[Senate Hearing 107-1142]
[From the U.S. Government Printing Office]
S. Hrg. 107-1142
PERSPECTIVES ON IMPROVING CORPORATE RESPONSIBILITY AND CONSUMER
SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE AND TOURISM
COMMITTEE ON COMMERCE,
SCIENCE, AND TRANSPORTATION
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
JULY 18, 2002
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SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION
ONE HUNDRED SEVENTH CONGRESS
ERNEST F. HOLLINGS, SOUTH CAROLINA Chairman
DANIEL K. INOUYE, Hawaii JOHN McCAIN, Arizona
JOHN D. ROCKEFELLER IV, West TED STEVENS, Alaska
Virginia CONRAD BURNS, Montana
JOHN F. KERRY, Massachusetts TRENT LOTT, Mississippi
JOHN B. BREAUX, Louisiana KAY BAILEY HUTCHISON, Texas
BYRON L. DORGAN, North Dakota OLYMPIA J. SNOWE, Maine
RON WYDEN, Oregon SAM BROWNBACK, Kansas
MAX CLELAND, Georgia GORDON SMITH, Oregon
BARBARA BOXER, California PETER G. FITZGERALD, Illinois
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
Kevin D. Kayes, Democratic Staff Director
Moses Boyd, Democratic Chief Counsel
Jeanne Bumpus, Republican Staff Director and General Counsel...........
SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE AND TOURISM
BYRON L. DORGAN, North Dakota, Chairman
JOHN D. ROCKEFELLER IV, West PETER G. FITZGERALD, Illinois
Virginia CONRAD BURNS, Montana
RON WYDEN, Oregon SAM BROWNBACK, Kansas
BARBARA BOXER, California GORDON SMITH, Oregon
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
C O N T E N T S
Hearing held on July 18, 2002.................................... 1
Statement of Senator Boxer....................................... 43
Prepared statement........................................... 44
Statement of Senator Dorgan...................................... 1
Statement of Senator Edwards..................................... 45
Statement of Senator Fitzgerald.................................. 46
Claybrook, Joan, President, Public Citizen....................... 18
Prepared statement........................................... 24
Article, dated July 17, 2002, entitled The Shareholder
Lawsuit: A Red Flag for Auditors?.......................... 21
Letters to Hon. Arthur Levitt................................ 39,40
Metzenbaum, Hon. Howard M., (Retired Senator), Chairman, Consumer
Federation of America.......................................... 2
Prepared statement........................................... 5
Minow, Nell, Editor, The Corporate Library....................... 48
Prepared statement........................................... 51
Moore, Hon. Richard, Treasurer for the State of North Carolina... 10
Prepared statement........................................... 13
Smith, Hon. Gordon, U.S. Senator from Oregon, prepared statement. 61
PERSPECTIVES ON IMPROVING CORPORATE RESPONSIBILITY AND CONSUMER
THURSDAY, JULY 18, 2002
Subcommittee on Consumer Affairs, Foreign Commerce,
Committee on Commerce, Science, and Transportation,
The Subcommittee met, pursuant to notice, at 9:35 a.m. in
room SR-253, Russell Senate Office Building, Hon. Byron L.
Dorgan, Chairman of the Subcommittee, presiding.
OPENING STATEMENT OF HON. BYRON L. DORGAN,
U.S. SENATOR FROM NORTH DAKOTA
Senator Dorgan. We call the Subcommittee hearing to order.
This morning's hearing will be conducted in 2 parts. Beginning
at 9:30 a.m., we will have the first portion of the hearing
dealing with the perspectives offered to us by a number of
organizations and individuals on corporate responsibility,
consumer protections, and related issues; all of us know that
we have had a crisis of confidence in this country--in many
instances, for very good reasons--in the economy and
Virtually every day, we hear additional news about some of
America's best-known corporations restating earnings. We have
news about corporations filing for bankruptcy. We have news of
companies--such as Xerox, Global Crossing, Qwest, WorldCom,
Merck, Enron, Tyco--restating earnings going back a quarter, a
year, 2 years, 3 years, 4 years. It seems to me each and every
day brings a new revelation about behavior and about practices
inside the companies, about the actions of accountants and law
firms that make you just shake your head and say, ``What on
earth were people thinking about?''
This is about public trust. The mechanism by which we
accumulate capital in this country is such that people must be
able to trust those who are running our companies, those who
are preparing financial statements, those who are running
accounting firms, those who are running the law firms. The
faith in those institutions and those organizations has been
sorely shaken in recent months.
We recently passed a piece of legislation in the Senate
dealing with corporate responsibility. Much more is yet to be
done, however. That needs to go to conference. There are things
that are left out of that bill. We will need to have a second
round on that issue. We thought it was important to continue
the work that we have done in this Subcommittee, much of it
focusing on Enron following the announcements with respect to
the Enron Corporation's scandals, I guess I would call it. The
more we looked into Enron, I said it was a culture of corporate
corruption, and I am more convinced of that now than ever. But
it is not just the Enron Corporation. It goes well beyond that.
We're going to have a hearing later this morning in which
we hear about mark-to-market accounting in the State of
California. Mechanisms by which I believe price fixing occurred
in the State of California to the tune of billions of dollars.
Billions of dollars taken out of the pockets of California
consumers by manipulation of wholesale electricity prices and,
therefore, the manipulation of retail electricity prices, as
well. This isn't petty theft. This is wholesale fraud, in my
judgment. We'll have some discussion about that later this
To give us a perspective from several different points on
the compass about corporate responsibility, consumer protection
and related issues--as a prelude to other activities this
Subcommittee will have dealing with WorldCom, Global Crossing,
Tyco, Xerox, and other companies, as well--we want to hear from
I would ask the four witnesses to step forward and come to
the table as I call their name--they are the Honorable Richard
Moore, the State Treasurer for the State of North Carolina, the
Honorable Howard Metzenbaum, a former colleague of ours; who is
now Chairman of the Consumer Federation of America. Senator
Metzenbaum, of course, served many years as a distinguished
Senator from Ohio here in the U.S. Senate. Ms. Joan Claybrook,
President of Public Citizen, and Ms. Nell Minow, Editor of The
Corporate Library. And let me thank all of you for being here
to testify this morning. My colleagues will be along in a bit.
We are holding this hearing in two parts this morning.
After receiving your testimony and asking some questions, we
will reconvene the hearing at 11 o'clock, to hear from Army
Secretary White on subjects that relate to the Enron
Corporation, his former employer.
Again, let me thank all of you for being here. As a matter
of courtesy, I'll call on Senator Metzenbaum first. Senator
Metzenbaum, we miss you here in the U.S. Senate, but we know
that you are doing great work as Chairman of the Consumer
Federation of America. Your voice has long been missed since
your departure. We welcome you this morning and appreciate your
willingness to offer testimony on behalf of the consumers of
Senator Metzenbaum, please proceed.
STATEMENT OF HON. HOWARD M. METZENBAUM (RETIRED SENATOR),
CHAIRMAN, CONSUMER FEDERATION OF AMERICA
Senator Metzenbaum. Thank you, Mr. Chairman, and I miss
being in the U.S. Senate, miss the opportunity to work with
you, and I appreciate your invitation to offer my comments on
this very important issue.
I am particularly pleased to appear before you, Senator
Dorgan, because you personally have done so much to highlight
corporate abuses and to propose real reform.
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 the heartless, unfettered
corporate greed than that revealed by the present widespread
accounting scandals. Companies like Enron and WorldCom lied to
their investors, lied to their employees, hid crucial
information about their finances, and, in some cases, actually
tried to influence, improperly, government officials. The
executives behind what appears to have been a massive fraud--
massive frauds on a grand scale should be brought to justice
This country finds itself in the midst of a corporate crime
wave. It's astounding. It's incredible. It's unbelievable. And
while the average citizens ponder their diminishing retirement
accounts and wonder whether they will be next to lose their
jobs, a debate rages in Washington over whether this is the
product of a few bad apples or evidence of a systemic
breakdown. The outcome will determine whether Congress and the
Administration adopt an effective policy response.
Back in the early 1940s, the number of corporate
restatements used to run at a pretty predictable 45 or so a
year. But around the middle of the last decade, it just took
off. From 1997 through 2001, there were 1,089 restatements,
including well known companies like Waste Management, Sunbeam,
Cendant, Rite-Aid, and, of course, Enron. Today, we are fast
approaching the point where 1 in 10 Americans--1 in 10 of
America's public companies will have recently been forced to
restate its earnings. That's more than the few bad apples the
President claims have a problem.
Our system of investor protections was ostensibly designed
with these many bad apples in mind. It was designed to work,
not just when corporate executives are honest and forthcoming
and aboveboard, but also when they are greedy, unethical, and
deceptive. That's why we have standardized disclosure rules and
SEC oversight and ratings agencies and corporate board audit
committees. And, above all, it is why we require an outside,
independent auditor to review and approve a company's financial
In the recent rash of accounting frauds and failures, all
of those safeguards failed. The accounting rules failed to
produce an accurate picture of company finances. Corporate
boards failed to ask tough questions, challenge questionable
practices, or require more transparent disclosures. Auditors
signed off on financial statements that clearly presented a
misleading picture of companies' finances or missed altogether
Mount Everest-sized reporting errors. In many cases, years had
passed since the SEC last reviewed the company and questioned
its financial statements.
At the end of the day, one conclusion is inevitable. The
system of corporate governance that we have long and rightly
touted as the world's best is just not adequate to ensure that
investors receive accurate information about the companies in
which they invest. And that has led to the current crisis of
investor confidence. Although most investors instinctively
understand that not all companies are corrupt, they also know
that they can't, on their own, reliably tell the difference
between those whose finances toe the mark and those with
troubling secrets hidden in the footnotes or kept out of the
financial statements altogether. And they have experienced
firsthand how quickly the bottom can drop out of a once high-
flying stock when questions about its accounting emerge.
If we want average Americans to continue to view our
financial markets as a place where they can entrust their long-
term savings, then we need to provide them with a reasonable
assurance that our system of investor protections is once again
functioning as it should, and that will require comprehensive
reforms. Not just a little--not ``reforms,'' comprehensive
reform. Not just a little reform; comprehensive reforms.
While a strong civil and criminal enforcement program is a
crucial element of such a plan, the President's plan just does
not go far enough. First, he's given no indication that he's
willing to fund the increased enforcement he's highlighting.
His recent speech said nothing about new funding for the
Department of Justice, which is already struggling with massive
new responsibilities from the war on terror. And the added
hundred-million dollars he has proposed for the SEC is like
throwing a drowning man a toothpick when what he needs is a
The House bill is even worse, much worse. It does nothing
to enhance auditor independence beyond what the major firms
have said they would do on their own. The bill's supposedly
independent oversight board for auditors would have a majority
of accountant representatives. How can you possibly stand up
and support such legislation? It is sham reform that
perpetuates the current system of self-regulation.
Nor does the Senate's accounting reform bill do the job,
although it is far superior to the President's proposal and the
House-passed bill. It would be far better, for example, if it
included your amendment, Senator Dorgan, to open up the
proceedings of the Accounting Oversight Board to the public.
It's a shame that that was not included. Or amendments offered
by you and Senator McCain to ensure that the SEC imposes a
broad ban on consulting services by accounting firms when they
are also auditing a particular company. Or Barbara Boxer's
amendment to prevent an accounting industry takeover of the
But the Senate bill does take a number of meaningful steps
forward to strengthen oversight of the accounting industry. It
is the minimum bill needed to improve investor confidence in
the reliability of corporate disclosures. I believe the House
should just accept the bill in the conference committee,
because there is virtually nothing--and I mean nothing in the
House bill worth keeping.
If the House refuses, then, at the very least, Senators
should insist that all conference negotiations are held in
public. That would minimize the danger that opponents of reform
would try to sneak in anti-investor proposals behind closed
In my written testimony, I mention a number of additional
reforms that should be enacted. I will not talk at length about
these measures now, but they include requiring corporations to
list stock options as an expense. They are and they should be
listed as an expense. Also requiring corporate boards to
improve their oversight of company management and eliminating
unwarranted restrictions in current law on private securities
In closing, let me say that I am nervous--very nervous, Mr.
Chairman--and uncomfortable that the current SEC will be
overseeing the new accounting board when it is enacted into
law, whether in the House or the Senate version. Unfortunately,
the Chairman's ties to the accounting industry and his
disappointing showing so far in addressing these issues
undermines his credibility as the right man to fulfill this
role. It is time for him to prove conclusively that he's
protecting the public interest, not special interests, or step
aside so that--for someone who will. Frankly speaking, the
President never should have appointed him, who had represented
so many of the accounting firms, in the position to which he
had been named.
To be specific, the Chairman needs to get off the sidelines
and push the House to adopt the Senate bill. He needs to
develop a real plan to restore independence to the so-called
independent audit, and he needs to, and we need to, see to it
that members appointed to the new oversight board will
represent investors' interests, not the accounting industry, if
the Senate bill becomes law.
It would be good if the Chairman were to make his
intentions known now. If the Chairman doesn't take these steps
as soon as possible--he could move on the first two items
immediately, for example--it is time for new leadership at the
SEC. I want to repeat that. If he doesn't move immediately with
respect to the first two items I mentioned, then it is time for
new leadership at the SEC.
Thank you, Mr. Chairman, for the opportunity to offer my
comments. It's a privilege to appear with these other----
Senator Dorgan. Senator Metzenbaum, thank you very much.
You haven't changed very much since you've left the Senate.
I must say, having listened to your testimony.
Senator Metzenbaum. I'm sorry that I soft-pedaled it, Mr.
[The prepared statement of Senator Metzenbaum follows:]
Prepared Statement of Hon. Howard M. Metzenbaum, (Retired Senator),
Chairman, Consumer Federation of America
Good morning, Chairman Dorgan, Senator Fitzgerald and Members of
the Subcommittee. My name is Howard M. Metzenbaum and I now serve as
Chairman of the Consumer Federation of America (CFA). CFA is a non-
profit association of some 300 pro-consumer organizations with a
combined membership of over 50 million Americans. Ensuring adequate
protections for the growing number of Americans who rely on financial
markets to save for retirement and other life goals is one of CFA's top
I appreciate your invitation to offer my comments on the very
important issue of corporate responsibility. I am especially pleased to
appear before you, Senator Dorgan, because you have done so much to
highlight corporate abuses of late and to propose real reform.
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 that revealed by
the recent, widespread accounting scandals. Companies like Enron and
WorldCom lied to their investors, lied to their employees, hid crucial
information about their finances and, in some cases, tried to
improperly influence government officials. The executives behind what
appears to have been massive frauds on a grand scale should be brought
to justice quickly. This includes officers at companies like WorldCom,
if they are found to have committed fraud, as well as the individuals
at accounting firms who should have known when their clients were
cooking the books.
The truth is this country finds itself in the midst of a corporate
crime wave. And while average citizens ponder their diminishing
retirement accounts and wonder whether they will be next to lose their
jobs, a debate rages in Washington over whether this is the product of
a few bad apples or evidence of a systemic break-down. While that may
seem to be an arcane argument in the face of so much real world pain,
the implications of this debate are significant because the outcome
will determine whether Congress and the administration adopt an
effective policy response.
The administration has been cynically arguing the ``bad apple''
theory. They have used this theory to justify a policy that allows them
to talk tough about sending corporate crooks to jail without forcing
them to impose real reforms on the corporate interests that so
generously fund their campaigns. Now most of us can agree that
corporate crooks should spend some time behind bars, but this argument
misses on two counts. First, what we are looking at here is more than a
few bad apples. Secondly, what we have is a system of investor
protections specifically designed to eliminate the bad apples; a system
that clearly is not working.
One measure of the scope of the problem is the recent dramatic rise
in companies forced to restate their earnings. Back in the early 1990s,
that number used to run at a predictable 45 or so a year, but around
the middle of the last decade, it took off. From 1997 through 2001,
there were 1,089 restatements, according to a recent study by the Huron
Consulting Group. The number grew every year over that five-year
period, from 116 in 1997 to 270 in 2001. The companies involved include
such well-known examples as Waste Management, Sunbeam, Cendant, Rite
Aid, and, of course, Enron--accounting failures that together cost
investors hundreds of billions of dollars in lost market
capitalization. But, they do not include Adelphia or Xerox or WorldCom
or any of the other companies whose actions have promised to make 2002
another record-breaking year. Today, we are fast approaching the point
where one in ten of America's public companies will have recently been
forced to restate its earnings. That is a lot of bad apples.
Furthermore, the companies involved are not unknown fly-by-night
operations, but the very symbols, in many cases, of innovative American
capitalism--Enron, WorldCom, Qwest, and Xerox--a company that, as one
writer put it is ``so established that its name has become both noun
and verb.'' Even if you were to accept the argument that we are dealing
with isolated cases of wrong-doing, when they involve the nation's
leading companies, does that not tell you the system is fundamentally
But the real point is that our system of investor protections was
ostensibly designed with the bad apples in mind. It was designed to
work, not just when corporate executives are honest, forthcoming and
aboveboard, but also when they are greedy, unethical, and deceptive.
First and foremost, it is why we require an outside, independent
auditor to review and approve a company's financial statements. It is
why we have standardized rules that govern what companies have to
disclose and how. It is why the SEC reviews financial disclosures for
accuracy, completeness, and compliance with appropriate accounting
rules. It is why rating agencies pore over massive amounts of
information to determine the creditworthiness of companies that issue
debt. It is why corporate boards have audit committees, made up
primarily of board members who are supposed to be ``independent,'' to
supervise the audit.
In the recent rash of accounting frauds and failures, all of those
safeguards failed. The accounting rules failed to produce an accurate
picture of company finances. Corporate boards failed to ask tough
questions, challenge questionable practices, or require disclosure that
is more transparent. Auditors signed off on financial statements that
clearly presented a misleading picture of company finances--or missed
altogether Mt. Everest sized reporting errors. In many cases, years had
passed since the SEC last reviewed the company in question's financial
At the end of the day, one conclusion is inevitable. The system of
corporate governance that we have long, and rightly, touted as the
world's best is not adequate to ensure that investors receive accurate
information about the companies in which they invest. And that has led
to the current crisis of investor confidence. Although most investors
instinctively understand that not all companies are corrupt, they also
know that they can not--on their own--reliably tell the difference
between those whose finances toe the mark and those with troubling
secrets hidden in the footnotes or kept out of the financial statements
altogether. They have experienced first-hand how quickly the bottom can
drop out of a once high-flying stock when questions about its
Another aspect of the current debate swirls around the question of
whether this recent explosion of corporate greed is something new or
not. The latter argument is based on the theory that the recent
revelations of corruption in the boardroom are simply the inevitable
hangover from the market boom--that this is simply how markets
``correct'' themselves, and we should simply get out of the way and let
the market do its work.
This argument also ignores an important point--that our markets are
no longer simply a place where the rich get richer. Increasingly, the
financial markets are where average, middle class Americans put their
money to save for retirement, to buy a home, or to send their children
to college. Since the time when the first President Bush took office,
the number of Americans investing in our markets has grown by roughly
60 percent. Today, approximately half of all households have money
invested either directly or indirectly in the stock of American
companies. It is this massive new influx of capital from average
Americans that provided the fuel for our recent period of unprecedented
When the bottom drops out, what these middle class families have at
risk is not whether they can vacation in Tuscany this year, or if they
will have to stay a little closer to home. It is not whether they have
to give up the private jet, or delay their plans to build a vacation
home in Aspen. What is at risk is whether they will be able to retire
in reasonable comfort, or even retire at all. What is at risk is
whether their children will be able to attend the college of their
choice, settle for a less expensive alternative, or miss out on college
altogether. What is at risk is whether they will have to delay
indefinitely their ability to participate in the American dream of
owning their own home. So, what is new is not just that the investor
losses from the recent spate of accounting failures are unprecedented
in their size, but that families who are far less able than the
investing class of the past to absorb such losses are feeling them.
If we want average Americans to continue to view our financial
markets as a place where they can entrust their long-term savings, then
we need to provide them with reasonable assurance that our system of
investor protections is once again functioning as it should. That will
require comprehensive reforms. While a strong civil and criminal
enforcement program is a crucial element of such a plan, the
President's plan does not go far enough. He has given no indication
that he is willing to fund the increased enforcement he is
highlighting. His recent speech said nothing about new funding for the
Department of Justice, which is already struggling with massive new
responsibilities from the war on terror. The added $100 million he has
proposed for the SEC is like throwing a drowning man a toothpick when
what he needs is a lifeboat.
The House bill is a disaster. It does nothing to enhance auditor
independence beyond what the major firms have said they would not
oppose. Its supposedly independent oversight board for auditors would
allow a super-majority of industry representatives. And the mechanism
it relies on to create the board--where a board applies for the job--
invites an industry take-over. This is sham reform that, in all but
name, perpetuates the current system of self-regulation.
Nor does the Senate accounting reform bill do the job, although it
is far superior to the President's proposal and the House-passed bill.
It would be far better, for example, if it included your amendment,
Senator Dorgan, to open up the proceedings of the Accounting Oversight
Board to the public or amendments offered by you or your colleague
Senator McCain to insure that the SEC imposed a broad ban on consulting
services by accounting firms when they are also auditing a particular
company. It would be far better with the amendments offered by Senator
Boxer to enhance the independence of the oversight board.
Although we were very disappointed that these amendments were never
voted on and that this important opportunity to improve the bill was
missed, make no mistake about it. The Senate bill is still by far the
best reform proposal on the table. It is the only proposal to create a
strong, effective new oversight board for auditors; to include
significant provisions to strengthen corporate board oversight of the
audit and enhance its independence; to lengthen the statute of
limitations for securities fraud; and to protect the independence of
the Financial Accounting Standards Board. Like the House, but unlike
the President's proposal, the Senate bill authorizes a meaningful and
much needed increase in SEC resources.
In short, the Senate bill is the minimum needed to justify renewed
investor confidence in the reliability of corporate disclosures. To
ensure that the best possible bill is passed as quickly as possible,
the House should accede to the Senate bill. If it refuses, then at the
very least, Senators should insist that the conference is held in
public. That would minimize the danger that the opponents of reform,
who are nervous about gutting the bill in public, would be bolder in
behind-closed-doors bargaining sessions.
But even if the Senate bill is adopted intact, more needs to be
done. In developing an agenda of additional reforms, policy makers need
to recognize that one reason the system has run amok is that too many
of the financial incentives reward doing the wrong thing. If you want
to bring about a new era of corporate responsibility, you are going to
have to eliminate those perverse incentives.
Stock Options Should Be Expensed
The Senate bill would enhance the independence of the Financial
Accounting Standards Board. Maybe that will give FASB the courage to do
what it was intimidated to do nearly 10 years ago--require that stock
options be reflected as an expense on corporate balance sheets.
Proponents of stock option compensation argue that this practice
benefits shareholders by aligning the interests of company executives
with those of company shareholders. But that is clearly not true. As
Paul Krugman recently wrote in The New York Times, options allow
executives to ``get a share of investors' gains if things go well,''
but don't force them to ``share the losses if things go badly.'' As a
result, and because of the massive size of many options grants, they
offer executives massive personal financial incentives to take whatever
risks necessary to drive up the stock price in the short term.
Clearly, granting executives shares of company stock, and forcing
them to hold that stock until after they leave the company, would do a
far better job of aligning their interests with those of typical
shareholders. But our accounting rules favor stock option compensation
over grants of company shares. This is because the grant of company
shares would have to be reflected immediately as an expense on balance
sheets, while the stock options can be relegated to the footnotes
without denting earnings. That makes no sense. As others have pointed
out--while it may be difficult to pin a precise value on options when
they are granted, the one thing we do know is that their value is not
If we truly want to align company executives' interests with
shareholders--a laudable goal--we need to remove this perverse
incentive in our accounting rules to use stock options rather than
grants of company shares to provide incentive compensation to
executives. But, despite the admirable efforts of Senators Levin and
McCain, this aim was not included in the recent Senate corporate reform
bill. The bill is incomplete without it.
Improve Corporate Board Oversight of Management
With all the focus on stock options, it is important to remember
that personal greed is not the only factor encouraging company
executives to push share prices ever higher. As Steve Liesman wrote in
the Wall Street Journal last January, ``stocks have become a vital way
for companies to run their businesses.'' Companies use stock to make
acquisitions and to guarantee the debt of off-the-books partnerships.
They rely on the stock market as a place to raise capital. As a result,
as Leisman said, ``a high stock price can be the difference between
failure and success.''
Clearly, simply fixing the accounting for options will not be
enough to eliminate the incentive for corporate executives to do
whatever it takes--including cooking the books--to create the financial
picture necessary to produce a rising stock price. Corporate boards are
going to have to do a better job of keeping management on the straight
In theory, corporate board members are supposed to represent
shareholders. But shareholders don't pick board members, CEOs do.
Recent proposals by the New York Stock Exchange and Nasdaq take a step
in the right direction by strengthening the independence requirements
for independent board members and by requiring that all members of the
audit and compensation committees be independent members. However, they
are not enough to overcome the influence management has by virtue of
the fact that it selects the board--and can stack it with cronies and
``yes'' men or boot those board members they view as trouble makers.
If we want corporate boards to represent shareholders, we need to
do a better job of giving shareholders a say in the selection of board
members. This is an area that we believe deserves additional attention
in the coming months.
Make the Independent Audit Truly Independent
Ultimately, however, the ability to ensure reliable disclosures
comes down to the effectiveness of the independent audit. Nothing else
can substitute for having a skeptical, independent outsider who
thoroughly looks over the books. But, here again, auditors faced with
bogus accounting have overwhelming financial incentives to look the
other way. Challenging management could cost them the audit engagement.
Given the decades-long relationships that are typical between auditors
and their clients, that means losing not just this year's audit fee, or
next year's audit fee, but decades of expected income. If the client is
a big one, the incentive to back down is enormous.
One thing that dramatically ups the ante is the increasingly common
practice among auditors of also providing consulting services to their
audit clients. The practice has become all but universal among large
companies, and the dollar amounts on the table for consulting contracts
are typically two or three times the audit fees. In some cases,
however, the imbalance is much greater, with consulting fees in some
cases bringing in twenty or thirty times the audit fees.
It is no wonder that expert after expert who testified before House
and Senate committees said no reform would be complete without a broad
ban on consulting services and mandatory rotation of audit firms.
Unfortunately, these central reforms never made the cut. The House bill
simply does what the major accounting firms said they would not
oppose--it expands the current ban to include internal audits and
financial system design and implementation. The Senate bill expands the
list a little further. But neither bill requires the rotation of audit
Where the Senate bill stands head and shoulders above the rest in
this area is with its requirement that board audit committees, made up
exclusively of independent board members, pre-approve any decision to
hire the auditor to perform non-audit services. Also key is the Senate
bill's provision making audit committees directly responsible for
hiring and compensating the auditor and for overseeing the audit and
giving the audit committee the tools it needs to do that job
While we respect the efforts the Senate has made to improve the
oversight of the audit, we do not believe reform will be complete until
auditors are forced to be truly independent from their audit clients.
That means the kind of broad ban on consulting services that has been
proposed by Senators Nelson, Carnahan, and McCain and mandatory
rotation, as included in the Nelson-Carnahan bill.
Improve Audit Standards
Because they lack those broad auditor independence reforms, the
House and Senate bills rely heavily on the new auditor oversight board
to ensure quality audits. But only the Senate bill gives its new board
the standard-setting authority that is key to its effectiveness. The
House bill leaves authority for setting standards with the accounting
profession. Even under pressure from recent scandals, the accounting
profession uses its authority to write audit standards that are full of
suggestions rather than mandates--standards that are more geared toward
minimizing accounting firms' liability than ensuring high quality
The Senate bill provides ample opportunity for industry
participation in this process, but it charges the oversight board with
final responsibility. That should ensure that those whose job it is to
protect the public interest, not the special interests, make decisions.
Of course, even if the House bill gave its regulatory board the
necessary authority, it would not matter. That is because, as we
mentioned earlier, the House bill is custom designed to ensure maximum
industry influence over its new ``regulator.'' It is essential that the
Senate oversight board structure and authority be adopted in the final
The Senate bill includes an impressive package of criminal and
civil penalties for corporate crimes. These should send the same
powerful message to white collar crooks that we have sent to street
criminals--don't do the crime if you can't do the time. The Senate and
House have also authorized dramatically increased funding to put more
cops on the beat at the SEC. You know as well as I do, however, that
authorizing funding and appropriating it are two very different things.
Particularly in light of the lack of administration support, members
will need to be vigilant to ensure that this promise of increased
resources is realized.
We also continue to believe that private lawsuits form an essential
supplement to regulatory enforcement efforts, particularly if you are
unwilling to adequately fund enforcement, as the President appears to
be. Unfortunately, the deterrent effect of such lawsuits is limited by
a number of factors, including the unreasonably high pleading standards
plaintiffs must satisfy before getting access to discovery, the
unreasonably short statute of limitations that governs such suits, and
the lack of aiding and abetting liability.
The Senate bill would address one of those problems, lengthening
the statute of limitations to 2 years from discovery, but no more than
5 years from the wrongdoing. This will make it more difficult for those
who commit fraud to escape liability simply by keeping their fraud
hidden for a short time. It will also make it less likely that suits
against secondary defendants are dismissed because the statute of
limitations has run while the motion to dismiss was pending, blocking
access to discovery.
Senator Shelby was prepared to offer another important amendment,
to restore aiding and abetting liability under the securities laws.
Unfortunately, like so many other important amendments that we have
discussed today, he was prevented from offering that amendment. This
reform is highly relevant to the current crisis since the lack of
aiding and abetting liability has been used by defendant after
defendant in the Enron lawsuits to argue that they cannot be held
accountable for assisting the fraud.
If you cannot fix this glaring shortcoming in our laws now under
the current environment, it is hard to imagine when that will be
possible. But perhaps when these lawsuits have worked their way through
the court system and we find that the victims have recovered only a
pittance, if anything, of their losses, perhaps then will certain
members be willing to abandon their phony rhetoric about frivolous
lawsuits and recognize that our legal system stands in the way of full
and fair redress in even the most meritorious of cases.
The recent corporate crime wave has delivered a wake-up call. The
system of corporate governance that we have grown accustomed to touting
is broken. The Senate has started down the road to reform. But our
system will remain vulnerable until we tackle the fundamental
incentives that encourage our corporate executives to do the wrong
thing and our auditors to turn a blind eye.
We have been given a wake-up call.
Senator Dorgan. Next, let me ask for testimony from the
Honorable Richard Moore, State Treasurer for the State of North
Carolina. Mr. Moore, you may proceed, and we will include your
entire statement in the record, so you may summarize.
STATEMENT OF HON. RICHARD MOORE, TREASURER FOR THE STATE OF
Mr. Moore. Thank you very much, Senators. Thank you for
I come before you today as North Carolina's elected
guardian of the State Treasury and as the sole trustee of $62
billion in public money, most of which is the pension funds for
the 600,000 active and retired public workers of our great
state--the teachers, fire and rescue workers, nurses, police
officers, sanitation workers, and state and local government
employees of North Carolina.
I come here today as an owner who needs help exercising the
full rights of ownership--nothing more, nothing less. Now, in
my prepared remarks, I have some quotations that go back and
show that, since Alexander Hamilton's day and George
Washington's first address to this body, we've always
understood that the power of the marketplace needs to be
regulated for the good of us all.
We can go back through the Great Depression. I wanted to
point out that the deep corruption of our public markets
brought about the passage of the Securities Acts of 1933 and
1934 and the passage of the Glass-Steagal Act. I am extremely
proud that my grandfather, as a member of this body, played a
significant role in drafting and championing many pieces of
these necessary reforms. And we find ourselves, 70 years later,
right back in very, very similar situations. Those reforms
produced a fair and stable marketplace that's been the envy of
the world for almost 70 years.
And I give you this historical background to make what
ought to be an obvious point. It is important to remember that
we are addressing regulations that apply only to public
companies and that no one forces a company to become public.
The choice to do so means that its corporate leaders
voluntarily give up some of their autonomy and agree to be
The tradeoff, which has been significant over the past 20
years, is that those companies may access capital at a severely
discounted rate to traditional sources. Even today, most
businesses and most of the folks I talk to in my home state are
not regulated, the businesses on Main Street across America.
And when they need additional capital, they pay a premium for
Publicly traded companies have been and must always be
regulated to make sure that the individual investor can
properly value his or her risk before an ownership decision is
made. This obvious point has been overlooked by many who are
afraid that additional government regulation will foul the
Today, more than 80 million Americans have decided to take
part in these public marketplaces, either through mutual funds
or pension plans. This, in itself, is remarkable. They have
been enticed--and I want to repeat that--they have been
enticed, through tax policy and professional advice, to
participate and share in this part of the American dream. It is
not your job, nor is it the job of corporate America, to ensure
that this dream comes true. However, it is your job to make
sure that the marketplace is fair to all so that some don't
profit while others lose from the exact same investment.
Our markets today contain about $12 trillion in assets.
More than $2 trillion of that is held by pension funds, like
the one that I run in North Carolina. Approximately--but here's
the point that a lot of people don't understand--while $8
trillion is controlled by mutual funds, most of the large
mutual funds' largest clients are pension funds like myself. So
we have tremendous clout in the marketplace, clout that I don't
think we have fully utilized or understood how to wield.
Institutional ownership has evolved over the last 30 years,
and I think that's one of the reasons we're not prepared. As a
result, we find ourselves, collectively, the largest
shareholders in virtually every major company in America. The
founder or the founder's descendants, at the same time, in many
instances, are no longer seated at the board table advocating,
out of self-interest, the interest for the shareholders. It is
truly a setting very much like government, where people are
spending other people's money.
Therefore, we, as institutions, must act like the owners
that we are. However, we cannot do it alone. We need Congress
and the Administration to help make sure we can properly
exercise our prerogatives of ownership. We need your help to
make sure that we can tell whether the interests of management
and shareholders are properly aligned. We need your help in
making sure that we, as investors, can properly price risk. We
need your help to make sure that the cops on this particular
beat have the resources and tools to do their job effectively.
We need your help now more than ever. And I won't recap all of
the events that happened.
I firmly believe that the vast majority of today's
corporate managers are smart and honest, but it is
disconcerting to see so many of them unmasked, not as captains
of industry, but as captains of greed, with callous disregard
for the welfare of the people whose money grows their company.
Simply put, where I come from, we know that the fox cannot
guard the hen house. No matter how well-meaning, at some point
the temptation to gorge will prevail.
Without proper regulation, history has proven that
hardworking Americans always pick up the tab--the Great
Depression, the savings and loan debacle, during which I was a
white-collar federal prosecutor, with nowhere near the
resources to do the job properly, 12 years ago; and, most
recently, as the Chairman has referred to, the power shortage
In carrying out my fiduciary duty to 600,000 beneficiaries,
we have begun to more actively exercise our ownership rights.
Last month, I was joined by the Comptroller of New York--he and
I are the two largest sole trustees in America--the Treasurer
of the State of California, Phillip Angelides, and the Attorney
General of New York, Elliott Spitzer, to announce important
investment protection principles. These proposals embody
simple, common sense, market-based solutions to some of the
problems that we face.
We, as owners, are exercising our ownership rights when we
put new terms on the table. If you want our money, this is what
we need from you. We're demanding that broker/dealers and money
managers eliminate actual and potential conflicts of interest
from the way they pay their analysts and conduct their affairs,
and we appreciate your help in this. We are asking that the
managers that we utilize look closer into the areas of
financial transparency and corporate conduct. As fiduciaries,
we must and will become more assertive in our ownership role.
Now, in closing, I would like to say that, as investors, we
cannot properly price our risk without getting fair and
accurate information regarding financial transparency and
corporate conduct. We must be able to assess accurate earnings
and the future impact of corporate initiatives on those
earnings. You have already signaled your willingness to help in
that area. And for that, I thank you.
In some areas, we need specific prohibitions. And Senator
Metzenbaum has hit on many of those. In other areas, this may
be unwise. I ask that in the areas that you feel outright
prohibition is unwarranted or unnecessary at this point, do
make disclosure standards tougher. Just as you have done in
food labeling and countless other areas, it is prudent and
appropriate to require that certain financial information be
prominently displayed in plain language in proxy statements and
annual reports. If you will help the large and small investor
alike learn how to find the information to properly price
``option overhangs'' and ``option run rates,'' the market will
go a long way in ridding itself of the truly abusive practices.
I would also ask--remind Congress that this situation has
shown that the defined benefit plans, in many ways, are far
more secure and better than defined contribution plans, as
someone who runs both of them. My defined contribution
investors--I had a lady stop me yesterday. Her money--they had
put $300,000 away as a public investor. Today she has only
$120,000 in that account, and she's grateful that my funds were
properly diversified and we haven't taken that kind of hit. So
I encourage you to look at those roles again.
The importance of the task before us cannot be overstated.
We must restore investor confidence. It is the pillar upon
which one of the great institutions of our society rests, the
open and fair marketplace.
[The prepared statement of Mr. Moore follows:]
Prepared Statement of Hon. Richard Moore, Treasurer for the State of
I come before you as North Carolina's elected guardian of the state
treasury, and as the sole trustee of $62 billion in public money, most
of which is the pension funds for the 600,000 active and retired public
workers of our great state--the teachers, fire and rescue workers,
nurses, police officers, sanitation workers, and state and local
government employees of North Carolina. And, I have come here today as
an owner who needs help exercising the full rights of ownership--
nothing more, nothing less.
As a student of history, I recognize that capitalism has never been
totally unrestrained in this country. Those leaders who have championed
capitalism and the building of economic markets have understood that
unregulated and unchecked, a pure laissez-faire marketplace is a
dangerous thing. In arguing that markets could never regulate
themselves, Alexander Hamilton wrote in his 7th Federalist paper that
``the spirit of enterprise'' when ``unbridled,'' leads to ``outrages,
and these to reprisals and wars.'' He later stated that we Americans
had ``a certain fermentation of mind, a certain activity of speculation
and enterprise which if properly directed may be made subservient to
useful purposes; but which if left entirely to itself may be attended
with pernicious effects.''
This mindset put forth by the founders of our nation has always
been understood by our nation's leaders. Agreeing with President
Theodore Roosevelt, President Woodrow Wilson felt that without ``the
watchful interference, the resolute interference of the government,
there can be no fair play between individuals and such powerful
institutions as [corporations].''
The Hamiltonian views were again embraced after the Great
Depression. The deep corruption of our public markets brought about the
passage of the securities acts of 1933 and 1934 and the passage of the
Glass Steagell Act. I am extremely proud that my grandfather, Frank W.
Hancock, Jr., as a business-oriented member of the House Banking
Committee, played a significant role in drafting and championing many
pieces of these necessary reforms.
The result of these and other reforms produced a stable and fair
public marketplace that has been the envy of the world for almost 70
It is important to remember that we are addressing regulations that
apply only to public companies, and that no one forces a company to
become public. The choice to do so means that its corporate leaders
voluntarily give up some of their autonomy and agree to be regulated.
The trade off, which has been a significant advantage over the last 20
years, is that those companies may access additional capital at a
discount to traditional sources. Even today, most businesses in this
country--those located on main streets across America--are not publicly
regulated, and when they need additional capital, they must pay a
premium for it.
Publicly traded companies have been and must be regulated to make
sure that the individual investor can properly value his/her risk
before an ownership decision is made. This obvious point has been
overlooked by some who fret that additional government regulation will
foul the market.
Today, more than 80 million Americans have decided to take part in
these public markets. Either directly or indirectly through mutual
funds and other pension plans, they have placed their hard earned
savings in these marketplaces. This in itself is remarkable. They have
been enticed through tax policy and professional advice to participate
and share in the American dream. It is not your job, nor is it the job
of corporate America, to insure that this dream comes true. However, it
is your job to make sure that the marketplace is fair to all so that
this dream does not turn into the nightmare of losing the family nest
Our markets today contain approximately $12 trillion in assets.
More than $2 trillion of that is held by pension funds like the one
that I run in North Carolina. Approximately $8 trillion of this
marketplace is controlled by mutual funds. Many of the largest
investors in mutual funds are pension funds, so we institutional
investors have tremendous market clout--clout that I do not think we
have yet fully utilized to bring about positive change.
Institutional ownership has evolved over the last 30 years. As a
result, we find ourselves collectively as the largest stockholders in
virtually every major company in America. The founder, or the founder's
descendents, in many instances are no longer seated at the board table
advocating--out of self-interest--for the interest of shareholders. It
truly is often a setting where people spend other people's money.
We must act like the ``owners'' that we are. However, we cannot do
it alone. We need Congress and the Administration to help make sure we
can properly exercise our prerogatives of ownership. We need your help
to make sure that we can tell whether the interest of management and
shareholders are properly aligned. We need your help in making sure
that we, as investors, can properly price risk. We need your help to
make sure the cop on this particular beat has the resources and tools
needed to do their job effectively.
We need your help now more than ever. The events of the last few
months have shown that our system is currently missing effective and
necessary checks and balances to insure that the fine line between
proper incentive and destructive greed is not crossed. I firmly believe
that the vast majority of today's corporate managers are smart and
honest, but it is disconcerting to see so many unmasked not as captains
of industry, but as captains of greed, with callous disregard for the
welfare of the people whose money grows their company.
Simply put, we know that the fox, no matter how well meaning,
cannot guard the hen house. At some point, temptation prevails. Without
proper regulation, history has proven that hard working Americans
always pick up the tab--the Great Depression, the savings and loan
debacle, and most recently, the power shortage in California.
In carrying out my fiduciary duty to my 600,000 beneficiaries, we
have begun to more actively exercise our rights of ownership. Last
month, I was joined by the Comptroller of New York, H. Carl McCall, the
Treasurer of California, Philip Angelides, and the Attorney General of
New York, Eliot Spitzer, to announce important investment protection
principles. These proposals embody simple, common sense, market-based
solutions to some of the problems that we face. We, as owners
exercising our ownership rights, have put new terms on the table--if
you want our money, this is what we need from you. We are demanding
that broker/dealers and money managers eliminate actual and potential
conflict of interest from the way they pay analysts and conduct their
affairs. We are asking the money managers we utilize to look closer
into the areas of financial transparency and corporate conduct. As
fiduciaries, we must and will become more assertive in our ownership
To date, we have been joined by several other large funds in our
initiative, with more who will likely follow.
As investors, we cannot properly price our risk without getting
fair and accurate information regarding financial transparency and
corporate conduct. We must be able to assess accurate earnings and the
future impact of corporate incentives on those earnings. You have
already signaled your intent to help us in these areas, and for that I
In some area, we need specific prohibitions. In other areas, this
may be unwise. I ask that in areas where you feel outright prohibition
is unwarranted, do make disclosure standards tougher. Just as Congress
has done in food labeling and other areas, it is prudent and
appropriate to require that certain financial information be
prominently displayed in plain language in proxy statements and annual
reports. If you will help the large and small investor alike learn how
to find the information needed to properly price ``option overhangs''
and ``option run rates,'' the market will then go a long ways in
ridding itself of truly abusive practices.
In the past 25 years, retirement savings have been systematically
shifted from defined benefit to defined contribution plans. While this
shift has been highly profitable to the mutual fund industry and
corporations, it has not strengthened overall retirement savings. The
401(k), IRA and Roth IRA are excellent supplementary savings plans.
However, they are insufficient, as has been evident in the past 2
years, for many Americans attempting to prepare for a comfortable
Moreover, defined contribution plans leave matters of corporate
governance and transparency in the hands of individuals who have little
time or money to study these issues. In 401(k) plans, these issues are
left in the hands of trustees who have little incentive to press mutual
fund managers or the underlying companies. Ownership in equities is a
proven way to build retirement wealth. However, it requires careful
attention to the demands of ownership.
I urge Congress to enact legislation promoting the expansion and
establishment of defined benefit plans. These plans are the foundation
of retirement security, and without them, I fear many hard working
Americans will face difficult retirement years. These plans should be
portable. We must recognize that lifetime employment is no longer
feasible or practical in our modern economy. These plans need to run on
assumptions that are realistic and fair.
The importance of the tasks before us cannot be overstated. We must
restore investor confidence. It is the pillar on which one of the great
institutions of our society rests--the open and fair marketplace.
July 1, 2002--State Treasurer Richard Moore Announces Landmark Public
Pension Fund Investment Initiative
RALEIGH--As North Carolina's State Treasurer, Richard Moore manages
the 10th largest public pension fund in the United States and the 24th
largest in the world. Add to that the funds managed by Moore's
counterpart New York State Comptroller H. Carl McCall, and you have a
total investment portfolio of nearly $170 billion. When that much money
talks, Wall Street takes notice.
That's why Treasurer Moore and Comptroller McCall have teamed up
with New York State Attorney General Eliot Spitzer to launch a major
initiative to establish stronger corporate disclosure standards for
investments made with public pension funds, the money that pays the
retirement of public workers. Under this initiative, which Moore and
McCall as sole trustees have implemented for their respective pension
fund investment portfolios effective immediately, the North Carolina
Public Employees' Retirement Systems and the New York State Common
Retirement System will require the following of investment banking and
money management firms that do business with the two pension funds:
Investment banking firms must adopt the conflict of interest
principles set forth in the agreement that New York Attorney
General Spitzer reached with Merrill Lynch in May of 2002
(referred to as the ``Spitzer Principles.'')
Money management firms must make disclosures regarding
portfolio manager and analyst compensation, the use of any
broker dealers that have not adopted the Spitzer Principles,
and any potential conflicts of interest arising from client and
corporate parent relationships.
Money management firms must adopt safeguards to ensure that
there are no potential conflicts of interest as a result of the
method compensation is provided to analysts that could
influence investment decisions made on behalf of the pension
Money management firms must scrutinize more closely the
auditing and corporate governance practices of companies in
which pension fund monies are invested.
``Recent conflict of interest and insufficient corporate governance
stories coming out of Wall Street firms have shaken the confidence of
investors, big and small,'' said Treasurer Moore. ``On behalf of the
hard-working public employees and retirees whose pension funds
Comptroller McCall and I manage, we are using our clout as large public
fund investors to set a higher standard. Because people are counting on
us to ensure their pension funds are secure, we must be able to know
the information we use to make sound, prudent investment decisions is
``I have been working for months on common sense, market-driven
solutions that will ensure that our funds are invested safely. I am
grateful for Attorney General Spitzer's guidance and to Comptroller
McCall for joining this effort.''
California Treasurer Philip Angelides today also pledged his
support for these measures, and will attempt to get them adopted by
CalPERS and CalSTRS (both $100 billion plus California public employee
``I am today sending out a letter to other pension fund managers
encouraging them to adopt similar measures, and will also be reaching
out to other large investors. Public pension funds also have assets of
about $2.3 trillion. I am, therefore, confident that we can build
enough support to bring about significant change, with or without
Congressional or administration action.''
The North Carolina and New York pension funds contract with dozens
of investment banking firms, and requiring those firms to adhere to the
Spitzer Principles will benefit all investors, not just pension funds.
In addition, public confidence in the stock market has a great impact
on the future growth of the pension funds. Adoption of these principles
should help restore confidence in the marketplace, which will have a
positive impact on both pension fund beneficiaries and individual
A copy of the Public Pension Fund Investment Protection Principles
adopted by North Carolina and New York is attached.
State and Public Pension Fund Investment Protection Principles
A. Effective July 1, 2002, every financial organization that
provides investment banking services and is retained or utilized by the
State Treasurer of North Carolina, the Comptroller of the State of New
York, or the State Treasurer of California (hereinafter ``the State
Investment Officers''), including but not limited to organizations
retained by the North Carolina Public Employees Retirement Systems and
the New York State Common Retirement Fund (hereinafter ``the Pension
Funds''), should adopt the terms of the agreement between Merrill Lynch
& Co., Inc. and New York State Attorney General Eliot Spitzer dated May
21, 2002 (hereinafter ``the Investment Protection Principles''). In
retaining and evaluating any such financial organization, the State
Investment Officers will give significant consideration to whether such
organization has adopted the Investment Protection Principles.
The Investment Protection Principles are as follows:
sever the link between compensation for analysts and
prohibit investment banking input into analyst compensation;
create a review committee to approve all research
require that upon discontinuation of research coverage of a
company, firms will disclose the coverage termination and the
rationale for such termination; and
disclose in research reports whether the firm has received
or is entitled to receive any compensation from a covered
company over the past 12 months.
establish a monitoring process to ensure compliance with the
B. Effective July 1, 2002, every money management firm retained by
a State Investment Officer, as a condition of future retention, must
abide by the following:
1. Money management firms must disclose periodically any client
relationship, including management of corporate 401(k) plans,
where the money management firm could invest State or Pension
Fund moneys in the securities of the client.
2. Money management firms must disclose annually the manner in
which their portfolio managers and research analysts are
compensated, including but not limited to any compensation
resulting from the solicitation or acquisition of new clients
or the retention of existing clients.
3. Money management firms shall report quarterly the amount of
commissions paid to broker-dealers, and the percentage of
commissions paid to broker-dealers that have publicly announced
that they have adopted the Investment Protection Principles.
4. Money management firms affiliated with banks, investment
banks, insurance companies or other financial services
corporations shall adopt safeguards to ensure that client
relationships of any affiliate company do not influence
investment decisions of the money management firm. Each money
management firm shall provide the State Investment Officers
with a copy of the safeguards plan and shall certify annually
to the State Investment Officers that such plan is being fully
5. In making investment decisions, money management firms must
consider the quality and integrity of the subject company's
accounting and financial data, including its 10-K, 10-Q and
other public filings and statements, as well as whether the
company's outside auditors also provide consulting or other
services to the company.
6. In deciding whether to invest State or Pension Fund moneys
in a company, money management firms must consider the
corporate governance policies and practices of the subject
7. The principles set forth in paragraphs 5 and 6 are designed
to assure that in making investment decisions, the money
management firms give specific consideration to the subject
information and are not intended to preclude or require
investment in any particular company.
North Carolina, Department of State Treasurer
Raleigh, NC, July 1, 2002
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Recently, I joined New York Attorney General Eliot Spitzer and the
Comptroller of New York State, H. Carl McCall, to announce public
pension fund investment protection principles that we are asking
broker/dealers and money management firms to adopt as a condition of
future retention by our pension funds. A copy of those principles is
enclosed for your review.
In light of the many incidents on Wall Street over the last nine
months, I feel these principles are necessary to ensure that the firms
managing the pension funds of North Carolina's hard-working employees
and retirees are doing business the right way. As two of the largest
pension funds in the marketplace, I believe North Carolina and New York
will be able to have some positive effect on the market. It is
important to publicly spell out what we, as fiduciaries of these
pension funds, expect firms to do if they want to keep us as customers.
I would like to ask for your feedback regarding the enclosed
principles, and would be interested in hearing if you have considered
similar measures. As you will see, in addition to requiring the use of
the Spitzer/Merrill Lynch conflict of interest principles, I hope to
institutionalize the reporting and benchmarking of accounting practices
and corporate conduct. I hope you will consider joining in our efforts
to add additional safeguards to the management of our funds. I believe
this measure will not only benefit institutional investors, but also
the effects will reach down to the average citizen who invests his or
her money, as well.
I thank you for your assistance and input in this matter, and look
forward to working with you in the future.
Richard H. Moore
Contacts for Top 25 Public Pension Funds
California Public Employees' Retirement System
James E. Burton, Chief Executive Officer
Mark J.P. Anson, Chief Investment Officer
400 P Street
Sacramento, CA 95814
California State Teachers' Retirement System
Jack Ehnes, CEO
Chris Ailman, Chief Investment Officer
P.O. Box 15275
Sacramento, CA 95851
Florida State Board of Administration
Tom Herndon, Executive Director
1801 Hermitage Blvd.
Tallahassee, Florida 32317-3300
Teacher Retirement System of Texas
Charles L. Dunlap, Executive Director
John Peavy, Chief Investment Officer
1000 Red River
Austin, TX 78701-2698
New York State Teachers Retirement System
George M. Phillip, Executive Director
10 Corporate Woods Drive
Albany, NY 12211-2395
New Jersey Public Employees' Retirement System
Steven Kornrumpf, Director, Division of Investment
Thomas J. Bryan, Director, Division of Pensions & Benefits
50 W. State Street
Trenton, NJ 08625-0295
Wisconsin Investment Board
Patricia Lipton, Executive Director
P.O. Box 7842
Madison, WI 53707-7842
New York City Employees Retirement System
John J. Murphy, Executive Director
335 Adams Street
Brooklyn, NY 11201-3751
Public Employees Retirement System of Ohio
Neil Toth, Investment Director
Laurie Fiori Hacking, Executive Director
277 East Town Road
Columbus, OH 43215
Michigan Department of Treasury
Alan H. Noord, Chief Investment Officer
Lansing, MI 48922
Pennsylvania Public School Employees' Retirement System
Dale Everhart, Executive Director
James H. Grossman, Jr., Chief Investment Officer
P.O. Box 125
Harrisburg, PA 17108
State Teachers Retirement System of Ohio
Herb Dyer, Executive Director
Robert A. Slater, Deputy Executive Director--Investments
275 East Broad Street
Columbus, OH 43215-3771
University of California Retirement Plan
P.O. Box 24570
Oakland, CA 94623-1570
Washington State Investment Board
2424 Heritage Court
Olympia, WA 98504-0916
Teachers' Retirement System of the City of New York
40 Worth Street
NewYork, NY 10013
Minnesota State Board of Investment
Howard Bicker, Executive Director
60 Empire Drive
Saint Paul, MN 55105-3555
Teachers' Retirement System of Georgia
Jeff Ezell, Executive Director
Two Northside 75
Atlanta, GA 30318
Oregon Public Employees Retirement System
Jim Voytko, Executive Director
11410 SW 68th Parkway
Tigard, OR 97281
Retirement Systems of Alabama
David Bronner, CEO
135 South Union Street
Montgomery, AL 36104
Public Employees' Retirement Association of Colorado
Meredith Williams, Executive Director
1300 Logan Street
Denver, CO 80203
Massachusetts Pension Reserves Investment Management Board
James B.G. Hearty, Executive Director
84 State Street
Boston, MA 02109
State Retirement Agency of Maryland
Peter Vaughn, Executive Director
Carol Boykin, Chief Investment Officer
120 East Baltimore Street
Baltimore, MD 21202
Senator Dorgan. Mr. Moore, thank you very much for your
Next, we will hear from Joan Claybrook, President of Public
STATEMENT OF JOAN CLAYBROOK, PRESIDENT,
Ms. Claybrook. Good morning, Mr. Chairman. Thank you very
The epic crime wave with pervasive wrongdoing that has
unfolded in recent months is no accident, and it's not limited
to a few bad apples. It's the predictable result of a
coordinated campaign with tons of campaign money over the last
quarter century to remove government oversight and regulation
of business practices and reduce or eliminate the
accountability of corporations and their officers to the
investors and the public.
This attack--it has covered not only financial, but health,
safety, environmental, investor, telecommunications, energy,
and consumer safeguards, as well as the civil justice system--
has now come home to roost, and it has devastated families
across America. It is time to restore accountability to
President Bush has talked tough about corporate crime, but
his proposals are meager and would make little change. He
should start by relieving Army Secretary Thomas White of his
duties. Mr. White headed a subsidiary of Enron that bilked
families and the State Treasury of California by cruelly and
fraudulently manipulating the deregulated energy markets. His
division, Enron Energy Services, colluded with other Enron
divisions to deceive the operators of California's electricity
grid into believing that transmission capacity was full,
triggering rolling blackouts and payments to Enron to ease
congestion on transmission lines, which was false.
In the first 3 months of the year 2001, at the height of
the California energy crisis, Mr. White's division traded more
than 11 million megawatts of electricity in the California
market, making nearly 98 percent of those trades with other
Enron units at astronomical prices. In addition to this
profiteering at the expense of California consumers and
taxpayers, Enron Energy Services participated in the accounting
trickery that artificially boosted stock prices and ultimately
led to Enron's collapse, causing many investors and employees
to lose their life savings.
Enron is under investigation for multiple criminal
violations. Mr. White was an intimate part of Enron's criminal
conduct. In 2001, he was paid $5.5 million, and he sold $12
million in Enron stock just before the company collapsed last
December. If Mr. White is not accountable for his company's
actions, why was he paid all this money? That's crony
capitalism at its worst. White has millions in assets from
Enron days in addition. He and his colleagues should be
required to restore and provide restitution, just like any
other criminal or thief, for his ill-gotten gains.
But until President Bush purges corporate malefactors from
his own Administration, it will be difficult to convince the
public that he is up to the task of reforming corporate
America. And what kind of example is this for our children, who
are told to obey the law and not to lie?
Turning to specific reforms, Public Citizen applauds the
Senate passage of the Sarbanes' bill. This is a remarkable
turnaround for the Senate on regulatory matters, one I hope
heralds a new mind set when it comes to government's proper
role in protecting consumers and workers and the environment
from the consequences of misdeeds wrought by greedy and
unethical corporate executives. But more is needed.
Congress should correct the way that corporate stock
options are treated in the corporate books. The common thread
in the recent scandals is the fact that corporate boards lavish
millions of dollars in stock options on top executives, giving
them a strong incentive to cook the books to cause short-term
spikes in stock prices so they could cash in. Enron CEO Ken Lay
exercised $180 million in stock options from 1998 to 2000. And
Jeffrey Skilling cashed in $117 million in options. Even though
these options dilute shareholder value, they are not counted
against profits and losses, and this is a scam on investors
that must be stopped.
One of the ways of measuring the extent to which a company
is involved in the option business is something called the
``run rate,'' which compares the number of options to the
number of shares, and generally it's conceded it should not
exceed 1 percent. The 200 largest corporations in America have
2.6 percent; whereas, in 1990, it was 1.08.
The Sarbanes' bill rightly curtails the widespread practice
of accounting firms providing non-auditing consulting services
at the same time they are auditing a company's books, but it
does not have an outright ban to this blatant conflict of
interest, and it should.
In my full testimony today, which I ask to be in the
record, the Public Citizen is releasing an analysis of
accounting and consulting fees paid to the top 20 companies in
the United States, and another 29 companies that are embroiled
in accounting scandals, and comparing the two. We found there
was a very close parallel between the two groups in terms of
the percentage of total accounting fees that went to non-
In 2001, the top 20 of the Fortune 500 paid a total of $880
million to accounting firms. That's $880 million, and 72
percent of that went for consulting services. Compare that to
Enron, where it was about 50 percent. So the top 20 companies
in the United States, in 2001, paid 72 percent to their
auditors in consulting amounts.
The 29 companies in trouble paid 75 percent, very close to
that. In other words, the incentive to falsify earnings is in
place in the top 20 corporations, as well as the ones in
trouble. And that's very close to the numbers for the year
Haliburton Company would have been in this group, except
that in the year 2001 it was reduced. But in the year 2000, the
last year of Vice President Dick Cheney's tenure as Haliburton
CEO--Haliburton paid--86 percent of its fees went to consulting
or non-audit services.
While legislation pending in Congress rightly addresses
abuses in accounting, the one thing it does nothing for is the
investor. It does nothing to help the investor recover the
losses experienced because of fraud. Teachers, firefighters,
police, factory workers, mail carriers, secretaries, small
businesses--these are the people who do the work of America.
These are the people who have lost the most in the stock
market, in terms of their pensions and other investments for
the future and their college savings.
Congress should reexamine three laws and one Supreme Court
decision, the Central Bank case, that passed in the 1990s that
seriously have undermined corporate accountability by making it
exceedingly difficult for individual investors to recover
damages for securities fraud. These actions helped create the
climate of ``anything goes'' arrogance in the corporate
And I would point out that there was an article yesterday
in The Washington Post that I would like to submit for the
record, which indicated that when these shareholders' lawsuits
are filed, it's a hint to the auditors that something is awry.
The headline is ``The Shareholder Lawsuit: A Red Flag for
[The article mentioned follows:]
[From the Washington Post, July 17, 2002]
The Shareholder Lawsuit: A Red Flag for Auditors?
(By Jonathan Krim, Washington Post Staff Writer)
Corporate directors and auditing firms serious about preventing
future accounting scandals might find clues in a place they typically
revile: shareholder lawsuits.
Suits alleging financial improprieties preceded scandalous
revelations at several companies, including WorldCom Inc., Tyco
International Ltd. and Rite Aid Corp. Although the suits did not
pinpoint the precise irregularities that have made recent headlines,
accounting and legal experts say they can be valuable harbingers of lax
Instead, shareholder suits often are treated as nuisance actions
filed by predatory trial attorneys seeking to capitalize on a company's
financial troubles, these experts contend.
They argue that as Congress and regulators grapple with an array of
proposals for restoring public faith in corporate America's books,
simply increasing the attention paid to the issues raised in such
suits--even if they are unlikely to be successful in court--could help
companies head off festering financial problems before they damage
corporations, employees and investors.
``What usually happens is that the suits go to the legal
department, and when they are mentioned if at all at board meetings,
it's like swatting a fly or a gnat,'' said Ralph Estes, emeritus
professor of accounting at American University and longtime advocate of
more accountable corporate governance.
Estes and others say word of such suits should spur board members
and outside auditors to inquire more aggressively and seek deeper
``Now, especially, boards need to ask more questions,'' said Peter
Gleason, chief operating officer of the National Association of
Corporate Directors. ``How did this issue make its way to a lawsuit?''
Rick Antle, an accounting professor at Yale University, said that
auditors ``should not just balance the checkbook, and audit the company
from a business point of view.''
Shareholder suits grew in popularity with the onset of the
technology bubble in the mid-1990s and its reversal of fortune in early
2000. When a company announced unexpectedly bad news, or its stock
price dropped after earnings failed to meet market expectations,
attorneys for shareholders would jump in to examine whether management
had misled investors before the news surfaced. Lawsuits quickly
Companies, especially technology firms whose stocks were volatile,
fought back in Congress, arguing that the suits often were without
merit and mere harassment. Industry won changes to the law that made
suits more difficult to bring, after Congress overrode a veto by
But suits continue to be filed regularly. According to the
Securities Class Action Clearinghouse at Stanford University Law
School, 485 suits were filed in 2001 and 127 so far this year.
In WorldCom's case, shareholders filed suit last summer alleging a
variety of fraudulent accounting practices, including failure to write
off accounts that were unlikely to ever be paid and deliberately
understating expenses overall. The suit was dismissed in March.
Last month, the company announced that it had improperly
reclassified $3.9 billion in operating expenses as capital
expenditures, enabling the firm to bolster its bottom line by spreading
costs over several years.
One person familiar with the matter said that when the suit was
raised at a WorldCom board meeting, it was not clearly presented as
being focused on accounting issues.
Late last month, the former chief executive of the Rite Aid Corp.
drugstore chain was indicted on charges of inflating the company's
earnings, destroying evidence, witness tampering and moving company
funds into a personal real estate business. Three other executives also
were charged. The actions took place between May 1997 and May 1999,
during which time several executives also received large bonuses from
Rite Aid was sued by shareholders in March 1999, when the company
restated earnings and erased $1.6 billion in profit. The company paid
out $193 million in claims.
``The indictments of Rite Aid management late in June 2002, which
include charges of lying to and misleading the auditors, and the
actions brought by the Securities and Exchange Commission at that time,
affirm our position that Rite Aid represents a clear example of an
auditing firm being victimized by company management,'' said KPMG
spokesman Robert Zeitlinger.
At Tyco International, shareholders charged in late 1999 that the
company issued materially false and misleading statements about key
acquisitions. The suit also alleged that during the period, certain
officers of the company sold Tyco shares at artificially inflated
prices, for proceeds of at least $270 million.
Early last month, Tyco chief executive L. Dennis Kozlowski
resigned, a day before he was indicted by a New York state grand jury
on charges of evading more than $1 million in sales taxes on $13.2
million in rare paintings. Investigators also are looking at whether
Tyco improperly paid for an $18 million Manhattan apartment and a $2.5
million home in Boca Raton, Fla., that belonged to a British nobleman
who joined Tyco's board in 1997.
``Whenever there is a shareholder lawsuit, we look into the
allegations carefully and defend ourselves where appropriate,'' said
Tyco spokesman Gary Holmes.
Representatives of the major accounting firms said that they, too,
respond to shareholder suits.
``If the auditors become aware of information that they think may
have an impact on the financial statements . . . they are required to
determine if the information is accurate and reliable,'' said Chuck
Landis, head of auditing standards for the American Institute of
Certified Public Accountants, a trade group. ``Maybe that's going to
management, unless the suit alleges fraud by management . . . then it
might be going to the audit committee.''
Landis said shareholder allegations, and the response from
management, should be treated by the auditor with ``professional
A former audit manager for Arthur Andersen, which approved
WorldCom's books during the time of its improper accounting, testified
before Congress that he was aware of the suit against WorldCom, and
claimed he took it into account.
``Any time when Andersen or any auditor does an audit, there is an
examination and review of litigation filed against a client,'' said
Andersen spokesman Patrick Dorton. ``It's a component of generally
accepted auditing standards and Arthur Andersen policy and audit
A spokesman for Ernst & Young declined to comment.
Attorneys for shareholders, many of whom were federal securities
prosecutors, say that what happens in practice is different.
``From the time I was a criminal prosecutor . . . I would say, `Why
didn't you guys do anything with the class-action lawsuit?' '' said
Kenneth Vianale, a partner of the class-action law firm of Milberg
Weiss Bershad Hynes & Lerach, which has pending cases against nearly 75
companies. ``The answer was `That's just a class-action lawsuit . . .
we don't pay any attention to that.' ''
Vianale, a former U.S. attorney in New York who prosecuted
securities cases, said he is amazed at the number of companies that are
sued by shareholders, pay out claims and then end up being sued again
for similar problems.
He cited the case of Sensormatic Electronics Corp., which late last
year was bought by Tyco. The Florida-based manufacturer of security
systems was sued by shareholders in 1995 for improper accounting
practices. It ultimately settled for $53 million.
The company has now been sued again by shareholders who charge
company officials with making false statements about the company's
Auditing firms also have been the targets of lawsuits, or are named
as co-defendants. Last year, Arthur Andersen paid part of a $229
million settlement with shareholders of Waste Management Inc.
Landis of the auditing institute said that in such cases, ``the
auditors must ask themselves . . . whether by being named in a suit
puts them in a position where they may no longer be objective'' to
conduct further audits.
It is a red flag for auditors. And yet in three statutes
passed by the Congress in the 1990s, every effort was made to
cut back on the capacity of the individual investor to regulate
the corporations that are misbehaving by filing lawsuits for
their own protection and recovery.
The Private Securities Litigation Reform Act that was
approved over President Clinton's veto in 1995 radically
diluted laws against making false earnings projections, which
we've certainly heard a lot about recently, and prevented fraud
victims from obtaining the evidence they needed to survive a
defendant's motion to dismiss. A securities fraud case against
WorldCom, for example, was dismissed earlier this year,
because, among other things, the Court found that the plaintiff
's complaint did not attain the heightened pleading standard
requirements for this type of case under the 1995 law.
Again, the corporate lobby came roaring back to further cut
investors' rights after they passed the 1995 law. In 1996,
Congress enacted the National Securities Markets Improvements
Act which preempted much state regulation of securities
transactions. And in 1998, they came back again, with Congress
passing the Securities Litigation Uniform Standards Act, which
forced virtually all securities fraud class-action lawsuits to
be tried in the federal courts under weakened federal
standards, taking away stronger protection for small investors
under tougher state class-action laws, such as longer statute
of limitations, aiding and abetting liability, and joint and
several liability. The consumer who invests has been really
harmed by the Congress' actions in the 1990s, and it has freed
up these megacorporations to misbehave again and again.
After the disastrous manipulations of the California energy
market, I am astounded that the Senate voted to repeal the
Public Utility Holding Company Act of 1935 (PUHCA), one of the
most basic protections that consumers have against rapacious
energy companies. This is included in the energy bill passed by
the Senate, not in the House bill.
Enron was able to manipulate markets and build a vast,
impenetrable network of subsidiaries primarily because of
loopholes that were created in PUHCA, and the law was not
properly enforced. We must keep this important law on the books
and ensure that the regulators enforce it, and we must see that
these loopholes are closed.
One interesting report that was released yesterday on NBC
Evening News was about the fees to the SEC. Each year, about
$2.1 billion in fees are paid by investors for their
transactions, but only $412 million of this goes to the SEC.
Since 1991, $11.7 billion in fees have been paid, and only $3
billion have gone to the SEC. In other words, over $7 billion
that the SEC could have had from the fees that are paid have
been taken by the Treasury and not been given to the SEC.
In conclusion, Ms. Chairman and Mr. Chairman, let me say
that corporate America loves Uncle Sugar. Uncle Sugar supplies
subsidies, tax breaks, and all the other goodies that
corporations love. But they don't like Uncle Sam. And Uncle Sam
is now, it seems to me, beginning to take back the driver's
seat. We urge that the Congress pass not only the Sarbanes'
bill, but additional laws as I have recommended in a long list
of remedies in my testimony so that the consumer and the
investor is properly protected for the future.
Thank you very much, Mr. Chairman.
[The prepared statement of Ms. Claybrook follows:]
Prepared Statement of Joan Claybrook, President, Public Citizen
The financial horror show that the American public has watched
unfold across the corporate landscape over the past few months is
nothing less than a corporate crime wave of epic proportions. We have
seen the rise and fall of a new generation of robber barons, bearing
striking resemblance--at least in greed and arrogance--to the Gilded
Age executives of a century ago and to the corporate titans of the
1920s, when corruption in the boardrooms helped usher in the Great
Depression. And to think it has been only a decade or so since
taxpayers lost billions to the high-living thieves who raped the
nation's savings-and-loan industry and drove it into the ground. How
soon we forget.
We should not fall victim to the corporate apologists who would
have us believe that this is the inevitable and natural consequence of
the economic boom of the 1990s and that there are only a few bad apples
involved. In fact, it is the opposite. We now are finding out that this
speculative bubble grew larger and larger precisely because corporate
executives were defrauding investors through accounting measures that
hid the true nature of their profits and losses. And they had plenty of
incentives to do so, because cozy board members, many with insider
deals, granted them stock options and cheap loans that encouraged CEOs
to cheat in order to run up stock prices in the short term so they
could cash in.
These are not victimless crimes. The victims are policemen and
firefighters, teachers, assembly line workers, mail carriers,
secretaries and, yes, honest business men and women--the people who do
the work of America, who live paycheck to paycheck and who fuel this
economy with their work and their spending. The victims are the
children whose college funds have evaporated, and the elderly, whose
savings have been stolen.
The American people are angry. And they should be. Since March
2000, when the stock markets peaked, investors have seen $7 trillion
evaporate into thin air. That's an unfathomable number for most of us.
But it means real pain for millions of Americans who have been
encouraged to invest their savings. Spurred on by corporate and
government policies that have reduced and in many cases eliminated the
old system of guaranteed pensions--and even facing the possibility that
Social Security as we know it will be phased out--Americans have
entrusted their retirement savings to the stock market. And now they
find out the game has been rigged, and that they go broke while the
crooks, who pay protection money to politicians, walk away with
This corporate crime wave is no accident. It is the result of a
well-focused political drive over the past quarter century to remove
government oversight of business practices and reduce or eliminate the
accountability of corporations and their officers to investors and the
public. Corporate America has campaigned with a full-scale attack on
regulation of the financial securities markets and energy markets as
well as the health, safety and environmental regulations that are
designed to protect the public from death, injury and disease and
ensure healthy, sustainable ecosystems, fisheries and wildlife.
Following the impressive citizen gains of the late 1960s and early
1970s--when Congress enacted a raft of new health, safety,
environmental, consumer and civil rights protections--corporate America
launched a cynical campaign to limit the government's power. This
coordinated attack on citizen safeguards has been propelled by
literally billions of dollars of shareholder money for political
contributions, right-wing think tanks, lobbyists, smear campaigns, TV
advertising and fake grassroots organizations. Both major political
parties have seen a dramatic increase in contributions from big
companies. Corporations have accounted for nearly 90 percent of all
soft money contributions to the parties since 1995, according to the
Center for Responsive Politics. Corporate soft money grew from $209
million in the 1996 cycle to $383 million in 2000. The corporate
leaders who give shareholder money to politicians demand--and usually
get--something in return for this political investment.
Corporate America's campaign of deceit portrays government
regulation as inherently evil, as an unwarrranted intrusion into the
free market system and as a drain on capital investment, profitability
and U.S. competitiveness. It also mocks and denigrates the judicial
system, which punishes wrongdoing, imposes discipline on corporations
when regulations fail, and allows injured parties to recover damages.
According to corporate America's mythology, free markets can solve all
our problems and government should just, as former President Reagan
said, ``get off our backs.'' Privatization of schools, Social Security,
Medicare, water supplies and other commons are sought. This free market
ideology, of course, does not extend to corporate welfare. The very
corporations that sponsor this hypocritical campaign continue to feed
at the public trough, using their political connections to obtain tax
breaks, subsidies, inflated contracts and other government largess.
This ideology is useful, it seems, only when it lines the pockets of
those preaching it.
This campaign by big business has severely distorted government's
purpose and its functions. Enforcement budgets have been slashed.
Health, safety and environmental protection rules have been sacrificed
to the altar of self-regulation and an unfounded trust in corporate
leaders. Congress and state legislatures across the country have
erected new barriers to prevent injured consumers from obtaining
justice in the courts. We now have a government that responds more to
the greed motive of corporate leaders than to the legitimate needs of
people. The system is rigged in favor of the business elite. And the
public is mad.
I am amazed by the breadth and depth of the corporate corruption
now being unraveled. But I am not surprised. Unfortunately, the weak
financial regulatory system that has failed the American people is only
one piece of deregulation. We have also seen politicians of both
parties rush to assuage their campaign contributors by whittling away
vital health, safety and environmental protections at the behest of
powerful corporate entities that fill their campaign coffers.
Corporate leaders remind me of Chicken Little. The sky is always
falling. Seldom is there a new regulatory proposal that does not elicit
howls of protests, typically characterized by complaints that new
consumer safeguards will harm the economy or U.S. competitiveness.
These complaints typically prove fallacious.
We should remember that government regulations do not just drop
from the sky without warning. They are almost universally based on real
societal needs, as demonstrated by deaths and injuries from faulty
products and workplace hazards, devastated ecosystems, polluted
groundwater, unhealthy air, and rivers laden with PCBs and other toxic
chemicals. Years of research, analysis and public debate precedes the
final implementation of most rules. In the 1960s, for example, we
lobbied for the first regulations to cover the safety of automobiles.
The automobile companies fought back furiously. Today, as a direct
result of improving automobile designs, cars and trucks are vastly
safer. In 1966, there were 5.5 fatalities for every hundred million
miles traveled by the American public. By 2000, that ratio had dropped
to 1.5--a remarkable difference. Despite their dire warnings, the
automobile companies are still in business and still making lots of
There are many, many more examples. So many, in fact, that
Americans now take these safeguards for granted. They know the air is
healthier than it was in the 1960s. They know rivers, lakes and bays
are cleaner. They know that many unsafe pharmaceutical drugs and other
products have been taken off the market, yet corporate America
continues to peddle its siren's song--that government regulation is the
enemy of free enterprise and profits. And their revolving-door
lobbyists are able to make headway because the road is paved with the
gold of massive campaign contributions.
This campaign money buys more than access. It buys policy. How else
can one explain the incredible deference paid by this Congress to the
pharmaceutical industry? This industry, in the current election cycle
alone, has given more than $10 million in unregulated soft money to
politicians of both major parties. This industry spent obscene amounts
of money on lobbying in 2001--$78 million--according to a recent Public
Citizen report, and employed 623 lobbyists--more than one for every
member of Congress. This money has stymied efforts to enact a
meaningful prescription drug plan under the Medicare program.
Another example is the nuclear industry, which just won passage of
legislation to build a massive nuclear waste dump at Yucca Mountain,
Nevada, requiring the transportation of 77,000 tons of high-level
nuclear waste through major population centers by truck, train and
barge over 30 years. Since 1997, the nuclear industry has contributed
more than $30 million in individual, PAC and soft money donations to
federal candidates and parties, 68 percent of which went to
Republicans. Why do they give this money if not to influence policy?
And how can anyone justify making government decisions based on
The point is that corporate America exercises far too much control
over what passes--or doesn't pass--through the Congress. It is time for
corporate rule to end. We must restore integrity to our business
entities and to the political process. To do that, the Congress and the
White House must stand up to the corporate lobbyists and start
legislating and governing on behalf of the American people. We need
strong regulation of corporations--standards that will prevent
wrongdoing and then punish executives who violate the public trust.
Army Secretary Thomas White
President Bush, who recruited his top government officials
liberally from the corporate boardrooms, is talking tough about
accountability for corporate leaders. But does he mean it? I would like
to read a quotation about corporate accountability for CEOs from
Treasury Secretary Paul O'Neill, from the July 11 edition of USA Today:
``Whatever happens in your organization, you're responsible for it.
There aren't any excuses for you to say, `I didn't know. I didn't
I agree wholeheartedly with Secretary O'Neill. To meet this
standard of conduct, and to begin restoring his credibility on this
issue with the American public, President Bush should immediately
relieve Army Secretary Thomas White of his duties. Mr. White is the
poster boy for corporate abuse. But instead of being held accountable,
he now has his hand on the Army's massive budget.
Before being appointed to his position, Mr. White headed a
subsidiary of the infamous Enron Corp. that blatantly manipulated the
energy market in California to cause an artificial shortage of
electricity, lied to state officials and cheated hard-working consumers
out of literally millions upon millions of dollars with intricate
schemes designed to rig the energy-trading markets and unfairly inflate
company profits. According to numerous sources, his division also
employed the same type of questionable accounting measures that have
defrauded investors and enriched corporate insiders at other companies.
Let me review the publicly available facts surrounding Mr. White's
tenure at Enron. Up until the day he was nominated by President Bush
and confirmed by the Senate in May 2001 to serve as Secretary of the
Army, Thomas White was a high-ranking executive at Enron, where he had
worked for 11 years. Since 1998, Mr. White served as vice chairman of
Enron Energy Services, a retail services and wholesale energy trading
subsidiary of Enron. As vice chairman, Mr. White shared oversight of
the division's responsibilities with Lou Pai.
As vice chairman, he was in charge of negotiating many of Enron's
retail energy contracts. During his tenure, Enron Energy Services
became one of Enron's fastest-growing subsidiaries through the use of
questionable accounting practices. Enron Energy Services' revenues
climbed 330 percent to more than $4.6 billion in 2000--up from $1
billion when Mr. White became vice chairman in 1998. Much of this
revenue increase is attributable to aggressive accounting techniques,
including so-called ``mark-to-market'' bookkeeping, under which Enron
booked much of the long-term retail contracts' revenue immediately--
providing the company with inflated revenues.
For example, in February 2001, Mr. White played a role in the high-
profile signing of a retail energy services contract with Eli Lily.
Enron claimed it was a 15-year deal worth $1.3 billion, but the details
of the contract show that Enron paid Eli Lily $50 million up front as
an enticement to sign the deal. Former employees of the division allege
Mr. White's division used questionable accounting practices to create
illusory earnings. Using ``mark-to-market'' accounting, Enron Energy
Services would, for example, estimate that the price of electricity
would fall over the life of a contract, and the unit would book an
immediate profit on the contract.
Glenn Dickson, an Enron Energy Services director laid off in
December, claimed that both Mr. White and Mr. Pai ``are definitely
responsible for the fact that we sold huge contracts with little
thought as to how we were going to manage the risk or deliver the
While Enron Energy Services' reputation on Wall Street was as a
retail supplier of energy, the division also was one of Enron's four
registered power marketers, trading substantial amounts of energy in
deregulated wholesale markets during Mr. White's tenure. According to
internal Enron memos obtained by the Federal Energy Regulatory
Commission and released in May, Mr. White's division played a key role
in manipulating the West Coast energy market from May 2000 until the
day he left in June 2001. Enron Energy Services colluded with other
Enron divisions to deceive operators of California's energy grid into
believing that transmission capacity was full. In the first three
months of 2001--at the height of skyrocketing prices and rolling
blackouts--this division traded more than 11 million megawatts of
electricity in the California market alone, making nearly 98 percent of
these trades with other Enron divisions at astronomical prices up to
$2,500 per megawatt hour.
This type of manipulation scheme was damaging because it led
California officials to believe that transmission lines were clogged,
and so power was intentionally shut off to millions of Californians.
Meanwhile, Enron was able to profit by getting the state to pay Enron
for relieving congestion on transmission lines. This naked profiteering
and fraudulent activity by Enron caused a massive disruption in the
economy of California and the lives of citizens there. Electricity
rates soared. Small businesses suffered. Rolling blackouts cut power to
millions. Pacific Gas and Electric, California's largest investor-owned
utility, was victimized by exorbitant wholesale rates that it could not
recover and sought bankruptcy protection in April 2001. California
Edison also went deeply into debt, but has not filed for bankruptcy.
The state of California was forced in January 2001 to begin spending
billions of dollars to purchase power for its residents.
Regulators found it difficult to trace Enron's trades because the
company had four separate divisions interacting in the wholesale and
retail markets, and with each other, with little transparency. These
practices also allowed various Enron units to overstate revenues and
contributed to the accounting gimmickry that artificially inflated the
company's share prices.
While it is unclear as to whether or not Mr. White personally knew
all of the details of these fraudulent trading practices, it is very
clear that he profited from them.
When President Bush nominated Mr. White for the post, he cited his
experience as a top Enron executive as a primary qualification. Mr.
White made tens of millions of dollars during his tenure at Enron. In
2001 alone, he was paid $5.5 million in performance-based salary and he
sold $12.1 million in Enron stock just before the company collapsed in
December 2001. Last year Mr. White owned three opulent homes and
condos, with a total value of more than $16 million.
And just like President Bush, Mr. White had a problem reporting
some of these stock sales to the Securities and Exchange Commission, as
required by law. Here is an excerpt from page 29 of a Schedule 14a
filed by Enron with the SEC on March 27, 1995: ``Section 16(a) of the
Securities Exchange Act of 1934 requires Enron's executive officers and
directors, and persons who own more than 10 percent of a registered
class of Enron's equity securities, to file reports of ownership and
changes in ownership with the SEC and the New York Stock Exchange.
Based solely on its review of the copies of such reports received by
it, or written representations from certain reporting persons that no
Forms 5 were required for those persons, Enron believes that during
1994, its executive officers, directors and greater than 10 percent
stockholders [sic] complied with all applicable filing requirements,
except that Thomas E. White failed to timely file one report for one
In addition, Mr. White has been habitually late in reporting to
Senators when asked to disclose his Enron holdings after being named
Army Secretary. He agreed to divest all of his Enron holdings within 90
days. He subsequently received at least two extensions from the Senate
Armed Services Committee. But he was reprimanded by the leadership of
the Committee when members learned that he continued to hold a large
chunk of Enron stock options into January 2001 and had failed to inform
them that he had accepted a pension partly paid by Enron.
Mr. White's ethical lapses continued, when in March 2002, he flew
on an Army jet with his wife at taxpayer expense to Aspen, Colorado, to
sign the papers on the sale of a $6.5 million estate.
While at Enron, Mr. White became a very wealthy man. What was the
purpose of his compensation? If he is not accountable for what went on
in his company, then why was he paid these millions? Was it because of
his business acumen? Was it because of his connections to the Defense
Department at a time when Enron was trying to win military contracts?
The bottom line is that if Mr. White knew what was going on with Enron
Energy Services, he has no business running the Army. If he did not
know, he is an incompetent manager and therefore should resign his
President Bush has appointed many others from the corporate
boardrooms, giving Americans the sense that the foxes are indeed
guarding the henhouse. No wonder the stock market has been plunging
since the president gave a tepid speech on Wall Street last week. The
former lawyer and chief lobbyist for the Big Five accounting firms, who
opposes the Sarbanes bill's independent accounting standards board, now
heads the Securities and Exchange Commission. And Deputy Attorney
General Larry D. Thompson, the president's choice to lead his new
corporate fraud task force, used to sit on the board of Providian
Financial Corp., a credit card company that paid more than $400 million
to settle allegations of consumer and securities fraud. Mr. Thompson,
according to the Washington Post, sold stock worth nearly $5 million
just a few months before Providian began to disclose business problems
that led to a collapse in the company's stock price. That is the same
pattern that we have seen with other corporate scandals. President Bush
himself, as well as Vice President Dick Cheney, also have been
implicated in possible accounting irregularities and stock sales that
preceded sharp drops in stock prices.
We are not inspired by President Bush's recent call for $100
million to be added to the SEC's budget, after he earlier sought to
slash the agency's budget. Under Bush's recommendation, the SEC would
have a budget of $513 million, a pittance compared to the Drug
Enforcement Agency's budget of $1.8 billion. Much more is needed. And
we should examine the penalties meted out to white-collar criminals.
The average sentence for white-collar criminals is less than 36 months.
By comparison, non-violent, first-time federal drug offenders get an
average sentence of more than 64 months.
We hope that President Bush is serious about putting corporate
criminals in jail. But the government's record over the past 10 years
is not good. The SEC has referred 609 offenders to the Justice
Department for criminal prosecution. Of those, 187 faced criminal
charges, and only 87 went to jail.
Incentives to Cook the Books
Fortunately, the Senate on July 15 passed legislation to begin
addressing these corporate abuses. Most unfortunately, the measure, the
Sarbanes bill does nothing to help defrauded investors. But Public
Citizen strongly endorses it as an important step because it: (1)
begins to put an end to the failed self-regulation of the accounting
industry by establishing an independent Public Company Accounting
Oversight Board to monitor the accounting industry; (2) forbids some--
but not all--non-auditing services performed by accounting firms that
are simultaneously providing auditing services (although the Senate
bill allows for case-by-case exemptions); (3) promotes a ``fresh pair
of eyes'' by forcing accounting firms to rotate the lead accounting
partners (but not accounting firms) on audits after five years; (4)
addresses revolving-door conflicts of interest by prohibiting
accounting firms from auditing companies whose top executives worked
for the firm during the year before the audit; (5) strengthens the
Financial Standards Accounting Board and gives it more independence
from the industry; (6) requires CEOs and CFOs of public companies to
personally vouch for the accuracy of financial reporting; (7) requires
disclosure of insider stock trading within two days; (8) prevents
executives from selling stock during employee stock sale blackout
periods; (9) financially penalizes executives for earnings
restatements; (10) restricts loans to executives; and (11) makes
securities fraud a criminal offense and increases prison sentences for
It is unfortunate that the bill does not address one of the major
underlying incentives that have prompted crooked executives and
accountants to cook the books--the practice of granting stock options.
The common thread woven through virtually all of the ongoing corporate
scandals is the fact that executives were granted exorbitant stock
options. Corporate boards have handed out stock options like candy, and
they are not required to count them as an expense on their balance
sheet, even though they dilute shareholder equity as surely as if the
payments were made in cash. Because corporations do not have to account
for these expenses, they have become an insider scheme to enrich
executives. Though they were once believed to align the interests of
management with shareholders, perversely, the opposite has occurred. As
we've learned from Enron and other companies like Global Crossing,
WorldCom and Qwest, the allure of stock options can drive executives to
intentionally distort the numbers to create temporary run-ups in stock
prices so they can cash out quickly, while investors are left to soak
up the losses.
Research shows that more and more corporations are turning larger
shares of their earnings over to insiders by increasing the number of
stock options issued to executives and directors. At Enron, for
example, Ken Lay exercised $180.3 million in stock options from 1998 to
2000, and Jeffrey Skilling cashed in $111.7 million in options.
``Stock option overhang'' is a measure of the number of stock
options granted to employees and directors (both the number already
issued and the number of options promised in the near future) compared
to the total number of shares held by investors and employees. This
measure can estimate the potential of investors' shares to be diluted
by stock options policy. Many institutional investors, such as large
pension funds, don't want a stock option overhang to exceed 10 percent
of shares outstanding. A February 2002 survey by the Investor
Responsibility Research Center showed that the stock option overhang
for the S&P 500 was 14.3 percent. And 13 of the 50 largest U.S.
corporations had a stock option overhang that exceeded 14.3 percent.
J.P Morgan Chase, for example, had an option overhang of more than 20
percent. Morgan Stanley was one of the highest at 36 percent.
Another way to measure the potential negative impact of stock
options is the ``stock option run rate.'' This adds up the stock
options granted over the past three years, divides by three, and then
divides by the total number of shares held by all investors and
employees. Many experts agree that a stock option run rate exceeding 1
percent is excessively diluting investors' equity. Two hundred of the
largest U.S. companies have stock option run rates of 2.6 percent, more
than double the rate of a decade ago (1.08 percent in 1991), according
to compensation consultants Pearl Meyer & Partners. Although a stock
option run rate of 3 percent may look small at first glance, if these
current scandals return the market to its historical 10 percent annual
rate of return, that would mean a company with a stock option run rate
of 3 percent would see one-third of the company's value siphoned off by
the time the stock options expire in 10 years.
It's also important to note the share of all stock options enjoyed
by the top executive. A CEO holding more than 5 percent of all stock
options should be considered excessive. So what to think about the CEO
of Freddie Mac (10.9 percent), American International Group (10.6
percent), Fannie Mae (7.4 percent) and Wells Fargo (5.6 percent)?
This is a scam on investors. Companies are currently allowed to
deduct these stock options as an expense in figuring their tax
liabilities--but are not required to do so in reporting profits or
losses to shareholders. Companies would not be so free in handing out
so many options if they were counted as an expense. Plus, there should
be requirements for executives to hold stock options for the long-
term--not cash in during stock price spikes or shortly before the
company announces bad news.
On July 16, the International Accounting Standards Board announced
a unanimous decision to require that executive stock options be counted
as a business expense by 2005 in the EU and Australia. The U.S.
legislation should be identical.
Another common thread in the scandals is the practice by accounting
firms of providing consulting services at the same time they are
auditing the finances of corporations. Accounting firms that collect
large consulting fees from the corporations they audit have a strong
incentive to look the other way when corporations cook the books. In
essence, the auditors are in part auditing their own company's work.
The big accounting firms, which are supposed to audit the books of
public corporations and certify to the board, public and investors that
they accurately portray a company's financial status, have been seduced
and corrupted by multimillion-dollar consulting services that they also
provide to the same companies they are auditing. This creates an
enormous and unconscionable conflict of interest that leads to the type
of abuses we have seen in Enron, WorldCom, Tyco, Halliburton, Global
Crossing, Adelphia, Xerox and others. The previous head of the SEC,
Arthur Levitt, sought to end this conflict, but in the deregulatory
climate of the 1990s, his proposal was quashed. And now working
Americans are paying a severe price.
While S. 2673, the Public Company Accounting Reform and Investor
Protection Act of 2002, does address these conflicts of interest by
banning certain types of consulting contracts, it still allows many
damaging consulting services--such as providing tax shelter advice--to
be performed by companies that are in charge of audits.
Submitted with my testimony today is a new study by Public Citizen
of these fees (see Appendix A and B). Public Citizen found that the 20
largest companies in the United States all had consulting relationships
with their accounting firms in 2000 and 2001 that, at the very least,
created incentives for cheating. In the aggregate, 72 percent of the
$880 million in fees paid by these Fortune 500 companies to their
accountants in 2001 were for consulting services--meaning that at the
same time accounting companies were supposed to be looking out for
shareholders, they were also helping their clients develop accounting
schemes to hide income from taxation, or conceal debt and revenues from
regulators and investors.
Some examples from the year 2001: AT&T paid $78 million to
PricewaterhouseCoopers, 86 percent of which went for non-audit
services. ExxonMobil paid $87 million to PricewaterhouseCoopers, 80
percent for non-audit services. General Motors paid $102 million to
Deloitte & Touche, 79 percent for non-audit services. Chevron paid $64
million to PricewaterhouseCoopers, 83 percent for non-audit services.
Duke Energy paid $15 million to Deloitte & Touche, 78 percent for non-
audit services. Bank of America paid $74 million to
PricewaterhouseCoopers, 81 percent for non-audit services.
We also looked at corporations whose practices have come under
recent scrutiny. Enron was one of the best. It paid $52 million to
Arthur Anderson in 2000, a mere 52 percent for non-audit services. The
highest percentage we found was for BristolMyersSquibb, which in 2001
paid $41 million to PricewaterhouseCoopers, 93 percent for non-audit
services. Halliburton in 2001 paid $27 million to Arthur Anderson, 73
percent for non-audit services. The year before, Halliburton paid $52
million to the company, 86 percent for non-audit services. Global
Crossing in 2000 paid $14 million to Arthur Anderson, 84 percent for
non-audit services. Tyco paid $35 million in 2001 to
PricewaterhouseCoopers, 62 percent for non-audit services. WorldCom
paid $17 million to Arthur Anderson in 2001, 74 percent for non-audit
How can this possibly be justified? Unless accountants are
completely banned from providing both auditing and consulting services
simultaneously to the same client, these conflicts of interest will
continue to plague the industry.
In addition to these regulatory failures dealing with stock options
and accounting rules, the rights of investors to protect themselves and
recover for losses due to fraud have been severely curtailed by
Congress and the U.S. Supreme Court. This has allowed corporate
criminals to swindle investors with the knowledge that there was little
they could do in return.
Laws Protecting Investors' Rights are Weakened
In the 1980s, a key target of this business attack on laws
punishing financial fraud was the civil RICO (Racketeer Influenced and
Corrupt Organizations Act) law. Amazingly, this onslaught was initiated
in the midst of the revelations of self-dealing, insider trading and
fraud by the savings-and-loan thieves. The scandal put a public face on
this arcane but potent law. For a number of years, Public Citizen
fought tooth-and-nail against the accounting industry lobbyists, who
liberally lathered both Democratic and Republican Members of Congress
with campaign money to obliterate this very effective law prohibiting
conspiracy to defraud with its important attorney fees and treble
damages for the victims. Without the determination and persistence of
Senator Howard Metzenbaum, we would not have succeeded in stopping this
corporate juggernaut. Without civil RICO, the bondholders in the
Charles Keating S&L fraud would not have been fully compensated. The
S&Ls and accounting firms paid out some $1.4 billion in damages for
their fraudulent practices.
In the 1990s, two key Supreme Court cases were decided by 5-to-4
votes, and after the Republicans took over the Congress in 1995, three
key pieces of legislation were enacted, the first one over President
Clinton's veto, that, together, have taken the federal, state and
investor cops off the corporate crime beat and have left many
securities fraud victims without a remedy. At the same time, the
funding of the Securities and Exchange Commission was not increased as
the financial markets grew exponentially. Predictably, a business
ethics gap matured into full flower, and we are now experiencing a
corporate crime wave of untold proportions that is undermining public
trust in our markets and robbing citizens of their pensions and life
savings and kids of their college tuition nest eggs. Not surprisingly,
the accounting industry gave liberally to Members of Congress from both
parties. From 1990 to 2002, this industry gave almost $57 million
dollars in campaign money, $24 million to Democrats and $33 million to
In 1991, the U.S. Supreme Court in Lampf, Pleva limited the federal
statute of limitations to one year from the discovery of securities
fraud or three years from the violation, whichever is earlier,
shortening the time that was allowed under federal law previously, when
courts borrowed the generally longer state law limitation periods. In
1994, in the Central Bank case, the Court came down with a strict
construction decision, holding that those engaged in ``aiding and
abetting'' are not liable in consumer or investor federal securities
fraud cases because these words are not specifically in the statute.
Aiding and abetting had been universally recognized as a federal
violation for 60 years since the enactment of the federal securities
laws and was accepted in every federal circuit. The S&L scandal could
not have been perpetrated without the active and knowing assistance of
numerous professionals, particularly lawyers and accountants. By
allowing these professionals to escape liability, this decision
undercut recovery by the victims and diminished the incentive to
exercise due care and prevent reckless or knowing misconduct in
assisting in the perpetration of a fraud in violation of federal
securities laws. Needless to say, Vinson & Elkins and Kirkland &
Ellis--Enron's lawyers--have cited Central Bank in recent motions to
dismiss shareholder litigation. We all know the power of corrupt
lawyers and accountants. They are the engines that drives corporate
fraud. They must be held accountable.
In 1995, following a massive lobbying campaign, Congress passed the
Private Securities Litigation Reform Act over President Clinton's veto.
It was promoted as necessary to stop so-called ``frivolous'' lawsuits,
even though investor lawsuits had barely increased in the seven years
prior to its enactment. But it was a nuclear bomb used to quash an ant
hill. The act for the first time radically diluted laws against making
false earnings projections (sound familiar today?). By rejecting an
amendment to overrule the Central Bank decision, it also gave
protection to accounting firms that approved false earnings statements,
such as those issued by Arthur Andersen for Enron's massive deception.
It granted companies and their accountants ``safe harbor'' protections,
which Public Citizen criticized at the time. Thus accountants who
failed to spot or disclose fraud could be given immunity from private
lawsuits, as were companies issuing false earnings projections, even if
The act also forced defrauded investors to meet a high pleading
standard with respect to a corporate officer's state of mind (generally
only required in criminal cases); stayed discovery proceedings until
the defendant's motion to dismiss is decided, thus preventing fraud
victims from obtaining the very evidence needed to defeat the motion;
for the first time limited liability of auditors and other conspirators
from full accountability under ``joint and several liability''; failed
to extend the statute of limitations imposed by the Supreme Court;
eliminated treble damages as punishment for deliberate fraud under
civil RICO; failed to restore private liability for aiding and abetting
securities fraud; and for the first time required plaintiffs to divulge
in the complaint any confidential sources, thus preventing fraud
victims from gathering key evidence from confidential informants such
as whistleblowers, employees, ex-employees, competitors and media.
The absence of these protections is directly related to the
corporate fraud and failures we have been witnessing with dismay day
after day. A securities fraud case against MCI WorldCom was dismissed
earlier this year because, among other things, the court found that the
plaintiff's complaint ``does not attain the heightened pleading
standard requirements for this type of case'' under the 1995 law. The
case alleged that the company and its top executives had ``cooked the
books'' and fraudulently misled investors by artificially inflating the
financial condition of the company, but the court found that there were
not enough facts showing CEO Bernard Ebbers had acted with ``actual
knowledge or conscious misbehavior.''
Also, a 1999 securities fraud case against Tyco International Ltd.
was thrown out because of the 1995 law. It was filed after reports of
spectacular earnings increases and huge stock sales by executives and
directors, including Chairman and CEO Dennis Kozlowski, who sold $187
million in stock, Director Michael Ashcroft, who sold $37.4 million,
and General Counsel Mark Belnick, who sold $7.6 million. There was a
total of $252.8 in insider stock sales. Tyco then ``restated'' its
financial statements after a limited SEC review. After two years of
attempting to meet the harsh pleading standards of the 1995 law, the
investors' action was dismissed by the court. Today, top executives are
fired, indicted or under investigation, and many walked away with
millions of dollars. The investors have not recovered their losses and
the shortened statute of limitations has run. As the Washington Post
headlined on July 17, 2002, ``The Shareholder Lawsuit: A Red Flag for
Auditors,'' these lawsuits serve a multitude of purposes--compensation
for victims, deterrence and notice to auditors, the board and
Not satisfied with these cutbacks severely limiting the possibility
of recovery by victims of securities fraud, the Congress in 1996
enacted the National Securities Markets Improvements Act, which
preempted much state regulation of securities transactions. Again in
1998, the Congress cut back investor protection. It passed the
Securities Litigation Uniform Standards Act, which forced virtually all
securities fraud class action lawsuits to be tried in federal courts
under the weakened federal law, taking away stronger protection for
small investors under tougher state class action laws, such as longer
statute of limitations, aiding and abetting liability, and joint and
At the same time, the independent Securities and Exchange
Commission under Chairman Arthur Levitt was trying to change SEC rules
to eliminate conflicts in the accounting companies by separating
auditing and consulting services. The number of financial fraud cases,
in Levitt's words, ``absolutely exploded.'' Three big accounting
firms--Arthur Andersen, Deloitte and KPMG--said, in Levitt's words,
``We're going to war with you. This will kill our business. We're going
to fight you tooth and nail. And we'll fight you in the Congress and
we'll fight you in the courts.''
Sure enough, Levitt shortly thereafter received a demand letter
from three top chairmen on the House Commerce Committee: Tom Bliley,
Mike Oxley and Billy Tauzin, making 16 demands for extensive
information that tied the agency up for weeks and in Levitt's words
``intended to really stand in the way of the rulemaking we had in
mind.'' Levitt has described how the heat was kept up with ``telephone
calls, congressional hearings, and ultimately by threatening the
funding of the agency . . . threatening its very existence.'' He was
also threatened with a rider on his appropriations bill if he
proceeded. Another letter came from Senate Banking Committee members
Rod Grams, Evan Bayh, Phil Gramm, Charles Schumer, Mike Crapo, Rick
Santorum, Chuck Hagel, Jim Bunning, Wayne Allard and Robert Bennett,
opposing auditor independence rulemaking. After being urged again by
many Members of Congress to make peace with the audit companies, Levitt
agreed to a compromise rule that just called for corporations to bring
to their Boards' audit committees any consulting contracts that they
had made with their auditor. At Enron, Wendy Gramm, former chair of the
Commodity Futures Trading Commission, sat on the audit committee.
As if these laws and court decisions had not harmed investors
enough, now securities firms are using mandatory arbitration agreements
to force aggrieved investors into a company's own, costly private
judicial system, where there is limited discovery, limited recovery and
where arbitrators must depend on the defendants for repeat business.
I recently received a letter from a member of Public Citizen who
wrote that he opened an investment account with Payne Webber and was
required to sign a statement agreeing to arbitration in the event of a
dispute with the company. He did this only after researching virtually
every stock broker in the country and finding that he could not buy
stocks without agreeing to arbitration. ``This is a tragedy,'' he
One more way that corporate America has put the screws to the
people without whom it could not survive.
Public Utility Holding Company Act
Particularly relevant to the fraudulent dealing and manipulation at
Enron in which Army Secretary Thomas White participated is deregulation
as it applies to energy policy. Despite the California electricity
scandals, the unraveling of the stock market and almost daily
revelations of new corporate abuses, we continue to see a drive to
deregulate business--even in the energy sector. There is a provision in
the recently passed energy legislation that will have a devastating
impact on consumers and lead to more Enron-style abuses. On April 25,
the Senate voted to repeal the Public Utility Holding Company Act
(PUHCA). This vote to repeal PUHCA comes at a time when courts are
finally using the law to rescue consumers. At a time when the Enron
disaster and the failure of electricity deregulation across the country
(a dozen states have repealed or delayed their deregulation laws)
illustrate how vulnerable consumers and investors are to impenetrable
corporate structures and unaccountable markets, PUHCA's protections are
needed now more than ever.
PUHCA was enacted in 1935 in response to the United States' first
Enron-style energy crisis in the 1920s. A handful of energy companies,
employing business strategies strikingly similar to Enron's, held
consumers hostage with complex, multi-state pyramiding schemes. These
holding companies purchased financial, fuel and construction businesses
through a complex web of subsidiaries. Not only did consumers pay
inflated prices for energy to fuel the acquisition and operations of
businesses unrelated to the core energy concerns, but investors were
robbed because the holding company's assets were artificially inflated.
These pyramiding schemes finally collapsed, ringing in the stock market
crash of 1929 and the Great Depression.
The Securities and Exchange Commission is supposed to enforce
PUHCA, which protects consumers by ensuring that multi-state utility
companies re-invest ratepayer money into providing affordable and
reliable electricity. A corporation must register as a ``holding
company'' if it owns at least 10 percent of the stock of an electric or
natural gas utility. Consumers benefit from PUHCA's requirements that
holding companies invest only in ``integrated systems''--utilities that
are ``physically interconnected''--thereby maximizing economies of
scale by operating a single, coordinated system. PUHCA has historically
prohibited holding companies from investing ratepayers' money in areas
that will not directly contribute to low bills and reliable service,
such as out-of-region power plants or non-electricity industries such
as water and telecommunications.
PUHCA is the most important protection the federal government
provides for electricity consumers. But the law's potency has been
eroded over the past decade. Enron, with help from regulators and
Congress, helped undermine the act's effectiveness by creating new
loopholes. Incredibly, rather than proposing to close these Enron
exemptions to prevent other energy companies from abusing consumers and
investors, the response by the Bush Administration and Congress
(including the Senate Democrat energy bill) is to repeal the entire
law. Repealing PUHCA will lead to a rash of mergers, further
PUHCA has lost much of its teeth as a result of deregulation,
Enron's lobbying, and decisions by the SEC to simply ignore the law.
First, Congress undermined PUHCA by passing the 1992 Energy Policy Act,
permitting holding companies to invest ratepayer money in foreign power
projects and divert resources away from American consumers. Second,
Enron pushed a gaping hole in SEC regulation when the SEC, in response
to a petition by the company, exempted power marketers like Enron from
PUHCA on Jan. 5, 1994. As a result, power marketers--creatures of
deregulation that don't own power plants but rather speculate on and
trade electricity contracts--can trade free from government oversight
in deregulated markets across the country. Finally, the SEC has refused
to enforce the investment provisions of PUHCA, instead rubber-stamping
mergers that are in direct violation of PUHCA's consumer protections--
including the foreign acquisition of several U.S. utilities.
These loopholes have already resulted in a significant increase in
utility consolidation. In 1992 (prior to the passage of the loophole-
creating Energy Policy Act) the 10 largest utilities owned one-third of
the national generating capacity. By 2000, the top 10 owned half of all
capacity, while the top 20 owned 75 percent. These numbers will become
more concentrated if PUHCA is repealed, inevitably resulting in
Although proponents of repealing PUHCA claim that the law's
ownership restrictions hinder adequate investment, corporate leaders
appear to be more interested in repealing PUHCA to satisfy their
craving for Enron-style accounting freedom and convergence. If PUHCA is
repealed, a flurry of mergers will bury our electricity markets,
rendering states incapable of regulating sprawling multi-state holding
companies. The already overwhelmed Federal Energy Regulatory Commission
(FERC) will face a daunting task in trying to regulate all energy
markets. Both Democrats and Republicans propose replacing PUHCA's
consumer protections with weaker ones that would be under the
jurisdiction of FERC, which the GAO recently concluded was deficient in
handling its current responsibilities. But these huge holding companies
will have incentive to cover their tracks with Enron-esque accounting,
and no state or federal agency will be able to verify the accuracy of
Enron's collapse exposed consumers and investors to the dangers of
inadequate government oversight inherent in electricity deregulation.
The combination of deregulated state wholesale electricity markets,
federal deregulation of commodity exchanges and the creation of
loopholes in PUHCA removed accountability and transparency from the
energy sector. Had PUHCA's loopholes been closed and the law properly
enforced, Enron's fraud against shareholders and consumers never could
have occurred! PUHCA's ownership limits would have prevented the
company from hiding revenues and debts in offshore tax havens and
failed foreign projects, such as Enron's Dabhol power plant in India.
The solution is to strengthen PUHCA rather than repeal it. First,
Congress must require the SEC to strictly enforce the act, and beef up
funding and staff for the SEC. Second, the harmful loopholes pushed
through by Enron and other energy companies must be closed. Holding
companies must no longer be allowed to divert funds secured from
consumers for this essential commodity to invest in foreign countries,
and power marketers must be subject to PUHCA. Third, Congress can
improve PUHCA by using it to address issues of market power. For
example, Congress should grant federal and state regulators the
authority to order holding companies to divest assets, expand anti-
trust investigations and enforcement, and create non-profit, consumer-
owned regional transmission councils to ensure non-discriminatory
access to the grid.
It is important to note a recent court decision that could require
the SEC to enforce PUHCA. In January 2002, the U.S. Court of Appeals
for the District of Columbia ordered the SEC to revisit its decision to
approve a merger between American Electric Power (AEP) and Central &
South West (CSW). Public Citizen had maintained that the SEC's earlier
decision to approve this merger between Ohio-based AEP and Texas-based
CSW violated PUHCA's requirements that holding companies have
interconnected systems. The SEC had ruled that because the two
utilities are connected by a lone, 250-mile transmission line owned by
an unrelated company that the merger satisfied PUHCA! The judge's
decision illustrates that the court has finally noticed that the SEC
has refused to enforce the law and will force the review of other
recently approved mergers that clearly violate PUHCA (Progress Energy,
a union between Florida Progress and Carolina Power & Light; Exelon, a
product of PECO Energy and Unicom; Xcel, a merger between Northern
States Power and Public Service Co., and the foreign acquisition of
Oregon-based Pacificorp by Scottish Power).
The public is paying a dear price for the follies of the 1990s. The
dreams and hopes of tens of millions of families across America are
being dashed by the misbehavior of unethical companies spurred by
greed. The Congress has permitted this disaster, and we are pleased to
see it taking some corrective action. We support the new corporate
accountability requirements contained in the Sarbanes bill but believe
Congress must go further to protect consumers, investors and employees
of corporations. We applaud the criminal penalties it contains. They
should apply as well to knowingly selling defective products that kill
One critical ingredient that is still missing is the ability of
investors to recover damages when regulators fail to prevent harm. We
all know that regulations alone are not sufficient to deter wrongdoing.
Federal agencies are often underfunded and are sometimes poorly
managed. Congress and several court decisions have undercut the ability
of citizens to seek proper justice in the courts. These rights must be
In addition, there are key consumer protections contained in the
Public Utility Holding Company Act, which is repealed in the Senate's
energy legislation. This law has been weakened in piecemeal fashion by
a lack of enforcement and Congressional actions. It should remain on
the books, be improved and be enforced vigorously. Finally, even with
the Sarbanes bill, there remain problems with corporate governance and
possible conflicts of interest in the accounting industry.
The following are Public Citizen's specific recommendations:
Investor Recovery for Fraud
The two Supreme Court decisions and the three statutes cutting back
liability to investors for corporate fraud must be changed, as I have
testified. Professionals, including accountants and attorneys, must be
liable for aiding and abetting. And the statutes of limitation must be
longer, as provided in the Sarbanes bill, given the difficulty of
learning the truth about fraudulent activity.
The Private Securities Litigation Reform Act must be largely
repealed to give investors a level playing field in their efforts to
recover against corporate giants who control all the information about
any financial misbehavior. And federal laws should not limit state
regulation or state courts from protecting investors merely because
some states have more progressive laws than the existing federal law.
Further, securities firms should not be allowed to impose their own
private legal system of mandatory predispute arbitration that prohibits
court adjudication of disputes. If companies know there is a strong
likelihood of federal or state government or private enforcement, they
will be far more likely to behave.
Gag orders in the settlement of litigation, often demanded by
corporations, must be prohibited if they would result in covering up
corporate fraud against investors.
Restoring Strong Regulation to Energy Markets
Do not repeal the Public Utility Holding Company Act in the pending
Re-regulate energy trading. Pass Senator Feinstein's bill, which
would restore accountability in energy markets by overturning the 1993
decision to not extend CFTC jurisdiction over energy trading contracts
and the Commodity Futures Modernization Act of 2000 (which deregulated
over-the-counter energy trading), allowing companies like Enron to
operate unregulated power auctions.
Strengthen the regulatory and enforcement power of the Securities
and Exchange Commission by extending jurisdiction over power marketers.
Amend the Federal Power Act, forcing the Federal Energy Regulatory
Commission to revoke market-based rates and order cost-based pricing in
all wholesale electricity markets.
Corporate Executive Obligations and Limits
First and foremost, stock options must be treated as an expense by
corporations, as Senator McCain has so effectively argued. Overuse of
options has distorted the financial markets, diluted shareholder value,
and encouraged greedy executives to manipulate corporate books to drive
stock prices higher in the short term at the expense of long-term
stability and financial health. If options are exercised, as Senator
McCain suggests, the net gain after taxes should be held in company
stock until 90 days after departure from the company.
Repricing or swapping of stock options for executives must be
prohibited (Business Week reports that 200 companies regularly did this
for the corporate elite).
Top executives and board members should be prohibited from selling
company stock while still employed or serving there.
Company loans to corporate officers or directors must be
prohibited. (412 of 1,000 U.S. companies lent money to top executives,
often at low interest rates, from 1991 to 2000--almost double the
number from the prior decade.)
Executives must return all compensation, as Senators Dorgan and
McCain have urged, that is directly derived from proven misconduct.
While the SEC already has authority to require disgorgement of ill-
gotten gains, in 2002 it has requested it in only four cases out of
hundreds of ``restatements'' and dozens of investigations of accounting
The Sarbanes bill properly requires auditors to report to the Board
(which is supposed to represent shareholders, not be handmaidens to
management). The bill limits auditors from providing many consulting
services and requires preapproval by the Board audit committee where
allowed. Consulting services by auditors should be completely
The Sarbanes bill requires the audit personnel to rotate every five
years but does not require a new audit company. A new audit company is
needed to take a fresh look at the company's books.
The corporate compensation committee must be composed of board
members with no personal relationship with management or special
relationship with the company. The compensation, audit and nominating
committees should be made up of only independent members.
No more that two board members should be insiders.
Directors should not serve on more than three boards.
If shareholder resolutions pass by a majority of votes cast for
three consecutive years they should be considered adopted.
Shareholder meetings should be held in locations where the largest
number of shareholders reside, not in remote locations where most
Securities and Exchange Commission
In addition to increasing staffing and funding for the SEC, the SEC
must ensure transparency of its actions and of reporting by companies
in formats that enhance the ability of shareholders to evaluate this
Limit the percentage of a company's stock that can go into a
Allow employees to move investments in pension plans from company
stock to other securities (a right denied to Enron's unfortunate
Require employees to have equal representation on the 401(k) boards
that oversee pension systems.
Require investment advisers to be independent, without ties to the
There are five attachments to my testimony: (A) a Public Citizen
compilation of spending for accounting services--auditing versus non-
auditing services--by corporations that have recently been implicated
for questionable accounting, for the years 2000 and 2001; (B) a Public
Citizen compilation of spending by the nation's 20 largest corporations
on accounting services in 2000 and 2001--auditing versus non-auditing
services; (C) a copy of the April 17, 2000, letter from the leadership
of the House Commerce Committee to then-SEC Chairman Arthur Levitt,
referenced in my testimony; (D) a copy of a Sept. 20, 2000, letter from
Enron CEO Ken Lay to then-SEC Chairman Arthur Levitt, commenting on the
SEC's proposed rulemaking regarding auditor independence; and (E) a
list of 50 thoughtful recommendations for stemming corporate abuses,
taken from ``Corporate Crime and Violence,'' a 1988 book written by
Russell Mokhiber, who is the editor of the weekly newsletter Corporate
I would like to finish with a quote from the May 6, 2002, edition
of Business Week. It says that ``the challenge in coming years will be
to create corporate cultures that encourage and reward integrity as
much as creativity and entrepreneurship. To do that, executives need to
start at the top, becoming not only exemplary managers but also the
moral compass for the company. CEOs must set the tone by publicly
embracing the organization's values. How? They need to be forthright in
taking responsibility for shortcomings, whether an earnings shortfall,
product failure, or a flawed strategy and show zero tolerance for those
who fail to do the same.''
Thank you very much.
Appendix A.--Corporations Embroiled in Scandal and Fees Paid to Accountants
Percent of Percent of
Fees in millions ($) 2000 fees for 2001 fees for Accountant Scandal in Brief
Adelphia $3.5 62 n/a n/a Deloitte & Touche Investigations by
Communications the SEC and 2
auditing 1.3 n/a
non-audit and 2.2 n/a
Bristol Myers Squibb 25.7 89 41.3 93 PricewaterhouseCoopers Under
auditing 2.8 2.7
non-audit and 22.9 38.6
Cendant Corp. 27.9 80 32.4 79 Deloitte & Touche Former Chairman
auditing 5.6 6.9
non-audit and 22.3 25.5
CMS Energy 3.9 60 5.6 71 Arthur Andersen Embroiled in
auditing 1.6 1.6
non-audit and 2.3 3.9
Computer Associates 2.9 42 n/a n/a KPMG Paid fine to
International Justice Dept.,
auditing 1.7 n/a
non-audit and 1.2 n/a
Dollar General Corp. 1.4 7 1.3 8 Ernst & Young
auditing 1.3 1.2
non-audit and 0.1 0.1
0.7 67 n/a* Deloitte & Touche Settled a class-
for $162 million
non-audit and 0.5
Duke Energy 15.2 78 15 78 Deloitte & Touche Investigations by
the SEC, CFTC
over trading and
auditing 3.4 3.3
non-audit and 11.8 11.7
Dynegy 7.3 56 8.0 59 Arthur Andersen Investigations by
the SEC, CFTC
over trading and
auditing 3.2 3.2
non-audit and 4.1 4.7
El Paso 5.9 68 12.3 65 PricewaterhouseCoopers Embroiled in
auditing 1.9 4.3
non-audit and 4.0 8.0
Enron 52.0 52 n/a n/a Arthur Andersen Took advantage of
auditing 25.0 n/a
non-audit and 27.0 n/a
Global Crossing 14.2 84 n/a n/a Arthur Andersen Under
the FBI and SEC
auditing 2.3 n/a
non-audit and 12.0 n/a
Halliburton 51.5 86 26.5 73 Arthur Andersen In May the SEC
auditing 7.4 7.2
non-audit and 44.1 19.3
IMClone Systems 0.2 63 0.4 58 KPMG CEO arrested for
auditing 0.1 0.2
non-audit and 0.1 0.2
Kmart 12.8 91 n/a** PricewaterhouseCoopers Under
the SEC for
non-audit and 11.7
Lucent Technologies n/a 62.6 88 PricewaterhouseCoopers Under
the SEC for
non-audit and 55.0
Martha Stewart Living 1.0 69 0.8 64 Arthur Andersen Martha Stewart is
the SEC for
auditing 0.3 0.3
non-audit and 0.7 0.5
Merck & Co 6.3 33 6.5 34 Arthur Andersen Shareholder
auditing 4.2 4.3
non-audit and 2.1 2.2
MicroStrategy 2.1 62 1.4 36 PricewaterhouseCoopers Settled a suit
brought by the
auditing 0.8 0.9
non-audit and 1.3 0.5
Mirant 13.5 84 13.1 77 Arthur Andersen Embroiled in
auditing 2.2 3.0
non-audit and 11.3 10.1
Network Associates 5.0 71 4.0 61 PricewaterhouseCoopers Under
the SEC for
auditing 1.5 1.6
non-audit and 3.5 2.4
Peregrine Systems 1.0 82 n/a n/a Arthur Andersen Under
the SEC for
auditing 0.2 n/a
non-audit and 0.9 n/a
PNC Financial 19.1 85 18.8 79 Ernst & Young Forced to restate
Services Group $155 million
auditing 2.9 3.9
non-audit and 16.2 14.9
Qwest Communications 7.9 86 11.8 89 Arthur Andersen Under
the SEC for
auditing 1.1 1.4
non-audit and 6.8 10.5
Reliant Energy 22.1 84 33.2 87 Deloitte & Touche Embroiled in
auditing 3.6 4.3
non-audit and 18.5 28.9
Rite Aid 20.6 50 7.9 37 Deloitte & Touche Indicted by the
auditing 10.4 5.0
non-audit and 10.2 2.9
Tyco n/a n/a 34.9 62 PricewaterhouseCoopers Under
the SEC for
auditing n/a 13.2
non-audit and n/a 21.7
Waste Management 79.0 39 23.3 41 Arthur Andersen Fined by the SEC
auditing 48.0 13.7
non-audit and 31.0 9.6
WorldCom 26.7 86 16.8 74 Arthur Andersen Under
the SEC for
auditing 3.8 4.4
non-audit and 22.9 12.4
Xerox 18.8 40 n/a n/a KPMG Paid a $10
million fine to
the SEC for
auditing 11.3 n/a
non-audit and 7.5 n/a
Totals, $448.3 67 $377.9 75
auditing $149.1 $94.2
non-audit and $299.1 $283.7
*Deloitte & Touche was dismissed as the auditor in September 2001.
**Filed for bankruptcy 8 days before they would have been required to disclose for 2001.
Appendix B.--America's 20 Largest Corporations and Consulting Fees Paid to Accountants
Percent of Percent of
Fortune 500 Fees in millions ($) 2000 fees for 2001 fees for Accountant
rank consulting consulting
15 AT & T 56.2 86 78.2 92 PricewaterhouseCoope
Auditing 7.9 6.6
Non-Audit & Consulting 48.4 71.6
16 Boeing 34.8 70 28.2 52 Deloitte & Touche
Auditing 10.5 13.4
Non-Audit & Consulting 24.3 14.8
17 El Paso 5.9 68 12.3 65 PricewaterhouseCoope
Auditing 1.9 4.3
Non-Audit & Consulting 4.0 8.0
18 Home Depot 4.5 78 6.2 81 KPMG
Auditing 1.0 1.2
Non-Audit & Consulting 3.5 5.0
19 Bank of America 49.4 73 74.2 81 PricewaterhouseCoope
Auditing 13.2 14.0
Non-Audit & Consulting 36.3 60.2
21 JP Morgan Chase 105.5 80 75.0 62 PricewaterhouseCoope
Auditing 21.3 28.8
Non-Audit & Consulting 84.2 46.2
Total Top 20 $938.6 74 $880.4 72
Auditing $243.9. $244.5
Non-Audit & $694.7 $635.8
Top 20 Fortune 500 companies as determined by the April 15, 2002 issue of Fortune magazine.
* 2000 ChevronTexaco includes only Chevron corp.
JP Morgan Chase, ranked 21st by Fortune, replaces Fannie Mae, ranked 20th, because Fannie Mae does not file
Schedule 14a filings.
Source: Company Schedule 14a filed with the Securities and Exchange Commission. Compiled by Public Citizen
Introduction of letter to Arthur Levitt, Chairman, Securities and
Exchange Commission, from Kenneth L. Lay
At the height of the debate over auditor independence in 2000, Ken
Lay sent this eye-opening letter to Arthur Levitt, then Chairman of the
SEC, urging him to back down on his efforts to eliminate the potential
conflicts of interest created when accountants provide both auditing
and consulting services to a single client. The letter argued that
Levitt was jeopardizing the productive relationship Enron had built
with Andersen, one in which Andersen had become so deeply intertwined
with Enron that its staff had moved into the same building, taken over
much of the internal auditing usually left to Enron employees, and
expanded rapidly into the highly profitable area of consulting.
Andersen touted this ``integrated audit'' as a new paradigm in
Although ostensibly from Lay, the letter was secretly co-authored
by Andersen partner David Duncan in consultation with the firm's
lobbyist in Washington as a part of the accounting industry's massive
lobbying effort against Levitt's reforms. Letters such as this one,
coupled with enormous pressure from Congress, forced Levitt to back
down on the issue of auditor independence and eventually to adopt a
less stringent rule, a move he later called the ``biggest mistake'' of
his time at the SEC.
Houston, TX, September 20, 2000
Hon. Arthur Levitt,
Securities and Exchange Commission,
Dear Chairman Levitt:
I would like to take this opportunity to comment on the Securities
and Exchange Commission's proposed rulemaking regarding auditor
independence, on behalf of Enron Corporation. Enron is a diversified
global energy and broadband company that prides itself on a uniquely
entrepreneurial business philosophy and on creating knowledge-based
value in emerging markets.
For the past several years. Enron has successfully utilized its
independent audit firm's expertise and professional skepticism to help
improve the overall control environment within the company. In addition
to their traditional financial statement related work, the independent
auditor's procedures at Enron have been extended to include specific
audits of and reporting on critical control processes. This arrangement
has resulted in qualitative and comprehensive reporting to management
and to Enron's audit committee, which has been found to be extremely
valuable. Also, I believe independent audits of the internal control
environment are valuable to the investing public, particularly given
the risks and complexities of Enron's business and the extremely
dynamic business environment in which Enron and others now operate.
While the agreement Enron has with its independent auditors
displaces a significant portion of the activities previously performed
by internal resources, it is structured to ensure that Enron management
maintains appropriate audit plan design, results assessment and overall
monitoring and oversight responsibilities. Enron's management and audit
committee are committed to assuring that key management personnel
oversee and are responsible for the design and effectiveness of the
internal control environment and for monitoring independence.
The proposed rule would preclude independent financial statement
auditors from performing ``certain internal audit services.'' The
description of inappropriate activities included in your current
proposal is so broad that it could restrict Enron from engaging its
independent financial statement auditors to report on the company's
control processes on a recurring basis as the company has now arranged.
I find this troubling, not only because I believe the independence and
expertise of the independent auditors enhances this process, but also
because Enron has found its ``integrated audit'' arrangement to be more
efficient and cost-effective than the more traditional roles of
separate internal and external auditing functions. Frankly, I fail to
understand how extending the scope of what is independently audited can
be anything but positive.
The SEC has supported a number of measures to ensure that audit
committees are informed of auditor's activities and feel the burden of
determining auditor independence. Enron's audit committee takes those
responsibilities very seriously. Given the wide-ranging impact of your
proposed changes, I respectfully urge the Commission to reassess the
need for such broad regulatory intervention when the business
environment is more dynamic than ever. I also respectfully suggest the
SEC give the new measures regarding the enhanced role of audit
committees in ensuring auditor independence a chance to work before
regulations of this magnitude are considered.
Kenneth L. Lay
Chairman and CEO, Enron Corporation
U.S. House of Representatives,
Committee on Commerce, April 17, 2000.
Hon. Arthur Levitt,
Securities and Exchange Commission,
In connection with its oversight of the securities markets, the
Committee has a number of questions relating to accounting practice.
Pursuant to Rules X and XI of the U.S. House of Representatives, please
respond to the following questions:
1. What empirical evidence, studies or economic analysis does the
SEC possess that demonstrates accounting firms having consulting
relationships with audit clients are less independent than firms that
do not have such relationships? Are there any specific administrative
findings that have concluded the provision of consulting services
resulted in a specific audit failure by the same firm?
2. What empirical evidence, studies or economic analysis does the
SEC possess that demonstrates accounting firms providing tax advice to
audit clients are less independent than those firms that do not provide
such advice? Are there any specific administrative findings that have
concluded the provision of tax advice resulted in a specific audit
failure by the same firm?
3. What are the investment restrictions to which employees of the
SEC are subject? How are they different from restrictions placed on
accountants? What is the rationale for those differences? Is there
evidence that share ownership by SEC personnel compromises their
independence or ability to discharge their duties in accordance with
the public interest? What are the similarities in access to material
non-public information shared with auditors and with the SEC staff
reviewing statements filed with the Commission? Estimate the number of
violations that would exist if the stock restrictions applicable to the
accounting profession were to be applied to the SEC and its staff on
January 2, 2000.
4. You and members of the Commission staff have suggested a new
regulatory oversight and disciplinary process for the accounting
process be adopted. Is the SEC developing recommendations on this
proposal? How would the SEC receive input on its recommendations? Under
what specific grant of statutory authority would the SEC propose to
implement these recommendations?
5. We understand the SEC has expressed its views on the question of
independence primarily in interpretive guidance or no action letters
issued by the staff. Have the policies in this interpretive guidance
ever been subject to rulemaking subject to notice and comment? Identify
all guidance which was adopted by rulemaking and the date of
consideration and adoption.
6. Members of the SEC staff have publicly supported restricting the
scope of services offered by accounting firms to audit clients beyond
current restrictions such as the prohibition on audit firms acting in a
management capacity for audit clients. Are such considerations
currently under consideration by the SEC or the staff? How would the
SEC receive input on and implement such changes?
7. Under Section 3(f) of the Exchange Act and Section 2(b) the
Securities Act [sic], the SEC is required to consider efficiency,
competition, and capital formation when engaging in rulemaking under
the public interest standard. The legislative history accompanying
these provisions, as well as a plain reading of the statute, makes
clear a thorough cost benefit analysis performed by the office of the
Chief Economist must be undertaken prior to any such rulemaking. Has
the SEC commenced cost benefit analysis of proposed changes to
limitations on the scope of services offered by accounting firms to
audit clients? If so, what are the findings of this cost benefit
8. Regulation S-X provides that the SEC ``will not recognize any
certified accountant or public accounting who is not in fact
independent.'' Has the SEC defined the principles by which it
determines that an accountant is not in fact independent? [sic]
9. Does the fact that audit firms are compensated for their
services create an ``appearance of conflict'' problem? If direct
compensation does not create an unacceptable appearance of conflict
issue, how are more attenuated relationships between an auditor and its
clients, such as the ownership of share in an audit client by a spouse,
child or son or daughter-in-law of an audit partner determined to be
unacceptable violations of independence?
10. What is your view on the proper role of the SEC and its chief
accountant regarding the Financial Accounting Standards Boards's
(``FASB'') agenda? What is the proper role of the Commission and its
Chief Accountant regarding FASB's deliberation on new GAAP rules?
Please identify all no-public meetings between SEC personnel and
members of the FASB or the FASB staff concerning recent proposals to
change the accounting treatment of business combinations.
11. Identify all private sector committees, commissions, boards or
other groups created at the request of the Commission or yourself
during your tenure at the SEC. For each group, identify the method and
criteria by which members of these boards were selected, including the
role you played in selecting members. What is the legal status of each
of these commissions or boards? What are the terms of existence of
these boards and the terms of their constituent members?
12. In what ways did the SEC seek to influence the actions of the
NASD and the NYSE as they considered the recommendations of the Blue
Ribbon Committee on Improving the Effectiveness of Audit Committees?
Did SEC officials meet with self-regulatory groups charged with
reviewing the recommendations regarding listing qualifications?
13. What is the status of SEC consideration of rules issued by the
Independence Standards Board (ISB) last December relating to
investments in mutual funds and related entities? Given the
consideration of these rules would be made under a public interest
standard, what specific criteria would the SEC use to reject a proposed
14. The SEC Chief Accountant stated the SEC intends to move forward
with proposals to modify independence rules. Is it the SEC's intention
to make recommendations to the ISB for action, or to undertake action
outside the ISB process?
15. In the area of rules and guidance on auditor independence
please indicate whether each of the following situations would be a
violation of auditor independence. For those that are a violation,
justify why the situation should be grounds for an independence
A partner's spouse participates in an employer sponsored
benefit plan that invests in securities issued by an audit client with
which the partner has no direct contact or responsibility. The benefit
plan is the only option offered to the spouse by the employer.
A partner's spouse participates in an investment club that
owns 100 shares of stock of an audit client of the firm's Detroit
office. The partner works out of the Seattle office and has no
involvement with the client. The investment is not material to either
The son-in-law of a partner is the beneficiary of a blind
trust that has a de minimis investment in an audit client of the firm's
Boston office. The tax partner works out of the Atlanta office and has
no involvement with the client.
A partner has a brokerage account with a securities firm
that is not audited by the accounting firm. Cash in the brokerage
office is automatically swept into a mutual fund that is audited by the
firm's New York office. The partner works out of the Denver office,
provides no services to the mutual fund, and is unaware the mutual fund
is a client.
The grandparents of a partner's children purchase a share
of an audit client and hold the share pursuant to the Uniform Gift to
Minors Act. The partner has no control over the purchase or disposition
of the stock and does not work for the client.
For the following situations also indicate what alternatives the
couples would have to come into compliance with independence
A partner's spouse is an executive at company A, and
through the only reasonable employer benefit plan has holdings in the
company. The partner works for a firm which audits company B, though
neither the partner's office nor the partner perform any work for
company B. Companies A and B merge and the spouse retains both holdings
and employment. The holdings are material to the couple. The firm
audits the merged company.
The spouse of a partner works in a non-management capacity
for a non-public company that is an audit client. The spouse has
holdings in the company which are material to the couple. Neither the
partner's office nor the partner perform [sic] any work for the
company. The company goes public.
A manager's spouse is promoted to CFO of an audit client
company. Neither the manager's office nor the manager perform [sic] any
work for the company. The manager is promoted to partner.
A partner's spouse works for a company as a non-management
employee and participates in the stock option and 401(k) program.
Neither the partner's office nor the partner perform [sic] work for the
company. Due to fluctuations in stock price, the value of stock in the
company represents 5.1 percent of the couples [sic] net work on
16. Accounting independence prohibitions were drafted at a time
when few women worked outside the home. Given the prevalence of women
in the workforce, both as accounting partners and as workers, managers
or executives in public companies, does the SEC agree current
independence restrictions are outdated and in need of modernization? Do
the restrictions as they stand discourage wives and daughters from
participating in the workforce?
Please respond to these questions 2 weeks from the date of receipt
of this letter. These responses will help to determine if hearings on
the SEC's oversight of the accounting profession are warranted.
Michael G. Oxley,
Chairman, Subcommittee on Finance and Hazardous Materials.
W.J. ``Billy'' Tauzin,
Chairman, Subcommittee on Telecommunications, Trade, and Consumer
Senator Dorgan. Ms. Claybrook, thank you very much for your
I just received a call from Senator Byrd, the Chairman of
the Appropriations Committee, and the conference on the
supplemental appropriations bill is convening at this moment.
I'm a conferee, so I'm going to briefly go to that conference.
Senator Boxer will continue to chair the hearing. We, have been
joined by Senator Edwards, as well.
Senator Boxer, thank you very much.
Senator Boxer [presiding]. Thank you. Let me tell you what
the plan is. I'm going to give a very brief opening statement.
Then I'm going to call on Senator Edwards. And then we're going
to go to Ms. Minow, and then we have some questions.
STATEMENT OF HON. BARBARA BOXER,
U.S. SENATOR FROM CALIFORNIA
Senator Boxer. I'm going to put my entire statement in the
record, but I want to just thank my Chairman, who just left,
for his steadfast adherence to justice. And if it wasn't for
him, and for Senator Hollings, we wouldn't have been able to
take a look at Enron and the larger issues that we're beginning
to look at today. So let me put that on the record.
Senator Metzenbaum and Joan Claybrook are institutions unto
themselves, and they both have a long history of fighting for
consumers. The organizations that they lead, the Consumer
Federation of America and Public Citizen, and the groups they
work with provide the invaluable service of, frankly, educating
lawmakers on the rights and interests of American consumers.
And sometimes it's a lonely battle for you. And I've been very
proud to stand with you on many of those battles.
But I believe if WorldCom and Enron and Tyco and Merrill
Lynch and the other corporate players, past and present, had
one-tenth of the ethics of both of you, we wouldn't be in
trouble today, and I think that's the basic point. Now, we
can't legislate that, but we can sure say that's the standard
we want to see, and people will have to pay the price if they
don't adopt new ethics.
Decades ago, when I was a stockbroker on Wall Street, it
was very different--very, very different. Granted, it was, when
I had a 12-million-share day in those days, it was a big deal.
There were fewer players. But the fact remains, the system
could have been gamed, and, of course, once in awhile, it was,
but really you didn't have what you have today.
When you had one of the big accounting firms sign off on a
balance sheet, on a statement, you could take it to the bank.
And now you take it to bankruptcy. Something is rotten, awful.
There's no check and balance here, and that's what we need to
do in Congress today, is to get a check and balance on this
type of behavior.
I've watched in horror to see consultants who were auditors
and analysts, who are supposed to be honest, telling you what
to buy, being rewarded with inside stock deals, and CEOs who
don't care about anyone but themselves. It is more than a
scandal. It's a moral crisis in our country. Corporate
irresponsibility has turned our nation's free market system
into a free for all for the privileged few. And when companies
lie and cheat and steal--and I want to say they're not
companies; they're people in companies--lie, cheat, and steal,
it causes a devastating ripple effect to the workers in those
companies who end up losing their jobs and their dreams and
their investments and their 401(k)'s and their savings.
And I'll tell you, I just don't want to see another group
of people coming up here in tears saying, ``All I wanted to do
was take my grandchildren to Disneyland or something, and I
can't even do that,'' or read about people who were ready to
retire who are now saying, even though they're tired, they have
to work another 5 years at least, because of what has happened.
This isn't a theoretical discussion, as you know. This is about
Fifty percent of all Americans invest in the stock market.
That's way up. It's at historic highs. And they count on those
investments to send their kids to college. And we don't want
them to walk away from being able to invest in a healthy
economy in a healthy stock market. But if you can't believe
what you read in a corporate statement, you're going to think
twice. And if you don't, you're making a mistake.
So what we're doing here I consider to be business-
friendly, because if we can restore confidence in business by
setting rules and regulations and checks and balances, we will
go back to having a healthy business climate.
So I'll put the rest of my statement in the record and say
that my state has suffered. On WorldCom, alone, pensions in my
state lost $1.2 billion, just from WorldCom alone. So, again,
it's very, very serious, and we all have to work together.
And I agree with the statements you've made. The Sarbanes'
bill is the best we've got. Yes, I had some amendments I was
hoping to get, and I'm going to talk about them later. But
it's, by far, the stronger bill, and I'd like to see the
President get behind it. I'd like to see the House Republicans
change their tune and get behind it. The Senate Republicans,
for the most part, did. I'm very glad of that. So we have some
[The prepared statement of Senator Boxer follows:]
Prepared Statement of Hon. Barbara Boxer, U.S. Senator from California
Mr. Chairman, thank you for calling this hearing on improving
corporate responsibility and for inviting such formidable consumer
advocates to testify before the committee.
Senator Metzenbaum and Joan Claybrook are both institutions unto
themselves who both have a long history of fighting for consumers. The
organizations they lead, the Consumer Federation of America, Public
Citizen, and the groups they work with provide the invaluable service
of educating lawmakers on the rights and interests of American
consumers. That information helps counteract the well-funded efforts of
high-paid K Street lobbyists working to weaken the government agencies
and regulations that were created to protect Americans from unethical
WorldCom, Enron, Tyco, Merrill Lynch, and the other corporate
scandals on today's front pages reflect structural flaws in our system.
But the Administration would have us believe that these are just a few
bad apples rather than worms of greed that have infested the corporate
orchard. The Administration wants to act on a case-by-case basis, only
grudgingly accepts the need for meaningful reform, and refuses to
acknowledge that the government has a responsibility to establish and
enforce rules that really protect workers and investors from abuse.
When we succeed in passing the legislation and enforcing the
stronger regulations necessary to improve corporate responsibility, it
will have been over the decades long objections of the right and in
spite of, rather than because of, the President.
Let's examine the record. This Administration refuses to force
corporate polluters to pay for the harm they inflict on our
environment. It has designed an energy package gift wrapped for
corporations while ignoring the needs of consumers or the long-term
interests of the people and the environment. It has failed to fully
support the Senate passed reform bill because its corporate friends
claim the new rules would be too stringent.
Even with workers losing retirement savings and the elderly
struggling to pay for prescription drugs, the Administration still
refuses to support meaningful pension reform or a prescription drug
program that works for all Americans.
Americans know who fights for them. For the last two decades, some
have fought to dismantle the rules and institutions that protect the
people. Too often, lawmakers have behaved as if they work at the U.S.
Chamber of Commerce rather than the U.S. Congress. The time to restore
corporate responsibility is now and the way to do it is for public
leaders to fight to protect consumers from corruption instead of
fighting to protect the corrupt from regulators.
Mr. Chairman, I look forward to hearing the testimony of our
witnesses and to working with you to move necessary reforms forward.
Senator Boxer. With that, I'll call on Senator Edwards and
then on Senator Fitzgerald, whom I welcome to the hearing.
STATEMENT OF HON. JOHN EDWARDS,
U.S. SENATOR FROM NORTH CAROLINA
Senator Edwards. Thank you. Thank you very much.
I first want to just echo what Senator Boxer just said. It
is so important not just to business and for the investors, but
for the entire economy, for us to restore some level on
confidence. I mean, I think there's no question that that's
playing a major role on what we're seeing both in the stock
market and Wall Street, but also what we're seeing with our
economy today. I think we have a responsibility to lead on this
issue and send a strong signal to the American people that
we're willing to do what's necessary to protect investors, to
restore confidence in corporate America, and, as a result,
restore confidence in the investments that they're making,
knowing that the information they get they can rely on, that
I also want to say a word about our State Treasurer, who
we're so glad to have here, Richard Moore, who's an old friend
of mine. He's a wonderful leader. We're very proud of what
you're doing, Richard, because you've really taken a lead
nationwide working with the folks in New York, the Attorney
General of New York and saying what needs to be said by more
people, which is, as the manager of the tenth largest public
pension fund in American, if you don't do right, if you don't
do what needs to be done to be responsible, we're not going to
invest with you. And I think if others would follow your lead,
and I'm hopeful that they will, that it would go a long way
towards doing what needs to be done, along with the work that's
being done here with the Senate with Sarbanes' bill here in the
So welcome. We're glad to have you here, very proud of you.
We've been watching your leadership on this issue, and we
couldn't be prouder of the work that you're doing.
I also want to say just a quick word to my friend Joan
Claybrook, who's just been such an incredible advocate for
consumers in this country who need a voice. Lots of other
powerful interests have voices up here, as she well knows, and
it's a good thing for there to be at least one loud, strong
voice for regular folks and for consumers in this country.
We're proud of what you're doing, and Senator Metzenbaum, who's
been a great champion for a long time of the little guy. We're
very proud of you, too, Senator Metzenbaum. We're happy to have
all the witnesses.
And, Madam Chairwoman, I thank you for letting me go.
Senator Boxer. Thank you so much, Senator.
STATEMENT OF HON. PETER G. FITZGERALD,
U.S. SENATOR FROM ILLINOIS
Senator Fitzgerald. Thank you, Madam Chairman, and thank
all of you for testifying today. I want to welcome you all to
And, Nell Minow, I want to especially welcome you. You grew
up in Illinois, and I consider you on honorary constituent for
that reason, and I compliment you for your work as editor of
The Corporate Library. And I know you've been involved in many
of these issues for years and years.
I wanted to ask some questions regarding the accounting for
stock options. I actually believe that the Sarbanes bill was a
very good bill. It was very well thought out, very well put
together. I think it does make some incremental improvement.
But I think both houses of Congress are ignoring a fundamental
problem here, and that is the lack of expense recognition for
stock options to corporate management and to employees.
Back in 1993, the Financial Accounting Standards Board
wanted to require companies to expense stock option
compensation. And yet corporate America came to Washington and
got politicians in Washington to thwart FASB. A resolution was
introduced in the Senate condemning FASB for having the
audacity to suggest that stock option compensation be recorded
on the earnings report, and a separate bill was introduced in
the Senate that would have eviscerated FASB and put them out of
business if they didn't back down. So FASB backed down. They
wanted to stay in existence. And since that time, there has
been a gargantuan, humongous acceleration in the issuance of
And you can see why. It's almost irrational, if you can get
a tax deduction for your stock-option compensation expense, but
you don't have to record it as an expense on your income
statement, you'd almost be irrational to pay your employees and
management in cash. Why not use stock options? You get the tax
deduction, but you treat it like manna from heaven on your
There is an analysts' accounting observer Jack--gosh,
Ciezelski, I think--is that the proper pronunciation? He has
just issued a report that indicates that the Standard and Poors
500 companies, that the lack of expense recognition for stock
options caused the earnings reports of the S&P 500 companies in
2001 to be overstated by 31 percent. And there are a number of
companies that he points out--and they have enough enemies
already; I won't read these companies out--but there are many
companies in America that all of their earnings last year were
delivered to the employees and management via stock options.
And had they taken an expense for their stock option
compensation, there would have been no recorded earnings.
My question to you is----
Senator Boxer. Well, we're not asking questions yet----
Senator Fitzgerald. Oh, you're not?
Senator Boxer.--because we haven't heard from the last
witness. We'll come back to you----
Senator Fitzgerald. OK. All right. Well, I'll rephrase
things. I guess the point I would want to make is, in part,
what's going on in the market now is that sophisticated
investors, led by the institutions, have figured out that
there's no reason to be a shareholder in companies that take
all of their profits and give it to their management and, in
some cases, their management employees. They've removed the
incentive to be a shareholder in one of these companies. And I
think those companies are getting their comeuppance now on the
I am much chagrined that there have been continued attempts
in Congress to thwart any kind of effort to deal with this
issue, because I believe that this is the root cause of all the
earnings restatements and debacles and corporate scandals we've
seen in recent months. The top 29 managers at Enron cashed out
$1.1 billion in stock options before the company went bankrupt.
And there's a recurring pattern at many of the corporations
that we have seen embroiled in scandal, that management there
was gorging themselves on stock options, they'd cash out their
options, many of them would then just leave the company,
knowing that it was going to hit the wall sooner or later.
At a certain point, while stock options might be a good,
healthy incentive that, to some extent, aligns the interests of
employees and management with the shareholders, at a certain
point, when there's too heavy an issuance of options, then the
management gets very short-term incentives, starts thinking
about keeping their own options in the money. And when they
start doing that, they're acting adversely to the interests of
the long-term shareholders.
And I think that there needs to be some discipline on
options, and certainly one discipline would be to require the
expense to be reflected in the earnings report. And I will be
interested in hearing from the panel on their thoughts on this
I want to thank Senator Boxer for chairing this hearing.
Senator Boxer. Thank you. Before you came, I want you to
know that a couple of our people did talk at length about
options. They agree with you. They--we haven't heard from Ms.
Minow. We're going to in a moment.
But I just want to say, in the interest of an interesting
debate, that I don't think the root cause of the scandals we're
facing now are stock options. I think the root cause of the
scandal is thieving corporate leaders. Thieving, breaking laws,
hiding losses, and also treating expenses as income.
Now, the stock option is another question, but it isn't
illegal, what they did. I would certainly like to make it
illegal to do some of the things that these corporate leaders
did with their stock options. I want to see them have longer
holding periods. Maybe they don't get to cash in until they
leave the company for a few years. Then maybe they'll have, you
know, the desire to do right by the company, not just to do
what you correctly stated, which is to phony up the earnings.
That's no question, but let's keep our eye on the prize here.
We didn't have any accountants that blew the whistle on these
And I do want to put on the record the fact that I come
from a state where stock options have been used by 100 percent
in some companies. I have letters that I'll put in the record
from women who are on the bottom of the ladder in the company
who were able to use their options.
[Letters are not available.]
Senator Boxer. So what I want to do with options is not
something really simple that eliminates them for the little guy
and keeps them for the big guy and allows the big guy--if you
just did expensing tomorrow, this is my prediction, because 11
million people have stock options, the top guys will still get
them, and they'll still abuse them unless we change the laws
surrounding what they can do with them.
So I think it's a very interesting debate, and I'm working
very hard to make sure that when we do make our move on this
issue that we move on it in a right fashion so that the little
guy doesn't get it in the neck again, but the big guy does. And
it makes a lot more sense.
So I don't think that there's division in our Senate at
all. I think the division is exactly what you do about it. But
everyone sees it as an evil that needs to be addressed, where
you keep the good side of it, but you get rid of the bad side
But I just would disagree that the cause of the scandal now
is stock options. They're a real problem. The causes of the
scandal are illegal acts, and that's why I'm so proud that
Senator Leahy and Members of the Judiciary Committee on both
sides were able to put together some stronger penalties.
But, with that, let's call on Ms. Minow, and we welcome
you. The whole panel has just been wonderful so far. I'm sure
you will continue in that tradition. I ought to say that you
are the editor of The Corporate Library.
STATEMENT OF NELL MINOW, EDITOR,
THE CORPORATE LIBRARY
Ms. Minow. Thank you very much, Madam Chairman. And,
Senator Fitzgerald, I may just have to move back to Illinois so
I can vote for you. I appreciate what you said very much. Thank
I want to begin, again, by thanking you for inviting me to
appear today. I've been working in this field, corporate
governance, for 16 years, and it's really been a shock to my
system not to have to explain to anybody anymore what that is.
American investors, consumers, and employees have been very
deeply shaken by the stories of corporate corruption, and it
has been very gratifying to see the Senate and Congress move so
quickly to respond. I really want to emphasize that if there
was ever an issue that required bipartisanship and even
statesmanship on behalf of the Senate and the Congress in
accepting responsibility for the causes of this problem and in
developing a response, this is definitely it. The one thing
that the Senate and Congress could do that would really create
more problems of investor confidence is turn this into a
The discussion of investor confidence reminds me of a story
about my dad, Newton Minow, who is a resident of Illinois. He
was asked to speak to a group of young lawyers at his firm, and
he told them that the most important thing that you could do as
a lawyer was to get the client to trust you. And one of the
hotshot young lawyers raised his hand, and he said, ``Well, Mr.
Minow, how do I do that?'' My father said, ``Well, you could
start by being trustworthy.'' And that is a lesson that our
corporations must learn. There is nothing that we can do to
solve that problem for them. We can create more penalties, we
can remove improper incentives, but they've got to learn that
In a way, we've all been enablers for bad behavior by
corporate managers and directors. We've been rewarding them at
a level unprecedented since they used to pay people their
weight in gold. Unfortunately, like that thankfully outdated
form of compensation, ours have not provided optimal
incentives, and the managers, therefore, have opted for short-
term self-dealing rather than long-term sustainable growth and
It was interesting that Madam Chairman referred to the
``root cause.'' This really has been like a root going off in a
lot of different directions. There are many different causes
here. And the challenge is that there have been so many
failures by so many different entities that it's difficult to
provide an effective and coordinated response.
I'm a big fan of everybody on the panel, but I have to
disagree. I think that Harvey Pitt is going to do a very good
job. He's very committed to doing a good job and just needs
some additional support to do it.
And I also have to disagree on the Securities Litigation
Reform Act. It was not a perfect act. Obviously anything could
be improved, but I personally have filed lawsuits under the
Reform Act, and the amount of settlements that, not only I
received, but other people have received have been
unprecedented. So I think it's actually been a net improvement.
I do want to talk a little bit about stock options and pay
disclosure. We have to take some responsibility for the problem
here. I really appreciate that Senator Fitzgerald mentioned the
way that Congress interfered with what FASB wanted to do
previously. I'd like to have Congress get out of the way so
that FASB will do the right thing now.
Going back to your point, Madam Chairman, the issue of how
long the employees must hold the exercised options I think is a
terribly important one. I'd like to see them not be allowed to
cash out until 3 years after leaving the company to make sure
that their perspective is a long-term one.
I particularly want to point out the fact that the SEC, not
too long ago, changed the rules to allow a cashless exercise of
options. I think that that has been insidious. Executives can
exercise the options and sell them immediately without having
to put any money down, and I think that that has created a
terribly perverse set of incentives.
What Congress should do is revisit the tax code to redefine
performance-based pay. The last time pay was an issue, Congress
tried to fix it by setting the million dollar pay cap and then
giving a get out of jail free card, basically, to performance-
based pay. I've brought a report from The Corporate Library on
the failure of U.S. stock option plans to tie pay to
performance. I don't intend to clog up the record here with it,
but I'm making it available to the staff.
I think what we need to do is instead of discouraging
indexed options tied to the performance of the individual
company, which our tax code right now makes almost impossible,
we need to encourage them.
Furthermore, there is this trend in corporate America that
I call the Leona Helmsley trend, the only ``little people pay
taxes'' trend, and that is to ``gross up'' CEO pay, meaning
that not only does the company pay the CEO, the company pays
the taxes of the CEO. I have to pay my taxes. You have to pay
your taxes. We should not allow that anymore.
My second point has to do with the enforcement of existing
laws. The SEC, under Mr. Pitt's predecessor, in particular, had
a terrible relationship with the Justice Department. And,
therefore, there was very little criminal enforcement. I think
that the Senate should require the SEC and the Justice
Department to work better to eliminate petty bureaucratic
differences and present a meaningful plan for enforcing the
laws already on the books. And it would help if we had a full
SEC and perhaps fewer people with ties to the accounting world.
The failures at all of the companies we've listed today are
not necessarily the failures of the accountants, analysts, or
regulators. It was really the boards of directors, and we need
to think carefully about a system that takes capable,
honorable, experienced people and puts them into a board room
where there's something about the oxygen that causes them to
lose half of their IQ points and all of their courage. We need
to really get out of their way.
And, in particular, we need to work on the fact that, the
Federal Government has more of a say in what goes on in your
local elementary school than it does in a board room because of
the deference to state law, meaning Delaware. If shareholders
could pick the state of incorporation, we'd have some
competition in the states to do better by them.
I support the New York Stock Exchange's proposals, which I
think are very constructive, but I worry that the NASDAQ
proposals are disappointing and make it harder for the New York
Stock Exchange to uphold the high standard.
Most important, all of the reform proposals currently focus
on what I call the supply side of corporate governance, what
companies, directors, and auditors must do. And none of this
will work unless we focus on Mr. Moore's side, the demand side,
what shareholders can and must do. I'm really happy to see
North Carolina weighing in here. Of course, your state, Madam
Chairwoman, has been the leader in this field, but what is
wrong with the other 48 states? Why don't we get the public
pension funds playing more of a role?
In the hotly contested Hewlett-Packard merger this year,
every vote counted. It was closer than Bush-Gore. In the
equivalent of the butterfly ballot, we had Deutsche Asset
Management, one of Hewlett-Packard's largest investors, voting
against the deal, and then getting paid a million dollar fee
from Hewlett-Packard; and then voting for the deal; and then,
of course, being upheld by the friendly courts of Delaware. If
we're going to allow that level of corruption on the
shareholder side, we will never have any meaningful oversight.
I draw your attention to the work done in the U.K. by the
Myners' Commission, which has been very, very worthwhile in
One thing that Senators understand better than anyone else
is the importance of a system of checks and balances to guide
the exercise of power and protect citizens from abuse. The
corporate system of checks and balances has been allowed to all
but tip over completely. The failures at what I believe are the
edges of the system have taught us some important lessons about
the obstacles to market efficiency, what we need to do to make
sure that the checks and balances are restored, and I hope to
be a constructive voice in that process.
Thank you, again. I welcome your questions.
[The prepared statement of Ms. Minow follows:]
Prepared Statement of Nell Minow, Editor, The Corporate Library
Mr. Chairman and members of the committee, I want to begin by
thanking you for inviting me to appear today. American investors,
consumers, and employees have been deeply shaken by the stories of
corporate corruption, and it has been very gratifying to see the Senate
and Congress move so quickly to respond.
My father, asked to speak to a group of new young lawyers at his
firm, told them that the most important goal was to get the client to
trust you. One young man asked him how to do that, and my father
responded, ``Well, you can start by being trustworthy.''
This is a lesson that our corporate leaders must learn. In a way,
we have all been enablers for bad behavior by corporate managers and
directors, rewarding them at a level unprecedented since they used to
give kings their weight in gold. Unfortunately, like that thankfully
outdated form of compensation, ours have not provided optimal
incentives, and managers have therefore opted for short-term self-
dealing rather than long-term, sustainable growth in shareholder value.
The complicating factor here is that there have been so many
failures by so many different entities that it is a challenge to
provide an effective and coordinated response.
I want to speak briefly about five problem areas and the place most
likely to provide some improvement. The one area I do not plan to
address is accounts and accounting firms, because I believe that it has
been thoroughly covered by the pending legislation. I will be happy to
answer questions about that issue as well as the others I am raising at
the end of my testimony.
1. Stock Options and Pay Disclosure
We all have to take a moment to accept some responsibility for the
problem here. Stock options would not have gotten so out of hand if not
for our last attempt to address these problems, back when CEO pay was
grabbing headlines in 1991. The result was a classic lesson in the law
of unintended consequences. Congress amended the tax code to put a
ceiling on deductibility of CEO cash compensation at $1 million, but no
limit on performance-based pay, meaning options. The result: all base
pay got raised to $1 million and the average option grant went from the
thousands to the millions. The stock doesn't have to do very well for 2
million options to be worth a lot of money. Seventy percent of option
gains are attributable to the overall market, not the performance of an
individual company, much less the individual recipient of the options.
And the tax code provides enormous obstacles to the most legitimate
option grants, indexed options, which would make sure that the
executives are rewarded only for their company's performance.
To make things worse, the SEC changed the rules to permit
``cashless exercise'' of options instead of encouraging or requiring
executives to hold on to the shares.
I do not believe Congress should get involved in setting accounting
standards. In fact, Congress was the problem the last time this came
up, with an unprecedented interference with FASB's attempt to require
that option grants be expensed. FASB wants to do the right thing, and
has additional support from the investor community and the
International Accounting Standards Board. All we need to do is get out
of their way and protect FASB from political interference.
What Congress should do is revisit the tax code to redefine
performance-based pay. Our recent report compares U.S. option grants,
which are generally not linked to performance, to those in the UK. Our
tax code should encourage compensation plans that truly link pay to
long-term performance and not short-term books-cooking.
The SEC should rescind its rule and prohibit cashless exercise of
Finally, the SEC should go back to its original disclosure
requirement for the top five highest paid executives. That rule was
changed to apply only to ``officers,'' creating a huge loophole that
permits companies to evade disclosure of crucial information.
2. Enforcement of Existing Laws
The SEC under the previous administration and the one before that
has done a poor job of coordinating with the Justice Department and as
a result, there have been far too few criminal prosecutions for
securities fraud. Oversight committees should insist that the SEC and
DOJ work closely together to eliminate petty bureaucratic differences
and present to Congress a meaningful plan for enforcing the laws
already on the books and making it so painful to violate securities
laws that the bad guys will reconsider and try something a little less
It would help a lot if we had a full set of SEC Commissioners, and
now would be a good time to put one or two investor advocates on the
commission, instead of the usual suspects who come from the other side.
One action has already been thrown out because two of the three sitting
SEC commissioners had conflicts. Let's get five commissioners on board,
with backgrounds with enough diversity that we will not have that
3. Boards of Directors
The greatest failure at Enron, WorldCom, Adelphia, Global Crossing,
and Tyco was not the failure of the accountants, analysts, or
regulators. It was the boards of directors. We need to think carefully
about a system that takes capable, honorable, experienced people and
puts them into a situation that does not allow them to do a good job.
What is it about the atmosphere of the boardroom that causes the most
distinguished people in America to lose half of their IQ points and all
of their courage?
Unfortunately, the Federal Government plays more of a role in a
local elementary school than it does in the boardroom. Our tradition is
to leave that role to the states, and that means Delaware, which long
ago won the race to the bottom by providing the most management--and
director-friendly legislature and court system in the country. Now, of
course, Bermuda beckons, and I hope Congress will cut off that route
before any other companies escape American law entirely.
But if we are to leave it to state law, we must create a race to
the top by allowing shareholders to choose the state of incorporation.
Every 5 years, shareholders should be allowed to submit a proposal to
change the state of incorporation. That would encourage
experimentation, innovation, and, especially, consideration of
The SEC should also require additional disclosure, including all
relationships between directors and officers of the company. And we at
The Corporate Library are hoping that our new board effectiveness
rating will someday become as important a part of the risk assessment
of an investment as the company's credit rating and performance
4. The Exchanges
The Self-Regulatory Organization structure has permitted the foxes
to guard the chicken coop. No wonder the chickens are scared. The
exchanges usually act as though they work for the issuers. In a rare
exception, the NYSE has produced a truly outstanding proposal for
enhancing its listing standards. NASDAQ, on the other hand, has
produced a proposal most charitably described as disappointing. If the
NYSE is not going to run the risk of scaring its listed companies over
to the more forgiving confines of the NASDAQ, the SEC has to have
authority to require it to match the NYSE's standards.
5. The Shareholders
All of the reform proposals currently focus on what I call the
``supply side'' of corporate governance--what companies, directors, and
auditors must do. None of this will work unless we also focus on the
``demand side,'' what shareholders can and must do.
Institutional shareholders manage the largest accumulation of
investment capital ever assembled. They include pension funds, mutual
funds, foundations, endowments, and others. There was a lot of
information about the potential problems at Enron, Global Crossing,
Adelphia, and WorldCom. Why didn't they act on it?
In the hotly contested merger at Hewlett Packard and Compaq this
year, every vote counted. One of HP's largest shareholders, Deutsche
Asset Management, voted against the merger. Then they got a million
dollar fee from the company. Then they changed their vote. Then the
This was challenged in the Delaware courts. But the Delaware court
upheld it, partly because, as I said earlier, they cater to management
because they want to keep that nice, clean income from the companies
``domiciled'' there. But the other reason was that the challenge was to
HP, and whether what they did was fair to HP shareholders. Putting that
issue aside, who is going to challenge it from the Deutsche Asset
Management side, and ask whether what they did was fair to the people
whose money they manage, the people who trust them to buy, sell and
vote stock based on what is right for them, regardless of what fees
they generate for themselves?
Where are the SEC and DOL? They both have the right to investigate
the exercise of proxy votes by institutional fiduciaries. But despite
extensive evidence of the deepest level of corruption and
mismanagement, there has never been a single enforcement action brought
because of the failure to exercise shareholder rights, including proxy
voting, in the interests of investors or plan participants.
Both agencies should issue prompt, clear, and unequivocal
statements to the institutional investors under their jurisdiction
calling for the strictest possible controls to ensure that proxy votes
are cast with integrity.
Institutional investors should have to disclose their proxy voting
policies and any votes inconsistent with those policies. They should
log every attempt to get them to change a vote.
Here is why these issues are suddenly so striking: The rising tide
lifted all the boats and the boom market hid a multitude of shortcuts
and fudges. But as the tide went out, boats foundered on the rocks, and
some of the rocks fell over, revealing some nasty creatures underneath.
One thing that Senators understand better than anyone else is the
importance of a system of checks and balances to guide the exercise of
power and protect the citizens from abuse. The corporate system of
checks and balances has been allowed to all but tip over completely.
The failures at what I still believe are the edges of the system have
taught us some important lessons about the obstacles to market
efficiency and about what we need to do to make sure that the checks
and balances are restored. I hope to be a constructive voice in that
Thank you again, and I welcome your questions.
Senator Boxer. Thank you to the whole panel.
Here's what we're going to do. We have a vote on the Senate
floor. I'm going to stay here till Senator Fitzgerald comes
back, then he's got some questions. And at that point, Senator
Dorgan should be back, so we're just having a little rolling
Mr. Moore, I also want to commend you for exposing
conflicts of interest at Merrill Lynch, working with Elliot
Spitzer, who you probably know we had before us. And I talked a
little bit about that. And on the Sarbanes' bill, I had an
amendment which was blocked by Senator Phil Gramm which would
have said that not only does an analyst have to say that he or
she owns the stock when they're making a recommendation, but
that members of the immediate family, that has to be disclosed,
I think that's important information, for two reasons. One,
you may decide, well, if the guy believes so much in it and he
has it, maybe it's a good thing; or, maybe it's a way to push
the stock up. And that's up to you. But at least it's what you
said; it's disclosure. And I wonder how you felt about my
amendment, if you thought that was a good idea, because we
still want to try to make the bill stronger in the conference.
Mr. Moore. Well, I've never seen a situation where
disclosure is not a good thing. And I think one of the things--
one of the reasons that I felt so strongly about this over the
last few months is that the leaders of Wall Street and the
leaders of corporate America, they're spending other people's
money, and it struck me as odd--they were much more like you
and me, who answer to the voters. And I remember the first time
I signed a bond offering document coming to the public
marketplace to borrow money for my state, I signed under the
oath of perjury. I mean, I faced a penalty that the corporate
executives did not.
So the more disclosure--we live in a glass bowl spending
other people's money--the better. And I'm not saying they have
to publicly disclose, but they should at least disclose to
their customers like me.
Senator Boxer, I would support that. I think you will see,
thanks to your state and your State Treasurer, who is my good
friend, we have more--as of 2 days ago, we have more than $600
billion behind the proposals that Elliott Spitzer and I wrote.
I don't think the market is going to be able to tell us no on
this, because what we're asking for is reasonable and right and
they owe us a clear fiduciary duty. So I think we're going to
get a lot of disclosure.
Senator Boxer. Good, because if you don't, then you don't
know who to believe or what to believe. It's sad that--you
know, we used to count on, as Ms. Minow said and I said before,
the checks and balances, that if something went through the
system, that at least the auditor would find it, somebody in
the corporation would speak up, so on and so forth.
And what we're seeing is just everybody's in the tank, you
know, from the--we heard that from Mr. Spitzer, from reading
his materials, and I'm sure you know this, that there was one
period of time where Merrill Lynch never issued a sell order.
They never suggested that a company they recommended be sold,
because they had all this involvement with them. It's just
So, you know, we try to clean that up, but we also want to
have a layered defense, which is, if you don't trust that
person, let's get to the disclosure. And I really--I really
want to thank you.
I'm going to ask one question.
Ms. Claybrook. Senator Boxer, could I----
Senator Boxer. Yes. Please.
Ms. Claybrook --comment on that?
Senator Boxer. Please.
Ms. Claybrook. I got a letter the other day from a member
of Public Citizen. He's a lawyer. He said he was trying to
decide what stockbroker to hire, and he looked at the different
forms that you have to sign when you hire a stockbroker. And he
said every single one of them required him to agree to
arbitration and to give up his right to go to court if he
wanted to challenge something that the company had done.
And, you know, here we have Merrill Lynch, who happens to
be my stockbroker, having engaged in these tremendous wrongs.
And when you sign that form, you have to agree to go to
arbitration. And the problems with arbitration are you have to
put the money up front--you, the consumer--in order to have an
arbitrator. These arbitrators again and again represent the
business defendants, so they don't want to irritate them too
much, because they won't be hired in the next arbitration by
that business defendant. And there's no discovery, there's no
opportunity for class actions, that is, for a lot of small
people harmed to joined together.
And so it seems to me this is an issue that should also be
addressed here, that this is like a private judicial system
that's being created, and it protects companies like Merrill
Lynch and others from ever having to disclose anything. So you
talk about public disclosure--well, it's one thing to require
regular disclosure. It's another thing when they misbehave to
get disclosure. And one of the ways that you get disclosure is
through lawsuits and discovery. And if you can't file a lawsuit
and you can't get discovery, the likelihood of your succeeding
as an individual investor is zilch.
Senator Boxer. Well, I want to thank you for that point.
And I think that you're right. And you're absolutely right. If
people know that there's no price they have to pay at the end
of their lies and their cheating and their scandalous behavior,
they'll just continue it. You know that's what we're seeing.
It's a very sad day in America, but that's what we're seeing.
And this whole notion, I never thought about arbitrators as
being perhaps in another conflicted situation, so I think we
need to take a look at how we can avoid that, because you're
right, if they want to be hired again, then they ought to come
down on the side of the business.
Ms. Claybrook. Well, the key issue here is it's mandatory
predispute arbitration. I love arbitration. I think arbitration
is fine. But if I'm required to go to arbitration----
Senator Boxer. I hear you.
Ms. Claybrook.--before the harm ever occurs, in order to
even get a stockbroker. That is where the wrong is. And this
individual who wrote to me said he checked every major
stockbroker in America and could not find one that didn't
insist on arbitration. So there's essentially a collusion among
the stockbrokers in America to insist that you have arbitration
so that there's no penetration of the wrongs that they do by
Senator Boxer. Right. Well, you've raised yet another layer
of an issue that we have to get to.
Because I'm going to be late now, I was hoping that Senator
Fitzgerald would come back, but he should be back shortly, or
Senator Dorgan, and so I will say adieu for the moment while I
go vote, and we'll stand adjourned until the next chair
Senator Fitzgerald [presiding]. We're going to call this
meeting back to order. I appreciate your indulgence while we
had a vote. I voted, and then--now Senator Boxer's voting. And
at 11 o'clock, actually, we're supposed to go to a second
hearing on somewhat different matters. And I do want to wrap up
with some rounds of questioning that will have to be brief by
necessity, and we apologize for that.
I know Senator Boxer discussed stock analysts, and I do
believe, to some extent, we addressed that in the Sarbanes
bill. But, again, I wanted to follow up on my comments from the
opening round about the lack of expense recognition of stock-
option compensation expense on earnings reports. And I noted in
my opening remarks that, according to a recent study, the
earnings of the Standard and Poors 500 companies in 2001 were
overstated by over 30 percent.
And I'd like to start with Ms. Minow. What effect do you
think this news coming out, that earnings reports are inflated,
is having on the stock market now? Do you think that is
inhibiting institutional and other investors because they're
really not sure that they can rely on the earnings reports of
companies that are out there?
Ms. Minow. Senator, I believe that there are a number of
reasons that investors feel that they can't rely on the
earnings reports. I had a reporter call me yesterday on this
issue of expensing stock options, and he said, ``Well, we just
really don't know how to value them, so how can we value
them?'' I said, ``Well, right now we are valuing them. We're
valuing them at zero.'' We're valuing them at a lot more than
zero when we give them away. But when we tell the shareholders
what we've done, we're saying that they're not worth anything.
And if they're not worth anything, then why don't you give them
to me? I'll take them. So I think that this is one of many
reasons that investors are feeling very shaky right now.
Also, ironically, as we are beginning to expense them, as
Coca Cola and Bank One and a number of companies have announced
that they're going to expense stock options the formulas are
based, in part, on past performance of the stock. We may be
getting overvaluations of these options, because it's unlikely
that the market will continue to perform as well as it has
Senator Fitzgerald. I have a follow-up question on that.
Some companies, particularly in Silicon Valley, pay ordinary
expenses--like they have a bill from their law firm, they'll
pay it in stock options. Do they--does anybody know whether
they're expensing those bills when they pay them in stock? And
my understanding is that they do, they have to expense it when
they're paying anybody but their own employees. What is the
public policy rationale if you pay an expense to your own
employees in options for not expensing it, but if you pay it to
a law firm or pay some ordinary bill in stock options, that you
do expense it?
Ms. Minow. Yes. In the go-go years, even landlords were
asking to have their rents paid in stock options.
Senator Fitzgerald. That is an expense, right? They do have
to report that as an expense on their earnings report?
Ms. Minow. It's an operating expense, absolutely, and
you've pointed out exactly the logical flaw, the fallacy, and
the corruption at the heart of this one exemption. Everything
else that the company pays out in the form of compensation does
have to be expensed. And this one great big loophole has
created a very perverse incentive and a distortion of the
Senator Fitzgerald. Now, let me ask you this. When a
manager has millions of stock options and they could make
millions of dollars--Ken Lay cashed out, I think, $250 million
worth of his stock options in Enron. There are many examples of
corporate executives who just feasted on options and can make a
lot of money by keeping the stock price of their corporation
high, and that often depended on keeping the earnings per share
high. At a certain point, when there's so many options in the
hands of senior management, doesn't that become somewhat of an
incentive to goose the earnings to keep the stock price high so
that the management can profit from their own stock options?
Ms. Minow. There is no question about it, and there have
been academic studies documenting corporate announcements and
developements and relating them to the exercise of options.
That's why I believe that it's very important that we rescind
this SEC rule that permits cashless exercise of options and
require those who exercise options to put the money down and
hold onto the stock, because that will truly align their
interests with the interests of the shareholders.
I want to really emphasize one point here. Seventy percent
of option gains are attributable to the overall market and have
nothing to do with the performance of the individual company.
And the fact that our tax system makes it impossible to give
out indexed options has also contributed to that same----
Senator Fitzgerald. Are you saying that's like rewarding
the weatherman because the weather turns out good?
Ms. Minow. Except that the weather turns good less often
than the market does well, so, in fact, it's a better bet.
Furthermore, just a few years ago, 100,000 options was
considered to be a very generous grant. They literally
redefined the term ``mega-grant'' of options, because everybody
was getting them. And if you have a million options, the stock
doesn't have to do that well for you to make a million dollars.
Senator Fitzgerald. There's one famous company, and I won't
mention its name, but it's my understanding they earned $5
billion last year; but if they had recorded an expense for
their stock options, they would have reported zero earnings.
Now, there are two ways of looking at that. They earned
nothing--one way of looking at it is they earned nothing, but
figured out a way to tell the public they earned $5 billion.
Ms. Minow. Right.
Senator Fitzgerald. Or another way of looking at it is that
they earned $5 billion, but they transferred the $5 billion in
profits to their employees and, to a lesser extent, their
management, and, to a lesser extent, their rank and file
employees. My question is, would not an investor be irrational
to want to hold stock in a corporation where 100 percent of the
profits are transferred to the employees? Why would someone
want to hold stock in a company like that?
Ms. Minow. You're completely right. And they're transferred
to the employees in a way that's very dilutive to the
shareholder value, not only to the shares themselves, but to
the voting rights that go with them. And the answer is, that's
why companies don't want to expense their options, because if
they told the truth about it, nobody would want to buy stock.
Ms. Claybrook. Mr. Chairman, I think it's also the point
that it's very hard for the investors to figure out how many
options are being given. This is not an easy type of
information to find. The calculation you just made, it may be
Senator Fitzgerald. Since it's not reported. But the
institutions have figured this out. I mean, they're coming into
my office begging to require expensing of stock options. But,
Ms. Claybrook. It's certainly not something that's readily
available to the average citizen, and I was just going to say
that Mr. Moore was talking earlier about transparency and
availability of information, and certainly we've done a lot of
research through the SEC files. It's not easy. Most consumers
could never do this. Most investors could never do this.
Senator Fitzgerald. So won't they just stay away from the
market? Figure this is a fool's game?
Ms. Claybrook. No, no----
Senator Fitzgerald. You think they'll--you don't--I mean,
aren't they doing that, to some extent, now?
Ms. Claybrook. They are now, because there's this huge
corporate crime wave going on, but, by and large----
Senator Fitzgerald. What's the motive for goosing the
earnings, though, if it isn't to cash in on the options?
Ms. Claybrook. Well, I completely agree that it is. I mean,
that is absolutely what it is.
Senator Fitzgerald. So isn't that the root cause, then?
Ms. Claybrook. Oh, I believe it is one of the root causes
of it, but when they goosed the earnings, they engaged in a lot
of illegal acts, and if there's no----
Senator Fitzgerald. But why goose the earnings unless it's
to pocket the money that, individually, you can make from your
own options and then leave the company?
Ms. Claybrook. That's the incentive, but if there's no
enforcement for doing it, then they're going to keep on doing
Senator Fitzgerald. Well, why don't we remove the incentive
to goose the earnings. I guess that--Mr. Moore?
Mr. Moore. And you're hitting on a couple of points,
Senator First of all, the reason that it's done to begin with,
the reason that people look at using options, is the tax policy
in place. You know, if you want to peel that back to root
cause, and both of you, Senator Boxer and Senator Fitzgerald,
have both made equally compelling points on this. Instead of
getting caught up on whether options are good or bad or not,
examine whether the taxing policy that encourages the use of
them is something you want to do.
And I would urge you to look back at another thing. We're
one of the few nations in the world that double-taxes
dividends. You know, maybe it wasn't such a bad thing for the
quality of corporate earnings to pay out dividends. And I've
been working with a group, with Warren Buffett, who, you know
how strong his opinions are that the quality of corporate
earnings are the worst they have ever been. Let's maybe take a
step backwards in that way.
Now, I agree with you, Senator Fitzgerald. I think it is
the root cause. As someone who spent several years of their
life prosecuting smart, white-collar criminals, there are two
types of people in the world that do these things--one, the
people who are criminals the day they enter the business, and
we're never going to stop them. I mean, the only thing is we
can prosecute them to the full extent of the law.
But there is the type of person that, if there is an
incentive--and I believe you're right; it's tied back to
options--that if they tell the truth or they lie, next year
they make $500,000, no matter what. If they tell the truth or
they lie. Well, which one are they going to do? They're going
to tell the truth.
Now, if you change the scenario, and if they lie, they make
$10 million next year, instead of a half million. Well, that's
a decision many people don't want to be faced with, and that's
what options do.
Senator Fitzgerald. So they're----
Mr. Moore. But it goes back----
Senator Fitzgerald.--giving incentives for good people to
do bad things.
Mr. Moore. But you didn't, you weren't here during my
testimony. And I think an appropriate middle ground on this is
do as you've done in food labeling, do as you've done in so
many things. If this is a contentious area, make them put it in
the proxy statements, in the annual reports, in a clear and
Senator Fitzgerald. How about in the earnings statement?
Mr. Moore.--and the market----
Senator Fitzgerald. How about the earnings statement?
Mr. Moore.--will take care of the options that do not align
management and ownership.
Senator Fitzgerald. But are you----
Mr. Moore. Because those are the----
Senator Fitzgerald. You're in favor of putting it in the
proxy statement and the annual report. It's already in a
footnote in the annual report. What I'm suggesting is they
should expense the expense in their earnings report. Are you in
favor of expensing stock option compensation on the earnings
Mr. Moore. I am in favor of that, but if you, as a body,
get caught up between the two, what I'm saying, at a minimum,
please put it in boldface, not in a footnote somewhere, so we
can value these overhang and run rates. We can do this. The
institutional investor can do this. And if we kill the stock
price, then we look after the small investor.
Senator Fitzgerald. Well, thank you.
Senator Boxer [presiding]. Let me just disagree. I don't
think good people do what these people did. So I will disagree.
Good people don't hide losses and show them as profit. Good
people don't do that. And so I do believe there are good people
who don't do that, but I don't believe the people who have done
Senator Fitzgerald. Do you believe that it's a temptation
Senator Boxer. I'll be happy to yield to my friend.
Senator Fitzgerald. Do you believe it's a temptation at
Senator Boxer. You know, I guess I'm a person that's kind
of right and wrong, black and white. It's the kind of family I
grew up in, it's the way I am. And I was taught, you know, you
don't take a two-cent lollipop out of that candy store even, if
it's right out there. Even when I was a little kid, and, boy,
if I ever did it, that would have been it.
So I would like to tell you that we need to do something
about changing the law here, because just note, this scandal,
the illegalities were not the exercising of the stock options,
as we've all pointed out; this is the law. So we need to do
something to change it. Some think if you expense it, you solve
the problem. I do not. Because I believe what will happen then
is the little guy gets squeezed out, the big guy will still get
it and will still be able to manipulate.
But I want to just put in the record what I think the roots
of the scandal are. Accountants acting as consultants, OK?
Analysts making false recommendations because of conflicts of
interest, Enron and others hiding losses in special-purpose
entities, executives encouraging their workers to put their
retirement savings, 100 percent of it, in employer's stock as
they were unloading--that's wrong--claiming false earnings. And
the rules of the game allowed them to do this.
But yet and still there's a lot of illegalities. Insider
trading, I would add, which I hope we're going to get to later
So I just want to thank the panel from my perspective,
because I think you've given me some great ideas. And, Ms.
Minow, I want to talk to you a little further about the ideas
you've put on the table, as far as how we should treat these
options, because FASB can meet today and do whatever they want.
And my fear is, you know, it will have unintended
consequences. We will take these away from the--out of the 11
million people, 10 or 11 million, we'll take it away from the
hardworking middle class, lower class folks, and the upper
class will still get their options and they'll still be able to
do all these things, these bad people will. And I want to make
sure that we have a fix here that's much broader than an
accounting fix, and that's what I'm working on. And I heard you
talk about that, holding periods and so on and so forth.
And so I want to thank you all. Mr. Chairman, we've had a
series of rolling chairs, and we're back to you.
Senator Dorgan [presiding]. Let us thank the witnesses and
excuse them. Thank you for your contribution.
[Whereupon, at 11:15 a.m., the hearing was adjourned.]
A P P E N D I X
Prepared Statement of Hon. Gordon Smith, U.S. Senator from Oregon
Mr. Chairman, thank you for holding this hearing today on
the perspective of improving corporate responsibility. So many
investors in this country have lost hope. They have lost hope
that honesty and integrity guide the businesses of America. A
sad state of affairs has led us to create a system of increased
checks and regulation. I am committed to preventing further
corruption and dishonesty from entering into corporate America.
I am proud of the legislation passed unanimously by the Senate
last week, S. 2673, the Public Company Accounting Reform and
Investor Protection Act of 2002, and I will continue to fight
for needed reform.
In the weeks before this bill was passed, I proposed an
Investors' Bill of Rights. I worked with colleagues on both
sides of the aisle to come up with bipartisan goals to prevent
corporate abuse and protect investors. I feel that there are
changes that investors should be able to count on coming out of
the United State Congress. Many changes will be made as a
result of this bill . . . and in other areas we may have to
I believe that investors must have access to information
about a company. We should ensure that every investor has
access to clear and understandable information needed to judge
a firm's financial performance, condition and risks. The SEC
will have the power to make sure companies provide investors a
true and fair picture of themselves. A company should disclose
information in its control that a reasonable investor would
find necessary to assess the company's value, without
compromising competitive secrets.
I believe that investors should be able to trust the
auditors. Investors rely on strong, fair and transparent
auditory procedures and the concept of the Oversight Board in
the Sarbanes bill is a sound one.
I believe investors should be able to trust corporate CEOs.
Unlike shareholders or even directors, corporate officers work
full-time to promote and protect the well-being of the firm. A
CEO bears responsibility for informing the firm's shareholders
of its financial health. I support the concept of withholding
CEO bonuses and other incentive-based forms of compensation in
cases of illegal and unethical accounting . . . further I do
believe that CEOs must vouch for the veracity of public
disclosures including financial statements.
I believe that investors should be able to trust stock
analysts. Investors should be able to trust that
recommendations made by analysts are not biased by promises of
profit dependent on ratings. It is only common sense that there
should be rules of conduct for stock analysts and that there
must be disclosure requirements that might illuminate conflicts
Finally I believe that we should be able to rely on the
Securities and Exchange Commission to protect investors and
maintain the integrity of the securities market. Current
funding is inadequate and should be increased to allow for
greater oversight--ensuring investors' trust in good
During the debate on this bill my attention has been called
to the plight of public pension systems, such as Oregon's
Public Employment Retirement System--known by the acronym PERS.
PERS was invested in both Enron and WorldCom stock and has been
hit hard by the debacles that occurred in each company. The
PERS system lost about $46 million after Enron self-destructed
and another $63 million following the WorldCom scandal.
These losses occurred because false profits were inflated
and corporate books were doctored. Under the PERS system, an 8
percent rate of return is guaranteed for the 290,000 Oregon
active and retired members of PERS. Oregon taxpayers have to
make up the difference following an ENRON debacle or WorldCom
scandal--and my state's budget is not prepared for this kind of
Further, I am interested in finding out if there is more we
can do. I am asking the General Accounting Office, in
consultation with the Securities and Exchange Commission and
the Department of Labor, to report to Congress on the extent to
which federal securities laws have led to declines in the value
of stock in publicly traded companies and in public and private
I believe that a study of this nature is necessary because
many public and private pension plans continue to rely on the
continued stock growth in publicly traded companies--much like
the PERS system. I believe that such a study would provide the
needed information so public and private pension plans can
reevaluate future investments in publicly traded companies.
We cannot stand by and watch our hard working Americans'
pension systems ruined while corrupt corporate executives take
advantage of investors. I am proud of the work the Senate has
done in the last week in creating accountability and
responsibility in corporate America and look forward to working
on this issue in a way that will help the investors and
pensioners in the PERS system in Oregon.
Thank you Mr. Chairman.