[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]



 
                  ACCOUNTING UNDER SARBANES-OXLEY: ARE
                  FINANCIAL STATEMENTS MORE RELIABLE?

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

                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 17, 2003

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-52



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                          WASHINGTON : 2004
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          CHARLES A. GONZALEZ, Texas
    Carolina                         MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California                 HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois               RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin                KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania      JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona             STEVE ISRAEL, New York
VITO FOSSELLA, New York              MIKE ROSS, Arkansas
GARY G. MILLER, California           CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania        JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           ARTUR DAVIS, Alabama
TOM FEENEY, Florida                  RAHM EMANUEL, Illinois
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania              
GINNY BROWN-WAITE, Florida           BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director



                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    September 17, 2003...........................................     1
Appendix:
    September 17, 2003...........................................    43

                               WITNESSES
                     Wednesday, September 17, 2003

Donaldson, Hon. William H., Chairman, Securities and Exchange 
  Commission.....................................................     5
McDonough, William J., Chairman, Public Company Accounting 
  Oversight Board................................................     7

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    44
    Emanuel, Hon. Rahm...........................................    45
    Kanjorski, Hon. Paul E.......................................    47
    Donaldson, Hon. William H....................................    48
    McDonough, William J. (with attachment)......................    59

              Additional Material Submitted for the Record

McDonough, William J.:
    Written response to questions from Hon. Jeb Hensarling.......    82


                  ACCOUNTING UNDER SARBANES-OXLEY: ARE

                  FINANCIAL STATEMENTS MORE RELIABLE?

                              ----------                              


                     Wednesday, September 17, 2003

             U.S. House of Representatives,
                   Committee on Financial Services,
                                           Washington, D.C.
    The Committee met, pursuant to call, at 10:07 a.m., in Room 
2128, Rayburn House Office Building, Hon. Michael Oxley 
[chairman of the Committee] presiding.
    Present: Representatives Oxley, Baker, Bachus, Lucas of 
Oklahoma, Kelly, Gillmor, Ose, Biggert, Shays, Miller, Capito, 
Kennedy, Hensarling, Garrett, Barrett, Frank, Kanjorski, 
Maloney, Watt, Hooley, Sherman, Inslee, Capuano, Ford, Lucas of 
Kentucky, Crowley, Ross, McCarthy, Baca, Matheson, Miller, 
Emanuel, Scott and Davis.
    The Chairman. [Presiding.] The Committee will come to 
order.
    Members are advised that we are, again, having difficulties 
with the audio system. The House recording studio has provided 
us with their last-resort backup system. The Chair apologizes 
for the inconvenience, but members should share the wireless 
microphones we have placed throughout the room for the 
remainder of the hearing.
    The Chair recognizes himself for 5 minutes for an opening 
statement. In light of the changing House schedule and after 
consultation with the Ranking Minority Member, the Chair asks 
unanimous consent that opening statements be limited to 16 
minutes per side, evenly divided, and that recognition for 
opening statements be limited to the Chair and Ranking Minority 
Member of both the full Committee and the Subcommittee on 
Capital Markets, Insurance and Government-Sponsored 
Enterprises. All members's opening statements will be included 
in the record. Without objection, so ordered.
    We are pleased today to welcome our distinguished 
witnesses. Last year, in the wake of an unprecedented erosion 
of investor confidence, the Congress responded by passing 
historic corporate reform legislation.
    The centerpiece of the one-year-old law, the Public Company 
Accounting Oversight Board, is charged with the critical task 
of ensuring that audited financial statements are informative 
and accurate. It is well known that trust in the financial 
reporting system is a foundation of our capital market system.
    Today we will hear from Board Chairman Bill McDonough, who 
assumed the reins of the PCAOB just a few months ago. I have 
known Chairman McDonough for some time and can say with great 
confidence the Board could not have a better leader. His 
actions to date illustrate his dedication to rigorous and 
effective oversight of the accounting industry.
    Thus, we should feel confident that under the leadership of 
Chairman McDonough and the other members of the Oversight 
Board, this new regulatory body has already changed the 
financial reporting system for the better and his work has only 
just begun.
    We will also hear, of course, from the Securities and 
Exchange Commission, which must approve all of the Board's 
proposed rules and sanctions. Chairman Donaldson has 
demonstrated exemplary leadership in his first year at the 
Commission. To cite but one example, enforcement actions 
against securities law violators have increased under his 
supervision. I look forward to his testimony.
    The Public Company Accounting Oversight Board is off to a 
good start. It has taken a number of important organizational 
steps, including hiring a first-rate staff, establishing strict 
ethics rules and standards of conduct for Board members and 
staff, and reviewing hundreds of registration applications.
    There are still difficult issues remaining to be resolved, 
including treatment of non-U.S. auditors, establishing 
permanent professional standards for auditors of public 
companies and implementing the soon-to-be-enacted inspection 
and investigation rules. Some have raised concerns about the 
cost of compliance with the new rules for a smaller firm. While 
it is essential that the new regulations governing our 
financial reporting system not leave dangerous gaps, it is also 
important for regulators to conduct an appropriate cost-benefit 
analysis in crafting these regulations. I know the Board is 
working diligently on these matters and I look forward to 
hearing more about the Board's progress on these issues today.
    The Chair would announce that I consulted with the Ranking 
Member. He has to be on the floor, as I speak, on a piece of 
legislation and will be returning shortly. In the meantime, I 
would like to recognize the gentlelady from New York for an 
introduction.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 44 in the appendix.]
    Mrs. Kelly. Thank you very much, Mr. Chairman.
    I simply want to say it gives me great pleasure to see two 
of my constituents sitting at the table before us. Both of them 
bring a great deal of knowledge and solid experience in their 
fields to the fore. I am so pleased that both of them have 
chosen to put that knowledge to the use of the United States of 
America.
    I look forward to their testimony today. And I thank you 
very much for letting me introduce two men from Westchester 
County, New York.
    The Chairman. I thank the gentlelady.
    The Chair now recognizes the subcommittee chairman of the 
Capital Markets Subcommittee, the gentleman from Louisiana, Mr. 
Baker.
    Mr. Baker. Thank you, Mr. Chairman. I thought you were 
about to make a really important announcement there.
    [Laughter.]
    I want to commend the Chairman for his continued leadership 
on this and many other matters, particularly his good work on 
the Sarbanes-Oxley Act. It has been, unbelievably, a year since 
the President signed what was historic legislation. I believe 
our panelists this morning are going to give us important 
insights into the effectiveness of that effort.
    We all know that in the performance of our capital markets, 
investor confidence is really the singular cornerstone on which 
it succeeds or fails. Americans, logically, will simply not 
participate in a system they believe that is inherently unfair 
or does not disclose appropriately the information to make 
informed decisions.
    Pursuant to Enron, WorldCom, Tyco and all the others, the 
average investor had a very cynical and cautious view of market 
performance. The Congress was called on, this Committee, and 
the Chairman responded with important legislation. It went a 
very long way to help restore investor confidence and provide a 
framework to ensure that markets would work in a transparent 
and fair manner for all participants.
    The PCAOB is well on its way to helping ensure the 
integrity of key financial information and be readily relied on 
as authentic and as equally available to all participants. 
Sarbanes-Oxley was a first step in restoring confidence, but 
there is much work yet to be done.
    I want to speak at the moment, even though the FDIC is not 
present this morning, to the importance of work they are 
engaged in with a pilot relative to extensible business 
reporting language, which is now underway for about 300 
federally insured depositories. Once this technology has proven 
its valued, then next year the FDIC intends to extend mandatory 
participation to all 8,400 institutions. And I will suggest to 
the Chairman that at the appropriate time, after the viability 
and value of that system has been determined, that it be made 
applicable to all publicly traded corporations.
    However, recent revelations with regard to another 
important market sector is cause for concern. Over 95 million 
Americans invest in mutual funds, making these funds by far the 
most popular choice among working families to provide for 
retirement or their children's education. Recent revelations 
provided by the SEC and other state officials have seemed to 
indicate significant and widespread abusive practices.
    On July 23, this Committee reported out, by unanimous vote, 
I would add, in response to many of these concerns, legislation 
which would enhance transparency and the fairness of disclosure 
in mutual fund fees. During the debate, concern was expressed 
by members that the legislation may have gone too far. After 
all, at that time of consideration there was no ``scandal'' in 
the mutual fund industry.
    However, as we meet here today, the SEC and the New York 
attorneys general are taking civil and criminal actions against 
market participants. These funds manage literally hundreds of 
billions of dollars of investor money. I do not now think 
anyone can or should say that there is not a problem worthy of 
correction.
    H.R. 2420, the Mutual Fund Integrity and Fee Transparency 
Act, was drafted to provide investors with an accurate picture 
of what was going on. And frankly, when drafted I thought it 
perhaps went as far as one could logically go. In light of the 
revelations recently disclosed by the SEC, I am not sure we 
have, frankly, gone far enough.
    As we look around today, my fear is that the bill may need 
dramatic additional work. I hope, time permitting, to look at 
another hearing later in the year, perhaps early next, and to 
receive the agency's comments and recommendations on whatever 
public policy modifications may be justifiable.
    I thank each of our panelists and certainly the Chairman 
for his continued leadership.
    The Chairman. The gentleman's time has expired.
    The Chair now recognizes the gentleman from North Carolina, 
Mr. Watt.
    Mr. Watt. Thank you, Mr. Chairman.
    Ranking Member Frank had to go to the floor to control time 
on the first suspension bill that is on the calendar today, and 
asked me to say a few words in his stead. He didn't tell me 
what to say, so from this point on, I am kind of on my own.
    [Laughter.]
    But I am sure that he would want to first thank Chairman 
Oxley for convening this important hearing. Reflecting back on 
when we debated Sarbanes-Oxley in the Committee, there was a 
tremendous tension between those who wanted to put more content 
and standards into the law itself, versus those who thought 
that, yes, we needed to do something to restore public 
confidence, yet we should not be rushing into micro-managing 
and writing in this Committee what the standards should be, and 
we should be delegating that instead to a more thoughtful 
process and body to develop those standards.
    That did not mean for those members who lost that debate, 
and the debate was lost to the delegating side, it certainly 
didn't mean that the members who wanted to control the process 
more and write the standards into the law should be left out of 
the process. I think the way members will feel more at ease 
about what we have done in setting up the process we have and 
delegating to them the authority to write the standards is for 
the Committee to continue to exercise aggressive oversight.
    I think that is the importance of this hearing because this 
is the first one on this particular topic. I think a number of 
people feel that the jury is still out, as it should be, and 
the standards are evolving, as they should be, in response to 
what the market needs and what standards need to be developed 
in response to potential problems that may develop in the 
market.
    So I think the importance of this hearing is to get 
feedback from the agencies to which we have delegated authority 
and said, ``You go, think about this, talk to the industry, 
talk to the public and decide what the appropriate new 
guideline should be and report back to us. And let's keep 
talking to each other and keep Congress in the loop through 
this process.''
    So this is an important hearing to hear what these bodies 
have been doing and to keep Congress involved. I applaud the 
Chairman for convening the hearing to give us an oversight role 
to set the people at ease who were advocating more for more 
aggressive standard-setting in the law itself as opposed to the 
delegation.
    I am looking forward to hearing what has been done with the 
delegation of authority to move us toward a more secure and 
safe set of standards in the accounting field and financial 
reporting field and financial statement field, in particular, 
today.
    I thank the witnesses who will be testifying today and 
thank Mr. Frank for giving me the opportunity to frame the 
issue in this way. I thank the Chairman for convening the 
hearing, so that we can continue our involvement constructively 
in this process.
    I yield back the balance of my time.
    The Chairman. The gentleman yields back.
    The gentlelady from New York is recognized.
    Mrs. Maloney. Thank you very much, Mr. Chairman. And I 
thank the two panelists for being here today and they both have 
served and lived in New York.
    Passage of the Sarbanes-Oxley legislation last year was an 
achievement. From what I have read and, based on interactions 
with business men and women, I believe it is making a positive 
impact on returning trust to our financial markets.
    Many people think that our financial markets run on 
capital. I think it really runs more on trust. While the law is 
working, it was drafted in a rushed response to some tremendous 
scandals. I believe it is very appropriate for this Committee 
to revisit this work and recognize that it may need to be 
improved in the future.
    Today I am very, very pleased to have Chairman Donaldson 
and Chairman McDonough before the Committee to report on the 
law's impact thus far. Chairman Donaldson and his staff have 
worked exceptionally hard to implement the law. I thank them 
for all that they have done.
    I also want to thank Chairman McDonough for his appearance 
today and for his decision to take this important job. He 
served with great distinction, they both did, in New York and 
have taken on really tremendous challenges for the whole 
country.
    As a new entity, the Board truly benefits from having 
someone with your distinguished background as its chairman. I 
thank you for all that you did in New York at the Fed and for 
your willingness to take on another public service assignment.
    So I thank both distinguished former New Yorkers for the 
work that they have done at the stock exchange, at the Fed, in 
private business and for deciding to serve their country. I 
look forward to your testimony. New Yorkers are very proud of 
you.
    The Chairman. Does the gentlelady yield back?
    Mrs. Maloney. Yes.
    The Chairman. Actually, Ms. Kelly indicates they are still 
New Yorkers. They may not be in New York City or even the East 
Side, but They are still New Yorkers.
    Let us turn now to our distinguished panel. The Chair is 
pleased to recognize first the Chairman of the Securities and 
Exchange Commission, the Honorable Bill Donaldson.

 STATEMENT OF HON. WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES 
                    AND EXCHANGE COMMISSION

    Mr. Donaldson. Chairman Oxley, Ranking Member Frank and 
members of the Committee, thanks very much for inviting me to 
testify today.
    Seven weeks ago, I had the pleasure of standing next to 
you, Chairman Oxley, and other leaders in Congress, as we 
marked the 1-year anniversary of the Sarbanes-Oxley Act. I want 
to compliment the Members of Congress again for your leadership 
in passing critical reforms at a time when we faced a growing 
crisis in investor confidence in our securities markets.
    Since the passage of Sarbanes-Oxley, the SEC has been hard 
at work implementing this vital legislation. Today you have 
asked me to testify on one element of the new law, the 
accounting profession and what the SEC is doing to strengthen 
it. The centerpiece of our efforts is the Public Company 
Accounting Oversight Board or PCAOB, if I may refer to it as 
such, and I will focus my comments on this important entity.
    I am pleased to have this opportunity to appear with Bill 
McDonough and to report to you on the Board's significant 
progress. I also want to assure you that the Commission is 
dedicated to working with the PCAOB to accomplish its mission, 
including restoring the confidence of investors in the 
integrity of the audit process and in the reliability of 
financial information that fuels our nation's securities 
markets.
    In a matter of months, the joint efforts of the commission 
and the PCAOB have turned what was an outline on paper into an 
energetic organization that is guided by a hardworking and 
entrepreneurial staff. The Board is absolutely vital to our 
markets going forward, and it has already launched a number of 
important measures, such as accepting accounting firm 
registrations, collecting the funds authorized by Sarbanes-
Oxley, initiating inspections of accounting firms, developing 
rules for its disciplinary programs and writing new auditing 
standards.
    We at the Commission were extremely pleased when Bill 
McDonough assumed the chairmanship of the PCAOB in June. He is 
exceptionally qualified to lead this important organization. We 
are fortunate that he agreed to accept the challenge.
    Prior to Bill's arrival, the other four board members, 
Kayla J. Gillan, Dan Goelzer, Bill Gradison and the Acting 
Chairman Charley Niemeier worked hard and effectively to make 
significant progress in developing the Board's operational 
infrastructure. As a result of their efforts, the Commission 
certified in April, as required by law, that the PCAOB 
possessed the capacity to meet the requirements of the 
Sarbanes-Oxley act. Under Mr. McDonough's leadership, we expect 
the Board to implement reforms that will restore confidence in 
the integrity of the financial information investors use every 
day to make investment decisions.
    While the PCAOB operates separate and distinct from the 
Commission, the Act vests the Commission with oversight 
authority and responsibility over PCAOB. In addition to 
appointing Board members, the Commission approves all of the 
Board's rules and professional standards before they may become 
effective, approves the Board's annual budget, acts as an 
appellate authority for PCAOB disciplinary actions and disputes 
relating to PCAOB inspection reports, and may assign additional 
tasks to the Board as appropriate.
    As part of its oversight, the Commission also has the 
authority to inspect the PCAOB in much the same way it inspects 
the securities exchanges and the National Association of 
Securities Dealers.
    I am pleased to report on the Commission's active role in 
helping the PCAOB meet its mandate. To date, the Commission has 
published three notices of PCAOB rulemaking, promulgated six 
orders related to the Board's financial matters and rules, 
published a Commission notice regarding auditors of broker-
dealers's financial statements registering with PCAOB, and 
provided the Board with three advances to fund its initial 
operations. There is a full explanation of these activities and 
a chronology in my written statement.
    The Commission and the PCAOB staffs have worked closely 
together during the past months on all of these efforts. In the 
startup days of the PCAOB, before the Commission recognized it 
as fully operational, Commission staff formally met in weekly 
meetings with the Board and its staff. The two staffs were in 
daily contact on matters related to the Board's organization, 
staffing, rulemaking and budget.
    Now that this critical infrastructure is in place, the 
Board can focus more on increasing its consideration of new and 
improved professional standards, on implementing its inspection 
process and beginning its disciplinary program.
    Joint consultations with the Commission continue on the 
Board's numerous projects, and we expect to maintain a close 
working relationship with the Board. As the Board expands its 
capability to carry out its mission on its own, the Commission 
will look increasingly to its expertise in setting and revising 
auditing standards and regulating the auditing profession, 
while continuing in our primary role to provide guidance and 
oversight.
    In conclusion, I can assure you that the PCAOB is off to a 
very strong start and is developing strong internal processes, 
policies and expert personnel that will enable us to beat the 
expectations that you set forth in the Sarbanes-Oxley Act.
    A strong PCAOB is absolutely vital to the integrity of our 
nation's security markets, but it alone cannot restore investor 
confidence in the integrity of the accounting profession. There 
must also be a willingness on the part of everyone in the 
industry to place the interests of investors above all else. 
Remaining independent and telling it like it is, is 
fundamental. The PCAOB can help install this culture, 
particularly with the leadership and integrity of a respected 
figure like Bill McDonough at its head.
    We are all fortunate to have him leading the Board's 
efforts, and I will leave it to him to describe the details of 
the Board's infrastructure and its other major initiatives.
    Thanks again for inviting me to testify.
    [The prepared statement of Hon. William H. Donaldson can be 
found on page 48 in the appendix.]
    The Chairman. Thank you, Mr. Chairman.
    And now we are pleased to turn to the Chairman of the 
Public Company Accounting Oversight Board, Mr. William 
McDonough.

  STATEMENT OF WILLIAM J. MCDONOUGH, CHAIRMAN, PUBLIC COMPANY 
                   ACCOUNTING OVERSIGHT BOARD

    Mr. McDonough. Chairman Oxley, Ranking Member Frank and 
members of the Committee, I am pleased to appear before you 
today on behalf of the Public Company Accounting Oversight 
Board.
    This is the first appearance of a PCAOB member before this 
Committee. On behalf of the Board, I would like to begin by 
commending the leadership shown by the members of this 
Committee as you addressed the crisis in public confidence 
brought on by the corporate failures of the last 2 years. The 
legislation, now law, that you worked so hard on, is a landmark 
reform of corporate governance and oversight and you should be 
proud.
    I am both proud and humbled to appear before you today as 
Chairman of one of the products of your hard work, the Public 
Company Accounting Oversight Board. There are many reasons I 
was willing to take on this job. Among them were my own strong 
feelings about the corporate scandals and the lack of 
leadership in the private sector. The mission of the PCAOB, as 
spelled out in the Act, gave me an opportunity to act on those 
strong feelings.
    When I joined the PCAOB on June 11, the day after I left 
the Federal Reserve Bank of New York, I found four fabulous 
colleagues, all as dedicated as I to the Board's mission. Those 
colleagues, Charley Niemeier, Bill Gradison, Kayla Gillan and 
Dan Goelzer, had already made tremendous strides in writing the 
unprecedented new rules that are required by the Act.
    We have a rapport and a collective will to maintain that 
momentum and fulfill the mandate you gave the PCAOB to protect 
the interests of investors and the public in the preparation of 
informative, accurate and independent audit reports for public 
companies.
    The Board started from scratch in January of this year and 
has grown to a talented and dedicated band of about 85 full-
time professional staff. We hope to be a force of 200 by year-
end, as we perform the four primary functions that Sarbanes-
Oxley set out for us: registration, inspection, enforcement and 
standard-setting.
    Let me start with registration. Under the Act, any 
accounting firm that audits a company whose securities trade in 
U.S. markets and any firm that plays a substantial role in 
those audits must be registered with the Board in order to 
continue that work. Under the law, U.S. firms must be 
registered with us by October 22nd. We have received more than 
450 registration applications from U.S. accounting firms and 
the Board will review each of those applications.
    The Board also voted to require non-U.S. accounting firms 
to register if they audit companies whose securities trade in 
U.S. markets. We recognize the special issues that arise with 
that requirement, so the deadline for non-U.S. firms to 
register is well into next year. In addition, we have begun a 
dialogue with our counterparts in other jurisdictions in order 
to find ways to coordinate in areas where there is a common 
programmatic interest.
    Registration is a prerequisite for accounting firms to 
continue their work as auditors of public companies. It is also 
the foundation established in the Act for the PCAOB to perform 
its important functions of inspection and enforcement.
    We have proposed far-reaching rules for inspections of 
registered firms, but we have not waited for those rules to be 
final to begin our inspection work. With the cooperation of the 
four largest firms, we have already begun limited inspection 
procedures at those firms in advance of registration.
    Going forward, our inspection staff, made up of 
experienced, skilled audit professionals, will annually inspect 
each accounting firm that audits more than 100 public company 
clients. Smaller firms will be inspected every 3 years.
    Through these inspections, we will be looking, of course, 
for fundamental compliance with professional standards. But our 
inspectors will also look closely at other things that bear on 
the quality of a firm's audit work.
    We will look at what we call the tone at the top. We want 
to know the nature of the communications coming from the 
highest levels of the firm. We want to know that the leaders of 
the firm and of audit teams get the message that Sarbanes-Oxley 
sends about the firm's responsibilities. We want to know that 
the message is reaching the firm's rank and file. We want to 
know what kinds of work the firm rewards through its 
compensation system. And we want to know how a firm decides to 
retain or fire a client.
    Registered accounting firms are subject to PCAOB 
inspections and they are also subject to enforcement authority. 
We are empowered to investigate possible violations of our 
rules, securities laws and professional standards. If we 
conclude that a firm has violated the rules, we have the 
authority and the responsibility to impose sanctions, even to 
the point of revoking a firm's registration or barring an 
individual from participating in audit work.
    The Board has proposed rules for investigation and hearings 
that are intended to implement our authority in a fair way, 
preserving all appropriate rights for the person subject to our 
jurisdiction. We expect to adopt final rules later this week or 
early next week, hurricane deciding.
    Finally, I want to outline our progress with respect to 
audit standards. The Act charged the Board with establishing 
auditing and related out-of-station standards, quality control 
standards, ethical standards and independent standards. The Act 
gave the Board the option of setting standards on its own or 
designating any professional group of accountants to propose 
new standards.
    Before I joined the Board, my fellow Board members made the 
decision not to delegate standard-setting to the accounting 
profession, but to have that responsibility rest directly on 
the Board's own shoulders. I firmly believe this was a wise and 
prudent decision and I strongly support it.
    The Board established an internal standard-setting division 
and began recruiting a talented in-house staff of professional 
auditors. Because of our access to information from our 
inspections and investigations programs, the Board and our 
standard-setting staff will be in a unique position to 
understand and head-off problems and practices. We will also 
tap the expertise of a standing advisory group made up of 
experts from a variety of fields.
    The first standards to come from the Board will be those 
prescribed in the Sarbanes-Oxley Act relating to auditors out 
of station, to management's assessment of internal controls. We 
held an excellent public roundtable discussion on internal 
controls in late July and we intend to have final rules in 
place by early 2004. We will hold another roundtable later this 
month to discuss audit documentation as we prepare to set 
standards in that area.
    But standard-setting registration, inspection and 
enforcement, the responsibilities you gave the PCAOB through 
the Sarbanes-Oxley Act, are tremendous. I have faith in our 
staff that my fellow Board members and they and I will live up 
to your expectations.
    I have not been shy about telling members of the accounting 
profession that we expect a lot from them, and that they will 
have to work harder than they could have imagined before 
Sarbanes-Oxley.
    Through a succession of scandals, the entire profession 
came to be judged harshly. But you and your colleagues, through 
the Act, did not merely judge them, but you gave them a 
meaningful shot at redemption. In my mind, facilitating that 
redemption and not just punishing miscreants is a key 
objective, one that the Board must not lose sight of even when 
we are, as we will need to be, tough on the profession.
    As we work toward that objective, my fellow Board members 
and I look forward to a long and constructive relationship with 
this Committee and with the Securities and Exchange Commission.
    Thank you.
    [The prepared statement of William J. McDonough can be 
found on page 59 in the appendix.]
    The Chairman. Thank you, Mr. Chairman.
    And thanks to both of you for your excellent testimony.
    Let me begin by asking Chairman Donaldson the issue that 
has been brought up a number of times to me, and I am sure to 
you, and that is the extraterritoriality issue as it relates to 
foreign firms that are listed in the United States. It is also 
that issue that would come before the Board.
    The number of contacts that I have had since the passage of 
the Act have been even to cause some concern within the 
European Union and European Commission as it relates to 
regulation on both sides of the Atlantic. I know that we tried 
in the legislation to provide as much flexibility to the SEC 
and to the Public Company Accounting Oversight Board regarding 
the registration of accounting firms.
    Where are we now? What has happened since the regulations 
were promulgated to you, Chairman Donaldson? And what else 
needs to be done to assure that we will provide the highest 
level of regulation, but at the same time recognize the 
inherent differences sometimes in various countries's attitudes 
toward the board make-up and corporate governance?
    Mr. Donaldson. The Commission approved the PCAOB rules 
requiring foreign auditors to register with the PCAOB. The 
PCAOB made significant accommodations in its registration 
system for foreign accounting firms, however, including 
eliminating the potential for compliance with the PCAOB 
registration provisions' resulting in a violation of the laws 
in an accounting firm's home country. They narrowed the scope 
of the information provided. They extended a deadline for 
foreign firms to register.
    If I can characterize this, I think there has been a 
correct insistence that the foreign firms will register. I 
think under Chairman McDonough's guidance now the PCAOB is 
working to, (A), understand and, (B), accommodate the 
particular circumstances that exist in certain foreign 
countries. They are also trying to accommodate foreign firms by 
utilizing some of their own domestic methodology, if you will, 
to achieve our purpose, which is the oversight of those firms 
that are working for U.S.-registered companies.
    Bill, I don't know if you want to add anything.
    The Chairman. What kind of feedback have you gotten so far 
regarding your ability to round off some of the sharp edges of 
the law and to accommodate it to those firms?
    Mr. Donaldson. Right. Going back to the beginning, and 
really prior to Bill McDonough's arrival, the PCAOB Board held 
a roundtable, if you will, an open discussion with 
representatives from countries throughout the world, and all of 
the members of the SEC were there to listen to those comments. 
I think it was a tremendously educational experience for all of 
us to focus in on particular problems each country had.
    I think since that time the understanding that we gathered, 
and now with the arrival of the Chairman, the feedback that I 
am getting is very good from Europe. I think that there is a 
feeling there that we want to work with them and that we are 
not going to simply impose in a regimented way without taking 
into consideration the particular problems that they have.
    The Chairman. At that point, you are referring specifically 
to the accounting firms, correct?
    Mr. Donaldson. Right.
    The Chairman. What about in a general sense with the 
initial law covering foreign companies listed on the exchanges 
here? What kind of feedback were we receiving after the regs 
came out regarding them?
    Mr. Donaldson. Are you referring to overseas or 
domestically?
    The Chairman. Overseas.
    Mr. Donaldson. Overseas. Yes, I think that, again, the 
reaction is not dissimilar to the reaction we have had 
domestically as we push ahead to implement the Sarbanes-Oxley 
laws. I think there is an initial reaction of reaching out to 
lawyers and advisers and thinking about the costs of 
implementing these regulations. I think as time has gone on, 
people are beginning to realize that the impact of the law is 
going to help them in their own internal governance.
    Truly there will be a cost, but I think the benefit that 
will be received and is being received is gradually being 
recognized. That is not universal. There are still some that 
are concerned only with the cost side, and I hope that the 
benefit side will soon appear.
    The Chairman. Thank you.
    One last question, if I may, ask of you, Chairman 
McDonough. The SEC recently approved a $68 million annual 
budget for you by assessing fees on public companies's mutual 
funds based on their relative market capitalizations. For a 
start-up, your Board needed a federal loan to pay for the 
initial cost with setting up your organization. Does the Board 
intend to reimburse the federal government for that $68 million 
loan?
    Mr. McDonough. Mr. Chairman, I am very happy to inform you 
that we have drawn, in three draws approved by the Securities 
and Exchange Commission, something in excess of $20.3 million 
from the Treasury of the United States and it will be repaid in 
full next Monday.
    The Chairman. Very good.
    With that positive note, I will now recognize the gentleman 
from Pennsylvania, Mr. Kanjorski.
    Mr. Kanjorski. Thank you very much, Mr. Chairman.
    Two question areas that I really have. Prior to the 
enactment of the law, there were 850 firms that were doing 
accounting for public corporations and I noticed from the Web 
site of the Board only 450 firms have applied for registration. 
Some of the management consultant people are predicting that in 
a not too distant period of time less than 100 firms will be 
doing corporate public accounting. Do you see any risk in this 
in limiting competition? And is there something we should do to 
encourage smaller firms to remain and to get involved in public 
auditing?
    Mr. McDonough. Congressman, we are hopeful that more than 
the 450 firms approximately which have applied for registration 
thus far will continue to apply. The registrations continue to 
come in.
    It would appear to me that there should be some additional 
number that are in the business, I think would like to stay in 
the business, and perhaps were looking at the October 22 
deadline, rather than noticing that we are supposed to have 45 
days to look at their applications. I can assure you that we 
will jump through every hoop possible to look at their 
applications on an accelerated basis and to register them by 22 
October.
    One does hear stories about certain small auditing firms 
that perhaps had one or two public companies that they were 
auditing, wondering if this is a business that they want to 
stay in. I very much hope that they do, because very large 
companies are typically audited by very large accounting firms. 
The smaller accounting firms audit small-and medium-size 
companies. And it is small-and medium-sized companies that 
create economic growth in the United States. That is where new 
jobs are created.
    So we want to do everything possible in everything the 
PCAOB does, to encourage small-and medium-size companies to 
stay in business. It would be tragic if a company that is 
relatively small that has gone public and really should have 
gone public and should stay public, should decide to go private 
just because of the Sarbanes-Oxley Act. I think we would all 
want to discourage that, I Assume, particularly the members of 
Congress who passed the Act.
    I can assure you that at the PCAOB, we will do everything 
we can. We have been reaching out to the small-and medium-sized 
accounting firms, reminding them, ``Hey, it's time to apply; 
please do so.'' And in talking with the accounting profession, 
we have encouraged them to use a concept that Chairman Oxley 
did in his opening remarks, and that is to apply a cost-benefit 
analysis. How much work did they really need to do in audit of 
a small-or medium-size company? It should be thorough and it 
should protect investors, but it doesn't have to do every bell 
and whistle that would be needed for General Electric.
    Mr. Kanjorski. I appreciate that, Mr. Chairman. I hope you 
keep us apprised if there is anything we have to do technically 
to help that out to keep the competition firm.
    Now I want to move to an area that I have discussed with 
Chairman Donaldson. I think this may be a good idea to throw up 
the issue. I notice that you would have authority to go in 
examining an auditing firm as to whether they acted properly or 
to their client to see whether they acted properly. And more 
than likely, in your investigative authority, you could ask for 
anything within that firm, including the e-mails.
    As you may recall, most recently the New York Stock 
Exchange engaged in an investigation of some of the specialty 
firms. It became a dispute between what is considered business 
e-mails and what are considered private e-mails, and it went to 
loggerheads. I think it has now been resolved by these 
specialty firms turning over what they considered private e-
mails.
    It goes to the issue of privacy. I am a little disturbed 
insofar as we have not thought-out a mechanism to protect 
communications between employees in firms of their private e-
mails, when they are caught up in an investigative process.
    Now, I have no problem with the Board or the SEC having 
that Authority, but we haven't put together any rules for 
nongovernmental entities that are doing this type of regulatory 
process. I was just wondering whether or not, if there is a 
dispute as to what is germane to the issue being examined by 
nonprofit organizations, that perhaps the Board would not be 
the proper arbiter of what is considered a germane e-mail to be 
considered and what can be held in camera, if you will, after 
the protest is filed.
    Mr. Donaldson, maybe I will direct that to you because you 
are aware of what I am talking about.
    Mr. Donaldson. I think the issue of confidentiality is one 
that the SEC wrestles with all the time. I think that, in the 
consultations with the PCAOB, we will attempt to work out those 
problems if there are problems.
    Mr. Kanjorski. I don't know if you had anything to do with 
the result of the issue on the New York Stock Exchange, but 
when regulators or quasi-regulators are involved with private 
entities and there is a question of private or business e-mail, 
do you think it would be appropriate for us perhaps to take 
some action to authorize or put the jurisdiction of the 
arbitration of that dispute within the hands of the SEC or the 
Board, and that they may be the properly constituted bodies to 
resolve that dispute so we don't have the invasion of privacy 
that obviously can occur in a very gross way?
    We don't seem to have any protection here, obviously 
because we have not been dealing with e-mails until most 
recently. But now we have seen a very flagrant example of how 
investigative authority even by a nongovernmental entity can be 
very invasive of privacy of employees within a firm. And there 
doesn't seem to be any resolve that we have structured to 
handle this. Perhaps this is a jurisdiction that we could give 
in public corporations to the SEC or to the Board. What is your 
thought on that?
    The Chairman. The gentleman's time has expired.
    The gentleman from Louisiana, Mr. Baker.
    Mr. Kanjorski. Can I have the answer on that?
    The Chairman. Oh, I am sorry.
    Did either gentleman wish to respond?
    Mr. McDonough. I think it might be indicative, Congressman, 
as to what the PCAOB's own role is regarding discretion.
    The Board has discretion to exercise its inspection 
authority in a manner appropriate to respect and protect 
individual rights. That is in the Act. I think what you are 
suggesting is, should there be something that would make the 
SROs have the same responsibility to protect rights.
    I think it will come up in every examination we do, 
especially as we get in, as part of the inspection of an audit 
firm, into their work on the audit of a particular client. But 
we take enormously seriously the respect of confidentiality, 
and our ethics code, which is awaiting approval by the SEC, is 
absolutely draconian on the issue not only when the person is 
an employee of the PCAOB, but for the rest of his or her life.
    Mr. Donaldson. Let me come back to your question. I was 
having a little trouble with your microphone there. I 
apologize.
    I think, part and parcel with our historical oversight of 
the SROs and stock exchanges and so forth has been the 
oversight of the enforcement aspects of those organizations, 
and in a way the procedures that they have to protect 
confidentiality.
    If you take a registered exchange, they all have 
constitutions. They all have constitutional rights, 
particularly on an investigative side, to investigate, to get 
data. We are very conscious, and I know many of them are very 
conscious, of the protection of that information that they get 
in a confidential investigative setting.
    The Chairman. The gentleman from Louisiana?
    Mr. Baker. Thank you, Mr. Chairman.
    I do believe that the consequences of Sarbanes-Oxley is to 
incentivize professional conduct and to bring about 
accountability where it does not occur. But in my judgment 
there is another pervasive incentive still within the context 
of the business world, the earnings report. Every 90 days, the 
CEO, the CFO begin from minute one of day one to figure out how 
to represent corporate performance in the most favorable light 
within the rules that currently constrain them, whether it be 
Sarbanes-Oxley or what may follow.
    It provides the investor with information which is a 
retrospective analysis of dated analytics that gives little 
indication about where the company may actually be going 
forward in risk-taking, new product development, customer 
satisfaction, any of those relevant pieces of information.
    What is more disturbing to me is that you may comply with 
the rules and do everything legally in conformity with 
expectations, but yet not provide an accurate portrayal of 
corporate financial conditions. It would seem to me that in the 
work going forward, and it would be a much larger task, that we 
really ought to evaluate the perspective of a more forward-
looking transparent disclosure regime that requires the 
disclosure of material facts that affect shareholder value when 
you, as a corporate official, become aware of that information. 
Not later, not take 29, 30, 45, 60 days to try to manage your 
way out before you disclose it, but to have almost mark-to-
market real-time disclosure as I believe would be provided by 
the XBRL pilot that the FDIC is now engaged in.
    I don't expect either of you to comment with regard to that 
technology today, but really want it on the record for both of 
your perspectives that I find the potential for that real-time 
disclosure regime to bring about real accountability, where you 
have the capacity to evaluate individual corporate performance 
against a relevant sector of the economy against the broader 
market. You can see the good guys from the bad guys.
    I think more information is always better than less. Some 
argue that this may add additional volatility. I can't see how. 
With what I see occurring with the whisper numbers on CNN or 
CNBC before the earnings reports come out the next morning, it 
is not very helpful to a stable functioning of the capital 
market. So I just wanted to bring that up for whatever it is 
worth in your future deliberations.
    Chairman Donaldson, I read with great interest the joint 
announcement by the Commission and NASD regarding formation of 
a working group to look at securities law enforcement. I want 
to commend you for taking this initiative. As you are aware, I 
have had great interest in this matter. H.R. 2179, which was 
reported from subcommittee, includes an amendment which was 
authored by Mr. Scott and myself that would reestablish SEC 
supremacy with regard to state remedies that impose new 
national market regulations.
    Would it be your intention that this working group will 
examine that particular issue?
    Mr. Donaldson. Congressman Baker, first I want to commend 
you for raising these important issues and encouraging us to 
focus our attention on a constructive approach to this 
important relationship. Your subcommittee sent a very strong 
message to both the Commission and the states regarding the 
need for communication, cooperation, and coordination on 
enforcement matters, particularly those that could result in 
new requirements affecting the operation of our national market 
system.
    The formation of this working group which you refer to, 
which will focus us on developing a sound protocol for our 
enforcement efforts at the State and federal level, is in large 
part intended to address these issues.
    I do want to be clear, however, that I know we both agreed 
that the states have played and must continue to play a vital 
role in security law enforcement, as the local cops on the 
beat. We should do nothing to diminish the enforcement vigor 
they bring to their work.
    Mr. Baker. Mr. Chairman, I agree with that view. In my 
opinion, H.R. 2179 did nothing to preclude such state action.
    But I understand the working group is now in its early 
stages. Do you have now an ability to give me an estimate of 
when those individuals on the Committee who were concerned with 
these issues can expect to see some working group 
recommendation?
    Mr. Donaldson. The working group is in its formative 
stages. As it comes together, it is going to develop an agenda. 
We expect them to submit a timetable for action on the agenda 
items. We will be encouraging members of the group to complete 
their work as soon as possible, and I would be happy to keep 
you apprised of the group's progress as we move along.
    Mr. Baker. Again, I want to thank you, Chairman, for this 
joint effort. I am inclined at this point to yield to the 
working group and give you the opportunity to resolve many of 
these issues. I would like to get your technical opinion on the 
revised language of Section 8B of H.R. 2179. The language would 
not, in my view, preempt by force of law anything the New York 
State Attorney General has done.
    As a matter of fact, I have even commended Mr. Spitzer, 
some days with more enthusiasm than others, I might add, for 
his efforts on behalf of mutual fund shareholders and for 
returning $30 million to injured investors. While it does not 
match the efforts of the SEC through the FAIR fund amounting to 
$1.4 billion, it is a very good start.
    In the Commission's opinion, would the language in H.R. 
2179 in any way, preempt states from carrying on such 
investigations?
    Mr. Donaldson. Chairman Baker, I appreciate your support in 
this effort, which I believe will help us to strike the balance 
necessary for effective and efficient enforcement of our 
securities law. I also appreciate your willingness to let us 
take some time to see where this process will take us.
    As to whether your proposed amendment would have impeded 
the New York Attorney General's efforts in the mutual fund 
area, let me start by saying that I am not qualified personally 
to give legal opinions, since I am not a lawyer. However, our 
legal staff has advised me that they do not believe your 
legislation would have come into play here. It is my hope that 
the working group will take a comprehensive look at all the 
federal-state efforts with respect to security law enforcement 
and that the end result would be one of more effective 
cooperation and coordination to the benefit of investors.
    Mr. Baker. I very much appreciate that perspective and look 
forward to working with you going forward.
    Finally, I am concerned about a related issue stemming from 
recent actions of West Virginia's Attorney General. Would you 
agree with the general principle that once an official has 
acted in an official capacity with respect to a state 
securities violation, a second official from the same state 
should not be allowed to double-dip or, in other words, that 
there should not be double jeopardy at the State level? Will 
the working group be examining this issue as well?
    Mr. Donaldson. As you know, this is a complex issue that 
has implications for both civil and criminal law enforcement. 
At the federal level, of course, the Justice Department and we 
bring parallel actions on the same underlying conduct quite 
frequently. Parallel civil actions by the same jurisdiction may 
be another story, of course.
    While this subject was not one that we had contemplated 
would be addressed in our working group, I believe it is an 
issue that merits further discussion.
    Mr. Baker. Thank you, Mr. Chairman. I want to commend you 
and Commissioner McDonough for both of your efforts in trying 
to bring about a functioning of a fair and efficient market for 
the benefit of all investors. Thank you.
    The Chairman. The gentleman's time has expired.
    The gentleman, Mr. Frank.
    Mr. Frank. Mr. Chairman, I have sat through a number of 
scripted colloquies on the floor of the House. I believe this 
is the first one I have seen in Committee. I am torn between 
commenting on the substance and complimenting the performance. 
The readings were quite good.
    Mr. Baker. I take that as a compliment. Thank you.
    Mr. Frank. I guess that underlines the delicacy of the 
subject, when the Chairman of the subcommittee and the Chairman 
of the SEC want to read that very carefully. I apologize for 
extemporizing on this subject, but nobody sent me my part. So I 
apologize. Perhaps I wasn't cast for it, but there is a certain 
amount of self-starting that is allowed.
    I must say with regard to that agreement with the 
regulators, et cetera, I spoke with the Secretary of State of 
Massachusetts, William Galvin, who has been one of the most 
energetic and I think constructive, State regulators here. I 
don't think he has done anything that in any way was disruptive 
of any need for uniformity where it exists.
    He has been, as I said, very energetic. He was very 
concerned about the negative implications of the gentleman from 
Louisiana's legislation. He also told me that he was not 
himself a supporter of this agreement that is just being 
discussed, and that he felt that there were others in the 
Secretary of State and the regulatory area who didn't. So 
obviously individuals are free at the State level to 
participate in what they want.
    I did want to report that, at least from my conversation 
with Mr. Galvin, who has been one of the most, as I said, 
creative and energetic users of State authority, he did not 
feel that he was bound by this process.
    I continue to be open to any examples people want to give 
me where State regulators interfered with a need for uniformity 
where it existed. On the whole, I think that the role of the 
various State regulators in New York and Massachusetts, and I 
have talked to some of my colleagues in other States who are 
very proud of the work that their regulators have done, I think 
it's been wholly supportive. Frankly, I think we at the federal 
level, and I would include the Congress as well as the 
executive branch and the independent agencies, have under-
performed in this area. All these things that have happened, I 
think all of us probably should have been paying more attention 
earlier.
    There are an awful lot of private activities going on out 
there, the overwhelming majority, of course, of which are 
entirely legitimate and wholly constructive, but I do not think 
we are at the point of having too many regulators. So I would 
be glad if people would give me examples of where they thought 
there might be a specific conflict. Perhaps Oklahoma is one, 
but I haven't heard anybody officially tell me that.
    I would just want to reiterate, one, that I continue to 
believe that legislation that would impinge on the state's 
ability to go forward would be a grave error. I do know that 
the State regulators who have been particularly active, the 
Attorney General of New York, the Secretary of the Commonwealth 
of Massachusetts, are very much opposed to the bill as it has 
existed because of its potential. If, as I said, there are 
examples of activities that interfere with uniformity, I would 
be glad to know them.
    So let me ask Mr. Donaldson, are there examples where State 
regulators have taken actions that in fact interfered with our 
ability to achieve what we all agree is necessary, some level 
of uniformity? Or uniformity, I guess by definition, if one 
state gets more active than other, it is not uniform.
    But have they interfered with the rational scheme that we 
need? Have states done things that were disruptive of our 
ability to maintain an overall scheme? Have we subjected people 
to inconsistencies, et cetera? So if you have any specific 
examples I would be glad to hear of them.
    Mr. Donaldson. To step back a moment, I think the issue 
here is that the SEC needs all the help it can get at the State 
and local area. We simply do not have the resources, even with 
our increased resources, to investigate malfeasance down at the 
local level. I applaud, as I have said in the past, the 
efforts, particularly the efforts recently by the Attorney 
General in New York, to bring to our attention areas of 
malfeasance.
    Where the problem arises is when the remedies, if you will, 
interfere with the national structure of the markets. That is 
our only problem.
    Mr. Frank. Has it happened? Are there examples of that? Are 
there examples of remedies imposed at the State level that have 
interfered with our ability to have a nationally structured 
market?
    Mr. Donaldson. I think there were potential examples of 
that on the global settlement had we not gotten together. This 
was basically before my time when that was negotiated. I think 
that was a perfect example.
    Mr. Frank. Okay. But in all fairness, the answer to the 
question of ``are there examples,'' is no.
    Mr. Donaldson. But to get very contemporary, I think that 
there was an action filed in Oklahoma by the Attorney General.
    Mr. Frank. The criminal case against Enron, or against 
WorldCom?
    Mr. Donaldson. It was an action which had already been 
worked on by the U.S. Attorney in New York and by the SEC, and 
we brought actions. This is the WorldCom situation. I think 
there is a danger here as it rolls out that that sort of an 
investigation could interfere with the very complex issues 
associated with it.
    Mr. Frank. Except that your work was pretty much completed. 
So again, let me ask you, and I will take this in writing after 
this, so I will have something in writing, too, and I won't 
feel left out of the writing process here.
    Would you send me any examples, not of potential conflicts 
between state regulatory actions and the need for a national 
structure, but any actual conflicts that have happened? If you 
could send me those in writing.
    Mr. Donaldson. I would be glad to give you a history from 
the SEC of conflicts where they have arisen. I can't give you 
that today.
    Mr. Frank. I am encouraged by that because I think you know 
a great deal. I will take the history. The later back they are, 
the less relevant they are. But yes, if you could give me that 
list that would be very helpful. I think would also be very 
short.
    The Chairman. The gentleman's time has expired.
    The gentleman from Oklahoma, Mr. Lucas.
    Mr. Lucas of Oklahoma. Thank you, Mr. Chairman.
    Gentlemen on the panel, let's shift for just a moment to a 
little different perspective. As I read Sarbanes-Oxley and the 
SEC rules, no accounting firm may provide tax services to any 
publicly traded company for which it serves as auditor, of 
course, without the approval of the company's auditing 
Committee. This additional layer of required scrutiny applies 
only to tax services provided by that company's auditor.
    I am concerned that in reality if at some point in time in 
6 months or 6 years corporate management wanted to engage 
perhaps in tax practices that were, to say politely, aggressive 
or, perhaps more descriptive, over the edge, that under the way 
this is coming together they would find substantially less 
scrutiny if they used anybody but the auditor for those tax 
services.
    I have dredged up a quote here from back in the year 2000 
from the SEC, that tax services generally do not create the 
same independence risks as other non-audit services, which I 
guess brings me back to my real point about aggressive tax 
planning.
    None of us want any companies to skirt the tax laws and to 
go beyond the pale, and if we should stop and recognize in that 
regard that the audit Committee approval process is our friend, 
do we potentially create the unintended consequence where 
basically anyone will secure their tax services from everybody 
but an auditing firm? Are we going to drive people over to the 
tax attorneys or other areas of advice? Will we ultimately not 
achieve what we want to do by this effort, gentlemen? I guess 
that is my curious question to you.
    Mr. McDonough. Which one of us do you want?
    Mr. Lucas of Oklahoma. I have great confidence in both. I 
would like insights from either.
    Mr. McDonough. Let me try my hand at it and then I will 
turn it over to Bill.
    I think there has been a sea change in the escalation of 
the responsibility of the audit Committee, in terms of just 
exactly who are the accountants working for. It is within that 
context that we have heightened the awareness of audit 
Committees to really delve into the potential conflicts of 
interest vis-a-vis accounting, auditing and other services. I 
think that it is very difficult to legislate that by rules. It 
is the on-the-scene oversight that comes from an awake and 
alert audit Committee.
    Mr. Donaldson. I think the key is the role of the audit 
Committee, When one is looking at how much the accounting firm 
that actually does the audit of a public company can do, the 
key that you are looking for is that they don't lose their 
independence.
    Now, there are those who say that they shouldn't be able to 
do any tax work at all. The SEC decided that they didn't agree 
with that, that the audit firm could do a considerable amount 
of tax work and actually there is a lot of basic stuff that the 
audit firm learns more about than anybody else except the 
management, simply in the course of doing the audit.
    So I think that there is not a question that it can be done 
and stay within the bounds of independence. Since it is a 
tricky area, it clearly should be approved beforehand and in 
considerable detail by the audit Committee.
    Now when we get to the area of very creative tax 
recommendations, I think that it would be impossible for the 
audit firm to provide that service and not lose independence 
because it would be in the position of auditing its own 
creative work. I think by definition it would lose 
independence.
    I do remember, though, that if the management went out and 
hired a consultant who would be immensely creative, the auditor 
and the auditing Committee have to look at that very creative 
recommendation and decide whether it is legal. I have the view 
that it should also decide whether it is moral. If it isn't, 
then the auditor should jump on it and the audit Committee 
should jump on it and that degree of creativity should be 
removed because it is not a good thing for investors or the 
American people.
    Mr. Lucas of Oklahoma. Exactly, and I share that 
perspective. I certainly am not a proponent of any concept of 
what my constituents would define as creative tax work. I just 
don't want us to create a situation by unintended consequences 
where in an effort to do the right thing, and I believe that is 
what this is well-versed on, we cause a shift of resources and 
we cause future management perhaps to look for alternatives to 
work their around against the existing rules, and we unfairly 
impede who are doing good honest efforts.
    I appreciate your response, gentlemen.
    The Chairman. The gentleman's time has expired.
    The gentleman from North Carolina, Mr. Miller.
    Mr. Miller of North Carolina. Thank you, Mr. Chairman.
    I suppose my question is for Mr. Donaldson.
    Among the provisions in the legislation enacted, Sarbanes-
Oxley, were attorney conduct standards. I know that the rules 
promulgated by the SEC pursuant to that legislation required 
attorneys to report up the line to the CEO any violations, and 
to the counsel and then the audit Committee if there is not 
appropriate remedial action. And then there would also be 
provision for a noisy withdrawal, for the attorney to say 
essentially, ``I am withdrawing; there is something wrong here; 
I can't say what it is, but there is something wrong here.''
    First of all, the rules that have been promulgated by the 
SEC, is there any evidence of how that is working? Are 
violations being reported and corrective action taken? And what 
evidence, if any, is there of what effect there might be on the 
candor of the relationship between issuers and their attorneys?
    Mr. Donaldson. Obviously this area of attorney 
responsibility is a complex one, given the long tradition of 
confidentiality associated with the legal profession. I think 
we have worked out now the issue of reporting up in the 
organization, the responsibility for the lawyers to report 
suspected malfeasance up to a recognized Committee, whether it 
be the audit Committee or some other point of contact.
    The issue of noisy withdrawal, if you will, and reporting 
out, I think that this has been a complex issue to work out. We 
have not written a rule on this yet. We have it under 
consideration. We have taken great encouragement from the 
changes in ethics responsibilities brought forth by the 
American Bar Association in August, basically in terms of their 
interpretation of lawyer responsibility. So I think we are 
moving toward a better understanding of how a rule might be 
written, though we haven't written it yet.
    Mr. Miller of North Carolina. With respect to the rules 
that you do have, do you have any evidence yet of whether top 
corporate management and CEOs, the audit Committees, the 
counsel, is learning about conduct they weren't learning about 
before and acting appropriately to correct it?
    Or the downside in that balance, the other side of that 
balance is the effect on the candor of the relationship between 
issuers and their attorneys. Do you have anything to go on yet? 
How is it working? I understood already that it was a complex 
issue, but how is it working, what we have done so far, or what 
you have done so far?
    Mr. Donaldson. I really think that it is too early to give 
you a definitive answer on that. It really is only fairly 
recently that the final year-long implementation of Sarbanes-
Oxley rules was accomplished. I can assure you that we will be 
monitoring as best we can how it is working. But I think it is 
too early to give you anything, except possibly anecdotal, but 
a meaningless reaction.
    Mr. Miller of North Carolina. One last question along the 
lines that Mr. Frank raised, with respect to litigation by 
State regulators or others and the orders that may result from 
that. My understanding of injunctive action where there has 
been a showing of wrongdoing is that frequently it is tailored 
specifically to the conduct specifically to the violations and 
tailored to try to make sure that the sinner go forth and sin 
no more.
    Why would you not want courts to have the flexibility to 
impose that kind of requirement where there has been a showing 
of a violation of law?
    Mr. Donaldson. The issue of State regulators and their 
ability to do what their mandate requires is something that our 
new Committee, between the State Regulator Association and 
ourselves, is trying to work out. I personally believe that 
this communication as quickly as possible is going to resolve a 
lot of the differences.
    I just want to emphasize that the thing we are concerned 
about is where the enforcement on the local level leads to 
structural changes in the way the markets are organized, and 
that is where the problem lies.
    The Chairman. The gentleman's time has expired.
    The Chair is pleased to recognize the gentlelady from New 
York, Ms. Kelly.
    Mrs. Kelly. Thank you, Mr. Chairman.
    One of the most important things that we tried to do with 
Sarbanes-Oxley was make sure that the people who had been 
defrauded of their monetary goods got that money returned. We 
established the FAIR Fund in Sarbanes-Oxley to try to do that.
    Chairman Donaldson, I would like to ask you, I think we 
both agree that we have to do everything possible to help make 
defrauded investors whole. Let us do everything to stop the 
fraud from investors.
    I think that given some of the recent settlements that 
states have engineered, it would be interesting to hear from 
you how many of those States have returned the money to the 
injured parties through the FAIR Fund or through any other 
means.
    Mr. Donaldson. Right after the global settlement, our 
Director of Enforcement, Steve Cutler, sent a letter to the 
states through NASAA encouraging them to return money back to 
the investors through the federal FAIR Fund. We understand that 
there are certain State regulations that preempt monies than 
going to the FAIR Fund, but we definitely encourage that 
vehicle wherever possible.
    Mrs. Kelly. Mr. Donaldson, if they can't give the money to 
the FAIR Fund, are there any States that you know of that have 
actually given the money back to the defrauded investor?
    Mr. Donaldson. I am trying to think of a couple of specific 
examples. Yes, there have been. I believe Missouri has used the 
FAIR Fund to return dollars to investors. A complete list of 
who has done that I guess would come from the NASD. But I 
think, as far as we are concerned, we are encouraging that in 
every way we can.
    Mrs. Kelly. I wonder if you would be willing, or Mr. 
McDonough if you know of any States that are returning the 
money? I am glad to hear that Missouri is. But it would be 
interesting to see if the states are in fact taking action and 
achieving large fines against these corporations, where that 
money is actually going. Is there any effort at the SEC to 
follow that money and see whether or not it is going back to 
the defrauded investors, because it is actually their money?
    Mr. Donaldson. We will definitely get back to you on that. 
But I want to say again that I agree with the concept of the 
FAIR Fund and the concept contained in Sarbanes-Oxley of 
returning monies to defrauded investors, that is where the 
money should go. Again, speaking personally, I don't feel we 
should be building roads with those monies, but we should be 
returning them to the investors who have been defrauded.
    Mrs. Kelly. I want to ask one more question. I have a 
little more time here. The Sarbanes-Oxley Act required the GAO 
to study the consolidation of accounting firms and the effect 
on competition. The GAO came back with its report in July and 
reported that the consolidation had occurred, and we were down 
to four huge firms. Yet, they didn't see that there had been an 
increase in the prices for audit services, which we were 
concerned about.
    They also reported, though, that there are significant 
barriers to any other auditing firm trying to build a business 
of auditing publicly held companies that would then build up a 
business that could challenge the Big Four.
    I am really concerned that the Big Four does not turn into 
the Final Four. So I am hopeful that you will answer a question 
about whether or not you are concerned with that kind of 
consolidation and if you have any plans to continue to study 
the trends in the industry and perhaps make sure that 
competition is out there, does not result in raised prices for 
accounting, and will in fact be a fair market for anyone trying 
to get in.
    I would really like an answer from both of you, if that is 
possible. Why don't we start with you, Mr. McDonough?
    Mr. McDonough. Thank you, Congresswoman.
    I think that there are two aspects to your question. The 
GAO study I believe made it quite clear that the real world 
that we will live in for quite a period of time is that there 
will be four big firms. That gives me an interesting challenge, 
as Chairman of the PCAOB, rather like the challenge that I had 
when I was a bank supervisor: Is there such a thing as a bank 
too big to fail? The answer is no, because as soon as you say 
yes, you have de facto nationalized the banking system.
    We cannot allow the Big Four accounting firms fed that any 
of them is too big to fail, but rather that they have to do 
everything internally to make sure that they improve the 
quality of their services, that they improve the level of their 
integrity in order that they deserve to stay in existence, and 
that is something the PCAOB will be looking at.
    Since it is not very likely that there will be a formation, 
say, of a group of regional firms or any other thing that would 
come together to be a new number five or number six or number 
seven or number eight, I think what we have to do, and I 
touched on this in response to an earlier question from Mr. 
Kanjorski, is to do everything we can to encourage the small-
and medium-sized accounting firms to stay in business, to grow 
their capability, to add to the services that they provide 
their small-and medium-size customers so that we don't get even 
more concentration in the Big Four.
    We will be making every effort to do that. But I think it 
is a combination of making every effort on all of our parts to 
get more competition into the accounting-auditing industry, and 
yet recognize that it is very highly concentrated and there are 
certain public policy issues that flow from that.
    Mrs. Kelly. Mr. Donaldson, do you want to answer that?
    Mr. Donaldson. I would concur with what Chairman McDonough 
has said. I believe that, when we step back from the situation, 
we do have a concentration. It is of concern. I think this is a 
policy issue.
    I think we will do everything in our power to encourage, as 
Bill just said, competition among accounting firms, among the 
four, but it is a problem. And I think that we will do 
everything that we can to encourage the smaller accounting 
firms.
    I think there are some 850 accounting firms in the country 
auditing public companies, and we will do everything we can to 
encourage them to continue to do so. I think that Chairman 
McDonough will, too, in terms of the registration of those 
firms and making it the least onerous it could possibly be.
    The Chairman. The gentlelady's time has expired.
    The gentleman from Georgia, Mr. Scott.
    Mr. Scott. Thank you very much, Mr. Chairman.
    Mr. Donaldson, consider me one of your foremost admirers in 
terms of the job that you are doing. It just seems like every 
day we read in the papers that the SEC is doing great work, and 
some of your actions. I think we have had about 443 since last 
October, and you are doing a great job.
    But as the Securities and Exchange Chairman, I would like 
to get your take, and I think we might be derelict in our 
responsibility if we didn't put this question to you, 
concerning Chairman Grasso. Could you give us your take on that 
issue? It just seems that this is raising some concerns about 
the credibility in our investing public.
    I mention that with great respect for Mr. Grasso. We had an 
excellent time going up as guests of the Business Roundtable 
and opening up the stock exchange. He is a fine person.
    But I do think the American people would want to know your 
take on this. Should he resign? Should he step down? And in 
your explanation of the huge compensation package, I would like 
to get your opinion on that, please.
    Mr. Donaldson. Let me try and put this issue in context. 
The SEC has a direct oversight responsibility for the 
governance of the New York Stock Exchange and for all the stock 
exchanges. Concern about the governance and the exercise of 
that oversight is why I sent letters to each exchange 6 months 
ago asking for a thorough review of their governance practices.
    Now, while this review is still a work in process, the New 
York Stock Exchange, in particular, came back to us with a 
movement toward changing some of their governance practices. 
While that was going on, reports began to surface about 
executive compensation at the New York Stock Exchange. That 
forced me to send another letter directly to the stock 
exchange, to the head of their Governance Committee, requesting 
detailed information about how such determinations were made 
and further questions about detailed aspects of the corporate 
governance structure.
    The information that we received gave us some very serious 
concerns about how the governance issues were being handled. 
Subsequent information and disclosure raised our concerns. 
Clearly, these are problems that have to be addressed.
    We will be asking the New York Stock Exchange some further 
questions based on the information we receive. We will be 
moving forward with an overall look at and reaction to the 
governance mechanism.
    But I want to emphasize specifically in terms of your 
question, your very direct question, that this is a matter of 
governance. You mentioned the Chairman of the New York Stock 
Exchange. I believe and I hope that with the publicity that has 
been reached here that the New York Stock Exchange Board itself 
will move with alacrity to look at their own internal 
mechanisms and look at them in terms of some of the disclosures 
that have been made. I think the first level of our oversight 
is to make sure they are doing that.
    We will come along as we finish our review and we will 
react to what they do and we will react to what we think we 
should do.
    Mr. Scott. So one can conclude then from your remarks that 
you don't think that Mr. Grasso should resign, but rather that 
the internal structure of how this came about, the compensation 
process itself, should be looked at. In other words, that the 
issue is the process, and not the person.
    Mr. Donaldson. I think that the issue here, Congressman, as 
I said before, is only partially the issue of exact 
compensation. The issue is how was that arrived at; what 
procedures were in place; how is it related to the other 
aspects of the financial side of the stock exchange. We have a 
responsibility, because we are active in approving fees that 
the stock exchange charges and so forth, so we have to have an 
oversight review on just how the Board arrived where they did.
    I think that my letter to the Chairman of the Governance 
Committee speaks for itself. I was upset by the disclosures, as 
were my fellow Commissioners. But I think we have got to put 
this in the context not of personalities, but of procedures.
    Mr. Scott. Thank you.
    The Chairman. The gentleman's time has expired.
    The gentleman from Connecticut, Mr. Shays.
    Mr. Shays. Thank you, Mr. Chairman.
    Mr. Donaldson, on June 25 Freddie Mac indicated its 
earnings could be restated by as much as $4.5 billion, and that 
its accounting lapses were more serious and more pervasive than 
previously announced.
    In its statement, the company also said the disclosure 
processes and disclosure in connection with those transactions 
and policies did not meet standards that would have been 
required if Freddie Mac had been an SEC registrant.
    Do you think Freddie Mac should be an SEC registrant under 
the 1933 and 1934 Act?
    Mr. Donaldson. Let me give you a little history on this.
    Mr. Shays. Not too long a history, I only have 5 minutes. I 
have a question. I just need an answer to it.
    Mr. Donaldson. Our position has been that there should be 
registration for both Fannie Mae and Freddie Mac. As you know, 
Fannie Mae has voluntarily agreed to registration and Freddie 
Mac has also. We are in the process of helping them prepare for 
registration. We were in the process when some of the issues 
arose in the press.
    I believe that they should be registered. I personally 
think, and we want to get to the bottom line, if we do it via 
voluntary registration or mandatory registration makes no 
difference to us.
    Mr. Shays. Is that true under both the 1933 and 1934 Acts?
    Mr. Donaldson. I think that we would draw a distinction 
between and have drawn distinction between their registration 
and a registration of the securities representing investments 
that they make.
    Mr. Shays. What?
    Mr. Donaldson. The floating of the investments that they 
make. We are instead talking about registration of the 
securities that are held by the public, ownership interests in 
both Freddie and Fannie.
    Mr. Shays. The head of the Federal Reserve, Mr. Greenspan, 
said that, in so many words, it's a no-brainer, of course, they 
should be under both the 1933 and 1934 Acts. Do you think there 
is a distinction? Do you agree with Mr. Greenspan?
    Mr. Donaldson. Distinction between what?
    Mr. Shays. He basically feels they should, like any other 
Fortune 500 company, have to comply with both the 1933 and 1934 
Acts. Do you disagree with Mr. Greenspan?
    Mr. Donaldson. Well, I would like to come back to you with 
a specific answer on that. I think these are complicated 
issues.
    Mr. Shays. It is true, isn't it, that the SEC has never 
taken a formal position on the 1933 Act. Is that correct?
    Mr. Donaldson. That is correct.
    Mr. Shays. Let me ask you this. Do you believe in the 1933 
and 1934 Acts? Do you think they make sense?
    Mr. Donaldson. Do we think the 1933 and 1934 Acts make 
sense?
    Mr. Shays. Yes.
    Mr. Donaldson. Yes.
    Mr. Shays. Okay. So following that simple logic, and your 
very generous smile, almost surprised that I would ask the 
question, why would we not have the 20th and 40th largest 
companies registered under New York Stock Exchange, and the 
second and fourth largest financial institutions, why shouldn't 
I smile in surprise that we would not have them under these 
Acts?
    This isn't a trick question.
    Mr. Donaldson. I want to give you a correct answer to this.
    In 1992, the Commission participated in a report on this 
subject. The Commission expressed its view that the disclosure 
for GSEs should comply with the disclosure requirements of the 
federal securities law.
    The Commission did not recommend in its 1992 report, nor 
has it subsequently believed that it would be appropriate, to 
remove the exemption in the federal security laws for the offer 
and sale of a mortgage-backed and related securities of the two 
entities. We do not believe it is necessary to repeal the 
security law exemptions for Fannie Mae and Freddie Mac.
    Mr. Shays. Okay. Why shouldn't I smile at the absurdity of 
saying that everyone else in the New York Stock Exchange has to 
register, and yet this company, particularly Freddie Mac that 
has shortchanged their statements by $4 billion or misstated 
them by $4 billion, shouldn't have to fit into the requirements 
that everyone else they compete with has to do? Why is it good 
for everyone else, but not Fannie Mae and Freddie Mac?
    I find it astounding, and no one has told me why they 
shouldn't comply.
    The Chairman. The gentleman's time has expired.
    He may respond.
    Mr. Donaldson. I think the issue of a government-sponsored 
enterprise, and particularly the issues of Fannie Mae and 
Freddie Mac, have been before a lot of the legislatures, 
yourselves and others. I think there is a reexamination of just 
what that means.
    I can only speak from the point of view of the SEC, and 
that is that we want to get them to register in the same way 
any other company does, in terms of the investor protections 
associated with that.
    The Chairman. The gentleman from Kentucky, Mr. Lucas?
    Mr. Lucas of Kentucky. Thank you, Mr. Chairman.
    Chairman Donaldson, as you are aware, I know FASB has 
recently proposed a new rule, FIN 46, regarding accounting for 
special purpose entities. Concerns have been raised about the 
difficulties it would create should this rule apply to the 
franchise or franchisee business model. Some of these 
franchisees are mom-and-pop operations. A lot of them are very 
big, but some of them are operating their financial records out 
of a cigar box.
    Do you believe that FASB should consider exempting these 
business models from the rules applications, the franchise or 
franchisee model?
    Mr. Donaldson. I think the FASB is looking at accounting 
associated with special purpose entities. I believe that we 
need to get back to you in terms of the work that the FASB is 
doing, and to understand better than I do right now, sitting at 
this table, exactly where they are at on those specific issues.
    Mr. McDonough. By chance, I know that the FASB is actually 
having a meeting this afternoon on the very subject that you 
are concerned about, Congressman.
    Mr. Lucas of Kentucky. Okay. Great. Because it seems like 
it is a practical impossibility for these folks to comply with 
those requirements. I mean, just to reach out that far to these 
franchisees who are very unsophisticated would be, I think, a 
virtual impossibility.
    Thanks. If you could get back to me. Thank you.
    The Chairman. Does the gentleman yield?
    Mr. Lucas of Kentucky. I yield back the balance of my time.
    The Chairman. The gentleman yields back.
    The gentleman from Minnesota, Mr. Kennedy.
    Mr. Kennedy. Thank you, gentlemen, for your testimony and 
your response to questions and your good work in restoring 
investor confidence, and the Chairman for having this hearing.
    I want to follow up on the questions that Congresswoman 
Kelly brought forth on consolidation a little bit. As part of 
the scandals that led to Sarbanes-Oxley, we went from five 
firms down to four, with one of those firms having an office 
that messed up, and the result being the entire firm was 
eliminated.
    My concern is, as good a work as you are working on, I am a 
finance guy. I happen to be a Big Eight audit alumni. So, how 
do we prevent that from happening again, and was that the right 
result? Because, you know, one of the concerns I have is that 
the Pentagon can't fight a war without soldiers. The Public 
Company Accounting Oversight Board and the SEC can't assure 
investor confidence without having auditors.
    And when you have people that are looking at career choices 
and they are seeing all those good, hard-working, honest, 
conscience people that were in other offices conducting their 
audits in commendable fashions, that all of a sudden lost 
everything, that doesn't create a big incentive for the young 
men and women of this age to be going and trying to be the best 
auditors in the future.
    So what do we have to prevent a situation like that 
happening again, so we go from four to three, or even beyond? 
And was it right that the whole firm was eliminated as the 
result of the actions of particular offices?
    Mr. McDonough. Congressman Kennedy, I think that you touch 
on an enormously important issue. The good news is, I was very 
concerned about whether the really good young people from 
really good universities would want to become accountants.
    Chairman Donaldson and I were at the 30th anniversary of 
FASB the other day. We arrived late and there were three very 
attractive young women who were sitting together and there were 
three empty seats. So Mr. Hertz, the Chairman of FASB, and the 
two of us joined them.
    They had just received master's degrees and were doing an 
internship. They went to outstanding universities, and they 
were happy as clams to be newly made CPAs. They were 
particularly happy that they had a multiplicity of job offers, 
and they were pointing out that their friends who had majored 
in marketing or strategic planning or such things were still 
looking for a job. That, I think, would make both of us feel a 
bit more assured.
    But more seriously, a major step forward has been replacing 
the relationship between management and the auditor by the 
relationship between the audit Committee and the auditor.
    I think it was very difficult, especially as accounting 
firms in the late 1990s really began to downplay the importance 
of the audit, their most important product in the protection of 
investors, and the consulting work became the order of the day 
and where people went ahead in the firm. That, of course, has 
been fixed to a great degree by Sarbanes-Oxley and by decisions 
of the Securities and Exchange Commission.
    Now we have a situation where it is the audit Committee 
which selects the audit firm, and it is the audit Committee 
which, in a way, is the reporting vehicle for the audit firm. 
So the temptation for an audit firm to keep business, or get 
more business, by having what became a much too close 
relationship with management in many cases, I think all of the 
cases where there have been scandals, that temptation has been 
by and large removed.
    Now, it demands, of course, that the audit Committees take 
their jobs very seriously. One of the things that we will be 
looking at in our inspections of the Big Four firms between now 
and the end of the year is do we have the impression that the 
audit Committees are taking their work seriously. Anecdotal 
evidence would say that the answer to that is yes.
    In looking at the audit firms, the tone-at-the-top issue I 
mentioned in my prepared remarks, we want to make sure that 
having got the message of Sarbanes-Oxley, which I think we 
would have to say is clearly discernible at the top of the shop 
in the major audit accounting firms, is being reflected 
throughout the entire organization.
    It may very well be that you would have X in charge of the 
office in some city who hasn't gotten the message and has 
developed an inappropriate relationship with management, and 
there is a little cooking of the books going on with the 
collusion of that part of the audit.
    We would hope that, first of all, that the overall 
management of the firm would catch the miscreant and pitch him. 
On the other hand, if in the course of the PCAOB inspections we 
spot that there is somebody in one of their offices, because we 
are going to be very thorough, especially starting next year 
when we do it once a year, we will be looking at the firm in 
its entirety in the United States.
    We will be looking at a lot of the audits that they do, you 
as a pro would know, we will be looking at the high-risk audits 
and then doing a sampling of the more ordinary audits. Through 
the samples we will be able to see if there are people in the 
firm who haven't gotten the message of the new virtue which 
they have to believe in.
    I think that the likelihood, therefore, of the kind that 
happened to Arthur Andersen happening again, it certainly 
hasn't been reduced to zero, but it is very, very much less 
probable.
    The main thing we have to count on is the accountants 
really have to want to reform themselves. When I was a kid or a 
much younger man, going into accounting was a very honorable 
profession. The worst anybody said is that accountants were a 
little boring. But your kids all thought that mom and dad were 
in a wonderful profession.
    That isn't what they are hearing, and they are very, very 
concerned about it. They are very concerned about the future of 
their profession and they should be. But that is something that 
we at the PCAOB can work with in helping the accounting 
profession reform itself.
    The Chairman. The gentleman's time has expired.
    The gentleman from New York, Mr. Crowley.
    Mr. Crowley. Thank you, Mr. Chairman.
    I thank both chairmen for being here today for your 
testimony and for your response to the questions put before you 
today.
    I think I would like to continue on the questioning started 
by Mr. Kanjorski and followed by Ms. Kelly and by Mr. Kennedy. 
That is in regards to the issue of small accounting firms and 
their ability to compete, basically, in this market.
    Chairman McDonough, I know you mentioned your concern for 
their future and their ability to stay in practice, to stay in 
business, and also expressed your desire not to do anything 
that could in some way have a negative effect on the Big Four 
as they exist right now. I understand that. There are a lot of 
jobs that have been consolidated within those four accounting 
firms.
    I was very supportive of Sarbanes-Oxley, a number of 
amendments that had passed that created new statutes concerning 
conflict of interest. And it is partly a thought, partly a 
question, in terms of, is that possibly a vehicle by which, and 
I think if the law is carried through by both departments, that 
because of the new conflict of interest laws that were in place 
that Big Four firms will not be able to take certain accounts 
because of those conflicts. Is that a possibility? Do you see 
that as a vehicle by which you can encourage some of the mid-
sized firms to stay in business?
    And just to follow up on a couple of the suggestions that 
have been made. One is that I have heard from some accountants 
the idea of the government sponsoring malpractice insurance for 
smaller firms that are looking to get into the public 
accounting field. That could help to address some of the 
concerns outlined in the GAO report that Ms. Kelly and others 
have mentioned, such as the lack of staff, industry, and 
technical expertise, capital formation, global reach, liability 
concerns, reputations suffered by small accounting firms 
because of their inability to compete.
    As well as another thought, and that is limiting the market 
share of the Big Four, in other words within the publicly 
traded companies and their ability to audit, thereby opening up 
some of that market share to smaller and mid-sized accounting 
firms.
    If I could have both of you comment, then I would 
appreciate it.
    Mr. McDonough. Congressman Crowley, I think that when a 
public company, or private company for that matter, is looking 
for an auditor, one of the things that you are looking at is 
does the auditor have the capacity to audit my company. If it 
is a relatively small company, lots of audit firms are able to 
do that.
    If it is a company, let's say, with national scope, with 
offices, with branches, with factories in various places, you 
would be looking for a firm that has enough people, enough 
sophistication to be able to handle your company.
    There are some middle-sized firms that I think in most 
cases could be the answer. There has been kind of the notion 
that if you were audited by one of the big eight, seven, six, 
five, now four, that there was something that was kind of 
prestigious.
    Mr. Crowley. There was an inclination that if it got past 
them that you had passed the test, basically.
    Mr. McDonough. Exactly. Now, I think we need to get away 
from that so that people will really go and find an auditor who 
can do the job, an auditor who knows what he and she is doing, 
and will bring a high level of integrity to the audit. In that 
way, I think that we can encourage competition.
    I am not sure, unless you were going to say to given 
companies, ``You may not use auditor X, Y, Z,'' how you would 
limit the market share. The market share, as the GAO report 
indicated, of the Big Four is huge. Whittling it down would be 
a great and good thing to do, but I don't think anybody can 
quite figure out how to do it until you get some of the medium-
sized firms to get big enough that they can really start 
competing, and that is going to be a process that will take a 
while.
    Mr. Donaldson. Let me just add to that. I think Mr. 
McDonough brings out, obviously, that one of the greatest 
impediments for smaller firms is their inability to operate on 
a global basis or a national basis, and that is really an 
impediment.
    Having said that, I think that there is an opportunity for 
those smaller firms that aspire to become bigger firms to 
compete on the quality of their product and the service that 
they give and all the other things that allow small 
organizations to compete with big organizations.
    I think that some kind of cutting up of the marketplace and 
allocation of market share and so forth would not be the way to 
do that.
    Having said that, I believe the issue of consolidation is 
one that is a problem and that has to be addressed in a lot of 
different ways. I hope it will be by the accounting profession 
and others.
    The Chairman. The gentleman's time has expired.
    The gentlelady from Illinois, Ms. Biggert.
    Mrs. Biggert. Thank you, Mr. Chairman.
    Chairman McDonough, one of the most important powers that 
Sarbanes-Oxley gave the PCAOB is the authority to inspect and 
discipline the firms engaged in the auditing. Do you think that 
there is any problem with confidentiality? Certainly, those 
firms are apt to have full information from the firm's clients.
    Do you have a plan for addressing legitimate business 
concerns for confidentiality, while being able to provide the 
kind of public disclosure that is demanded by investors and 
really envisioned in the Act?
    Mr. McDonough. Congresswoman, in actually doing the 
investigations we have very rigid controls of the 
confidentiality of the information.
    There is one aspect which was established in the statute, 
and that is, if we find that somebody has really made a major 
transgression which should be prosecuted or should be a matter 
for an enforcement action, we can move immediately.
    But then there are the things that are not at that level, 
but are negatives. The statute establishes that we will not 
make those negative comments public for 12 months, and if the 
accounting firm solves all those problems within 12 months, 
that it will never be made a matter of public information. That 
is in the law, and so obviously we will enforce it.
    On the other hand, being a new lad there on June 11, I 
asked myself, ``Well, why?'' I think actually it is a very good 
thing, because what it says is, especially since the view of 
the PCAOB is that we are trying to help the accounting 
profession to reform itself, and that if you say to somebody, 
``Look, here is a list of things that you are really not doing 
well, and you got to fix in the next 12 months, but if you do 
fix them in the next 12 months, they will never be made 
public.'' Twelve months is not a very long time if you have any 
kind of a decent-size firm.
    Therefore, it is really quite a stern discipline, and I 
must admit that the more I get acquainted with it, the more I 
like it. I think it is a very good idea. It gives us a very 
effective vehicle to say, ``Here are some things that need 
fixing, fix them.'' And the reward for fixing them is that the 
world doesn't know that they needed to be fixed. If at the end 
of 12 months they haven't been fixed, then it is a matter of 
public record.
    Mrs. Biggert. So you don't think there is any concern that 
some of the businesses might not want to give the audit 
companies full information, because it might be made public? 
That is not an issue?
    Mr. McDonough. I think it is an issue, but it is a 
manageable one.
    Mrs. Biggert. Okay. Just one other quick question then. 
What are your views on the mandatory firm rotation?
    Mr. McDonough. We now have new regulations that say that 
the audit partner must be rotated every 5 years, rather than 
every 7 years as in the past, and the concurring partner must 
be rotated every 5 years also.
    I think that is a good step in the right direction and we 
should really see how much progress is made through that and 
the overall application of Sarbanes-Oxley and the work of the 
PCAOB, and then reflect in the future, rather than now, on 
whether the mandatory rotation of firms would really add value.
    Mrs. Biggert. Thank you.
    Thank you, Mr. Chairman. I yield back.
    The Chairman. The gentlelady yields back.
    The gentleman from Alabama, Mr. Davis,
    Mr. Davis. Thank you, Mr. Chairman.
    Mr. Donaldson, let me try to return, if I can, to the focus 
of Mr. Miller's questions earlier about the requirement of a 
withdrawal, and notice to the SEC in the event of client 
misconduct.
    A lot of us on this Committee, as you know, are attorneys 
and while that is a provision or a contemplated provision that 
has not gotten a lot of public commentary, certainly as an 
attorney I am a little bit struck by it for a number of 
reasons.
    As I understand the current ABA rules of professional 
conduct that most states have mimicked around the country, an 
attorney or counsel can have the discretion to withdraw in the 
event a client is engaged in ongoing fraud. A counsel has the 
discretion to notify authorities in the event that a client is 
about to commit something that could cause immediate bodily 
injury.
    In neither of those instances is it compelled that counsel 
make the disclosure, and indeed in only rare instances is it 
even contemplated that the counsel could even think about 
withdrawing.
    This provision seems several steps beyond the ABA's current 
standards that, number one, as I understand it, it doesn't 
simply make withdraw discretionary, it makes it mandatory. And 
then, second of all, not only does it make withdraw mandatory, 
but it makes disclosure mandatory.
    That strikes me as being enormously radical in two senses. 
Number one, given the fact that that is the only circumstance 
in which the SEC has to be notified of withdrawal in an 
instance of misconduct or failure to correct, if you will, by 
the client, it amounts to the attorney being compelled to make 
a statement against the interests of his or her client. I don't 
see how a reasonable person could really see the statement as 
being one other than that.
    Can you comment on this proposed rule and the fact that it 
is so much beyond the mainstream of where the ABA stands right 
now on disclosure and on withdrawal?
    Mr. Donaldson. As I tried to discuss a little earlier, I 
think you bring up some very good points in terms of the whole 
issue of the noisy withdrawal and whether it is mandatory and 
exactly how it is done and so forth. I think one of the reasons 
that we have not written a rule in this area is because we are 
trying to evaluate some of the issues that you just brought up 
and trying to balance them off against people that feel 
differently about this.
    I think the thing that we are trying to make clear is the 
fact that attorneys who work for corporations work for the 
corporation. They are not representing individual people within 
the corporation. They have an obligation as an attorney for the 
corporation to take action if they see something that they 
disagree with.
    I think that the first step here is this reporting up rule 
that we have written. And I think it is only when that fails 
that this issue of reporting out noisily comes up. It is a very 
contentious issue. I can only assure you that we are going to 
make every effort to get it right in writing a rule.
    Mr. Davis. Let me follow up and ask just maybe one more 
question along these lines. I certainly appreciate the 
complexity of the issue, as you do.
    One of the things that occurs to me is that there is a 
potential ambiguity in the provision as it is contemplated and 
as I understand it, and it is this: What is the time frame that 
counsel would have to make an evaluation of whether appropriate 
remedial action has been taken? Has the SEC given any thought 
to what that time frame would be? And closely related to that, 
what happens to a counsel who in good faith is not sure what 
his or her obligations are under this new provision if it comes 
about?
    Let us say that you have gone up the chain of command at 
your company. You have reported a violation. There has not been 
a prompt correction, but they say in effect, ``We are working 
on this and we are going to get back to you.'' Let's say, 7 
months from now, they say, ``We are working on this and trying 
to get to the bottom of it.''
    Realistically, to whom would counsel go to get guidance 
about the scope of his or her responsibilities without also, in 
effect, breaching the privilege and making a disclosure?
    Mr. Donaldson. For the very reason of the issues that you 
bring up, the specificity of what you are saying, that is what 
makes writing rules in this area so difficult.
    I can only say that we are doing everything in our power to 
expose people who are working on this to the concerns that you 
have and the kind of, I won't even say details, very important 
aspects of just exactly how does this come into play is 
something that we are working very hard on. Give us a little 
time.
    Mr. Davis. Thank you, Mr. Chairman.
    The Chairman. The gentleman's time has expired.
    The gentleman from New Jersey, Mr. Garrett.
    Mr. Garrett. Thank you and good afternoon. I appreciate the 
opportunity to be with you, and your answers, so far, quite 
honestly. Most of the concerns I had earlier have been raised, 
but I will just ask one, which will be a follow-up for Chairman 
Donaldson.
    I just wanted to follow up on one question that was raised 
by a colleague from the other side of the aisle, when he shared 
my thoughts of congratulating you on your work in the past, 
Chairman, as far as your inquiry as far as the compensation 
packages that are being looked at right now.
    Just to follow up as far as your inquiry, where you are 
going, it seems that your answer is that you are going to be 
looking more to the issue of what the procedures are or maybe 
just use the word the ``culture,'' perhaps, as far as on the 
Boards and the way in which they got there as far as the 
compensation package was achieved. Is that correct?
    Mr. Donaldson. The issues associated with the governance of 
a stock exchange are very much in our purview, very much our 
responsibility, very much something that, because of what has 
happened recently, we are going to have to take a very hard 
look at.
    I think I would say, in terms of the culture of the 
governance of the stock exchange, the same thing to the 
governance of corporations across America, and that is that 
there has to be an attention to the issues that many 
corporations haven't spent time on.
    I think, as far as the stock exchanges are concerned, it is 
a much more complex situation because of what the stock 
exchange represents. It represents a lot of very different 
constituencies, the floor brokers, the specialists, and so 
forth. It has a responsibility to the listed companies.
    It doesn't fit into a corporate governance mold. I think 
that what is needed here and what we will be working on is an 
examination of that, and I hope that we will be working 
eventually with whatever the stock exchange comes up with to 
come up with a set of procedures that make sense.
    Mr. Garrett. What do you think it says to Main Street 
America when you read the comments in the paper by some of the 
people after this has begun, and obviously some of the people 
who have made the decisions are basically defending their 
decision that they make, on the one hand, and then some other 
folks who are no longer in that position are making statements, 
like, well, maybe this was not the most appropriate decision 
that could have been made.
    What does this say to Main Street America as far as the 
compensation packages of the rest of corporate America, when 
you consider that there may be a lapse of fiduciary 
responsibility by these individuals on the exchange? We see the 
excesses, in some people's perspective, as far as compensation 
packages elsewhere, but there is not responsibility at the top, 
at the exchange and the rest of corporate America. I would say 
the little guy on Main Street must be scratching his head, ``Is 
this a place that I feel secure in anymore?"
    Mr. Donaldson. I think that the position of the stock 
exchanges, in particular the New York Stock Exchange as the 
largest market in the world, is very special as far as 
corporate America is concerned. I think the rules that the 
stock exchange writes in terms of how the place is run, what 
companies must do to qualify to be listed, et cetera, these are 
all issues where the stock exchange itself must be the exemplar 
of what they require of others.
    All I was trying to say earlier is that the governance 
issue is a lot more complex in that organization because of its 
central position and the responsibility it has to others. I 
think the American people have a right to expect that from the 
governance of the New York Stock Exchange.
    Mr. Garrett. I close by saying I agree with you, and I hope 
that that message gets sent appropriately.
    Thank you.
    The Chairman. The gentleman's time has expired.
    The gentleman from Washington, Mr. Inslee.
    Mr. Inslee. Thank you.
    Mr. Donaldson, I had to come late, so I may have missed 
some of your testimony, but I wanted to ask you in a lay sense 
to comment on the enforcement activities of the New York 
Attorney General as it relates to the SEC regulatory and 
enforcement activity.
    I want to relay this as a question that I get asked, in a 
sense, in grocery stores and it is the kind of question you get 
from folks on the street. I would like you to address it in 
that sense.
    I have been asked on several occasions by people why there 
has been some vigorous, aggressive, apparently successful 
regulatory actions by the New York Attorney General involving 
various security-related issues, and an apparent absence by the 
SEC of similar regulatory enforcement activity that at least 
the lay people I talk to believe would be in the jurisdiction 
of the SEC. Maybe that is because William O. Douglas came from 
Washington and we are particularly proud of that history and 
legacy.
    But I would ask for you to tell me what you think the 
answer should be to that type of question to our constituents 
as to why there is, at least to them, rigorous action from one 
quarter of our enforcement community and regulatory community 
and at least a seeming absence to the lay people on the street 
of our federal regulatory authority. If you could address that 
broadly I would appreciate it.
    Mr. Donaldson. I think that the recent action by the New 
York State Attorney General illustrates what I had been saying 
earlier, and that is that we need a combined force of Federal 
and State policemen, if you will, to uncover the fraud that 
goes on in this country. We cannot be everywhere. We depend on 
local law enforcement, and in particular securities enforcement 
agencies in the states to uncover malfeasance that may fly 
under our radar.
    Having said that, I think that there will always be 
instances where a specific knowledge of a fraudulent activity 
gets reported to one agency or another. That was a case here 
recently in terms of the accusations of the problems between a 
hedge fund and a mutual fund. It is very hard to uncover that 
in your routine examinations, particularly if there are 
purposeful efforts to hide it, particularly in this case where 
we do not have the authority yet to register hedge funds or to 
inspect them.
    So I guess what I am saying is that we welcome this 
activity. The only two caveats are that, one, there attempt to 
be the coordination that comes from colleagues working on a 
common problem so that there isn't redundancy. The other is 
that, when the remedy involves changing the laws and the 
regulations, that cannot be done on a state-by-state basis. 
There has to be a national regulator to do that.
    Mr. Inslee. I appreciate that. Let me ask you about 
Sarbanes-Oxley. I have some inquiries from some small cap 
companies who are experiencing difficulty that they relate to 
me with compliance, costs associated with that. The have 
wondered, posited if there is some relief for small caps in 
that regard to get to the heart of what we were driving at in 
that bill, but perhaps recognize some of the onerous burdens 
that they have. Is there anything under consideration in that 
regard for small caps, or should we be thinking about that in 
any sense?
    Mr. Donaldson. Right. Again, Sarbanes-Oxley has only been 
in existence in its completed form for a very short period of 
time. We are well aware of small cap companies, problems 
associated with conforming to Sarbanes-Oxley and the expenses 
associated with that. I think we have tried to be flexible in a 
number of ways in terms of phasing in conformity.
    I think we need more data in terms of the cost-benefit of 
the Act. I think it is too early to do anything more in the 
rules we have written than to be aware of the greater burdens 
the Act places on a small company.
    Whether we need to write new rules or whether there needs 
to be some modification of the legislation, I think it is too 
early to even suggest that.
    Mr. Inslee. I would heartily encourage you to consider 
that, because we are looking at job growth coming out of these 
small caps, and hope that you can look at ways to give them a 
little more flexibility in that regard. Thank you.
    The Chairman. The gentleman's time has expired.
    The gentleman from Alabama, Mr. Bachus.
    Mr. Bachus. Chairman Donaldson, as I think all of us 
realize, the market goes up on good news and down on bad news, 
and there are market-moving events like a Microsoft 
announcement of earnings or a catastrophe or someone being 
awarded a contract.
    Knowing this, I would like your views on this late trading 
where preferred customers have been allowed to place what is 
called not an order, but a possible order before the market 
closes, and then they get to wait until the market closes and 
then they get to wait to see what the market-moving events are, 
and they then have a better idea of whether the market the next 
day is going up or down.
    And then those orders by the mutual fund are either placed 
at the expense of all the other mutual fund investors or they 
are destroyed, which I would think executing them is illegal, 
taking the order is illegal, destroying the orders is illegal, 
or concealment, and it is clearly in violation of the SEC 
rules. And as you know, the New York Attorney General has 
issued both criminal and civil charges and has called this 
larceny.
    Number one, I would agree with him that it is larceny. It 
is stealing from the other mutual fund investors.
    But my question is this, as the SEC you have clear 
jurisdiction under the Investment Company Act to investigate 
this type of activity. In the past, have your investigations 
led to uncovering this activity in the past?
    And number two, when you discover such activity, 
improprieties, illegalities, concealment by mutual fund 
managers or directors failing to do their jobs, is this 
disclosed to the public so that the public can be warned?
    Mr. Donaldson. As you know, we have been out in the field 
examining a lot of aspects of mutual fund organizations, sales 
practices, particularly the disclosure incentives for the sale 
of particular fund shares, et cetera.
    The issue of timing of mutual fund purchases has always 
been an abhorrence on the part of mutual fund organizations for 
timing, if you will, and many of them have written it into 
their prospectuses.
    Mr. Bachus. But the late trading is actually more than just 
timing. I mean, it is actually illegal under the SEC's present 
law, is it not?
    Mr. Donaldson. Well, there are two aspects to this. There 
is the illegal stamping and timing and so forth of just exactly 
when the order did arrive. That is obviously illegal. There is 
also the problem associated with different time zones, European 
securities, et cetera, that close much earlier than we do, and 
a time lag there.
    We have always counseled the mutual fund industry in times 
of market interruptions to substitute their judgment of values 
on certain securities where there have been movements and the 
market does not reflect that. I think the whole issue now is 
under review, and we will see where we go on it.
    Mr. Bachus. When you find this type of activity and you 
discipline, will the public be advised?
    Mr. Donaldson. I am sorry?
    Mr. Bachus. When you find that there has been a violation 
of the law, that there has been illegal activity, there has 
been concealment by a mutual fund manager in your 
investigations, will this be kept confidential or will you 
disclose it so that people that have invested in that mutual 
fund, number one, know that their investment has been 
diminished by this illegal activity, and number two, to warn 
members of the public against, that may possibly warn them not 
to invest in that fund?
    Mr. Donaldson. I think that our first step is to determine 
how widespread some of the alleged practices have been, and we 
are doing that right now.
    Mr. Bachus. What is your sense?
    Mr. Donaldson. We are in the field right now. We have asked 
a number of questions. We have sent a number of letters. We 
have sent a number of our examiners in. The timing, I believe, 
depends upon just what we find.
    In terms of answering your question directly, I believe it 
is the responsibility of the SEC to either reassure the 
American public that some of these practices are not 
widespread, if they are not. I think we have a responsibility 
to write rules and regulations addressed to correcting these 
problems if it is widespread.
    In terms of how we display that to the public, enforcement 
actions, obviously, are confidential; and we do not disclose 
the internal workings enforcement matters until we have made a 
determination.
    Mr. Bachus. I will close here simply by saying that when 
you find these instances of concealment and illegality which 
have affected people's investment and I think is a clear 
violation of the law, I would hope that you would disclose that 
to those victims of that fraud.
    The Chairman. The gentleman's time has expired.
    The gentleman from California, Mr. Sherman.
    Mr. Sherman. Thank you, Mr. Chairman.
    I have a lot to say in only 5 minutes. The greatest asset 
of the Roman Empire was arguably Rome itself. Nero fiddled 
while Rome burned. Arguably, the greatest asset of the United 
States is the trust we put in our capital markets, and we are 
fiddling while neighborhood after neighborhood of that 
metaphorical city burns, WorldCom, Enron, 92nd Street Y, 
Schoolgate. The list goes on and on.
    I am surprised that we are not holding these hearings since 
we have Chairman Donaldson here, on which 100 people have been 
incarcerated; which assets have been seized; which special 
courts or constitutional amendments, or which special courts 
have been created, or priority in courts. Instead, we are 
sitting here and we just want to see how many more scandals 
before people lose faith in our markets.
    I am flabbergasted. I mean if a street gang had done one-
millionth of 1 percent of the damage that has been done by the 
shenanigans on Wall Street, would there be not a single person 
incarcerated? I am flabbergasted that we are just working 
around the edges here, but I guess that is what these hearings 
are about.
    I do in the spirit of that want to focus my questions on 
Chairman McDonough. First, with the idea of the structure of 
accounting firms. Back when I was an auditor, we understood 
that financial accounting is the only game where the umpire is 
paid by one of the teams. The engagement partner was under 
incredible pressure to do whatever the client wanted and was 
incredibly rewarded if the client would just pay their bills.
    But we had two things. We had a review department that 
called the final shots and we had unlimited liability for the 
partners of the firm, which is why they insisted that the 
review department call all the shots and so one of their 
partners bent upon advancing his own career wasn't down in 
Houston signing anything and everything.
    The AICPA has, I think perhaps as a result of my 
correspondence with them, provided some guidance to the 
accounting firms that the review department, partners 
independent of the engagement, not rewarded for selling 
services, people who don't golf with Ken Lay, call the shots.
    Has your board imposed that or about to impose that on the 
accounting profession or will we continue to have a 
circumstance in which someone's career can rise because they 
get the bill paid and that is the person who calls the shots 
and the review department acts on a ``don't ask, don't tell'' 
basis or a respond-only-to-questions basis?
    Mr. McDonough. Congressman, I think it is generally 
believed that the demise of Arthur Andersen was a direct result 
of having the engagement partner be able to make the final 
decision and the review department could be just overlooked.
    As I mentioned earlier, I think that the thing that really 
brought the debacle in the accounting profession is that there 
was a relationship between the engagement partner and the top 
management, the CEO and the CFO, that made it very tempting for 
the engagement partner.
    Mr. Sherman. If I can interrupt, that relationship will 
always exist. That is why they call them the billing partner.
    Mr. McDonough. What has been established, I think, which is 
a major step forward, is that the engagement partner now deals 
with the audit Committee, not with management. That is only 
effective as how good the audit Committee is. I think it is a 
very serious step in the right direction.
    Mr. Sherman. So we are only going to have fraud where a CEO 
is able to stack the audit Committee of his own board. Gee, how 
often does that happen?
    Mr. McDonough. One of the things that is going to be very 
challenging in our formation of our rules is the relationship 
between the auditor and the audit Committee.
    Mr. Sherman. Sir, my question is the relationship inside 
the audit firm between the billing partner and the review 
department. Now, if you don't want to address that question 
because you want to talk about the audit Committee thing that 
you got out there, that is fine. But within a few years we will 
return to the circumstance that has been the tradition where a 
CEO is often able to control every aspect of the board of his 
corporation.
    The Chairman. The gentleman's time has expired.
    The gentleman may respond.
    Mr. McDonough. We are in the business of setting quality 
control standards. It is my personal opinion that you are 
right, that the review area of the firm should be making the 
final decisions. Since I am the Chairman, I would hope that 
that view would prevail, but in fact the PCAOB has not yet 
ruled on it.
    The Chairman. The gentleman from Texas, Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman.
    Gentlemen, the absolute necessity of Sarbanes-Oxley is 
readily apparent to me, as are many of the benefits. But I 
think that some of the costs perhaps are not so readily 
apparent, and I would like to use my limited time to explore 
those. If some of this is redundant, please forgive me, but I 
unfortunately missed some of your testimony.
    Specifically, I would like to go back and review the impact 
of Sarbanes-Oxley on small cap companies. I represent a fair 
amount of the city of Dallas. Just recently, I had one CFO of a 
company called Abatix tell me that due to Sarbanes-Oxley, they 
have a 50 percent increase in their compliance cost in order to 
remain public. Another company, Electric and Gas Technology, 
says that their audit fees have doubled, due to compliance with 
Sarbanes-Oxley.
    Is this a microcosm of what is going on in the marketplace? 
If both you gentlemen would respond.
    Mr. McDonough. The real answer, Congressman, is we don't 
know. We are hearing anecdotes of the kind you describe.
    Generically, what the PCAOB is trying to do, and we are at 
the stage now of both acting on inspections, but also going out 
and preaching the gospel, is that there has to be cost-
effectiveness in what is going on.
    It is absolutely contrary to what you sought to establish 
in Sarbanes-Oxley if we are pricing small and medium-size 
companies out of business.
    Now, if they had no compliance capability at all and had to 
put one in, that is a one-time cost which is probably justified 
and the shareholders should think it is a very good idea. If 
the audit firm had been so underpricing the audit that you get 
what you pay for, so the audit wasn't worth a whole lot and now 
they get a decent audit, a proper audit, as a result of paying 
a more reasonable fee, that might be justified.
    But as a generic, we simply cannot allow the choking off of 
growth in the American economy coming from small-and medium-
size companies by having the implementation costs of Sarbanes-
Oxley be excessive.
    We are encouraging the accounting profession to use common 
sense and a rule of reason in, for example, when we establish 
what the internal control attestation requirements are, not to 
think that a small-and medium-size company, unless a small-and 
medium-size was very complicated, which most of them are not. 
They don't need every bell and whistle and internal controls 
that a General Electric should have. Therefore, it is not 
appropriate for those to be demanded. We will be continuing to 
push that very hard.
    Mr. Hensarling. Recently, I had a survey cross my desk from 
a securities law firm. I can't attest to their methodology, 
much less their credibility. But under this survey, they claim 
that D&O insurance is averaging an increase of 94 percent, 
accounting costs are up 105 percent, board compensation is up 
98 percent, training up 81 percent, and compliance personnel 
267 percent for small cap companies.
    As the evidence starts to come in from the field, do you 
have any sense whether these figures may be in the ballpark, 
out of the ballpark?
    Mr. McDonough. The other sort of scary anecdotes I have 
heard have not been that scary. So these would seem to be on 
the outer edge of what people are saying is the cost of 
implementation. But as I mentioned earlier, we don't have 
enough data yet to know what the real cost is.
    I think what we have to have is what I suggest is the rule 
of common sense, that demands for implementation should be 
reasonable in relation to the nature and the size of the firm.
    Mr. Donaldson. I might just add to that, beyond just the 
costs associated with the auditing and accounting and so forth, 
there is a start-up cost, if you will, in terms of getting 
going on conforming to Sarbanes-Oxley, and that means the front 
end-loaded legal fees and so forth.
    I think, as people get used to working under the Act, those 
costs are going to go down, and only time will tell whether I 
am right on that. But I think that I would just echo what Mr. 
McDonough has said, which is that we are very aware across the 
board of the costs of Sarbanes-Oxley and the potential for a 
disproportionate burden on small companies.
    Mr. Hensarling. Last question with my remaining time. Have 
you seen an increase in shareholder lawsuits, and do you have 
an opinion on what is happening on director retention and 
recruitment?
    Mr. Donaldson. I don't know the answer to that. I am sorry. 
I am having trouble hearing with the microphone system, but 
your question was, do we know whether there has been an 
increase in shareholder lawsuits? And I just don't have that 
answer, but I will get it for you.
    Mr. Hensarling. Thank you. My time is expired.
    Thank you, Mr. Chairman.
    The Chairman. The chair now recognizes the gentleman from 
Illinois to wrap up.
    Mr. Emanuel. Thank you, Mr. Chairman, for holding this 
hearing. Chairman Donaldson, thank you for being here.
    Chairman Donaldson, I assume the SEC's report on hedge 
funds will be out soon. I wonder if the SEC has drawn any 
preliminary conclusions that you can share with the Committee? 
Specifically, on what type of oversight needs to be done, if 
any; whether Congress has a role; and what is going on in an 
industry that is growing exponentially.
    Mr. Donaldson. As you know, we have had for more than a 
year, but more intensively in the last 6 months, a look at 
hedge funds. We have had several meetings and roundtables. We 
have gathered testimony, and our people have been in the field, 
and our staff has been working on the results of that 
investigation. The Commission is just a very short period away, 
very short, from receiving a report from the staff, with the 
results of all the work we have done and some recommendations. 
I think you can expect to hear from us very shortly.
    Mr. Emanuel. When the report is released, would you be 
willing to appear before the Committee to discuss the SEC's 
findings?
    Mr. Donaldson. Absolutely.
    Mr. McDonough. Absolutely.
    Mr. Emanuel. Thank you. We have dealt with the issue of 
research and investment banking and the conflicts of interest 
inherent in the auditor-client relationship. My question 
relates to another area in which conflicts may exist. Do you 
think Congress should examine the ``tying'' issue as it relates 
to commercial and investment banks offering products and 
services under the same corporate umbrella? Do you see a 
significant problem in this area concerning the tying of 
products and services? Is the SEC currently examining this 
issue?
    Mr. Donaldson. The issue of tying between commercial and 
investment banking clearly is an area that we have looked at. 
We continue to review. It is an area that falls primarily in 
the area of bank regulation.
    I think the whole thesis, if you will, of some of the 
mergers and acquisitions as between investment banks and banks 
was the thought that there could be cross-selling. You know, 
when does cross-selling become tying? It is a major issue. It 
is one that is on our agenda to take a look at.
    Mr. Emanuel. Okay. At this point you don't see it as a real 
problem? I'm interested in whether there is a concern among 
those who monitor and regulate these industries.
    Mr. Donaldson. I think it is one which, with our increased 
resources, we will have the resources to take a look at. It is 
of concern personally for me, but I am not speaking for the 
Commission.
    Mr. Emanuel. With that, I have no further questions. Thank 
you Chairman Donaldson, for taking the time to share your views 
and expertise with us today. I yield back the balance of my 
time.
    The Chairman. Does the gentleman yield back? Thank you.
    We are in your debt. We thank you so much for what was a 
very wide-ranging hearing that, perhaps as almost predictable, 
went beyond the narrow scope of the announced intention of the 
hearing. But in any event, both of your appearances and 
testimony were superb, and I know I speak for the entire 
Committee in thanking you for your service.
    The Committee is now adjourned.
    [Whereupon, at 12:39 p.m., the Committee was adjourned.]


                            A P P E N D I X

                           September 17, 2003

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