that companies be required to identify
    critical accounting policies--that is, the accounting policies of a
    company that are most important to the presentation of its financial
    condition and financial results and that require the most subjective or
    complex accounting estimates. Investors need a greater awareness of the
    sensitivity of financial statements to the methods, assumptions, and
    estimates underlying their preparation. In our December 12, 2001
    release, we have asked companies to begin addressing that need.\14\ We
    intend to adopt new rules to elicit more uniform and precise
    disclosures about critical accounting policies in the MD&A section of
    annual reports, registration statements, and proxy and information
    statements, with quarterly updates of that disclosure.
    ---------------------------------------------------------------------------
        \14\ This release is annexed as Attachment C.
    ---------------------------------------------------------------------------
        Although, we are still formulating our precise critical accounting
    policies rules, it is already manifest they should include, at a
    minimum, basic disclosures investors need to understand how a company
    identifies those policies, and a discussion of those policies in the
    context of the company's financial results, explaining which accounting
    estimates and assumptions relate to them. Investors will benefit from
    knowing what uncertainties could affect those estimates and
    assumptions. Simple quantitative analysis could show investors the
    sensitivity of a company's estimates, and the impact on a company's
    financial statements of possible changes--both positive and negative--
    of those estimates. Past changes a company has made in estimates may be
    relevant, as well as disclosure of any trends or uncertainties that may
    cause a company to change the accounting method it uses. Investors also
    should know whether management discussed the selection, application,
    and disclosure of the critical accounting policies with the audit
    committee of the board of directors. Finally, to be truly useful, any
    new disclosure about critical accounting policies must be clear,
    concise, and understandable--not legalese or ``accountingese.''

     SPE's and Related Party Transactions

        Investors have become increasingly interested in the sufficiency of
    disclosure regarding off balance sheet obligations and contingencies,
    including use of special purpose entities. A company's relationships
    with unconsolidated entities facilitate its transfer of, or access to,
    assets. Investors need to know more about liquidity risk, market price
    risks, and effects of ``off balance sheet'' transaction structures.
    MD&A should mandate specific disclosures by companies concerning
    transactions, arrangements and other relationships with these
    unconsolidated entities, or other persons, when they are reasonably
    likely to have a material effect on a company's liquidity, its capital
    resources or its requirements for capital. If a company's liquidity is
    dependent on the use of off balance sheet financing arrangements, such
    as securitization of receivables or obtaining access to assets through
    special purpose entities, investors also need to know the factors that
    are reasonably likely to affect its ability to continue using those off
    balance sheet financing arrangements. Such matters could affect the
    extent of funds required within management's short- and long-term
    planning horizons. The Commission will clarify the need for this type
    of information in MD&A.\15\ As indicated in our February 13 press
    release, we also intend to propose rules requiring current disclosure
    of transactions that increase a company's obligations, including
    contingent obligations, whether or not reflected on its balance
    sheet.\16\
    ---------------------------------------------------------------------------
        \15\ See Statement About Management's Discussion and Analysis of
    Financial Condition and
    Results of Operations (January 22, 2002), available at www.sec.gov/
    rules/other.
        \16\ The Commission's Press Release regarding these rules is
    annexed as Attachment G.
    ---------------------------------------------------------------------------
        Many readers of financial statements also have cited a lack of
    transparent disclosure about transactions where that information
    appeared necessary to understand how significant aspects of the
    business were conducted. The investors would better understand
    financial statements in many circumstances if companies' MD&A
    disclosures included descriptions of the terms of broader categories of
    material transactions that differ from those that likely would be
    negotiated with the clearly
    independent parties, whether or not they involve ``related parties'' as
    traditionally defined. Investors need to understand a transaction's
    business purpose and economic substance, its effects on the financial
    statements, and the special risks or contingencies arising from it.
    More specific MD&A requirements relating to the effects of these kinds
    of transactions would aid investors.

     Trend Information

        The third phase of our MD&A rulemaking will improve MD&A
    disclosures relating to trend information. We believe investors will be
    better able to see a company through management's eyes if MD&A includes
    information about the trends that a company's management follows and
    evaluates in making decisions about how to guide the company's
    business. This disclosure would in many cases entail certain forward-
    looking information. Thus, with the envisioned improvements in
    companies' financial trend disclosure, we will need to address
    lingering issues relating to when a company needs to update disclosure
    that is forward-looking and viable in the marketplace. With expanded
    disclosure obligations, we also are mindful of the liability issues and
    the liability standards associated with new disclosures. Our goal is to
    assist investors by providing more meaningful and understandable
    information, but not to convert our disclosure system into an
    attractive nuisance for increased litigation.

    1.1.2. Clarity and Accountability
        In addition to these planned MD&A disclosure reforms, we have in
    mind two very different initiatives, both of which would improve the
    quality and the utility of the corporate disclosure system. These are
    still in the conceptual planning stage.
        First, we believe investors would benefit if companies could
    produce clear and concise financial statements. This would not be an
    initiative to ``dumb down'' or omit the complete picture that current
    financial statements are intended to provide. Rather, it would be an
    effort to give companies the flexibility to produce and disclose
    financial information in ``layers'' ranging from those with a general
    ``big picture'' focus to those that encompass the minutest detail, all
    of which would be readily
    accessible to investors electronically. This would permit investors to
    ``drill down'' to whatever layer they wish. The layers would allow
    companies to explain financial statement disclosure to investors in
    ways that are more clear, concise, and understandable.
        The second initiative is to improve the corporate disclosure system
    by increasing the CEO's individual accountability for his or her
    company's disclosure. As the President noted in his March 7 speech on
    corporate ethics and disclosure,\17\ it is unacceptable for the CEO of
    a company to disclaim responsibility for, or deny awareness or
    understanding of, the financial disclosures that his or her company
    makes. We are committed to addressing and reinforcing that
    responsibility. Our vision is a rule that would require CEOs' to
    certify to shareholders that any significant information of which the
    CEO is aware has been disclosed to shareholders, and that the
    disclosures made are not misleading, inaccurate, or false. We believe
    this ``sign on the dotted line'' approach will focus CEOs' attention
    very acutely on responsibilities that already exist under current law.
    We are also considering rulemaking that would call for the
    establishment of procedures designed to bring significant information
    to the attention of top management.
    ---------------------------------------------------------------------------
        \17\ President George W. Bush, Remarks During 2002 Malcolm
    Baldridge National Quality Awards Ceremony (March 7, 2002); President's
    Plan to Improve Corporate Responsibility and Protect American
    Shareholders, available at www.WhiteHouse.gov/infocus/
    corporateresponsibility.
    ---------------------------------------------------------------------------
    1.2. More Timely Disclosure
        In addition to improving MD&A and other initiatives to improve the
    quality of the corporate disclosure system, we also intend to take
    other steps to modernize and improve the timeliness of corporate
    disclosures. We are working on three sets of
    proposed rules that would do this.

    1.2.1. Accelerated Annual and Quarterly Reports
        We are considering proposing rules that would shorten the filing
    deadlines for annual reports from 90 to 60 days after a company's
    fiscal year end and would shorten the filing deadlines for quarterly
    reports from 45 to 30 days after a quarter's end. The current secondary
    market disclosure system under the Exchange Act requires companies to
    provide updated information to investors at annual and quarterly
    intervals, with a small number of specified significant events reported
    somewhat more timely. The SEC has not changed its annual and quarterly
    report deadlines for more than 30 years. Thirty years ago, the
    companies still were dependent on paper and pencil, adding machines,
    carbon paper, and the U.S. mails to prepare and file their reports with
    us. Significant technological advances in the intervening decades,
    including computers, remarkably quick and sophisticated financial and
    other software, speed-of-light communications, e-mail, video
    conferencing and the like, have enabled companies to capture,
    communicate, and evaluate information and prepare their
    reports more rapidly.
        The revolution in information technology and communications that
    allows companies to disseminate and collect information broadly and
    swiftly also has both
    increased investors' demand for, and provided the means for companies
    to supply, corporate disclosures on a more ``real time'' basis. Many
    public companies have adopted the practice of routinely issuing press
    releases to announce their annual and quarterly results significantly
    in advance of the due dates for their Exchange Act reports.\18\ This is
    concrete empirical evidence that a more rapid time line for corporate
    disclosures is feasible and achievable. For all of these reasons, it is
    long overdue for us to modernize our periodic reporting system by
    significantly shortening report deadlines. The Commission for years has
    recognized the critical need for such reform.\19\ We are committed to
    implementing those reforms.
    ---------------------------------------------------------------------------
        \18\ Of course, there can be problems in such releases, especially
    in the presentation of ``pro forma'' earnings, which caused the
    Commission to issue its cautionary guidance on December 4, 2001.
    Cautionary Advice Regarding the Use of ``Pro Forma'' Financial
    Information in Earnings Releases, Securities Act Release No. 8039
    (December 4, 2001).
        \19\ See The Regulation of Securities Offerings, Securities Act
    Release No. 7606A (November 13, 1998), Sections XI.A-XI.B.
    ---------------------------------------------------------------------------
    1.2.2. More Accessible Filings
        Today, the first and most obvious resource for many investors
    trying to find information about a company is through that company's
    website. We want to assure that investors can find companies' reports
    there. We therefore intend to move toward a system where public
    companies with Internet websites will post their periodic
    reports there no later than the same day they are obligated to file
    reports with the Commission.

    1.2.3. Accelerated Disclosure of Corporate Insiders' Trading Activities
        Under current law, corporate insiders are not required to file
    reports of their trading activities with the Commission until 10 days
    after the end of the month in which the trading occurred.\20\ Six years
    ago the Commission adopted a rule that allows insiders who sell their
    holdings back to their companies to postpone disclosure of those
    transactions for up to an additional year.\21\ Under current law, we
    cannot accelerate statutory reporting requirements applicable to
    insiders. But we can and intend to impose obligations on companies to
    report immediately any transactions by corporate insiders, including
    those with the company. Legislation is currently pending that would
    amend Section 16 of the Exchange Act to require the reporting (by
    electronic media) of securities transactions by officers, directors, or
    other affiliated persons of the issuer within a much shorter time frame
    (a business day or two). While there are practical issues to work
    through regarding electronic filing, the concept of requiring insiders
    to report their trades more expeditiously is unassailable. Legislation
    of this nature is worth consideration, but we do not think it is
    critical. We intend to act by rule in order to expedite the flow of
    this important information to the market.
    ---------------------------------------------------------------------------
        \20\ Section 16(a) of the Securities Exchange Act of 1934 (15
    U.S.C. 78p(a)).
        \21\ See 17 C.F.R. 240.16a-3(f) and 16b-3(e), adopted by Exchange
    Act Release No. 37260 (May 31, 1996).
    ---------------------------------------------------------------------------

    1.2.4. More Current Disclosure
        We also intend to solicit public comments soon on a significantly
    expanded list of items to be disclosed by companies between their
    current periodic reporting periods. In addition, we intend to
    accelerate the filing deadline for these disclosures. At present, only
    five corporate events trigger mandated intra-period disclosure on Form
    8-K. These include a change in the company's independent auditor;
    resignation of a director; a change in control; the acquisition or
    disposition of a significant amount of assets not in the ordinary
    course of business; and bankruptcy or receivership.
        The proposals being drafted would add approximately a dozen new
    significant events requiring companies to make expeditious Form 8-K
    filings. In addition to transactions by insiders in company securities,
    described above, companies would be required to report the following
    events on a current basis:

     Changes in rating agency decisions about a company.
     Defaults and other events that could trigger acceleration of
        direct or contingent obligations.
     Transactions that result in material direct or contingent
        obligations not included in a prospectus filed by the company with
        the Commission.
     Offerings of equity securities not included in a prospectus
        filed by the company with the Commission.
     Waivers of corporate ethics and conduct rules for officers,
        directors, and other key employees.
     Material modifications to rights of security holders.
     Departure of the company's CEO, CFO, COO, or president.
     Notices that reliance on a prior audit is no longer
        permissible, or that the auditor will not consent to the use of its
        report in a Securities Act filing.
     Definitive agreements that are material to the company.
     Losses or gains of material customers or contracts.
     Material write-offs, restructurings or impairments.
     Movement or de-listing of the company's securities from an
        exchange or quotation system.
     Any material events, including the beginning and end of lock-
        out periods, regarding the company's employee benefit, retirement
        and stock ownership plans.

        Under existing Form 8-K requirements, companies must file a Form 8-
    K within 5 business or 15 calendar days after the triggering event,
    depending on the nature of the event. Given the significance of these
    disclosures to participants in the secondary markets, we intend to
    propose that companies be required to file their Form 8-K reports no
    later than the second business day following occurrence of the events.
    We also will consider whether some of the events should be disclosed by
    the opening of business on the day after the occurrence of the event.
    The need for more current disclosure of a broader range of significant
    corporate activities is something the Commission recognized several
    years ago.\22\ We are committed to having companies provide better
    current information.
    ---------------------------------------------------------------------------
        \22\ See Securities Act Release No. 7606A (November 13, 1998),
    Section XI.B.
    ---------------------------------------------------------------------------
        Over a longer term, we also will consider amendments to the basic
    framework of the reporting system to require public companies to
    disclose vital information on a ``current'' basis. We intend to
    formulate revisions to our rules that would impose a duty on companies
    quickly to disclose events that are unquestionably significant to
    investors. This would include, but not be limited to, the updating of
    the trend information that we envision adding to the MD&A disclosure
    requirements.

    1.3. Corporate Governance Reforms
        As discussed, there are a number of ways current corporate
    governance standards can be improved to strengthen the resolve of
    honest managers and the directors who oversee management's actions and
    make them more responsive to the public's expectations and interest. In
    considering these reforms, it is important to keep in mind that,
    traditionally, corporate governance issues and standards have been left
    to the States to develop and enforce. We do not recommend a change in
    that basic division of responsibilities between the States and the
    Federal Government. Nonetheless, because our markets are national and
    international, not solely intrastate, and because the consequences of a
    lack of meaningful and cohesive corporate governance reform are
    dramatic, we are devoting considerable attention to the ways in which
    our system can be improved. Other witnesses have raised similar
    concerns.\23\ We support the ``race to the top'' of best practices on
    corporate governance.
    ---------------------------------------------------------------------------
        \23\ See, e.g., Senate Banking Committee testimony of John
    Whitehead on March 19, 2002 (``The authority of the SEC should also be
    extended to create a new self-regulatory entity charged with drafting a
    voluntary code of best corporate governance practices linked to an SEC
    disclosure requirement. Companies would then disclose whether they
    comply with the voluntary code, and explain areas of noncompliance.'').
    ---------------------------------------------------------------------------
        To this end, last month we asked the New York Stock Exchange and
    Nasdaq to review their corporate governance and listing standards,
    including important issues of officer and director qualifications and
    codes of conduct of public companies. We also separately asked
    Financial Executives International to review its code of ethics in
    light of recent developments. Both the NYSE and Nasdaq responded
    quickly to our requests. Both have commenced reviews of existing
    requirements, and have appointed committees to assist that effort. We
    expect to receive results of their reviews shortly. And, this past
    Tuesday, FEI presented us with a series of recommendations, as well as
    revisions to its acclaimed code of ethics.\24\
    ---------------------------------------------------------------------------
        \24\ The FEI's recommendations and revised code of ethics are
    annexed as Attachment J.
    ---------------------------------------------------------------------------
        We also intend to implement the President's directive to us to
    require CEO's to certify their company's annual and quarterly filings
    in a meaningful way. As we envision this, we believe that CEO's should
    be able to attest to the fact that anything they consider important in
    running their companies has been disclosed to investors. In addition,
    the President called upon us to seek disgorgement from corporate
    officers and directors of compensation and bonuses predicated on
    corporate performance that turns out to have been illusory or
    fraudulent. In fact, on March 13, we filed an action seeking exactly
    such disgorgement from the former president and chief operating officer
    of IGI, Inc. for violations of the antifraud, periodic reporting,
    record-keeping, internal controls and lying to auditors provisions of
    the Federal securities laws.\25\ We intend to proceed similarly in
    other appropriate situations where principal corporate officers and
    directors can disgorge to investors and their companies unearned or
    undeserved bonuses, stock options, and compensations.
    ---------------------------------------------------------------------------
        \25\ See SEC Files Financial Fraud Actions and Settled
    Administrative Proceedings Against Former Senior Officer and Managers
    of IGI, Inc., and Against IGI, Inc., Litigation Release No. 17410
    (March 13, 2002). The action is pending.
    ---------------------------------------------------------------------------
    1.4. Capital Raising Reforms
        Finally, contemporaneous with this renewed focus on the corporate
    disclosure system, we will pursue our plan to implement long-needed
    reform in the regulations governing capital raising. Our capital
    markets need to be strengthened by revising many of the communications
    restrictions imposed under the Securities Act and its regulations and
    by modernizing the delivery system for information, including
    prospectuses. In addition, once the Commission truly has put in place a
    current disclosure system, it will then be both possible and
    appropriate to provide accelerated access to the public markets for
    seasoned reporting companies with the largest market capitalization.
        These offering initiatives remain a priority and the work on them
    is well underway; they should go hand-in-hand with some of the other
    initiatives I have already mentioned. In prior years, the Commission
    recognized the need for this kind of reform, but did not implement
    these improvements.\26\
    ---------------------------------------------------------------------------
        \26\ See Securities Act Release No. 7606A (November 13, 1998), See
    also Report of the Advisory Committee on the Capital Formation and
    Regulatory Processes (July 1996).
    ---------------------------------------------------------------------------
    1.5. Legislative Assistance
        I have highlighted some of the items on the Commission's agenda for
    improving the quality and timeliness of corporate disclosures and
    modernizing the offering process. There are a few areas where we
    believe we need the assistance of Congress to implement fully some of
    the initiatives I have discussed, and to take other important steps in
    improving the integrity, quality, and timeliness of the corporate
    disclosure system.

    1.5.1. Additional Enforcement Tools
        As noted, the President has called upon us to improve the system of
    personal accountability for corporate disclosures on the part of
    corporate officers and directors. The President also endorsed our need
    for administrative authority to bar officers and directors who
    seriously violate their duties to public shareholders. At present, the
    securities laws authorize us to seek officer and director bars in court
    in appropriate cases.\27\ But some courts have taken an inhospitable
    approach to the plain legislative language, thwarting our ability to
    prevent some officers and directors who inflict serious harm on
    investors from repeating that kind of conduct.\28\ We will continue to
    press for a more enlightened and hospitable reading of the statutory
    language, but we believe the Commission should have the ability,
    administratively, to effect such relief promptly, subject of course to
    subsequent judicial review of the Commission's action. We also think
    the Commission should have the authority to impose penalties in these
    instances. By removing existing judicial restraints, and by providing
    for judicial review of the Commission's imposition of such a sanction,
    you will be giving us a tool we need to address and deter corporate
    malfeasance and misfeasance--akin to our authority to do the same with
    brokerage firm personnel, stock exchange officers, directors and
    others, akin to the authority of the banking regulators to bar future
    service by banking officers and directors. A recent edition of Business
    Week reported that a significant majority of the chief financial
    officers polled by Business Week and the Financial Executives
    International favored harsher penalties for officers and directors who
    fail to discharge their duties properly.\29\
    ---------------------------------------------------------------------------
        \27\ Section 21(d)(2) of the Securities Exchange Act.
        \28\ SEC v. Patel, 63 F.3d 137, 141 (2d Cir. 1995) (in reversing
    the lifetime injunction against an officer of a company who was found
    to have violated the Federal securities laws, the court discussed a
    nonexclusive six factor test for considering fitness to serve as
    officer or director: (1) the egregiousness of the violation; (2)
    whether the defendant was a recidivist; (3) the defendant's position
    when he engaged in the fraud; (4) the degree of scienter; (5) the
    defendant's economic gain from the violation; and (6) the likelihood
    that the defendant would repeat the misconduct).
        \29\ ``The CFO's Weigh in on Reform,'' Business Week (March 11,
    2002).
    ---------------------------------------------------------------------------
        In addition, as I noted during my confirmation hearings, the amount
    of recidivism in the securities field is alarming. We believe that both
    the Commission and the courts should be under an obligation to impose
    officer and director bars in any case of repeat fraudulent misconduct
    by officers and directors.
        Another tool we seek to enable us to deal with recidivists is
    statutory flexibility for the Commission to seek civil contempt
    penalties for those who violate prior judicial or administrative
    sanctions and restrictions. The Commission believes that the Department
    of Justice also should be given the ability and the resources to pursue
    instances of criminal contempt, on its own or at the Commission's
    urging, with a simplified statutory test that will not bog these cases
    down in endless proceedings.
        Under existing law, the civil liability provisions for violation of
    disclosure requirements include disgorgement of all gains, but for
    those without gains the maximum civil liability is $120,000 or the
    ``gross amount of pecuniary gain'' for each violation, even for
    fraudulent disclosure violations. We seek legislation that increases
    the sanctions for defective disclosure. Legislation was passed in 1984
    to address the previously insufficient sanctions under the securities
    laws for insider trading.\30\
    ---------------------------------------------------------------------------
        \30\ See Insider Trading Sanctions Act of 1984, Pub. L. 98-376, 98
    Stat. 1264.
    ---------------------------------------------------------------------------
        A similar need exists today to increase the sanctions for violation
    of disclosure requirements without regard to trading. Investors can be
    harmed by disclosure that violates applicable requirements to the same
    degree, whether or not those responsible for the violations are
    trading. Since the purpose of these sanctions is to deter future
    misconduct, and redress past misconduct, looking at this problem from
    the vantage point of defrauded investors is the appropriate approach.
    While large monetary sanctions will not, by themselves, rid us of
    misconduct, they will give all those involved in our capital markets a
    greater incentive to abide by the statutes and rules administered by
    the SEC.

    1.5.2. Increased Emergency Powers
        On November 13, 2001, the House of Representatives passed H.R.
    3060, the Emergency Securities Response Act of 2001, to augment the
    emergency authority of the SEC by revising Section 12(k) of the
    Exchange Act, to allow emergency powers for 30 business days. We had
    found, in the wake of the business repercussions from the significant
    damage and loss of life inflicted on lower Manhattan following the
    horrific events of September 11, that the existing provision of 10
    business days was not sufficient. I commend this legislation to the
    Committee's attention and ask for your support to present such
    legislation to the Senate.

    1.5.3. Increased Shareholder Powers over Option Plans
        To ensure that shareholders are both aware of, and have some right
    to evaluate, the proposed issuance of securities of a public company to
    its officers and directors, we believe all national securities
    exchanges and national securities associations should adopt listing
    rules in the next 6 months that require companies to seek shareholder
    approval for plans that allow corporate officers or directors to
    acquire company securities. We intend to ask the exchanges and
    associations to implement such proposals, and we believe, based upon
    our excellent working relationships with them, that they will do so,
    but we would like to make this a matter of law, rather than a matter of
    choice.

    1.5.4. More Timely Access to Reports
        To ensure the greatest degree of investor access to corporate
    disclosure, we seek clear authority to require public companies to
    maintain corporate websites, and to post corporate disclosures and
    other documents on their websites. While we believe that we can effect
    this result, clearer authority would move us quickly and easily to the
    desired result whereby all corporations recognize that the time has
    come for them to understand that constant and immediate communications
    with shareholders are essential.
        Also, to ensure the ability of the Commission to modernize the
    delivery of corporate information, the Commission needs unambiguous
    authority to permit delivery of corporate disclosure through electronic
    means subject to such conditions as the Commission requires for the
    protection of investors.

    1.5.5. Private Securities Litigation
        Even though more must be done to minimize the likelihood that
    future Enrons can occur, it is also important to recognize that there
    is neither enough money, nor people, to prevent hucksters from
    defrauding innocent investors. The SEC has a critical role to play in
    protecting investors. But private litigation, when properly formulated,
    is a very necessary supplement to the SEC's mission. To be effective,
    however, private litigation must be designed to help investors, not
    their lawyers. Though not a principal focus of concern, some have
    suggested that the Private Securities Litigation Reform Act of 1995
    (P.L. 104 -67) is somehow responsible for, or contributed to, the
    collapse of Enron, and that reforms, or even outright repeal of the
    Act, are warranted.\31\ Because this Committee took the lead in
    promoting the PSLRA, we think it appropriate to express the
    Commission's position with respect to these issues surrounding the
    PSLRA.
    ---------------------------------------------------------------------------
        \31\ See, e.g., ``Now Who, Exactly, Got Us Into This?'' The New
    York Times, Sec. 3, p. 1, dated February 3, 2002.
    ---------------------------------------------------------------------------
        The PSLRA was the subject of, literally, years of debate and
    consideration by the Congress. In 1995, after numerous hearings,
    exchanges with the Commission, and debate, the bill was initially
    approved by a vote of 320 to 102 (with one abstention) in the House of
    Representatives, and by a vote of 65 to 30 in the Senate. After
    President Clinton vetoed the bill, the Congress moved to override the
    President's veto message, voting 319 to 100 (with one abstention) in
    the House, and 68 to 30 in the Senate, after which the bill
    automatically became law.
        Just prior to Congresses' consideration of the bill, then-
    Commission Chairman Levitt wrote to then-Senate Banking Committee
    Chairman D'Amato on November 15, 1995, on behalf of the Commission:

              At the outset, let us express our appreciation for your
            willingness to heed the concerns of the Commission . . . [W]e
            believe the [current] draft . . . responds to our principal
            concerns. We understand the need for a greater flow of useful
            information to investors and the markets and we share your
            desire to protect companies and their shareholders from the
            costs of frivolous litigation.\32\
    ---------------------------------------------------------------------------
        \32\ A copy of this letter is annexed at Attachment K.

        Since the enactment of the PSLRA, the dollar amount of class action
    awards and settlements have increased substantially, while the number
    of issuers sued has not changed significantly.\33\ In addition, by
    requiring courts to consider who the plaintiffs should be in any class
    action, one intended beneficial result of the PSLRA is that larger, and
    more thoughtful, institutional plaintiffs have become more involved in
    the shareholder litigation process, rejecting cases that are frivolous,
    but pursuing vigorously those cases that reflect serious misconduct. We
    should all be alert to possible unintended consequences that may arise
    from any legislative enactment; but, in the absence of any empirical
    data suggesting a nexus between the PSLRA and situations like Enron, we
    strongly urge the Committee to refrain from making any changes in that
    legislation.
    ---------------------------------------------------------------------------
        \33\ According to the Stanford Law School Securities Class Action
    Clearinghouse (available at securities.stanford.edu):

         The absolute number of issuers sued does not appear to
    have changed dramatically since passage of the Act, once the effects of
    the IPO Allocating Litigation are excluded. Litigation
    activity declined in 1996, but that decline was likely a transition
    effect.
         Since passage of the Reform Act, a larger percentage of
    litigation activity centers on allegations of accounting fraud, with
    revenue recognition issues emerging as particularly significant causes
    of litigation.
         Since passage of the Reform Act, a larger percentage of
    litigation activity also alleges trading by corporate insiders during
    periods when frauds are allegedly ``alive'' in the market.
         The dollar magnitude of settlement has increased
    noticeably, particularly in the settlement of ``mega-cases.'' There
    have been five post-Reform Act settlements in excess of $200 million.
    The Cendant litigation was settled for $3.525 billion ($3.185 billion
    in the common equity settlement and $340 million in the Prides
    settlement); the Bank of America Litigation settled for $490 million;
    Waste Management settled two separate class actions for $457 million
    and $220 million; and 3Com settled a class action proceeding for $259
    million.
    ---------------------------------------------------------------------------
    2. Accounting Reforms

    2.1 The Public Accountability Board
        The number of sudden and dramatic reversals of public companies'
    financial conditions has called into question the regulatory system
    currently used to oversee the quality of the audits of financial
    statements that are filed with the Commission and relied on by
    investors. In particular, it appears that the current system of firm-
    on-firm peer reviews, overseen by a Public Oversight Board that lacks
    the power to
    direct the conduct of those reviews or to discipline auditors for
    unethical or incompetent conduct, has not produced a credible result.
    The current system does not provide investors with sufficient
    confidence in the efficacy of the audit process.
        We are proposing ``private sector'' regulation, not ``self ''
    regulation. Self-regulation implies that the accounting profession
    would regulate itself. We are suggesting regulation by the private
    sector, but not by the profession. Rather than a body that functions
    under the aegis of the American Institute of Certified Public
    Accountants, which represents the accounting profession, the Commission
    announced on January 17 our intention to create a new, private sector,
    independent body that can direct periodic reviews of accounting firms'
    quality controls for their accounting and auditing practices and
    discipline auditors for incompetent and unethical conduct. We
    believe there is substantial consensus on this approach.
        This private sector body would supplement our enforcement efforts,
    by adding a layer, or tier, of new regulation. There should be no
    misunderstanding. In the first instance, we, and our Division of
    Enforcement, will continue vigorously to investigate and pursue
    instances of illegal conduct. The SEC has had a successful history with
    two-tier regulation that involves the private sector. Such two-tier
    regulation has been largely successful with the brokerage industry.
    Private regulation presents major advantages, in terms of available
    resources, quality control and discipline. The SEC is best suited to
    bring actions for civil violations of law--fraud and such. Private
    regulation can govern conduct that may not be unlawful, but reflects
    ethical lapses or deficiencies in competence. It allows quality control
    that is more flexible, but also more effective. And discipline can be
    applied more quickly and therefore more effectively. The accounting
    profession and the investing public both would benefit from such an
    approach.
        In order to understand how the Commission's proposal regarding
    oversight of the accounting profession is a substantial improvement
    over the present system, it is important to understand what has been
    misunderstood by many who have commented on this issue--the structure
    of the AICPA's Public Oversight Board. The POB was created by the AICPA
    in 1977 and charged with overseeing and reporting on the programs of
    the AICPA's SEC Practice Section (SECPS), created that same year. The
    SECPS is comprised of accounting firms that audit the financial
    statements of public companies, and establishes quality control
    requirements for those firms. While intended to be autonomous (the POB
    could set its own budget, establish its own operating procedures, and
    appoint its own members, chairperson, and staff ), the POB relied on
    voluntary dues paid by SECPS members for its funding. In addition, the
    POB lacked the ability to organize and implement its own quality
    control reviews. And the POB was not given disciplinary authority. All
    of these deficiencies will be remedied in the private-sector regulatory
    regime we have proposed.
        Another issue receiving a great deal of attention is whether
    legislation is needed to implement our proposed private sector
    regulatory body. First, it is critical to separate the regulatory model
    from the issue of whether there is a need for legislation. We think
    there is substantial agreement on the model we have proposed, and that
    is the first step in moving toward a more effective regulatory system.
    Legislation is not required to establish private sector regulation with
    SEC oversight. If the
    Congress determines that legislation is appropriate, however, we are
    committed to assist that process. Whether or not Congress acts, it is
    incumbent for the SEC to move forward with the most responsible
    proposal it can.
        The new body we suggest, which we refer to as the Public
    Accountability Board or PAB, must have certain attributes, and its
    mission must be based on certain immutable principles.

    2.1.1 Private Sector Regulation
        Today, we are even more convinced than we were when we initially
    proposed the PAB in January that there must be private sector, not self
    regulation of the profession in the areas of discipline and quality
    control. The AICPA's Public Oversight Board has not been as effective
    as it could have been, and the disciplinary process has not been
    sufficiently swift or transparent. There is near total consensus on
    this point. Indeed, the AICPA and the major accounting firms have
    recognized this is a needed change to restore public confidence.
        This new entity is a means to assure that accountants conform not
    merely to the law, but to the highest ethical and competence standards
    as well. In the details of our proposal that follow, such as an assured
    source of funding, and a required super-majority (at least) of public
    board members unaffiliated with the accounting profession, our guiding
    principle was to avoid the shortcomings of the current system, and to
    learn from those shortcomings. The POB was a good idea a quarter
    century ago, but it does not meet the needs of today.

    2.1.2. Predominately Public Membership of the Board
        For the same reason that we believe that public oversight, rather
    than self regulation, is needed to restore faith in the accounting
    profession, we believe that it must be clear that the PAB places the
    public interest and the interest of investors above all else. This
    means that representatives of the public must be in the position to
    make all significant calls on quality control and disciplinary issues.
    At its core, we believe the board should be composed predominantly of
    independent public members, unaffiliated with the accounting
    profession. This would help ensure oversight of the accounting
    profession that is free from undue influence from the accounting
    profession. In the Roundtables we have held so far, there has been
    general agreement that our proposed composition of the board--
    predominantly public members, not from accounting firms--was
    appropriate. During this Committee's recent hearings, virtually every
    witness endorsed the notion of a new regulatory structure of the kind
    we are proposing.
        At the same time, we believe the public will benefit if the PAB
    also includes a small minority of members from the accounting
    profession. They bring necessary expertise and an understanding of
    current accounting issues. We think it ill advised to exclude them
    completely. As we consider reforms for oversight of the accounting
    profession, we need to take into account the likely effects of new
    initiatives--
    intended and unintended. If those with expertise are excluded from
    providing any oversight of their own profession, the PAB is likely to
    devolve into a board known more for its lack of understanding of issues
    than for its vigorous oversight. If we had to construct a board to
    oversee the structural integrity of a bridge, we would not exclude
    bridge builders or engineers. Having a small minority of members who
    are affiliated with the accounting profession will assure necessary
    expertise.
        In order to obtain independence without sacrificing expertise, we
    believe that the PAB should be composed of public members and members
    associated with the accounting profession. Whether the board has a two-
    thirds majority of public members or three-quarters or some other super
    majority is an important detail, but should not detract from the
    underlying principle that the board must be independent, and must
    function independently.
        To assure the quality and the independence of the members, the
    selection of the initial group of PAB members, and the appointment of a
    chairperson (who should be a public member), should be made by the
    Commission. After the appointment of the initial members through a
    selection process directed by the SEC, the PAB itself should have the
    responsibility of choosing new members, and new chairpersons, to
    replace those who depart. Those selections should be subject to
    Commission approval. The PAB chairperson should always be selected from
    among the public members. The PAB should meet frequently, as
    distinguished from the current Public Oversight Board, and all of its
    members should be required to devote substantial time to the PAB and
    directly manage the entity.
        The PAB appointment process should operate solely under the aegis
    of the SEC. The Commission has statutory authority to set accounting
    principles.\34\ We have
    direct oversight responsibility for the quality of financial reporting,
    including enforcement powers. We recognize some witnesses and some
    legislative proposals would include other Government officials, such as
    the Secretary of the Treasury, the Chairman of the Federal Reserve
    Board or the Comptroller General, in the selection process on an
    ongoing basis. We think this involvement by additional Government
    officials with no direct responsibility for the governance of the
    accounting profession could dilute clear lines of oversight
    responsibility and unnecessarily complicate the selection process. In
    addition, we believe that the Commission, as an independent agency,
    should be protected from the appearance of pressure from other
    Government sectors and agencies.
    ---------------------------------------------------------------------------
        \34\ See, e.g., Section 19(a) of the Securities Act (15 USC
    77s(a)), and Section 13(b)(1) of the
    Securities Exchange Act (15 USC 78m(b)(1)).
    ---------------------------------------------------------------------------
    2.1.3. Diverse, Involuntary, and Independent Funding
        One of the most important steps to restore public confidence in the
    discipline and quality control of the accounting profession is to
    assure a funding source that is
    secure and independent. If all funding comes from the accounting
    profession, and voluntarily at that, as was the case with the POB, the
    PAB could operate under a cloud in the public's opinion. Well meaning
    legislative reform proposals that keep the funding source solely from
    the accounting profession are not as viable as those that spread the
    funding burden to all users of financial statements. We see funding
    coming from a variety of sources. First, membership in the PAB should
    be mandatory, in which case the PAB would be able to impose membership
    fees on accounting firms and their members. But, more importantly,
    additional funding should come from issuers whose financial statements
    are filed with the SEC and certified by independent public accountant
    members of the PAB. We believe, in contrast to a POB that is wholly
    dependent on voluntary funding from the accounting profession, the
    involuntary, broad-based funding from all users of audit services would
    protect the PAB from even the appearance of undue influence. We believe
    we have the
    authority under existing law to implement our funding concepts for the
    PAB.

    2.1.4. Mandatory Membership
        No matter how well conceived, the PAB will be effective only if all
    accountants, as well as all accounting firms, that audit public
    companies are required to abide by its directives. An auditor should
    not be able to circumvent the quality control and disciplinary
    mechanisms of the PAB simply by declining to register with the PAB.
    Therefore, we propose that membership in, and being subject to the
    PAB's processes, must be a prerequisite to an auditor's ability to
    supply audit opinions on which a registrant may rely to satisfy its
    filing obligations under the securities laws. Also, we propose to
    implement this requirement by making membership in the
    PAB a condition for certifying financial statements, as required under
    our Regulation S-X.\35\
    ---------------------------------------------------------------------------
        \35\ Form and Content of and Requirements for Financial Statements,
    Securities Act of 1993, Securities Act of 1934, Public Utilities
    Holding Company Act of 1935, Investment Company Act of 1940, and Energy
    Policy and Conservation Act of 1975 (Regulation S-X), 17 C.F.R. Part
    210.
    ---------------------------------------------------------------------------
        Remaining in good standing with the PAB must also be a prerequisite
    to the ability to continue to audit the financial statements of public
    companies. As discussed in more detail below, PAB discipline, and the
    possibility of that discipline, must be meaningful, and to be
    meaningful, the failure to be in good standing with the PAB (reflected
    in a PAB-imposed suspension or revocation of registration, or
    limitation of functions) must have significant consequences.

    2.1.5. Improved Quality Control Reviews
        While individuals within accounting firms generally take firm-on-
    firm peer reviews seriously, investors and critics of the program often
    consider it to be a ``one hand washes the other'' approach to
    regulation.
        To avoid this perception, we believe that quality control reviews
    should be directed and principally conducted by PAB staff, and PAB
    staff should make all key decisions during the conduct of the reviews.
    The PAB should be sufficiently staffed to carry out this
    responsibility, although it should be feasible for the PAB to draw upon
    professional personnel from the profession to assist in the reviews, as
    long as any such personnel are subject exclusively to PAB direction.
        The PAB should promulgate standards for its quality control review
    process. It should publish those standards for public comment, and the
    standards ultimately adopted must be subject to Commission approval.
    The current system provides for reviews only every 3 years, which we
    believe is insufficient. Therefore, along with promulgating review
    standards, the PAB should determine how frequently to conduct routine
    reviews and should determine what events or circumstances will trigger
    nonroutine reviews. The firms that audit the vast majority of public
    companies should be reviewed annually.
        While we believe that the Auditing Standards Board (ASB), the
    entity tasked with promulgating quality control standards for audits,
    has performed that task well, we expect that the PAB, through its work
    in conducting quality control reviews, will be well positioned to make
    very useful recommendations about those standards. We therefore believe
    that the PAB's mission must include the expectation that it will, as it
    deems appropriate, influence the agenda of the ASB and make public
    recommendations about quality control standards. We also believe that
    the ASB should have a formal mechanism for considering, and obtaining
    public comment on, those agenda items and recommendations.
        Many commentators, and prior witnesses before this Committee, have
    offered suggestions on the structure of the accounting firms
    themselves, and how these firms could change their internal governance
    structure to better reflect the public interest needs. Improving risk
    management, improving internal controls over audit quality, enhancing
    the supervision of the audit process are all laudable goals. We believe
    many of these issues, as they reflect competency and ethical standards,
    could be
    addressed more quickly and effectively by the PAB.
        Similarly, calls for a statutory imposition of an affirmative duty
    of supervision of audit personnel, similar to the supervisory duties
    that arise from the defense available under the Federal securities laws
    to broker dealers, may overshoot the mark.\36\ The Commission already
    looks up the chain of command on any defective audit, when seeking to
    enforce the law, and we are concerned that a statutory provision may
    limit, rather than expand, the potential reach of the existing
    proscriptions.
    ---------------------------------------------------------------------------
        \36\ With respect to broker-dealer supervision, see Section
    15(b)4(e) of the Securities Exchange Act of 1934.
    ---------------------------------------------------------------------------
        Finally, ideas concerning the restructuring of the governance of
    the audit firm, requiring public members, or a majority of public
    members, or an independent oversight board, such as that adopted by the
    Andersen firm and chaired by Paul Volcker, are interesting and
    productive suggestions, but may be best left to individual firm
    consideration. The market has a large appetite for improved audit
    governance, and enhancements in this area should be supported by the
    SEC, but not mandated. We should encourage a ``race to the top'' in the
    adoption of best practices, but should be careful not to impose a one-
    size-fits-all solution.

    2.1.6. Disciplinary Powers
        The SEC has long had power to discipline accountants for failing to
    meet their professional standards of conduct. Rule 102(e) currently
    embodies that authority. The PAB should have parallel authority, such
    that the SEC could refer cases to it, and could take back
    investigations from it, at any time. This is similar to the current
    enforcement relationship the Commission has with NASDR and the NYSE.
        Principal criticisms of the current system are that it takes too
    long to discipline an errant accountant, and that the sanction is not
    sufficient. Through mandatory membership of both firms and individual
    accountants in the PAB, the PAB could remove the accountant or the firm
    from practice before the SEC. If individual and firm membership in the
    PAB is a prerequisite to conducting audits of public companies, the
    temporary or permanent removal of an accountant or firm from the PAB's
    membership would operate to prevent the accountant or firm from
    practicing before the Commission. Additional remedies, such as
    limitations on the firm taking on new business, or specific quality
    control changes and other undertakings, should also be the subjects of
    PAB authority. The PAB would be required to take immediate action on
    any matter referred to it from the SEC. The public members of the PAB
    would oversee that immediate inquiry, and the public members would
    determine the sanctions. A further sanction would allow the PAB to
    require the rotation of auditors, that is, to force a public company to
    obtain a new firm, in light of the misconduct found on the part of the
    present auditor. This sanction we view as more meaningful than the
    wholesale call of some for automatic rotation of auditors, without any
    showing that there was misconduct, or a need for such rotation.
        A further concern about private sector regulation is the lack of
    authority to compel production of documents and testimony. Due to the
    required membership in the PAB for both firms and individuals, and
    supplemented through contractual requirements with any issuer using
    financial statements prepared by a PAB member, we believe the PAB could
    conduct rapid inquiries, with the right to revoke or suspend for a time
    the registration of any member firm or individual, thus providing the
    clout necessary to get discovery of the facts in any investigation.
    This could work as effectively as if the PAB had subpoena power. In
    fact, the SRO's regulating the brokerage community do not possess
    subpoena power, but through the available sanction of throwing the
    broker out of the business can nonetheless effectively compel
    cooperation in investigations. Moreover, we believe that, in cases in
    which the PAB was denied certain information, the Commission could
    assume responsibility for a particular accounting enforcement matter,
    and use its own subpoena enforcement authority to make sure that a full
    record is developed.
        Persons subject to PAB disciplinary decisions should be able to
    obtain meaningful review of those decisions. The PAB should routinely
    and promptly transmit its disciplinary decisions to the Commission, and
    those decisions should be reviewable by the Commission either at the
    request of the disciplined person or on the Commission's own
    initiative. That review process would, of course, be public. These
    procedures could all be implemented under the Commission's existing
    statutory
    authority.

    2.1.7. Commission Oversight
        Although the Commission's relationship with the POB was based on
    the desire to assure the Congress and the public that the peer review
    process and related programs were working well, the Commission had
    limited ability to affect the work of the POB or the peer review
    program.
        For the PAB to be credible, the Commission must have a direct role
    in the operation of the PAB's regulatory programs by exercising
    effective and rigorous oversight of its membership, rules, and
    activities. In addition, in order to promote an understanding of its
    processes and to inform the public of the results of its programs and
    proceedings, the PAB should be required to issue periodic reports.

    2.1.8. Method of Formation
        We believe we must act quickly to restore faith in the accounting
    profession and our markets that rely on it. The Commission can, through
    its existing authority, effectively establish a PAB with all of the
    attributes described above quickly. In our Roundtables regarding the
    proposed PAB structure, all panelists seemed to agree that integrity
    and competence of auditors was crucial, and that these characteristics
    likely cannot be legislated into existence.
        We view authority for the PAB to flow from our authority to
    determine the nature of financial statements filed with the Commission,
    and the nature of the certification required on those financial
    statements. Just as the independence requirements of the SEC flow from
    its ability to define the term ``independent'' as used in the
    securities laws, so, too, do the competency and ethics requirements of
    Rule 102(e), and indirectly of the PAB, flow from the Commission's
    authority to determine the nature of the filings made to it. The
    Commission's authority to create an administrative disciplinary system,
    presently embodied in Rule 102(e) has already been judicially
    recognized.\37\
    ---------------------------------------------------------------------------
        \37\ Touche Ross & Co. v. SEC, 609 F.2d 570 (2d Cir. 1979).
    ---------------------------------------------------------------------------
    2.2. Auditor Independence Requirements
        There has been considerable debate concerning what, if any, changes
    to the Commission's auditor independence rules are necessary to restore
    investors' confidence in the integrity of the audit process. The
    Commission's current rules on auditor independence were adopted less
    than 18 months ago, and were targeted to address problems about which
    there had been considerable study, discussion, and debate. The
    Commission's approach at that time should be tested by practical
    application, over a reasonable period of time. If problems are
    empirically shown to exist in this area, any needed reforms can be
    tailored to address the precise problems uncovered. Some of the
    restrictions on nonaudit services adopted in those auditor independence
    rules have not yet even taken effect, due to the rules' phase-in
    provisions. With this in mind, we are considering these matters
    carefully, in light of the rules adopted previously by the Commission,
    the additional evidence before us, and legislative proposals that have
    already been made.
        Most Roundtable panelists expressed the view that critical
    independence issues occur in the relationship between engagement
    personnel and the audit client. Audit firms must play an important role
    by ensuring that audit teams adhere to the highest standards of
    auditing, including their independence. By focusing independence
    concerns on those who perform the audit, in the first instance, we can
    resolve the real issues confronting the profession. An individual audit
    partner whose income
    increases even by relatively modest sums of money from cross-selling
    consulting services may lose proper perspective in resolving difficult
    accounting issues. To be effective, independence restrictions must deal
    with both levels of concern--first, the engagement auditors should be
    precluded from receiving any compensation for cross-selling any
    nonaudit related services to an audit client. Second, firms must be
    incentivized to ensure that every audit meets the highest standards of
    the profession, and must be subject to meaningful sanctions where
    audits are not performed at those levels.
        This is the analysis reflected in an AICPA policy paper I helped
    prepare in 1997 for submission to the then newly-created Independence
    Standards Board, a body formed by the SEC and AICPA to address
    independence issues in the profession.\38\ In recent years,
    independence reforms have primarily focused on the independence of the
    firm. Narrow rules focused mainly on this area can give investors and
    Members of Congress the false sense that the problems that gave rise to
    Enron's collapse effectively have been eliminated. The Commission's
    responsibilities do not permit us to accept simple solutions for
    complicated issues. In the area of independence, we must move to a
    system that recognizes that true independence lies not only with the
    firm, but also with the engagement team, and any conflict, external or
    internal, that might impair the team's independence, must be addressed.
    ---------------------------------------------------------------------------
        \38\ David E. Birenbaum and Harvey L. Pitt on behalf of the AICPA,
    Serving the Public Interest: A New Conceptual Framework for Auditor
    Independence (October 20, 1997).
    ---------------------------------------------------------------------------
        Some have suggested firewalls as a means to separate the financial
    and personal aspects of the consulting engagement from those who
    perform the audit. In its
    recent rulemaking the Commission did not require that auditors and
    their audit
    clients forsake all nonaudit service arrangements; those of us
    currently on the Commission do not believe that it is necessary to
    propose such a ban at this time. Information gained through consulting
    engagements may be useful in performing an audit. In fact, auditing
    literature requires auditors to ask firm personnel who have provided
    consulting or other services to the client if they have any information
    that would be relevant or useful during the audit.\39\
    ---------------------------------------------------------------------------
        \39\ AICPA, Planning and Supervision, AU Sec. Sec. 311.04b,
    9311.03.
    ---------------------------------------------------------------------------
        The Commission's existing independence requirements provide a
    conceptual framework to be applied to any proposed nonaudit service to
    determine whether that service is inconsistent with independence. We
    believe this framework, adopted in late 2000, will, over time, serve
    investors better than would a blanket ban on the receipt of nonaudit
    services from the auditor that certifies the financial statement.
    Indeed, that was the precise reason that former Chairman Levitt, in
    endorsing the existing rules as they had been revised, claimed that
    they were better than an absolute ban.\40\
    ---------------------------------------------------------------------------
        \40\ ``Accounting Firms, SEC Agree on Audit Rule; Compromise
    Expected To Avert Legal Face-Off,'' The Washington Post, p. E01,
    November 15, 2000 (``Though the SEC dropped its proposed ban on
    information technology consulting, Levitt said, `We got something I
    think is better, with the requirement for audit committee approval and
    disclosure.' '').
    ---------------------------------------------------------------------------
        It is useful to recall that there were large audit failures before
    accounting firms had any significant consulting business.\41\ It should
    be apparent, therefore, that merely mandating the separation of
    consulting from auditing--to create an ``audit only'' firm--does not
    guarantee an ``audit failure free'' future. And there are costs to be
    weighed. An ``audit only'' firm might lack certain expertise,
    especially if tax consulting were eliminated, necessary to perform high
    quality audits. An ``audit only'' firm would be more dependent, not
    less, on their audit clients, and a single, large audit client could
    exert far more influence on such a firm than is the case with firms
    that have multiple sources of revenues.
    ---------------------------------------------------------------------------
        \41\ See, e.g., Dirks v. SEC, 463 U.S. 646 (1983) (regarding
    trading prior to the failure of Equity Funding in 1973); U.S. v. Simon,
    425 F.2d 796 (2d Cir. 1969) (regarding the financial fraud on the books
    of Continental Vending Machine Corporation).
    ---------------------------------------------------------------------------
        We believe that limiting those services that create an inherent
    conflict with auditing, barring inappropriate compensation mechanisms
    (such as compensation for cross-selling services) and penalizing firms
    whose aggregate and individual audit performance is substandard (most
    likely by limiting the ability to take on new clients for significant
    periods of time and compelling termination of client relationships) are
    more likely to prevent audit failures than the suggestion that we
    increase the reliance of all audit firms on their audit clients. We
    believe it is appropriate to pursue, and we intend to pursue, the
    following changes in this area.

    2.2.1. Change of Auditors
        As discussed above, allowing the PAB to exercise judgment, subject
    to prompt Commission review, to direct auditors to step down from an
    engagement could address risks that auditors that have worked with a
    client for a number of years may become either complacent or too
    dependent on the audit client.
        Some have suggested the possibility of requiring that public
    companies replace their auditors after a specified number of years. The
    Commission believes that this approach, often referred to as
    ``mandatory rotation,'' would be unwise. Studies over the last three
    decades suggest that the number of financial frauds in the first years
    of a new auditor's engagement is unacceptably high.\42\ Mandatory
    periodic rotation of firms also could lead to ``opinion shopping'' in
    the decision on which new firm to select. Another concern is the unique
    strengths particular audit firms bring to the clients in certain
    industries. Large accounting firms are not fungible; one firm is not
    identical to another, and there can be valid market-driven reasons,
    such as expertise in a certain industry, for selecting and retaining
    one firm over others. This freedom of choice should lie with the
    corporation; it should not be a Government-
    imposed mandate or a decision delegated to the stock exchanges.
    ---------------------------------------------------------------------------
        \42\ Mandatory rotation of auditing firms, on some multi-year
    cycle, was discussed at the time of the Moss / Metcalf hearings in the
    mid-1970's and has often been suggested since that time. The 1977
    Metcalf report states, ``Rotation of audit firms and personnel has been
    widely discussed as a means of strengthening the independence of
    auditors. . . . The subcommittee believes rotation needs more study by
    the Commission before a sound conclusion can be reached.'' The
    rationale in support of firm rotation is that it would result in a
    periodic ``fresh'' look at the financial statements, would result in an
    auditor knowing that another firm will be reviewing the positions it
    has taken, and would limit anticipation of a longer relationship.
        The Cohen Commission Report recommended against rotation of audit
    firms based, in part, on its finding that most audit mistakes occurred
    in the first year or two of an audit engagement. The Cohen Commission
    found that most mistakes occur in the first year or two of an audit
    engagement, that rotation would limit firms' incentives to ``learn the
    business'' of their clients, and that firms might be inclined to have
    their personnel focus on new work and lessen the attention given to
    matters during the last year or two of an audit.
        Subsequent studies have reported information that tends to support
    the case against rotation. For example, the 1987 National Commission on
    Fraudulent Financial Reporting (Treadway Commission) examined 42 cases
    brought by the Commission against independent accountants from July
    1981 to August 1986 and stated that these cases ``revealed that a
    significant number involved companies that had recently changed their
    independent public accountants. . . . Additional research commissioned
    by the Committee of Sponsoring Organizations of the Treadway Commission
    (COSO) in 1999 examined 88 cases occurring between 1987 and 1997 where
    the Commission had alleged an audit failure and the name of the auditor
    could be determined. It found that 26 percent of the 88 companies
    changed auditors between the period in which the company issued its
    last ``clean'' set of financial statements and the period in which it
    issued the allegedly fraudulent financial statements. This study
    concluded that ``most auditor switches
    occurred during the fraud period (versus before the fraud period). . .
    .''
    ---------------------------------------------------------------------------
        Required rotation of the lead audit engagement partner (every 7
    years) could be reviewed by the PAB to determine whether a deeper
    rotational requirement, affecting more members of the audit team, would
    be advantageous. This is an area where it may be useful for the PAB,
    over time, to evaluate different quality control approaches to the
    issue and eventually make appropriate recommendations.

    2.2.2. Compensation for Cross-Selling
        Because the engagement partner learns a great deal about a company
    during the audit process, he or she might be in the best position to
    suggest services that a company needs and help the company find
    credible people to provide those services. Some firms provide
    additional compensation to audit engagement partners who sell nonaudit
    services to audit clients. The Commission believes that such
    compensation practices could cause serious conflicts and should be
    stopped.

    2.2.3. Undue Influence by Clients
        As discussed above, conflicts can occur if an auditor becomes
    overly dependent on a client, even if there is no cross-selling of
    services. For example, over the years the argument has been made that,
    since the company hires the auditor and pays the auditor's fee, the
    auditor can never be really independent from management. But the
    proposals that attempt to address this issue offer a cure that is worse
    than the disease. For example, there have been suggestions that the
    exchanges select the auditors of listed companies' financial
    statements. Significant practical difficulties would impede
    implementation of this suggestion. As discussed above, there may be
    very legitimate business reasons for management to prefer one auditor
    to others. It may be beyond the exchanges' current expertise to chose
    auditors, negotiate a reasonable fee, evaluate the auditor's
    performance, or determine if a complaint by the company about an
    auditor was legitimate or was made because the auditor was taking tough
    positions on accounting and auditing issues.
        There has also been a concern that engagement partners would
    subordinate their judgment to that of the client merely to retain the
    business. Firms uniformly have required consultation and review
    procedures to assure that engagement partners are not compromised. We
    would strengthen these protections by calling on audit committees to
    provide the necessary counter-weight to management to avoid
    inappropriate pressure of the accounting firm.
        Finally, some have suggested that there should be either a ban on
    auditors going to work for audit clients or a ``cooling off '' period
    ranging from 1 to 5 years between the time the individual provided any
    services for the audit client and the time that he or she becomes an
    employee of that client. As a general matter, especially for smaller
    companies that have more limited options for hiring seasoned accounting
    personnel, this could work a serious hardship. The Commission rule
    adopted in 2000 provides that if a person takes on ``an accounting role
    or financial reporting oversight role'' at an audit client, then
    independence is impaired unless he or she does not influence the
    accounting firm's operations or financial policies, has no capital
    account at the firm, and has no financial arrangements with the firm
    other than a fully funded retirement plan that pays a fixed dollar
    amount (which is not dependent on the firm's revenues or earnings).
    Again, this is a rule that we believe should be evaluated after it has
    been given time to work. The first place we would look is to provide
    additional comfort against risks to independence is the audit
    committee. Certainly audit committees should closely examine and
    approve any decision to employ individuals that have provided audit
    services to the company.

    2.3. Accounting Standard Setting
        While the SEC has statutory authority to establish financial
    accounting and reporting standards for publicly-held companies, for
    over 60 years the Commission historically has looked to the private
    sector to provide the initiative in establishing and improving
    accounting principles.\43\ The high quality of our accounting standards
    and our capital markets can be attributed in large part to the private
    sector standards setting process, as overseen by the SEC.
    ---------------------------------------------------------------------------
        \43\ See note 34, supra, and accompanying text.
    ---------------------------------------------------------------------------
        Since 1973, the Financial Accounting Standards Board (FASB) has
    been the designated organization in the private sector for establishing
    standards of financial accounting and reporting. The FASB was designed
    to be an independent body, insulated from political pressure, to
    provide it with the opportunity to focus on creating neutral accounting
    standards that are transparent to the underlying economics. An
    oversight body appoints the members of FASB. This oversight body, the
    Financial Accounting Foundation (FAF), is composed of investors,
    business people, and accountants. The FASB's standards are designated
    as the primary level of Generally Accepted Accounting Principles
    (GAAP), which is the framework for accounting. The interpretative body
    of FASB, the Emerging Issues Task Force (EITF), meets every other month
    to provide interpretative guidance, or develop new guidance, on narrow,
    new, or emerging issues that arise under existing GAAP and when GAAP
    does not exist.
        The secondary standard setter is the Accounting Standards Executive
    Committee (AcSEC), which provides guidance in the form of Statements of
    Position (SOP's), subject to the affirmative concurrence by FASB at
    every step in the process. The principal purpose of AcSEC, which is a
    committee of the AICPA, is to develop standards for specialized
    industries.
        Some have opined that the public interest at stake in establishing
    accounting standards is too important for that function to be left to a
    nonpublic body not responsible to the Congress. Those who make this
    suggestion apparently have lost confidence in FASB's processes.
    However, we believe that the accounting standard setting function
    should remain in the private sector. When done properly, standard
    setting in the private sector is the best option for our capital
    markets as it provides a number of advantages over Federalized standard
    setting. Private sector standard setting has greater flexibility to
    complete rules more quickly than accounting standards set by the
    Government.
        Federalization of the FASB not only would require substantial
    increases to the Federal budget, but also might disenfranchise those
    who are best qualified to address the highly complex business and
    accounting issues that must be resolved. The FASB is composed almost
    entirely of accounting experts and has a greater ability to attract and
    retain qualified personnel. Similarly, AcSEC and the EITF are composed
    of members with accounting expertise.
        Moreover, Government agencies may be more susceptible to political
    pressure than private bodies. This political pressure could result in
    the development of accounting standards that are not solely designed to
    meet the needs of those who use financial statements in economic
    decisions. For example, many question whether the FASB's proposal to
    expense stock compensation would have been better for investors. This
    concept was set forth in 1994, when it was the sense of the Senate that
    FASB's private sector nature should be respected and safeguarded and
    that Congress should not impair the objectivity or integrity of FASB's
    decisionmaking process by legislating accounting rules. We believe the
    concept remains sound today.
        We do believe, however, that FASB's processes can and must be
    improved. In fact, even before Enron's collapse, we recognized that
    FASB needed to address concerns about timeliness, transparency, and
    complexity, and we asked FASB to address these concerns. The markets
    and investors simply cannot wait a decade or more
    for standards regarding such important matters as revenue recognition
    and consolidation of special purpose entities. Moreover, the work of
    the standard setters must result in standards that ensure illumination
    and not obfuscation in financial reporting.
        From the beginning of my tenure as Chairman, I have recognized that
    the SEC historically had abdicated too much of its obligation to ensure
    that accounting standards meet the objectives of the Federal securities
    laws. The SEC consequently plans to take a more active role than it has
    in the last decade to ensure that standards are implemented and benefit
    our markets and investors. I believe that with strengthened Commission
    leadership and cooperation by FASB, FASB can be effective, and
    confidence in the process can be restored. Private-sector standard
    setting can work in our current business environment, even as financial
    transactions become more complex.
        As discussed in more detail below, we plan to use our existing
    statutory authority to oversee the standard setting process to ensure
    that it functions in the best interest of investors, including by: (i)
    broadening funding sources to decrease FASB's
    dependence on revenues from the accounting profession; (ii) providing
    SEC input to the selection of projects on FASB's agenda; and (iii)
    ensuring that FASB's standards evolve to become general principle-based
    standards instead of overly complex, rule-based standards.

    2.3.1. Involuntary Funding for the Private-Sector Standard Setter
        Currently, the Financial Accounting Foundation (FAF) is responsible
    for selecting the members of FASB and its Advisory Council, funding
    their activities, and exercising general oversight. FAF receives
    contributions to fund FASB and approves FASB's budget. To enhance
    FASB's independence, we believe that its funding source should be more
    secure and should strengthen both the reality and the appearance of
    independence. Funding should be made involuntary. This funding change
    will help to ensure that FASB continues to be independent so that it
    can continue to be objective in its decisionmaking and to ensure the
    neutrality of information resulting from its standards. We also believe
    that the Commission must have a direct role in the selection and
    approval of the members of FASB.

    2.3.2. FASB's Agenda
        FASB at times has operated too slowly to be responsive to changes
    in the marketplace. For example, while FASB's Emerging Issues Task
    Force (EITF) has provided limited guidance on unique issues related to
    special purpose entities, FASB has been working on its overall
    consolidation project, which includes the consolidation of special
    purpose entities, for many years.
        In addition, the FASB has not always added critical or significant
    projects to its agenda on a timely basis. For example, revenue
    recognition is usually the largest single item in financial statements;
    studies indicate that it is the single largest category of financial
    statement restatements, and our recent experience with actions brought
    by our Division of Enforcement involving financial statements indicate
    this is the core issue in over 50 percent of our actions. While certain
    narrow industry specific guidance exists, it was only on January 28,
    2002, 27 years after its inception, that FASB issued for public comment
    a proposal to broadly address revenue recognition. Because there is no
    general standard on revenue recognition, issues involving revenue
    recognition are among the most important and the most difficult that
    accountants face. A final revenue recognition accounting standard could
    take several years to complete without a fundamental change to the
    FASB's current
    processes.
        The SEC plans to work with FASB to develop a mechanism that will
    ensure that each project on its agenda is completed on a timely basis.
    Moreover, FASB must ensure that its agenda is responsive to those
    issues facing investors and accountants. To help achieve that goal, the
    SEC will provide more input to the selection of projects to FASB's
    agenda, and direct FASB to address promptly priority items.
        In addition, we will actively oversee the standard setting process
    to ensure that it functions in the best interest of investors. The SEC
    has exercised, and should
    exercise, its authority over the accounting standards it will accept
    for filings made with the agency. We should not use this power
    indiscriminately; it should be reserved for those exceptional
    situations where the public interest demands it. The reason for this
    approach by the SEC is clear: FASB has acted in the public interest and
    has brought a level of sophistication and professionalism to the
    accounting standard setting process that we should not heedlessly shunt
    aside.

    2.3.3. Principle-Based Standards
        Much of FASB's recent guidance has become rule-driven and complex.
    The areas of derivatives and securitizations are examples. This
    emphasis on detailed rules instead of broad principles has contributed
    to delays in issuing timely guidance. Additionally, because the
    standards are developed based on rules, and not on broad principles,
    they are insufficiently flexible to accommodate future developments in
    the marketplace. This has resulted in accounting for unanticipated
    transactions that is less transparent and less consistent with the
    basic underlying principles that should apply.\44\ The development of
    rule-based accounting standards has resulted in the employment of
    financial engineering techniques designed solely to achieve accounting
    objectives rather than to achieve economic objectives.
    ---------------------------------------------------------------------------
        \44\ On February 13, 2002, the SEC Chief Accountant wrote to the
    Auditing Standards Board calling for them to prohibit SAS 50 letters on
    ``hypothetical transactions,'' thereby preventing the potential for
    these preference letters to help investment bankers market structures
    designed to get around particular FASB principles. A copy of this
    letter is annexed as Attachment L.
    ---------------------------------------------------------------------------
        The SEC believes that FASB's standards, at least going forward,
    should evolve to become general and principle-based, instead of
    encyclopedic and rule-based, standards. While principle-based standards
    can also be subject to abuse, and some level of standardization is
    necessary for comparability and verifiability, we believe that
    principle-based standards in general are better suited to the rapidly
    changing financial landscape in which many companies operate. Moreover,
    the abuses should be minimized if our other suggestions are adopted,
    especially those regarding emphasis on overall accuracy and
    completeness of financial reporting and other disclosures, rather than
    disclosure based merely on compliance with specific rules. Of course,
    FASB and the SEC should continue to provide appropriate specification
    where the circumstances require and should use professional groups,
    like the EITF, to fill in the interstices of broad principles-based
    pronouncements.

                               SEC FUNDING NEEDS

        Let me conclude with a point that may be last but is certainly not
    least. We need legislative assistance in increasing our funding for
    both this and subsequent fiscal years. The SEC regulates industries and
    markets that have grown enormously, in both size and complexity. The
    Commission currently oversees an estimated 8,000 brokerage firms
    employing nearly 700,000 brokers; 7,500 investment advisers with
    approximately $20 trillion in assets under management; 34,000
    investment company portfolios; and over 17,000 reporting companies.
        The President's budget for fiscal 2003 requested an appropriation
    of $466.9 million for the Commission, an appropriation that I supported
    when it was first formulated. But since the time that appropriation was
    formulated, pay parity legislation has passed, and the Commission has
    had to respond to three crises. As a result of those recent events, we
    critically need additional funds to enable us to phase-in a modest pay
    parity plan. We also need authorization to add new staff to address
    pressing immediate needs. We have discussed our interim personnel and
    resource needs with OMB, and they have indicated their receptivity to
    our request for an additional $15 million to fund 100 new lawyers and
    accountants.

    1. Pay Parity
        The Commission has been subject to extremely high attrition,
    principally because our employees earn substantially less than their
    counterparts in the other financial service regulatory agencies. The
    ``Investor and Capital Markets Fee Relief Act'' (P.L. 107-123), enacted
    this January, authorized pay parity, but the Administration's proposed
    fiscal 2003 SEC budget provides no new money to implement this vitally
    important program. Once pay parity was a reality, however, the failure
    to provide funding was a disappointment to our most valued employees.
    We estimate that an additional $76 million is needed to provide a
    modest implementation of pay parity for the agency in fiscal 2003.\45\
    At this critical time for the Nation's financial markets, we must rely
    on our most experienced, talented, valuable and productive
    employees. The only way to do that is for us to be able to provide our
    staff with pay parity at levels comparable to those with whom they
    regularly work at the other Federal financial regulatory agencies. If
    we receive funding for pay parity, I assure you that the SEC intends to
    make responsible increases in staff salaries and benefits, with a
    significant component of the increases subject to true merit pay.
    ---------------------------------------------------------------------------
        \45\ In fiscal 2001, the Commission received approval and funding
    to implement ``special pay'' to help begin addressing our recruitment
    and attrition problems. In fiscal 2002, we also received funding to
    continue special pay. The appropriation proposal for fiscal 2003
    provides $19 million to fund special pay. We estimate that an
    additional $76 million is needed to fund pay parity for fiscal 2003.
    ---------------------------------------------------------------------------
        The failure to fund pay parity now would only exacerbate the
    problems that the legislation passed by Congress last December was
    intended to cure. By raising expectations and hopes in anticipation of
    finally achieving pay parity, we will face even greater employee losses
    and suffer greater irreparable harm to morale if pay parity is not
    funded in fiscal 2003, and thereafter. Even if we can cobble together a
    pay parity program for the remainder of this fiscal year, which OMB has
    said it supports, the threat of either terminating the program in
    fiscal 2003 or terminating approximately 700 employees--the number we
    estimate would have to be cut from the agency to continue the program--
    would cripple many of the projects we have underway, which are
    important for the protection of investors and Americans whose
    retirement accounts are invested in the securities of public companies.
        As I mentioned before, we are extremely grateful to have bipartisan
    backing from this Committee. We especially appreciate Chairman
    Sarbanes' and Senator Gramm's calls for full funding of pay parity. The
    SEC cannot afford to continue suffering the staffing crisis it has
    endured for the past decade at such an important juncture. Pay parity
    provides benefits we truly need to meet the increasing regulatory
    challenges we face. We continue to work closely with OMB to persuade
    them of the need for these funds. In the interim, I am committed to
    proceeding with our implementation of the reforms the President has
    directed us to effect.

    2. Additional Personnel
        In addition to the absence of any funds to implement pay parity, we
    were also given a ``no-growth'' budget, which means that we cannot add
    any new personnel. Indeed, under current funding levels for 2002, we
    are effectively precluded from
    hiring any new personnel. The solution to every problem does not start
    and end with larger and more expensive Government. I have started a
    thorough review of our deployment of personnel, to see whether we can
    effectuate some meaningful efficiencies.
        But the tragedy of 9/11 and the very issues we are discussing here
    today made any contemplative review of our needs impossible. Given the
    enormous surge in our enforcement activities, the desire to do a better
    job than has been done previously at reviewing public company filings,
    and overseeing a restructured accounting profession, the SEC must seek
    a staffing increase of 100 positions in fiscal 2003 even before looking
    for efficiencies. This would allow us to add:

     Thirty-five accountants and lawyers in the Division of
        Enforcement to deal with the increasing workload from financial
        fraud and reporting cases.

     Thirty professional staff, including accountants and lawyers,
        in the Division of Corporation Finance to expand, to improve, and
        to expedite our review of periodic filings.

     Thirty-five accountants, lawyers, and other professionals in
        the other divisions--including the Office of Chief Accountant--to
        deal with new programmatic needs and policy.

        These are the minimum staffing levels required to deal with our
    immediate post-Enron needs. Under a pay parity system, this increased
    staffing level will require an additional $15 million. The Commission
    has not received a staffing increase in the last 2 years, despite the
    additional responsibilities we have received as a result of the
    Commodity Futures Modernization Act and the Gramm-Leach-Bliley Act:
    Financial Services Modernization. A staffing increase is even more
    critical in light of recent events.

    3. Additional Resources
        In addition to the initiatives discussed in my testimony above,
    which will take substantial resources, there are other important
    initiatives we are undertaking in the areas of enforcement, investor
    education, and technology that will require additional resources in the
    coming years.

     One of our major new initiatives--``real-time'' enforcement--
        is an important component of our fiscal 2003 budget. Our goal is to
        provide quicker, and more effective, protection for investors, and
        better oversight of the markets with our limited enforcement
        resources. As recent experience has reinforced, the SEC must
        resolve cases and investigations before investors' funds vanish
        forever; that means we must act more quickly, both in identifying
        violations and taking prompt corrective action to protect
        investors. These efforts necessarily require resources, the most
        important of which is appropriate staffing.

     Even with our shift toward real-time enforcement and our
        current efforts to
        improve financial disclosure, the first line of defense against
        fraud is always an educated investor. The Commission works with
        numerous public and private organizations to foster investor
        educational programs. Our staff gives presentations to countless
        schools, religious organizations, and investor clubs, explaining
        basic investing concepts and answering questions. We also host
        ``Investor Town Meetings'' across the United States that bring
        together industry, Federal, and local government officials to
        educate investors on basic financial concepts. And this spring we
        will host our first ``Investor Summit,'' to discuss policies and
        proposals that impact them. We want to give all Americans an
        opportunity and an avenue to weigh in on the broad policy
        objectives that ultimately could impact their ability to send their
        children to college or retire comfortably. We plan to use the
        Internet to broadcast the summit so that anyone can participate. We
        also are asking people to write us and call us so that we can hear
        the broadest possible range of viewpoints. We want to hear the
        concerns and aspirations of America's investors.

     Like the rest of the Government, our needs in the area of
        information technology continue to increase. Given the critical and
        increasing role of technology in the financial markets, the
        President's budget requests $4.0 million to fund the SEC's e-
        government initiatives. This is an area where the Commission needs
        to improve, both internally and externally. Technology is
        constantly altering the landscape of our markets, and SEC staff
        must have the necessary tools at their disposal to successfully
        meet the increasing demands that we face. In particular, funds
        proposed for fiscal 2003 will allow the SEC to get better and more
        timely enforcement
        information from the markets, enhance our intrusion detection
        capabilities, and meet the President's security requirements for
        information technology. These initiatives are a small, but
        important, first step toward meeting the Commission's technology
        needs.

     With the advent of alternative trading systems that have grown
        from only a handful to over 60 today, and as a result of the
        Internet, the SEC also must consider what effect our regulatory
        actions and decisions have on the industry's use of technology. To
        respond to this need, I have created a new position of Chief
        Technology Officer to provide the Commission with the technical
        expertise and advice necessary to improve the Commission's
        oversight of the markets. Generally, this office will be
        responsible for ensuring that the SEC's regulatory, disclosure,
        examination, and law enforcement programs are implemented with the
        benefit of a state of the art understanding of technology. Through
        this process, the agency can be confident that what we implement or
        approve is technologically sound and cost effective to the private
        sector.

                                   CONCLUSION

        While it remains strong, our system has shown signs of strain over
    the last 5 to 10 years, resulting in unacceptable and potentially
    avoidable losses to those who believed in the truth of what they were
    told and took comfort that what they did not know would not hurt them.
    The present financial reporting and disclosure system for public
    companies has not changed significantly in many decades. Investors
    should continue to have confidence in our present system, but there
    must be determination to make improvements.
        I take quite seriously my stewardship responsibilities and the Oath
    of Office I took when I became Chairman of the Commission. I look
    forward to continuing to work with you to make sure that we discharge
    our obligations prudently, generously and in the spirit with which the
    Federal securities laws were adopted: To protect investors and maintain
    the integrity of the securities markets.
        Thank you for the opportunity to testify today. I am pleased to
    respond to any questions the Committee may have.