    [Senate Hearing 108-840]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 108-840

                             IMPLEMENTATION OF THE
                           SARBANES-OXLEY ACT OF 2002

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

                                    HEARINGS

                                   before the

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

                          ONE HUNDRED EIGHTH CONGRESS

                                 FIRST SESSION

                                       ON

      THE DRAMATIC CHANGE ACROSS THE CORPORATE LANDSCAPE TO RE-ESTABLISH
       INVESTOR CONFIDENCE IN THE INTEGRITY OF CORPORATE DISCLOSURES AND
                              FINANCIAL REPORTING

                                   __________

                      SEPTEMBER 9, 23, AND OCTOBER 2, 2003

                                   __________

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

          Available at: http: //www.access.gpo.gov /congress /senate/
                                senate05sh.html

                                     ______

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                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      RICHARD C. SHELBY, Alabama, Chairman

    ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
    WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
    MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
    CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
    RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
    JIM BUNNING, Kentucky                EVAN BAYH, Indiana
    MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
    JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
    ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
    LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

                 Kathleen L. Casey, Staff Director and Counsel

         Steven B. Harris, Democratic Staff Director and Chief Counsel

                    Douglas R. Nappi, Deputy Staff Director

                           Bryan N. Corbett, Counsel

                 Martin J. Gruenberg, Democratic Senior Counsel

                           Dean V. Shahinian, Counsel

                       Stephen R. Kroll, Special Counsel

       Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                           George E. Whittle, Editor

                                      (ii)

                                C O N T E N T S

                                  ----------

                           TUESDAY, SEPTEMBER 9, 2003

                                                                       Page

    Opening statement of Chairman Shelby.............................     1

    Opening statements, comments, or prepared statements of:
        Senator Sarbanes.............................................     3
        Senator Crapo................................................     3
        Senator Santorum.............................................     4
        Senator Dole.................................................     5
            Prepared statement.......................................    31
        Senator Bayh.................................................     5
        Senator Stabenow.............................................    16
            Prepared statement.......................................    31
        Senator Corzine..............................................    18
        Senator Dodd.................................................    20
        Senator Schumer..............................................    23
        Senator Carper...............................................    25
        Senator Enzi.................................................    32

                                    WITNESS

    William H. Donaldson, Chairman, U.S. Securities and Exchange
      Commission.....................................................     6
        Prepared statement...........................................    33

                  Additional Material Supplied for the Record

    The Wall Street Journal article, by Michael Schroeder, ``Cleaner
      Living, No Easy Riches,'' submitted by Senator Paul S.
      Sarbanes, dated July 23, 2003..................................    48
    Letter from Senator Debbie Stabenow to William H. Donaldson,
      Chairman, U.S. Securities and Exchange Commission, dated August
      5, 2003........................................................    51
    Letter from William H. Donaldson, Chairman, U.S. Securities and
      Exchange Commission to Senator Debbie Stabenow, dated September
      3, 2003........................................................    55
    Chicago Tribune article, by Ameet Sachdev, ``New Rules No Bar to
      Mergers in Accounting,'' submitted by Senator Christopher J.
      Dodd, dated August 11, 2003....................................    60
    Memo from the Division of Enforcement, U.S. Securities and
      Exchange Commission on the SEC's Enforcement Activities Since
      Passage of the Sarbanes-Oxley Act of 2003, submitted by William
      H. Donaldson, Chairman, U.S. Securities and Exchange
      Commission, dated October 29, 2003.............................    62

                                  ----------

                          TUESDAY, SEPTEMBER 23, 2003

    Opening statement of Chairman Shelby.............................    65

    Opening statements, comments, or prepared statements of:
        Senator Enzi.................................................    66
        Senator Dodd.................................................    68
        Senator Reed.................................................    69
        Senator Corzine..............................................    77
        Senator Sarbanes.............................................    78

                                   WITNESSES

    William J. McDonough, Chairman, Public Company Accounting
      Oversight Board................................................    69
        Prepared statement...........................................    96
    Samuel A. DiPiazza, Jr., Chief Executive Officer,
      PricewaterhouseCoopers.........................................    82
        Prepared statement...........................................   102
    Edward Nusbaum, Chief Executive Officer, Grant Thornton, LLP.....    84
        Prepared statement...........................................   110
    Sean Harrigan, President, Board of Administration, CalPERS.......    86
        Prepared statement...........................................   115
    Sarah Teslik, Executive Director, Council of Institutional
      Investors......................................................    89
        Prepared statement...........................................   118

                                  ----------

                           THURSDAY, OCTOBER 2, 2003

    Opening statement of Chairman Shelby.............................   121

    Opening statements, comments, or prepared statements of:
        Senator Sarbanes.............................................   136
        Senator Allard...............................................   139
            Prepared statement.......................................   169
        Senator Corzine..............................................   141
        Senator Carper...............................................   143
        Senator Dodd.................................................   147

                                   WITNESSES

    Peter G. Peterson, Co-Chairman, the Conference Board Commission
      on
      Public Trust and Private Enterprise, Chairman and Co-Founder,
      Blackstone Group...............................................   123
    Ralph Larsen, Former Chairman of the Board and Chief Executive
      Officer,
      Johnson & Johnson..............................................   127
    Charles A. Bowsher, Former Chairman, Public Company Accounting
      Oversight Board................................................   129
        Prepared statement...........................................   169
    Paul A. Volcker, Former Chairman of the Board of Governors,
      Federal
      Reserve System.................................................   132
        Prepared statement...........................................   172
    Brian P. Anderson, Senior Vice President and Chief Financial
      Officer, Baxter
      International, Inc.............................................   152
        Prepared statement...........................................   175
    John J. Castellani, President, The Business Roundtable...........   154
        Prepared statement...........................................   178
    Keith D. Grinstein, Chairman, Coinstar, Inc......................   155
        Prepared statement...........................................   180
    Richard L. Trumka, Secretary-Treasurer, American Federation of
      Labor and
      Congress of Industrial Organizations...........................   157
        Prepared statement...........................................   183

                               IMPLEMENTATION OF
                         THE SARBANES-OXLEY ACT OF 2002

                                  ----------

                           TUESDAY, SEPTEMBER 9, 2003

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

        The Committee met, at 10:01 a.m., in room SD-534, Dirksen
    Senate Office Building, Senator Richard C. Shelby (Chairman of
    the Committee) presiding.

            OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Chairman Shelby. The hearing shall come to order.
        I would like to welcome today's witness, Chairman William
    Donaldson of the SEC. A little over a year ago, President Bush
    signed the Sarbanes-Oxley Act into law and ushered in a new era
    of corporate responsibility. Today's hearing is the first
    hearing in a series that will examine the impact of Sarbanes-
    Oxley on corporate America.
        When the ``bubble'' burst in the second quarter of 2000, it
    became apparent that the explosive growth in market
    capitalization in the late 1990's had been accompanied by
    egregious examples of corporate misconduct and an all too often
    disregard for business ethics. All too often, auditors turned a
    blind eye. As these problems came to light through a series of
    corporate scandals, investors lost confidence in corporate
    management and financial reporting and withdrew their money
    from the markets. The Sarbanes-Oxley Act was enacted, in part,
    to demonstrate to investors a commitment to fairness and
    integrity in corporate America. The Act aims to deter corporate
    misconduct and restore investor confidence primarily by
    increasing the accountability of corporate actors,
    strengthening corporate governance, and improving the
    transparency and reliability of audited financials.
        First, the Act recognizes the respective roles that
    principal executive officers, lawyers, and accounting firms
    play in the operation and oversight of a public company.
    Sarbanes-Oxley assigns new responsibilities to these corporate
    actors to ensure that they are accountable for the operation of
    the companies with which they work. Through the creation of the
    Public Company Accounting Oversight Board, the Sarbanes-Oxley
    Act aims to restore confidence in the accounting profession.
    With new requirements regarding financial statement
    certifications, auditor independence, and lawyer reporting, the
    Act increases the accountability of corporate actors for their
    decisions or advice.
        Second, the Act seeks to change the ``tone at the top.''
    For too long, boards of directors have operated in a ``country-
    club'' culture in which directors were more focused on
    networking than on the difficult task of objectively and
    critically analyzing management performance.
        The Act recognizes that the board of directors, which is
    held accountable by a company's shareholders, is the focal
    point of the governance system. By mandating fully independent
    audit committees with the authority to hire and fire auditors
    and engage outside advisers, the Act takes an important step
    toward separating the board from management and restoring
    confidence in corporate governance and financial reporting.
        And finally, Sarbanes-Oxley seeks to improve the
    transparency and the reliability of audited financials by
    requiring a range of new disclosures, including whether there
    is a financial expert on the audit committee, whether the
    company has a code of ethics for certain officers, and
    additional information regarding certain financial disclosures.
        While recognizing the beneficial impact of Sarbanes-Oxley
    on corporate America, I also acknowledge that the
    implementation of the Act does not come without a cost for
    public companies, both domestic and international. To satisfy
    the requirements of the Act, companies have dedicated
    additional funds and resources to modify their operations and
    practices. These regulatory costs, however, were necessary, I
    believe, to address the surprising erosion of business
    principles and lack of investor confidence.
        The Act has also had a significant impact on international
    companies that trade in U.S. markets. These companies have
    engaged in the process of harmonizing the mandates of Sarbanes-
    Oxley with their respective national laws. This process,
    however, ensures that global investors in U.S. markets receive
    consistent, comparable financial information on which to base
    their investment decisions.
        In addition to criticizing the implementation costs
    associated with the Act, critics argue that the Act deters
    corporate risk-taking. By requiring companies to adopt
    regulatory checklists, critics argue that the Act encourages
    companies to be overly cautious and to focus on procedure and
    process at the expense of innovative management. I disagree.
    The Act does not penalize risk-taking but rather promotes
    transparent and honest business practices. Informed risk-taking
    and honesty within a company are not mutually exclusive
    policies. Although Sarbanes-Oxley was enacted only a little
    over a year ago, it has already caused beneficial changes in
    the corporate practices. The overall impact of the Act,
    however, will not become apparent until it has been fully
    implemented. The true measure of the Act will be whether it
    restores investor confidence in the markets and causes enduring
    changes to the corporate culture. To accomplish these goals,
    Congress and the SEC must be vigilant in supervising and
    enforcing Sarbanes-Oxley.
        I would at this point like to recognize the SEC's
    commitment to implementing Sarbanes-Oxley during the past year.
    The President and Congress charged the SEC, Mr. Chairman, with
    an important task that it admirably accomplished. Chairman, I
    look forward to your testimony in a few minutes.
        Senator Sarbanes.

                 STATEMENT OF SENATOR PAUL S. SARBANES

        Senator Sarbanes. Thank you very much, Chairman Shelby, and
    I join you in welcoming Chairman Donaldson back before the
    Committee for this important hearing, the first in a series, to
    review the implementation of the landmark legislation of last
    year and the efforts to restore investor confidence.
        Just over a year ago, as the President signed this
    legislation into law, he called it ``the most far-reaching
    reforms of American business practices since the time of
    Franklin Roosevelt.'' With the legislation now firmly in place,
    it is appropriate to assess the progress made in its
    implementation and more generally the efforts to restore
    integrity to our capital markets--and with that, restore the
    confidence of investors in those capital markets.
        It is not yet 2 years since the collapse and bankruptcy of
    Enron Corporation. That event, shocking and unexpected as it
    was, was not isolated, but a pattern in which a number of
    major, highly regarded public companies and their auditors
    relied upon convoluted and fraudulent accounting devices in
    order to inflate earnings.
        The result was not a ripple in the market but, indeed, a
    tidal wave. In the sober estimate of The Wall Street Journal,
    ``The scope and scale of the corporate transgressions of the
    last 1990's now coming to light exceed anything the United
    States has witnessed since the years preceding the Great
    Depression.''
        That legislation, of course, came out of this Committee
    with an overwhelming 17-4 vote, as the Chairman will recall,
    and went on, of course, for overwhelming enactment through both
    the Senate and the House of Representatives.
        I think it is appropriate, at this point, to engage in the
    oversight of the legislation, how it is being implemented, of
    course, keeping in mind that our objective is to ensure the
    integrity of our capital markets and to restore to investors
    the confidence that the information on which they base their
    investment decisions is complete, accurate, comprehensible, and
    timely. We also need to keep in mind the other significant
    changes taking place in the private sector, in the corporate
    boardrooms, in company-auditor relations, and at the exchanges,
    changes not mandated by the law but which have arisen as part
    of a general examination and reevaluation of the practices that
    were taking place. I think these hearings will be helpful in
    that regard as well, Mr. Chairman.
        I am pleased to welcome Chairman Donaldson. I want to
    commend Chairman Donaldson and his fellow Commissioners and the
    very dedicated staff at the Commission for proceeding, as they
    have, to implement the statute with diligence and skill. I
    think the staff there is not always fully recognized, and, Mr.
    Chairman. You are fortunate to have so many capable people in
    the organization. I know you are very aware of that and, in
    fact, have been trying to do what you can to enhance the
    capacities at the SEC. We are up here trying to provide you
    some additional money with which you can do that and I look
    forward to your testimony this morning.
        Chairman Shelby. Senator Crapo.

                    STATEMENT OF SENATOR MIKE CRAPO

        Senator Crapo. Thank you very much, Mr. Chairman. I
    appreciate your holding this hearing very much. And, Chairman
    Donaldson, I appreciate you being here and the important work
    that you are doing at the Commission.
        Our Chairman and our Ranking Member have very well stated
    already the reasons why the Sarbanes-Oxley legislation was
    needed and the benefits that we needed to achieve from it. I
    think that the necessity to restore integrity in capital
    markets and to achieve the transparency and honest business
    practices that have been described was evident to everyone in
    America.
        I truly appreciate, however, the opportunity of this
    oversight, because at the time many of us were concerned about
    the law of unintended consequences and the fact that, although
    we needed to achieve the objectives that we sought to achieve
    to restore consumer confidence in our markets, we did not want
    to end up causing consequences that are more detrimental or
    going beyond the mark and causing difficulties that are
    unnecessary on American business, and doing what our Chairman
    said was a concern that has been raised, that is, causing
    resources of American business to go into regulatory compliance
    that does not achieve the necessary purposes and that diverts
    money away from the kind of creativity and entrepreneurship
    that we need to have in a dynamic economy.
        And I am concerned about that. I think that we have
    achieved significant aspects of our objectives with Sarbanes-
    Oxley. But at the same time, I continue to receive concerns
    raised to me. I was in Idaho this August meeting with a number
    of small businesses who are looking at going public but,
    frankly, are not sure it is a good idea anymore because of the
    regulatory costs that they are going to pick up. And it is not
    all just this statute, but it is our entire regulatory burden
    that we put on American businesses today that I think we need
    to have a strong oversight of. And that is why I thank our
    Chairman and our Ranking Member for bringing this legislation
    forward.
        Again, we need to hit the mark and achieve the integrity in
    our capital markets. But we need to make sure that we do not go
    past the mark, and it is that law of unintended consequences
    that I hope we have an opportunity as we review this
    legislation and other legislation that impacts our economy in
    the United States.
        I thank the Chairman for holding this hearing and also for
    giving us the opportunity to come back, and I hope we will have
    continued opportunities to come back and take a close look and
    give the kind of scrutiny that is necessary to the way that we
    are managing these incredible policy issues in our country
    today.
        Thank you.
        Chairman Shelby. Senator Santorum.

                   STATEMENT OF SENATOR RICK SANTORUM

        Senator Santorum. Thank you, Mr. Chairman. I, too, want to
    thank you for holding this hearing.
        I just want to echo some of the concerns that my colleague
    from Idaho has mentioned. I have heard words--and I agree with
    him--of the importance of integrity and transparency. I also
    believe in the importance of efficiency and productivity. And I
    am just concerned that we make sure that with this statute we
    have struck the proper balance between those very important
    interests.
        I heard the gentleman from Idaho talk about talking to
    people who are thinking about going public. I have talked to a
    lot of people who have gone private because of this statute and
    because of the regulatory burden placed upon a lot of small
    businesses, and so they have gotten out of the regulatory
    scheme under this legislation and have gone private.
        Now, in some cases, that may have been a good thing.
    Particularly in the 1990's, a lot of people went public who
    should not have gone public, and it is probably best that they
    go back and go private. And so maybe that is a positive. It may
    be unintended, but it may be an intended consequence of getting
    people in the proper markets.
        But at the same time, I am concerned that we have chased
    people out of the public markets who, candidly, should be in
    the public market for the purposes of this economy and the
    growth that this economy needs to expand and create jobs and do
    the things that are necessary to move this country forward.
        I would be curious to get some reviews as to the potential
    impact on the economy and growth as a result of this
    legislation. So, I think there is a good story to tell, and I
    think the Chairman and Ranking Member laid out a lot of
    positive things. And I would agree with a lot of the positive
    things that have happened as a result of this legislation. I am
    concerned that, as the Senator from Idaho suggested, there may
    be some unintended consequences, and I think we have to be
    vigilant even though ever Member who was here last year voted
    for this legislation. And I am very proud that I voted for it.
    I want to make sure that we are not burying our heads in the
    sand just claiming victory when there are some things we might
    have to look at, both in potentially enhancing some of the
    provisions, but maybe stepping back on some of those provisions
    that may not have the consequences that would be beneficial to
    both efficiency, profitability, transparency, and integrity on
    the other side.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Dole.

                   COMMENTS OF SENATOR ELIZABETH DOLE

        Senator Dole. Mr. Chairman, I have a statement that, in the
    interest of time, I am going to submit for the record.
        Chairman Shelby. It will be made part of the record.
        Senator Dole. And I am to be at three hearings in the same
    hour this morning.
        Chairman Shelby. Senator Bayh.

                     COMMENTS OF SENATOR EVAN BAYH

        Senator Bayh. Thank you, Mr. Chairman for holding this very
    important series of hearings. I have some of the same questions
    about the role of small business, but I will wait and raise
    those in the question period so that we can hear from our
    witnesses.
        Chairman Shelby. Thank you.
        Senator Sarbanes. Mr. Chairman.
        Chairman Shelby. Senator Sarbanes.
        Senator Sarbanes. Mr. Chairman, I would like to put in the
    record, given the comments that have been made, an article from
    The Wall Street Journal of July 22 of this year entitled
    ``Cleaner Living, No Easy Riches,'' reporting on the concerns
    that some smaller companies are avoiding public offerings or
    going private in order not to comply. The article states,
    ``Still, there is no sea change. Of roughly 15,000 public
    companies, only 83 went private in 2002, 63 percent more than
    the year earlier, but slightly fewer than the 89 companies in
    2000, according to Thompson Financial, which compiles market
    and investment data for corporate clients. So far this year, 41
    companies have announced plans to revert to private
    ownership.''
        As they say, there is no major sea change, and it may well
    be that companies that in the past went public should probably
    have thought about it a little more and stayed private. Once
    you go public and go on an exchange, you assume significant
    additional obligations because any investor anywhere here or,
    indeed, in the world can purchase your stock. And if you are
    not really up to that standard, falling shy will----
        Chairman Shelby. You should not be there.
        Senator Sarbanes. --cast a doubt on the validity, the
    honesty, and the integrity of our capital markets, which is,
    after all, one of our major economic assets. But, in view of
    some of the comments, I would like to put that article in.
        Chairman Shelby. Without objection, the article will be
    made part of the record in its entirety.
        Chairman Shelby. Chairman Donaldson, again, we welcome you
    to the hearing. If you have a written statement it will be made
    part of the record. You may proceed as you wish.

                   STATEMENT OF WILLIAM H. DONALDSON

           CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

        Chairman Donaldson. Thank you, Chairman Shelby, Ranking
    Member Sarbanes, and Members of the Committee. I would like to
    make just a brief beginning statement. Thanks for inviting me
    to testify on behalf of the Securities and Exchange Commission
    concerning the implementation of the Sarbanes-Oxley Act.
        As you noted, it has been just over a year since Congress
    passed and President Bush signed the Sarbanes-Oxley Act into
    law. Sparked by the dramatic corporate and accounting scandals,
    the Act represents, in my view, the most important securities
    legislation since the original Federal securities laws of the
    1930's. Your backing of the Act and the efforts to implement
    its sweeping reforms, along with the strong support of your
    counterparts in the House and our authorizing committees,
    demonstrates Congress' dedication to ensuring the integrity and
    vitality of our markets.
        The Act set ambitious deadlines for more than 15 separate
    rulemaking projects by the Commission, called for the
    Commission to complete several studies on different aspects of
    the capital markets, and gave us new tools to enforce the
    securities laws. The bulk of the rulemaking was required by
    January 26, 2003, 180 days after the Act was signed, making
    this past January the busiest month of rulemaking in the
    Commission's history.
        Because of the dedicated efforts of the professionals at
    the Commission, I am pleased to say we have met all the
    mandates and challenges set out by the Act, and in record time,
    without sacrificing our other work or obligations, including
    our robust enforcement program and numerous regulatory
    initiatives unrelated to Sarbanes-Oxley. The professionals at
    the Commission not only worked quickly and efficiently but also
    thoughtfully.
        In fulfilling the mandates of the Act, we provided a number
    of opportunities for public input on our proposals and
    carefully considered thousands of comment letters. We have also
    used our new enforcement tools, both on our own and in
    conjunction with the President's interagency Corporate Fraud
    Task Force, to expose and punish acts of corporate corruption.
        I am pleased to report the Public Company Accounting
    Oversight Board, a cornerstone of the Act, is up and running
    under the strong leadership of its new Chairman, Bill
    McDonough, former President of the Federal Reserve Bank of New
    York. The Commission and the PCAOB will continue our joint
    efforts, which have already turned what was an outline on paper
    into a proactive organization that is registering accounting
    firms, operating an independent funding mechanism, developing
    inspection and disciplinary programs, and writing new auditing
    and attestation standards.
        The framework for the reform mandated by the Act has
    largely been put in place and companies, their boards and
    executives, and other gatekeepers to our capital markets are
    proceeding to implementation. These are landmark rules and will
    require hard work and significant expenditures in the short-
    run. Some in the business sector feel that they are under siege
    from new regulations and the threat of additional litigation.
    But the short-term costs of compliance, particularly efforts to
    improve internal controls, should be seen, in my view, as an
    investment. In the long-term, I believe that the reforms
    realized from the Act will result in sounder corporate
    practices and more reliable financial reporting. New
    requirements coming out of the Act, such as the personal
    certification by CEO's and CFO's of their companies' financial
    disclosures, the renewed focus on the independence of corporate
    boards, and the focus on internal controls and procedures, will
    strengthen companies in the long-run if they focus on the
    underlying intent of the Act rather than on mere compliance.
        Early on, almost every corporate law firm rushed to tout
    their expertise in navigating the new requirements, some in
    ways that emphasized technical compliance rather than real
    reform. But I have been pleased to observe, I believe, a shift
    in that attitude. More and more companies and their advisers
    seem to be channeling their energies into true compliance with
    the spirit of the Act. Good, honest companies realize that
    corporate governance is not primarily about complying with
    rules. It is about inculcating in a company and all of its
    directors and officers and employees a mind-set to do the right
    thing.
        As I have said before, the focus on doing the right thing
    should become part of the companies' DNA. Companies that view
    the new laws as opportunities--opportunities to improve
    internal controls, improve the performance of the board, and
    improve their public reporting--will be better run, more
    transparent, and more attractive to investors.
        There have been suggestions that requirements of the Act
    and recent crackdowns by criminal and civil authorities have
    discouraged honest risk-taking. I take a different view. I
    believe that the Act and the other steps that have accompanied
    it will lead to an environment where honest business and honest
    risk-taking, the foundation of American entrepreneurship, will
    be encouraged and rewarded. We do not want to discourage
    legitimate business risk-taking, but we are very concerned
    about activities some have sought to disguise as honest
    business risks but which are really legal and accounting
    maneuvers that have nothing to do with the underlying business
    of the company. Nothing in the law, its implementation, or in
    the Commission's agenda should make business fearful.
        Indeed, during the past year we have been monitoring areas
    that may merit future attention, considering whether there are
    particular issues arising from the Act that should be
    addressed. For example, we have attempted to reduce the
    compliance burdens on smaller public companies and foreign
    issuers where appropriate and permitted by the Act, and the
    Commission staff has issued Frequently Asked Questions on the
    implementation of some of its views. The Commission has been
    and will remain vigilant through the implementation of the
    provisions of the Act and will consider further actions as
    appropriate in furtherance of its objectives.
        While much has been done so far under the Act, its full
    impact has not yet been felt. Many of the rules that the
    Commission adopted are still taking effect, and some, such as
    the adoption of new exchange listing standards for audit
    committees, are still underway. While we will keep a close
    watch for regulatory burdens and loopholes that might need to
    be addressed down the road, I believe that the markets should
    be allowed to adjust to the significant new disclosures we will
    see this year, as well as the effect of other reforms put in
    place by the Act, before significant additional changes are
    made.
        In conclusion, let me thank you again for your important
    leadership and support in the initiative to reestablish and
    strengthen investor confidence and integrity in our Nation's
    capital markets. While it may be a bit too early to judge the
    impact of all of the various provisions of the Act, I assure
    you that the Commission and its staff will continue to monitor
    its implementation and effects to ensure that its goal of
    protecting investors and restoring confidence in our securities
    markets remain paramount. And beyond Sarbanes-Oxley, the
    Commission will continue pressing ahead on multiple fronts,
    including addressing such critical areas as shareholder access
    to the director nomination process, the mutual fund and hedge
    fund industries, the structure itself of our securities
    markets, and the many issues that are embedded in the need for
    improved corporate governance.
        I look forward to continuing and building on the strong and
    cooperative relationship that our agency has developed with you
    in the past as we move forward with fulfilling the promise of
    the Act. This is a critical time for our capital markets and
    the Agency, and the way we address the challenges before us
    will determine not only where we go tomorrow but also for years
    to come.
        Thanks again for inviting me, and I would be happy to
    answer any questions.
        Chairman Shelby. Thank you, Mr. Chairman.
        Sarbanes-Oxley, as you well know, Mr. Chairman, is a
    frequent topic of discussion with representatives from the
    European Union. I appreciate what the SEC has been doing to
    deal with the sensitive concerns raised by European governments
    and companies during this rulemaking process.
        Can you today describe the process for addressing European
    concerns during the rulemaking and how that dialogue has
    impacted the final rules, if any?
        Chairman Donaldson. Yes, I would be glad to. Our efforts
    are to understand not only the European but also the world
    view, if you will, of mandates in the Sarbanes-Oxley Act, and
    particularly the registration of accounting firms who operate
    on U.S. companies' subsidiaries. We held a conference a number
    of months ago and invited many of the participants, if you
    will, from Europe, Japan, and elsewhere to come sit down with
    us, with the PCAOB Board, and with the Commissioners. We all
    were there, and listened over the course of a day to the
    objections and problems that they saw, including, but not
    limited to, the possibility that some regulations would run
    counter to national laws.
        I think in addition to that, with the arrival of Bill
    McDonough as Chairman of the PCAOB, I think under Bill's
    leadership now we have been working to reach out to the
    European community, to reach out to other countries in the
    world.
        I think the dialogue that has been underway has been very
    constructive. I think we have been uncompromising in the
    execution of a mandate that these accounting firms be
    registered. But we are attempting to seek a common ground here
    in terms of the actual coordination of our rules and national
    mandates.
        Chairman Shelby. Mr. Chairman, have you observed a
    noticeable decline in the number of international companies
    registering with the SEC as a result of this legislation?
        Chairman Donaldson. Well, I think that the decline in the
    number of companies registering is a part of an overall
    syndrome here. It is not a syndrome, really, but I think we are
    seeing an advance in the competitive nature of international
    markets. I think that, where the U.S. markets were the only
    real markets in the world for a number of years, we are seeing
    an improvement in the capability of American investors to
    execute orders in international companies in their home
    markets. I think that is a natural evolution of the trading
    techniques, if you will.
        I suspect that there will be a period of time when
    companies are evaluating just what the new mandates here and
    the regulations, mean to them. And I think that is only
    natural.
        Chairman Shelby. This goes on anyway.
        Chairman Donaldson. Pardon?
        Chairman Shelby. This goes on every day.
        Chairman Donaldson. Yes, but I hope that in the final
    analysis, the non-U.S. companies that wish to access the
    markets that we have will realize that the rules and
    regulations we put in are in their interest, and in their
    shareholders' interest.
        Chairman Shelby. Sure. Mr. Chairman, I understand that at
    the SEC you have initiated a rulemaking regarding increased
    disclosure concerning the director nomination process and
    shareholder communications. What is the concern that the
    shareholder proxy proposal is intended to address? And how will
    the increased disclosure improve corporate governance?
        Chairman Donaldson. A very good question. Let me try and
    briefly answer it.
        As you know, and I believe the Committee knows, we have a
    number of proposed actions underway now that we put out for
    comment having to do with the entire proxy process.
        Chairman Shelby. Absolutely.
        Chairman Donaldson. I would divide this into two things:
    first of all, philosophically, I believe that, as Sarbanes-
    Oxley has moved the center of responsibility back to the board
    of directors, where the board of directors hires the CEO, not
    vice versa. I think we are----
        Chairman Shelby. The shareholders elect the board, don't
    they?
        Chairman Donaldson. The shareholders select the board, and
    the board selects the management.
        Chairman Shelby. Right.
        Chairman Donaldson. And we are in the process of reflecting
    that in terms of the increased responsibility that the board
    has.
        Concurrent with that is the access to the board and the
    formation of the board, the election process by shareholders.
    And what we have put out for comment are several different
    proposed rules. Two of them are already out there. The first
    has to do with making companies explain in their proxy
    materials just how shareholders can have access regarding their
    concerns at a company. To whom do they write? Where is the
    forum for them to express, outside of voting, their views?
        Number two is we have asked companies to explain in their
    proxy material just how they have gone about selecting
    directors. What is the process that the company has used to
    bring forth its slate? And how have they treated self-
    nominating people? How have they examined people? How have they
    made the selection and choice on directors?
        Another part of our effort is upcoming, and that has to do
    with giving--in the event that there is indication that the
    company is not listening to the large shareholder groups--and
    by this we mean that when you have certain things in a proxy
    statement that have a 30- or 40- or 20- or 25-percent vote
    against certain things that shareholders want to have happen,
    and the company says, ``Thank you very much,'' and then just
    goes on, we say that is an indication of some nonresponse to a
    legitimate shareholder concern of that magnitude.
        In that case--and we have not yet proposed rules on this--
    we are saying that, if there is substantial evidence of that a
    situation or if there is substantial evidence of withholding of
    votes on the management slate indicating dissatisfaction, we
    want to make it possible for shareholders to get together and
    get somebody on a management slate.
        Now, I do not want to go into too much detail here.
        Chairman Shelby. You probably do not need to.
        Chairman Donaldson. But there will be, I believe,
    safeguards associated with this if the Commission moves ahead
    with it, safeguards indicating that a nominated person cannot
    and will not be an employee of some special group that puts
    forth the nomination; that the nominated person that goes on a
    management slate will be subject to the same conflicts of
    interest protections, if you will, so that competitors do not
    get put on the board. A whole series of safeguards, if you
    will.
        But we think that it is time--and, again, I am speaking for
    myself now because the Commission has not voted on this. We
    think that it is time----
        Chairman Shelby. You feel you are on the right road, don't
    you?
        Chairman Donaldson. I am sorry?
        Chairman Shelby. You are on the right road here, aren't
    you?
        Chairman Donaldson. Well, I believe we are.
        Chairman Shelby. Thank you very much.
        Senator Sarbanes.
        Senator Sarbanes. Thank you, Mr. Chairman.
        Chairman Donaldson, first I want to thank you for a very
    comprehensive statement. I know you abridged it in your oral
    presentation, but it is very helpful to have this very thorough
    and thoughtful review which the Commission has provided us here
    this morning.
        Chairman Donaldson. Thank you.
        Senator Sarbanes. When we did the first hearing on
    accounting and investor protection issues raised by Enron, we
    had five former Chairmen of the SEC here to lead that off, and
    they all expressed concerns about a culture on Wall Street that
    led to the scandals. Chairman Ruder described a philosophy that
    seeks to skirt the edges of accounting rules. Chairman Williams
    described an attitude that form is more important than
    substance, whether complying with the letter of the law rather
    than the spirit is acceptable. Chairman Arthur Levitt
    characterized it as an obsessive zeal by too many American
    companies to project greater earnings from year to year in what
    he called a culture of gamesmanship that says it is okay to
    bend the rules, tweak the numbers, and let obvious and
    important discrepancies slide, in which the companies'
    analysts, auditors, and directors are all complicit.
        And when you testified in May of this year, you said,
    ``Recent remarks by some business leaders lead me to worry that
    some just do not get it. While I certainly hope and think that
    many do get it, let me say very clearly we are not just going
    to assume that Wall Street or the business community gets it.
    We are going to be vigilant. We are going to be watching for
    compliance.''
        Now, since those comments, and in view of the earlier
    comments by your predecessors, do you think that more and more
    business leaders are, in fact, now getting it? Do you sense any
    change in the culture that led to these deficiencies that we
    sought to address in the legislation?
        Chairman Donaldson. Well, without repeating and boring you
    with the repetition of what I might have said here before, let
    me say again, in direct answer to your question, that I think
    we are making some progress. This is a multifaceted attack on
    what I consider to be a complacency and an erosion of ethics,
    if you will, that occurred during almost the past decade of the
    bull market. And, again, going into history, if you look back
    to 1929, the history unfortunately does repeat itself. Similar
    things that went on back in 1929 that gave rise to the
    securities acts in the early 1930's.
        I do not think that you turn that attitude around on a
    dime. I think it requires a multifaceted attack on it, and we
    are doing that. You have helped us do that with the Sarbanes-
    Oxley Act, which has brought a lot of companies and company
    boards up short in terms of their procedures. And I think that
    is step one.
        I think the fact that we have the PCAOB now riding herd on
    the accounting profession and with a new level of supervision
    is step two. And I think that is beginning to have its effect.
        I think the results of the so-called global settlement and
    the separation of research from the investment banking industry
    hopefully will place research back in its proper role. And
    hopefully a combination of all of these things will add to the
    beginning of the end of the game of earnings manipulation, and,
    again, the beginning of the end of that attitude that says we
    can play with our numbers, we can postpone expenses, or we can
    hide earnings in order to conform with the straitjacket of
    unrealistic earnings per share growth every quarter that Wall
    Street has insisted upon.
        I think that is gradually changing. I do not think it will
    change overnight. My own personal hope is that perhaps long
    after I am gone, finally, companies will tell Wall Street how
    they are going to run themselves as opposed to Wall Street
    telling them how they are going to run their companies.
    Hopefully companies will announce that we are not going to have
    earnings per share growth every quarter, that we are going to
    reinvest, we are going to do what is necessary to make us a
    good, long-term investment. I believe eventually that will
    happen.
        But that is an elaborate answer to your question, I think
    my own judgment on the intangible aspect of what we are trying
    to do, stopping short of going out to the new red line of law,
    of not skating on thin ice, I think that is beginning to
    happen. Although if you take a look at some of the sensitive
    areas of, let's say, compensation and so forth and look at what
    happened in the last proxy season, I think there still are
    areas where people are not getting it as far as pay for
    performance and definition of what performance is.
        Senator Sarbanes. Mr. Chairman, my time is up. I will defer
    to the next round.
        Chairman Shelby. Senator Dole.
        Senator Dole. Mr. Chairman, in the past few years, many
    commentators have raised concerns about the prevalence of pro
    forma financial statements, those statements that are not
    required, as you know, of course, to comply with generally
    accepted accounting principles. Can you tell us whether
    Sarbanes-Oxley and other reforms have reduced the use of pro
    forma financial statements? Do these issues still exist? Or has
    the law discourage market participants from making additional
    disclosures?
        Chairman Donaldson. Well, I think that increasingly the use
    of misleading pro forma kinds of calculations is being whittled
    out of the system. I think the issue, Senator, is one of
    misleading people. I mean, it is fine to have discussion of pro
    forma results so long as people get the GAAP results, the true
    results, and are not misled by a management decision to take
    out certain expenses and pro forma something based on what they
    think is the real earning power of the company.
        Senator Dole. It has been reported that there were problems
    implementing the CEO certification provisions of Sarbanes-
    Oxley. It was reported that problems have resulted from the two
    different CEO certification provisions contained in the
    securities law and in the criminal law.
        Did reconciling these differences present a problem for the
    SEC? And has the provision really served its intended purpose?
        Chairman Donaldson. Well, I will answer that in one way.
    The head of one of America's largest corporations came to see
    me to discuss this, and he made the statement to me that he
    always felt that when he signed his name on anything, it should
    mean something. And he said it did not make any difference to
    him whether he had to sign these new statements or not. I
    thought that was an interesting comment. Referring back to the
    legal advice that a lot of companies are getting in the initial
    stages, I think lawyers have scared managements about the risk
    they are taking in signing these things. I think the whole
    process will be viewed eventually as a positive one. It
    requires a very careful internal review of what is going on,
    and it is not just a piece of paper that is passed by the CEO
    and he signs. He signs it, and he is careful with what he
    signs, and I suspect he is very careful with the numbers coming
    upward in the organization to him, requiring the same
    carefulness, if you will, and precision to the numbers coming
    up to him.
        Senator Dole. Could you discuss with us some of the
    findings of the I believe it is Section 702 of Sarbanes-Oxley
    that required a study of credit rating agencies. Could you tell
    us a bit about what the findings with regard to this part of
    the law are? And did the Commission find barriers to entry for
    credit rating agencies? Would we benefit from more credit
    rating agencies? And should the Commission even be involved in
    the process?
        Chairman Donaldson. Well, this is a major issue before the
    Commission right now. As you know, we have a system where
    access to being a recognized credit rating agency severely
    circumscribed. And it raises a number of issues as to whether
    there should be more access to becoming a recognized credit
    rating agency. It raises the issue of confidentiality of
    information given to the credit rating agencies.
        Clearly, I think that the oversight that we have, we are
    part and parcel of the circumstances leading to the limited
    number of credit rating agencies there are right now. And we
    have put forth a whole series of questions and suggestions for
    public comment on the issue of credit rating agencies, and I
    expect I will be back to you at some point with some final
    conclusions that we have.
        Senator Dole. Could you tell us how much money has been
    returned to defrauded investors through the Fair Fund at this
    point?
        Chairman Donaldson. The Fair Fund?
        Senator Dole. Yes.
        Chairman Donaldson. Approximately a billion dollars.
        Senator Dole. A billion?
        Chairman Donaldson. A billion. But that money has not been
    distributed yet because the distribution mechanisms are still
    before the court in terms of the distributions of the money.
        Senator Dole. How do you envision the relationship of the
    SEC and the PCAOB? Has the PCAOB taken any action that the SEC
    disagrees with?
        Chairman Donaldson. The bottom line is that we have an
    excellent relationship, an increasingly good relationship with
    the PCAOB. The PCAOB is a start-up organization faced with not
    only renting offices but also setting standards and so forth
    against a tremendously demanding schedule.
        I think that the schedule and the deadlines have been met,
    and I think that the PCAOB directors and staff deserve a lot of
    credit for meeting the schedule.
        I will not say ``clash,'' but the natural interface, if you
    will, between the PCAOB as they put forth these rules and
    regulations and our people as they review them against a
    deadline has caused a creative and constructive dialogue
    between the organizations.
        Some of those deadlines are past. We have a new Chief
    Accountant coming to the SEC, arriving at the end of this
    month. We have a great leader who has come to the PCAOB. We
    interface with them on a daily basis, and that the relationship
    is excellent.
        Senator Dole. Thank you.
        Chairman Shelby. Senator Bayh.
        Senator Bayh. Thank you, Chairman Shelby.
        Thank you, Chairman Donaldson. I am very grateful for your
    taking on this arduous task and for getting off to such a
    positive and productive start. I regret that I was not able to
    hear the opening statements of our Chairman and Ranking Member,
    but I do share your positive assessment about the effects of
    this law. There is nothing more important than the transparency
    of our capital markets, and you have been played a big role in
    helping to get us off to this positive start.
        I did not have a chance to hear the comments either of
    Senator Santorum or Senator Crapo, but I wanted to focus my
    remarks and my questions on small business. And you alluded to
    the fact that your staff has tried to look at small businesses
    and what we can do to try and lighten their loads, if at all
    possible.
        My interest in this subject stems from the role that small
    businesses play in our economy. I believe the statistics show
    that over the last couple of decades the Fortune 500 companies
    have created close to zero net new jobs in our country, while
    small businesses have generated millions and millions of new
    jobs. So they tend to be one of the real dynamic forces in our
    economy, and anything that we can do to help to ensure their
    continued productivity, job hiring capacity, while meeting the
    transparency requirements, I think is in the best interests of
    our society. So it is how to strike that right balance,
    particularly for these smaller companies.
        Most of the comments I have heard tend to focus on a couple
    of things, and let me just throw them out and see if I can ask
    for your response. The internal audit functions in the smaller
    companies, they have lower cashflow, and yet the smallest
    publicly held companies most often are held to the same
    standards as the ones that are much, much larger. And for them
    it is no big deal to meet these requirements.
        Has your staff or have you focused on, given any thought to
    any additional flexibility there or what might be done to
    lighten their burden in that regard?
        Chairman Donaldson. Yes. Let me begin by making a personal
    comment, and that is that I was a small businessman at one
    point, and I went through the growth of a company and then
    through the decision to go public with that company. And as a
    result of that experience, I think I would emphasize that when
    one reaches the stage that you want to have access to public
    money and to bring in outside shareholders, you assume a new
    level of responsibility and cost.
        Senator Bayh. Of course, but we should help them to meet
    that in as efficient a way as possible, recognizing that there
    are differences between the smallest publicly held companies
    and the gargantuans.
        Chairman Donaldson. Yes, and I just want to start by saying
    that, because I think there is an additional cost. And clearly
    the other side of this is that we are very aware--the
    Commission is and the staff is--of the burdens on smaller
    companies. We have tried as much as we could within the context
    of our obligations to recognize that. We have given some of the
    smaller capitalized companies an extension of time to get
    themselves organized in terms of bringing in outside directors,
    et cetera.
        Senator Bayh. Well, let me ask about that before my time
    expires. That is another challenge I hear them mention with
    some frequency. Many of the smallest businesses, as you know,
    have a very high percentage of insider ownership, and very
    often seats on the board are held by venture capitalists. These
    are sophisticated investors who are unlikely to be confused in
    one way or another, and they want a seat on the board.
        The perception of the greater risk of liability under the
    new standards and the pending changes in the treatment of stock
    options have made it, among other things, more difficult to
    attract outside independent directors for some of these smaller
    businesses.
        Anything we can do about that?
        Chairman Donaldson. Yes, I think there is. I think not only
    for smaller businesses but also for larger businesses, we are
    putting more obligations, more responsibility on directors, and
    I think that means that companies--even large companies, but
    also small companies--are going to have to reach outside the
    traditional sources of directors. I mean, not everybody can
    have a CEO or a group of CEO's on their board. And there is a
    huge number of highly qualified people out there who could
    become directors. And I think one of our jobs and one of the
    jobs of the educational system in this country is to work on
    the education of a new class of directors, if you will.
        Senator Bayh. My time has expired. I would just say one of
    the challenges--at a time when the downside of becoming a
    director is greater because of the potential for more
    liability, the upside has been affected because of the pending
    change in the treatment of stock options. And many of the
    smaller companies, it is much harder for them to pay cash. A
    Fortune 500 company has more tools in their arsenal to attract
    some of this new legion of potential directors you have
    referred to.
        Chairman Donaldson. Right. In terms of options for a
    second, I think that your statement is just right, that the
    options are only one tool. There is restricted stock. There is
    cash. There are a lot of noncash ways of compensating
    directors. In fact, I suspect in the type of company you are
    talking about that the expense--a recognition of option, the
    true expense of options will not eliminate the issuance of
    options. It will maybe make people a little parsimonious with
    them because now we know what their real cost is.
        Senator Bayh. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Stabenow.

                  COMMENTS OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Thank you, Mr. Chairman, for having this
    important hearing, and thank you, Chairman Donaldson, for your
    leadership in this challenging time.
        I would like to specifically ask for your comments
    regarding a portion of Section 301 that I authored concerning
    corporate whistleblowers, and I have written a letter directly
    to you and I appreciate the response. As we lay out the
    strategies for making sure this does not happen again and we do
    not see in the future tens of millions of dollars in equity or
    thousands of jobs lost are to make sure that those within the
    company or those who are investors who have information
    concerning questionable auditing practices, accounting
    practices, have the ability to speak directly to the audit
    committee. And as you know, that provision in Section 301 does
    allow that every employee at companies would have a mechanism
    through which to submit confidential and anonymous concerns
    about questionable auditing practices and procedures directly
    to the public company's audit committee.
        What I am disappointed about is that the Commission opted
    not to create a clearer and more extensive rule implementing
    this portion of the law. The rule language that the Commission
    ultimately adopted basically mirrors the law itself without
    additional guidance, which I know has been raised as a concern
    by many that I have talked to.
        I am certainly not supporting an overly prescriptive rule,
    but I do think that the current Commission guidance is
    insufficient regarding this point and is really stymieing
    effective enforcement. And I wonder if you might speak to a
    Wall Street Journal report on July 22, when they indicated that
    many observers feel that, ``there still is not an easy way for
    corporate whistleblowers to communicate directly with board
    members. ``Even more troubling,'' the article went on to say,
    ``many executives have set up hotlines to take complaints from
    employees, investors, and others about ethical misdeeds, but
    executive often screen those confidential complaints before
    sharing them with directors.''
        Clearly, prescreening of the concerns does not comply with
    my intent or, I believe, the intent of the Members in passing
    this. And I am very concerned that some companies who are
    prescreening would argue that they are complying because the
    rule at this point is vague concerning that point.
        The Wall Street Journal goes on to further confirm reports
    I have heard from other sources, including a major accounting
    firm, that, in fact, the rule is not being fully and
    effectively enforced. And so I am sure you share the desire to
    have it fully and effectively enforced, so I would like to have
    you speak, first of all, to the report that some executives are
    prescreening confidential submissions by employees to their
    companies. Would you address that and whether or not you
    believe that is appropriate?
        Chairman Donaldson. Thank you for 301, and thank you for
    your concern. I think the Commission decided that, at least at
    this juncture, it would be a mistake to have a one-suit-fits-
    all hard and fast rule. I think that we decided to place within
    the audit committee the responsibility--and it can go beyond
    that if the overall board wants it to--for structuring a
    whistleblower system or regime that was appropriate to that
    company. Companies are all different sizes. There are many,
    many different ways of skinning a cat, if you will, in terms of
    having access to legitimate whistleblowing kinds of
    communication.
        I think that this will be an area that we will continue to
    monitor very closely. And, again, hopefully access by
    shareholders to the board that we are putting forth in our
    proxy suggestions here should give another venue to
    communicating with the board if the whistleblowing procedures
    by individual corporations are not working. But as of right
    now, I think we wanted to give the flexibility to arrive at the
    suit of clothes that fit the particular situation.
        Senator Stabenow. Mr. Chairman, I appreciate that, but I
    also know that without guidelines, without some more specific
    direction, it will be unclear to monitor whether or not they
    are complying with the law. And that is my concern, and I guess
    I would ask if companies, in fact, have management engaged
    right now in confidential communications that are supposed to
    be going directly to the audit committee, do you think that is
    appropriate?
        Chairman Donaldson. Well, I do not. I am glad to hear your
    comments. You have heighten my interest in this area, and you
    can be sure that when we come back to you at some point we will
    give you a report on our appraisal of the whistleblowing
    effectiveness.
        Senator Stabenow. I see that my time is up, but I would
    just indicate I very much want to continue to work with you,
    and we continue to work with those in the field, and the
    feedback we are receiving is that it would be very helpful if
    the Commission were giving greater guidelines, understanding
    different sizes of companies and different structures. But if
    we are, in fact, going to use the knowledge of employees and
    have them feel they can come forward, as well as investors and
    others, to provide critical information, we have to be able to
    evaluate whether or not a company is, in fact, conforming with
    the requirements of this section of the law. I believe we have
    some work to do in order to make that happen.
        Chairman Donaldson. Let me offer to submit for the record a
    more elaborate analysis of the current status of the
    whistleblowing situation.
        Senator Stabenow. Thank you.
        Thank you, Mr. Chairman.
        Chairman Shelby. Thank you.
        Senator Corzine.

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman, I appreciate very
    much your holding this hearing. I think it is one of those
    oversight functions that we need to do on a pretty regular
    basis. I think a lot of us agree that the real test of this
    legislation and its impact will be through time, at times when
    people are a little less sensitive and markets are a little
    more robust; and time will be the real test of whether much of
    this stands in good stead. I predict that it will.
        I compliment then Chairman Sarbanes, and Senators Dodd and
    Enzi and the current Chairman for their leadership in this
    effort. I think we have laid out a very strong framework.
        I want to ask a couple of questions that I hear regularly
    tossed around, although as the stock market goes up, I hear
    less of this. There is a macro concern that Sarbanes-Oxley was
    somehow undermining the risk-taking taste of American business,
    that it had undermined the will of those to be entrepreneurial.
        Have you, Mr. Chairman, seen any signs of that? Are there
    any indications about diminished risk-taking in our corporate
    world that are a function of this particular legislation?
        Chairman Donaldson. I, of course, hear those comments even
    as you do.
        Senator Corzine. They seem to be diminishing as the Dow
    goes up each 100 points or 50 points.
        Chairman Donaldson. I think that we have had a situation in
    this country in which we have had a recession, major
    overcapacity in particular industries, a major belt-tightening,
    and all of this against a backdrop of concerns that anybody who
    is running a company has, concerns as to making capital
    expenditures, in terms of working off the excess capacity
    before new expenditures are made, concerns obviously about the
    international situation, whether it be terrorism or Iraq. There
    are lots of reasons why business leaders might be not quite as
    eager to make certain kinds of business decisions based on the
    business situation.
        I do not believe that Sarbanes-Oxley is a major part of
    that. I do not believe that this law has inhibited. I think
    businesses will make business decisions if they are good
    business decisions, and I do not think--again, there is a cost
    to Sarbanes in terms of the actual costs of implementing it,
    but in terms of----
        Senator Corzine. But obviously there are benefits that come
    from greater transparency and security.
        Chairman Donaldson. Exactly. As I said before you were
    here, I believe that ultimately people will recognize that
    business processes have been improved by Sarbanes-Oxley and
    businesses are running better because of them.
        Senator Corzine. Thank you. I am quite obviously in total
    agreement with that point of view.
        We have recently seen in nonpublic forums some rising
    concern about governance of mutual funds within the context of
    some of the activities and the use of fees and interlocking
    relationships to generate relationships.
        Do you think this is one of those areas where the safe
    haven of being a private enterprise since mutual funds
    interface with the public so much that we may want to examine
    some of the governance rules that Sarbanes-Oxley and reporting
    with respect to the governance rules might also apply? Have you
    thought that through? I suspect the Commission is concerned
    about some of the reports we have heard, but is this another
    place where we should examine governance and have some of the
    same requirements in application?
        Chairman Donaldson. As you know, we have been in the field,
    if you will, with a number of examinations in terms of some of
    the practices of the mutual fund industry in terms of
    inducements to sell their shares, inducements that are not
    known by the purchaser. This also has to do with the brokerage
    firms that sell the shares. We are looking at a number of
    issues in the mutual fund industry, and in many ways, that all
    tracks back to governance and oversight, and I clearly believe
    that this is an area, particularly in view of some recent
    developments, where the whole issue of oversight comes front
    and center.
        Senator Corzine. Thank you. I see my time is up. I have a
    number of questions----
        Chairman Shelby. You go ahead.
        Senator Corzine. --not unlike Senator Stabenow with Section
    307, your early views with regard to the lawyer provisions and
    whether you think the rules of reporting up the chain of
    command are accomplishing the end. Have you had enough
    observation--enough datapoint of observation--to understand
    whether it is effective and any general comments you have on
    it. I think it ultimately could be one of the more important
    checks and balances that you put into a system. And I know
    there is a lot of controversy about who is representing who
    with regard to this. Lawyers see a lot of the activities.
        Do you have comments that you would like to make?
        Chairman Donaldson. Yes. You touch on a number of things
    there. Clearly, in terms of the so-called reporting up, I think
    that this has been clarified. I think it has been helped by
    some of the recent rulings of the House of Delegates of the ABA
    in terms of flying in the face of traditional lawyer concepts
    of confidentiality.
        As far as how well is it working, I think it is too early
    to tell, but I think major progress has been made in terms of
    the acceptance of the reporting up issue.
        Senator Corzine. Are there empirical examples where you
    have seen--or objective situations--that process work in a
    different way than you would have expected it to prior to
    Sarbanes-Oxley?
        Chairman Donaldson. I really hesitate to make a judgment on
    that right now. It is in place, and I just do not think we have
    had enough experience with it.
        Still unresolved is the issue of reporting out, so-called
    ``noisy withdrawal'' and so forth; that is a much more
    complicated issue, and we are thinking about it, but we have
    not addressed it yet.
        Senator Corzine. This is one of those areas, Mr. Chairman,
    where I am sure I will ask questions in the future, because I
    think it does have tremendous power in bringing discipline to
    the internal processes of checks and balances on behavior.
        Chairman Shelby. Thank you.
        Senator Dodd.

                STATEMENT OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Thank you, Mr. Chairman.
        First of all, Mr. Chairman let me add my voice to others'
    and thank you for the hearing today. This is extremely
    worthwhile. I do not know of anything that we have done in this
    area in the number of years that I have been on the Committee
    that is as important as the Sarbanes-Oxley legislation.
        Let me also commend my colleague from New Jersey. While he
    sits at the end of the table here in terms of Senatorial
    seniority, his contribution to the product that ultimately
    became Sarbanes-Oxley was immeasurable, and his previous
    experience added a great deal of value to the debate and
    discussion. And Mike Enzi as well as my colleague from
    Maryland, played critical roles.
        The wonderful thing is that no legislation is ever perfect,
    of course, and this is no exception, but it has been remarkable
    for this Senator, anyway, the tremendously favorable comments.
    Normally, with something this radical in many ways, done in the
    period of time in which we did it, considering how short a
    period there was between basically February and July, I think
    it was, Paul, stunning the positive response I have received,
    anyway, from members of the corporate community on how well
    this is working. Now, obviously, it is early yet in the
    process, but I fully expected far more negative reactions to
    this, at least in the early phases of it, and I am getting
    quite the opposite reactions.
        I think we are also fortunate, Chairman Donaldson, to have
    you heading the SEC, and I do not say that lightly. We have
    known each other for a long time, but aside from that personal
    friendship, I think you are the right person here at the right
    time and am very grateful for your willingness to serve.
        I just had a couple of quick questions I wanted to ask, but
    let me preface the comments if I may about some concerns that I
    have. One is the accounting industry--and this probably does
    not need to be said with this audience here, but it is
    critically important--obviously bears a tremendous burden for
    an awful lot of the problems that occurred with Enron and with
    WorldCom. But we also need to make it clear that with the idea
    of capital formation in this country, a healthy, vibrant
    corporate sector depends absolutely and critically on a vibrant
    accounting industry. And sometimes I worry that there are those
    who almost think that we can be better off without an
    accounting industry, but it is going to be extremely important
    that we restore the confidence that this industry contributes
    to the restoration of confidence and that we do the same. It is
    going to be absolutely essential.
        I state that as a backdrop to a couple of questions about
    what is going on. There have been some articles recently that
    indicate there has been a surge in mergers occurring within the
    accounting industry. I wonder if you might share with us your
    thoughts about this, if you have any at this moment. Is this a
    positive or a negative thing?
        A lot of it, we are told, at least in the articles I have
    read, is occurring as a result of Sarbanes-Oxley. Some firms
    are, of course, applauding the Sarbanes-Oxley legislation as
    providing new opportunities for them. I note one article that
    caught my attention on the subject matter, written for The
    Chicago Tribune by--and I hope I do not mispronounce the name--
    Ameet Sachdev, a Tribune staff reporter. It goes on and talks
    about since January, there have been about 10 deals led by New
    Jersey-based J.H. Cohn acquisition of the Videre Group. In the
    Midwest, there have been some smaller transactions.
        The article goes on to say it is not exactly merger mania
    of a few years ago, but there are some clear trend lines that
    are occurring in this area.
        I will ask unanimous consent that this article be included,
    along with my questions, so that people can get some sense of
    it here.
        Chairman Shelby. It will be made part of the record.
        Senator Dodd. But my question is, as I have stated already
    to ask you, do you think these mergers will have a positive or
    a negative effect on the industry as a whole, and does the
    existence of fewer accounting firms, which may be the end
    result here as we are looking at it, indicate less competition
    as a logical outcome of the mid-size firms expanding to compete
    with the Big Four accounting firms?
        Chairman Donaldson. I think that the challenges facing the
    accounting industry are considerable, and I think that we are
    lucky to have the PCAOB in business and operating as it is,
    devoting the resources to the oversight of the accounting
    industry, and in terms of its standards, registering the
    participants, et cetera.
        The challenges facing the accounting industry are
    considerable. Number one has been the shrinkage down to four
    major firms and the change in the structure that these firms
    have been faced with in getting rid of their consulting
    activities and so forth. I think that as a business, the
    accounting business has lots of challenges.
        Number two is that our generally accepted accounting
    practices are under considerable need for review, particularly
    as we move into trying to reach an international standard, if
    you will, as we become more globalized. And the tradeoffs
    between rules-based and principle-based accounting are very
    difficult to reconcile in terms of attitudes toward that,
    particularly in Europe and here. If you want to go one step
    further, we are a post-industrial society, and we have an
    accounting system that is based on a heavy industrial society.
    And they are not particularly pertinent or realistic in terms
    of the service society we are in and the whole change of
    valuation of human assets as opposed to plant and equipment.
        So, I think there are tremendous competitive issues. I
    think the fact that we have only four major accounting firms is
    a matter of concern to me. I do not have an answer to that, but
    that is a problem for the Nation, I believe.
        Senator Dodd. Well, the merger issue is one; it goes to
    that point of dropping of clients. I read here, if I could go
    back to this article, that, ``Ernst & Young LLP has parted ways
    with about 200 public and private clients.'' Some have left
    over fee disputes and so forth, according to this article. But
    one of the purposes of having a hearing like this is to
    determine what is happening out there in the marketplace, and I
    happen to have been a strong supporter of all the provisions in
    the Sarbanes-Oxley legislation--although none of us can
    guarantee there will not be unintended consequences. Obviously,
    there have been issues raised about the functions, the
    combination of functions, the consultative function in addition
    to the traditional accounting function and the prohibition in
    those areas that probably led to some of this.
        What are the implications of that? Are you monitoring this?
    Are you watching it? How is the accounting profession changing
    its practices? We notice already, according to one survey here,
    that prior to the adoption of Sarbanes-Oxley, audit committees
    were meeting--they are now meeting more frequently with outside
    auditors. Before the Act, as determined by one accounting firm,
    only 15 percent of their corporate clients surveyed met at
    least six or more times per year. Since the passage, that
    number has jumped to 60 percent, from 15 to 60 percent--
    obviously a very positive outcome.
        What is going on? This is obviously an area that is
    critical, as I said at the outset of my questions. We need to
    get this accounting industry right. You are not going to
    function if it does not get right. I am uneasy about a lot of
    mergers and acquisitions that could even further limit the
    number of firms. A lot of firms are not taking on public
    clients at all, do not want to deal with public clients. What
    are the implications of that?
        That is the thrust of my question.
        Chairman Donaldson. Yes, it is a very legitimate question.
    I think that one statement I would make is that I believe we
    have very strong leadership now in the various government or
    quasi-government agencies having to do with the accounting
    industry. At the FASB, the standard-setting organization, I
    think we have very strong leadership there, facing up to a
    number of problems that have not been faced up to. I think we
    have, as I mentioned before, strong leadership in PCAOB in
    terms of not only oversight but also constructive oversight.
        I think we have a need on the part of the industry itself,
    the profession itself, to have a recognition of past failures
    or breakdowns and internally what can be done about that. It is
    a group effort.
        I think we are moving in the right direction, but, as I
    say, the challenges are immense.
        Senator Dodd. Yes, I know that. You might keep an eye on
    this. As I say, I realize all of that is from the regulatory
    and governmental standpoint, but watching what goes on at the
    marketplace as a result of what we are doing here is also very
    much--I am interested in monitoring and following that and what
    sorts of behavior and changes in behavior--some are obviously
    very positive. You only had 15 percent of the corporate clients
    who were meeting more than six times a year as an audit
    committee--no wonder--it amazes me we did not have more
    problems--maybe we did, we just did not find them. In fact,
    that number has jumped from 15 percent to 60 percent. It is
    tremendously healthy and a very positive outcome.
        I am not even sure that maybe more mergers and acquisitions
    make sense. I am not even suggesting it is negative. I just
    want to know what you think about it, or what the SEC thinks
    about it, as to whether or not this is a trend line that should
    cause us some pause or some concern, as we monitor the
    implications of Sarbanes-Oxley.
        Anyway, we can stay in touch on this. I do not expect
    necessarily a categorical answer today, but I would like to
    follow up on that, Mr. Chairman, if we could, to keep an eye on
    that.
        Chairman Shelby. Sure.
        Chairman Donaldson. Yes.
        Senator Dodd. Thanks.
        Chairman Shelby. Senator Schumer.

                 COMMENT OF SENATOR CHARLES E. SCHUMER

        Senator Schumer. Thank you, Mr. Chairman, and thank you,
    Chairman Donaldson.
        I want to follow up on some questions I asked you at your
    confirmation hearing on an issue that has been of concern to me
    all along, and that is the balkanization of some of our laws
    and securities laws in particular; the need for, one, national
    securities regulation and two, how having State involvement
    affects that.
        Obviously, you want all prosecution of wrongdoing done by
    no matter who does it, but then, when there are settlements,
    those tend to be on the borderline between punishment for a
    single act and setting new rules. I was interested in the
    recent indictment by the Oklahoma Attorney General of WorldCom
    executives. In the past this would have been a national
    function, because each State again could have its own rules,
    and there could be 20 different indictments. If there were ever
    a need for national markets, it is in these kinds of things.
        So the question is where is the balance. There have been
    some articles suggesting that maybe things have tipped too far,
    and frankly, some of them say that--I do not know if this
    applies to WorldCom--but there has been a vacuum in the SEC,
    and that is why State regulators have moved in, or State
    prosecutors have moved in, to fill it.
        I would be interested in your perspective now. We talked
    about this early on, and you were aware that this was a danger.
    Now you have been there for several months. Do you see a risk
    to our national system and a risk to national competitiveness
    from a balkanization of securities policy and enforcement?
        How successfully have you been able to work with State
    prosecutors and State regulators that involve the securities
    industry as they operate both within their States and at the
    Federal level?
        Chairman Donaldson. As I said before, and, now that I have
    been in this role for a little bit longer, I do not think my
    opinions have changed at all except to recognize that the SEC
    has had an excellent relationship with the local State security
    regulators. We have worked cooperatively with them. We need
    them. They operate at a level that, for many reasons, we may
    not be able to get at in terms of being on the ground locally
    and having the ability to get into situations that may fly
    under our radar; so that we enjoy working with them. And I
    think that the more cops we have on the beat out there, the
    better.
        On the other hand, when it comes to the solution, if you
    will, when it comes to not only finding the bad things and so
    forth, but also when it comes to what you are going to do about
    it, then I believe very strongly that we have to have a
    national securities regulatory mechanism, which we have in the
    SEC. And I think that we cannot tolerate the balkanization of
    that. It would be intolerable to have different rules in
    different States for how prospectuses should read or whatever.
        I think that, unfortunately, there has been a
    politicization, if you will, of enforcement in some areas of
    the country, and I think this is very dangerous. Let me cite
    the fact that both the civil and criminal procedures here are
    very delicate, as you know very well, and when you have people
    coming in from left field and not communicating with the people
    who are handling these procedures and run the risk that the
    people who are guilty of something are going to get away
    because of crossed wires, that is extremely dangerous.
        To my knowledge, Oklahoma, to use a specific example, did
    not consult with the authorities who were working on that case,
    did not consult in New York with the U.S. attorneys. They
    certainly did not consult with the SEC. And I think that that
    is not good.
        In terms of the uncovering of certain securities law
    violations, I think we really encourage that uncovering, and I
    believe that there should be cooperation. I believe that, if a
    tip is given to a local regulator, it would be only natural for
    them to come and talk to the SEC about it and try to work
    together on it. There should not be competition for glory, if
    you will, or political whatever, and unfortunately, that does
    tend to creep in.
        As our Director of Enforcement said the other day, relative
    to your State, we commend the Attorney General for the
    announcement last week that he brought forward. We wish that he
    had talked to us about it. We are working with him right now.
    But as far as there being any problem with his doing that, we
    have none.
        I think the only problem we have is in the structuring of
    the marketplace, which cannot be balkanized.
        Senator Schumer. You mention the marketplace, and I know
    Senator Corzine mentioned this before I came in, and I would
    like your judgment on this as somebody who represents New York
    and represents a lot of the financial service people. You are
    beginning to hear that because the rules, the goal lines are
    moving, that there is a dampening of entrepreneurial spirit.
    And one thing that has always been great about our markets is
    its entrepreneurial vigor. We have always had two kinds of
    regulation--we have had a banking industry where you put your
    money, and you want it to be safe, and it has been far more
    regulated. We have had a securities industry where you might
    make a fortune. You might lose a fortune. And obviously, the
    guidelines have been disclosure and treating all investors, big
    and small, equally; but otherwise, you are pretty much on your
    own.
        Do you worry about a decline in the entrepreneurial vigor?
    What some have gone so far to say is that we could push our
    securities markets overseas to other places if this goes too
    far; that when someone has a good idea or a potentially good
    idea that might have a big down side, they are not going to
    launch it in the United States anymore, and they might go
    overseas.
        I have not heard any examples specifically of that
    happening, but I have heard some talk about it. Could you give
    me your opinion? I am not sure what is the right answer on that
    one.
        Chairman Donaldson. Yes. I think that businessmen--and
    particularly legitimate businessmen and women--have a right to
    expect that they are not going to be unwarrantedly attacked
    from all angles by uncoordinated regulators. I think that they
    have a feeling that ``the Government''--Federal, State--is
    coming at them from all directions in the securities industry.
    I understand that feeling, and I think they have a right to
    demand that there is some coordination, that there is some
    cooperation between the regulatory authorities, and I think we
    can improve that. We are working to improve that right now with
    the North American Securities Administrators Association. We
    have a project underway with them now, working to set down some
    voluntary codes between us, which I think will enhance the good
    relationship that we have had.
        But I am sympathetic with those who feel that the
    uncoordinated attacks are coming from all directions.
        Senator Schumer. One final question if I might, Mr.
    Chairman.
        Chairman  Shelby. Go ahead.
        Senator Schumer. A different issue--your views on the gap
    between a public company's financial accounting, which is book
    income, and its tax accounting or tax income. The IRS
    statistics showed that in 2 years, the difference between these
    two widened from $92 to $159 billion, and most of that was in
    large companies who have assets of more than $250 million.
        There are clearly differences in the underlying rules, such
    as depreciation and stock options, but they do not explain the
    large difference. What you end up having is companies in their
    reports say, ``Hey, we made all this money,'' and to the IRS
    saying, ``Oh, we did not make much money at all,'' and I think
    it is a problem.
        I have drafted legislation that basically says, without
    exposing any proprietary information that might help a
    competitor, that we would require companies to reveal both, and
    that would have a prophylactic effect--it would not change any
    rules, but it would have a prophylactic effect of decreasing
    the gap.
        What do you think of that idea, just off the top of your
    head preliminarily?
        Chairman Donaldson. Off the top of my head, I think it is a
    pretty interesting idea. I have a few experts here----
        Senator Schumer. Well, do you know what? I think I am going
    to quit while I am ahead, and I would ask you to respond in
    writing. But I think it is a very good idea, and I have been
    talking to some of the regulators about this, and Mr. Chairman,
    I would just ask unanimous consent that Chairman Donaldson be
    given a period of time to respond in writing to that one for
    the record.
        Chairman Shelby. That would be fine.
        Senator Schumer. Great. Thank you.
        Chairman Shelby. Senator Carper, you are just in time for
    the first round if you have any questions.

                  COMMENTS OF SENATOR THOMAS R. CARPER

        Senator Carper. Thanks, Mr. Chairman.
        Mr. Chairman, how are you?
        [No response.]
        Senator Carper. I will say it again. Mr. Chairman, how are
    you?
        Chairman Donaldson. Great. Thank you.
        Senator Carper. You are not sure, are you? Welcome.
        Well, you have had a while to settle in; how does it feel?
        Chairman Donaldson. I am sorry, I did not hear you.
        Senator Carper. You have had a while to settle in; how does
    it feel?
        Chairman Donaldson. How do I feel? I feel pretty good,
    thank you.
        Senator Carper. How do you feel about the team you have
    assembled?
        Chairman Donaldson. How do I feel about----
        Senator Carper. The team you have assembled. Some of them
    are sitting right behind you.
        Chairman Donaldson. I feel very good about the team--and
    again, I am going to define that not only as the people who
    have come into the SEC while I have been there, but also I feel
    very good about the people who were there. As mentioned earlier
    here, I think they have done an incredible job in conforming to
    the dictates of Sarbanes-Oxley. I feel even better about the
    team that we are starting to build now. As we build up, with
    new people coming in and we are seeing some excellent
    candidates. I feel very good about the team that has been built
    with the PCAOB and the leadership there.
        So, I feel pretty good.
        Senator Carper. Good. When I was Governor of Delaware, I
    used to make regular ``customer calls.'' I would call on the
    businesses in our State, and I would ask them three questions.
    I would say: ``How are you doing? How are we doing, our
    administration? And what can we do to help?''
        I have already asked how you are doing. How are we doing on
    the legislative side?
        Senator Sarbanes. A key question.
        Chairman Donaldson. I think you are doing just exactly what
    you should do, which is to have a hearing such as this and get
    a report and feedback from me. I think you should get it as you
    do as part of your job, if you will, of being out there and
    listening to people. I think you can provide good feedback for
    us.
        We are working ourselves to listen. My role is to talk this
    morning, but I think we are trying to listen to what people are
    saying and their legitimate concerns about what we are doing.
        In terms of--if I may put in a plug here--I think the
    resources that you have given us are really needed as we build
    this thing up. I hope we are going to have the ability to stay
    with those resources coming down the pike, because we cannot
    build this thing up and move it back down again. The SEC has
    needed more resources that we have now, so I thank you for
    that.
        Senator Carper. You and your predecessor both encouraged us
    to provide those resources, and we have done that.
        Chairman Donaldson. You have done that.
        Senator Carper. And I am pleased to hear that they are
    proving adequate.
        What can we do to help?
        Chairman Donaldson. How can you help?
        Senator Carper. What can we do to help further, to enable
    you to do your job better, and your troops to do your job
    better?
        Chairman Donaldson. I think that we are working as fast and
    as hard as we can to address a number of issues. I think you
    have been helped by understanding in terms of the people
    buildup we have, that we are undergoing, that we are doing it
    carefully, that we are not going to run out and spend this
    money ill-advisedly. So we are going to build the new people in
    very carefully, and I think an understanding on your part would
    be helpful to us.
        We need to recognize that some of the rules and regulations
    that we are contemplating now need to be put through a process.
    They cannot be done overnight. We are trying to go about our
    work on hedge funds. We are trying to go about our work on
    market structure, on a whole series of issues facing us, and we
    are trying to do it carefully and brick-by-brick, and I know
    that there are some who may feel that these things should be
    done more quickly, and some feel they should not be done at
    all. And your support of what we are doing--and I do not ask
    your support other than if you believe testimony by me and
    others from the SEC that we are working as hard as we can to
    get done what I think you want to have done.
        Senator Carper. Thank you.
        A last question if I could, Mr. Chairman.
        Chairman Shelby. Go ahead.
        Senator Carper. Just real briefly, what do you feel best
    about in terms of your accomplishments so far, you and your
    team; and what are some areas where it is really work in
    progress, that you are working on it, but you are not there
    yet?
        Chairman Donaldson. Well--your microphone is just a little
    garbled for me, but if I understood----
        Senator Carper. It is probably not the microphone.
        Chairman Donaldson. --but if I understand what you are
    saying, one of the things we have not talked about at all in
    terms of projects yet to be completed is the structure within
    the SEC. I mean, we are adding a lot of people, and we have a
    structure and organization that we are trying to shift and
    change so that it will be more anticipatory than it is now, so
    that we will be able to have more communication between the
    divisions and more what I would call looking around the corners
    and over the hill to try to anticipate problems coming down the
    pike rather than just responding to stuff coming in over the
    transom, and that is a work in process.
        Also, and as I said before, we will make a terrible
    mistake, I believe, if we add people and simply have four
    people doing what three used to do. That requires organization
    and structure change, and we are working on that.
        Senator Carper. Unless maybe those three people did not
    have a life before, and now they do because there is a
    reasonable number of people to help them do their jobs, and you
    are not losing them or having the kind of turnover you were
    faced with before.
        Okay, good. Thanks. Good to see you. Our best to you and
    your team. Thanks for the work that you are doing.
        Chairman Donaldson. Thank you.
        Chairman Shelby. Senator Sarbanes.
        Senator Sarbanes. Thank you very much, Mr. Chairman.
        Chairman Donaldson, I am interested, as you know from our
    past discussions, in this pay parity issue for your employees
    with the other Federal financial regulators.
        When we put that provision in the law, we also said ``and
    benefits,'' so it is not just salaries, it is also the
    benefits--in other words, the entire employee package. And it
    is my understanding that as yet, a system of full comparability
    with the other financial regulatory agencies has not been
    achieved with respect to salary and benefits--in other words,
    the total package.
        We put that in because we were concerned about losing good
    personnel and about attracting personnel. We know we are not
    going to reach the levels that people can reach by going into
    the private sector, but at least we wanted to even the playing
    field as far as the public sector was concerned.
        Where are we on that issue?
        Chairman Donaldson. In terms of pay parity, I think we are
    very far along. I think we have pay parity. In terms of the
    benefits side of the equation, we are working right now with
    the unions. We have similar benefits, but not exactly the same,
    and, as in any organization going through change, we are
    working hopefully with those concerned to work at a benefits
    side that is consistent with benefits elsewhere and also
    consistent with the dictates of running an efficient
    organization.
        Senator Sarbanes. Sometimes, you know, the 401(k)
    provisions or the supplemental health benefits, things of that
    type, can make a very big difference in people's calculation
    about their employment situation, about the prospects of moving
    over to some other Federal financial agency that provides those
    things, and I think it is important for the SEC--we constantly
    cite the SEC as the premier regulatory agency in the financial
    field--that the whole package, both pay and benefits, be
    comparable to what is provided by the other financial
    regulators. I urge you to continue to look at that matter
    closely.
        Now, Mr. Chairman, I have a lot of questions that I could
    ask, but I know the hour is getting late, and I want to take
    the balance of my time--this is somewhat out of the ordinary--
    but I really want to quote from Chairman Donaldson's statement
    just to underscore it.
        Chairman Shelby. Go ahead. I agree with you this is an
    outstanding statement.
        Senator Sarbanes. Yes, yes, it certainly is.
        Toward the end of it, you have the heading, ``Honest
    Business in the Current Environment.''

        Just as the Commission has been moving forward with
    implementation of the Act, so too must American businesses.
    Corporate leaders are responding not only to the Act's
    mandates, but also to the movement toward increased
    transparency that underlies Sarbanes-Oxley. However, I have
    become aware that some in the business sector feel that they
    are under siege from new regulations, and the threat of
    additional litigation.
        As I have mentioned before, good, honest companies should
    fear neither Sarbanes-Oxley nor our enforcement efforts.
    Rather, they should recognize that the improved standards that
    the Act mandates and smart and fair enforcement of the laws are
    the right thing to do and help attract capital and investment.
    As William O. Douglas, then Commission Chairman and future
    Supreme Court Justice, pointed out in a 1938 speech: ''To
    satisfy the demands of investors there must be in this great
    marketplace not only efficient service but also fair play and
    simple honesty. For none of us can afford to forget that this
    great market can survive and flourish only by grace of
    investors.

        End of Chairman Douglas' quote, and resuming with Chairman
    Donaldson's statement:

        Good corporate governance is not primarily about complying
    with rules. It is about inculcating in a company, and all of
    its directors, officers, and employees, a mindset to do the
    right thing. As I have said before, the focus on doing the
    right thing should become part of the DNA of a company and
    everyone in the company from top to bottom. For companies that
    take this approach, most of the major concerns about compliance
    disappear. Moreover, if companies view the new laws as
    opportunities--opportunities to improve internal controls,
    improve the performance of the board and improve their public
    reporting--they will ultimately be better run, more
    transparent, and therefore more attractive to investors.
        I believe that this attitude is beginning to take hold in
    corporate America. During my travels, and in my discussions
    with company officials, countless people have told me that
    America cannot afford a return to the lax standards that
    preceded Sarbanes-Oxley. Many have added that while they
    initially questioned the merits of the Act, they now see that
    it can help show the way to a brighter, more competitive era in
    American business.
        The success of a new era under the Act must involve a
    continued measures of the risk-taking and entrepreneurship that
    are the hallmarks of honest American business. There have been
    suggestions, including in the press, that the recent crackdowns
    on corporations and executives by criminal and civil
    authorities, including the Commission, have discouraged honest
    risk-taking.
        I have a different perspective on recent developments. I
    believe the Act and the other steps that have accompanied it
    will lead to an environment where honest business and honest
    risk-taking will be encouraged and rewarded. What should be
    discouraged, and what we are committed to stamp out, are the
    activities that some have sought to disguise as honest business
    but that, in reality, are no such thing.
        Transactions with no substance that are designed solely to
    assure increased earnings or cashflow in financial reports
    involve no risk and are not honest business. Neither are
    transactions that are disguised as rewards for entrepreneurship
    or superior management but that in fact provide risk-free,
    excessive compensation or facilitate self-dealing for the
    benefit of insiders.
        I hope we have learned some lessons from the era just
    passed--and I believe we have. I also hope that America's
    corporate leaders will not use Sarbanes-Oxley as an excuse for
    putting off innovation and investment. Looking back 1 year, and
    also looking forward, nothing in the law, its implementation,
    or in the Commission's agenda should make business fearful.
    Indeed, a period marked by the responsibility and realism I
    have just discussed can provide the foundation for a new era of
    long-term growth and prosperity.

        Mr. Chairman, I agree with that statement of yours, and I
    urge you on in your endeavors.
        Thank you, Mr. Chairman.
        Chairman Shelby. Chairman Donaldson, I will try to wrap
    this up if I can.
        Sarbanes-Oxley, as you well know, provided the Securities
    and Exchange Commission with increased enforcement authority
    regarding corporate fraud and created new criminal liability
    for principal executive officers.
        There is a public perception that all too often, executive
    officers escape liability despite their fraudulent and criminal
    acts. Can you please describe--and you can do it for the record
    if you want to--can you describe the enforcement actions that
    the Securities and Exchange Commission and the Corporate Fraud
    Task Force have taken based on Sarbanes-Oxley, and has
    Sarbanes-Oxley led to a greater number of convictions and
    guilty pleas?
        As I said, you can do it for the record if you want to.
        Chairman Donaldson. Yes. Let me give you a complete list
    here.
        Chairman Shelby. Sure.
        [Pause.]
        Chairman Donaldson. In fiscal year 2003--and that is not
    yet over--the Commission has already brought 60 more
    enforcement actions than fiscal year 2001.
        Chairman Shelby. Did you say 60?
        Chairman Donaldson. More enforcement actions.
        Chairman Shelby. Sixty enforcement actions.
        Chairman Donaldson. Yes, 60 more enforcement actions than
    in fiscal year 2001, which is the last year before Sarbanes-
    Oxley came into effect.
        In terms of cracking down on corporate wrongdoing,
    particularly issuer financial fraud and reporting violations, a
    top priority--as of August 20 in fiscal year 2003, the
    Commission has filed 543 enforcement actions of which 147
    actions, or 27 percent of the total, involve issuer financial
    fraud and reporting violations.
        Further, during this period, the Commission sought to bar
    144 offending corporate executive officers or directors from
    holding such positions with publicly traded companies--nearly
    three times----
        Chairman Shelby. What was that last number--how many?
        Chairman Donaldson. That is 144.
        Chairman Shelby. One hundred forty-four.
        Chairman Donaldson. One hundred forty-four offending
    corporate executive officers and directors from holding such
    positions with publicly traded companies. That is nearly three
    times the number barred just 2 years ago.
        The Commission has achieved these results without
    sacrificing other areas of enforcement. Issuer fraud, insider
    trading, and misconduct by regulated entities and persons are
    all important program areas.
        I can go through these statistics in detail----
        Chairman Shelby. You can furnish that for the record.
        Mr. Donaldson. --and I would be glad to provide them to
    you.
        Chairman Shelby. But you are making progress under this Act
    is the message you are giving us right now; is that correct?
        Chairman Donaldson. Right. Well, let me stop there and say
    that I think the trends are in the right direction, and we are
    pleased with these results--not so pleased that we are going to
    let up, but pleased with the results to date.
        Chairman Shelby. You are sending a strong message, aren't
    you, that you mean business?
        Chairman Donaldson. Yes. We are trying to do that.
        Chairman Shelby. We appreciate your appearance, and we
    appreciate what you are doing with your leadership at the SEC.
    Keep it up.
        Thank you.
        Chairman Donaldson. Thank you.
        Chairman Shelby. The hearing is adjourned.
        [Whereupon, at 11:53 a.m., the hearing was adjourned.]
        [Prepared statement and additional material supplied for
    the record follow:]

                  PREPARED STATEMENT OF SENATOR ELIZABETH DOLE

         It is truly remarkable when we compare this year's business
    climate to the one we were experiencing just 1 year ago. Last year
    seemed to bring almost daily revelations of corporate scandal that
    extended all the way up to the very highest officers of some of our
    Nation's largest corporations. The greed exhibited by a handful of
    business leaders caused heartbreak for millions of Americans as
    pensions were lost and stock prices fell dramatically. The end result
    was that while some companies went out of business or struggled to
    regain their footing, the entire American economy underwent a grave
    crisis of confidence.
         While our economy continues today on its difficult path to
    recovery, there is little doubt that the recent scandals paved the way
    for valuable reforms. Most notably, the Sarbanes-Oxley Corporate
    Accountability law has given us new confidence in the financial
    statements of our businesses.
         While I do believe there are steps that can be taken to further
    ensure true auditor independence, we are seeing many positive results
    of the Act that President Bush signed into law a little over a year
    ago. Because of the scope of the law as well as its relatively recent
    implementation, I believe we must give the initiatives contained in
    Sarbanes-Oxley a chance to fully take effect before we consider
    additional steps.
         While Chairman Greenspan commented that he saw the expanded
    criminal penalties as the most significant portion of the bill, I would
    point as well to other important results of Sarbanes-Oxley. For
    instance, it has been reported that 2 years ago only 1 percent of Wall
    Street analysts recommended that investors sell. Today, that number is
    up to 20 percent. Honest assessments of a companies potential helps
    investors and employees alike.
         Of course, many of us still have questions as to how effective
    some of the initiatives in the law have been. That is why I want to
    thank Chairman Shelby for conducting today's hearing--so we can hear
    from Chairman Donaldson of the Securities and Exchange Commission about
    his agency's perspective on the implementation of the legislation. The
    SEC deserves special acknowledgement for their excellent work on
    Sarbanes-Oxley, which they have taken on in addition to all of their
    normal duties. Chairman Donaldson, I thank you for taking the time to
    join us here today and I look forward to your testimony.
         I believe the enactment of Sarbanes-Oxley marked a turning point
    in our Nation's economic history. While a few will still seek to
    manipulate financial statements for short-term gains, we now have
    strong checks against such efforts and even stronger penalties for
    those who perpetrate fraud on investors and employees. In addition, we
    have in Sarbanes-Oxley a mechanism to return funds to defrauded
    investors. This is a significant change in how corporations and the law
    will operate, and all of America is better for it.

                                   ----------

                 PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

        Thank you, Mr. Chairman. I appreciate that you have called this
    hearing to provide oversight on the implementation of the Sarbanes-
    Oxley Act.
         Although scandals like those that occurred at Enron and WorldCom
    are no longer front page news, it is essential that we remain vigilant
    and that we ensure that Sarbanes-Oxley is having the intended effect of
    restoring investor confidence and leading to greater accuracy and
    transparency in the financial statements of publicly traded companies.
         I am particularly interested in examining today how a portion of
    the law that I authored is being implemented. I am referring to Section
    301's whistleblower reporting mechanism.
         I offered that language to the bill because it became obvious to
    me during our 10 Committee hearings on the subject that, people knew
    there were problems in these companies and tried to speak up.
    Unfortunately, they were trapped in a corporate culture that silenced
    them. If their concerns had reached the proper people early on, maybe
    some of these companies would have stopped their phony accounting
    practices and tens of millions of dollars in equity and thousands of
    jobs would have been saved.
         As you know, Mr. Chairman, the amendment I offered to Sarbanes-
    Oxley ensured that, for the first time, every employee at these
    companies would have a mechanism through which they could submit
    confidential and anonymous concerns about questionable accounting
    procedures directly to the public company's audit committee. It is the
    audit committee, after all, that is ultimately responsible.
         I was disappointed to learn that the Commission opted not to craft
    a clearer and more extensive rule implementing this portion in the law.
    The rule language that the Commission ultimately adopted closely
    mirrors the law itself without sufficient additional guidance.
         While I would not have supported an overly proscriptive rule, the
    current Commission guidance is insufficient and this is styming its
    effective enforcement.
         Indeed, as The Wall Street Journal reported on July 22, many
    observers feel that, ``there still isn't an easy way for corporate
    whistleblowers to communicate directly with board members.'' Even more
    troubling, the article goes on to state that: ``Many executives have
    set up hotlines to take complaints from employees, investors, and
    others about ethical misdeeds. But executives often screen those
    confidential complaints before sharing them with directors.''
         Prescreening of these concerns clearly does not comply with my
    intent nor the intent of the greater Congress in passing this
    accounting reporting mechanism. But I fear that some companies who
    prescreen can and will argue that they are complying because the rule
    is too vague.
         This Wall Street Journal article only further confirms for me
    reports I have heard from other sources, including the head of a major
    accounting firm, that the rule is not having the full effect intended.
         That is why I decided to wrote Chairman Donaldson last month about
    the need to clarify the rule. I ask that a copy of my letter and his
    reply be included as a part of this hearing.
         In my letter, I articulated seven key actions that the SEC should
    be taking to make the corporate whistleblowing mechanism more
    effective. This list included: (1) instructing companies to make
    information about the reporting mechanism widely available to employees
    and shareholders; (2) requiring audit committees to examine ALL
    submissions, without interference or editing by company management; (3)
    keeping all submissions for at least 7 years; (4) interpreting the
    definition of ``employees'' for purposes of the rule to have a broad
    meaning, and, (5) moving to implement the rule more quickly.
         I am strongly committed to seeing this rule implemented
    effectively and I hope that Mr. Donaldson and I will have the
    opportunity to discuss this further today. I truly believe that this
    reporting mechanism is essential to restore investor confidence and
    avert any number of Enron-like scandals in the future.
         Thank you, Mr. Chairman. I appreciate your holding this hearing
    today, and I look forward to working with you, Senator Sarbanes, and
    our other colleagues to ensure that our securities markets can remain
    strong and vibrant.

                                   ----------

                 PREPARED STATEMENT BY SENATOR MICHAEL B. ENZI

        It does not seem so long ago that we would find ourselves back in
    the days of a seemingly endless list of corporate scandals. Almost
    every day we heard story after story of big corporations that had
    serious and severe financial problems and accounting staffs that had
    failed to live up to their responsibilities.
        As the only accountant serving in the Senate, I was very concerned
    about my profession and the very large black eye it received--and
    justifiably so--from the activities it had pursued over the years. I
    believe that we took the right step in passing the Sarbanes-Oxley Act
    to put the corporate governance system on the right track.
        At the events marking the first anniversary of the law, Chairman
    Donaldson, you remarked that, ``There is much, much work still to be
    done--many miles to travel.'' I fully agree with you. While the SEC has
    finished nearly all of its regulatory tasks the true work and effects
    of the law are just being realized.
        Now that we have passed the first anniversary of President Bush's
    signing of the Sarbanes-Oxley Act into law, we have witnessed broad
    changes in the marketplace and in overall corporate governance. We also
    have witnessed the placement of independent directors and effective
    auditors who are now an integral component of corporate oversight.
        As we now move into the next phase of the Sarbanes-Oxley Act, I
    urge the SEC to be vigilant in ensuring that small auditors and small
    publicly traded companies do not incur a disproportionate regulatory
    effect of the law. The growth of our small business community is vital
    to the health of our capital markets, and therefore, vital to our
    economic growth.
        The passage of the Sarbanes-Oxley Act was but the starting point of
    returning regulatory control back to the Securities and Exchange
    Commission. Another important step came with the enactment of the
    Accountant, Compliance, and Enforcing Staffing Act of 2003 that the
    President signed into law on July 3. This law provided the Securities
    and Exchange Commission with the much needed authority to hire
    accountants just as the Agency could then hire attorneys. This
    demonstrates the importance of accountants as an integral part of a
    strong regulatory system.
        In addition, the establishment of the Public Company Oversight
    Accounting Board has begun to make a difference in the auditing world.
    As Chairman McDonough continues to bring the Board up to speed, we will
    see the public company auditors providing financial accounting
    oversight on a much higher level.
        Just as important as it was to improve the corporate governance
    structure in the public markets, it now appears that we need to improve
    the corporate governance structure of the regulators of our securities
    markets. Recently, you sent a letter to the New York Stock Exchange on
    its corporate governance practices. I am very interested in the
    Exchange's response and would greatly appreciate if you would share it
    with me. I strongly believe that the regulators of our securities
    markets should not permit themselves to be held at a much different
    standard than we require of the companies that they regulate.
        Finally, I would like to thank Chairman Donaldson for taking such
    quick and firm control of the reins as Chairman of the Securities and
    Exchange Commission and for working with the Congress to ensure the
    implementation of the provisions of the Sarbanes-Oxley Act is done with
    investor respect and confidence in mind. I also would like to recognize
    all of the hard work of the SEC Commissioners and staff who have made
    the implementation of the law possible.
        Chairman Donaldson, I look forward to your testimony today.

                                   ----------

                   PREPARED STATEMENT OF WILLIAM H. DONALDSON

               Chairman, U.S. Securities and Exchange Commission
                               September 9, 2003

        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee, thank you for inviting me to testify today on behalf of the
    Securities and Exchange Commission concerning implementation of the
    Sarbanes-Oxley Act of 2002. I appreciate having the opportunity to
    discuss this important matter with you.

    Introduction
        It has been just over a year since Congress passed and President
    Bush signed the Sarbanes-Oxley Act into law. Sparked by dramatic
    corporate and accounting scandals, the Act represents the most
    important securities legislation since the original Federal securities
    laws of the 1930's. The Act effects dramatic change across the
    corporate landscape to reestablish investor confidence in the integrity
    of corporate disclosures and financial reporting. Your backing of the
    Act and the efforts to implement its sweeping reforms, along with the
    strong support of your counterparts in the House and our authorizing
    committees, demonstrates convincingly that the Congress is dedicated to
    ensuring the financial integrity and vitality of our markets.
        The first year of the Sarbanes-Oxley Act has produced an impressive
    record of
    accomplishments in an incredibly short period of time. The Act set
    ambitious deadlines for more than 15 separate rulemaking projects by
    the Commission to implement many of the Act's provisions. The
    Commission provided a number of opportunities for public input on its
    proposals, and we carefully studied thousands of letters of public
    comment in crafting final rules. The bulk of the required rulemaking
    was required by January 26, 2003, and this past January was the busiest
    month of rulemaking in Commission history. The Act also called for
    several mandated studies on particular aspects of the capital
    markets.\1\
    ---------------------------------------------------------------------------
        \1\ The Commission has issued five studies as required by the Act.
    The Commission is preparing one remaining study and report required by
    Section 401(c) of the Act on special purpose entities. The Act also
    mandated other studies, such as those to be conducted by the General
    Accounting Office on consolidation of public accounting firms (Section
    701), mandatory rotation of accounting firms (Section 207), and
    investment banks (Section 705). The Act also called for reviews of
    Federal Sentencing Guidelines by the U.S. Sentencing Commission
    (Sections 805, 905, and 1104).
    ---------------------------------------------------------------------------
        Because of the dedicated efforts of the Commission and the select
    corps of professionals who work at the SEC, I am pleased to say we have
    met all of the mandates and challenges set out by the Act, and in
    record time. Moreover, we met these deadlines without sacrificing our
    other work or obligations--including our robust enforcement program and
    numerous regulatory initiatives unrelated to Sarbanes-Oxley.
        The Act also provided welcome new enforcement tools to combat
    corporate fraud, punish corporate wrongdoers and deter fraud with the
    threat of stiffer penalties. The Commission, both on its own and in
    conjunction with the President's interagency Corporate Fraud Task
    Force, is moving decisively to utilize these new tools to expose and
    punish acts of corruption, improve corporate responsibility, and
    protect America's investors.
        For the fiscal year through August 20, 2003, the Commission has
    filed 543 enforcement actions, 147 of which involve financial fraud or
    reporting violations. During this period, the Commission has sought to
    bar 144 offending corporate executives and directors from holding such
    positions with publicly traded companies. Further, we are holding
    accountable not just the companies who engage in fraud, but also the
    other participants. For example, recent actions signify the
    Commission's willingness to pursue directors who are reckless in their
    oversight of management. And we have increasingly designed strategies
    that take advantage of the creative provisions of the Act to return
    funds to investors who have suffered losses rather than merely collect
    those funds for the Government.
        I am pleased to report that the Public Company Accounting Oversight
    Board, a cornerstone of the Act, is up and running under the strong
    leadership of its new Chairman, William McDonough. We will continue to
    crack down on malfeasance, and thanks to the Sarbanes-Oxley Act we have
    the tools and resources we need to tackle this task. The rules mandated
    by the Act are in place and companies, their boards and executives, and
    other ``gatekeepers'' to our capital markets are proceeding to
    implementation. These are landmark rules. They will require hard work
    and significant expenditures in the short-run. But the short-term costs
    of compliance, particularly efforts to improve internal control over
    financial reporting, should be viewed as an investment. In the long-
    term, the reforms realized from the Act will result in sounder
    corporate practices and more reliable financial reporting. Moreover,
    the spirit of the Act and its requirements are sinking into corporate
    America. Companies should, as I have said before, make the approach of
    doing the right thing--in disclosure, in governance, and otherwise in
    their businesses--part of their companies' DNA.
        The Commission has been and will remain vigilant in the
    implementation of these and other provisions of the Act and will
    consider further action as appropriate in furtherance of its
    objectives. And beyond Sarbanes-Oxley, we will continue pressing ahead
    on multiple fronts in the months ahead, including addressing such
    critical areas as shareholder access to the director nomination
    process, the mutual fund and hedge fund industries, the structure of
    our securities markets, and the many issues embedded in the need for
    improved corporate governance.
        In these and other endeavors, I look forward to continuing and
    building on the strong and cooperative relationship that our agency has
    developed with you in the past as we move forward with fulfilling the
    promise of the Act. This is a critical time for our capital markets and
    the Agency, and the way we address the challenges before us will
    determine not only where we go tomorrow, but also for years to come.
    Before reporting in more detail on the Commission's achievements in
    implementing the Sarbanes-Oxley Act to date, I would first briefly put
    the Act in perspective.

    Events Leading to Sarbanes-Oxley
        The specific events leading to passage of the Act are now well
    documented. The mid-1990's saw the beginning of the full flourish of
    the so-called ``new economy'' in America. The stock market reflected
    the enormity of the changes taking place in the economy. Stock averages
    rose at increasing rates from the mid-1990's through early 2000. New
    entrants undertaking IPO's in the market were among the biggest
    gainers, especially those that symbolized the ``dot.com'' sector of the
    economy. Communications, the explosion of information technology, and
    changes in the culture of equity investing, including the shift to more
    self-directed retirement accounts, brought millions of individuals with
    their savings into our stock markets for the first time.
        Starting in the second quarter of 2000, the bubble burst. Stock
    prices plummeted. Investors fled the markets. The IPO market
    disappeared. As happened after the crash of 1929, the falling market
    that began in 2000 led to other revelations. Starting with the
    unfolding of the Enron story in October 2001, it became apparent that
    the boom years had been accompanied by fraud, other misconduct, and a
    serious erosion in business principles. The low points in this story
    are now household names--not just Enron, but also WorldCom, Tyco,
    Adelphia, and others. There was other serious misconduct as well,
    including in the once-celebrated IPO market, which in too many cases
    lacked both fairness and integrity. The cost of this corner-cutting to
    investors has been enormous. While thankfully we have not witnessed the
    same intensity of human suffering that came with the Depression of the
    1930's, the most recent downturn in the market directly affected many
    more investors than the 1929 market crash, because many more
    individuals had much more of their savings invested in the stock
    market.
        In addition to the grossest displays of greed and malfeasance,
    there were other more subtle but still pernicious developments. During
    the boom years, corporate America increasingly emphasized a short-term
    focus, fueled by an obsession with quarter-to-quarter earnings. In some
    cases this focus was sharpened by the temptation that inherently
    resulted from massive amounts of stock options granted to corporate
    insiders. Analysts, some tainted by conflicts of interest, became
    cheerleaders for the game of ``hitting the numbers.'' Winning that
    game, rather than creating the conditions for sound, long-term strength
    and performance, became the primary goal. Finally, the perception that
    uninterrupted earnings growth was the hallmark of sound corporate
    progress caused too many managers to adjust financial results with the
    purpose of meeting projected results--in ways that were sometimes large
    and sometimes small, but, especially given the purpose, in all cases
    unacceptable.
        To address the widespread collapse of investor confidence and the
    recognition that something had gone seriously awry in segments of
    corporate America, Congress approved and the President signed into law
    the Sarbanes-Oxley Act. At the East Room signing ceremony, the
    President promised, ``to use the full authority of the Government to
    expose corruption, punish wrongdoers, and defend the rights and
    interests of American workers and investors.''

    Implementation of Sarbanes-Oxley
        The sweeping reforms in the Sarbanes-Oxley Act address nearly every
    aspect and actor in our Nation's capital markets. The Act affects every
    reporting company, both domestic and foreign, as well as their officers
    and directors. The Act also affects those that play a role in ensuring
    the integrity of our capital markets, such as accounting firms,
    research analysts, and attorneys. The overarching goals of the Act are
    far-reaching and include restoring investor confidence and assuring the
    integrity of our markets. Within these goals, the principal objectives
    addressed in the Act can be grouped into the following themes:

     To strengthen and restore confidence in the accounting
        profession;
     To strengthen enforcement of the Federal securities laws;
     To improve the ``tone at the top'' and executive
        responsibility;
     To improve disclosure and financial reporting; and
     To improve the performance of ``gatekeepers.''

    Restoring Confidence in the Accounting Profession
        A strong central focus of the Sarbanes-Oxley Act is to enhance the
    integrity of the audit process and the reliability of audit reports on
    issuers' financial statements. As discussed below, the Commission has
    taken the actions directed by the Act and, when appropriate, pursued
    additional measures with the goal of restoring public confidence in the
    independence and performance of auditors of public companies' financial
    statements.

    Public Company Accounting Oversight Board
        A centerpiece of the Act is the creation of the Public Company
    Accounting Oversight Board, or PCAOB. In 1 year, the joint efforts of
    the Commission and PCAOB turned what was an outline on paper into a
    proactive organization that already is accepting accounting firm
    registrations, operating an independent funding mechanism, actively
    developing inspection and disciplinary programs, and writing new
    auditing and attestation standards, starting with those related to
    auditors' reports on companies' internal controls over financial
    reporting.
        Under the Sarbanes-Oxley Act, the Commission, among other things,
    appoints PCAOB members, approves all of the PCAOB's rules and
    professional standards, and the PCAOB annual budget and support fee,
    acts as an appellate authority for PCAOB disciplinary actions and
    disputes related to PCAOB inspection reports and generally oversees the
    PCAOB's operations. Accordingly, the Commission has appointed the
    PCAOB, approved the PCAOB's bylaws, registration system for public
    accounting firms, funding rules, interim auditing and other
    professional standards, annual budget and support fee, and has in
    process a review of the PCAOB's ethics code and various proposed rules
    related to the PCAOB's standards-setting process and inspection
    program.
        We were extremely pleased when William McDonough, formerly the
    President of the Federal Reserve Bank of New York, assumed the Chair of
    the PCAOB last June. Prior to his appointment, Charles Niemeier, then
    the PCAOB Acting Chairman, and PCAOB members Kayla Gillan, Dan Goelzer,
    and William Gradison developed the infrastructure necessary for the
    Commission to determine in April that the PCAOB was appropriately
    organized and had the capacity to carry out the requirements of the
    Sarbanes-Oxley Act. Under Chairman McDonough's leadership, we expect
    the PCAOB to continue to grow and to implement reforms that will
    restore investors' confidence in the audit process and in the integrity
    of the audited financial information that investors use every day to
    make investment and voting decisions.

    Auditor Independence
        Auditor independence is at the heart of the integrity of the audit
    process. As directed by the Sarbanes-Oxley Act and under the
    Commission's general rulemaking authority, the Commission strengthened
    its rules regarding auditor independence last January. The principal
    thrust of the revisions is to:

     Expand the nonaudit services that, if provided to an audit
        client, impair an auditor's independence;
     Require an issuer's audit committee to preapprove all audit
        and nonaudit services provided to the issuer by the auditor;
     Require that certain partners on the audit engagement team
        rotate off the engagement after either 5 or 7 years depending on
        the partner's role in the audit;
     Establish a ``cooling off '' period between participation on
        the team auditing an issuer's financial statements and assuming
        certain functions as a member of that issuer's management;
     Require the auditor to report certain matters to the issuer's
        audit committee; and
     Require certain disclosures to investors of information
        related to audit and nonaudit services provided by, and fees paid
        to, the auditor.

        The Commission also adopted rules stating that an accounting firm
    would not be independent with respect to an audit client if certain
    partners on the audit engagement receive compensation based on their
    procuring engagements with that client for services other than audit,
    review, or attest services.\2\
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        \2\ In addition, to assist companies and the auditors of their
    financial statements in implementing the auditor independence rules,
    the Commission staff recently published on the Commission's website a
    list of Frequently Asked Questions about those rules. The FAQ's clarify
    the application of certain rules related to nonaudit services, partner
    rotation, audit committee preapproval of services, auditor
    communications with an issuer's audit committee, the disclosure by an
    issuer of fees paid to the auditor of its financial statements, and
    other matters.
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    Improper Influence on Auditors
        On April 24, 2003, the Commission adopted a provision pursuant to
    Section 303 of the Act prohibiting officers and directors of an issuer,
    and persons acting under their direction, from taking any action to
    coerce, manipulate, mislead, or fraudulently influence the auditor of
    the issuer's financial statements if that person knew or should have
    known that such action, if successful, could result in rendering the
    issuer's financial statements materially misleading. These rules, in
    combination with other Commission rules, prohibit officers and
    directors from subverting the auditor's responsibilities to investors
    to conduct a diligent audit of the issuer's financial statements and to
    provide a true report of the auditor's findings.

    Retention of Records Relevant to Audits and Reviews of Financial
            Statements
        On January 22, 2003, the Commission adopted rules pursuant to
    Section 802 of the Act that, for the first time, require auditors to
    retain certain records relevant to their audits and reviews of issuers'
    financial statements. These records, which are to be retained for 7
    years, include an accounting firm's workpapers and certain other
    documents that contain conclusions, opinions, analyses, or financial
    data related to the audit or review.

    Recognition of the Financial Accounting Standards Board
        Section 108 of the Act sets forth criteria that must be met by an
    accounting standard-setting body in order for that body's standards to
    be considered ``generally accepted'' for purposes of the securities
    laws.\3\ In April, the Commission announced its determination that the
    Financial Accounting Standards Board and its parent organization, the
    Financial Accounting Foundation, meet the criteria in the Act and that
    FASB's pronouncements would be considered to be ``generally accepted''
    and must continue to be followed in the preparation of financial
    statements filed with the Commission.\4\ Subsequently, as required by
    Section 109(e) of Act, we reviewed the FASB support fee for 2003 and
    found that it is consistent with the Act.
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        \3\ The criteria include, among other things, being a private
    entity; having, for administrative and operational purposes, a board of
    trustees that serves the public interest; being funded as provided in
    the Act; having procedures to ensure prompt consideration, by majority
    vote of its members, of changes to accounting standards to reflect
    emerging issues and changing business practices; and considering the
    extent to which international convergence of accounting standards is
    necessary or appropriate in the public interest.
        \4\ The Commission's determination was premised on an expectation
    that the FASB would address certain issues announced by the Commission
    and that the FASB would continue to serve the public interest and
    protect investors.
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    Study on Principles-based Accounting Standards
        In enacting the Sarbanes-Oxley Act, Congress recognized that
    accounting standards that contain too many exceptions, interpretations
    and bright-line percentage tests might have contributed to efforts by
    managements and accountants to structure transactions that provide a
    desired accounting result and yet allow the company to avoid clear
    disclosure of the economic consequences of those transactions in its
    financial statements. Congress, therefore, mandated in Section 108(d)
    of the Act that the Commission study whether a system of ``principles-
    based'' accounting standards should be adopted in the United States.
    The Commission staff released its study in July.
        After considering the issue, our staff found that standards
    reflecting only a stated principle of accounting (principle-only
    standards) would present enforcement difficulties because they would
    provide little guidance or structure for exercising professional
    judgment in applying that principle. The staff also found that
    accounting standards that are too detailed (rules-based standards)
    often provide a vehicle for circumventing the intention of the
    standard.
        As a result, the staff indicated that the best approach would be to
    develop accounting standards that:

     Are based on a conceptual framework;
     Clearly state the accounting objective of the standard;
     Provide sufficient detail and structure so the standard may be
        applied on a consistent basis;
     Minimize exceptions from the standard; and
     Avoid the use of percentage tests that allow financial
        engineers to achieve technical compliance with the standard while
        evading the intent of the standard.

        The staff 's recommendation is consistent with the approach
    currently being developed by the Financial Accounting Standards Board.

    Strengthening the Enforcement of the Federal Securities Laws
        The Act also has helped the Commission to restore investor
    confidence in the capital markets by strengthening enforcement of the
    Federal securities laws. The Act added a number of new weapons to the
    Commission's enforcement arsenal to better deter would-be securities
    wrongdoers and compensate injured investors. It also required the
    Commission to undertake studies of enforcement actions and report to
    Congress. These studies contain important recommendations to further
    strengthen the Commission's enforcement program.

    New Enforcement Tools
        With the Act, Congress provided the Commission a number of new
    tools with which to further our enforcement mission. The Act
    strengthened the Commission's ability to obtain meaningful remedies and
    expanded our authority to return funds to harmed investors. Significant
    new enforcement tools include:

     Authority, in certain cases, to distribute civil money
        penalties to harmed investors, under the ``Fair Funds provision;''
     Authority, during an investigation of a public company or its
        officers, directors, or others, to seek a temporary order from a
        Federal district court to escrow extraordinary payments;
     A more appropriate standard for the Commission to obtain an
        officer and director bar in an injunctive action;
     Authority to seek officer and director bars, under the new
        standard applicable in injunctive actions, in cease-and-desist
        proceedings;
     Authority to censure or restrict brokers, dealers, investment
        advisers, and associated persons, who are subject to certain final
        State, Federal banking agency, or National Credit Union
        Administration orders;
     Access to audit workpapers of foreign audit firms that issue
        an audit opinion or perform material services upon which a
        registered public accounting firm relies in issuing an audit
        opinion; and
     Authority to seek penny stock bars in injunctive actions.

    Use of Sarbanes-Oxley Enforcement Tools
        This fiscal year, the Commission has used the new tools to
    facilitate maximum return of funds to harmed investors. For example,
    the Commission has twice invoked Section 1103 of the Act, which
    provides that during an investigation of a public company or its
    officers or directors, the Commission may seek a temporary order from a
    Federal court to escrow ``extraordinary payments'' if it appears likely
    the company will make such ``extraordinary payments'' to an officer or
    director. Section 1103 helps ensure that company insiders do not
    receive unusual rewards during the course of an SEC investigation that
    may uncover misconduct by those individuals. This ``preventive
    measure'' helps to address one of the toughest challenges facing the
    Commission--finding, recovering, and returning funds to defrauded
    investors--by securing funds before they are provided to alleged
    securities-law violators.
        In its most recent use of Section 1103, the Commission successfully
    petitioned the court to place in escrow for 45 days, a $37.64 million
    payment intended for two former officers of Gemstar-TV Guide
    International. This allowed our Enforcement staff to advance its
    investigation, and the Commission to file securities fraud charges
    against the two former Gemstar officers in Federal court, without
    permitting the officers to receive, and then dissipate, funds that
    allegedly belong to the company and its investors.
        Section 308(a) of the Act, the ``Fair Funds'' provision, has also
    quickly become an important tool. Before the Act, by law, all civil
    penalties were paid into the U.S. Treasury, and, as a result, kept out
    of the hands of defrauded investors. Now, however, the Commission has
    authority, in certain circumstances, to use civil penalties to help
    make defrauded investors whole. In just over 1 year, the Commission has
    used the Fair Funds provision to designate over $1 billion in penalties
    for distribution to defrauded investors. A significant example of the
    effectiveness of the Fair Funds provision is in the Commission's case
    against WorldCom, Inc., where the company has agreed to satisfy its
    civil penalty obligation by paying $500 million in cash and $250
    million in stock to defrauded investors. Thanks to the Fair Funds
    provision, all of this amount can be made available to harmed
    investors.

    Studies and Reports
        The Act required the Commission to conduct several enforcement-
    related studies. Section 308(c) directed the Commission to review and
    to analyze its enforcement
    actions in which disgorgement and penalties were sought to determine
    how such proceedings may best be utilized to provide recompense to
    injured investors. The principal findings of the Commission's study
    were set forth in a report submitted to Congress on January 24, 2003.
        This enforcement study, along with others conducted pursuant to
    Sarbanes-Oxley, made several recommendations intended to bolster the
    Commission's collection program, strengthen its enforcement efforts
    generally and provide more compensation for defrauded investors.\5\
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        \5\ Section 703 of the Act directed the Commission to study
    securities professionals who violated the Federal securities laws, and
    Section 704 of the Act directed the Commission to study enforcement
    actions to identify areas of issuer financial reporting that are most
    susceptible to fraud, manipulation, and inappropriate earnings
    management. Both studies were submitted to Congress on January 24,
    2003.
    ---------------------------------------------------------------------------
        These recommendations included:

     Permitting the Commission, under the Fair Funds provision, to
        use penalty moneys for distribution to investors even if no
        disgorgement is ordered;
     Removal of State law impediments to the Commission's
        collection of judgments and administrative orders;
     Expressly authorizing the Commission to hire private attorneys
        to conduct litigation to collect its judgments;
     Expanding the Commission's access to grand jury materials;
     Providing nationwide service of trial subpoenas; and
     Facilitating cooperation by preserving the privilege of
        information produced voluntarily to the Commission by a person or
        entity under investigation.

        These recommendations provided a basis for several provisions of a
    bill, H.R. 2179, now pending in the House of Representatives.
    Improving the ``Tone at the Top'' and Executive Responsibility
        Another critical purpose of the Act was to improve the ``tone at
    the top.'' This important theme dates back to President Bush's ten-
    point plan of March 2002, even before passage of the Sarbanes-Oxley
    Act. The tone set by top management is the most important factor
    contributing to the integrity of the financial reporting process.

    Executive Certification of Company Reports
        The Act contains two different executive certification provisions,
    Sections 302 and 906, each of which requires CEO's and CFO's of
    reporting companies to certify the financial and other information in
    their reports filed with the Commission.\6\ On August 27, 2002, the
    Commission adopted rules to implement Section 302 of the Act. Section
    906 of the Act, which contains a separate certification requirement
    subject to specific Federal criminal provisions, is self-operative and
    became effective immediately upon enactment. On May 27, 2003, the
    Commission adopted amendments to its rules under Section 302 in
    connection with its implementation of the internal control reporting
    requirements of Section 404, and also mandated that the certifications
    under Sections 302 and 906 be submitted as exhibits to Commission
    reports to aid investors and regulators in locating these statements.
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        \6\ The Act's provisions complement previous actions by the
    Commission regarding executive certifications. Before enactment of
    Sarbanes-Oxley, the Commission had previously published proposals to
    require CEO and CFO certifications for Exchange Act reports. See
    Release No. 34-46079 (June 17, 2002). In addition, the Commission
    required written statements, under oath, from the CEO's and CFO's of
    the 947 largest public companies regarding the accuracy of their
    companies' financial statements and their consultation with the
    companies' audit committees. See File No. 4-460: Order Requiring the
    Filing of Sworn Statements Pursuant to Section 21(a)(1) of the
    Securities Exchange Act of 1934 (June 27, 2002).
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        These certifications affirm senior executive responsibility for
    financial reporting.\7\ An important aspect of the certifications is
    the CEO's and CFO's responsibility for establishing and maintaining
    disclosure controls and procedures. In addition to the required
    certification regarding these controls and procedures, the Commission
    included an express requirement in its rules that reporting companies
    must maintain disclosure controls and procedures. These are controls
    and other procedures designed to ensure that information required to be
    disclosed is recorded, processed, and accurately reported within the
    required time frame. The combination of the certification requirements
    and the requirement to establish and to maintain disclosure controls
    and procedures has been to focus appropriate increased senior executive
    attention on disclosure responsibilities and has had a very significant
    impact to date in improving financial reporting and other disclosure.
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        \7\ For example, the rules adopted by the Commission pursuant to
    Section 302 require a company's CEO and CFO each to certify that:

         They have reviewed the report;
         The report does not contain an untrue statement or fail to
    state a material fact;
         The financial statements fairly present in all material
    respects the financial condition and results of operations of the
    company;
         They are responsible for establishing and maintaining
    disclosure controls and procedures and internal control over financial
    reporting for the company and have:

           Designed such disclosure controls and procedures to
    ensure that material information relating to the company is made known
    to them;
           Designed such internal control over financial reporting
    to provide reasonable assurance regarding the reliability of financial
    reporting and the preparation of financial statements;
           Evaluated and reported on their company's disclosure
    controls and procedures; and
           Disclosed any material change in the company's internal
    control over financial reporting; and

         They have disclosed to the auditors and audit committee:

           All significant deficiencies and material weaknesses in
    the design or operation of internal control over financial reporting;
    and
           Any fraud, whether or not material, that involves
    management or other employees who have a significant role in internal
    control over financial reporting.
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    Code of Ethics for Senior Financial Officers
        To further focus attention on honest and ethical conduct, the
    Commission adopted rules on January 15, 2003 pursuant to Section 406 of
    the Act. These rules require a reporting company to disclose annually
    whether the company has adopted a code of ethics for the company's
    principal executive officer and senior financial officers.\8\ If a
    company has not adopted such a code, the company is required to explain
    why. The rules also require a company to disclose on a current basis
    amendments and waivers relating to the code of ethics for any of those
    officers. The Act required disclosure only of the applicability of the
    code of ethics to senior financial officers. Given the role of the CEO
    in setting the ``tone at the top,'' the Commission also included a
    company's principal executive officer in its final rules.
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        \8\ Companies are required to provide the new disclosures regarding
    codes of ethics in annual reports for fiscal years ending on or after
    July 15, 2003.
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    Disclosures of Insider Transactions
        Section 403 of the Act effected two important changes that will
    result in earlier public notification of insiders' transactions in
    their company's securities and wider public availability of information
    about those transactions.
        First, on August 27, 2002, the Commission adopted rules to
    implement the accelerated filing deadline applicable to change of
    beneficial ownership reports. The Act accelerated these deadlines to
    the second business day following the execution date of such
    transactions. As provided for in the Act, the Commission provided
    limited relief for certain transactions only where the two business day
    period is not feasible.\9\
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        \9\ This limited relief focuses on limited categories of
    transactions where the insider does not select the date of execution.
    For these transactions, the reports must be filed within two business
    days after the insider receives notice of the transaction, but the
    notification date may be no later than the third business day after the
    transaction is executed.
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        Second, on April 24, 2003, the Commission adopted rules to
    implement Section 403(a)(4) of the Sarbanes-Oxley Act, which requires
    electronic filing of insider transaction reports and Internet
    accessibility of such reports. To facilitate the implementation of this
    requirement, the Commission created a new online filing system for
    these forms.\10\
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        \10\ These changes became effective on June 30, 2003, 1 month ahead
    of the statutory deadline.
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    Prohibition on Insider Trading During Pension Fund Blackouts
        On January 15, 2003, the Commission, after consultation with the
    Department of Labor, adopted rules implementing Section 306 of the Act.
    Section 306 prohibits any director or executive officer of a company
    from purchasing or selling any equity security during a pension plan
    black out period that prevents plan participants and beneficiaries from
    engaging in transactions involving those securities. Section 306
    equalizes the treatment of corporate executives and rank-and-file
    employees with respect to their ability to engage in transactions
    involving company equity securities during black out periods.\11\
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        \11\ The Commission's rules, which implement both the trading
    restrictions and the black out notice requirements of Section 306,
    became effective on January 26, 2003.
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    Improving Disclosure and Financial Reporting
        Apart from increasing focus on executive responsibility, the Act
    takes several important steps toward improving disclosure and the
    financial reporting process. Accurate and reliable financial reporting
    lies at the heart of our disclosure-based system of securities
    regulation and is critical to the integrity of our securities markets.
    Investors need accurate and reliable information to make informed
    investment and voting decisions. Investor confidence in the reliability
    of this information is fundamental to the liquidity and vibrancy of our
    markets.

    Internal Control over Financial Reporting
        The impetus for reform that culminated with the Sarbanes-Oxley Act
    helped coalesce widespread support for extending internal control
    reporting requirements to all public companies.\12\ On May 27, 2003,
    the Commission adopted rules to implement Section 404 of the Act, which
    requires public companies to file an annual internal control report as
    part of their annual reports. This report will address management's
    responsibility to establish internal control over financial reporting
    and will require management to evaluate the effectiveness of internal
    control over financial reporting.
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        \12\ Since 1993, larger depositary institutions or their bank
    holding companies have been subject to similar requirements under the
    FDIC Improvement Act of 1991 (FDICIA). In addition, the Commission has
    twice, in the past, proposed an internal control report requirement. A
    mandated internal control reporting requirement also was one of the
    recommendations of the National Commission on Fraudulent Financial
    Reporting, also known as the Treadway Commission, in its landmark 1987
    report.
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        In addition, the Act requires the auditor of the company's
    financial statements to attest to, and report on, management's
    assessment of the company's internal control over financial reporting
    in accordance with standards established by the Public Company
    Accounting Oversight Board.\13\ In this regard, the Commission's
    Director of the Division of Corporation Finance and our Deputy Chief
    Accountant recently participated in a PCAOB Roundtable on internal
    control attestations. Roundtable participants included representatives
    of institutional investors, public companies, Federal and State
    regulators, accounting firms and others. The PCAOB intends to consider
    the information and views provided at the Roundtable as it develops a
    new standard on auditor attestations of an entity's internal control
    over financial reporting. There will be an opportunity for public
    comment before the PCAOB finalizes its standard, and this standard,
    like all PCAOB rules, will be subject to Commission approval before it
    becomes effective.
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        \13\ Section 404(b) of the Act. See also Section 103(a)(2)(A)(iii)
    of the Act, which directs the PCAOB to write an auditing standard that
    requires an auditor to describe in the audit report the scope of the
    auditor's testing of the company's internal control structure, as
    required by Section 404(b), and to present (in such report or in a
    separate report): (1) the findings from such testing, (2) an evaluation
    of whether the company's internal control structure (a) includes
    maintenance of records that in reasonable detail accurately and fairly
    reflect the transactions and dispositions of assets of the company, and
    (b) provides reasonable assurance that transactions are recorded as
    necessary to permit preparation of financial statements in accordance
    with generally accepted accounting principles, and that receipts and
    expenditures are being made only as authorized by management or the
    board of directors, and (3) describes material weaknesses in, and
    material noncompliance with, those controls.
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        For many companies, the new rules on internal control reports will
    represent the most significant single requirement associated with the
    Sarbanes-Oxley Act. The establishment and maintenance of internal
    control over financial reporting has always been an important
    responsibility of management.\14\ An effective system of internal
    control over financial reporting is necessary to produce reliable
    financial statements and other financial information used by investors.
    By requiring a report stating management's responsibility for internal
    control over financial reporting and management's assessment regarding
    the effectiveness of such control, investors will be better able to
    evaluate management's stewardship responsibilities and the reliability
    of a company's disclosure. The required annual evaluation of internal
    control over financial reporting will encourage companies to devote
    adequate resources and attention to the maintenance of such control.
    Additionally, the evaluation should help to identify potential
    weaknesses and deficiencies in advance of a system breakdown, and may
    help companies detect fraudulent financial reporting earlier and
    perhaps thereby deter financial fraud or minimize its adverse effects.
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        \14\ As the Commission emphasized in its release implementing
    Section 404, the design, implementation, documentation and testing of
    internal control over financial reporting, as well as documentation of
    that testing, are responsibilities of management. See Release No. 33-
    8238 (June 5, 2003).
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        In light of the substantial time and resources needed to properly
    implement the rules and the corresponding benefit to investors that
    will result, our final rules provide for a transition period based upon
    the type of reporting company.\15\ The additional time also will permit
    the PCAOB to develop revised attestation standards.
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        \15\ Larger companies subject to our accelerated filing deadlines
    must comply with the new rules as of the end of their first fiscal year
    ending after June 15, 2004. All other companies, including small
    business and foreign issuers, must comply beginning with their first
    fiscal year ending after April 15, 2005.
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    Off-Balance Sheet Transactions
        One of the revelations of the recent corporate accounting failures
    was the abuse of off-balance sheet transactions. On January 22, 2003,
    the Commission adopted amendments to implement Section 401(a) of the
    Sarbanes-Oxley Act, which requires each annual and quarterly financial
    report filed with the Commission to disclose all material off-balance
    sheet transactions, arrangement, and obligations.\16\ The Act's mandate
    complements efforts of both the Commission and the FASB in this
    area,\17\ and the Commission's final rules also require most companies
    to provide an overview of certain known contractual obligations in an
    easy-to-read tabular format.
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        \16\ Companies are required to comply with these new disclosure
    requirements in Commission filings that include financial statements
    for fiscal years ending on or after June 15, 2003.
        \17\ See, for example, Release 33-8056 (Jan. 22, 2002) (Commission
    cautionary advice on off-balance sheet transactions); Financial
    Accounting Standards Board Interpretation No. 45 (Nov. 2002); and
    Financial Accounting Standards Board Interpretation No. 46 (Jan. 2003).
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    Non-GAAP Financial Measures
        On January 15, 2003, the Commission adopted rules implementing
    Section 401(b) of the Act to require that any public disclosure of a
    non-GAAP financial measure by a public company (referenced as ``pro
    forma financial information'' in the Act) must be presented in a manner
    that:

     Does not contain an untrue statement of a material fact or
        omit to state a material fact necessary in order to make the non-
        GAAP financial measure, in light of the circumstances under which
        it is presented, not misleading; and
     Reconciles the non-GAAP financial measure with generally
        accepted accounting principles (GAAP).\18\
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        \18\ The Commission's rules on this topic became effective on March
    28, 2003. Like Congress, the Commission also had been concerned with
    the use of non-GAAP financial information. Most recently, in December
    2001, the Commission issued cautionary advice regarding the use of such
    information. See Release No. 33-8039 (Dec. 4, 2002). See also In the
    Matter of Trump Hotels & Casino Resorts, Inc., Release No. 34-45287
    (Jan. 16, 2002).

        In addition to defining the category of financial information that
    is subject to the mandate, the Commission took a two-step approach to
    regulating the use of non-GAAP financial information. First, the
    Commission adopted new Regulation G, which applies whenever a company
    publicly discloses or releases material information that includes a
    non-GAAP financial measure. This regulation prohibits material
    misstatements or omissions that would make the presentation of the
    material non-GAAP financial measure misleading and requires a
    quantitative reconciliation of the measure to GAAP (by schedule or
    other clearly understandable method). Second, the Commission adopted
    rules that address the use of non-GAAP financial measures in filings
    with the Commission. These amendments apply to the same categories of
    non-GAAP financial measures covered by Regulation G, but contain more
    detailed requirements than Regulation G.

    Authorizing a ``Real Time'' Disclosure System
        Each investor should have prompt access to critical information.
    Section 409 of the Act obligates public companies to disclose ``on a
    rapid and current basis'' information concerning material changes in
    the financial condition or operations of the company as the Commission
    determines, by rule, is necessary or useful for the protection of
    investors and the public interest. This authorization is consistent
    with the Commission's ongoing mission to modernize the public reporting
    system and improve the usefulness of these reports to investors.
        For example, on September 5, 2002, the Commission adopted
    amendments to accelerate the filing deadlines for quarterly and annual
    reports by nearly one-third for larger, seasoned reporting companies.
    The deadlines for these reports were last changed over 30 years ago. In
    part to accommodate the implementation of other provisions of the
    Sarbanes-Oxley Act, the changes to filing deadlines will be phased in
    over 3 years.
        On January 15, 2003, the Commission adopted amendments to require
    public companies to furnish to the Commission their earnings releases
    or other announcements disclosing material nonpublic information about
    completed annual or quarterly fiscal periods.\19\ These amendments will
    not require the issuance of earnings releases or similar announcements;
    however issuing such releases and announcements will trigger the new
    requirement. Bringing these disclosures into the formal reporting
    system will provide widespread and uniform access of this information
    to investors. Special accommodations were made to address presentations
    made orally, telephonically, by webcast, or by similar means.
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        \19\ These rules became effective March 28, 2003.
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        Current Commission proposals to expand dramatically the list of
    significant events requiring prompt disclosure between reporting
    periods are also consistent with the mandate of Section 409. These
    proposals go a long way toward implementing a ``real time'' disclosure
    system. Specifically, the proposals would:

     Require current disclosure of 11 new items or events;
     Move two items that are currently required only on an annual
        or quarterly basis to disclosure on a current basis;
     Augment several existing items that are required to be
        disclosed on a current basis; and
     Accelerate the deadline for reporting all of the items
        required on a current basis.

        I expect the Commission will revisit these proposals in the coming
    months.

    Improving the Performance of ``Gatekeepers''
        In addition to addressing auditors and the accounting profession,
    as discussed above, the Sarbanes-Oxley Act and our new rules require
    better focus by other gatekeepers in our capital markets on their
    proper roles. The effective operation of these gatekeepers is
    fundamental to preserving the integrity of our markets. Revelations
    from the recent corporate and accounting scandals revealed that these
    parties did not always fulfill their proper responsibilities.

    Audit Committee Listing Standards
        Recognizing that financial statements, financial reporting, and the
    audit itself is the bedrock upon which full and accurate disclosure is
    built, and also recognizing the importance of the audit committee in
    these processes, Congress in Section 301 of the Act called for, and on
    April 1, 2003 the Commission adopted, rules directing the Nation's
    exchanges to prohibit the listing of any security of a company that is
    not in compliance with the audit committee requirements established by
    Section 301. Under the new rules, listed companies must meet the
    following requirements:

     All audit committee members must be independent;
     The audit committee must be directly responsible for the
        appointment, compensation, retention and oversight of a company's
        outside auditors, and the outside auditors must report directly to
        the audit committee;
     The audit committee must establish procedures for the receipt,
        retention, and treatment of complaints regarding accounting and
        auditing matters, including procedures for the confidential,
        anonymous submission of concerns by employees; and
     The company must establish funding for the audit committee,
        including the means to retain and compensate independent counsel
        and other advisors, as the audit committee determines necessary to
        carry out its duties.

        The new rules apply to both domestic and foreign companies that
    list in the United States. Based on significant input from and dialogue
    with foreign regulators and foreign issuers, several provisions,
    applicable only to foreign issuers, were included in the final rules to
    address potential conflicts with foreign legal requirements where
    consistent with fulfilling the investor protection mandate of the Act.
    These provisions include accommodating foreign ``co-determination''
    requirements, allowing shareholders to select or ratify the selection
    of auditors consistent with requirements in many foreign countries and
    allowing alternative structures, such as boards of auditors, to perform
    auditor oversight functions where such structures are provided for
    under local law.
        We are continuing our work with the Nation's markets to implement
    these requirements into their listing rules, and the Commission established
    ambitious deadlines in its final rules for the Nation's markets to
    implement the new listing standards.\20\ These efforts complement
    reform efforts previously instituted by our Nation's markets at the
    Commission's request to strengthen corporate governance listing
    standards for publicly traded companies. In particular, the proposals
    by the New York Stock Exchange and the Nasdaq, which will both be
    finalized within the next few weeks, will increase board independence
    and effectiveness by, among other things, mandating that boards be
    composed of a majority of independent directors, requiring executive
    sessions outside the presence of management, and requiring strong
    audit, compensation, and nominating/governance committees composed of
    independent directors. We have already approved changes to listing
    rules to require shareholder approval of equity compensation plans.
    ---------------------------------------------------------------------------
        \20\ The affected markets were required to submit proposed listing
    rules by July 15, 2003, and all of them met that deadline. Final
    listing rules must be approved by the Commission by December 1, 2003.
    The vast majority of listed companies must comply with the new rules by
    the earlier of their first annual shareholders meeting after January
    15, 2004 or October 31, 2004. This time frame was selected to coincide
    with a company's next annual shareholders meeting to facilitate any
    elections for new audit committee members that may be necessary to meet
    the rule's independence requirements. Given that foreign issuers and
    small business issuers were previously not subject to rules of this
    type, they were given additional time (until July 31, 2005) to comply.
    ---------------------------------------------------------------------------
        These are significant changes that should have a lasting impact on
    improving responsibility and accountability in our markets. They also
    have focused attention on corporate governance reforms by the private
    sector. Many companies already are moving to adopt the new
    requirements. In addition, leading private sector organizations have
    been hard at work studying ways to increase corporate governance. In
    May, the Conference Board released its report, Corporate Governance
    Best Practices: A Blueprint for the Post-Enron Era, in which it
    suggested numerous corporate governance best practices. Similarly, the
    Business Roundtable has issued its own Principles of Corporate
    Governance suggesting further best practices.

    Research Analysts
        On July 29, 2003, the Commission approved rules proposed by the
    NYSE and NASD that satisfy Section 501 of the Act, which directed the
    Commission to adopt, or to direct the SRO's to adopt, rules designed to
    further address research analyst conflicts of interest. The Commission
    worked closely with the SRO's to conform their rules to meet the
    directives of the Act.
        Some of the Act's requirements were satisfied by NASD and NYSE rule
    provisions existing at the time of enactment. Others necessitated
    amendments, such as to limit the compensatory evaluation of analysts to
    officials not engaged in investment banking activities and to further
    define periods during which a member firm engaged in a public offering
    of a security as an underwriter or dealer may not publish research on
    such security. The new rules also require analysts and members to
    disclose specified conflicts of interest to the extent that the member
    or analyst knows or has reason to know, including whether the member or
    any affiliate received any compensation from the issuer that is the
    subject of the research report; and whether that issuer has been a
    client of the member firm and, if so, the types of services provided.
        As urged by commenters, to clarify the scope of information about
    which the analyst or member would be deemed to have reason to know, the
    SRO rules set forth two mechanisms by which analysts and their firms
    can satisfy the requirement that they disclose noninvestment banking
    compensation that was received from the issuer by an affiliate of the
    member. The rules provide that the disclosure requirement will be
    deemed satisfied if the member, on a quarterly basis, discloses
    affiliate noninvestment banking compensation that it has identified as
    having been received from the issuer. In the alternative, the rules
    provide that a member or analyst would be presumed not to have a reason
    to know of noninvestment banking compensation received by an affiliate,
    if the member has in place informational barriers designed to prevent
    the analyst or any influential employee from receiving such information
    from the affiliate.
        Also of note, in the compensation disclosure provision, the Act
    explicitly authorized the Commission to permit an exception for
    material nonpublic information regarding specific potential future
    investment banking services transactions of the subject company. The
    SRO rules also apply that exception to the client disclosure provision.
    We believe that providing this exception in the client disclosure
    provision is consistent with the Act's compensation disclosure
    provision, and fulfills the Act's mandates that rules be adopted that
    are reasonably designed to provide disclosure of broker-dealers'
    clients and client services, while appropriately addressing concerns
    related to the potential dissemination of material nonpublic
    information.

    Standards of Conduct for Attorneys
        On August 5, 2003, the Commission's rule implementing Section 307
    of the
    Sarbanes-Oxley Act became effective, setting ``standards of
    professional conduct for attorneys appearing and practicing before the
    Commission in any way in the representation of issuers.'' The rule,
    adopted last January, requires an attorney to report evidence of a
    material violation ``up-the-ladder'' within the issuer to the chief
    legal officer of the company. It also requires an attorney, if the
    chief legal officer does not respond appropriately to the evidence, to
    report the evidence to the issuer's audit committee, another committee
    of independent directors, or the full board of directors.
        In addition to requiring up-the-ladder reporting, the final rule
    allows an attorney, without the issuer's consent, to reveal
    confidential information related to his or her representation to the
    extent the attorney reasonably believes necessary: (1) to prevent the
    issuer from committing a material violation likely to cause substantial
    financial injury to the financial interests or property of the issuer
    or investors; (2) to prevent the issuer from committing an illegal act;
    or (3) to rectify the consequences of a material violation or illegal
    act in which the attorney's services have been used.
        At the same time as the Commission adopted its final rule, it
    approved an extension of the comment period on the so-called ``noisy
    withdrawal'' provisions of the original proposed rule and put out for
    comment an alternative reporting out rule that would require the issuer
    to report to the Commission its attorney's withdrawal from
    representation. The Commission has not decided how it wishes to proceed
    with respect to ``noisy withdrawal.''

    Rating Agencies
        On January 24, 2003, the Commission submitted to Congress and the
    President a report on the role and function of credit rating agencies
    in the operation of the securities markets in response to the
    Congressional directive contained in Section 702 of the Act. The report
    was designed to address each of the topics identified for Commission
    study in Section 702, including the role of credit rating agencies and
    their importance to the securities markets, impediments faced by credit
    rating agencies in performing that role, measures to improve
    information flow to the market from credit rating agencies, barriers to
    entry into the credit rating business, and conflicts of interest faced
    by credit rating agencies. The report also addresses certain issues
    regarding credit rating agencies that go beyond those specifically
    identified in the Act, such as allegations of anticompetitive or unfair
    practices, the level of due diligence performed by credit rating
    agencies when taking rating actions, and the extent and manner of
    Commission oversight of credit rating agencies.
        In preparing the report, the Commission pursued several approaches,
    both formal and informal, to conduct a thorough and meaningful study of
    credit rating agencies. These efforts included informal discussions
    with credit rating agencies and market participants, formal
    examinations of credit rating agencies and public hearings where market
    participants were given the opportunity to offer their views on credit
    rating agencies and their role in the capital markets.
        To further address issues raised in the report, the Commission
    published a concept release on June 4, 2003 seeking comment on a number
    of issues relating to credit rating agencies, including whether credit
    ratings should continue to be used for regulatory purposes under the
    Federal securities laws, and, if so, the process of determining whose
    credit ratings should be used, and the level of oversight to apply to
    such credit rating agencies. The comment period for the concept release
    ended on July 28, 2003, and the Commission received 42 comment letters
    from a wide range of interested persons. The staff is currently
    preparing an analysis of the comment letters to assist the Commission
    in determining what further action may be appropriate.

    Audit Committee Financial Experts
        On January 15, 2003, the Commission adopted rules pursuant to
    Section 407 to require a reporting company to disclose annually whether
    it has at least one ``audit committee financial expert,'' and if so,
    the name of such expert and whether the expert is independent of
    management. A company that does not have an audit committee financial
    expert will be required to disclose this fact and explain why it has no
    such expert. These disclosures will improve transparency to investors
    in evaluating the experience of the audit committees of companies in
    which they invest.\21\ In response to public comment, the final rules
    broadened the categories of experienced individuals with accounting and
    financial expertise that could meet the definition of ``financial
    expert'' from our original proposals, while still incorporating all of
    the considerations for the definition set forth in Section 407. The
    rules also provide several limited safe harbors to address concerns
    that being designated as an audit committee financial expert would
    dissuade qualified candidates from board service.
    ---------------------------------------------------------------------------
        \21\ Companies are required to provide the new disclosure in annual
    reports for fiscal years ending on or after July 15, 2003. Small
    business issuers will be required to provide the new disclosure in
    annual reports for fiscal years ending on or after December 15, 2003.
    ---------------------------------------------------------------------------
    Investment Companies
        We also have fully implemented the requirements of the Act with
    respect to mutual funds and other registered investment companies
    (funds). With few exceptions, the Act did not draw any distinctions
    between operating companies and funds, and the rules that we have
    adopted generally apply with equal force to both. In some cases, this
    has required us to adapt the requirements of the Act to address the
    unique circumstances of funds, such as the fact that, unlike most
    operating companies, funds are typically externally managed by an
    investment adviser. For example, in implementing the statutory
    requirement that an issuer's audit committee preapprove permissible
    nonaudit services provided by its auditing firm, we applied the
    preapproval requirements not only to services provided to a fund, but
    also to certain fund-related services provided to the fund's adviser
    and other entities in a fund complex. The positive effects of our rules
    under the Act with respect to funds will be reinforced as we continue
    to vigorously pursue other initiatives to improve the disclosure that
    funds provide to investors, particularly with respect to fees and
    expenses.

    Moving Forward After Sarbanes-Oxley
    Commission Operations
        Section 601 of the Act authorized substantial additional
    appropriations for the Commission. I believe that the efficient
    functioning of the SEC is as much a part of investor protection as
    ushering in new rules and regulations. I am committed to ensuring that
    every penny of the new money granted to the Commission is spent wisely.
    We will bring on the people we need to help us fulfill our mission, and
    not simply to increase our head-count. I have been working with senior
    staff of the Agency to determine appropriate changes to address both
    our internal and external needs. As an illustration of the seriousness
    with which we view this part of our responsibilities, I recently
    reorganized the Office of the Chairman to include three managing
    executives, one of whom is the Managing Executive for Operations and
    works full-time on the SEC's efficiency and operational effectiveness.
        On February 20, 2003, the President signed into law the
    Consolidated Appropriations Resolution, providing the Commission with a
    fiscal year 2003 appropriation of $716 million, which is $278 million
    more than our fiscal 2002 appropriation. A portion of these funds will
    be used to hire 842 new staff to:

     Implement the Sarbanes-Oxley Act, including the review of each
        registrant's financial statements every 3 years;
     Enhance our enforcement program so we can bring more
        investigations and complete them sooner;
     Review investment advisers and investment companies more
        frequently, based on risk criteria; and
     Conduct more broker-dealer branch-office examinations.

        Without the Accountant, Compliance, and Enforcement Staffing Act of
    2003, many of these initiatives would be in jeopardy due to our
    difficulties hiring additional professional staff in a timely manner.
    We are extremely grateful for the support of the Congress and the
    President in quickly addressing our personnel and operational needs.
        With the addition of a substantial number of accountants to our
    Division of Corporation Finance, we will strive to achieve the 33
    percent annual review level mandated by Section 408 of the Act. The
    Division also will continue its focus, also mandated by Section 408, on
    the largest companies and other companies where review is most
    important. In addition, the Division has modified its selective review
    process in a manner that will allow it to focus on companies and on
    disclosure that appear to be critical to an understanding of each
    company's financial position and results. The Division will continue to
    refine this process to allow it to efficiently use its resources and
    review material disclosure issues in a broad range of companies.
    Through increased staffing and focused reviews, the Division will
    strive to complete either a full, financial, or other review of the
    filings of one-third of the reporting companies each year.

    The Agenda Beyond Sarbanes-Oxley
        Implementing Sarbanes-Oxley has been a tremendous accomplishment in
    its own right. I also want to touch on some of our other areas of
    progress, as well as our ongoing priorities, which reflect our desire
    to restore investor confidence while helping America's financial
    markets to continue allocating capital effectively and sparking job
    creation.
        For example, we are continuing to build on the July 15 report of
    our Division of Corporation Finance, which recommends improved
    disclosure and greater shareholder access to the director nomination
    process. We have already issued proposals on improved disclosure, and
    the Commission will consider proposals in the shareholder access area
    as soon as this month.
        We are examining the mutual fund industry, and its impact on
    investors, looking at everything from how fund companies do business to
    the fees they charge and the information they disclose to their
    customers. We are also in the process of reviewing the hedge fund
    industry, given its extraordinary recent growth, to ensure that
    investor protection remains paramount. Recommendations from the SEC
    staff in this area are likely to be issued in the near future.
        We also are taking a comprehensive look at the complex issues
    involving the structure of our securities markets--including their
    regulation, the balance between competition and fragmentation, and the
    use of market data--all in the context of our global marketplace and
    its impact on investors. These market structure issues are among the
    thorniest the Commission faces, but also among the most important.
    Revolutions in technology and communications and the unrelenting pace
    of globalization make it imperative that we revisit on a comprehensive
    basis the framework of our system for regulating markets.
        We will continue to monitor areas that may merit future attention
    and whether there are particular items, regulatory burdens or
    unintended consequences that should be addressed. For example, the
    Commission staff has issued Frequently Asked Questions on
    implementation of the non-GAAP financial measure rules and the auditor
    independence rules. In addition, we have attempted to reduce the
    compliance burdens on smaller public companies where appropriate and
    permitted by the Act. While initial concerns that the costs of the Act
    would drive many public companies to go private have not played out, we
    intend to continue to review the effects of the new requirements on
    smaller public companies.
        Similarly, we will continue to pay attention to possible unintended
    consequences of the Act for foreign issuers. The Commission and its
    staff have had extensive consultations with foreign regulators and
    members of the foreign community, and have considered ways to
    accommodate foreign requirements and regulatory approaches, while
    safeguarding the investor protection objectives of the Act. This
    approach should preserve the attractiveness of the U.S. markets to
    foreign investors.

    Honest Business in the Current Environment
        Just as the Commission has been moving forward with implementation
    of the Act, so too must American businesses. Corporate leaders are
    responding not only to the Act's mandates, but also to the movement
    toward increased transparency that underlies Sarbanes-Oxley. However, I
    have become aware that some in the business sector feel that they are
    under siege from new regulations, and the threat of additional
    litigation.
        As I have mentioned before, good, honest companies should fear
    neither Sarbanes-Oxley nor our enforcement efforts. Rather, they should
    recognize that the improved standards that the Act mandates and smart
    and fair enforcement of the laws are the right thing to do and help
    attract capital and investment. As William O. Douglas, then Commission
    Chairman and future Supreme Court Justice, pointed out in a 1938
    speech, ``To satisfy the demands of investors there must be in this
    great marketplace not only efficient service but also fair play and
    simple honesty. For none of us can afford to forget that this great
    market can survive and flourish only by grace of investors.''
        Good corporate governance is not primarily about complying with
    rules. It is about inculcating in a company, and all of its directors,
    officers, and employees, a mindset to do the right thing. As I have
    said before, the focus on doing the right thing should become part of
    the DNA of a company and everyone in the company from top to bottom.
    For companies that take this approach, most of the major concerns about
    compliance disappear. Moreover, if companies view the new laws as
    opportunities--opportunities to improve internal controls, improve the
    performance of the board, and improve their public reporting--they will
    ultimately be better run, more transparent, and therefore more
    attractive to investors.
        I believe that this attitude is beginning to take hold in corporate
    America. During my travels, and in my discussions with company
    officials, countless people have told me that America cannot afford a
    return to the lax standards that preceded Sarbanes-Oxley. Many have
    added that while they initially questioned the merits of the Act, they
    now see that it can help show the way to a brighter, more competitive
    era in American business.
        The success of a new era under the Act must involve a continued
    measure of the risk-taking and entrepreneurship that are the hallmarks
    of honest American business. There have been suggestions, including in
    the press, that the recent crackdowns on corporations and executives by
    criminal and civil authorities, including the Commission, have
    discouraged honest risk-taking.
        I have a different perspective on recent developments. I believe
    the Act and the other steps that have accompanied it will lead to an
    environment where honest business and honest risk-taking will be
    encouraged and rewarded. What should be discouraged, and what we are
    committed to stamp out, are the activities that some have sought to
    disguise as honest business but that, in reality, are no such thing.
        Transactions with no substance that are designed solely to assure
    increased earnings or cashflow in financial reports involve no risk and
    are not honest business. Neither are transactions that are disguised as
    rewards for entrepreneurship or superior management but that, in fact,
    provide risk-free excessive compensation or facilitate self-dealing for
    the benefit of insiders.
        I hope we have learned some lessons from the era just passed--and I
    believe we have. I also hope that America's corporate leaders will not
    use Sarbanes-Oxley as an excuse for putting off innovation and
    investment. Looking back 1 year, and also looking forward, nothing in
    the law, its implementation or in the Commission's agenda should make
    business fearful. Indeed, a new period marked by the responsibility and
    realism I have just discussed can provide the foundation for a new era
    of long-term growth and prosperity.

    Conclusion
        In conclusion, let me again thank you for your important leadership
    and support in the initiative to reestablish and strengthen investor
    confidence and integrity in our Nation's capital markets. Throughout
    the massive directed rulemaking project under Sarbanes-Oxley, the goals
    of the Commission and its staff have been to protect investors and
    restore confidence in our securities markets. While it may be a bit too
    early to judge the impact of all of the various provisions of the Act,
    the Commission will monitor carefully the implementation and effects of
    the new rules and requirements, and we will take actions as appropriate
    to ensure that the objectives of the Act are achieved. We will continue
    our strong tradition of cracking down on corporate wrongdoing. And
    thanks to the Act and your efforts, we have the tools and resources we
    need to carry out these important objectives.
        Thank you again for inviting me to speak on behalf of the
    Commission. I would be happy to answer any questions that you may have.

    Michael Schroeder
    The Wall Street Journal

                         Cleaner Living, No Easy Riches

    Critics Say Sarbanes-Oxley Law Hobbles Stocks, Chills Risk Taking, But
                          Upshot Is Far Less Dramatic
                                 July 22, 2003

        Washington--Critics blame the Sarbanes-Oxley Act for everything
    from slowing the stock-market recovery to draining the pool of
    corporate-board directors to undermining capitalism itself.
        But the real-world effect of the year-old legislation that ushered
    in sweeping new accounting and boardroom rules hasn't been so dramatic.
    ``A lot of urban myths,'' dismisses Patrick McGurn, vice president at
    Institutional Shareholder Services, a research firm that advises large
    mutual funds. ``There is little substance behind the complaints.''
        Warren Neel, director of the University of Tennessee's Center for
    Corporate Governance, says the center is preparing to evaluate the
    bill's impact, but so far has found a dearth of data largely because
    major parts of the bill's 68 sections aren't even in effect yet.
        That data gap hasn't kept the critics quiet.
        William Niskanen, chairman of the libertarian Cato Institute,
    argued at a recent forum that the accounting changes have caused so
    much uncertainty that investors have shunned the stock market.
        His evidence? ``My remark that Sarbanes-Oxley delayed the recovery
    of the stock market by about 6 months was strictly a conjecture,
    without any study or directly relevant quantitative evidence,'' Mr.
    Niskanen acknowledges. His criticism springs from Cato's view that
    government regulation is largely unnecessary.
        Top executives have been wringing their hands about Sarbanes-
    Oxley's potential to create a shortage of candidates to fill board
    seats. Boards now must have more independent directors who work a lot
    harder; audit committees are expected to have at least one member with
    professional financial expertise. ``A supply crunch is emerging as
    boards attempt to comply with Sarbanes-Oxley,'' says Tom Neff, head of
    Spencer Stuart, a large executive-search firm. The law has been good
    for his company. Mr. Neff says Spencer Stuart is now looking for
    candidates to fill some 300 board seats, up 50 percent from a year
    earlier.
        Still, there seems to be no shortage. The National Association of
    Corporate Directors has a registry of 2,000 potential candidates for
    board seats. The Financial Executives Institute also has a list of 300
    corporate financial officers qualified to serve on audit committees.
        Others predict permanent economic damage. Robert Elliott, former
    partner of KPMG LLP and former head of the American Institute of
    Certified Public Accountants, says Sarbanes-Oxley has resulted in ``the
    criminalization of [corporate] risk taking, which is the same as
    criminalizing capitalism.''
        When companies are discovered cooking the books, directors and
    management no doubt will feel more heat, including stiffer criminal
    penalties. As a result, Mr. Elliott contends that a wrong bet on an
    acquisition or new product that prompts a write-down of an investment
    could trigger a flood of class-action lawsuits or an investigation by
    an overzealous prosecutor.
        Treasury Secretary John Snow offers a blunt defense of the new
    rules: ``Nothing in Sarbanes-Oxley changes the fundamental norms of
    good corporate governance.'' As for the notion that management will
    become timid, he chides, ``the management team is entrusted with a
    critically important function in our society: to take risks.'' He adds,
    ``You are never going to bat 1.000. It is the nature of uncertainty.''
        J.T. Battenberg, chief executive of Delphi Corp., the largest auto-
    parts supplier, with $27.4 billion in sales, says the increased
    liability from the legislation won't affect his company's investment
    strategy. ``Does that inhibit you from making good, tough decisions?''
    he said. ``No. It may slow you down a bit. It may cause you to probe a
    little deeper.''
        One point of universal agreement: Thanks to Sarbanes-Oxley, fees
    for director and officer insurance as well as lawyers and outside
    auditors are on the rise.
        Audit fees represent the lion's share of added expense. A survey by
    Johnsson Group, a Chicago-based auditing consultant, found that fees
    for outside auditors are tripling this year for companies with at least
    $3 billion in sales. The typical $2 million expense is now $6 million.
    For companies whose sales exceed $15 billion, fees are expected to
    skyrocket to $8 million from $2 million.
        ``Price gouging!'' declares Johnsson Group Chairwoman Marge
    Johnsson, who traces the problem to opportunistic accounting firms. ``I
    am upset about the exploitation of the legislation for the benefit of
    four companies I thought were supposed to be getting their hands
    slapped,'' she says of the Big Four accounting firms who audit most
    public companies.
        William Ezzell, AICPA chairman, says ``the law requires additional
    work, responsibilities and obligations on the part of the outside
    auditor, management and the audit committee'' to meet the goal of
    increasing investor confidence.
        To be sure, Sarbanes-Oxley sets high hurdles for small, publicly
    traded companies. Securities and Exchange Commission member Cynthia
    Glassman said, ``We have heard that some companies--especially smaller
    companies, including small banks--are avoiding public offerings or
    going private, to avoid having to comply'' with Sarbanes-Oxley.
        Still, there is no sea change. Of roughly 15,000 public companies,
    only 83 went private in 2002, 63 percent more than the year earlier--
    but slightly fewer than the 89 companies in 2000, according to Thomson
    Financial, which compiles market and investment data for corporate
    clients.
        So far this year, 41 companies have announced plans to revert to
    private ownership. ``Sarbanes-Oxley is not even among the top 10
    reasons'' that Lillian Vernon Corp., the big direct marketer based in
    Rye, N.Y., is going private, says spokesman David Hochberg. Similarly,
    Susan Hauke, vice president of finance at InvestorsBancorp of Waukesha,
    Wis., says Sarbanes-Oxley did not weigh heavily in the decision to go
    private. Instead, the chairman wants to buy the thinly traded bank,
    which has $178 million in assets, Ms. Hauke says, adding that the move
    will save $115,000 in annual SEC financial-reporting expenses.
        The seeds of Sarbanes-Oxley were sown in mid-2001--before the
    spectacular accounting scandals piled up one after another--by House
    Financial Services Chairman Michael Oxley (R., Ohio), who began holding
    hearings into whether Wall Street research analysts were really
    independent.
        A few months later, with Enron Corp. and its auditor, the now-
    defunct Arthur Andersen LLP, engulfed in an accounting scandal,
    lawmakers in the House and Senate were up in arms, pushing for broad
    legislation to force Wall Street and corporations to clean up their
    acts. But by the spring of 2002, Capitol Hill was preoccupied with
    terrorism, anthrax and Afghanistan, leaving corporate-overhaul efforts
    stalled.
        In April, the House passed a modest bill sponsored by Mr. Oxley.
    But a stronger version offered by Senate Banking Committee Chairman
    Paul Sarbanes (D., Md.) bogged down until a wave of scandals--Global
    Crossing Ltd., Tyco International Ltd., WorldCom Inc. and others--
    propelled it out of the legislative doldrums.
        Fearing a backlash in 2002 midterm elections from voters who had
    lost their nest eggs as the market plunged, Republicans embraced the
    Senate measure's tough line on business. As he requested, President
    Bush had legislation on his desk before Congress's August recess. A
    first step required companies to certify each quarterly financial
    report.
        But Sarbanes-Oxley hasn't been the last word.
        State politicians have been jumping on the bandwagon--so much so
    that John Olson, a securities lawyer at Gibson, Dunn & Crutcher in
    Washington, says companies are exasperated.
        California and Connecticut have already adopted additional
    certification requirements, and 35 states have approved or are
    considering legislation to regulate corporate accounting and other
    behavior, according to the North American Securities Administrators
    Association, which represents state securities regulators.

                                *      *      *

                Fighting Conflicts With a Pen: What Has Changed?

        Below, some major provisions of the Sarbanes-Oxley Act of 2002,
    which aims to reform accounting firms' practices, corporations' boards
    and Wall Street stock analysts.
        Better Governance: Companies must disclose whether a board's audit
    commitee has at least one ``financial expert'' and if not, the reason
    for the absence. In a subsequent rulemaking, the Securities and
    Exchange Commission said companies must disclose the financial expert's
    name, define his qualifications and state whether the expert is
    independent of management.
        Independence Day: It will be generally ``unlawful'' for an
    accounting firm to provide any major nonaudit service (bookkeeping, for
    example) to a client while completing that company's audit.
        Taking Responsibility: The CEO and CFO must swear to the accuracy
    of the company's quarterly and annual financial reports. An officer who
    certifies a report that does not conform to the act's requirements of
    Sarbanes-Oxley faces a fine of not more that $1 million and a sentence
    of not more than 10 years in jail or both.
        Watchdog: The act established the Public Company Accounting
    Oversight Board, or PCAOB--quickly nicknamed Peekaboo. The board of
    five ``financially literate'' members answers to the SEC.
        Cleaning Up Wall Street: New rules separate Wall Street's stock
    analysis from its deal-making side--and punish companies who
    ``retaliate'' against analysts who criticize them.
        Jail Threat: Makes tampering with corporate records a crime.
    Maximum penalty for mail and wire fraud increased from five to 10
    years.

    Ameet Sachdev
    Chicago Tribune

                   New Rules No Bar to Mergers in Accounting

                       Consolidation for a Sector in Flux
                                August 11, 2003

        Accountant Dan Fensin feels like he has a target on his back in
    more ways than one.
        For the past year, the managing partner of Chicago firm Blackman
    Kallick Bartelstein LLP has had to deal with public outrage over the
    profession's role in the massive financial scandals that pummeled
    investors.
        But the litany of new regulations and increased scrutiny hasn't
    stopped some accounting firms from growing through acquisitions,
    putting a bull's-eye on Blackman Kallick, one of the city's largest
    locally owned firms.
        But so far the numbers do not add up for Fensin and his 28
    partners.
        ``We are not interested in joining any of these groups,'' he said.
    ``We are happy with our position in the marketplace.''
        Still, the growing interest in consolidation reminds him of the
    mid-1990's, when financial-services powerhouses like American Express
    Co. targeted markets like Chicago for acquisition blitzes of midsize
    firms. The consolidators were interested in finding new small-business
    customers for their financial products and services, from retirement
    planning to investment advice.
        This time around, regional accounting firms have expanded to
    neighboring cities or beefed up existing services--like tax consulting
    or internal audits--to attract new clients. The Big Four could be
    vulnerable amid the industry upheaval.
        Since January, there have been about 10 deals, led by New Jersey-
    based J.H. Cohn's acquisition of the Videre Group to create a Northeast
    firm with about $100 million in revenue, the largest merger since March
    2001, according to Public Accounting Report.
        In the Midwest, there have been some smaller transactions, such as
    Indiana-based Crowe Chizek and Co.'s purchase of Kruse & Associates of
    Nashville.
        It is not exactly the merger mania of a few years ago when four
    major consolidators acquired more than 100 firms, but the tide is
    building, industry experts said. Now, there are approximately 65
    midsize firms, which average 20 to 25 partners, that 10 to 15 larger
    regional firms could be eyeing for acquisition.
        ``As bad as the publicity has been for the accounting industry,
    merger prospects are bullish,'' said Alan Koltin, chief executive of
    PDI Global Inc., a consultant to accounting firms. ``That is the No. 1
    topic right now.''
        The deals are happening against the backdrop of the most dramatic
    changes in the accounting industry in decades. Last summer's Sarbanes-
    Oxley Act created an entirely new system for regulating accountants in
    an attempt to transform them into better watchdogs who could prevent
    the kinds of massive financial fraud that occurred at Enron Corp. and
    WorldCom Inc.
        The four largest firms, which audit about 78 percent of all U.S.
    public companies, have responded by increasing auditor training,
    enhancing fraud-detection techniques and setting tougher standards for
    accepting and retaining clients.
        During the past year, for instance, Ernst & Young LLP has parted
    ways with about 200 public and private clients. Some left after fee
    disputes--fees have risen as much as 20 percent in some cases. In other
    cases, the major firms have stopped working with some clients
    voluntarily because of the law. Sarbanes barred auditors from
    performing technology consulting work and from doing internal audits
    for clients.
        Whatever the reason, regional firms say the climate has never been
    friendlier for competition in audit and consulting services.
        ``Traditionally, clients have been afraid to go to someone other
    than the Big Four,'' said Jim Smart, managing partner of Smart and
    Associates, a Philadelphia firm that last fall entered Chicago by
    purchasing small CPA firm Glenn Ingram & Co. ``Now, I think the
    marketplace is looking for new players.''
        He added with a bit of glee: ``Sarbanes is a wonderful thing from
    our perspective.''
        But Smart is not looking to add any public companies as audit
    clients. In fact, his firm does not audit any public companies.
        Indeed, smaller firms like Smart's face significant barriers to
    break into the audit market for multinational public companies,
    according to a U.S. General Accounting Office study on competition in
    the public accounting industry released last week. Among the barriers
    the study found: a lack of staff and technical expertise, and increased
    litigation risk and insurance costs.
        Despite the industry forces working against them, Smart and other
    regional firms are gunning for consulting work from clients who have
    conflicts with their auditor and work from larger private companies. To
    do that, they figure they need to bulk up and are finding some willing
    suitors, especially smaller firms where the partners are nearing
    retirement age and may be looking to cash out.
        Crowe Chizek, one of the nation's top 10 public accounting firms,
    acquired Kruse last month in an attempt to build a national practice
    advising building contractors and other construction-related companies,
    said Chief Executive Mark Hildebrand. The expansion in Nashville also
    allows the firm to market its expertise in auditing and consulting with
    midsize manufacturing companies.
        Midwestern regional firms, such as Virchow Krause & Co. of Madison,
    Wis., and BKD LLP of Springfield, Mo., have made no secret of their
    desires to blow into the Windy City. So far, they have found slim
    pickings.
        Many of the local midsize accounting firms were swept away during
    the consolidation wave of the 1990's. For instance, Friedman,
    Eisenstein Raemer & Schwartz, which had $40 million in yearly revenue,
    sold out to H&R Block Inc. in 1998.
        The remaining independent firms, including Blackman Kallick, have
    shunned their more recent advances. But Blackman Kallick's managing
    partner left the door open, albeit slightly.
        ``There is always somebody calling up,'' Fensin said, ``and the
    fact of the matter is, I will eat lunch with anybody.''

                               IMPLEMENTATION OF
                           THE SARBANES-OXLEY ACT AND
                         RESTORING INVESTOR CONFIDENCE

                                  ----------

                          TUESDAY, SEPTEMBER 23, 2003

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Committee met, at 10:02 a.m., in room SD-538, Dirksen
    Senate Office Building, Senator Richard C. Shelby (Chairman of
    the Committee) presiding.

            OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Chairman Shelby. The hearing will come to order.
        I would first like to welcome today's first witness. We
    will have a second panel that we will introduce later. Our
    first witness is Chairman William McDonough of the Public
    Company Accounting Oversight Board. That is a mouthful, as we
    know.
        Accurate financial reporting and disclosure are the
    foundations of our capital market system. And in order for our
    markets to operate fairly and efficiently, investors must have
    faith that a company's audited financial information is
    reliable, accurate, and timely. Without this trust, investors
    will abandon the markets for fear that they will be the
    unknowing victims of a financial scheme.
        Following the collapse of Arthur Andersen and the
    announcement of billion-dollar restatements, investors quickly
    lost faith and confidence in the accounting profession. Many
    investors regarded the auditors as co-conspirators in corporate
    schemes and believed that auditors simply rubber-stamped the
    financial statements that management prepared. Revelations
    about companies' purchasing millions of dollars of nonaudit
    services from their auditors furthered the perception that the
    accounting industry was rife with conflicts of interest, and
    that auditors were profiting at the investors' expense.
    Although the corporate scandals of the recent past tarnished
    the image of the accounting profession, the industry is now
    presented with an opportunity to rehabilitate its reputation,
    reassuring investors that auditors are carefully reviewing
    corporate books without conflicts.
        A primary focus of the Sarbanes-Oxley Act is to restore
    confidence in the accounting profession by improving the
    integrity of the audit process and financial reporting through
    vigorous oversight of audit firms and new rules defining
    auditor independence. The Act creates the Public Company
    Accounting Oversight Board to supervise the accounting firms
    that audit the books of public companies. Audit firms are now
    accountable to a regulator rather than operating within a self-
    regulatory structure. The Oversight Board is tasked with
    registering accounting firms, developing inspection and
    disciplinary programs, and drafting new auditing and
    attestation standards.
        Under Chairman McDonough's leadership, the Oversight Board
    has successfully begun the process of registering domestic and
    international accounting firms and started inspections of the
    Big Four accounting firms themselves. Although the Oversight
    Board is in its infancy, investors should feel confident that
    it will continue to grow and implement reforms that will
    restore integrity to the audit process.
        While creating a new regulator for the accounting industry,
    Sarbanes-Oxley also mandates new rules establishing greater
    independence between auditors and their clients. Prior to the
    Act, many accounting firms treated audit services as a loss
    leader for securing more lucrative consulting contracts, and
    many audit partners were compensated for procuring engagements
    for consulting services. Concern existed that auditors are all
    too often willing to overlook questionable accounting practices
    in order to retain profitable consulting business for the firm.
    The Act addresses these conflicts by, among other rules,
    prohibiting a company's auditors from performing certain
    nonaudit services, requiring a company's audit committee to
    preapprove all audit and nonaudit services that the company
    receives, and mandating audit partner rotation. These rules
    were necessary to address conflicts of interest that caused
    investors to doubt the credibility of auditors and the accuracy
    of financial reports.
        Sarbanes-Oxley has laid the foundation for the accounting
    industry to earn back the trust of investors. By cooperating
    with the Oversight Board and complying with the auditor
    independence standards, audit firms can prove to investors that
    they are
    committed to reinvigorating the audit process and restoring
    faith in financial reports. Accounting firms must also
    demonstrate that they will force public companies to comply
    with proper accounting rules, even after the focus on reform
    has diminished. By ensuring that public companies maintain
    adequate internal controls and sound audit committee practices,
    audit firms can further serve the investors who rely on them to
    serve as financial gatekeepers.
        As the Oversight Board continues to develop, it must stand
    strong in the face of industry criticisms and remind both the
    accounting firms and the investors that there is a new watchdog
    for the industry. Chairman McDonough and his team have a
    difficult task ahead of them, one that is crucial to restoring
    investor confidence in our markets. Mr. Chairman, we look
    forward to your testimony here this morning.
        Senator Enzi.

                  STATEMENT OF SENATOR MICHAEL B. ENZI

        Senator Enzi. Thank you, Mr. Chairman, and thank you,
    Chairman McDonough, for being with us today to discuss the
    Public Company Accounting Oversight Board, PCAOB. And I think
    you have come up with a word for that, some way to say that in
    one----
        Mr. McDonough. ``Pea-cobb,'' but it does not seem to be
    selling well, Senator.
        Senator Enzi. Oh, okay. I am sorry to hear that. At any
    rate, I am anxious to hear about the implementation, and I
    appreciate all of the people that are testifying today for
    getting their testimony in so that we would have an opportunity
    to read that in advance, and probably much fuller than you will
    be allocated time to be able to present that information.
        I know that you and your staff have accomplished a great
    deal in a short period of time. Last week, Chairman Donaldson
    of the SEC testified that the primary rulewriting phase of the
    SEC is virtually complete and that now the primary focus of the
    rulewriting and implementation of the law will be on PCAOB. I
    will try and help promote that name.
        While the Sarbanes-Oxley Act established a new regulatory
    oversight body for the auditing industry with registration and
    enforcement authority, I believe the single most important
    mission for the Public Company Accounting Oversight Board is
    establishing the auditing standards for the industry. The
    future of our securities markets are dependent on how these
    standards are developed, how they are implemented, and how the
    auditing firms put them to use. And we are having a little
    deviation from how it used to be done, and I am certainly
    hoping that AICPA will be a voice in helping with that.
        It is my understanding that PCAOB intends to work in an
    open process with a broad cross-section of the accounting,
    financial, and investing communities to develop these
    standards, and I applaud you for that.
        Another area of concern for me is the ability for small
    auditors to stay in the business of conducting audits for
    small, publicly traded companies. One key question on the
    passage of the Sarbanes-Oxley Act was whether the small-
    auditing community would be able to weather the increased
    regulatory climate and the increased administrative
    requirements. Now, the recent GAO study on consolidation in the
    accounting industry was inconclusive on this; however, it may
    be that the study was too premature to capture the full effect
    of the law on the industry.
        The survival of small auditors is important not only for
    the community but also for the small companies that strive to
    reach those public markets, and we have had quite a decline in
    IPO's being filed. Mr. Chairman, I know that you have been a
    strong supporter of the small auditor, and we have had
    conversations about it, and I look forward to hearing how the
    PCAOB is working with the small accounting industry.
        I would personally like to thank you for taking such quick
    and firm control of the reins as Chairman of PCAOB and for
    working with Congress to ensure the implementation of the
    provisions of the Sarbanes-Oxley Act, and that is done with
    investor respect and confidence in mind. I congratulate you for
    your efforts.
        Thank you, Chairman Shelby.
        Chairman Shelby. Senator Dodd.

                STATEMENT OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Well, thank you, Mr. Chairman, and let me
    begin by commending you once again for--this is our second
    hearing now on looking back at Sarbanes-Oxley, and this is very
    worthwhile. I spoke to a group in Boston yesterday and spent a
    good bit of time just talking about this in the Q and A period.
    This was with some of the leaders in the financial services
    sector in Boston, and I was interested in how they thought
    things were working. And I had a tremendous response. They were
    very upbeat and very positive on how this was working so far.
    Obviously, they are monitoring it carefully and watching it
    closely from their perspective. But I think having oversight
    hearings like these really helps us take a look back, since we
    did enact this legislation rather rapidly, much more rapidly
    than one would have anticipated given the sweep of this
    legislation. And so having this oversight is tremendously
    worthwhile.
        We have done this in the past, but it deserves being
    repeated. Certainly our colleague from Maryland, Senator
    Sarbanes, Mike Enzi as well--who deserves a great deal of
    credit for being a principal author of Sarbanes-Oxley. His name
    does not appear when the name gets said, but history should
    record that he and Jon Corzine played a tremendous role in
    this. And it would not have happened without their leadership,
    and so I thank them for their work.
        And I am delighted Bill McDonough is here. He has been an
    old friend for many, many years, someone whom I have a high
    regard for, enjoyed working with him on numerous occasions on a
    variety of issues, not only from obviously financial services
    issues, given his background, but also on Latin America, in
    which we share a strong common interest.
        He speaks wonderful Spanish, Mr. Chairman, by the way.
        We are very lucky and fortunate that you agreed to take on
    this responsibility, and we thank the Chairman of the SEC for
    imploring you to do this and for your willingness to take it on
    and for your family's willingness to take it on. So we thank
    you very, very much for taking it on.
        I keep on asking, how do we pronounce this thing? And I
    have just listened to Mike Enzi, and since he is a principal
    author of the bill, I am going to ask--PCAOB, is that what it
    is? It sounds like some rare fruit that you have here. But
    thank you for taking on that responsibility.
        Obviously, our Nation's first securities laws enacted in
    the 1930's established the foundation, Mr. Chairman, by which
    our Nation's free markets function, and that foundation that is
    built on rules, rules that give investors worldwide the
    confidence that investing in America is safe and secure. In my
    almost 24 years now on this Committee, and in almost that
    length of time being either the Chairman or the Ranking Member
    of the Securities Subcommittee, that has been the byword,
    ``investor confidence.'' And that is why the world comes here.
    There is always a better deal someplace else in the world. If
    you are looking for a fast buck, there are plenty of other
    places around the world that will offer you a potentially
    greater return on your investment. But the reason the world
    comes here is because we are fair. The rules are fair. It does
    not guarantee you a great win, but you know that when you
    invest your money, it is fair. There are rules and we operate
    by them. And when that gets shattered for any reason at all,
    then it is a great loss to our Nation and a great loss
    obviously to our economy.
        And so it is critically important that we do everything
    possible to restore investor confidence, and we are very
    hopeful that this legislation, particularly the creation of the
    Public Company Accounting Oversight Board, will lend itself to
    that result. We need rules that uphold the basic principles of
    any market competition, credibility, responsibility, and
    honesty, and rules that have helped make our economy the
    strongest and the most vibrant one the world has ever seen.
    Sarbanes-Oxley is one of those defining rules, and I believe it
    will have a lasting positive impact on our financial reporting
    system.
        The creation of PCAOB as prescribed in the bill with a new
    regulator for the accounting profession has already restored, I
    think, some of that integrity lost in the recent accounting
    scandals. And it is my fervent hope that we are on the path to
    restoring greater investor confidence in both the accounting
    profession and our system of financial regulations. By nearly
    all accounts, the establishment of PCAOB has gone exceptionally
    well. I am anxious to hear what our witnesses have to say about
    that this morning and getting a status report.
        So, Mr. Chairman, I am delighted to have been a part of
    this effort as well over the last number of months, and again,
    thank you for holding these hearings, and I look forward to
    hearing from our witnesses.
        Thank you.
        Chairman Shelby. Thank you.
        Senator Reed.

                     COMMENTS OF SENATOR JACK REED

        Senator Reed. Thank you very much, Mr. Chairman. Welcome,
    Mr. McDonough. And Senator Dodd said it very, very well. I will
    not repeat it. But I, too, want to thank you, Mr. Chairman, for
    holding these hearings. I think it is important after we pass
    landmark legislation like this that we continue to revisit it
    and to make sure that we have taken the right steps and we make
    improvements where necessary.
        Again, I would also like to commend Senator Sarbanes for
    his efforts and Senator Enzi, my colleague, classmate,
    whatever, who was instrumental in doing this and brought great
    wisdom from his own experience as an accountant to the process.
        Thank you very much, Mr. Chairman.
        Chairman Shelby. Thank you.
        Mr. McDonough, your written testimony will be made part of
    the record in its entirety. You proceed as you wish. Welcome to
    the Committee.

                   STATEMENT OF WILLIAM J. McDONOUGH

                        CHAIRMAN, PUBLIC COMPANY

                       ACCOUNTING OVERSIGHT BOARD

        Mr. McDonough. Thank you, Chairman Shelby. Gentlemen, I am
    pleased to appear before you today on behalf of PCAOB. I think
    we could say New Englanders would say it ``pea-COBB'' and
    Midwesterners would say it ``PEA-cobb.'' But, at any rate, it
    is a great improvement over anything else that has been heard.
        Senator Dodd. Irving Berlin.
        Senator Reed. No. Cole Porter.
        Senator Dodd. Cole Porter. Thank you.
        Mr. McDonough. This is the first appearance of a PCAOB
    member before the Committee. On behalf of the Board, I would
    like to begin by commending the extraordinary leadership of
    this Committee in response to the crisis to public confidence
    brought on by some devastating failures in financial reporting
    and in auditing. The legislation--now law--that you worked so
    hard on is a landmark reform of corporate governance, financial
    reporting, and auditing, 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. Among the
    many reasons I was willing to take on this job were my own
    strong convictions about the need for an aggressive response to
    the corporate scandals and the lack of leadership in the
    private sector. It is an honor to have the opportunity to act
    on those convictions by helping to build an organization, in
    the form envisioned by you, to restore the linchpin of the
    American financial system--trust in the integrity of financial
    reporting.
        When I joined the PCAOB on June 11, I found four
    outstanding colleagues, all as dedicated as I am to the Board's
    mission. Those colleagues--Acting Chairman Charlie Niemeier,
    Bill Gradison, Kayla Gillan, and Dan Goelzer--had already made
    tremendous strides in writing the unprecedented new rules that
    are required by the Sarbanes-Oxley 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,
    fair, and independent audit reports for public companies. The
    Board started from scratch in January. We are now up to 84
    full-time professional staff.
        As provided in the Act, the Board received an advance from
    the U.S. Treasury to fund its start-up expenses. Yesterday, we
    repaid the advance in full, $20,300,000. Fees assessed on
    public companies will fund our operations going forward as we
    perform the four primary functions that the Act 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, they must
    be registered with us by October 22. We have received almost
    500 registration applications from U.S. accounting firms. The
    Board approved the first 38 of those applications last week,
    and we will continue our review of the remaining 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. And 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, a fruitful one, with our counterparts in other
    jurisdictions in order to find ways to coordinate in areas
    where there is a common programmatic interest. Registration is
    not only a prerequisite for accounting firms to continue their
    work as auditors of public companies, but it is also the
    foundation for us to perform the important functions of
    inspection and enforcement.
        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.
        The fundamental goal of our inspection program is to assess
    and thoroughly test whether they are improving the quality of
    the firm's audit work. We will review selected audits, but we
    will also look closely at firm-wide policies and practices that
    bear on integrity and judgment.
        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 a 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
    fire a client.
        Registered accounting firms are subject to PCAOB
    inspections, and they are also subject to our 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
    disciplinary hearings that are intended to implement our
    authority in a fair way, preserving all appropriate rights for
    the persons subject to our jurisdiction. We expect to adopt
    final rules next week.
        And, finally, I want to outline our progress with respect
    to audit standards. The Act charged the Board with establishing
    auditing and related attestation standards, quality control
    standards, ethical standards, and independence standards. The
    Act gave the Board the option of setting standards on its own
    or designating any professional group. Before I joined the
    Board, the decision was made that the Board would do it itself,
    and I firmly support that decision.
        To assist the Board in developing standards, we have begun
    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
    problems in practice. We will also tap the expertise of
    standing advisory group and ad hoc task forces made up of
    experts from a variety of fields.
        The first standards to come from the Board will be those
    prescribed by the Act relating to auditors' attestation 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, in time to meet the SEC's June 15 deadline for management
    to begin filing internal report forms. We will hold another
    roundtable next week to discuss audit documentation as we
    prepare to set standards in that area.
        With your vision in establishing authority for independence
    standard setting, registration, inspection, and discipline, you
    have given PCAOB the responsibility and the tools to build a
    new future for auditing. I have faith that our staff and my
    fellow Board members 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; rather,
    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 look forward to that objective, my fellow Board
    members and I look forward to a long and constructive
    relationship with the Committee, and I do like the idea, Mr.
    Chairman, of coming up to see you periodically to tell you what
    we have been doing.
        Chairman Shelby. I think that is a good idea.
        Mr. McDonough. Thank you.
        Chairman Shelby. Thank you.
        Mr. Chairman, can you please describe briefly the process
    to the Committee for addressing some of the concerns raised by
    European governments and companies concerning the application
    of the Oversight Board's registration and oversight rules?
        Mr. McDonough. Thank you, Senator. It is very clear that
    the sense of Congress, even though the Act itself said that we
    could have exempted the audit firms outside the United States,
    that it was the intent of Congress--and two Members, Senator
    Corzine and Senator Dodd, wrote a letter to the SEC making it
    very clear the intent of Congress--that foreign firms should be
    registered. I think they should be.
        The question is: What are we trying to achieve under
    Sarbanes-Oxley, and can we achieve that so that it, in fact,
    spreads the Sarbanes-Oxley philosophy worldwide?
        We are trying to protect investors in securities sold in
    our markets. Many of the people whom we are protecting are not
    Americans. They are foreigners. At the same time, there are a
    lot of Americans who invest in securities issued by and sold in
    foreign markets. So what we have been trying to do is to reach
    out to other entities--the European Community beginning with,
    the Canadians, the Japanese, beginning the conversations with
    the Swiss--and saying it is required under the Act that
    registration take place. But the Act does not say that the
    registration has to be exclusively with us. We could have a
    joint registration, for example, in which a firm could register
    with its local authority and us. With all that Sarbanes-Oxley
    requires, we get everything we want, but the home country also
    has the dignity of the process including them.
        As I pointed out, registration is just the beginning. It is
    how you get started. It has taken on a bit too much of a life
    of its own in the discussions abroad and some of the reactions.
        Once we actually get the registration past us, then I think
    we would look at what if a foreign PCAOB wanted to have an
    inspection of one of its auditing firm's activity in the United
    States. Well, I would volunteer to say we will do it for you,
    just tell us what you want done.
        We think that in jurisdictions where there is really up-to-
    snuff inspection capability, rather than send 15 Americans who
    speak wonderful English over to a country where that might not
    be the local language, if we could have a combined inspection
    where a lot of the work would be done by the local people, as
    long as I could assure you we are enforcing the Sarbanes-Oxley
    Act just as much through that process as we are in the United
    States, I would suggest we would have reached a point where 2
    plus 2 equals lots more than 4. That is what we are working on.
        Chairman Shelby. But, after all, it is the substance you
    are after, not just the form.
        Mr. McDonough. Precisely.
        Chairman Shelby. Mr. Chairman, beyond rulemaking, regarding
    oversight of accounting firms' attestation standards, what
    issues do you think that the Oversight Board will address in
    the next year?
        Mr. McDonough. Mainly what we are hoping to achieve, to be
    most generic, is to restore the faith of the American people in
    the accounting profession. And everything I am hearing from
    sensible people in the accounting profession is they want that
    at least as much as I do.
        Now, their interest is in improving the quality of their
    own profession and its reputation, and improving their own
    firms. I represent the public interest. PCAOB represents you,
    represents the American people. If they are doing a very good
    job, we can work hand in glove with them. If they are not doing
    a very good job, we will push and prod, and do what is
    necessary. That is, I think, the biggest challenge.
        Chairman Shelby. But it is in their best interest to do
    that, and I think most of them know that.
        Mr. McDonough. I think so.
        Chairman Shelby. Mr. Chairman, we are down to four big
    audit firms with the demise of Andersen. There has been some
    concern regarding market concentration because of this. Are you
    concerned about this consolidation? And do you see a role for
    the Oversight Board in facilitating competition?
        Mr. McDonough. Mr. Chairman, there was a very good, highly
    realistic report by the GAO that I think leads one to the
    conclusion that there are four big accounting firms and there
    will continue to be four big accounting firms. It is very
    difficult to see exactly how you get number five, six, or
    seven--in fact, number five is represented on your second
    panel--up to that size. I would love to have it happen if it
    took place because I would like to have more than four. But I
    think we must be realistic.
        Something I think the PCAOB can do, however, is to nurture
    and cherish the firms, the small and medium-sized audit firms,
    because they audit the small and medium-sized companies. My
    whole theory of economic development is small and medium-sized
    companies is what makes America great. The creative
    construction of a market economy comes from small and medium-
    sized companies. We want them to have good auditors who are
    helpful and cost-conscious so we are not pricing these small
    and medium-sized companies out of business. We are enforcing
    Sarbanes-Oxley but with a very high degree of common sense
    governing how we apply it.
        Chairman Shelby. Thank you.
        Senator Reed.
        Senator Reed. Thank you very much, Mr. Chairman. Thank you,
    again, Mr. McDonough.
        When the legislation was being considered, many small
    accounting firms in my community, perhaps with one or two
    public clients, expressed some concern about the requirements.
    Could you comment on the receptivity of the industry, not the
    Big Four but the smaller firms around the country, to the
    changes?
        Mr. McDonough. It is really a little bit early to tell. A
    lot of the foreign small and medium-sized firms have
    registered. Some of them have groaned very loudly because the
    registration form is pretty much set out in the statute, and
    although we tried to make it kinder and gentler, there was very
    little we could do about it. So it is a pretty elaborate form
    for a small or medium-sized auditing firm to fill out, but they
    filled it out.
        We have a very busy time between now and October 22 because
    of all these registrations that the Board has to look at. But
    as soon as that is behind us, and then by that time we will
    also have some visitors from other countries to continue the
    dialogue, but I see October 22 as Freedom Day for Bill
    McDonough to do what he likes to do, which is to go out around
    the country and start meeting, probably with the help of, say,
    in your case, the Rhode Island overseer of public accountants
    or their version of the certified public accountant group and
    ask them to organize a meeting, and then sit down and just
    listen and talk and learn and see how I can be most helpful.
        Senator Reed. Part of the Sarbanes-Oxley Act calls for a
    study of a principle-based system of accounting, and I know
    that the SEC has completed their study on July 25, and they
    recommended the approach. The FASB has also I think taken an
    endorsement of that approach. Can you comment, your views, and
    also will in fact PCAOB take a position with respect to this
    issue?
        Mr. McDonough. I am not sure, Senator, that PCAOB-cum-PCAOB
    has to take a position, but I will.
        I think that the study that was done by the SEC is really
    very good indeed because it says that rules-based accounting
    has gotten to a point where it is really very questionable as
    to whether it is doing the right job. The most infamous one is
    the literature on hedges and derivatives which has 800 pages of
    prose. But the theory is that you are supposed to find anything
    that you want in the 800 pages, but if you are devious you can
    also find a way to do anything you want to in the 800 pages.
    That is not good. The pure principles based, ``thou shalt not
    steal,'' that is very easy to understand, but as an accounting
    principle it is a little hard to be that clear.
        I think what the SEC is suggesting is that you would have
    something pretty straightforward like ``thou shalt not steal,''
    but then you would have some explanatory language which would
    say to a reasonable person what does that mean, so that maybe
    the 800 pages of prose on hedge and derivatives might be
    replaced by 25, 30, 35 pages, but at least that is an enormous
    step in the right direction. I think that as a very good piece
    of work and a very good place to start, the SEC study is really
    first class.
        Senator Reed. Thank you, Mr. Chairman.
        A final question. The issue of auditor independence. Are
    you considering additional functions that you would proscribe
    for auditors and with respect to certain tax services and other
    issues? That is an ongoing inquiry by PCAOB?
        Mr. McDonough. It is an ongoing area of interest to us. I
    think however when we are trying to reform the U.S. private
    sector, which is what Sarbanes-Oxley is all about, we do not
    want to keep changing the ground rules. The SEC, early this
    year, came out with what I thought was a very balanced
    statement repeating their traditional view that accounting
    firms can in fact do a considerable amount of tax work. A lot
    of it really just flows right out of the audit, and if you had
    somebody else that had to come in and do it, without any
    question, it would increase costs and I am not sure what you
    benefit.
        The very most important thing is the role of the audit
    committee and the time-honored test of auditor independence.
    Once you get to the highly creative end of how you can reduce
    your taxes to very little or zero, I really kind of question
    whether auditors should be doing that work anyway, but
    certainly you could not be doing that work for an audit client,
    because without question you would break independence by
    auditing your own work. I think short of that there is a lot of
    tax work that can be done, and although we have not formally
    considered it, I believe I speak as the consensus of the Board,
    that it is very likely that we will say that that which the SEC
    decided is the right decision.
        Senator Reed. Thank you very much, Mr. Chairman.
        Thank you, Chairman Shelby.
        Chairman Shelby. Senator Enzi.
        Senator Enzi. Thank you, Mr. Chairman.
        I appreciate the effort that you have made with the small
    auditing firms, and I understand that we have 500 auditors
    registered as of last week, and then your staff made telephone
    calls even to remind them of the need to register, and you even
    have an electronic register system. I am interested if there
    are any problems you are having with that electronic
    registering system. I also appreciate the fact that you did
    town hall type meetings with industry representatives. Again,
    along this line of the small auditors, are you going to be
    holding any of those for small auditing firms to cover some of
    the problems?
        Mr. McDonough. Senator, in response to the last question,
    as I mentioned in response to Senator Reed, I do really plan,
    and I am sharing this with my staff right now, that we will be
    getting out to the territories to see as many people as we can.
        I am really very worried about the undesirable and
    unintended consequences of having Sarbanes-Oxley get too
    expensive in its application. We have to really make sure that
    that which is done needs to be done and is not done just for
    the sake of having bells and whistles, which might make all the
    sense in the world for General Electric but does not make a
    whole lot of sense for a smaller company. When we get into
    internal controls that will certainly apply.
        I think that auditors have to question not can I justify
    testing everything in sight, or is there a level of reason at
    which I have tested enough to form an opinion? The idea of cost
    effectiveness we have to get out there, and I think that is
    best done by just going out and talking to people. If you are
    bouncing back and forth as I do between New York and
    Washington, one is deprived of all the wisdom in the rest of
    America, and I am really looking forward to getting out there.
        Senator Enzi. Good. Rhode Island is real close. Wyoming is
    a long way away. We will look forward to hosting you out there.
        One of the concerns of the auditing industry is how the SEC
    and PCAOB will conduct investigations, and they are worried a
    little bit about whether there will be two separate
    investigations, one by PCAOB and one by the SEC, when there is
    a single enforcement incident. Can you explain to me how this
    joint authority will work?
        Mr. McDonough. I think, Senator, there we are back into the
    rule of common sense. We have an excellent working relationship
    with the SEC at all levels. The Chairman of the SEC is the man
    who convinced me that I should be in front of you today, and I
    think that just working together. It would be really
    unfortunate if we were doubling up both the resources from the
    SEC-PCAOB, and then one might say with some trepidation,
    wasting the time of the entity being investigated by just
    having too many people crawling around the premises. So we will
    make every effort to avoid that.
        Senator Enzi. I appreciate that answer and look forward to
    seeing it in action. A final question here. When PCAOB adopted
    the rules that established the criteria for the advisory group,
    they announced that it was putting together an advisory group
    with a broad cross-section of accounting, financial, and
    investing communities, and you have explained a little bit
    about the status of the advisory group. I guess what I am
    interested in is how the Board and the advisory group would
    seek professional guidance from the AICPA. That was a major
    concern when we were drafting the bill.
        Mr. McDonough. Since we have not yet formed the advisory
    group, Senator, it could very well be that one or more people
    associated with the AICPA could be on it. I think it is very
    important for us to work with the AICPA. We have taken over an
    important part of what used to be their responsibility because
    we set the audit standards for public companies. Since private
    companies not infrequently become public companies, one would
    hope that the audit standards for public companies have a great
    similarity with the audit standards for private companies. I
    would hope that without duplicating effort and therefore
    costing the accounting industry unnecessary expense, that the
    PCAOB and the AICPA could work together. We have had a number
    of meetings. It is certainly my intention to avoid having them
    take over some of the responsibility that you in fact gave
    PCAOB. If I were they, I would think that a pretty neat thing
    to do, but we cannot let it happen. At the same time they have
    a very noble purpose of lots of other things to do, and I am
    hopeful that as adults we can figure that out and have--my
    favorite statement to say again--if you can ever have 2 plus 2
    equal more than 4, that is the way to go. That is what we will
    try.
        Senator Enzi. I appreciate all the effort that you are
    putting into it and have a lot of confidence based on your
    leadership. Of course, one of our concerns was the potential
    trickle-down effect into the private companies of having some
    excessive things, but I am confident that you will watch out
    for that and I thank you for the answers and this opportunity.
        Thank you, Mr. Chairman.
        Chairman Shelby. Thank you, Senator.
        Senator Corzine.

                  STATEMENT OF SENATOR JON S. CORZINE

        Senator Corzine. Thank you, Mr. Chairman. I welcome
    Chairman McDonough. It is great to see you again.
        I am going to take a little bit of step toward overall
    assessment of Sarbanes-Oxley. I was interested to read a
    Business Week review that went through the various groups. I do
    not know whether you are familiar with it. It gave regulators
    high marks and CEO's not such good marks, and most of the
    others in between. Also, it did assign the view that the
    accounting industry has been quite cooperative in the process
    of working with the PCAOB and others in moving to accomplish
    the audit of auditors and fulfilling its responsibility. I want
    to get on record, your clear view that you are generally seeing
    the kind of cooperation that anyone would reasonably expect in
    this whole process of implementation of Sarbanes-Oxley.
        Mr. McDonough. The cooperation, Senator, that we are
    getting from the accounting profession so far is even better
    than I had hoped it would be. The Big Four firms voluntarily
    agreed to be inspected before they were registered. They could
    easily have told us that, ``You have no business in our
    premises until we are registered.'' They did not do that. I
    thought that showed good judgment. But there was no twisting of
    arms or anything else. We just said: Is that agreeable? And
    they said yes. That is a big positive.
        The other firms throughout the profession with whom we have
    been in contact are taking a very similar attitude. I think
    part of the reason for that is I have been as explicit as I
    can. If X number of years from now the American people think
    that the accounting profession is the great thing that
    everybody thought accountants were when I was a kid, that will
    be wonderful, and if the PCAOB has not hanged anybody in public
    in the meantime, that is great. We really want to achieve
    something and the more the accountants can figure it out that
    they are going to do it themselves with PCAOB watching and
    making sure it is happening, that is best for the American
    people. So far their record is just fine.
        Senator Corzine. Let me flip that. It gets at the issue of
    internal controls, which I think is one of the more difficult
    rubs in Sarbanes-Oxley, at least in the minds of the private
    sector. I hear a lot of complaints about it, and then I also
    hear and see surveys that show CEO's are overwhelmingly
    thinking that this is a box-checking exercise as opposed to an
    exercise in moving forward and putting in place the disciplines
    and the checks and balances that I think was intended by the
    legislation.
        Is there any evidence that there is that same element of
    cooperation going on broadly in public companies to embrace
    this as a constructive element that I think we see in the
    accounting industry? I am sure there are highs and lows among
    different institutions. Why are we seeing so much resistance to
    putting in place a framework that was designed actually to put
    in checks and balances? Internal controls actually are good
    things for companies, and even though there is nothing going
    wrong at a given point in time that does not mean 2 years from
    now or 5 years from now something will not come up that
    actually would damage a company. We have seen that with the New
    York Stock Exchange and other things. Why is this resistance
    continuing to exist in your view?
        Mr. McDonough. Senator, I think it is extremely difficult
    to understand because it simply makes no sense. Any firm that
    does not have good strong internal controls should have them,
    and if the heads of those firms are complaining that it is
    expensive to have them, I think the answer is, well, you should
    have had them a long time ago. We do not feel sorry for you
    that you have to invest in them now. I cannot imagine being a
    CEO of even an 85-member gang like PCAOB without having some
    very good internal controls.
        One of the things I think that may be happening is that I
    believe there are a great many CEO's that are being advised by
    counsel that you have to be very careful in saying that you did
    not have it quite right before you can say, and I am going to
    fix it, because they are concerned about litigation. It would
    seem to me that the sensible thing to do would be to say, it is
    my intent, because of Sarbanes-Oxley and running my company
    very well, that I am going to do the following things. I do not
    think you have to refer to the past and be contrite about it.
    There might be a little of that included, and it might be very
    appropriate. But I do think that it is important for the
    American business leadership to say: The American people passed
    Sarbanes-Oxley by vast majorities through the Congress of the
    United States because the American people were angry with the
    private sector with very good reason, and it is now time for
    the private sector leadership to get itself together and lead
    the way to restore the faith of the American people in our
    economic system, and it is not going fast enough.
        Senator Corzine. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Sarbanes.
        Senator Sarbanes. Thank you very much, Mr. Chairman. I
    apologize, but the roads are flooded all over the place this
    morning. It was difficult getting in. I want to take some
    moments of my question period to in effect give a statement
    that I would have made when I first came in.
        Chairman Shelby. Go ahead.

                 STATEMENT OF SENATOR PAUL S. SARBANES

        Senator Sarbanes. I want to thank Chairman Shelby for these
    oversight hearings on the implementation of last year's
    legislation. We have already heard from SEC Chairman Donaldson,
    and next week we will be hearing from representatives of the
    corporate community and other interested parties.
        Today's subject is the ongoing changes in the way U.S.
    companies are audited and how those changes affect the
    confidence of the U.S. investing public. Markets cannot
    function without accurate and trusted financial information.
    Markets depend on investor confidence, and of course the whole
    purpose of last year's legislation was to alter the system in
    such a way that we could contribute to the restoration of
    investor confidence.
        Mr. Chairman, I believe a strong team is now in place to
    address these issues: SEC Chairman Donaldson; William
    McDonough, who is with us this morning, the Chairman of the
    Public Company Accounting Oversight Board; and Bob Herz at the
    Financial Accounting Standards Board. They are all making good
    progress, and are moving I think on a fast timetable.
        The Public Company Accounting Oversight Board now has
    responsibility for registration, inspection and investigations,
    and disciplinary proceedings involving auditors of public
    companies. I am looking forward to hearing about its work. The
    Board has met its statutory deadlines, has already received, as
    I understand it, online registration applications from just
    under 500 accounting firms, and has begun its inspection
    programs.
        I am looking forward to the testimony we will hear this
    morning from the representatives of the accounting industry.
    Public company auditors are now subject to outside oversight
    for the first time through the Public Company Accounting
    Oversight Board. Public company auditors are also facing basic
    changes in their relationships in many instances with their
    audit clients. They will be hired by and report to independent
    board audit committees rather than management, and their
    nonaudit activities for audit clients will be limited and
    reviewed.
        SEC Chairman Donaldson told the Committee last week that
    true change is less about complying with rules than about
    building into companies the mindset to do the right thing. I am
    prompted to recognize what Senator Corzine was just talking
    about. Auditors, in a truly effective independent audit system,
    obviously must have the same mindset.
        Finally, I am pleased that we are going to hear from
    representatives of the large institutional investors through
    which savings of ordinary Americans are invested. Institutional
    investors have been in the forefront of calls for change in the
    framework for auditor oversight, auditor independence, and
    corporate governance. The perspective of the Nation's
    institutional investors on the extent of our progress in
    restoring investor trust is especially important because of the
    pool of savings for which they have responsibility.
        I want to close my statement by repeating a unanimous
    Supreme Court decision some 30 years ago, an excerpt from it,
    about the role of auditors in our free market system. The
    Committee actually made reference to this last year in
    considering the legislation, and I now quote the Supreme Court
    again.

        In certifying the public reports that collectively depict a
    corporation's financial status, the independent auditor assumes
    a public responsibility. That auditor owes ultimate allegiance
    to the corporation's creditors and stockholders as well as to
    the investing public. This ``public watchdog'' function demands
    that the accountant maintain total independence from the client
    at all times and requires complete fidelity to the public
    trust.

        That summary provides the best single statement of the
    mindset we are all seeking to put into place as we deal with
    the problems that we were confronted with in recent times.
        If I have time, I would like to ask Chairman McDonough----
        Chairman Shelby. Go ahead.
        Senator Sarbanes. You may have already done this, but could
    you just lay out for us a little bit the issues that you see
    ahead of you in the next year or two, the work program of the
    oversight board, how quickly you will be up and in, ``full
    operation,'' so we have some sense of what lies ahead.
        Mr. McDonough. Senator, we are sufficiently, even with 85
    people, we are sufficiently staffed now to be able to go in to
    the four big firms and to do a limited inspection this year,
    which is going very well, by the way.
        Senator Sarbanes. By this year you mean this calendar year?
        Mr. McDonough. Yes Senator, 2003. And by December we will
    have I think a good feel for whether the four big accounting
    firms, not just at the top--they are definitely saying the
    right things at the top--but whether the troops are getting the
    message. That is I think the single most important thing to
    look at. Although we will not comment on what we saw at
    individual firms, we will have something to say publicly on
    that.
        By 2004, we have the requirement to inspect annually in a
    much deeper inspection any firm that audits more than 100
    public companies. There are seven such firms. Other firms we
    look at every 3 years, but we will have to get started with
    some of those next year as well. I expect to be able to be up
    to do that fully.
        In the auditing standards area we have adopted the AICPA
    standards. As I mentioned earlier, we will be putting out the
    internal control attestation standard, a very important one,
    early next year, well in time to have it implementable in mid
    June.
        I discussed at some length, before you came in, the ongoing
    negotiations that we have with some of the European community,
    the Japanese, the Canadians. Those are going quite well, and my
    test will be, which you among others have made sure I
    understand is the test, that we will have to be fully applying
    Sarbanes-Oxley, have no negative effect on the application
    domestically, but rather I think what we can have is the
    spreading of the philosophy of Sarbanes-Oxley internationally.
    There is quite a lot of receptivity to that. I really think we
    can make that a win-win.
        Senator Sarbanes. Where are you on putting the fee
    structure into place, and the assessments on the public
    companies, in order to provide the monies for your budget and
    for the budget of FASB?
        Mr. McDonough. The system is running very well. It brought
    in enough money that we were able to repay the U.S. Treasury in
    full yesterday. It was a monumentally complicated----
        Senator Sarbanes. That is an opportune question for me to
    ask.
        [Laughter.]
        Mr. McDonough. Yes. Monumentally complicated information
    technology challenge, which we managed very successfully, so
    that the money is coming in for both--it is coming in very well
    to finance both FASB and the PCAOB this year. In both cases,
    FASB and the PCAOB has to have budgets approved by the SEC
    before the end of the year, and then from that we can figure
    out what the assessment has to be for next year.
        Senator Sarbanes. Does the PCAOB set the assessment?
        Mr. McDonough. It is set in relation to the budget of FASB
    and the PCAOB. By and large everybody pays both except since
    the FASB budget is smaller, there is a cutoff, so there are a
    relatively small number of companies that just pay us but not
    them. There are two bills sent out. FASB has asked us to be
    their agent in the collection process, but somebody gets two
    bills and sends in two transfers.
        Senator Sarbanes. So the system is up and running now?
        Mr. McDonough. Working beautifully.
        Senator Sarbanes. And you no longer have to draw advances
    from the SEC?
        Mr. McDonough. Correct.
        Senator Sarbanes. I want to just ask a question--do I have
    time?
        Chairman Shelby. Yes, sir.
        Senator Sarbanes. On the convergence of standards. There is
    an attempt of course to produce convergence of U.S. GAAP and
    International Accounting Standards, and that is something that
    FASB and the IASB are working on. Have you been approached
    about a convergence project with respect to auditing standards?
    As one thinks about that, I just want to raise this question.
    It strikes me it might be a little more difficult because the
    International Auditing Standards are still promulgated by a
    board that is part of the industry.
        Mr. McDonough. Yes.
        Senator Sarbanes. Whereas the IASB, the International
    Accounting Standards Board is separate and apart, has an
    independent status, as does FASB. So you have two independent
    groups working there in order to get the convergence of
    standards. We do not yet have the same structure with respect
    to auditing standards. Do you have any thoughts on that
    question?
        Mr. McDonough. I do, and I think that you explained the
    issue very well. If there were a PCAOB International, that is,
    not within the profession but at a Government-approved level, I
    think actually as a technical matter it would be easier to
    agree on audit standards than on accounting standards. However,
    as you know, I spent about 3 days in Brussels a couple of weeks
    ago working with the European Commission. That is very much a
    work in progress.
        Senator Sarbanes. Let me just interject right there.
    Senator Shelby and I were there in August, and of course every
    time they asked a hard question, we would say to them, ``Just
    wait. Chairman McDonough will be here very shortly.''
        [Laughter.]
        Mr. McDonough. That was very kind of you gentlemen.
        [Laughter.]
        Mr. McDonough. But I think we are working in a direction in
    which, by 2005, the European company law could evolve--I am not
    saying it will--but it could well evolve in the direction of
    having standard setting in the auditing area in a PCAOB look-
    alike. And that I think would be a step very much in the right
    direction.
        Senator Sarbanes. That would be very helpful.
        Thank you very much, Mr. Chairman.
        Chairman Shelby. Mr. Chairman, we appreciate your
    appearance. We know you are going to be coming back and working
    with us, and we also appreciate your meetings with a lot of us
    on the Banking Committee, Senator Sarbanes, myself and you have
    a lot of work to do, but we believe you and Chairman Donaldson
    are up to the task. Thank you very much.
        Mr. McDonough. Thank you, Mr. Chairman.
        Chairman Shelby. We have a second panel. We will go ahead
    and call them up. We have on the second panel Mr. Sam DiPiazza.
    He is a CEO of PricewaterhouseCoopers. I might add he is a
    native of Birmingham, Alabama and a distinguished graduate,
    Senator Sarbanes, of the University of Alabama, and of course
    we are proud of what he has achieved as the CEO of
    PricewaterhouseCoopers. Mr. Ed Nusbaum, CEO and Executive
    Partner, Grant Thornton, LLP; Mr. Sean Harrigan, President,
    CalPERS Board of Administration; and Ms. Sarah Teslik,
    Executive Director, Council of Institutional Investors.
        We welcome all of you as our second panel, and we
    appreciate your patience here this morning. All of your written
    testimony will be made part of the Banking Committee's record
    in its entirety, and we will hope you would sum up your
    testimony as briefly as possible. I must tell you, we are in
    session in the Senate, and we are expecting a vote a little
    later, and at that time we will have a recess so Senator
    Sarbanes and I can vote and return.
        Sam, we will start with you.

                  STATEMENT OF SAMUEL A. DiPIAZZA, JR.

            CHIEF EXECUTIVE OFFICER, PRICEWATERHOUSECOOPERS

        Mr. DiPiazza. Thank you, Chairman Shelby, Ranking Member
    Sarbanes, and the Members of the Committee. Good morning.
        My name is Samuel DiPiazza, Jr., and I am the Global CEO of
    PricewaterhouseCoopers. On behalf of the many thousands of
    PricewaterhouseCoopers professionals in the United States and
    around the world, it is a real honor to be here on behalf of
    the profession discussing the implications of the Sarbanes-
    Oxley Act.
        The Act laid the foundation for significant improvements in
    corporate governance and accountability, and it has also
    reinforced confidence in the U.S. capital markets. I applaud
    Congress for its actions. The Act created three fundamental
    areas of change for those responsible for protecting the
    interest of investors.
        First, there has been a very beneficial shift of power and
    governance from the executive suite to the boardroom and,
    notably, to the audit committee. This has significantly
    enhanced the audit process because the audit committee is much
    more attuned to investor protection and in turn supporting the
    efforts of the audit firm. Second, and most importantly,
    auditors who perform public audits, like PwC, are now regulated
    with Government oversight, rather than a self-regulatory
    system. Third, public entities and auditors are now more
    transparent in the information they disclose.
        The challenge for all of the market participants now is to
    implement the necessary reforms in the interest of the investor
    above all else. Therefore, in addition to complying with the
    letter of the law, we must be especially diligent in
    implementing the spirit of the law. My comments today will be
    how PwC has embraced this changed environment, the impact of
    future requirements, and maybe some issues out to the future.
        We, at PwC, are sincerely embracing the call for renewed
    focus around the interested investing public. We are changing
    the culture of the firm, and that starts with me, right at the
    top of our organization. My dialogue with our people is about
    our responsibility and accountability to the public, about our
    audit quality and our central role in the capital markets. At
    the same time we have developed new policy systems and
    methodologies to comply with both the letter and the spirit.
        For example, we have improved our audit methodology and
    procedures to help detect fraud. We have employed forensic and
    technology specialists on audits to determine whether there is
    a higher risk of fraud, and we have placed greater emphasis on
    controlled environment. We have made significant investments in
    upgrading our compliance and independent systems. We have
    resigned or refused to take on high-risk clients, clients with
    an overly aggressive management of business model or an
    absentee board. To date, we have terminated relationships
    representing over 250,000 audit hours. We have enhanced our
    communication with audit committees. We now test the
    information that management uses to run its business and we
    reconcile that information with external reports to test
    transparency, and we have realigned our partner compensation
    system to ensure their appropriate behavior. We have made
    significant investments around training to change cultural
    change and
    increase the knowledge of our people, and to address questions
    concerning the Act and regulations we have been aggressive with
    webcasts, white papers, articles, both internally and
    externally.
        The impact of the new requirements have been significant.
    Our audit procedures have expanded. Audit committees are asking
    us to do more. Our senior people are spending more time on
    complicated accounting issues. Audit scope increases and an
    increased emphasis on fraud detection and clear and transparent
    disclosure has increased the time on engagement. All of this
    adds additional cost, but I am confident that the benefit
    greatly outweighs the cost. We need to get it right the first
    time to protect investors.
        The provision of tax services to audit clients continues to
    be a focus in the market. There is a continuing drumbeat that
    auditors who provide tax services to audit clients are not
    independent even though Congress and the SEC considered the
    issue and concluded to the contrary. As a result our U.S. tax
    practice has experienced a decrease of over 20 percent. I
    believe that tax services are an integral part of the services
    provided by an accounting firm and better audits are performed
    when tax professionals are involved with complex and difficult
    judgments around tax. It is also important to note that our
    liability costs have now become our second largest cost, second
    only to compensation of our people.
        In terms of regulatory oversight, we fully support and are
    committed to the success of the PCAOB. Our profession is at a
    critical juncture. We can no longer count on a proud history to
    speak for its importance. We must stand up and be counted, and
    in doing so establish a professional reputation that ensures we
    are recognized as leaders in the capital markets. Our integrity
    must be beyond question.
        In addition to conducting business in an appropriate
    manner, a number of other matters must be addressed. Our firm
    must have the right tone at the top and a commitment to
    quality, excellence, and restoring investor confidence;
    recruiting, attracting, and retaining the best and the
    brightest; converging, auditing, and accounting systems; and
    making sure our business model balances risk.
        In conclusion, Benjamin Franklin once said, ``That which
    hurts instructs.'' Undoubtedly, our profession has learned from
    painful lessons of the last few years, and we have engaged and
    returned wiser and invigorated.
        Thank you for inviting me to speak.
        Chairman Shelby. Mr. Nusbaum.
        Senator Sarbanes. Mr. Chairman, could I just interject?
        Chairman Shelby. Sure.
        Senator Sarbanes. I understand Mr. Nusbaum's train from New
    York was flooded out at Landover, and he left the train and
    took a cab in order to get here, and we appreciate that extra
    effort.
        Chairman Shelby. You were traveling parallel routes to get
    here, through flooded roads in Maryland.

                      STATEMENT OF EDWARD NUSBAUM

              CHIEF EXECUTIVE OFFICER, GRANT THORNTON, LLP

        Mr. Nusbaum. Chairman Shelby, Ranking Member Sarbanes, and
    Members of the Committee, thank you for inviting me to testify
    today concerning the impact of the Sarbanes-Oxley Act. I
    appreciate the opportunity to discuss this important subject
    with you.
        We have seen the effects of the Act firsthand and our chief
    conclusions are, number one, that the Sarbanes-Oxley Act has
    had a positive influence on corporate America, financial
    reporting, and the accounting profession. Grant Thornton
    congratulates you on having had the courage and foresight to
    adopt this Act. Number two, a principles-based approach is
    necessary for the successful implementation of the Act. Number
    three, there is more that needs to be done. Grant Thornton and
    other accounting firms must work with the PCAOB to improve the
    audit process. The business reporting model and the quality and
    transparency of information used by investors and creditors
    needs to be improved.
        Before I get started, a quick word about Grant Thornton.
    Since our founding in 1924, Grant Thornton has focused on
    providing audit and tax services to mid-size companies,
    generally those with revenues between $25 million and $2
    billion, although we have clients both larger and smaller.
    Grant Thornton International is the world's leading accounting,
    tax, and business advisory organization, primarily dedicated to
    mid-size companies. Through our network of 585 offices in 110
    countries, including 50 offices in the United States, partners
    of the member firms of Grant Thornton audit multinational
    companies by providing personal attention and seamless service
    delivery to public and private clients throughout the world.
        I believe that the tone of an organization starts at the
    top. As I wrote in Chief Executive magazine this past year,
    which was cited in the House Committee on Financial Services'
    recent publication on the Act, the role of the CEO has taken on
    new dimensions as numerous new responsibilities and potential
    for penalty for corporate wrongdoing, including prison, now
    stop directly at the desk of the CEO.
        In the past many CEO's did not worry about the state of
    their internal control systems. Many CEO's, absent a specific
    regulatory mandate, came to believe that their control system
    was adequate even though they had no way to prove that to be
    the case. Today, because of Sarbanes-Oxley, CEO's must back up
    that fact with a signature and actual evidence. The increased
    role of the CEO in financial reporting has been, based on our
    experience, a positive step.
        The Act has clarified and, in some cases, strengthened the
    role and responsibility of boards of directors and audit
    committees. Boards can no longer blindly rubber-stamp the
    actions of management. They must now work side-by-side with the
    auditors to ensure that the shareholders' interests are
    protected. Audit committees must be more independent and expert
    in carrying out their vital duties. Again, our experience has
    been that most audit committees and boards of directors have
    increased the number and quality of meetings, and the members
    of most audit committees and boards appear to be taking their
    role more seriously since the adoption of the Act.
        The Act is forcing public companies and their auditors to
    make sure that the financial statements are clean.
    Restatements, as you know, have jumped 30 percent over the past
    year.
        Thanks to Sarbanes-Oxley, the quality of information
    provided to investors from corporations has improved. We also
    believe that changes mandated by the Act prohibiting auditors
    from providing consulting services, such as consulting, to
    their public audit clients has helped in restoring trust in the
    accounting profession. In fact, a recent Gallup poll found that
    the image of the accounting profession has significantly
    improved over the past year, more than any other profession
    tested.
        We believe that accounting firms must not only cooperate
    with the PCAOB, but also act as thought leaders to improve the
    audit process. Likewise, the PCAOB should not only monitor and
    discipline accounting firms, but also should work with the
    firms to improve audit quality. This cooperation between the
    new board and the accounting firms should result in further
    improvements in the quality of financial information.
        Although there have been several well-publicized
    allegations of accounting misdeeds and auditing failures, there
    are many more instances where auditors have properly discharged
    their professional responsibility.
        I am proud to say that in February 2002 we issued a five-
    point plan to restore the public's trust, and three of the five
    of our proposals were included in the Sarbanes-Oxley
    legislation. We are one of the first global accounting firms to
    advocate the need to a principles-based approach to accounting
    standards. And that same principles-based approach should be
    used in adhering to Sarbanes-Oxley. There are areas in the
    legislation that are clear, and some of them might be
    interpreted differently by others, but the guide in the gray
    areas should be the spirit of reform and protection of
    investors that you, the bill's authors, intended.
        Last month, Grant Thornton became the first and only one of
    the six global accounting organizations to go on the record
    publicly and prohibit services for its public audit clients
    related to the documenting of internal controls. Consistent
    with our guiding principles, we will not provide these services
    because we believe to do so violates the spirit of Sarbanes-
    Oxley. On the other hand, we have developed tools and trained
    our people to independently test the internal controls designed
    and documented by management.
        Going forward, there must be a renewed effort to improve
    the current business reporting model. In December 2002, the
    AICPA formed a special committee on enhanced business
    reporting, chaired by our managing partner of strategic
    services, Mike Starr. This committee will establish a
    consortium of investors, creditors, regulators, management, and
    other stakeholders to improve the quality and transparency of
    information used for decisionmaking.
        Working as a team, Grant Thornton and the other accounting
    firms, together with regulators and standards setters and
    leaders of the business and financial community, can continue
    to improve the quality and transparency of information used by
    creditors and investors.
        In 1933, Congress passed the Securities Act that led to the
    creation of the SEC, designed to restore investor confidence in
    our capital markets. Now, 70 years later, Sarbanes-Oxley has
    further protected American investors. I know that I speak not
    only for Grant Thornton and the other accounting firms, but
    also for many Americans in thanking you for the countless hours
    spent in bringing this landmark legislation to fruition,
    resulting in improvements in our financial reporting system in
    the past year and for many years to come.
        Thank you.
        Chairman Shelby. Mr. Harrigan.

                       STATEMENT OF SEAN HARRIGAN

              PRESIDENT, BOARD OF ADMINISTRATION, CalPERS

        Mr. Harrigan. Good morning. Chairman Shelby, Ranking Member
    Sarbanes, and Members of the Committee, it is a pleasure to be
    here today to discuss Sarbanes-Oxley. It is a topic that is of
    extreme importance to investors.
        My name is Sean Harrigan. I am President of the CalPERS
    Board of Administration. CalPERS has been a strong advocate for
    corporate governance for more than a decade now. When we
    recognized the depth and magnitude of the financial crisis in
    recent years, we were one of the first investors to embark upon
    a financial market reform initiative.
        Now, almost 2 years later, we have accomplished what I
    believe is a great deal. The primary vehicle for reform has
    been Sarbanes-Oxley. We know that the full implementation of
    the Act is a long-term goal, but I think it is safe to say that
    this historic legislation was an excellent first step toward
    restoring investors' confidence and improving the credibility
    of our financial markets.
        It is to this Committee's credit, and Senator Sarbanes in
    particular, for whom we have the utmost respect, that we have
    this Act. On behalf of CalPERS and its members, I want to thank
    Senator Sarbanes and each of you for your courage and
    leadership on this most important issue. We are proud to have
    supported this effort with you.
        Today, I want to offer one perspective on the effectiveness
    of the Act. I would also like to offer some suggestions for the
    next steps that are critical to completing the job, restoring
    the public's trust and confidence in our financial markets.
        We believe the Act accomplished three important reforms:
        First, auditor independence. Without question, the
    independence of the auditors in corporate America is returning.
        Second, it provided accounting industry oversight. A new
    independent body was created to oversee audit firms so
    structurally we will never be as bad off as we were before. The
    Public Company Accounting Oversight Board is up and operating.
    I think it is making progress toward its inspection and
    disciplinary programs. I am especially pleased that the Board
    is preparing its own auditing standards and standards related
    to the signing off on a company's financial statements.
        Third, the Act strengthened the enforcement of Federal
    securities laws. It provided a number of enforcement tools to
    strengthen the ability of the SEC to regulate the securities
    market and compensate injured investors.
        Let me turn to what I believe are some of the next steps.
    Please do not get me wrong, there are many other provisions of
    the Act that have helped investors. The three I have mentioned
    are the ones that paved what I believe was new ground.
        Where should we go from here? We need to strengthen even
    more auditor independence. The Act does not address two
    significant types of nonaudit services. Auditors may still
    under certain circumstances be paid providing tax planning and
    consulting services as well as certain information technology
    consulting.
        We feel that an outright ban on nonaudit services is
    necessary. We analyzed proxy disclosures and found
    approximately 50 percent of the total revenue to audit firms
    was nonaudit related. About 40 percent can be attributed to
    consulting, advisory, or planning services that include tax-
    related work. This is a deeply troubling situation that has
    significant potential to impair the objectivity of the so-
    called independent auditor. We have taken steps to communicate
    our concerns directly to companies in which we invest. In fact,
    during the 2003 proxy season we withheld our votes for audit
    committee members when they used their auditors for nonaudit
    services. We plan to do the same in the upcoming proxy season.
        We urge you to pursue tougher rules through the Securities
    and Exchange Commission and the Public Company Accounting
    Oversight Board to address this important issue. Let me return
    to the accounting industry oversight. We need internal controls
    over financial reporting. We do not accept the criticism by
    some in the business community that the focus of PCAOB in this
    area is misplaced or that the cost for improving internal
    controls is not worth it. We rely on financial statements, and
    we believe controls are critical.
        Next, I think strengthening the enforcement of the
    securities laws is in order. We urge you to study whether the
    SEC should have additional authority to ban individuals when it
    is proper to do so from serving as officers or directors at
    public companies convicted of misconduct. You may also want to
    study additional authority for the SEC to claw back gains from
    executives that are in any part attributable to misconduct.
        Large payouts that follow corporate failure due to poor
    financial performance adds insult to injury for damaged
    investors. This is especially true in any portion of the gain
    realized by an executive can be attributable to malfeasance.
        Next, I think it is time to examine the role of market
    participants. The SEC, as well as other organizations, are
    continuing to conduct analysis of the role of various
    industries within the financial system. The audit industry, and
    many other industries, has a role in maintaining the market's
    integrity. Some industries have significant structural conflict
    that are contrary to the interests of investors and the
    markets, such as firms that provide investment banking and
    equity research.
        We urge you to continue to examine all industries that can
    have conflicts. We ask you to balance their needs to operate in
    an effective manner with the public's need for integrity in the
    financial markets. Greater focus has to be placed on increasing
    the resources for the SEC, but that is only half the problem.
    To ensure that the SEC can be an objective market regulator and
    continue to build a sustainable and consistent program, it
    should have a greater degree of independence from the Federal
    budget process. Investors need open access to the proxy. This
    is the crown jewel of reform. At the heart of many problems
    that face investors, is the lack of accountability of board
    members to the owners of the corporation.
        The root cause of problems like abusive executive
    compensation, lack of oversight that helps permit fraud, and
    plain old poor financial performance, is the lack of
    accountability of board members to their owners. A reasonable
    and balanced approach to providing investors with greater
    access to management's proxy statement will directly address
    this problem.
        Last, but not least, is the topic of NYSE reform. Today, we
    stand on the verge of transforming the New York Stock Exchange
    into the world's best model of corporate governance. I hope
    that they will find a permanent chairman with impeccable
    credentials who can meet the needs of the New York Stock
    Exchange ultimate consumer, the investors. We believe we need
    to form a much smaller and accountable NYSE Board made up of 50
    percent from the investor community. Once that is done, the New
    York Stock Exchange needs to adopt a permanent corporate
    governance structure that will serve as a model for the world's
    financial markets, and include independent nominating
    committees and transparency, transparency in compensation, and
    transparency in financial statements. I think they will need
    all of our support.
        Chairman Shelby, Ranking Member Sarbanes, and Members of
    the Committee, I would like to once again offer my sincere
    gratitude for all that Sarbanes-Oxley has done for investors.
    You have done more to restore investor confidence with your act
    of courage than you might well imagine. We need your help. We
    need your leadership. Working Americans who rely on the
    financial markets for their retirement benefits will benefit
    from your leadership, and they will count on it for decades
    into the future. Together, we have achieved some early
    successes with Sarbanes-Oxley. I hope you will build upon this
    landmark accomplishment, known as Sarbanes-Oxley.
        And on behalf of the 1.3 million members whose retirements
    have become safer as a result of your leadership, I want to say
    again, thank you very much.
        Chairman Shelby. Ms. Teslik.

                       STATEMENT OF SARAH TESLIK

                     EXECUTIVE DIRECTOR, COUNCIL OF

                        INSTITUTIONAL INVESTORS

        Ms. Teslik. I realize that as the last speaker on the last
    panel, what you mainly want from me is an executive summary. I
    think the executive summary for this hearing about the status
    of a bill passed 14 months ago, was actually stated a few
    decades ago during Nixon's historic trip to China. As you, I am
    sure, are very familiar with this story, when Kissinger at a
    state dinner asked the legendary Cho En Lai what he thought of
    the French Revolution, Cho En Lai paused for a moment and said,
    ``Too early to tell.''
        Although I think it is genuinely way too early to tell how
    Sarbanes-Oxley will affect business worldwide, there have
    nevertheless been an awful lot of people whining loudly, and I
    suspect that is one of the reasons we are here today, about how
    this Act is stifling corporate ingenuity. It is making it
    impossible to fill board seats, which is a really funny
    allegation when you think about it. And it is requiring
    American companies to reincorporate on the Moon to avoid
    incredibly astronomical compliance costs.
        In fact, one of my favorite legal memos that came out right
    after the bill was passed and circulated to many American
    companies, told them that it was now illegal to have corporate
    credit cards because Sarbanes-Oxley bans loans to executives,
    and credit cards are, of course, a loan. I got a call from a
    CEO who got the memo when I did, and he asked what I thought,
    and I said, ``Ditch the firm, keep the cards, and get a grip.''
    I think a lot of the hysteria that we are seeing over the bill
    comes from that kind of thinking or lack thereof.
        There is no question that there are a number of new costs
    incurred because of Sarbanes-Oxley, but I think there are five
    things to keep in mind. First, whenever you change a system
    from one to another there will be change-over costs. If the
    U.S. adopted the metric system, we would have costs changing
    over, and that does not mean the metric system is a bad system,
    it means we are changing systems.
        Second, a lot of the costs come from conflicting advice
    that has nothing to do with the bill. I asked the chairman of a
    major oil company on Friday what his main costs were because of
    Sarbanes-Oxley, and he said different law firms are giving us
    different bits of advice, and we are paying $700 an hour for
    them to contradict each other. I think that kind of thing will
    sort itself out as people figure out that you can have
    corporate credit cards despite what advice you are given.
        Third, I think a lot of the costs that are being incurred
    are potentially unnecessary. I asked the head of a major
    pharmaceutical company last week what their major problem was,
    and he said, well, actually, law firms, consultants, and
    accounting firms are trying to sell us elaborate packages that
    we need to adopt, and the fact is we do not need to adopt them,
    because of internal controls that we have. Good internal
    controls should not cost any more because to divide up
    functions does not mean you duplicate functions. It means you
    separate them. So, I think as the hysteria dies down, there
    will be companies recognizing they do not need to spend what
    they have been told and still comply fully with the letter and
    the spirit of the law.
        Fourth, I think that most people are forgetting to talk
    about how most of the provisions in Sarbanes-Oxley entail
    almost no changeover costs. It does not cost any more for the
    board to hire the auditor than it does for management. It is
    just a different group. It should not cost much more for the
    PCAOB to do its job than the entities that did it before, it is
    just that it will be more independent. There is an entire list
    I could go through, but I will not.
        And fifth, it is good that some new costs are being
    incurred. As was mentioned before, if a company does not have
    internal controls and it needs to learn to get them, then I am
    happy to spend that kind of money and I am sure all Americans
    are.
        Finally, I think the whining fails to take into account the
    fact that there are already measurable benefits from Sarbanes-
    Oxley, and that is remarkable because Sarbanes-Oxley is
    basically an effort to strengthen safety nets. So you have to
    wait a period of time before enough bad behavior that might
    otherwise have occurred gets caught before you can, in fact,
    measure the net effect. But I should remind the Committee that
    in the 2 years leading up to Sarbanes-Oxley, if you look only
    at the thousand largest firms that lost 75 percent or more of
    their value, $66 billion of that money went into the
    executives' pockets of those companies. It was not money just
    lost because someone made a dumb decision, it was value
    transferred from shareholders to insiders, and that $66 billion
    is not being repeated since Sarbanes-Oxley.
        I think it is also important to note in closing the more
    important long-term value of Sarbanes-Oxley which was alluded
    to earlier but I think not specifically enough. Everyone likes
    to say that our markets are the best in the world, and for the
    past several decades it has been true. It will not necessarily
    always stay true. The reason people invest here is that our
    markets are perceived to be cleaner and more efficient.
        Both of those two things can change and change quickly,
    particularly when special interests have an ability to come to
    you, the regulators, and get favors when the average Americans,
    who we represent, cannot.
        I think the importance of Sarbanes-Oxley was that it was a
    statement to the rest of the world that we will do a great
    deal, including standing up to some terrific pressure--and let
    us not pretend that did not exist--to say that we are going to
    take some actions that keep our markets more efficient and
    cleaner, and unlike any other industry in which America is
    dominant, markets can flow overseas almost instantly. I think
    for that reason alone, which affects all Americans, including
    Americans who do not have pensions because actually our jobs,
    our houses, our entire democratic system depends on the wealth
    generated by these markets, Sarbanes-Oxley was a major step in
    the right direction.
        Thank you.
        Chairman Shelby. I understand that the Oversight Board has
    already initiated its annual inspection of
    PricewaterhouseCoopers. Could you describe this process and
    provide for the Committee the perspective of the Oversight
    Board's inspection procedures?
        Mr. DiPiazza. Yes, Senator Shelby. The process has begun,
    and I think as the Chairman of the PCAOB said, it has been very
    constructive at this point. We began with a discussion around
    the tone at the top of our organization. The inspection
    included a review of our communications, our policies from the
    top of the organization to our partnership. Beyond that,
    interviews, extended interviews with our leadership are ongoing
    at this point. Then in October/November, there begins a process
    of a review of specific engagements.
        I can only second Mr. McDonough's comments. I think the
    PCAOB is bringing a high level of professionalism, and I am
    very confident that this process will make us better as a firm.
    So far, so good.
        Chairman Shelby. Mr. Harrigan, pension funds lost millions
    of dollars in the recent corporate scandals over several years.
    Would you give us your perspective of the state of corporate
    governance and whether you have observed any renewed investor
    confidence because of corporate governance changes, or is it a
    work in progress?
        Mr. Harrigan. I think it is still a work in progress.
    Obviously, I think there has been some restored confidence in
    the financial markets, and then all of a sudden something
    happens like the problem with Mr. Grasso's compensation at the
    New York Stock Exchange, and I think it takes a turn downward.
        As I mentioned earlier, I think the most important reform--
    and Sarbanes-Oxley was important and I think it did make a
    difference and will continue to make a difference--but the most
    important reform is the reform that the Securities and Exchange
    Commission is reviewing right now and that is access to the
    proxy. It is time for the managers of America's corporations to
    be accountable to the owners. The only way that that can occur
    is through access to the proxy. I think that if we want to
    effectively deal with the problems that have been evident in
    this market over the last several years, we have to create more
    accountability, more transparency, and I think that is the one
    reform that I would urge the Members of this Committee to be
    supportive of because I think it can make a huge difference in
    terms of the integrity of America's corporations.
        Chairman Shelby. Mr. Nusbaum, we recognize that accounting
    firms have had to expend greater costs and resources like it
    was alluded to, to comply with Sarbanes-Oxley because there has
    been a change. Could you describe the compliance costs that
    Grant Thornton has absorbed or passed on or both during the
    implementation of Sarbanes-Oxley?
        Mr. Nusbaum. We have taken several steps to make sure that
    we are not only complying with the actual Act but also the
    spirit of the Act. We have certainly improved our quality
    throughout our entire organization. We have added professional
    standards personnel to help ensure that quality. We have
    increased the number of people that are in the quality control
    process. We have already adopted the auditing standards for
    fraud. We have revised our audit approach to ensure that we do
    a better job detecting fraud going forward.
        In addition, we have spent a considerable amount of money,
    as I alluded to earlier, on tools to test and audit the
    internal controls of corporations. We have developed new
    software and conducted training for all of our audit personnel
    to make sure that they know how to test internal controls that
    are designed and documented by management. And that has been
    quite an endeavor, but one we are proud of and pleased with the
    results.
        And while it is additional cost, some of which we will
    certainly absorb, unfortunately, and maybe some of which we can
    pass on to clients--it will be a blend, I am sure. But,
    regardless of who absorbs the cost, it is a positive step in
    the right direction, and I think it benefits corporate America.
        Chairman Shelby. Ms. Teslik, as time moves on following the
    enactment of Sarbanes-Oxley, are you convinced that reform
    efforts will continue if we have a bull market?
        Ms. Teslik. Memories are short, and I think that some of
    the changes which have occurred in corporate boardrooms, among
    other places, have occurred not necessarily because of the Act,
    but because these people do not want to see their names in the
    papers the same way as the Enron directors, and those memories
    fade.
        And so, I think it is not appropriate to let one's guard
    down. I do not know that any additional legislation is needed,
    even in a bull market, although the regulatory follow-up that
    Mr. Harrigan mentioned is important.
        Chairman Shelby. Ms. Teslik, what do you see as the
    prospect of reforms coming in the next 12 to 18 months
    internally?
        Ms. Teslik. I think there are two very important ones.
    Sarbanes-Oxley was passed in a very short period of time, in a
    lot of heat and with frauds happening every week. I think there
    are two main areas left unaddressed.
        One is that the first line of defense against fraud and
    against mismanagement is the board of directors, and the
    ability of shareholders to elect the board is critical to the
    board's being effective. The SEC is currently addressing that.
        The second area, which is being addressed but needs to be
    addressed more broadly, is that for some reason, some decades
    ago it was considered a wise thing to take Government
    regulatory authority and delegate it to a number of private
    sector companies. Obviously, that was reversed in Sarbanes-
    Oxley with respect to the accountants when the PCAOB was
    established. It was reversed by Sarbanes-Oxley with respect to
    FASB by giving it independent funding. It has not yet been
    addressed with respect to the stock exchanges, and they do have
    a lot of rules which affect our capital formation process.
        I think those two things easily trump everything else.
        Chairman Shelby. Senator Sarbanes.
        Senator Sarbanes. Thank you, Mr. Chairman. I know there is
    a vote on.
        First of all, I want to thank all members of the panel for
    their testimony. We appreciate it very much.
        Before I ask this question, I want to observe that there
    are a number of efforts to raise standards that are taking
    place separate and apart from the legislation itself. First of
    all, the SEC has now been given resources which would better
    equip it to carry out its various authorities, which are quite
    extensive when one examines the statutes.
        But the exchanges are introducing new requirements,
    although, of course, the New York Stock Exchange itself is now
    in the spotlight with respect to its own governance. Clearly,
    that is another arena in which we may succeed in getting
    improved standards.
        Then there are a number of efforts going on within the
    business community for best practices, and I want to focus on
    one of them. The Conference Board's Commission on Public Trust
    and Private Enterprise recommended in January, ``Against public
    audit firms performing services that put it in an advocacy
    position such as proffering novel and debatable tax strategies
    and products that involve income tax shelters and extensive
    offshore partnerships or affiliates.''
        Now, this was an issue we wrestled with when we did the
    legislation. The legislation, of course, does not prohibit tax
    activities, and the argument was very strongly made to us that
    there is a range of normal tax activities that has always been
    a part of accounting activities. In a sense, we were not in a
    position to draw the line with respect to these activities that
    I just mentioned, which were not the whole range of them. I
    repeat it again, ``advocacy positions such as proffering novel
    and debatable tax strategies and products that involve income
    tax shelters and extensive offshore partnerships or
    affiliates.''
        Now, there is authority in the PCAOB to address this
    question, and my question to the members of the panel is: Is
    this a matter which you think needs to be addressed? Mr.
    DiPiazza, why don't we start with you and we will come right
    across the panel.
        Mr. DiPiazza. Thank you, Senator Sarbanes. Let me begin by
    stating that I am a tax partner in our firm. I have served 20
    to 25 years serving clients throughout the country, gaining an
    understanding of their business, and being deeply involved in
    the audit process in turn of doing that.
        Tax is a central piece of an accounting firm. It is
    traditional. It is a very important part of the quality of an
    audit. And, in fact, it has enhanced my career and my ability
    to serve as an auditor and as a tax partner.
        Today, you have board preapproval for any transaction
    involving tax consulting. You have full disclosure in the
    public domain. The discussion of tax shelter has been one that
    has had a forefront in governance issues. And I do believe
    that, frankly, exotic tax shelters, the question is really one
    of policy. Should anybody, whether it is accounting firms,
    auditors, lawyers, investment banks, be promoting exotic tax
    shelters?
        We exited that business as a firm because we did not see it
    as a moral place to be, long before Sarbanes-Oxley. I think the
    debate has been had. I do believe boards today understand it
    and we get it. So, I think today the landscape is pretty clear
    on the point?
        Senator Sarbanes. Mr. Nusbaum.
        Mr. Nusbaum. Well, I am an audit partner, not a tax
    partner, but like Mr. DiPiazza, I agree that tax is an integral
    part of what accounting firms do, an important service that
    should continue to be provided. However, like Mr. DiPiazza, we
    have also exited the sale of these abusive tax shelters and
    exotic strategies.
        So, I think there is a question that should be addressed
    here and something that more research should be done to define
    exactly what should be banned, and if appropriate, I would
    support and I think we would certainly support the banning of
    these. We certainly do not offer these to our publicly traded
    audit clients, and, in general, do not offer them at all. So, I
    think that it is something that should have a little further
    research to make sure we do not cross over into general tax
    services. But as long as we can draw that line, I would support
    the action completely.
        Senator Sarbanes. Mr. Harrigan.
        Mr. Harrigan. My prepared comments, I think, addressed
    exactly where CalPERS is. We do not believe any nonaudit-
    related services should be allowed. As I mentioned, about 50
    percent of the revenue generated by audit firms is based on
    nonaudit services, mainly in the tax area and the IT area. We
    believe that it does create a conflict and that it should be
    prohibited.
        Senator Sarbanes. Ms. Teslik.
        Ms. Teslik. I can only speak for the Council, and we do not
    have a policy, and members are not of one mind on this subject.
        Senator Sarbanes. If I could ask one quick question, and
    then we have to go.
        Chairman Shelby. Go ahead.
        Senator Sarbanes. I know we have to go vote.
        The GAO recently reported to the Committee about the extent
    of concentration in the U.S. audit industry. Very quickly, how
    serious a problem is this? And if it is a serious problem, how
    might it be addressed? Very quickly.
        Mr. DiPiazza. You have to reflect on how we got here. When
    there were eight firms, they simply did not have the coverage
    and the depth around the world to provide the audit quality
    that the investor needed. And that went from eight to six to
    five. Going from five to four was the tragedy. We did not need
    that to happen.
        There is plenty of competition in the marketplace, and
    there is capacity in the marketplace. I think the GAO study
    said it well.
        Senator Sarbanes. Mr. Nusbaum.
        Mr. Nusbaum. I disagree with those comments, and I disagree
    with the GAO report in this particular area. The report is very
    long, and I support the vast majority of the report.
        We certainly believe that there are many accounting firms,
    obviously Grant Thornton and other international firms, that
    can audit multinational companies and have the capability,
    skill set, and resources to do that. In fact, I believe we have
    the capability to audit the vast majority of public companies
    out there. And, again, it is not just Grant Thornton, but if
    you look at the AICPA major firms group, there are probably at
    least 25 and maybe more accounting firms that should be
    encouraged to audit public companies. We think that
    consolidation is an issue and that the PCAOB as well as the
    Government should do everything it can to promote smaller CPA
    firms to audit publicly traded companies.
        Senator Sarbanes. Mr. Harrigan.
        Mr. Harrigan. I would agree with those comments. I think
    that it is becoming a problem and that we should do everything
    that we can to promote the opportunity for smaller firms to
    participate in the audit process.
        Senator Sarbanes. Ms. Teslik.
        Ms. Teslik. A number of our corporate members have
    complained that there is no place else to shop, and they
    believe that the cost of an audit, which has skyrocketed, has
    gone up in part because the competition has gone down.
        Senator Sarbanes. Thank you, Mr. Chairman.
        Chairman Shelby. I have one observation. All these firms
    had to grow from something, did they not, over time? And so if
    we grow, if it is Grant Thornton or someone else who continues
    to grow--and I hope they do--more competition is good for
    everybody, is it not?
        Mr. Nusbaum. Absolutely.
        Mr. Harrigan. Yes, it is.
        Chairman Shelby. We appreciate your appearing here today.
    As Senator Sarbanes has just reminded us, we do have a vote and
    we hope to make it. Thank you.
        The hearing is adjourned.
        [Whereupon, at 11:43 a.m., the hearing was adjourned.]
        [Prepared statements supplied for the record follow:]

                   PREPARED STATEMENT OF WILLIAM J. McDONOUGH

              Chairman, Public Company Accounting Oversight Board
                               September 23, 2003

        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee, I am pleased to appear before you today on behalf of the
    Public Company Accounting Oversight Board (PCAOB or the 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 extraordinary
    leadership of this Committee in response to the
    crisis in public confidence brought on by some devastating failures in
    financial reporting and auditing. The legislation--now law--that you
    worked so hard on is a landmark reform of corporate governance,
    financial reporting, and auditing 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. Among the many reasons I was willing to take on this
    job were my own strong convictions about the need for an aggressive
    response to the corporate scandals and the lack of leadership in the
    private sector. It is an honor to have the opportunity to act on those
    convictions by helping to build an organization, in the form envisioned
    by you, to restore the linchpin of the American financial system--trust
    in the integrity of financial reporting.

    Introduction
        A little over a year ago, the Congress passed and the President
    signed the Sarbanes-Oxley Act of 2002 (the Act).\1\ The Act, of course,
    established the PCAOB and charged it with ``oversee[ing] the audit of
    public companies that are subject to the securities laws, and related
    matters, in order to protect the interests of investors and further the
    public interest in the preparation of informative, fair, and
    independent audit reports for companies the securities of which are
    sold to, and held by and for, public investors.''\2\
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        \1\ P.L. No. 107-204 (2002).
        \2\ Sarbanes-Oxley Act, Section 101(a).
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        To carry out this vital charge, the Act gives the Board significant
    powers. Specifically, subject to the oversight authority of the
    Securities and Exchange Commission (the Commission), the Board's powers
    include authority----

     To register public accounting firms that prepare audit reports
        for issuers;
     To conduct inspections of registered public accounting firms;
     To conduct investigations and disciplinary proceedings
        concerning, and to impose appropriate sanctions where justified
        upon, registered public accounting firms and associated persons of
        such firms;
     To enforce compliance by registered public accounting firms
        and their associated persons with the Act, the Board's rules,
        professional standards, and the securities laws relating to the
        preparation and issuance of audit reports and the obligations and
        liabilities of accountants; and
     To establish or adopt, or both, by rule, auditing, quality
        control, ethics, independence, and other standards relating to the
        preparation of audit reports for issuers.\3\
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        \3\ Sarbanes-Oxley Act, Section 101(c).
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    Overview of the Board's Organization
        Since the initial Board members took office in January, the Board
    has taken a number of administrative steps to position it to carry out
    its core programs.

    Staffing
        Like any other start-up, much of the Board's effort has been
    devoted to creating an organizational structure and hiring staff
    members in a manner that will foster our long-term success. One of the
    Board's objectives in this regard is to foster a working environment
    marked by enthusiasm for the Board's mission and by commitment to
    integrity. Starting from scratch in January 2003, the Board has grown
    to 84 full-time professional staff. While the staffing effort is still
    underway, most of the top positions have been filled. In addition, our
    inspections group, which ultimately will be the Board's largest
    division, has grown to some 21 inspectors.

    Office Space
        The Board has leased space and opened offices in Washington, DC and
    New York City, as well as an information technology center in Northern
    Virginia. The Board anticipates that the space it has secured will be
    adequate to meet the anticipated growth of the organization for several
    years.

    Bylaws
        To govern its operations and decisionmaking process, the Act
    contemplates that the Board, like other private corporations,\4\ will
    adopt bylaws. The Board adopted its initial bylaws at its first meeting
    on January 9, 2003, and amended them on April 25, 2003. The Board's
    bylaws were approved by the SEC on July 23, 2003.
    ---------------------------------------------------------------------------
        \4\ Under the Act, the Board is a private body with the powers of a
    District of Columbia nonprofit corporation.
    ---------------------------------------------------------------------------
    Ethics Code
        The Act also requires the Board to establish ethics rules and
    standards of conduct for Board members and staff. At its public meeting
    on June 30, 2003, the Board adopted an ethics code that will apply to
    Board members, staff, and designated contractors and consultants. The
    purpose of the ethics code is to ensure the highest standards of
    ethical conduct within the Board's operations, and to provide the
    public with confidence in the objectivity of the Board's decisions by
    seeking to avoid both actual and perceived conflicts of interest. As
    required under the Act, the ethics code has been submitted to the SEC
    for approval.

    Public Accessibility
        The Board recognizes the importance of keeping the investor
    community, the issuer community, the accounting profession, and the
    public informed of developments as the Board carries out its mission.
    The Board has established a general practice of conducting its
    rulemaking in a public forum and seeking public comment on proposed
    rules. We also maintain a website, www.pcaobus.org, where we provide
    timely and detailed information about our rules and policies, and where
    we webcast the public meetings and roundtable discussions that we hold
    to gather public input on substantive issues.

    Budget
        Section 109(b) of the Act requires the Board to prepare and submit
    to the Commission for approval a budget for the Board's first fiscal
    year. At its public meeting on April 23, 2003, the Board approved a
    budget for the 2003 fiscal year of approximately $68 million. The SEC
    approved the Board's budget on August 1, 2003.

    Funding
        The Act establishes a mechanism for the funding by publicly traded
    companies of the Board and of the accounting standard-setting body
    designated pursuant to Section 19(b) of the Securities Act of 1933.\5\
    To implement this funding mechanism, on April 18, 2003, the Board
    issued final rules with respect to the allocation, assessment, and
    collection of its accounting support fee.\6\ The SEC approved the
    Board's funding rules on August 1, 2003. Under the Act and the Board's
    rules, larger public companies and investment companies are assessed
    based on their average market capitalization during the preceding
    year.\7\ As a result, about 62 percent of the issuers assessed will pay
    $1,000 or less in accounting support fees to the PCAOB. The largest
    1,000 issuers will pay about 87 percent of the total fees due. Pursuant
    to its rules, the Board sent notices of assessment to some 8,500
    issuers beginning on August 4, 2003.
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        \5\ On April 25, 2003, the SEC designated the Financial Accounting
    Standards Board (FASB) as the authoritative standard-setter under
    Section 19(b). The PCAOB is serving as the FASB's collection agent for
    purposes of assessing and collecting its accounting support fee. In
    addition, a smaller portion of the Board's budget is to be recovered
    through fees assessed on registered public accounting firms, based on
    the estimated costs associated with processing and reviewing the firms'
    registration applications and periodic reports.
        \6\ PCAOB Release No. 2003-003 (April 18, 2003).
        \7\ Pursuant to the Board's rules, issuers with average monthly
    market capitalization of less than $25 million (and investment
    companies with net asset values, or market capitalization, of less than
    $250 million) are not subject to the accounting support fee.
    ---------------------------------------------------------------------------
    Registration
        The Act and the Board's rules require that beginning October 22,
    all U.S. accounting firms that prepare or issue audit reports on U.S.
    public companies, or play a substantial role in the audit of a U.S.
    public company, must be registered with the PCAOB. To implement the
    registration of public accounting firms, the Board adopted registration
    rules on April 23, 2003 and the Commission approved the Board's
    registration rules on July 16, 2003.\8\
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        \8\ In approving the Board's registration rules, the Commission
    stated:

        Title I of the Act assigns the Board the formidable task of
    designing and implementing a registration and oversight system within a
    relatively short period of time. The investor protection goals of the
    Act justify the need for prompt action, but the importance of the
    Board's task and its potential impact on the public securities markets
    demand that it be undertaken in a thoughtful and reasoned manner. After
    careful review of the Board's proposed registration system, the
    Commission finds that it is consistent with the requirements of the Act
    and the securities laws and is necessary and appropriate in the public
    interest and for the protection of investors.

        Order Approving Proposed Rules Relating to Registration System,
    Exchange Act Release No. 48180 (July 16, 2003).
    ---------------------------------------------------------------------------
        Registration is critical to the Board's regulatory oversight of
    public accounting firms. As a legal matter, registration is the
    predicate for the Board's other oversight programs--compliance with
    auditing and related professional practice standards, inspections,
    investigations, and discipline. In addition, registration provides the
    Board with critical information about the public accounting firms that
    apply for registration. As required by the Act, registration
    applications must include, among other things, a list of issuer audit
    clients and fees billed those clients, the number and a list of the
    firm's audit professionals, a statement of the firm's quality control
    policies, and regulatory and enforcement actions against the firm and
    its professionals. This information will both serve as the basis for
    the Board's registration decisions and help inform the Board's exercise
    of its authority and focus its limited resources appropriately.
        Registration of a public accounting firm is not automatic upon
    application. In order to approve an application, the Board must
    determine that registration of the applicant is consistent with the
    Board's responsibilities under the Act to protect investors and to
    further the public interest in the preparation of informative, fair,
    and independent audit reports for public companies.
        To make that determination, the Board is committed to a careful and
    fair review of all applications. Under the Act, the Board must, within
    45 days of receiving an application, either approve the application,
    provide notice of disapproval, or request additional information. To
    facilitate the registration process, and to support the Board's
    inspection and other functions, the Board developed its own web-based
    system for the registration of public accounting firms. Receiving
    application information from registering accounting firms in electronic
    format expedites the registration process and allows the Board to
    maintain a sophisticated database of information relevant to its other
    processes.
        To facilitate registration further, the Board published in July a
    collection of answers to frequently asked questions about the
    registration process. We have also established a help line staffed by
    the analysts responsible for reviewing registration applications. Since
    its inception, these analysts have responded to over 850 telephone
    inquiries regarding the registration process. Last month, these
    analysts also contacted firms known to audit public companies which had
    not sought access to the Board's registration system to inform the
    firms of the applicable deadlines for registration. Through this
    outreach program, the analysts contacted approximately 500 firms.
        The Board received its first registration application on August 7,
    2003, and as of September 17, 2003, the Board has received almost 500
    applications. The Board approved the first 38 of those applications
    last week and continues to review the remaining applications.\9\
    ---------------------------------------------------------------------------
        \9\ In July, the Board proposed a rule on procedures by which a
    firm, once registered, may seek to withdraw from registration. Under
    the proposed rule, a registered firm may seek to withdraw its
    registration at any time if it is not engaged in activity for which
    registration is required. Withdrawal would not be automatic, but could
    be delayed until the completion of any pending or imminent disciplinary
    proceedings, or for the Board to complete other relevant processes,
    such as inspections and investigations. In the absence of a pending
    disciplinary proceeding, however, the proposed rule would not allow the
    Board to delay withdrawal for longer than 2 years. The Board is
    currently considering the comments it has received in response to that
    proposed rule.
    ---------------------------------------------------------------------------
    Registration of Non-U.S. Auditors
        Under the Act and the Board's rules, non-U.S. accounting firms that
    prepare or issue audit reports on U.S. public companies, or play a
    substantial role in the audit of a U.S. public company, must register
    with the PCAOB by the middle of next year.
        Because registration is the predicate to all of the Board's other
    oversight programs, an exemption from registration for non-U.S.
    accounting firms would be tantamount to a complete exemption from any
    oversight by the Board. The Board believes that investors in the U.S.
    markets are entitled to the same protections regardless of whether an
    issuer, or an issuer's auditor, is foreign or domestic, and that it
    should provide investors with confidence that non-U.S. issuers and
    auditors adhere to U.S. generally accepted accounting principles and
    U.S. auditing standards.
        At the same time, the Board has made certain accommodations in
    light of the special issues raised by the registration of nonU.S.
    firms. Non-U.S. accounting firms need not provide certain information
    on their registration application if by providing such information the
    firm would be violating laws in the jurisdiction in which the firm is
    located. Moreover, the nature and scope of the Board's oversight over
    non-U.S. accounting firms that audit the financial statements of U.S.
    public companies is the subject of ongoing dialogue between the Board
    and its foreign counterparts. Through this dialogue, the Board is
    exploring ways of accomplishing the goals of the Act without subjecting
    non-U.S. firms to unnecessarily redundant or conflicting requirements.

    Inspections
        As you know, the Act requires the Board to conduct a continuing
    program of inspections of registered public accounting firms. The
    purpose of these inspections is to assess the degree of compliance of
    each registered public accounting firm, and associated persons of that
    firm, with the Act, the rules of the Board, the rules of the
    Commission, and professional standards, in connection with its
    performance of audits, issuance of audit reports, and related matters
    involving issuers.
        The Board's inspection program is, perhaps obviously, where we will
    have the most extensive contact with registered firms and their
    personnel. It is where we are going to find out about the quality of
    the audits that have been conducted, and it is one of the places where
    we will exert pressure to change auditor behavior, when necessary. It
    will provide us with a direct window into the registered firms to see
    how they are implementing the standards the Board sets, areas where
    they are doing particularly well, and areas where improvements are
    needed.
        There are a number of areas on which our inspections will focus
    that have not been the traditional focus of the peer review process.
    These include----

     An evaluation of the ``tone at the top'' of registered firms.
        We want to know the nature of the messages that are coming from the
        highest levels of the firms and their frequency;
     We are going to look at partner compensation and promotion. We
        are going to look into what behaviors are rewarded--and thus
        reinforced--through compensation and promotions; and
     We will consider the firms' overall communication and training
        practices with regard to all firm professionals.

        On July 28, 2003, implementing the directive in Section 104 of the
    Act, the Board proposed rules relating to inspections of registered
    public accounting firms. The comment period has ended on the Board's
    rulemaking and the Board intends to finalize its inspection rules soon.
        Under the proposed rules----

     ``Regular'' inspections are to take place annually for those
        firms that issue audit reports for more than 100 U.S. public
        companies.
     Other firms are subject to regular inspection every 3 years.
     A ``special'' inspection may be authorized by the Board at any
        time.

        For 2003, limited inspection procedures are already being conducted
    on the four largest accounting firms, which have agreed to cooperate
    with the Board prior to their registration. Those inspections are
    already in process. In 2004, regular inspections will begin for all
    accounting firms. Inspections of those firms with less than 100 issuer
    audit clients will be phased in over a 3-year period.
        Generally, under the Act, information obtained in inspections is
    confidential. Portions of a final inspection report that deal with
    criticisms of or potential defects in a firm's quality control system
    cannot be made public by the Board if the firm addresses the items to
    the Board's satisfaction within 12 months of the report. Final
    inspection reports will be provided to the Securities and Exchange
    Commission and appropriate State regulatory authorities, however, and
    the Board may refer information learned from inspections to relevant
    authorities and commence an investigation or disciplinary proceeding if
    the facts and circumstances warrant. Moreover, the Board has proposed
    rules pursuant to which the Board would publish reports about findings
    from the inspections process to discuss any matter the Board considers
    of public interest, including criticisms and potential defects in
    firms' quality control systems. Under that proposed rule, the Board
    would not identify specific firms in issuing such reports.

    Investigations and Discipline
        The Act authorizes the Board to conduct thorough investigations
    when there are indications that a registered firm or an associated
    person may have violated the Act, the Board's rules, certain provisions
    of the securities laws and the Commission's rules, or professional
    standards. The Act further authorizes the Board to use the results of
    those investigations as a basis for formal disciplinary proceedings. If
    a violation is established in those proceedings, the Act authorizes the
    Board to impose a range of sanctions on the firm or associated person
    who committed the violation.
        On July 28, the Board publicly proposed an extensive set of rules
    relating to investigations and disciplinary hearings. We received
    substantial public comment on the proposal. We have been considering
    the comments and we expect to consider adopting final rules very
    shortly. We are also in the process of staffing a Division of
    Investigations and Enforcement, which will have responsibility for
    carrying out the Board's investigative work and disciplinary
    proceedings.
        Among other things, the Board's proposed rules implement the Act's
    provisions granting the Board broad authority to demand testimony,
    production of documents, and other cooperation from firms and
    associated persons during an investigation. As with inspection
    materials, the Act provides for the confidentiality of the Board's
    investigative processes and protects all such information from
    discovery by private parties. Firms and associated persons must provide
    the necessary information and cooperation, or risk the possibility of
    being sanctioned for noncooperation with an investigation. As provided
    in the Act and our proposed rules, noncooperation with an investigation
    can result in sanctions as severe as revoking a firm's registration or
    barring a person from association with a registered firm.
        The Board's investigative and disciplinary work will also
    necessarily involve a need to obtain documents and testimony from
    public companies and other persons who are not legally required to
    cooperate with our investigations. While the Act does not authorize the
    Board to compel cooperation from those persons, it does authorize the
    Board to ask those persons to supply information voluntarily. The Act
    also gives the Board the option of working through the Commission to
    serve legally enforceable Commission subpoenas for any such information
    that is relevant to a Board investigation but is not supplied
    voluntarily. Our proposed rules would implement these provisions as
    well.
        The proposed rules also include detailed procedures to govern the
    conduct of Board disciplinary hearings in order to ensure a balanced
    process in which the respondent has fair notice of, and a full and fair
    opportunity to defend against, allegations of misconduct. Like the
    investigative process itself, disciplinary hearings will be nonpublic
    unless the Board and the respondent agree otherwise, as required by the
    Act.
        Finally, the proposed rules implement the Act's provisions for
    imposing sanctions if a violation is established through the hearing
    process. The sanctions the Board may impose range from the most severe
    sanctions--revocation of registration and bar on association--to lesser
    sanctions such as monetary penalties, limitations tailored to the
    particular violation, requirements to retain consultants for particular
    purposes, and requirements to obtain additional professional
    education.\10\
    ---------------------------------------------------------------------------
        \10\ Sarbanes-Oxley Act, Section 105(c)(4). Under the Act, a firm
    or associated person sanctioned by the Board may seek review of that
    determination by the Commission. In the event of an appeal to the
    Commission, the Act provides that the sanction will be stayed unless
    and until the Commission affirms the sanction or otherwise
    affirmatively terminates the stay.
    ---------------------------------------------------------------------------
    Professional Standards
        The Act directs the Board to establish certain standards related to
    the work done by auditors of public companies. Those include standards
    for auditing and related attestation work, standards for quality
    controls, ethics standards, and independence standards. As part of the
    authority to establish standards related to auditor independence, the
    Act authorizes the Board to add to the categories of nonaudit services
    that auditors are prohibited from providing to their audit clients.
    Early on, the Board made the decision to establish professional
    standards by creating a standard-setting division of the Board, made up
    of highly-skilled experts, rather than by delegating the standard-
    setting function to another body, such as the AICPA's Auditing
    Standards Board.
        The Act required the Board to adopt professional standards as
    initial or transitional standards prior to the Commission's April 25,
    2003, determination of the Board's capacity to carry out its
    responsibilities under the Act.\11\ Accordingly, at a public meeting on
    April 16, 2003, the Board announced the adoption of certain interim
    auditing, attestation, quality control, ethics, and independence
    standards to be used by registered public accounting firms in the
    preparation and issuance of audit reports, and the Commission approved
    those standards as part of its April 25, 2003 determination.
    ---------------------------------------------------------------------------
        \11\ Sarbanes-Oxley Act, Section 103(a)(3)(B).
    ---------------------------------------------------------------------------
        The standards adopted on an interim basis include the standards
    with which the profession is, or should be, familiar. They include the
    following standards, as they existed on April 16, 2003:

     GAAS, as previously established by the AICPA, including
        Statements on Auditing Standards, auditing interpretations,
        auditing guidance included in AICPA Audit and Accounting Guides,
        and auditing Statements of Position;
     Attestation Standards and related interpretations and
        Statements of Position as previously adopted by the ASB;
     the AICPA's Statements on Quality Control Standards and
        certain AICPA SEC Practice Section membership requirements;
     the AICPA's Code of Professional Conduct on integrity and
        objectivity; and
     the AICPA's Code of Professional Conduct regarding
        independence, and the standards and interpretations of the
        Independence Standards Board.\12\
    ---------------------------------------------------------------------------
        \12\ With regard to independence standards, if the SEC's rules are
    more restrictive, then registered public accounting firms are expected
    to comply with the more restrictive requirements.

        The Board has not determined that any of these standards should be
    permanently adopted, however, and the Board has announced plans to
    review systematically all of the interim professional standards and to
    determine whether each of the interim standards should be modified,
    repealed, or made permanent.
        The Board has also announced its plans for a general process
    related to setting the permanent auditing and other professional
    standards. The process will include the appointment of an advisory
    group, as envisioned by the Act, including members of the accounting
    profession, issuers, investors, regulators, and others. The Board has
    adopted a rule concerning the composition of the advisory group \13\
    and expects to begin the process of forming the advisory group shortly
    after the Commission approves the rule.
    ---------------------------------------------------------------------------
        \13\ See PCAOB Release No. 2003-009 (June 30, 2003).
    ---------------------------------------------------------------------------
        We expect that the standing advisory group will be comprised of
    approximately 25 members with a variety of backgrounds. Our intent is
    that the standing advisory group act at a high level, providing advice
    and recommendations on policy matters, significant issues related to
    specific standards setting projects, and our agenda and priorities. The
    standing advisory group will not be a standard setting committee, in
    the more traditional sense, drafting and debating all the provisions of
    proposed standards. Most of that work will be done by the Board's
    staff.
        We also plan to use other means to obtain the expertise and advice
    of the profession and the public, including such things as ad hoc task
    forces based on our need for specific expertise. We also have the
    option of convening roundtable discussions, which we have already held
    on certain issues, public hearings, and other types of public forums to
    obtain input and advice as needs arise.
        The Act itself sets forth the Board's initial standard setting
    agenda. Section 404 of the Act, which mandates public reporting on
    internal control over financial reporting, becomes effective for fiscal
    years ending in June of 2004. On July 29, 2003, the Board held a public
    roundtable discussion to explore whether revised auditing and
    attestation standards on this subject are needed. The roundtable
    included representatives from issuers, auditors, investors, consumer
    groups, and regulators.
        The Act also mandates that we establish requirements in the
    auditing standards for the retention of audit documentation and for a
    second-partner review, and we already are working on those subjects.

    Conclusion
        With your vision in establishing authority for independent standard
    setting, registration, inspection and discipline, you have given the
    PCAOB the responsibility and the tools to build a new future for
    auditing. I have faith that our staff and my fellow Board members 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 Sarbanes-Oxley
    Act, did not merely judge them; rather, 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.
        Thank you.

                 PREPARED STATEMENT OF SAMUEL A. DiPIAZZA, JR.

                Chief Executive Officer, PricewaterhouseCoopers
                               September 23, 2003

        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee, on behalf of thousands of PricewaterhouseCoopers \1\
    professionals in the United States (U.S.) and my colleagues from around
    the world, it is a distinct honor and pleasure to appear before you
    today. My profession and PricewaterhouseCoopers (PwC) are going through
    dramatic change, and I do not see this change abating greatly in the
    foreseeable future. We stand at a crossroads today and have a unique
    opportunity to redefine our profession, ensure our continued relevance,
    and, importantly, restore a high level of investor confidence.
    ---------------------------------------------------------------------------
        \1\ ``PricewaterhouseCoopers'' refers to the network of member
    firms of PricewaterhouseCoopers International Limited, each of which is
    a separate and independent legal entity.
    ---------------------------------------------------------------------------
    Introduction

    A Profoundly Different Landscape for the Accounting Profession
        Two very significant and interrelated events have created a
    landscape that is far different today than anything my profession has
    previously experienced. A series of high profile corporate failures
    raised significant doubts on the part of the investor community as to
    the reliability of the capital formation process and as to whether
    auditors deserved the degree of trust historically conferred upon them.
    This lack of trust, of course, was not just directed at auditors but at
    all significant players involved in reporting financial information to
    investors and other stakeholders. As a consequence of these failures
    and the crisis in confidence that resulted, Congress passed--and
    President Bush signed into law--the Sarbanes-Oxley Act (the Act) just
    over 1 year ago.
        Following the Act's passage, the Public Company Accounting
    Oversight Board (the PCAOB) established itself as the primary regulator
    of public company auditors. Using the Act as a guide, the Securities
    and Exchange Commission (SEC or Commission) implemented various rules
    designed to ensure the financial integrity and vitality of our capital
    markets. We recognize and commend the great effort that the Commission
    and the PCAOB have made over the last year to enhance investor
    confidence in the efficacy of our capital markets.

    Three Fundamental Areas of Change
        The Act created three fundamental areas of change for those with
    responsibility for protecting the interests of investors. First, there
    has been a shift of power and governance from the executive suite to
    the boardroom and, notably, the audit
    committee. Second, auditors who perform public company audits, like
    PwC, are now regulated with Government oversight, rather than the self-
    regulatory system that previously existed. Third, public entities and
    their auditors must be more transparent in the information disclosed to
    others--in particular--information relating to the effectiveness of
    control systems, a requirement commonly referred to as Section 404,
    which has not yet been fully implemented but will greatly enhance
    corporate reporting in the future. Today, I want to concentrate my
    comments on: (1) What PwC has done to lead change in the new
    environment; (2) how the new requirements are impacting PwC and the
    profession; and (3) what needs to be done in the future.

    Meeting the Rules in Letter and Spirit
        Now, the challenge is for all of the market participants to
    implement the necessary reforms in a manner that places the interests
    of investors above all others. The Act requires participants in the
    financial reporting process to take responsibility for their actions
    and every party must play his or her role. For example,
    managements, boards, and audit committees need to carry out their
    fiduciary responsibilities, investors should research companies prior
    to investing, underwriters should see that adequate due diligence is
    performed, lawyers should perform as officers of the court, regulators
    should enforce the rules, and auditors must provide unbiased opinions
    on the information that is being provided to investors.
        The Act clearly intended that investor interests be the overriding
    requirement. Therefore, in addition to complying with the letter of
    law, we must be especially diligent in implementing the spirit of the
    law.
        The Act and the rules adopted by the SEC establish clear lines of
    accountability. Accountability is an important deterrent to
    objectionable behavior. Behavior drives many of the areas addressed in
    the Act (such as executives' compliance with ethical codes), but
    ethical behavior cannot be legislated. Therefore, public trust will
    only be attained and the goals of the Act achieved if the people with
    responsibility for implementing the requirements do so with integrity.
    Where integrity is lacking, neither rules, regulations, laws, concepts,
    structures, processes, best practices, nor the most progressive use of
    technology, can ensure accountability or compliance. This will only
    occur when people of integrity do the right thing, not what is
    expedient or even necessarily permissible. Ultimately, people's actions
    are what matter, not what they say or the wording of a particular
    regulation.
        We fully support the PCAOB's mission to refocus the accounting
    profession to help restore public trust. PCAOB Chairman William
    McDonough's comments in a recent speech given at a New York State
    Society of CPA's conference are hard-hitting and appropriate,

            I expect that you, as members of a regulated profession, know
            what the rules are. I expect that you are following those
            rules, both in their letter and their spirit . . . If you
            depart from those expectations--that is, if you break the
            rules, if you ignore the spirit of the law even while meeting
            the letter--woe be unto you.

    Embracing Change
        Many of the Act's provisions have and will require change in the
    way we do business. Change can be unsettling but also very positive. At
    PwC, we are embracing these changes, implementing them both in letter
    and spirit, and doing everything in our power to regain trust in our
    profession.
        Like any profession, we would have preferred a self-regulatory
    model that worked. Clearly, the former model did not, and it has been
    replaced with something far
    different. The PCAOB is now our independent regulator with
    responsibility for standard setting, quality control, and discipline.
    We and others in the profession are committed to the success of the
    PCAOB. Our profession has a critically important role in the financial
    reporting supply chain, and given the importance of this role, our
    regulatory system must be effective in fact and in appearance. As an
    independent body overseen by the SEC, the PCAOB will promote that
    effectiveness. And we intend to do our part by working constructively
    with the PCAOB to restore the public trust.
        We are implementing the changes brought on by the Act across our
    global organization. PwC member firms have approximately 120,000
    employees and 8,000 partners worldwide, and operate in more than 140
    countries. Our firms are generally organized as separate national
    partnerships, but share a common strategy, common methodology, and
    quality control system. Many of the provisions of the Act affect our
    operations outside the United States, especially those firms that audit
    significant numbers of entities registered on U.S. exchanges. The
    impact of the Act on these non-U.S. operations is especially
    challenging because of the interplay among different regulatory and
    legal systems in the various countries.

    Examples of Change within PwC
        PwC and many of the other large accounting firms are developing new
    policies, tools, systems, and methodologies for complying with the
    letter and spirit of the Act. The following section highlights some of
    the key changes that are being made at PwC.

    Audit Methodology
        We have updated our audit procedures to ensure we are addressing
    today's risks and meeting investors' expectations. To that end, recent
    policy changes and improved guidance focuses on the following key
    areas:

            Helping audit teams develop a better understanding of their
            clients' businesses and industries, in order to effectively
            evaluate the risk of material misstatement and the controls
            that management has in place to mitigate that risk.

        PwC Audit, our global audit methodology, sets forth a framework to
    help audit teams understand their clients' businesses. This framework
    includes information about the markets in which the companies operate,
    their strategy for increasing shareholder value, critical value
    drivers, and internal performance metrics used by management. Our
    research shows that this is the type of information investors use to
    make investment decisions and, therefore, it is an important input for
    the audit team in forming its point of view on the client's business
    and risk, including audit risk.
        In testing the information that management uses to run and control
    its business, we reconcile this information with that which management
    communicates to the investors in its external financial reports. This
    helps us assess the transparency of financial reporting, as well as the
    risk of material misstatement. We also provide guidance to our teams to
    use specialists when audit risk is increased by the presence of complex
    information technology systems, or when the risk of material error due
    to management fraud exists.
        In anticipation of next year's reporting requirements around
    internal controls under Section 404 of the Act, our public company
    audit engagement teams have been encouraged to take a greater
    ``controls-based'' approach to their audits this year. While this level
    of controls testing is not the same as will be required for an
    attestation under the Act, it will enable our teams to communicate
    identified weaknesses in key controls to audit committees in the
    current year, as part of the financial statement audit process.
            Increasing our consideration of the risk of management fraud
            and our ability to detect a material misstatement in the
            financial statements due to fraud.
        Our audit teams around the world are increasing their emphasis on
    understanding the risk of fraud in the companies we audit as well as
    the fraud deterrence controls and procedures within those
    organizations. They are also performing additional fraud detection
    procedures as part of the financial statement audit. These procedures
    include:

     Consideration of key incentives and pressures to commit fraud;
     How best to conduct client interviews regarding fraud;
     Consideration of five key fraud risk areas: (1) Revenue
        recognition, (2) journal entries and other adjustments, (3)
        management's accounting estimates, (4) significant unusual
        transactions and (5) suspense and inter-company accounts.

        Engagement teams are required to determine, as part of our annual
    client acceptance and continuance process, whether heightened fraud
    risk exists based on specific criteria set forth in our policy. If the
    team determines there is a heightened risk of fraud, they should
    consult with a risk management partner and a fraud detection specialist
    to determine whether additional procedures should be performed to
    mitigate the risk of error due to management fraud.
            Recognizing our changing relationship with audit committees
            through increased communication.
        Communicating effectively and candidly with audit committees is
    critical in today's environment. We have implemented a required audit
    committee communications framework that is used throughout the audit,
    from planning to completion. The framework covers four specific topics:
    Our audit approach; our views on the
    company's level of audit risk and management's controls to mitigate key
    risks; the reliability and transparency of management's financial
    reporting; and corporate governance. Our public company engagement
    teams around the world are engaged in a dialogue with audit committees
    on these topics. This is in addition to the required communications
    under the Act and U.S. Generally Accepted Auditing Standards (GAAS).

    U.S. Partner Compensation System
        Many of the key components of our partner compensation system were
    in place prior to the Act. However, the Act provided the impetus to
    review the current system to ensure compliance with the rules. The
    resulting changes have been fully implemented for our current fiscal
    year.
        PwC's reward system is aligned with the behaviors we expect from
    our partners. Our policy is to reward all partners equitably based upon
    the partner's responsibilities, role in the firm, and thier actual
    performance. The PwC U.S. Partner Income System is primarily based on
    two components of income: The partner's level of responsibility within
    the firm (Responsibility Income) and the firm's performance (Equity
    Share Income). In addition, in a year when a partner delivers
    outstanding performance, he or she may also receive a performance
    award. We recognize the potential conflict of interest that can arise
    when a partner is directly compensated for selling nonaudit services,
    and consistent with the SEC's rule, we do not compensate audit partners
    for selling nonaudit services. Further, our system is not commissions-
    based, nor is it tied to audit or nonaudit service revenue targets. The
    following is an expanded description of our compensation structure:

     Responsibility Income. The responsibility component of a
        partner's income reflects what the partner does and the degree of
        complexity inherent in that role. Each partner is assigned an
        appropriate responsibility level with a fixed level of income.
     Equity Income. The equity component of a partner's income is
        based on how well the overall firm has performed and the assigned
        number of equity units or shares for the partner's level of
        responsibility.
     Performance Income. Performance income is awarded to a small
        number of partners each year, based on the partner's individual
        performance against goals established at the beginning of the year.

        In compensating our partners, the firm is mindful and fully
    supportive of the SEC's public policy goals. Most important, good
    judgment must be exercised in all cases to comply with both the letter
    and spirit of the Act.

    Compliance and Independence Systems
        PwC has made significant investments in state of the art systems
    for independence compliance. We are committed to continuing to provide
    the resources, systems, and processes that our firms and people need
    globally to comply with the rigorous auditor independence standards
    established by standard-setting bodies and regulators in the many
    different territories in which we operate.
        The compliance framework that we have put in place predated the
    Act, and we have been able to use this robust framework quite
    effectively to implement
    the necessary regulatory changes. PwC member firms operate around the
    globe. Audit engagements performed in any given country (especially
    those that span borders) involve a complex--sometimes overlapping,
    sometimes contradictory--web of independence rules. PwC has addressed
    this challenge by putting in place a global framework of people,
    policies, processes, and systems to ensure compliance with all
    standards. Within this framework, PwC firms are responsible for
    establishing policies and conducting activities to help ensure
    independence compliance. The global organization establishes baseline
    standards and monitors territory \2\ activity to help ensure
    compliance. Key elements of this framework include a global
    organization of independence experts, global independence policies,
    sophisticated compliance monitoring systems, a global database of
    restricted entities, periodic training programs and technical
    communications, and substantive disciplinary processes.
    ---------------------------------------------------------------------------
        \2\ ``Territory'' refers to all of the PwC legal entities within a
    country. In certain instances, the legal entities in multiple countries
    comprise a territory.
    ---------------------------------------------------------------------------
        PwC's Global Independence Policy sets forth principles and
    requirements to be followed with regard to all PwC audit clients, with
    emphasis given to major independence requirements that apply to certain
    types of audit engagements, for example, SEC audit clients. The global
    independence policy is based on the International Federation of
    Accountants (IFAC) Code of Ethics, since the Code is the only
    recognized worldwide standard for independence with respect to all
    audit engagements. The policy sets forth basic requirements that apply
    to all audit clients, and provides for incremental restrictions and
    processes with respect to SEC audit clients and such other audit
    clients as necessary.\3\
    ---------------------------------------------------------------------------
        \3\ As an example, the IFAC Code permits an audit firm to have an
    immaterial joint business relationship with an audit client as long as
    certain safeguards are applied. The SEC rules prohibit joint business
    relationships with SEC audit clients regardless of materiality or
    safeguards.
    ---------------------------------------------------------------------------
        In many instances, we have consciously established independence
    policies that exceed the requirements of IFAC, the SEC, and other
    standard setters. This remains true even today with all of the
    additional requirements resulting from the Act. For example, the PwC
    independence policy generally prohibits partners from investing in any
    PwC audit client, while the IFAC Code restricts only those partners
    that have certain direct connections to the audit engagement.
        While policies, communications, and systems are important
    components of the compliance framework, we also conduct compliance
    reviews of our firms and our people. Beginning this year, we have
    instituted a global process to formally review and test compliance with
    independence activities in each territory. In conducting these reviews,
    we focus on the territory's organization, processes, policies, and
    compliance with PwC, regulatory, and local professional independence
    rules.
        The PwC disciplinary policy holds persons found to have violated
    the PwC independence policy accountable for their actions, and
    discipline is based on the severity of the violation. Partners and
    staff who violate the independence policy are subject to sanctions
    including written reprimands, suspensions, monetary fines, and
    termination.

    Selectivity Process
        Some clients present us with much more risk than others. The
    riskier clients tend to have poor internal controls and/or an overly
    aggressive management. These clients generally have more errors and
    misstatements in their financial statements. This often carries too
    much risk for us. Accordingly, during the last year, the PwC U.S. firm
    chose to reexamine its entire client portfolio--with the primary goal
    of reducing overall risk. Engagement partners, risk management
    partners, and firm leadership reviewed all clients that exhibited a
    higher level of risk as determined by guidelines established by our
    Risk & Quality Group.
        In total, 842 public and nonpublic clients were selected for such
    review. In each case, the client's risk factors were carefully
    evaluated as to whether the audit team could effectively manage the
    risk. For those clients where it was determined that PwC's risk was too
    high, the situation was discussed with the client's audit committee
    and/or management, who were given the opportunity to make the necessary
    changes within their organizations. If we believed the risk profile was
    still too high, PwC exited the relationship. The U.S. firm terminated
    relationships with 159 clients--representing about 250,000 annual audit
    hours.
        Our actions have sent a strong message to the business community
    that PwC is standing firm on audit quality. PwC will continue to
    reevaluate client relationships in this manner and exit those
    relationships where the client risk profile is beyond our acceptable
    limits.

    Thought Leadership
        When the Act was first passed, many were unclear on how its myriad
    provisions would impact them from both a technical and practical
    standpoint. In response, we got out in front of the issues and
    presented our viewpoints by developing a variety of thought leadership
    pieces that explored how the Act would impact the various market
    participants and our profession. These activities included the
    following:

     Webcasts: We held a series of webcasts designed to explore the
        implications of the Act----

         Corporate Responsibility under Section 302 of the
    Sarbanes-Oxley Act;
         Discussion on the Hill;
         Final Rules on Auditor Independence and;
         Web cast Series on Section 302, Section 404, and Auditor
    Independence.

     White Papers: We produced three white papers that focused on
        key issues highlighted by the Act----

         The Sarbanes-Oxley Act of 2002: Strategies for Meeting New
    Internal Control Reporting Challenges--November 2002
         The Sarbanes-Oxley Act of 2002 And Current Proposals by
    NYSE, Amex, and Nasdaq: Board and Audit Committee Roles in the Era of
    Corporate Reform--February 2003
         The Sarbanes-Oxley Act of 2002: Understanding the
    Auditor's Role in Building Public Trust--August 2003

    Learning and Education
        In January 2002, the U.S. firm launched PwC University for its
    partners. The University provided partners with a forum to discuss our
    business strategy and reinforce a culture of quality throughout our
    organization. The design is built around several themes, which include
    driving quality throughout PwC and living our values of leadership,
    excellence, and teamwork. We also stress the need for personal
    development and continuous improvement. Since its inception, over 1,700
    U.S. partners have attended this program.
        In May 2002, we launched the first Quality Lens educational course
    for our audit partners and 995 partners had completed the course by
    year-end. Among other things, Quality Lens focused on the underlying
    behaviors essential for an auditor, including: Professional skepticism,
    objectivity, and independence. In May 2003, we relaunched Quality Lens
    for our audit partners and managers to further strengthen our focus on
    quality. Training included coaching and mentoring; performing
    investigative interviews; and handling other difficult situations.
    Finally, partners and managers participated in an audit simulation,
    which focused on the application of audit methodology and
    communications with audit committees and management. To date, over
    2,000 partners and managers have attended this 3-day program. In
    addition to the above, we have rolled out training for our partners and
    staff focusing on the framework for internal controls and testing,
    business risks, controls that mitigate those risks, fraud, and the use
    of specialists.
        Finally, skills and knowledge related to U.S. generally accepted
    accounting principles (GAAP) are critical to our profession and, as
    such, represent a significant area of training for our partners and
    staff. A core part of the curriculum comprises just-in-time training on
    Financial Accounting Standards Board (FASB) releases and implementation
    guidance from the FASB's Emerging Issues Task Force (EITF). Additional
    classroom training provides a forum for discussion and guidance on
    complex accounting issues related to topics such as stock-based
    compensation, derivatives, affiliated entities, income taxes, and
    revenue recognition.

    Impact On the Way We Do Business
        The Act has already had a profound impact on our business--from our
    audit and tax practices to our firm's structure and the regulatory
    environment in which we operate.
    Dramatic Changes to the Audit Relationship
        One of the most significant changes arising from the Act is our
    direct linkage to audit committees. The Act now requires all public
    company audit committees to accept a higher level of responsibility,
    and we have begun to see the impact of that requirement. Audit
    committees are meeting much more often. They are more involved. They
    are probing much more deeply, and they are challenging what they are
    being told. This is excellent news for the investing public.
        This change is significantly enhancing the audit process because
    the audit committee is much more attuned to investor protection and is
    actively supporting our audit efforts. All of this comes at a cost,
    however, and we should recognize this. We are spending more time on our
    audits as is appropriate. Audit committees are asking us to do more,
    our audit procedures have been expanded, and we have more senior people
    spending more time on audits resolving complex accounting questions.
    Our audit fees reflect this new environment, but it is a cost that is
    relatively small compared to the benefit--a greater focus on investor
    protection.
        Another cost is associated with the new Section 404 requirements to
    attest to the soundness of internal controls. We believe that this is
    one of the more significant requirements of the Act. When accounting
    problems occur it is often because the internal controls are weak. I am
    confident that the benefits of more transparent reporting and improved
    controls will far outweigh these additional costs.
        On average, this expansion in the scope of the audit has increased
    the time spent on audit engagements by about 10-15 percent. This
    increase does not include the additional work required for full
    compliance with Section 404 of the Act. We have invested significant
    dollars in hiring, training, and retaining highly qualified staff to
    ensure that the high quality of our audits is maintained. A tight
    market for auditing professionals has required us to increase
    compensation more than normal, and we have also spent about 15 percent
    more in training costs so that our staff has the necessary skills to
    deal with the new rules and regulations. Finally, our insurance
    premiums for practice protection have soared due to increased
    litigation in the accounting arena, fewer reinsurers, unfavorable
    investment returns for insurance companies, and large insurance company
    losses. For our U.S. firm, practice protection costs are now the second
    largest cost of doing business, second only to the compensation
    provided to its people.

    A Significant Decrease in the Demand for Tax Services
        One of the more controversial audit independence issues arising
    from the Act has been the provision of tax services to audit clients.
    The SEC largely settled the debate on tax services in the accompanying
    discussion section to its auditor independence rule, which rightfully
    acknowledges Congress's intent to expressly permit audit firms to
    provide tax services to audit clients. This was in recognition that
    these services are an integral part of the services provided by an
    accounting firm and that better audits are performed when tax
    professionals are involved with the complex and difficult judgments
    that need to be made with regard to a client's tax accruals and
    expenses.
        Nonetheless, there seems to be a continuing drumbeat that auditors
    who provide tax services to audit clients are not independent--even
    though Congress and the SEC carefully considered the issues and
    concluded to the contrary. As a result, our tax practice has
    experienced a significant decrease in demand for these services from
    our SEC audit clients. The decrease in the United States has been
    around 20 percent and evidence shows that the trend is continuing. One
    of the great checks and balances built into the Act is the audit
    committee's preapproval process. We fully support this process but the
    continuing rhetoric around tax services may be pushing the pendulum too
    far from the mark. Precluding accounting firms from rendering tax
    services to their audit clients and the inevitable long-term
    consequences of an exodus of tax talent from accounting firms will not
    serve investors well.

    Changes to the Business Model
        In recent decades, accounting firms, traditionally providers of
    audit, tax, and related advisory services, became multifaceted service
    providers. This development, in my view, commenced in the 1960's with
    the dawning of the information technology age, and was further
    accelerated by the removal of marketing restrictions by the Federal
    Trade Commission. To meet the demand for a broader array of services,
    accounting firms began to employ a wide range of professionals with
    varied backgrounds. Over time, the influence of these professionals
    grew and, as a result, the cultures within the firms slowly evolved
    from ones that were built around providing traditional audit, tax, and
    related advisory services to ones that de-emphasized those areas in
    favor of consulting services. In the 1990's, these consulting practices
    grew enormously.
        We disposed of our consulting practice in October 2002. In
    addition, we disposed of certain other businesses such as our human
    resource consulting group and corporate valuation business.
        Today, our practice is made up of three lines of service: Audit,
    tax, and advisory. Our audit practice is focused on providing assurance
    on financial information. Our tax practice provides a broad range of
    tax services from preparing tax returns to providing advice on the
    optimal treatment of economic transactions. Our advisory practice
    provides a broad range of services focused in large part on risk
    assessment and risk management. This practice is built on the core
    skills found in our audit and tax practices.

    New Regulatory Oversight
        In August, the PCAOB inspection staff began what they refer to as
    ``limited inspection procedures'' for each of the Big Four firms. The
    first part of the inspection process includes interviews with our
    national leaders and reviews of internal documents to gain an
    understanding of our firm's policies and procedures, and gain other
    insights into our operations. The second part consists of visits to
    certain practice offices and interviews with professional staff members
    at all levels. It will also include verification of information
    accumulated at the national level. Further, the inspection staff has
    told us that they will perform an in-depth inspection of the working
    papers in certain areas of selected issuers' audit engagements.
        In the letter accompanying their data request, the PCAOB staff
    confirmed that the procedures they perform this year would focus on
    behavior, culture, and other important processes including: tone at the
    top; partner evaluation, compensation, promotion, assignment of
    responsibilities, and discipline; independence implications of nonaudit
    services; business ventures, alliances, and arrangements; commissions
    and contingent fees; client acceptance and retention; our internal
    inspection program; practices for establishing/communicating audit
    policies, procedures, and methodologies, including training; and
    policies/procedures for work performed by foreign affiliates on foreign
    operations of U.S. audit clients.
        Their data request covered a wide range of items: our values and
    Code of Conduct; organization charts; agendas for and minutes of
    management and board meetings; policy materials in the areas listed
    above; client satisfaction survey forms and summary results; staff
    survey forms and summary results; lists of public company proposals/
    reproposals; public clients we no longer audited in the last year;
    descriptions of our current business model and strategic business
    plans, and the financing structure of the firm; descriptions of
    industry and geographic programs; communications from leadership to
    partners and staff; and details about our partner evaluation and
    compensation process and its outcomes, among other things.
        We have provided all of the data requested and are responding to
    follow-up questions and requests for additional details. The interviews
    with national leaders have all been scheduled and will be completed by
    October 1. The first office visit is scheduled for October 6. We
    understand that the PCAOB's goal is to issue their report in December.
        Our interactions to date provide us with a glimpse into our future
    in this new environment. It is clear that the scrutiny will be intense.
    We have approached our interactions with the PCAOB and its staff with a
    mindset of cooperation and openness, with the hope that PCAOB will
    share our goal of continually enhancing our systems and processes. We
    hope that the foundation of the inspection process will be the shared
    purpose of rebuilding the public trust in our profession rather than
    reprimands for unintentional errors.

    Future of the Accounting Profession
    Entrants into the Profession and Accounting Education
        Much has been said about the need for the profession to recruit the
    best and the brightest. But the issues the profession faces in this
    area are really two-fold. First, can we continue to attract the right
    people into the profession and second, is the quality of education
    today sufficient to properly train these young people?
        One has to be concerned, given the events of the last couple of
    years, about whether the best and the brightest students believe this
    profession offers them the long-term opportunity they are seeking. With
    confidence in the profession at a low point, with the media constantly
    focusing on the negative, and with the example of one of the most
    prestigious firms--Andersen--failing, I am concerned about the appeal
    of our profession to the next generation.
        We cannot fulfill our mission without attracting and keeping the
    best and the brightest. No profession can. All the best efforts to
    restore public confidence will fail if independent auditing
    professionals are not on an equal intellectual and motivational footing
    with the executives of the companies they audit.
        We have some concerns about the curricula. The U.S. firm sponsored
    a study of the curricula at nine universities that produce a large
    number of graduates for the large public accounting firms. Completed in
    late 2002, this research broke new ground in the breadth and depth of
    its analysis of what is actually happening in the classroom and in
    understanding the intersection between collegiate education and
    continuing professional education. To stimulate productive dialogue on
    the future of accounting education, we distributed our monograph,
    Educating for the Public Trust: PricewaterhouseCoopers Position on
    Accounting Education, to over 4,000 U.S. accounting faculty and
    business school deans.
        In addition, the firm and its partners and staff commit millions of
    dollars each year to support various curricula, faculty research, and
    other accounting educational programs in the United States. We also
    sponsor PwC conferences and training programs for faculty as well as
    other initiatives that promote our profession among high school and
    college students.
        Not only do we provide significant financial support, but we also
    spend a significant time and effort attracting top talent. This year
    alone, 700 partners will spend 35,000 hours on this effort. Our
    continuing investment and commitment to accounting education is
    absolutely critical to our future--it is our future.

    The Success of the Profession
        The profession is at a critical juncture. We can no longer count on
    our proud history to speak for our importance. We must stand and be
    counted; and in doing so, establish a professional reputation will
    ensure that we are recognized as leaders in the capital formation
    process. Our integrity must be beyond question. In addition to simply
    conducting business in an appropriate manner, a number of matters will
    need to be addressed by PwC, the profession, regulators, investors,
    attorneys, underwriters, analysts, and others.
        The following should be at the forefront of the profession's
    agenda:

     Ensuring that our firms have the right ``tone at the top'' and
        commitment to quality, excellence and restoring investor
        confidence;
     Recruiting, developing and retaining the best and brightest
        professionals;
     Converging systems, standards, and regulatory regimes globally
        and;
     Making sure that our business model appropriately balances our
        risks.

        I also believe that, for the sake of the investing public, the
    PCAOB needs to set auditing standards that will enhance investor
    confidence. The PCAOB should seek the advice of professionals who have
    the practical experience to effectively develop auditing and other
    technical standards for the profession.
        I invite my colleagues in the profession as well as investors,
    regulators, attorneys, and others to join me in addressing these
    complex matters. We must remain true to our vision. We must also make
    sure that we hold one another to the highest possible standard and
    encourage those seeking entry into the market. Investors will benefit
    from having a broad range of qualified auditors. In this regard,
    regulators and others need to recognize how their actions may create
    barriers to entry.

    A Proper Assessment of the Effects of the Act
        The Act provides a good roadmap for moving ahead. However, as the
    most comprehensive piece of legislation affecting corporate governance
    and financial reporting since the securities laws of the 1930's, the
    new regulations adopted under the Act must be given ample time to prove
    their usefulness. It is critically important that we all be patient and
    not rush to judgment if something does not appear initially to be
    achieving its goal.
        By taking a long-term approach, we will discover the law's true
    effectiveness in meeting its objectives. Auditors, audit committee
    members, executives, and others have just begun to work through the
    many nuances of complying with the new regulations and some aspects are
    not yet effective. Additional time must pass before we step back and
    evaluate the effect of the Act to see whether its key objectives--to
    protect investors by improving the accuracy and reliability of
    financial disclosures and restoring investor confidence--have been met.
    It is absolutely critical, however, that we first allow the rules to
    ``sink in'' to corporate America's consciousness and truly have a
    measurable effect on financial reporting and investor confidence. Only
    then can we make a valid assessment of the law's impact. To evaluate
    too soon and launch further rulemaking projects would layer regulation
    upon regulation and risk further erosion of the public trust.

    A Concerted Effort is Needed
        Many parties, including corporate managements, boards of directors,
    audit committees, auditors, investment banks, attorneys, securities
    analysts, rating agencies, standard-setters, and regulators were
    accused of contributing to the string of U.S. corporate failures that
    shocked the world financial community. As SEC Chairman William
    Donaldson testified recently before this Committee, ``The sweeping
    reforms in the Sarbanes-Oxley Act address nearly every aspect and actor
    in our Nation's capital markets.'' Because many viewed the corporate
    failures to be the fault of so many, Federal lawmakers adopted a law
    that was intentionally far-reaching in scope and effect. As mandated by
    the law, the SEC adopted rules that implement several provisions of the
    Act, and the General Accounting Office (GAO) and SEC launched various
    studies. Shortly thereafter, the major U.S. stock exchanges proposed
    new rules for listed companies. The PCAOB worked quickly to establish
    itself and commence rulemaking and registration activities.
        The lawmakers and the regulators have responded. Now it is time for
    groups and individuals who prepare, communicate, or use corporate
    reporting information to stand and be counted. Clearly, it is not
    enough that lawmakers and regulators change the rules; the players must
    be ready, willing, and able to apply them in the spirit in which they
    were intended. If they do not, then the effect of the Act will be muted
    and the desired impact lost. As auditors, we stand ready not to let
    that happen. As a firm, we have championed the cause of the Act by
    authoring books, white papers, and articles and making those
    publications widely available. We have taken every opportunity to
    spread the message of what needs to be done both inside and outside of
    the accounting profession to strengthen and safeguard our capital
    markets and restore investor faith in those markets. We will continue
    these efforts.

    Conclusion
        In conclusion, let me thank you for your leadership and support to
    reestablish and strengthen investor confidence and integrity in the
    capital markets. Rest assured that, at PwC, we understand the
    importance of the role that we play in the capital formation process.
    Further, we eagerly look forward to embracing change in the future as
    well as today. I have great faith in the market and the private sector.
    This market is the most effective and efficient ever devised.
        Thank you again for inviting me to speak on behalf of
    PricewaterhouseCoopers. I would be happy to answer any questions.

                                   ----------

                      PREPARED STATEMENT OF EDWARD NUSBAUM
                  Chief Executive Officer, Grant Thornton, LLP
                               September 23, 2003

        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee, thank you for inviting me to testify today concerning the
    impact of the Sarbanes-Oxley Act (the Act). I appreciate having the
    opportunity to discuss this important subject with you.
        We have seen the effects of the Act first-hand and our chief
    conclusions are:

        (1) The Act has had a positive influence on corporate America,
    financial reporting, and the accounting profession. It has been a step
    in the right direction to restore trust and confidence in the capital
    markets. Investors are the winners from this Act, with greater
    reliability in financial information. Grant Thornton congratulates you
    on having the courage and foresight to adopt this Act. With the benefit
    of 1 year of history, the Sarbanes-Oxley Act has been, in our opinion,
    a success.
        (2) Proper continued execution of the Act is key to restoring
    investor confidence. The Act contains many provisions that are just now
    being implemented. Government regulators, the new Public Company
    Accounting Oversight Board, the accounting profession, corporate
    America, and all other stakeholders must work together to accomplish
    the objectives of the Act. A principles-based approach is necessary for
    the successful implementation of the requirements of the Act.
        (3) And there is more that needs to be done. To improve financial
    reporting worldwide, each of those bodies responsible for accounting,
    auditing or independence standards must implement principles-based
    standards and international accounting and auditing standards must
    converge. Grant Thornton and other accounting firms must work with the
    PCAOB to improve the audit process. Working as a team, corporate
    America, investors, the Securities and Exchange Commission (SEC), the
    PCAOB, the Financial Accounting Standards Board (FASB), the
    international standard setters, the accounting profession, and other
    stakeholders can improve the business reporting model and the quality
    and transparency of information used by investors and creditors.
        (4) Grant Thornton and other leaders in the business community have
    responded to both the spirit and substance of the Act. We have spoken
    out on the need for reform and worked hard to support the
    implementation of the Act. Again, we appreciate your efforts to adopt
    this important legislation. Grant Thornton is committed to take the
    steps necessary to ensure its continued success.

    About Grant Thornton
        Since our founding in 1924, Grant Thornton has focused on providing
    audit and tax services to mid-size companies, generally those with
    revenues between $25
    million and $2 billion, although we have clients both larger and
    smaller. Grant Thornton International is the world's leading
    accounting, tax and business advisory organization primarily dedicated
    to mid-size companies. Through our network of 585 offices in 110
    countries, including 50 offices in the United States, partners of the
    member firms of Grant Thornton provide personal attention and seamless
    service delivery to public and private clients around the globe.

    How the Act has Positively Impacted American Business and
    the Accounting Profession
        I believe that the tone of an organization starts at the top.
        As I wrote in Chief Executive magazine this past year--which was
    cited in the House Committee on Financial Services' recent publication,
    The Sarbanes-Oxley Act: The First Year; Rebuilding Investor Confidence,
    Protecting U.S. Capital Markets--under Sarbanes-Oxley, the role of CEO
    has taken on a new dimension as numerous new responsibilities and
    potential for penalties for corporate wrongdoing--including prison--now
    stop directly at the desk of the CEO.
        In the past, many CEO's did not worry about the state of their
    internal control systems. Many CEO's, absent a specific regulatory
    mandate, came to believe their control system was adequate--even though
    they had no way to prove that to be the case if asked. Today, because
    of the Act, the SEC requires CEO's to back up that fact with a
    signature and actual evidence. The increased role of the CEO in
    financial reporting has been, based on our experience, a positive step.
        The Act has clarified and, in some cases, strengthened the role and
    responsibility of boards of directors and audit committees. Boards can
    no longer blindly rubber-stamp the actions of management. They now must
    work side-by-side with the auditors to ensure the shareholder interests
    are protected. Audit committees must be more independent and expert in
    carrying out their vital duties. Again, our experience has been that
    most audit committees and boards of directors have increased the number
    and quality of meetings, and the members of most audit committees and
    boards appear to be taking their role more seriously since the adoption
    of the Act.
        The Act is forcing public companies and their auditors to make sure
    that the financial statements are squeaky clean as restatements have
    jumped 30 percent over the past year. And despite warnings of increased
    lawsuits against corporations, that has not happened, as according to
    The Wall Street Journal, ``Both the number of class-action lawsuits and
    the size of settlements are consistent with previous years.'' (The Wall
    Street Journal, ``Sarbanes-Oxley Affects Suits Little, Study Says,'' by
    Kara Scannell, July 24, 2003.)
        Thanks to the Act, the quality of information provided to investors
    from corporations has improved, and we believe that changes mandated by
    the Act prohibiting auditors from providing certain services, such as
    consulting, to their public audit clients has helped in restoring trust
    in the accounting profession. In fact, a recent Gallup Poll found that
    the image of the accounting profession has improved significantly over
    the last year, more than any other profession tested.
        According to the poll analysis, ``The one industry whose image has
    improved the most compared to last year's is accounting, which has
    risen from a net rating of 0 percent last year (that is, as many people
    gave it a negative rating as a positive one) to a +31 percent this
    year. Other industries and business sectors tested include the computer
    industry, real estate, banking, the legal field, the airline industry,
    and healthcare.'' While one could argue that the accounting profession
    had significant room to improve, we are pleased to see that the Act,
    combined with the actions of Grant Thornton and other accounting firms,
    has helped to restore the public's image of our profession. Most
    important, the Act has helped restore the public's confidence in
    financial reporting.

    Execution of the Act is Key to Improvements in our Financial Markets
        The Act established the PCAOB, which is now beginning to execute
    its provisions. We believe that accounting firms must not only
    cooperate with the PCAOB, but also act as leaders to help the PCAOB
    operate effectively. Likewise, the PCAOB should not only monitor and
    discipline accounting firms, but should also work with the firms to
    improve the audit process. This cooperation between the new Board and
    accounting firms should result in further improvements of the financial
    reporting process. The functioning of the PCAOB will be a major factor
    in evaluating the success of the Act in future years. The focus of the
    PCAOB and the Government should not be on increased litigation against
    accounting firms, but instead on helping accounting firms work with the
    PCAOB and Government to ensure the successful implementation of the Act
    into the foreseeable future.
        Although there have been several well-publicized allegations of
    accounting misdeeds and auditing failures, there are many more
    instances where auditors have discharged their professional
    responsibilities, uncovering fraudulent acts. It is equally important
    that the PCAOB, in addition to disciplining auditors, find the means to
    recognize and reward auditors who act without self interest to protect
    investors.
        Some provisions of the Sarbanes-Oxley Act are crystal clear. Other
    provisions are subject to interpretation. Grant Thornton believes that
    any gray areas in the Act must be implemented in the spirit of
    transparency and investor protection. We believe that was the intent of
    you, the bill's authors.
        The internal control provisions of the Act are also just now being
    implemented. The degree of an auditor's independence is driven by the
    separation between management (which produces the financial
    information) and the users of the information provided by management.
    The standard for independence is heightened as that separation
    increases. We firmly believe that the auditors of publicly held
    companies must hold themselves to the highest possible standard of
    independence.
        For this reason, Grant Thornton will not accept engagements to
    document, evaluate, or design our public audit clients' internal
    controls, including engagements to document existing controls, or to
    perform evaluations of existing controls that management uses to
    support their conclusions regarding the effective design of those
    controls. To do so, we feel, is a conflict of interest. Instead, as
    auditors, we will audit the internal controls as designed, documented,
    and evaluated by management, in accordance with the provisions of the
    Act.

    What Still Needs to be Done
        For the last 20 months, we have been advocating the need to adopt a
    principles-based approach to accounting standards setting. Enron's
    former Chief Financial Officer Andrew Fastow created hundreds of
    ``special-purpose entities'' to hide Enron's debt. He argued they were
    within the letter of the law, under the current rules-based approach to
    accounting. But we must ask ourselves, ``Is this right?'' Is this what
    financial disclosure is about? Or is it presenting the truth and
    transparency to investors and other stakeholders? I strongly believe
    that the accounting profession and the standards setters (the FASB,
    SEC, PCAOB, etc.) need to embrace a 'spirit of the law' versus ``rule
    of the law'' approach to standards setting. The current rulebook
    approach for all standards setting fosters a culture of ``if the
    rulebook does not specifically forbid it, it must be okay.''
        Albert Einstein said, ``The problems that we have created cannot be
    solved at the same level of thinking that created them.'' A principles-
    based approach is necessary for the successful implementation of the
    requirements of the Act. Rather than establishing a new set of
    complicated rules--which is the approach that fostered the problems the
    Act seeks to solve--we believe a focus on principles will result in
    stronger adherence to the spirit of the Act. A principles-based
    approach would provide greater assurance to the public and investors
    that management, auditors, and those responsible for corporate
    governance will do the right thing.
        Convergence with international accounting standards will also
    improve the global quality of reporting. Consistent accounting
    principles throughout the world will allow global corporations and
    auditors the ability to improve financial reporting. Further, a
    principles-based approach to accounting standards would provide greater
    assurance to the public and investors that management, auditors, and
    those responsible for financial reporting will provide information that
    is in the public's best interest.
        There also must be a renewed effort to improve the current business
    reporting model. Grant Thornton has taken a leadership role in this
    effort. In December 2002, the board of directors of the American
    Institute of Certified Public Accountants (AICPA) formed a special
    committee on enhanced business reporting (the special ommittee) and
    appointed our Managing Partner of Strategic Services, Mike Starr, as
    the Chair. Under the leadership of Mr. Starr, the special committee
    adopted the following mission:

            ``To establish a consortium of investors, creditors,
            regulators, management, and other stakeholders to improve the
            quality and transparency of information used for
            decisionmaking.''

        The special committee has also written a monograph, Enhanced
    Business Reporting, which grounds the project intellectually and guides
    future activity.
        Ned Regan, President of Baruch College and former New York State
    Comptroller, is set to meet with the special committee to discuss the
    steps necessary to establish and launch the consortium. Mr. Regan will
    lead the efforts to recruit a small group of very prominent U.S.
    business and civic leaders to help put together an Enhanced Business
    Reporting Consortium. The members will be high-level representatives of
    prominent business, accounting, auditing, investor, creditor,
    foundation, and Government groups. This will be done carefully so the
    Consortium will have representatives from all the key groups necessary
    to make this significant change in reporting.
        It is anticipated that the Consortium members, from their positions
    of national stature, will be advocates for enhanced business reporting
    and guide our collective activities to make the project goals a
    reality. When fully organized, the Consortium will be freestanding,
    with financial support coming from the AICPA and several foundations.
    Subject to special committee approval, staff, research, and conference
    activity is expected to be headquartered at Baruch. Academic and
    foundation partners in other parts of the country are expected to join
    with Baruch in supporting the Consortium's activities. The objective is
    simple; improve the quality and transparency of business reporting as
    part of the process to rebuild investor confidence and protect capital
    markets.
        The first building block for improving the business reporting model
    is effective corporate governance, and effective corporate governance
    starts with a board of directors who demonstrate a fierce commitment to
    integrity; demand excellence in all efforts; provide leadership, and
    motivation; and, display respect for people, ethical standards, laws,
    and regulations. Strong corporate governance is the bedrock upon which
    high quality, transparent information is built. And executive and
    director compensation is the litmus test for determining the
    effectiveness of corporate governance.
        The second building block is transparency. However, it must be
    noted that effective corporate governance is necessary to ensure that
    there is transparency in the information reported by management. Warren
    Buffet explained the need for transparency in his letter to the
    shareholders in the Berkshire-Hathaway, Inc. 2000 annual report,
    stating that:

            ``At Berkshire, full reporting means giving you the information
            that we wish you to give us if our positions were reversed.
            What Charlie and I would want under that circumstance would be
            all the important facts about current operations as well as the
            CEO's frank view of long-term economic characteristics of the
            business. We would expect both a lot of financial details and a
            discussion of any significant data we would need to interpret
            what was presented.''

        Investors and creditors should have the right to see an entity
    through the eyes of management. Competitive disadvantage should not be
    used as an overarching basis to avoid providing information to
    investors and creditors. Competitors frequently know a great deal about
    an entity from former employees, mutual suppliers and customers, market
    research, industry publications, engineering studies of products, and
    the marketplace itself.
        Globally accepted accounting principles are at the core of enhanced
    business reporting. In addition to the basic financial statements,
    management needs to provide users with insight into management's
    assessment of:

     Competition and industry factors that effect the entity's
        position in the business environment;
     Current and future regulatory developments that may effect
        business strategy; and
     Factors such as the general economy or demographics that may
        effect business performance.

        Currently, MD&A is nothing more than a narrative recitation of
    information contained in the financial statements. Management needs to
    provide information about the entity's strategy, plans, opportunities,
    and risks. These quantitative and qualitative disclosures need to focus
    on key performance indicators and how these indicators compare to
    industry peers. We need to develop commonly accepted definitions and
    principles for these performance indicators.
        The enhanced business reporting model requires a change in the
    auditor's role. Auditing standards need to provide guidance on how to
    provide assurance on the qualitative disclosures required by
    information transparency. As stated above, Grant Thornton and other
    accounting firms must work with the PCAOB to improve the audit process.
    Working as a team, corporate America, investors, the SEC, the PCAOB,
    FASB, the international standard setters, the accounting profession,
    and other stakeholders can improve the business reporting model and the
    quality and transparency of information used by investors and
    creditors. We ask you to continue to support the cooperation and
    efforts to accomplish this goal.

    What Grant Thornton is Doing
        I am proud to say that in February 2002, we issued the Grant
    Thornton Five Point Plan to Restore Public Trust. As a result, Grant
    Thornton became the first global accounting organization to provide a
    program of reforms to regain public trust in financial information. The
    points are:

        The policies and reward systems of the major firms must reflect an
    uncompromising commitment to professional excellence. The actions of
    the management of those major firms must make it clear that nothing is
    more important than their professional responsibility. In addition, all
    the major firms must collectively agree to limit the nature and extent
    of services provided to publicly held clients. Such agreement should
    specify that the firms would only provide assurance and advisory and
    tax services to their publicly held audit clients. For example, certain
    consulting services such as outsourcing should be prohibited. We must
    change our business models significantly in response to the demands
    from the public. To do otherwise ignores a fundamental precept: That
    businesses set priorities based on those drivers that have the greatest
    impact on earnings. Assurance and advisory and tax services must once
    again be the business drivers and focus for the auditors of SEC
    registrants.
        Audit committees must ensure that the auditor's primary
    responsibility is to the shareholders and that the auditor's
    relationship with management is clearly subordinate to such
    responsibility. Audit committees must do a better job of protecting
    shareholder interests. They must challenge management and the auditors
    on the treatment of significant accounting issues. They must be
    diligent in determining that their auditing firms are free of conflicts
    of interest. The audit committee plays a critical role in this regard.
    The regulators need to take the steps necessary to reinforce the audit
    committee's need to be truly independent of management. Audit
    committees must be vigilant in performing their duties to ensure that
    the appropriate auditor-client relationship is maintained and that
    management is challenged on all significant transactions, including the
    underlying business purpose of those transactions.
        The SEC must amend its rules for proxy disclosures of auditor's
    fees. The amended rules should require separate disclosure of fees for
    (1) assurance and advisory services (for example, those services that
    meet the definition for assurance services), (2) tax services and (3)
    all other services. The current proxy rules for disclosure of the fees
    paid to the auditors, which resulted from a compromise, are misleading
    because services that do not give rise to a conflict of interest are
    inappropriately combined with services that can and, in some instances,
    have created conflicts of interest.
        A principles-based approach should be adopted for all standards
    setting areas: accounting, auditing, and independence. In addition, the
    auditing standards should be expanded to incorporate a forensic
    approach. A year ago, the previous administration at the SEC fueled a
    public debate that effectively killed the Independence Standards Board
    and its proposed principles-based independence framework. Those same
    individuals conveniently continue to ignore that this framework,
    properly constructed and implemented, would have addressed some of the
    very issues that we are trying to solve today. The current rulebook
    approach for all standards setting fosters a culture of ``if the
    rulebook does not specifically forbid it, it must be okay,'' where
    there is more concern about the form of transactions than their
    substance. A principles-based framework for setting standards provides
    greater assurance to the public that management, auditors, and those
    responsible for corporate governance will do the right thing.
        AICPA should coordinate a review of the audit methodologies of the
    major accounting firms. We believe that Grant Thornton has an excellent
    auditing methodology and we are willing to share our best practices
    with others. We assume that others feel the same about their
    methodology. The best practices of these firms should be shared with
    the entire accounting profession. This unprecedented sharing of best
    practices by the major firms would serve the public interest by
    ensuring that all auditors of SEC registrants have access to the best
    practices of the leaders of the profession.

        I am pleased that three out of our five proposals were included in
    the Act.
        Grant Thornton with its staff, industry and technical expertise,
    and global reach has expanded its market share of public audit clients
    in the last 2 years with the consolidation of the profession. I am
    proud that Grant Thornton was the first of the major accounting firms
    to file the registration application with Public Company Accounting
    Oversight Board. We are anxious to begin working with the Board.
        We have also taken actions to implement, and spoken out on the
    effective implementation of, the Act. Last month, as stated above,
    Grant Thornton became the first and only one of the six global
    accounting organizations to go on the record publicly and prohibit
    services for its public audit clients related to the documenting of
    internal controls. Consistent with our guiding principles, we will not
    provide these services because to do so violates the spirit of the Act.
    On the other hand, we have spent millions of dollars to develop
    auditCARE sm, our proprietary tool for controls assessment
    and risk evaluation, and to train our people to better audit the
    internal controls designed and documented by management. We have
    discussed our process and tools with the staff of the PCAOB.
        We are also very involved in increasing transparency of information
    providing to investors. As mentioned above, our partner, Mike Starr, is
    leading these efforts and Grant Thornton has endorsed the entire
    process.
        Grant Thornton has consistently spoken out on the need for reform,
    the proper execution of those reforms, and the need to continue to
    improve the financial information used by investors. One of our
    strategic initiatives is to provide thought leadership to our clients,
    the accounting profession, and the business and investing community.
    Grant Thornton is proud and honored to be a part of this hearing, and
    looks forward to assisting you in any way we can to improve business
    reporting and restore investor confidence.

    Conclusion
        In 1933, Congress passed the Securities Act that led to the
    creation of the SEC, designed to restore investor confidence in our
    capital markets after an estimated $50 billion in new securities had
    became worthless to investors.
        Now 70 years later, Sarbanes-Oxley has further protected American
    investors. I know that I speak for many Americans in thanking you for
    the countless hours spent in bringing this landmark legislation to
    fruition, resulting in improvements in our financial reporting system
    in the past year and for many years to come.

                                   ----------

                      PREPARED STATEMENT OF SEAN HARRIGAN

               President of the Board of Administration, CalPERS
                               September 23, 2003

        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee, it is an honor and pleasure to be here with you today to
    discuss a topic of such importance to investors.
        My name is Sean Harrigan. I am the President of the Board of
    Administration of the California Public Employees' Retirement System
    (CalPERS).
        CalPERS has long been a leader in corporate governance. It goes
    without saying that CalPERS has had serious concerns over the crisis in
    our financial markets. Our organization was one of the fist investors
    to embark upon an initiative of financial market reform as the depth
    and magnitude of the crisis facing our markets became increasingly
    apparent in early 2002.
        Now, almost 2 years later, we have accomplished a great deal. The
    primary vehicle for reform has been the Sarbanes-Oxley Act that was
    passed just over 1 year ago. While I recognize that implementation of
    the Act will realistically go on for some time, I think it is safe to
    say that this historic legislation is to be credited with an excellent
    start toward restoring investor confidence and improving the
    credibility of our financial markets.
        Today, I would like to highlight some of the important elements of
    the Sarbanes-Oxley Act which have had a tremendous impact. I would also
    like to offer some suggestions for the next steps that are critical to
    completing the job that we have all set out to accomplish--restoring
    the public's trust and confidence in our financial markets. I still
    believe that this goal is an admirable one. It will help us as long-
    term investors to satisfy our obligation to our membership. But it will
    also help strengthen the efficiency of our markets which is crucial for
    effective capital allocation and sustainable economic growth.
        First, however, I would like to offer my sincere gratitude on
    behalf of CalPERS and its members for all that this Committee, and in
    particular Senator Sarbanes, for his leadership on this issue. As can
    be expected when industries with a vested interest face real reform,
    there was significant resistance to the Sarbanes-Oxley Act. We are
    proud to have been a vocal supporter, and we continue to play a role in
    implementing the Act and evaluating the effectiveness of reform.
        It is from this perspective that I offer our analysis and comments
    on the impact of the Act over 1 year after its enactment and on what we
    are focused on going forward. There are several components of the Act
    that we feel are most important and I will focus on those areas
    broadly.

    Auditor Independence
        We believe there are significant conflicts of interest created when
    an auditor is simultaneously receiving fees from a company for audit
    services and nonaudit services such as consulting. CalPERS supported an
    outright ban on nonaudit services for the external independent auditor.
    The Sarbanes-Oxley Act went a long way toward addressing this issue by
    establishing a list of prohibited services.
        However, from our perspective as a significant investor and user of
    financial statements, this is perhaps the main area in which the Act
    can be improved.
        Investors rely upon financial statements for accurate and objective
    information. We have witnessed how much harm can come from inaccurate
    and fraudulent accounting. Auditors play a crucial and irreplaceable
    role in ensuring the accuracy of financial statements.
        While the goal of the Act was certainly aimed at eliminating the
    conflicts inherent when an independent auditor receives fees for
    nonaudit services, two significant types of services remain permitted.
    Under the rules implementing the Act, auditors may still under certain
    circumstances provide tax planning and consulting services as well as
    certain information technology consulting.
        CalPERS continues to feel that an outright ban on nonaudit services
    is necessary. In response to this issue, CalPERS has taken steps to
    communicate our concerns directly to companies in which we invest.
    During the 2003 proxy season, CalPERS withheld its votes for audit
    committee members when they used their auditors for any nonaudit
    services.\1\
    ---------------------------------------------------------------------------
        \1\ CalPERS adopted two narrow exceptions to this rule. Under these
    exceptions we consider corporate tax form preparation and SEC
    compliance work to be acceptable services for external auditors.
    ---------------------------------------------------------------------------
        We have also analyzed proxy disclosures in an effort to monitor how
    companies use their external auditor. Again, it is important to
    remember the rules adopted by the SEC related to audit independence are
    still being implemented. However, our analysis indicates that
    approximately 50 percent of the total revenue to the audit firms in our
    study was nonaudit related. More specifically, approximately 40 percent
    can be attributed to consulting, advisory, or planning services that
    include tax related work. This remains a deeply troubling situation
    that we feel has the significant potential to impair the objectivity of
    the independent auditor.
        In the coming proxy season, CalPERS will continue to withhold its
    vote for audit committee members at companies that use the auditor for
    nonaudit services. Because this remains such a significant concern we
    urge you to pursue tougher rules through the Securities and Exchange
    Committee (SEC) and the Public Company Accounting Oversight Board
    (PCAOB) to address this issues.

    Accounting Industry Oversight
        In response to the clear failure of the accounting industry to self
    regulate, the Act created a new independent body to oversee audit
    firms. CalPERS strongly supported this provision. In particular, we
    advocated for strong independence, strong regulatory powers (such as
    the ability to subpoena and discipline), and independent funding.
        The PCAOB is now operational and is making progress toward its
    inspection and disciplinary programs. I am pleased to see that the
    PCAOB is preparing its own auditing and attestation standards. As you
    are aware, the Board is currently focused on internal controls over
    financial reporting. To investors, ensuring proper internal controls
    over financial reporting is critical. I do not accept the criticism by
    some in the business community that the additional focus on this area
    is misplaced or the cost associated with improving internal controls is
    not worth it. To investors that rely on financial statements and
    controls, it is completely worth it. The benefits clearly outweigh the
    costs. I applaud your focus on internal controls in Sarbanes-Oxley.

    Strengthening the Enforcement of Federal Securities Laws
        The Act provided numerous enforcement tools to strengthen the
    ability of the SEC to regulate the securities markets and compensate
    injured investors. It will take a number of years to completely
    evaluate the effectiveness of these new tools. However, there are some
    areas where we feel particular attention should be paid to ensuring
    that the SEC is adequately equipped. The Committee should consider
    studying whether additional authority for the SEC to ban individuals
    from serving as an officer or director at public companies is
    appropriate. In addition, the Committee may wish to study additional
    authority for the SEC to claw back gains from executives that are in
    any part attributable to misconduct. The SEC has already exercised new
    authority (under Section 1103) to escrow ``extraordinary payments''
    during an investigation. In its most recent action under Section 1103,
    the SEC successfully petitioned the court to escrow for 45 days a total
    of $37.64 million intended for two former executives of Gemstar
    International. CalPERS applauds this action and in fact filed an amicus
    brief in support of the SEC's efforts.
        Scenarios in which a significant payment follows corporate failure
    as a result of poor financial performance adds insult to injury for
    harmed investors. This is especially true when any portion of a gain
    realized by an executive can be attributable to malfeasance. Any
    reasonable authority we can provide for the SEC to rectify these types
    of situation should be duly considered.

    Next Steps
        There are too many other detailed provisions within the Act to
    mention today. At this time, I would prefer to focus on some of the
    actions we think still need to be addressed.
        The next steps that we think are most important are still focused
    on the same goal, which is to help restore investor confidence in the
    U.S. financial markets. While there are many issues we feel are
    important, I would like to focus on five reform items that are among
    our most important:

    Audit Independence
        As I mentioned, CalPERS will continue to take action through its
    governance program and other means to help strengthen the independence
    of the external auditor. As a major investor and financial statement
    user, we feel strongly that there should be a bright line ban on
    nonaudit services. Again, the primary concern we have is that external
    auditors are still permitted under certain circumstances to provide tax
    consulting and planning services and certain IT consulting services.
    These services provide a clear conflict of interest because the auditor
    may still be in a position to audit their own advice and must maintain
    a ``client'' relationship beyond the audit that impairs objectivity.

    Examining the Role of Market Participants
        The SEC as well as other organizations continue to conduct analysis
    of the role of varying constituencies within the financial system. Much
    like the audit industry, many of the remaining constituencies have a
    role in maintaining the market's integrity. In some cases, these
    players are proving that their industry has significant structural
    impediments or conflicts that are contrary to the interests of
    investors and the markets. For example, CalPERS has been active in
    helping to curb conflicts inherent in firms that provide both
    investment banking and equity research. We urge the Committee to
    continue to examine these various constituencies with a balance in mind
    that recognizes both their need to operate in an effective manner and
    yet fill a meaningful role in helping ensure the integrity of the
    financial markets.

    SEC Budget
        Congress and the President have dramatically increased the budget
    of the SEC, and CalPERS has supported this action on numerous
    occasions. As our primary market regulator, The SEC plays a crucial
    role in ensuring the integrity of the U.S. capital markets. This has
    obvious long-term implications for the health of our economy and on our
    ability as an investor to satisfy our obligation to our members. We
    feel that the focus on increasing the resources for the SEC is highly
    appropriate (and a good long-term investment in our market), but it is
    only half of the problem. To ensure that the SEC can be an objective
    market regulator and continue to build a sustainable and consistent
    program it should have a greater degree of independence from the
    Federal budget process. This position is similar to the support CalPERS
    has given for independence in funding for the PCAOB and the Financial
    Accounting Standards Board (FASB). Congress recognized the merits of
    providing a safe and independent funding source for these
    organizations, and we believe the same arguments apply to the role of
    the SEC, and are perhaps even stronger given the SEC's prominent role.

    Open Access to the Proxy
        The SEC is currently considering action that would provide
    investors with greater ability to nominate directors and have those
    candidates appear on the same proxy as management nominated directors.
    Of all the reforms that have been considered or enacted since the
    crisis began, this is perhaps the most significant one for investors.
    At the heart of many problems that face investors is a lack of
    accountability of board members to the owners of the corporation. We
    believe that one of the root causes for such issues as abusive
    executive compensation, lack of oversight that helps permit fraud, and
    plain old sub-optimal financial performance is the lack of
    accountability of board members to their owners.
        A reasonable and balanced approach to providing investors with
    greater access to management's proxy statement will directly address
    this problem. Because we will be able to gain greater accountability we
    will expect more behavior that is consistent with long-term owners'
    interests and less short-term decisionmaking and self-interested
    behavior that has been so damaging to all of us.
        We urge the Committee to help us in support of a reasonable open
    access policy that provides long-term investors with the ability to
    nominate directors without the prohibitive costs involved in launching
    a full flown proxy contest.

    NYSE Reform
        As this Nation's principal securities market and a so-called self
    regulatory body, the NYSE has a distinctive role in helping to restore
    and then maintain the integrity of our financial markets. We were
    appalled with the disclosures that came from the NYSE regarding the
    compensation package of the former chairman. We feel that the NYSE has
    a unique opportunity to meet the challenges that it now faces and to
    set an example for corporate America and indeed the world. I sincerely
    hope that the resignation of Chairman Grasso does not take the focus
    away from more substantive reform. Among some specific governance
    reforms that the Exchange should consider, we feel strongly it is time
    to have real investor representation on the NYSE. This reform alone
    would provide a change in perspective that would help ensure that the
    governance of the Exchange will be responsive to its primary
    constituency and that any regulatory role it retains going forward is
    meaningful.
        In summary, I would like to once again offer my sincere gratitude
    for all that Sarbanes-Oxley has done for investors. This has been a
    truly remarkable time in the history of the U.S. financial markets. I
    feel strongly that your leadership has been a significant boost in our
    efforts to recover. We still need that leadership. I hope you take my
    comments accordingly, and as we celebrate the early success of
    Sarbanes-Oxley, we also keep a watchful eye on its continued
    implementation and pursue opportunities to responsibly improve upon its
    reforms.
        Thank you and I would be pleased to answer any questions you may
    have.

                                   ----------

                       PREPARED STATEMENT OF SARAH TESLIK

             Executive Director, Council of Institutional Investors
                               September 23, 2003

        On behalf of the Council's 300 members, I thank you for this
    opportunity. The executive summary of this hearing, which examines the
    effects of the 14-month-old Sarbanes-Oxley Act, was actually written
    decades ago during President Nixon's historic trip to China. As I am
    sure you recall, during a state dinner on that trip, Secretary of State
    Kissinger asked the legendary Cho En Lai what he thought of the 18th
    century French Revolution. Cho's response: ``Too early to tell.''
        For many reasons it is similarly much too early to write the
    history of SOXA. But that has not stopped many from whining loudly to
    anyone who will listen--including all of you--that the Act:

     snuffs entrepreneurial spirit,
     prevents board seats from being filled, and
     forces companies to reincorporate on Mars to avoid killer
        compliance costs.

        For example: law firm memos breathlessly warned companies that
    company credit cards might now be illegal because the Act bars loans to
    executives. One CEO asked me what I thought of this and I responded,
    ``Ditch the firm. Keep the cards. And tell everyone to get a grip.''
        Of course there are some new costs. But let us remember 5 key
    things:

     Any change will incur temporary change-over costs. If the
        United States converted to the metric system, we would have huge
        change-over costs and that does not mean the metric system is bad;
        it just mean change takes time and costs money.
     Some costs arise from conflicting advice. A major oil company
        chairman told me on Friday that his company's main SOXA costs came
        from conflicting advice from consultants, accountants, and lawyers.
     Some costs are unnecessary. Remember, consultants, lawyers,
        and accountants make money if they advise companies that they need
        to be hired to revamp something or other. The CEO of a major
        pharmaceutical company told me last week that most of the
        compliance packages marketed to their company offered unnecessary
        bells and whistles.
     Many features of SOXA entail very few additional costs.
     It is GOOD that some costs are up. Companies that did not have
        internals controls should spend money to adopt them. If the PCAOB
        costs a bit more because it does a better job, that is money well
        spent.

        Finally, the whining we hear fails to ignore the clear financial
    benefits that SOXA is producing. Have we already forgotten that at the
    largest 1,000 companies that lost over 75 percent of their value in the
    2 years before SOXA, insiders nabbed fully $66 billion of shareholders'
    equity and kept it? That is now much, harder to pull off and the number
    of frauds is declining.
        Boards are now acting better. Nearly everyone can tell you that.
    Boards are also acting faster. Does anyone believe the NYSE or Freddie
    Mac boards would have acted as fast before SOXA? SOXA strengthens
    safety nets so that when wrongdoers attempt to put a spanner in the
    spokes of our markets, they are stopped earlier.
        SOXA could not cover everything in the short time it was enacted.
    It is essential that the SEC follow up with increased shareholder
    access to the corporate proxy. It is essential that SRO's and GSE's,
    such as the New York Stock Exchange, get restructured so that their
    regulatory functions are aligned with investor interests. These are
    critical add ons.
        But SOXA has other value besides its immediate effects.
        I am sure everyone in this room agrees that the fact that our
    markets have been for the past many decades the cleanest and most
    efficient in the world has brought great wealth to most of us; even to
    Americans who hold no shares and have no pensions. People all over the
    world invest here because they believe that are markets protect their
    investments best; this creates jobs, pensions, and a vibrant economy.
        But we are at very real risk of losing this edge. Increasingly
    special interests have been successful at rewriting the rules that
    govern our markets so that they benefit and investors suffer. Special
    interests visit Washington daily; average Americans cannot.
        As soon as it is recognized that our markets are losing their
    integrity--they can and will flow almost immediately to any other
    country that maintains a better system. Markets can move overnight
    unlike other industries so this risk is very real.
        What you all did here just over a year ago was to stem this erosion
    and take a bold stand in favor of clean, investor-protective markets.
    On behalf of my members' beneficiaries and on behalf of all of our
    children, who have the most to lose if our markets lose their edge, I
    ask you--no, I beg you--to stand firm. Our jobs, our pensions, our
    homes, and our way of life depend on real protection of--not lip
    service to--clean markets. You hold the key--little else you do here
    has greater importance. Thank you.

                             THE IMPLEMENTATION OF
                           THE SARBANES-OXLEY ACT AND
                         RESTORING INVESTOR CONFIDENCE

                                  ----------

                           THURSDAY, OCTOBER 2, 2003

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

        The Committee met at 10:05 a.m., in room SD-538, Dirksen
    Senate Office Building, Senator Richard C. Shelby (Chairman of
    the Committee) presiding.

            OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Chairman Shelby. The hearing will come to order.
        Senator Sarbanes is probably stuck in traffic somewhere
    between here and Baltimore, but I will tell you, he will be
    here as soon as he can get here, and he wanted me to say that.
        This is the final hearing in a series examining the
    implementation of the Sarbanes-Oxley Act and its impact on
    investor confidence. A primary focus of Sarbanes-Oxley is to
    change the ``tone at the top'' of public companies by
    increasing the accountability of officers and directors and
    strengthening corporate governance principles. The Act mandates
    new audit committee requirements and requires executive
    officers to certify their financial statements, institute
    rigorous internal controls, and disclose more information
    regarding operations. The Act addresses a boardroom culture
    that for too long was characterized by cozy relationships and
    the lack of objective and critical analysis of management's
    performance.
        More important than any one provision of Sarbanes-Oxley is
    the underlying message that corporate America needs to change
    its ways in order to regain the trust of investors. Even though
    Sarbanes-Oxley has contributed to a renewed investor
    confidence, some remain concerned that the Act is too costly
    and will negatively impact corporate behavior. Many believe
    that companies have incurred unreasonably high compliance costs
    associated with increased auditor and legal fees. Others
    contend that Sarbanes-Oxley has hurt the markets by requiring
    executives to focus on process at the expense of corporate
    risktaking.
        As with any landmark legislation, companies will experience
    a certain amount of uncertainty and cost increases as they
    implement the law and modify their business practices. Although
    I
    acknowledge increased compliance costs associated with
    implementing Sarbanes-Oxley, I also recognize that these costs
    were necessary to address the surprising erosion of business
    principles that became evident with the recent scandals.
    Further, the Act does require executives and directors to focus
    on procedure and process in order to ensure that corporate
    decisions are the result of considered decisionmaking.
    Attention to process, however, does not have to come at the
    expense of corporate innovation.
        As I have previously stated, the Act does not penalize
    risktaking but rather promotes transparent and honest business
    practices. With the enactment of Sarbanes-Oxley, the President
    and Congress laid the foundation for a new era of corporate
    accountability and governance. Congress, however, cannot
    legislate that boards of directors tackle difficult issues or
    that investors trust the markets. We cannot penetrate the
    executive suites and boardrooms to ensure that officers and
    directors have taken Sarbanes-Oxley to heart and have changed
    their practices. True reform will be manifested in new
    corporate cultures that adopt the spirit of Sarbanes-Oxley and
    reflect the shareholders' best interests. I think it will take
    a great deal of time and effort before investors fully regain
    their trust and confidence in the markets. Therefore, much
    needs to be done before corporate America can state that it has
    addressed the root causes of the recent scandals.
        A successful implementation of Sarbanes-Oxley is the first
    step. Executives, directors, and their advisers must remain
    vigilant in guarding against conflicts of interest and
    misconduct that result in corporations' profiting at their
    shareholders' expense. As corporate governance and financial
    reporting standards evolve, corporations and their advisers
    must proactively adopt new guidelines that maintain a high
    level of integrity.
        As we have recently learned, it is all too easy to lose
    investors' trust, and it is much harder to earn it back. The
    witnesses on our first panel today play an important role in
    establishing new standards for corporate governance and
    financial reporting. The Conference Board Commission on Public
    Trust and Private Enterprise was convened in June 2002 to
    address the recent corporate scandals and crisis in investor
    confidence. The Conference Board issued a set of findings and
    recommendations addressing a number of prospective reforms that
    companies should consider to further improve governance and
    financial reporting.
        With us from the Conference Board are its Chairman and
    three Commissioners. I would like to welcome Chairman Pete
    Peterson and Commissioners Charles Bowsher, Ralph Larsen, and
    Dr. Paul Volcker, former Chairman of the Fed.
        The witnesses for our second panel will be Brian Anderson,
    the CFO of Baxter International; John Castellani, the President
    of the Business Roundtable; Keith Grinstein, the Chairman of
    Coinstar; and Richard Trumka, Secretary-Treasurer of the AFL-
    CIO.
        Gentlemen, thank you for joining us today. We will start
    with you, Mr. Peterson. Your written testimony will be made
    part of this hearing record in its entirety. You proceed as you
    wish.

                     STATEMENT OF PETER G. PETERSON

              CO-CHAIRMAN, THE CONFERENCE BOARD COMMISSION

                 ON PUBLIC TRUST AND PRIVATE ENTERPRISE

               CHAIRMAN AND CO-FOUNDER, BLACKSTONE GROUP

        Mr. Peterson. Mr. Chairman, I want to make clear that we
    speak to you today as individual members of the Conference
    Board, that Treasury Secretary John Snow and I co-chair. Fellow
    Commissioners Paul Volcker and Chuck Bowsher will speak on our
    auditing and accounting recommendations. Mr. Ralph Larsen on my
    left here, former Chairman and CEO of Johnson & Johnson--widely
    considered to be one of the most ethical companies in America--
    and former Chairman of the Business Council, will discuss the
    critical importance of building an ethical culture within
    corporations.
        In my view, Mr. Chairman--I have been in 50 years now--I
    have never seen public trust at this low a level. It matters
    because our savings levels in this country are at unprecedented
    low levels. We depend on unprecedented amounts of foreign
    capital, and, therefore, confidence in our markets is
    extraordinarily important.
        I am going to focus my comments today, Mr. Chairman, on
    executive compensation, which we believe is the most
    fundamental and most toxic cause of the great breakdown in
    public trust. The recent example of Richard Grasso at the New
    York Stock Exchange has only punctuated the need for reform in
    this area.
        Before going getting into our recommendations, I would like
    to say just a few words about Sarbanes-Oxley and the possible
    future role of this Committee and the Congress.
        As to Sarbanes-Oxley, it is in my view, by and large, a
    very constructive and much needed piece of legislation.
    Already, I sense a sea change, Mr. Chairman, in the attitudes
    toward corporate governance practices to implement better
    governance. I have never seen boards of directors and CEO's as
    diligent and as proactively involved as they are today.
        Moreover, I believe that the private sector needs some time
    not only to fully digest Sarbanes-Oxley, but also to make
    constructive changes in other areas of corporate governance.
    Frankly, Mr. Chairman, history seems to teach us that,
    particularly in the area of executive compensation,
    Congressional action has in times past had some serious
    unintended and negative effects and resulting in certain very
    ironic, unintended side effects and rigidities. Let me give you
    an example. In 1993, the Congress passed the $1 million cap on
    cash compensation deductibility. It inadvertently set off an
    absolute explosion, Mr. Chairman, in the awards of what we call
    fixed-price options and inflating senior compensation
    dramatically in the process. That was hardly the intent of that
    legislation. This kind of well-intentioned but unfortunate
    Congressional involvement is the political equivalent of what
    the medical profession, borrowing from the Greeks--I thought
    Senator Sarbanes would be here, so I was going to appeal to
    him.
        Chairman Shelby. Please repeat it. He will get here.
        Mr. Peterson. The medical profession has something called
    the ``iatrogenic effect''--that is, diseases or ill effects
    that are caused by the ``iatro,'' the doctor, in Greek.
        Now, when we started our work, Mr. Chairman, I, at least,
    had assumed that these widely reported general increases in
    compensation would present the major problem to the public. All
    of us on this Commission had read the BusinessWeek report that
    showed CEO compensation going up 9.5 times faster than the
    average worker. We also saw reports that in 1980, the average
    CEO made 42 times what the average employee did, and then it
    was, 20 years later, 500 times--far higher than any country in
    the world, that ratio.
        We were also very much aware, Mr. Chairman, of those who
    questioned management's sincerity in saying that compensation
    should be related to productivity. Critics asked the question:
    Has management's productivity grown 9.5 times faster than the
    average worker? William McDonough, whom you know well, and
    someone I respect a great deal, head of the Public Accounting
    Board now but then-head of the Federal Reserve Bank in New
    York, in a widely publicized speech at the Trinity Church of
    New York, said the following: ``I am old enough to have known
    both the CEO's of 20 years ago and those of today. I can assure
    you that the CEO's of today are not 10 times better than those
    of 20 years ago.''
        Now, this huge imbalance between the compensation of senior
    executives and other management and workers has certainly
    contributed to the plummeting public trust. But as we looked
    further, Mr. Chairman, into this issue, I came to believe that
    the more dominant contributor to the loss of public trust were
    the highly publicized cases of excessive and, I would say,
    egregious compensation of CEO's in failing or failed companies.
    You will probably recall a Financial Times headline saying, ``A
    Stunning Payoff For Corporate Failure.'' Who could have not
    been impressed with the Fortune magazine cover showing kind of
    a rogues' gallery of CEO's, saying, ``You Bought, They Sold.''
    These were companies whose stock prices had fallen 75 percent
    or more shortly after they got big gains and the stockholders
    had big losses. As the headline of the Fortune article said,
    ``Since 1999, hundreds of Greedy Executives in America's Worst
    Performing Companies Have Sold $66 Billion Worth of Stock.'' In
    effect, the Fortune article seemed to be asking the corporate
    version of the Watergate question. It may be ironic that a
    Nixon Cabinet officer would bring up that metaphor but,
    nonetheless, it is appropriate: What did these executives know
    about their companies' declining prospects? And when did they
    know it?
        These kinds of public suspicions led to our recommendation
    of full, conspicuous, and readily understandable--plain
    English, plain sight--disclosures of all executive compensation
    arrangements. In addition, to reassure the public that senior
    management was not involved in stock transactions involving the
    company in advance of material information, we recommended that
    executive officers give advance notice of their intention to
    dispose of the company's equity securities.
        Now, why do I believe that excessive compensation at these
    failed or failing companies--rather than simply the overall
    increase in compensation--is the more dominant explanation of
    the precipitous decline in the public's trust? Mr. Chairman,
    you know that many Americans believe that the American Dream is
    a real possibility for them. Witness the interesting
    statistical anomaly that 20 percent of Americans believe they
    are in the upper 1 percent of income, and another 20 percent
    believe they will be someday. Moreover, $20 million salaries
    for genuine sports stars do not engender anything comparable to
    the criticism or anger engendered by executive compensation.
    Their success is perhaps seen as something to be admired as
    long as they perform, with the hope that they or their kin can
    someday achieve that success.
        In many of the corporate scandals, the public witnessed
    certain executives reaping unprecedented gains just prior to
    the time when their shareholders suffered huge losses, and many
    of their employees lost their jobs and at the same time saw
    their retirement savings suffer irreparable damage. You know,
    Mr. Chairman, that the most highly visible publicized case was
    the case of Enron. You may recall that Dan Yankelovitch, the
    well-known public opinion expert, reported that Americans were
    particularly outraged and frightened by widely publicized
    reports that restrictions that were placed on employees selling
    their company stock held in their retirement accounts during
    periods of rapidly falling prices were far greater than those
    placed on Enron's executives. Employees and the public alike
    saw this phenomenon as still another example of a rigged system
    that favored executives over nonexecutive employees.
        So after much analysis, our Commission came to this triad
    of principles that I will briefly review.
        Number one, a renewed focus on the long-term--and I
    emphasize ``long-term''--success of the company.
        Two, a renewed focus on corporate operating performance,
    not simply on stock price performance, which can obviously be
    capricious. With this in mind, the Commission recommended that
    very independent compensation committees who hired and fired
    any compensation consultants and suggested they should be
    unconstrained by industry median compensation statistics or by
    the company's own past compensation practices or levels when
    awarding senior compensation. We, instead, thought that the
    board should establish performance-based incentives that
    reinforce the corporate performance goals approved by the
    board, for example, return on equity, profit growth, cost
    containment, operating cashflow, cash management, and other
    nonfinancial objectives.
        Three, we emphasized there should be a renewed focus, Mr.
    Chairman, on long-term stock ownership which can validate
    operating performance and help drive long-term corporate
    performance, and more truly align the long-term interests of
    the shareholders with that of management. History teaches us
    that stock prices and operating performance can deviate a good
    deal over the short-term. But over the long-term, there is a
    much higher correlation. That is why we believe that it is
    critical to focus executive compensation on the long-term.
        Our recommendations longer holding periods for equity-based
    compensation and for substantial stock ownership requirements
    by senior management and directors that fit into this practice.
    If you think about it, Mr. Chairman, if we had just had the
    requirement of longer holding periods and long holdings of
    stock, many of the scandals that occurred would never have
    occurred in the first place.
        A few words about the fixed-price stock options which came
    to dominate the entire compensation field. They were not
    expensed and did not reduce operating earnings. Nevertheless,
    as I am sure you know, they conferred substantial tax
    deductions on employers. As a result, there became a
    perception, Mr. Chairman, in some companies that they were
    either free or very low cost. This, along with the 1993 tax
    legislation that I referred to, led to an absolute explosion in
    the number of these fixed-price options. For example, Mr.
    Chairman, in a very short period of time, stock options as a
    percent of total equity doubled, and in many, many cases, stock
    option gains came to dominate the compensation of executives.
    The combination, of one, huge number of options, two, a bull
    market; and three, short holding periods, led to be highly
    seductive in some cases and led to the practice of ``managing''
    short-term earnings. This phenomenon also led to unprecedented
    short-term gains by some executives--gains unrelated to
    corporate operating performance or, if you prefer, too de-
    linked from operating performance.
        We, therefore, came to believe that the elimination of the
    accounting bias toward fixed-price options, which we felt had
    led to an inadequate focus on operating performance, is one of
    the most powerful reasons to favor the uniform expensing of all
    forms of equity-based compensation. We would hope that the
    Financial Accounting Board and the International Accounting
    Standards Board would adopt a uniform standard, thereby
    increasing transparency and comparability among companies on an
    international basis, Mr. Chairman. The uniform expensing of
    equity-based compensation would also, we believe, improve the
    comparability of earnings among companies operating across
    different industries. I, at least, was surprised to learn that,
    whereas expensing of options in Standard & Poor companies
    generally would decrease reported earnings by perhaps 10
    percent, in the information technology industry the expensing
    of options would reduce earnings by approximately 70 percent.
        We believe that a more level accounting playing field would
    result in a far greater use of long-term compensation incentive
    programs that are closely tied to actual operating performance
    and that would not distort financial results for investors. If
    all forms of compensation were treated similarly in terms of
    their impact on profitability, then it seems to me that
    companies will be much more likely to choose programs that
    offer real, balanced incentives to help create long-term value.
        It pleases me to report that 175 of the Nation's largest
    500 companies have announced their intention to expense
    options. Even greater progress has been made in the important
    area of achieving better balance of power and checks and
    balances by either appointing a nonchairman CEO, a presiding
    director, or a lead director.
        Mr. Chairman, I want to assure you that we are not going to
    stand by and simply hope that the private sector will
    substantially improve their executive compensation practices.
    We are now very actively involved in getting a large number of
    corporate directors, CEO's, large investors, and others to
    participate in public advertisements and other public
    statements that pledge their companies and themselves to
    implement executive compensation principles I have just
    outlined.
        To sum up, Mr. Chairman, we thank you warmly for your
    constructive efforts in formulating and passing the Sarbanes-
    Oxley legislation. At the same time, before developing further
    legislation, particularly in the area of executive
    compensation, we ask that you give those of us in the private
    sector some time to make the changes that are so obviously
    needed.
        Thank you, Mr. Chairman.
        Chairman Shelby. Thank you.
        Mr. Larsen.

                       STATEMENT OF RALPH LARSEN

                    FORMER CHAIRMAN OF THE BOARD AND

               CHIEF EXECUTIVE OFFICER, JOHNSON & JOHNSON

        Mr. Larsen. Thank you, Mr. Chairman. Picking up on Pete's
    comments, I would like to just give you my personal perspective
    on the reception and impact of the Sarbanes-Oxley legislation
    and make some other points. I, obviously, cannot speak for
    other chief executive officers, but in talking with a wide
    range of business leaders, I sense that the Sarbanes-Oxley
    legislation has been well received and is well on its way to
    being implemented.
        The legislation has had, I think, significant positive
    impact in a number of important areas, specifically increased
    director engagement, awareness, and expertise; increased
    disclosure and transparency in financial reporting; a
    significantly heightened sense of personal responsibility and
    attention to detail. And I think those things are very
    important.
        So, on balance, I think the legislation has been accepted
    well in corporations throughout the United States, and their
    directors and senior executives are working hard to fulfill all
    of its requirements. And I can assure you based on everything
    that I have seen that Sarbanes-Oxley is being taken very, very
    seriously.
        With that said, I would like to focus my comments this
    morning on just one point that I think is vitally important,
    and it is something that I am sure each person in this room has
    learned through their own life experiences, and that is, the
    importance of the tone at the top.
        Clearly, it is essential that we have a basic structure and
    framework of laws and regulations to define the boundaries of
    acceptable personal and corporate behavior. But, I would argue
    that all of the laws in the world cannot ensure that
    corporations or the individuals that run them will perform with
    integrity day in and day out. The reality is there will always
    be those few souls who are inclined to compromise, or to put it
    bluntly, chisel or to connive, or who lie awake nights
    conniving how to circumvent laws.
        But after 40 years in business and 13 as a chief executive
    officer, one of the most fundamental things that I learned is
    the importance of a values-based culture to the success, the
    long-term success of the enterprise. A culture that honors
    integrity and demands it of all.
        I also learned that the example set by the chief executive
    officer of a company has a profound and far-reaching impact on
    how the entire organization behaves. For better or worse, the
    tone at the top largely establishes the cultural norm within an
    organization. It defines what is acceptable and what is
    unacceptable. I learned that, yes, people listened to what I
    said in the endless speeches that I gave, but much more
    importantly, they watched how I behaved, particularly when the
    going got tough and the stakes were high. They watched as a
    management to see whether we made ethical decisions, whether
    our walk matched our talk. In our company culture, we
    encouraged people to challenge our decisionmaking process, and
    we tried to make it as open as possible.
        I was particularly struck by how closely they followed and
    often emulated the processes by which we made our business
    decisions, particularly when we were wrestling with issues in
    which there was no clear right and wrong, where we were
    operating in uncharted waters. They watched whether we strove
    for ethical solutions to the issues at hand. In the give and
    take of internal debate, was the conversation and the
    discussion honorable? Was it honest? Was it transparent? Did we
    make it clear that integrity, both personal and corporate, were
    of paramount importance? Or did we somehow signal that we were
    willing to consider bumping up against the ethical line if the
    stakes were high enough?
        The reality is, and the point I am making is, that
    individuals and organizations learn most quickly and most
    memorably by watching the conduct of their leaders. If you have
    questionable ethics at the top, that tone will permeate the
    entire organization, and it will poison ultimately the entire
    organization. To put it plainly, you show me a conniver at the
    top, and I will show you a corporation headed for big-time
    trouble.
        The good news here is that the boards of directors and
    chief executive officers are focusing as never before on the
    importance of personal integrity and a values-based culture.
    They are focusing on it because they realize that in order to
    thrive and prosper over the long-term, businesses must be built
    on trust. It must be trusted by all of its constituency--
    customers, employees, share owners, and, yes, government.
    Boards realize that in any large organization with people
    scattered all over the world, a values-based culture is the
    only way to ensure that the enterprise for which they stand
    responsible does not engage in misconduct, does not break
    trust, and does not become tomorrow's headline.
        The scandals of the past few years have once again
    demonstrated the importance of the tone at the top--a tone that
    makes it clear through word and personal example that a
    commitment to the highest ethical standards are the way the
    business will be run, and nothing less is acceptable.
        This point is made well in the Commission's report. We
    stressed the importance of the board of directors' assessment
    of ethical values in choosing a chief executive officer and
    gauging their performance over time. We emphasized the
    importance of having tools and processes to measure and
    evaluate their adherence to ethical standards. And we
    encouraged ways to ensure that those standards were promulgated
    down through the organization in a clear and effective way.
    And, finally, we stressed the need for a reporting mechanism to
    allow employees to safely report their views on misconduct.
        In summary, while the well-publicized behavior of a few
    individuals and companies give us much to be concerned about,
    the fact is, I believe, that there is much to celebrate. We
    have the greatest and most inventive economic system in the
    world. We have a wonderful group of growing and vital
    companies. And I believe that the vast majority of men and
    women in senior management positions in our companies in the
    United States are decent and honorable men and women who are
    striving to do the right thing in the face of a very
    complicated and competitive world. And, by and large, they are
    men and women who recognize that the most fundamental
    responsibility of leadership is to set the proper tone at the
    top.
        Thank you very much.
        Chairman Shelby. Thank you.
        Mr. Bowsher.

                    STATEMENT OF CHARLES A. BOWSHER

                    FORMER CHAIRMAN, PUBLIC COMPANY

                       ACCOUNTING OVERSIGHT BOARD

        Mr. Bowsher. Thank you very much, Mr. Chairman, Senator
    Sarbanes, and Members of the Committee. It is a great pleasure
    to be here today.
        One thing I would like to do is start out by saying that I
    think the Sarbanes-Oxley Act is really an excellent piece of
    legislation, especially in the auditing and accounting area,
    which I have spent most of my life and career working in. It
    was long overdue, and many of the things that you have in that
    legislation really were taken from past efforts in the private
    sector on various commissions, blue-ribbon panels, and things
    like that to try to improve the accounting and auditing in this
    country. But a lot of it did not ever get accomplished, and now
    it has been codified in the Sarbanes-Oxley Act, and I think
    things are moving ahead. I agree with Chairman Peterson and my
    predecessor, Mr. Larsen, and I am sure Paul will agree that we
    are making real progress here in the private sector at this
    point in time.
        One of the first issues in our report in the accounting and
    auditing area, which was the third section of the conference
    report, was the emphasis on the audit committee, because,
    again, as Ralph points out, the tone at the top really sets the
    way things go in these big organizations. And what we have
    pointed out is that it was awfully important to get qualified
    people--not only independent people but also qualified people--
    people who were financially literate, serving on the audit
    committees so they could ask the tough questions not only of
    management but also of the auditing firm and the internal
    auditors. And we think that there is progress being made here,
    but this is one area that the Committee should follow very
    carefully and maybe have the SEC monitor it and give you
    updates as to how it is moving along, because I think it is
    essential to really getting the accounting and auditing
    scandals behind us to have first-rate audit committees serving
    on the boards representing the investors of this country.
        I have served on some boards here and some audit
    committees, and I can tell you I see a huge difference between
    when I first went on in 1997, when I left the Government, and
    the current time. I am on a New York Stock Exchange company in
    Chicago where the first meeting lasted a half-hour, and I do
    not think there were any tough questions asked of anybody. Just
    a month ago, when we were closing out the fiscal year of June
    30, we had 6-hour audit committee meeting. We now have the
    right people serving on the audit committee. We have the
    questions being asked. We have the auditing firm identifying
    the major issues in two- and three-page memos to the audit
    committee, and it just is so much more professionally done with
    everybody playing the part that they are supposed to play. So,
    I think the audit committee is very crucial, and although
    progress is being made--I think that General Electric is a good
    example that Ralph serves on. They set the tone when they made
    the changes right away.
        The first issue we did recommend in the Conference Board
    report is that sometimes it is not so easy to ask people who
    have been serving with you to step aside, maybe because they do
    not have the right qualifications. So we recommended that
    bringing in a law firm or a consulting firm to evaluate the
    audit committee membership and to see if everybody should be on
    that committee is a good way of doing it and making progress.
        The second issue we took up was really on the continuing
    education and the need of education and training for audit
    committee members. When you looked at the unfortunate gentleman
    who represented Enron's audit committee, you recognized that
    this was a gentleman who had impeccable credentials, but
    probably really was not current on this very intricate world of
    derivatives and the financial instruments that the investment
    bankers are selling these days. And so you have to understand
    the business that you are serving on the board and on the audit
    committee, and you have to keep up through training and
    education and everything like that.
        The third issue area that we took up is the internal
    control, Section 404, which is becoming more and more now an
    important issue, as you indicated, Senator Shelby, in your
    opening statement. This is to me one of the really most key
    parts of the Sarbanes-Oxley bill because what it really is
    saying is that in 1933 and 1934, when the Securities Act was
    passed, why, you required that all public companies have an
    annual financial report, management's responsible to produce
    that, but to have an outside independent accounting firm come
    in and check it out and give a certificate on it.
        Over the years, we have never really had strong
    requirements to make sure that the accounting systems
    underneath those financial reports were properly in place,
    properly documented, or properly checked out. That is what
    Section 404 says. And it will cost some money as an investment
    for the companies.
        But I would just like to read one paragraph from my
    prepared statement that says this: ``For companies that have
    adequate and well-documented internal controls and an adequate
    internal audit function''--which now the New York Stock
    Exchange requires--``it will not find the reporting on internal
    controls to be a major or costly effort. However, those
    companies that have not put an emphasis on internal controls
    will have a one-time investment to make, but investors will be
    much better protected once management and outside auditors can
    attest to proper internal controls. This area is the basic
    framework for the CEO and CFO certifications regarding the
    annual financial statements and quarterly reports.''
        If I could just amplify a little bit on that, once you get
    your internal controls in shape in the big companies, they are
    going to ask the division vice presidents and the people down
    the line to certify, too, so that when the CEO and the CFO are
    certifying, they are doing it because their senior management
    has already checked out things. If you have the right internal
    controls, the internal auditing checking it out, management
    certifying, the CPA firm checking things out, then reporting to
    the audit committee, I think it is going to be very seldom that
    we will run into the cases like WorldCom where they were
    slipping through journal entries at the end of the year to cook
    the books. And that is really what we are trying to change and
    provide here.
        I might also say on the cost, we recommended to this
    Committee and to the Congress after the S&L crisis that this
    type of reform be included in the banking reform legislation of
    1991. I remember a lot of lobbyists being paid a lot of money
    to come over here and say this would be the end of Western
    civilization if you left that in the bill.
        Chairman Shelby. Some of us were here.
        Mr. Bowsher. Yes. But, you know, a few years later, I went
    on the board of an international bank, and I asked them at the
    annual presentation, and they said, no, it is fine, it was a
    good reform, it is working fine. And if you think about it
    today, we have not had many failed banks, only really a couple
    scandals with failed banks. But the banking legislation, I
    think, has contributed dramatically to the success that we have
    had there of getting rid of the problems that we had in the
    late 1980's and the early 1990's. And Section 404 really is a
    takeoff practically from that legislation and that success. And
    I think when we get it achieved in the corporate world, it is
    going to make a big difference for everyone. And when you think
    of the cost, the losses that we had in these scandals, why, the
    individual costs to the companies to get their things
    straightened out I think will be very much an economic thing.
    In fact, I think Chairman Donaldson once said, ``Benefits of
    new rules will outweigh the cost.'' And I do not think there is
    any question about his position.
        The next issue area that we spoke to was on rotation of
    auditing firms. Now, this is something that the auditing firms
    do not like. I want to be upfront with you on that. And I know
    that in the Sarbanes-Oxley bill you asked the GAO to do a study
    on rotation, and they have not quite completed that report, and
    it is coming over to you here, I think, in the next few weeks.
        But the one thing we said is the private sector should
    consider audit rotation, no matter whether it is required or it
    is not required by the Government, and we laid out just a
    couple of criteria here. We said any audit firm that has been
    employed by the company for a substantial period of time, say
    over 10 years, would be one thing to consider. Another would be
    if you have former partners or managers of the audit firm
    employed by the company. If you remember the Enron situation,
    all of the accounting staff practically had come from the
    accounting firm. Or if you were still having significant
    nonaudit services provided by the company, in other words,
    getting to the independence issue here.
        I might say that Mr. Breeden's report recently here on the
    WorldCom reform did pick up our first item and said that every
    10 years the auditors should be rotated.
        This is just something, I think, that is awfully important
    for the audit committees to consider, and they certainly should
    be considering that after 7 to 10 years. But we have 7 years in
    our report--or 10 years, I guess, in our report, but I know
    some are thinking of 7 years.
        The next two issue areas Paul Volcker, my colleague here,
    will discuss in our accounting and auditing, and that is on
    professional advisers for the audit committees and also the
    outside services performed by the accounting firms.
        Chairman Shelby. Thank you.
        Dr. Volcker, welcome back to the Banking Committee. You
    spent many days and hours here when you were Chairman of the
    Federal Reserve.
        Mr. Volcker. Indeed. The Committee room is the same. Even
    some of the Senators are the same.
        [Laughter.]
        Mr. Volcker. It is nice to be back.
        Senator Sarbanes. The one thing that is different now is we
    have a no-smoking rule.
        [Laughter.]
        Senator Sarbanes. In those days, the room would be
    enveloped with smoke when Paul Volcker testified.
        Mr. Volcker. Some of my valued pictures at home show me
    behind cigar smoke in this very room. I remember those days.
        Mr. Peterson. Senator Sarbanes, I used to accuse the
    Chairman that his blowing smoke was his particular technique
    for the kind of creative obfuscation that some Chairmen used.
        [Laughter.]
        Chairman Shelby. Well, Dr. Volcker is not known for that,
    though.

                      STATEMENT OF PAUL A. VOLCKER

               FORMER CHAIRMAN OF THE BOARD OF GOVERNORS

                     OF THE FEDERAL RESERVE SYSTEM

        Mr. Volcker. The policies were very clear, despite the
    smoke. That is my defense.
        I am at the end of this distinguished panel here, and I
    will be short. Chuck just mentioned I have been asked to
    mention specifically and comment on the recommendations of the
    Conference Board Commission on access of auditing committees to
    professional help and the controversial area of the services
    that auditing firms might perform. But before commenting on
    that briefly, I just want to join my colleagues here in saying
    that nothing has happened since this bill was passed to suggest
    the thrust and the detail of the bill were not appropriate. We
    are still being barraged, as you well know, week by week,
    almost day by day, with indications of performance by our big
    accounting firms that simply do not meet the standards that we
    expect and must demand and that are required by Sarbanes-Oxley.
    The quicker we can make that history and not current and
    future, the better off we will be.
        It is maybe a sad story that that great profession has lost
    its discipline and lost the primacy that the auditing function
    deserved and needed to be informed by constructive legislation.
    I congratulate you on doing that.
        In areas that I was asked to comment on, Mr. Bowsher
    certainly made clear the burdens on auditing committees these
    days, and that is one the primary results of this legislation--
    in fact, demanded by this legislation. It is an entirely
    different atmosphere for auditing committees. And there is a
    common-sense--I believe it is common-sense--recommendation that
    the Commission made consistent with the burden on auditing
    committees, they should feel free to engage outside
    professional help, and they should have the authority to do
    that and feel free to do that in discharging their
    responsibilities. It sounds to me like common sense at this
    point, but I am sure it has not historically been the practice
    in the past where there was not that feeling of professionalism
    and independence in the auditing committees, or at least too
    often that was lacking. So that seems to me pretty
    straightforward.
        The other area has been more controversial, and that is the
    question of what services accounting firms should be providing
    and the degree to which they may conflict with the primary
    auditing responsibility. As you well know, the Sarbanes-Oxley
    bill attacks that head on by indicating some important, almost
    dominating services that accounting firms were performing for
    auditing clients would not be permitted and others might be
    permitted with the careful consideration of the auditing
    committee, which in turn may ask for outside advice.
        That no longer, I think, in terms of what the bill suggests
    is particularly controversial, but there is one area that
    remains open that the bill did not deal with that I think very
    much does deserve consideration and action. That is in the area
    of tax services. To some degree, auditing firms have
    traditionally provided tax preparation and other tax services.
    What is relatively new is the emphasis that these firms have
    put on a very profitable activity, what I would term as
    ``aggressive tax planning.'' And that is an area in which I
    think we have seen dramatic indications since the bill was
    passed of the potential conflict that that involves. When a
    firm is involved at one and the same time in advising a firm
    or, in cases that we have seen, advising the senior officers of
    that firm, on elaborate schemes for tax evasion. That requires
    a psychological approach of let's see how we can get around the
    rules. Then being asked to audit the firm in terms of whether
    it is following the tax rules and the accounting rules is a
    rather basic problem.
        Fortunately--and I think deliberately--the bill has
    provided authority to the SEC or to the Public Company
    Accounting Oversight Board, if I have got all those initials or
    words straight in order, to review that matter. And the SEC, as
    I understand it, took a look at it and said, ``well, we will
    pass that on to the Board,'' and the Board, I believe, has that
    on their agenda. And I think that is an area that should be
    followed. It is a difficult and subtle matter, perhaps, to
    define what is appropriate and what is not appropriate. But at
    the extremes, I think it is clear enough. I would like to think
    that there are some very common-sense criteria. If an
    accounting firm is involved in advising a firm or its
    executives to use three offshore tax havens and gets a success
    fee for the tax savings, you begin to get suspicious that that
    may involve a conflict and be inappropriate.
        Let me, if I may, just very briefly talk about
    compensation. I cannot match the eloquence that Mr. Peterson
    brings to this subject, but I do want to reinforce the point
    that I think the root of these egregious excesses has been the
    increased use of fixed-price stock options, which happened to
    coincide in a way nobody expected with this historic boom in
    the stock market, resulting in compensation amounts beyond
    earlier imagination. But once you have them, they begin seeming
    normal. You have seen no greater example of that than in the
    recent developments in the New York Stock Exchange, which did
    not directly involve stock options, but it certainly involved a
    mentality that said everybody else is getting rich in stock
    options, we should do something for this fellow. And it just is
    an example of how these things spread because of the stock
    options.
        I think pricing of stock options and expensing of stock
    options involves some very difficult issues. I am happier about
    the tendency beginning in some business firms to recognize that
    fixed-price stock options for big public companies really
    involves capricious compensation results demonstrably bad and
    perverse incentives that focus on the short-term stock price
    rather than the continuing value of the business. And it has
    led to demonstrable distortions in business behavior.
        I am delighted that we are beginning to see even in
    Microsoft, a great new-technology company, deciding that stock
    options are not an appropriate method of compensation.
        I would make one other point. We have had a lot of
    concentration on auditing, deservedly so. Auditors have a
    special responsibility. But I do not think we should lose sight
    of the fact that the responsibilities of other so-called
    gatekeepers in the financing process have fallen by the wayside
    too often. Accounting firms have not been alone in designing
    and encouraging elaborate schemes to circumvent accounting
    principles, to dodge taxes, and to embellish and smooth
    earnings. Far from it--I am quoting from a speech I gave
    recently:

        Far from it, there were battalions of investment bankers,
    lawyers, consultants, and financial engineers prepared to go to
    the edge or even beyond ethical practice. Too often they have
    lent their professional authority to practices of their own
    clients that fraudulently misrepresent operating results. In
    the process, investors are ill-served and the long-term
    prospects for the business jeopardized.

        I say all that to reinforce the importance of what Ralph
    Larsen is talking about. If the top of the firm is not setting
    and following ethical standards themselves, you cannot rely
    upon these professional advisers and their clients to do it for
    them.
        Chairman Shelby. Thank you. I thank all of you.
        Mr. Peterson--or Secretary Peterson, as I remember you--
    your report proposes alternative means to address what we call
    the imperial CEO that characterized many of the recent
    corporate scandals. What is your perspective on the governance
    issues at the New York Stock Exchange that has been in the news
    so much lately?
        Mr. Peterson. I will probably get in trouble for saying
    this----
        Chairman Shelby. Oh, you will not get in trouble, not here.
        Mr. Peterson. I have done it before. The only thing, Mr.
    Chairman, anybody ever remembers about my service as Secretary
    of Commerce is an indiscreet comment I made that I could not
    pass the physiological loyalty test. My calves were so fat I
    could not click my heels.
        [Laughter.]
        And that is the only thing that is remembered that I did.
        But it is indeed ironic that the New York Stock Exchange
    that saw fit to have a group of corporate CEO's make
    recommendations for corporate governance and independence and
    lack of conflict in the companies that were operating under the
    New York Stock Exchange would itself indeed practice some
    egregious negative examples of the very principles that they
    were espousing.
        I chose to talk to you today about executive compensation,
    and I said there is nothing more important than a thoroughly
    independent, unconflicted compensation committee.
        Now, if you look at the interlocking relationships on the
    New York Stock Exchange, I think it violates the very
    fundamental principle that we are talking about. So, again, I
    would be indiscreet in saying it, but I would not be surprised
    if someday at the Harvard Business School the New York Stock
    Exchange will be used as kind of a poster child of things to
    avoid in the areas of corporate governance.
        Chairman Shelby. Thank you.
        Mr. Larsen, it seems like companies evaluate corporate
    ethics by looking at whether they have complied with the rules
    in the employee handbook at times. But would you elaborate on
    how you would move beyond technical compliance to fundamentally
    change the corporate culture?
        Mr. Larsen. Mr. Chairman, I think it is a difficult thing
    to do. You cannot legislate morality, and you cannot legislate
    a good heart.
        Chairman Shelby. Ethics, anything like that.
        Mr. Larsen. It is very difficult.
        Having said that, I think it starts with choosing a chief
    executive officer, a senior management that you know, that you
    have confidence in that person's character and reputation. I
    mean, typically, by the time somebody reaches that level, they
    have been in business for 20 or 25 years. They have developed a
    track record. You should be able to divine that. Some people
    may go bad at the end, but not usually. And my experience is
    that, as you watch young executives coming up, there will be
    some who have a tendency to bump up against the line. And I
    have always taken the position of getting rid of them because
    they will get us in trouble someday. Getting rid of them early
    before they can cause big-time trouble.
        So, I think it is a cultural thing that has to start at the
    top, but it has to be reinforced by the board of directors
    making sure that they make it clear to everybody that it is a
    fundamental requirement. But it is a cultural issue. It takes
    years to build up, and it is greatly influenced by the tone of
    the individual that is on top.
        Mr. Peterson. Ralph, if I may interrupt, I think the
    Senators might profit from a brief discussion of your credo and
    how you implement it, because I think it is one of the most
    innovative and basic I have seen anywhere in America.
        Mr. Larsen. What Secretary Peterson is referring to is we
    have a very simple document within Johnson & Johnson. It was
    written back in 1940. It was revolutionary at the time. It says
    that our first responsibility as a company is to our customers,
    to do what is right by them and provide them with good-quality
    products at fair prices. Our next responsibility is to our
    employees, to treat them fairly, with dignity, and respect. Our
    third responsibility is to the communities in which we operate,
    to be good corporate citizens and to enhance the environment.
    And, finally, we say that if we do a good job in those three
    things, the shareholder will come out okay. And that is exactly
    what has happened over all of these years.
        But what it has done for our employees and, frankly, for me
    as a chief executive officer, is I did not have to think too
    hard about what our principles were. I mean, our first
    responsibility was to our customers, then to our employees,
    community, and then the shareholders will do okay. We never
    focused on the stock price. We never focused on shareholder
    return in that sense. That was the end result of good
    management and good ethical behavior. And then we have a whole
    set of mechanisms where about every 2 or 3 years worldwide, our
    people fill out an anonymous survey judging their local
    management on how well they are adhering to the ethical
    principles of the credo. And it is not healthy for management
    to get a bad score in that regard.
        Chairman Shelby. Thank you.
        Senator Sarbanes.

                 STATEMENT OF SENATOR PAUL S. SARBANES

        Senator Sarbanes. Thank you very much, Mr. Chairman, and I
    apologize that I was detained and was not here at the outset.
        Chairman Shelby. You should have been here. They were
    saying nice things about your legislation.
        [Laughter.]
        Senator Sarbanes. I caught part of that, so I did not miss
    it entirely. But I want to take just a couple of minutes to
    make a statement.
        First of all, I want to commend Chairman Shelby for holding
    this informative and productive series of oversight hearings on
    the legislation that we developed last year. I think this was
    an opportune time to do it as we approach the end of this
    session of the Congress. The legislation was signed a little
    over a year ago, and while not everything has yet been fully
    put in place, it was an opportune time to take a look.
        We heard from Chairman Donaldson of the SEC, Chairman
    McDonough of the PCAOB, and leaders from the accounting
    industry and institutional investors, and we have this panel
    and another distinguished panel to follow this one this
    morning.
        First of all, I want to particularly acknowledge the work
    done by the Conference Board's Commission on Public Trust and
    Private Enterprise. Four of its 12 members are at the table
    before us, and I just want to mention the names of the others,
    because it really an all-star group. In addition to the four
    witnesses here this morning, John Snow, who, of course, is now
    Secretary of the Treasury; John Biggs, the former head of TIAA-
    CREF; John Bogle, Founder and former Chairman of Vanguard;
    Peter Gilbert, the Chief Investment Officer of the Employees'
    Retirement System of Pennsylvania; Andy Grove, the Chairman of
    Intel Corporation; Arthur Levitt, former SEC Chairman; Lynn
    Sharp Paine, Professor at the Harvard Business School; and our
    old colleague, Warren Rudman. And I have to say this was really
    an all-star panel, and its charge as it launched into its work
    when it was convened, was, ``to address the causes of declining
    public and investor trust in companies that are leaders in
    America's capital markets.''
        In undertaking this inquiry, the Conference Board acted on
    the underlying commitment that dates back to its founding
    nearly a century ago in an earlier contentious period of market
    activity, ``to create and disseminate knowledge about
    management and the marketplace to help businesses strengthen
    their performance and better serve society.'' And the
    Commission went on and defined the crisis in stark terms: ``A
    clear breach of the basic compact that underlies corporate
    capitalism.''
        The Commission found that in many instances this compact
    among shareholders, boards, and management has been
    significantly weakened, diminishing the trust that investors
    and the general public have in our system of corporate
    governance.
        Of course, the Commission has come forward with a set of
    recommendations and findings. The Conference Board has also
    recently published a set of corporate governance best
    practices. And I think they have made an extremely important
    contribution to trying to address this issue.
        The statute is by no means the be-all and end-all. It is
    really to provide a basic framework within which activities
    will take place. But as the Conference Board's Commission has
    indicated--and we have efforts now on the exchanges with
    respect to their listing requirements; we have other efforts
    going on in the private sector with respect to best practice--
    there is a considerable amount that needs to be done
    complementary to or in addition to the parameters of the
    legislation. So, I really want to pay my respects to the work
    of the Conference Board and their recommendations.
        Now, before my time completely expires--and presumably I
    will get another round.
        Chairman Shelby. You will get another round.
        Senator Sarbanes. I just wanted to ask just a question or
    two.
        I want to address this internal controls issue for a
    moment, Section 404 of the legislation, management's annual
    assessment and independent auditor attestation of the internal
    controls. We are getting some complaints, of course, about the
    costs of complying with this. One of the witnesses in the panel
    to follow you states in his written statement, ``My overall
    concern here is that both reporting companies and external
    auditors will spend an enormous amount of time, energy, and
    money to ensure compliance with Section 404 without necessarily
    achieving the desired outcome of ensuring that companies have
    systems in place to identify potential weaknesses in their
    financial reporting.''
        And another witness on the next panel predicts that ``the
    SEC's rules relating to internal controls over financial
    reporting may provide to be the most costly of the Sarbanes-
    Oxley Act reforms.''
        And I put to the panel: How important are the provisions of
    Section 404 on the maintenance of sound internal controls by
    public companies? What is the source of these increased costs
    that they make reference to? And what is your response to these
    criticisms?
        Mr. Bowsher, let us start with you? Then the others can
    add.
        Mr. Bowsher. Well, as I said in my testimony there, it is
    an investment that has to be made. How large is the investment
    that a company has to make? It depends on what the status of
    their controls is right now, and they should be in good shape.
    But lots of times, unfortunately, they are not.
        And so those companies will have to make quite an
    investment, but it is an investment that they cannot afford, it
    is not an investment they should be making to protect their
    investors, their workers, and the pensions for their workers.
    In other words, you cannot run a large company today and not
    have a good set of internal controls without sometimes running
    into big trouble.
        I remember I went on one board, a major New York Stock
    Exchange company, when I left the Government, and I asked all
    the right questions at the first audit committee meeting about
    are the controls in place. I was told, oh, yes, they are in
    place, and the auditors were there, and they agreed with it.
    The financial statements, I especially worried about the
    inventory because it was a manufacturing company. Oh, no
    problem there.
        And then two meetings later, why, we found out, we had all
    kinds of problems in the financial reporting. At the end of the
    year, the outside auditors even said we had a material weakness
    in how we closed the books--which we did. They were right. They
    were just about 5 years late in telling the audit committee or
    the board about these problems. And we got them cleaned up in 6
    months. We spent a lot of money because by that time you are in
    a crisis mode, and you are trying to get it all done.
        But I think if you would go about it in an organized
    fashion--the SEC and the PCAOB has given industry another year
    to do this--I think the companies that are in good shape will
    not have that big of a cost. I think the others need to spend
    the money to get their controls in place.
        Again, it is the underpinning of the certifications that
    the CFO's and the CEO's have to make.
        I was at one audit committee meeting recently where
    somebody raised the issue of cost because it was costing this
    firm. And I always remember the CFO and the CEO saying, ``well,
    if we have got to certify, we sure want this work done and we
    want this in good shape.'' So, I think that is the issue.
        Senator Sarbanes. Does anyone else want to add to that on
    the panel?
        Mr. Larsen. I agree with Mr. Bowsher's observations.
        Senator Sarbanes. My time has expired and I have other
    questions, but just let me make this observation. We talk about
    these internal controls as helping the investors, but it seems
    clear to me it helps the management. I would think that the
    management of a corporation of any consequential size would
    want strong internal controls in order to enable them to really
    know what is going on and exercise control over their company.
    So it is not something that management just does to help the
    investor, although that is an important part of it. It seems to
    me it is a real tool for management itself.
        Mr. Bowsher. Absolutely. In fact, if you look at a lot of
    the bankruptcies and companies that have to get acquired, a lot
    of times it is the fact that management did not have that
    attitude.
        If you remember the Bank of New England, which was one that
    went under 10 years ago, it had done a lot of acquisitions. It
    did not get control of their accounting, and pretty soon they
    did not know what was happening, and all of a sudden the
    cashflow ran out.
        So management has a huge stake in whether they have good
    controls or not, absolutely.
        Chairman Shelby. Senator Allard.

                    COMMENTS OF SENATOR WAYNE ALLARD

        Senator Allard. Thank you, Mr. Chairman. I also apologize
    for being late. I have an opening statement I would like to ask
    be made part of the record.
        Chairman Shelby. It will be included as part of the record
    in its entirety.
        Senator Allard. Dr. Volcker, a GAO study completed in July
    that examined the impact of mandatory rotation of registered
    accounting firms, concluded that mainly the Big Four were the
    firms doing the majority of the auditing of public firms, and
    that the medium-size or smaller firms were facing some
    significant barriers into the market. Last week, the Chairman
    of the PCAOB appeared before the Committee and seemed to agree
    that a disparity did exist, and that the PCAOB could nurture
    and cherish the small and medium-size companies to see that
    they enter the auditing market.
        First of all, from your observations, do you agree with the
    GAO and the Chairman of the PCOAB assessment? If so, what do
    you believe we could do to break down some of those barriers?
        Mr. Volcker. Your stumbling over these initials matches my
    own. I would recommend maybe you amend this bill so we would
    have simpler initials for this board.
        I am not familiar with the report of the GAO in this area
    and the particular contrast that you are drawing. My experience
    has mostly been with these big companies, and in the area that
    I have been concerned with, with these conflicts in the variety
    of services, it is the big companies that are totally dominant
    in auditing big companies. The big accounting firms are
    dominating in auditing the big companies, and that is where the
    problem lies.
        I cannot comment on, I think, the typically more
    specialized firms or firms that deal with very small companies,
    and I am not aware of so many problems there.
        Senator Allard. Maybe other members on the panel would like
    to respond to that comment.
        Mr. Bowsher. Yes, I can comment. What you have is an
    unfortunate situation where we have too much of a consolidation
    in our accounting profession. We had eight big firms for many,
    many years. In fact, when the Moss-Metcalf hearings were held
    in the late 1970's, it showed that the concentration of the
    auditing firms was not near as great as maybe the industry was
    by industry classification. But then they consolidated down to
    four, and they really were planning to go down to three. KPMG
    was going to merge with Ernst & Young. And, luckily, they
    called that off because with Andersen disappearing, we would be
    down to three now instead of four.
        And they do a very high percent of the audits of all the
    big companies, not only in the United States but also all over
    the world. I mean, it is 85, 90 percent when you look at the
    dollar value. And so this is a problem.
        There has always been this wish and hope that these medium-
    size firms would grow up into being the big firms and small
    firms could grow up. But it has not happened in the last 20,
    30, 40 years because now the investment to come into the
    business, to have overseas offices and everything like that, is
    very difficult.
        I see this as a potential problem down the road, no
    question.
        Senator Allard. Yes, and especially if you have a
    corporation that is looking at rotating your auditing firm.
        Mr. Bowsher. Right, right.
        Senator Allard. Pretty soon you run out of choices out
    there, and I think that has to be----
        Mr. Volcker. Rotation may not mean very much when you have
    only got four firms. There are not many people to rotate to.
        Senator Allard. Yes. I also have talked to a few
    accountants and understand that some of the smaller
    corporations that are now public firms may decide to go out of
    the public realm and go into more of a private realm. Do you
    see that happening at all? Or is that in your observations?
    Anybody?
        Mr. Volcker. I have a great sample of one. I know a friend
    of mine that runs a small public firm is considering going
    private because he thinks the auditors have become too tough
    now. I would not generalize from that particular experience,
    but in relation to Senator Sarbanes' earlier question, I think
    this bill was really aimed at big public companies. That is
    what we are talking about, and the comments Mr. Bowsher made
    about that are relevant. If you have a really small company--
    and some are simpler than others--some of this seems a little
    burdensome. But I think this can be hopefully alleviated by
    common sense and administration.
        Senator Allard. So at this point, you would consider that
    would not be a big concern to----
        Mr. Volcker. No, I would not think it is a big concern, but
    I understand that----
        Senator Allard. I appreciate that. Yes, I do, too.
        It has been about a year now since Sarbanes-Oxley was
    signed into law. After this first year, what observations would
    you make about Sarbanes-Oxley as far as potential changes that
    may be needed in the near future? I am not talking about, you
    know, 10 years out, but maybe within the next 4 or 5 years? Or
    do you see any? Anybody want to comment on that?
        Mr. Bowsher. I would stick with the Chairman's opening view
    there, that we should give this enough time, a longer period
    than 1 year, and let the private sector have time to implement
    it. I think all of us believe that they are making progress
    here, but I think in 3, 4, or 5 years it would be worth looking
    at.
        Senator Allard. I want to push that a little further. Any
    potential areas? Yes?
        Mr. Volcker. I have a special pleading here, which really
    is not special pleading. But I have responsibilities with the
    international accounting framework in an effort to get
    consistency around the world. And the concern reflected in
    Sarbanes-Oxley about the equivalent U.S. body, FASB, about how
    they are financed has been dealt with by providing a mechanism
    for the assured financing of FASB. I was disappointed that you
    did not extend that explicitly to an American share of the
    International Accounting Standards Board, because we have the
    same problem. We have the same question that arises. I do not
    think there is really a great substantive problem, but we are
    financed by voluntary contributions from accounting firms and
    major international businesses.
        I presume we can continue that way, but we have also been
    looking at alternative methods of financing that might provide
    greater assurance of independence if necessary. And I would
    like to think that this bill even could be interpreted as
    permitting FASB to extend some of their financing to us for the
    U.S. share of the IASB. It is a relatively small amount
    compared to what FASB spends, but I think it is a relevant
    issue given the importance of international accounting
    standards.
        Senator Allard. Thank you for your comments. I see my time
    has run out. Thank you, Mr. Chairman.
        Chairman Shelby. Thank you, Senator Allard.
        Senator Corzine, we have a few minutes. Do you want to
    start?

                   COMMENTS OF SENATOR JON S. CORZINE

        Senator Corzine. Well, I want to commend----
        Chairman Shelby. We have a vote on the floor----
        Senator Corzine. --you, Mr. Chairman, for bringing such a
    distinguished panel. There are not four better minds to speak
    to the issue that we are doing in the review of this, and I
    compliment all of them for their contributions, not only with
    regard to corporate governance and ethics and all the other
    issues that you have addressed, but also for your leadership in
    the country as well.
        I particularly want to say that Chairman Larsen is a person
    that I am distinctly proud of, being a New Jersey-based
    company, and the values that he talked about are exhibited by
    the company that he led very clearly in the community and
    society in general. A remarkable period of leadership.
        All those nice words. Let me ask a couple of questions that
    you might not interpret quite so nicely.
        You know, I look at what happened to the New York Stock
    Exchange, some of the things that we see in mutual fund
    practices and governance issues that are associated with that.
    My own anecdotal feel with regard to the sniping and griping
    about Section 404 and some of the questions that have come up
    and resistance to shareholder resolutions and proxies and
    democratization of boards leads me to wonder whether there
    really is a buy-in yet from corporate leadership. You know, I
    certainly believe there has been by some, but is it as broad
    and widespread?
        I would also say another example where I worry about it is
    I often see some in corporate leadership speak about risk
    aversion that has been built into the system because of
    Sarbanes-Oxley, and I would like to understand whether your
    assessment is generally the view of all of the members. I hope
    it is because I think this values-based view about how you lead
    companies is the right approach.
        Mr. Volcker. If I may comment on that. I think there has
    been a lot of talk about overkill and in some applications I
    can understand that. But my concern has been at least as great
    about what I perceive as essential denial still in industry
    generally. Certainly you see it in accounting firms, which are
    the most directly affected.
        You have seen recently an accounting firm having several of
    its partners disbarred from practice in auditing public
    companies because of really willful bad behavior over a series
    of years. These are settled in a noncriminal context with the
    firm saying, ``well, we really did not do anything wrong under
    the standards that existed at the time.'' I do not know how
    they interpreted the standards existing at the time. These are
    pretty egregious examples of behavior, and people are still
    employed by the company.
        I can only see that as a symptom of denial.
        Senator Corzine. Any other comments?
        Mr. Peterson. Senator Corzine, my needle is probably stuck
    on this subject, but I have read every public opinion study, I
    think, known to man on this subject, and before you came, I
    pointed out I have never seen public mistrust at the level it
    is today. And I really think the ultimate litmus test that
    would help answer your question is whether there is a
    fundamental change in executive compensation, because that is
    the issue with the American public.
        Now, with regard to the questions of these outside
    advisers, the theory in corporate governance, as you know, was
    that you not only had directors representing the stockholders,
    but they also had so-called independent outside advisers. I am
    talking about auditors. I am talking about compensation
    consultants. I am talking about law firms and so forth.
        Now, the theory was that for their monitoring purposes,
    their client were the outside directors and ultimately the
    shareholders. But I think what happened with many of these
    firms, in their understandable desire to grow, they got into a
    lot of businesses that had very little to do with the
    monitoring function, but it was where the big fees were. And
    you and I were in private firms for a long time, and we know
    how partners get compensated in private firms. They get
    compensated, importantly, by the overall revenues that they
    produce.
        If I am an auditing firm and I am getting huge fees for
    consulting--and in the year 2000, 2001, the consulting fees
    were 3 times the auditing fees. In the case that Paul Volcker
    was talking about, these tax planning, tax advantage
    strategies, the success fees were 3 times, or thereabouts, what
    the auditing fees were. Or law firms that were getting huge M&A
    fees that were unrelated to a specific problem that came up.
    And I have had the painful experience in three public companies
    where we had to be investigated for some alleged improper
    behavior. And when the management picked the regular law firm,
    I can assure you the investigation was not appropriate or
    independent.
        So, I think part of the answer to this problem is for the
    outside directors to take charge of all other relationships
    with these outside firms, to hire them and fire them and make
    it clear that their client is the outside committee and outside
    directors.
        We went so far as to suggest, among other things, aside
    from tax advantage strategies, that in the case of an
    investigation you should not use the law firm that is your
    regular law firm. And I think if we can get that best practice,
    you are going to see the performance of these independent firms
    be much more independent.
        Senator Corzine. Chairman Shelby, I have one quick
    question.
        Chairman Shelby. Quickly, because our time has run on our
    vote.
        Senator Corzine. The point that Mr. Peterson made in his
    testimony about the negative consequences of Congress' placing
    a $1 million cap on cash compensation deductibility, it is a
    topic that can be discussed long and needs a lot of detail. But
    do you think we should be addressing that legislatively and go
    back and correct that? Because I do believe, as I think you
    believe, it led to this emphasis on options and other types of
    compensation.
        Mr. Peterson. This gives me a chance to bid Mr. Sarbanes--
    Paul, I used--excuse me, Senator Sarbanes, I used a word called
    ``iatrogenic effects'' from the Greek. I definitely think that
    was a case where it had unintended effects, and I do not know
    how my colleagues feel, but I do not think it was a helpful
    piece of legislation, and still do not think it was helpful.
        Chairman Shelby. Our time has run out. Senator Carper, we
    are going to recess now to go vote. Do you want the panel to
    come back?
        Senator Carper. I will move very quickly to the floor and
    back, but if the panel could stay, I would appreciate it.
        Chairman Shelby. You want to bring them back?
        Senator Carper. If that is possible.
        Chairman Shelby. And if you get back, you can reconvene the
    Committee.
        Senator Carper. We will move some legislation.
        [Laughter.]
        Chairman Shelby. We will be in recess for a few minutes.
        [Recess.]

                  COMMENTS OF SENATOR THOMAS R. CARPER

        Senator Carper. [Presiding.] Before the Chairman returns, I
    will ask the clerk to report out by unanimous consent
    legislation affording Delaware special privileges.
        [Laughter.]
        I just want to say, when we were walking down the hall,
    Chairman Shelby, Senator Sarbanes, and I were just remarking on
    what a terrific panel this is. And I know Senator Corzine said
    this earlier, but just to each of you, thank you for, in some
    cases, your service to our country, your continued service to
    our country, and the example you have provided to others in the
    business community. We are just grateful for all that you have
    done and that you continue to do. And I very much appreciate
    your willingness to hang in here with us for a little bit.
        First of all, with respect to corporate governance, I want
    to ask a question on the ability of corporations' boards to
    attract quality members, the kind of well-qualified members
    that you speak to in your recommendations. It is a lot tougher
    to serve on boards these days, at least to do a good job. How
    are companies finding the difficulty of attracting the kind of
    people that they need to serve and keep them?
        Mr. Larsen. It is becoming increasingly difficult to find
    qualified board members. I think most individuals are limiting
    the number of boards that they are willing to serve on, and I
    think the issue is particularly significant in companies that
    have problems, business problems of one kind or another, or
    historically regulatory or legal problems. And when they need
    it most, they are finding it very, very difficult to attract
    anybody onto that board for fear of being drawn into extensive
    litigation.
        It is an issue, and I do not know what to do about it.
        Senator Carper. There is a statement here in your section
    on corporate governance that says, ``Companies will certainly
    have to develop ways to motivate and attract such independent
    directors in an era of rapidly increasing government
    requirements.''
        Are you aware of any best practices that are out there that
    have evolved in the last year or two that we might hold up as
    examples to other companies? Anybody?
        Mr. Larsen. I do not think there are any simple answers to
    this. Clearly, what I have seen is that it is taking the
    combined efforts of many board members to go out and recruit
    other board members. So it is no longer a simple case of making
    a phone call and asking somebody whether they are interested,
    but rather now you have to go visit with them, they often want
    to do their own due diligence to find out what they are walking
    into before they get into it. And I think that is healthy
    because at least they then know what they are getting into.
        But I spend a considerable amount of time on a number of
    boards where I will go out and try to personally recruit
    another board member and assure them that it makes sense for
    them and divulge completely what the situation is. So, I think
    it is taking a lot more effort on the part of individual board
    members, and that is probably a good thing.
        Senator Carper. Yes, sir, Mr. Bowsher?
        Mr. Bowsher. Yes, I would second the way Ralph ended there
    about it is a good thing, because I think that they are paying
    a lot more attention through the nominating committees of the
    boards now as to who do they need on the board, what kind of
    skills, what kind of background, and everything like that.
        I think also you are seeing some people who maybe would not
    have been considered in the past that do have the
    qualifications. I was just out in Chicago talking to a board
    that wanted me to come on. I could not do it because I am kind
    of full up right now. But there was a young lady there who is
    the CFO of a major corporation, and she was describing the two
    or three companies that she had been asked to come on the board
    to be the financial expert. And she is highly qualified. She
    was a partner with a big firm. She is CFO of a major company.
    And I think sometimes in the past that she would not have been
    given those opportunities.
        So, I think there is a broadening now of looking at the
    talent base, and the search firms are very much more involved
    now, in other words, trying to find quality directors and
    everything like that. And I think that is healthy. I really do.
        Senator Carper. All right. Thank you. Your comment about
    the woman who is a CFO gives me an opportunity to segue to
    another question. I was out in Silicon Valley talking with a
    CFO who is also a female, and a company that had been around
    for about 10 years. And she was arguing--not arguing, but
    advocating forcefully that the stock options should not be
    expensed.
        Mr. Bowsher. That is Silicon's Valley view.
        Senator Carper. Yes. If you can just make the point, put
    yourself in their shoes, and if one of you could just make
    their point, and then counter those arguments. Please, anybody?
        Mr. Larsen. I will take a stab at it, Senator. The
    arguments that I have heard from Silicon Valley--which I am
    sympathetic with, by the way, and I do not hold quite the same
    views that Dr. Volcker has on the evil of stock options. But if
    you look at the Silicon Valley firms and you look at some of
    the remarkable things that they have accomplished, there was a
    high, high level of risk for those young men and women who went
    into those businesses 5, 10, and 15 years ago. Frankly, the
    only thing--and I have some personal experience with it--that
    attracted these people in, was the chance to really hit a home
    run. And I think stock options were an important part of that.
        Now, as companies mature and as the upward movement in
    their stock moderates, it has less pull. But I can understand,
    if I were starting up a firm and I did not have any money and
    the only thing I had is to offer a young Ph.D. electrical
    engineer the opportunity to strike it rich if he hung in with
    me and built this technology, I can understand where that is an
    important draw.
        Having said that, I think the expensing of stock options is
    something that needs to happen at some point because it is a
    real cost and it is diluting the shareholders' equity.
        Mr. Peterson. Senator, you are probably aware of this on
    stock options, but in the event you are not, let's clarify
    something.
        One of the anomalies of accounting was that if you had a
    fixed-price option, you did not need to expense it. But if you
    had a performance-based option or a grant, one that said they
    vest if you achieve a return-on-equity goal or an operating
    cashflow or something, that was expensed. So that led to this
    curious bias against injecting the very performance measures
    that would have made them far more effective. And that is why
    one of the great virtues of expensing, and if we can agree with
    ourselves and foreigners on a common set of standards, is we
    think it will drive it much more toward performance, which is
    our basic theme here.
        Senator Carper. Thank you.
        Mr. Volcker.
        Mr. Volcker. I think I better state my position on stock
    options a little more carefully.
        [Laughter.]
        Senator Carper. It was interesting. In the section here,
    there was a footnote to the section under corporate governance
    that suggested that you and I think Mr. Grove had a somewhat
    different view than the rest of the panel.
        Mr. Volcker. We did indeed. When I state my position, what
    I say is for a large publicly owned company with diversified
    ownership, the use of fixed-price stock options needs a lot of
    careful justification as to why it suits their particular
    circumstances when I think demonstrably the temptation to abuse
    stock options is great; it has been demonstrably so clear.
        That does not say it--you are a start-up company in Silicon
    Valley, you have no cash, you want to give away some of your
    company prospectively, that is your decision. You are the
    owner; you can do it. I think there are other ways of giving
    equity. I am not objecting to start-ups, whether in Silicon
    Valley or anyplace else--I am not ruling it out for anybody.
    But I am saying the temptation is so great to give these
    options away, that do not appear to cost anything that, in
    fact, often give perverse incentives, not for that young
    engineer in Silicon Valley but the chief executive of unnamed
    companies, which we have seen quite a few examples of recently,
    is a different matter.
        Mr. Peterson. That is particularly true, Senator, if you
    have short holding periods. You see, one of the things--New
    York University did a study of what executives did with stock
    options, and the vast majority of the executives sold the stock
    right after it vested. So if you have a very short holding
    period, that creates the short-term-itis and managing short-
    term earnings. The incentive is terrific because you get huge
    gains that have little to do with long-term performance.
        Senator Carper. Mr. Bowsher.
        Mr. Bowsher. I have a son who is an MBA and a venture
    capitalist on Sandhill Road in Silicon Valley, and he has asked
    me the question that you have just asked more than once,
    because he believes in stock options. But I really say
    basically what Ralph and Paul have, that for the smaller
    company, the private company, it certainly is a viable vehicle,
    I think, in compensation to get the company off and going and
    everything like that.
        When you become a public company, I think that does really
    change the ball game, and I think Paul's point is that they
    were badly used by a lot of public companies, and that is what
    we are trying to get at here so that we get rid of the bad
    features of these stock options.
        Senator Carper. One last question, if I could. I am going
    to quote this. It is from your corporate governance section
    again. It reads, ``The Commission also believes that
    policymakers''--I think that would be us--``should find ways to
    create incentives for investors to hold for the long-term
    perhaps such an increasing''--let me just--yes--``the
    differential tax rate for the long-term and short-term holders.
    The Commission believes, however, that any detailed
    consideration of tax policy is beyond the scope of its current
    work.'' This is, again, with respect to attracting investors
    who are going to hold the stock for the long-term as opposed to
    the short-term.
        I realize this is not part of what you are trying to do as
    members of this Commission, but any thoughts you have with
    respect to----
        Mr. Peterson. Senator, I will take a crack at that. Jack
    Bogle educated me a lot, at least. Corporate governance theory
    has this notion, you know, of the symmetry of interests between
    long-term owners and management. That raises the interesting
    question: Who are these long-term owners you are talking about?
    The average turnover of a New York Stock Exchange stock
    annually is about 110 percent, which means it is held about 11
    months. On Nasdaq, it is 300 percent. So you have people who
    are, as Jack Bogle points out, more in the nature of short-term
    speculators rather than long-term owners, and get here we are
    talking about your long-term responsibilities as owners of the
    business.
        Warren Buffett has been advocating what you are talking
    about. Should there be a tax treatment that encourages people
    to hold stock for very long periods of time by, for example, in
    the extreme case, having a zero capital gains rate if you hold
    a stock 5 or 10 years or something, in the attempt to encourage
    many more real owners of businesses, because there are a lot of
    constituencies--there are employees, communities, and so forth,
    who have an interest, as Ralph suggested, in the long-term
    viability of the company. And yet we have these financial
    incentives that are all very short-term and quite speculative.
        Senator Carper. Thank you. And thank you all again for
    being here today and for sharing your thoughts with us and for
    continued good work.
        Thank you.
        Chairman Shelby. Senator Dodd.

                COMMENTS OF SENATOR CHRISTOPHER J. DODD

        Senator Dodd. Mr. Chairman, thank you, and I apologize for
    getting here late. But let me thank all of you for your
    participation today. I know all of you fairly well. Mr. Larsen
    and I do not know each other that well, but I have enjoyed your
    advice and counsel on a number of issues over the years, and it
    has been tremendously worthwhile. And I picked up from my staff
    some of the comments you made earlier.
        Mr. Chairman, I thank you for inviting such a distinguished
    panel to be here.
        Chairman Shelby. Thank you.
        Senator Dodd. Mr. Peterson, I enjoyed--I was going to
    insert in the record here for the benefits of my colleagues
    your piece you wrote in The New York Times Magazine, several
    months ago I guess now.
        Mr. Peterson. The enthusiasm in some quarters was a bit
    restrained.
        [Laughter.]
        Senator Dodd. That is why I thought I would mention it
    here, to try and help. But it was, I thought, a very, very good
    piece, and let me just say--we have said this in the past,
    those of us who are here, but Paul Sarbanes and certainly Jon
    Corzine, Mike Enzi, and Mike Oxley did a great job on this
    bill. I ask every one of my business groups in Connecticut,
    large and small, how they are reacting to this. I am very
    curious. And these are very private kind of meetings, I must
    say the response has been overwhelmingly positive. That is not
    to say they are not concerned about some aspects of this and
    how this will ring out and we are still discovering areas that
    may need some tinkering with. But overall, from a Connecticut
    standpoint, it has been overwhelmingly supportive, in fact,
    welcomed.
        I do not want to draw the analogy too tightly here, but it
    reminded me of the Foreign Corrupt Practices Act which Senator
    Sarbanes was involved in, and others. There was such opposition
    to that. Of course, that took a much longer time to get done.
    But today the reaction to that piece of legislation, generally
    speaking, has been fairly positive. It has done a lot more good
    than people thought it would do. Here the response has been
    more rapid, but overall pretty positive, and giving them an
    opportunity to clean out boards, get audit committees
    functioning, doing things that many of these CEO's wanted to do
    for years, did not have the--they did not think, anyway--
    authority to really do it as well, and Sarbanes-Oxley gave them
    that chance.
        Chairman Volcker, I am anxious to you and Mr. Bowsher,
    given your experience in this--and I haven't had a chance to--I
    was troubled on the Arthur Andersen issue, and I want to thank
    you, by the way, for your efforts there. You did a tremendous
    job, and I do not think it has been publicly recognized as
    widely as it should be, your Herculean efforts to save what was
    a great, great company. And just as a layman looking at this,
    clearly, no one is arguing about what should have happened to
    those responsible in the Enron issue. I also know there were
    thousands of other people that worked for this company globally
    that got swept away in all of this.
        Obviously, someone has made the point that in the future it
    will be very hard to deal with any of the other accounting
    firms in the sense that you are not going to have any left.
        I wonder if you might just share with us your own thoughts
    in retrospect. Were there things that we could have done or
    should have done differently that might have created a
    different situation so that we may be faced with similar
    problems coming down the road. And I would love to have at
    least some brief thoughts and comments on what might have been
    done differently to avoid losing a great company, in my
    opinion.
        Mr. Volcker. Well, look, I approach this in a rather
    romantic frame of mind. Arthur Andersen was a big company, and
    they obviously had a lot of difficulties over a period of time.
    But I had this feeling, with the help of Mr. Bowsher and a few
    others, that we could have reformed that company, and it would
    have been a different company, and that would have been a good
    example for the accounting industry in general. We would be
    better off having that company in a fully reformed mode, so to
    speak, which we do not now have.
        You are absolutely right. As I have observed this process,
    people are very chary now, seeing what happened to that firm
    when it got indicted, in dealing with other firms. They are
    using maybe more kid gloves than is desirable.
        So it has had a kind of perverse reaction. I obviously have
    a special point of view. We did not get the reform done in a
    way that it could have been done within the private system, and
    it has also to some degree, I think, affected prosecutorial
    zeal in other areas.
        Senator Dodd. From a public policy standpoint--and maybe
    you would want to think about this some more and get back to
    us--but was there something we could have done as public policy
    setters here, delayed this in some way or given you more of a
    chance to operate?
        Mr. Volcker. I do not think you in the Congress could do
    anything at that point. It was not an area subject to
    legislation. I do not fully understand, obviously I am in no
    position to understand, why the Department of Justice and the
    SEC together--the SEC did not make the decision--but wanted to
    indict. I think they knew what the consequences would be. And I
    understand, you know, that there were a lot of activities in
    that firm, just on the auditing side, that were very egregious
    examples of failure of professional responsibility.
        It was not an easy call, but, romantically, I think we
    could have done it another way and a better way.
        Mr. Bowsher. I certainly agree with Paul. I think we could
    have easily reformed that. When he asked me to come and have
    breakfast one morning to discuss trying to save Arthur
    Andersen, he turned to me and said, ``Do you think we can do
    this?'' And I said, ``Compared to some of the other things that
    you and I have been involved in, like the Penn Central and the
    S&L crisis and things like that, this is going to be a piece of
    cake.''
        [Laughter.]
        Then, you know, 3 months later, Andersen was gone.
        Mr. Volcker. He is more of a romantic than I am.
        [Laughter.]
        Mr. Bowsher. Paul once said that, you know, we knew our
    company was a little lame. We did not know that our Government
    was going to come out and shoot this horse. That is what I
    think happened. I think it was very unfortunate. I am a retired
    partner--I was with Arthur Andersen for many years, up until
    1981.
        Senator Dodd. That is why I asked. I know you were.
        Mr. Bowsher. I know a lot of people, the widows and others
    were really badly hurt, who had nothing to do with the Enron
    situation. I believe think it does come to one big public
    policy issue, and that is, do you hold people accountable
    criminally at the top for a large organization where something
    happens way out in the organization? You know, if the top is
    involved in some policy that truly is--but to think that this
    destroying of the records, which later they produced most of
    the records, as I understand, from other sources, was so
    egregious that you had to hold the whole firm accountable for
    it. It just I think was a terrible overreaching by the Justice
    Department, and unfortunately, as Paul said, we are now down to
    four times. We have one less firm, and that firm could have
    become what it used to be, and that was the gold standard for
    auditing.
        Senator Dodd. Yes, it was.
        Mr. Volcker. Let me just make one comment that does not
    directly respond to your question, but it responds to Sarbanes-
    Oxley. You could not get involved with Andersen, for however
    short a period of time, when they were in crisis and under
    stress, without understanding the conflict between the auditing
    side and the services side was so intense, they almost could
    not make a decision.
        Senator Dodd. Well, they spent more money. Actually, the
    contract for the consulting was larger than the auditing
    contract.
        Mr. Volcker. Yes. And, you know, every decision they made,
    how would this affect the auditing, how does it affect the
    consulting side? And there was no decision that did not affect
    one side or the other, so they did not make any decisions.
        Senator Dodd. That is a good point, and that has been,
    obviously, corrected by steps we have taken here. I appreciate
    your observations, and, again, I commend both of you for the
    efforts you made. As I say, all of us have constituents that
    worked in that company, and I just felt terrible. These people
    had nothing at all to do with this, and they had their
    careers--in fact, embarrassed even to mention they were
    associated with this remarkable firm.
        Mr. Volcker. One of the ironic experiences of that, I was
    invited to go out and give a lecture at Northwestern
    University, in Arthur Andersen Hall, Leonard Spacek Auditorium,
    about 2 days before they went down the drain.
        Senator Dodd. And Arthur Andersen, when you think of who he
    was and what a great contribution he made.
        Mr. Volcker. He was a great paragon of effective auditing,
    and other firms told me, whoa, we used to be so jealous of
    Arthur Andersen because it was so strong and their disciplines
    were so good.
        Chairman Shelby. I think, Dr. Volcker, if they had just
    shot the rider or the jockey and not the horse, we would be a
    lot better off. The aim was too broad. That is my observation.
        Senator Dodd. Thank you very much, Mr. Chairman.
        Chairman Shelby. Senator Sarbanes, do you have further
    questions?
        Senator Sarbanes. I have just one question I wanted to ask
    because I want to try to develop a record here.
        In testimony presented to the Committee last week, the head
    of PricewaterhouseCoopers stated that his firm's tax practices
    experienced a significant decrease in demand for tax services
    from their SEC audit clients. He went on to say that the
    decrease in the United States has been around 20 percent, and
    evidence shows that the trend is continuing. And he concluded
    by arguing that precluding accounting firms from rendering tax
    services to their audit clients and the inevitable long-term
    consequences of an exodus of tax talent from accounting firms
    will not serve investors well.
        I would like to get your reactions to that statement.
        Mr. Bowsher. I was surprised when he stated the number the
    way he did because he did not give you the other half of the
    situation. In other words, there is no question that each firm
    is seeing a reduction in the tax services for their audit
    clients. But that means that most of the companies--and
    American Express is a good example, where they went out and
    hired another firm to handle the tax and a lot of its special
    work, and that was Pricewaterhouse. And so there are millions
    of dollars of fees coming into these firms that did not used to
    come in from clients that they do not audit because they now
    are working with two or three of the firms rather than just one
    firm.
        So, I think that the idea that they were having a big loss
    but not having the gain in the services, you did not get the
    total picture.
        Mr. Volcker. My comment would be whether they have lost
    some revenues or not, it just is an area, not in the
    traditional type of tax preparation work, but in the aggressive
    stuff for which they are paid success fees--whatever they call
    them, they amount to success fees--which is contrary, as I
    understand it, to auditing ethics. It just creates dangers that
    have been highlighted repeatedly now in recent incidents. It
    has finally disturbed the IRS itself to take action that has
    embarrassed some of these firms.
        Senator Sarbanes. We looked at this when we were trying to
    develop the legislation, but we just did not have the time to
    come up with the line that would divide traditional tax
    services, which have always gone with accounting practice, from
    aggressive tax planning that involved clear potential conflicts
    of interest. But, increasingly, you know, they have been
    engaged in providing counsel and developing an effective
    exploitation of loopholes, and that I think has created a very
    real problem.
        The other point that I think Mr. Bowsher made which is
    important--and it applies not only to tax services, but there
    is also a whole list of consulting activities which, if you are
    the auditor, you cannot engage in. Other consulting activities
    you can engage in only if the audit committee approves it.
    Auditing firms may lose consulting activities, the other ones
    on that list from thier audit clients, but they may well pick
    these service up from their nonaudit clients since other firms
    will have to drop them. So it just shifts it around, and that
    is particularly the case when you only have four auditing
    companies that do 90 percent of the public company work.
        Mr. Bowsher. Deloitte Touche just announced their earnings
    were up 21 percent this past year, and that is a big part of
    it, the new work that they are getting from clients that they
    are not the auditors because those firms have decided to work
    with two or three firms.
        Mr. Volcker. But I would also say I would like to see the
    revenues of these auditing firms go up if they are charging
    more for better audits--not if they are just charging more for
    the same old audits. But I think auditing has too often been a
    kind of loss leader a given of things they are willing to do
    because they are only providing a minimal audit. If they are
    providing the audit that Sarbanes-Oxley calls for, I think they
    are going to have to be better paid--for the audit itself, not
    for ancillary services.
        Senator Sarbanes. Thank you.
        Chairman Shelby. Thank you, Senator Sarbanes.
        I want to thank the panel. This has been a great panel, and
    we welcome all of you back here.
        On options, I think most people believe there is a place
    for options if properly used. But some nonexpensing options----
        Mr. Volcker. I may even believe----
        Chairman Shelby. The nonexpensing of options was always
    troubling to a lot of us.
        Dr. Volcker.
        Mr. Volcker. I may even believe that there is a place for
    options if properly used, to use your words.
        [Laughter.]
        Chairman Shelby. And I believe Secretary Peterson said that
    in a different way.
        Mr. Peterson. Precisely.
        Chairman Shelby. He explained it in detail, and so did Mr.
    Larsen and Mr. Bowsher.
        We appreciate your appearance here today. We know it has
    been long, but you add a lot to the record. Thank you very
    much.
        Chairman Shelby. We are going to call up the second panel
    now, if we can get started on that.
        I want to thank the second panel for your patience here
    this morning, all of you. Your written statements will be made
    part of the record in their entirety. You can tell it is
    afternoon here, a few minutes after 12 o'clock noon. We will
    start with you, Mr. Anderson, if you could briefly sum up your
    relevant points. Thank you so much. Welcome to the Banking
    Committee.

                     STATEMENT OF BRIAN P. ANDERSON

           SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER

                   BAXTER INTERNATIONAL INCORPORATED

        Mr. Anderson. Good afternoon, Mr. Chairman. I will
    definitely be brief.
        Chairman Shelby. Absolutely.
        Mr. Anderson. I am Senior Vice President and Chief
    Financial Officer of Baxter International, a global health care
    company, listed on the New York Stock Exchange, with
    approximately $8 billion in sales and about 50,000 employees in
    100 countries around the world.
        I am very pleased to have the opportunity today to join you
    to look at the implementation of Sarbanes-Oxley 1 year later,
    particularly from my perspective as the chief financial officer
    of a large public company as well as the chairman of the audit
    committee of another large public company. Sarbanes-Oxley
    represents a bold step toward restoring public confidence and
    rebuilding trust in the capital markets that is so essential to
    the proper functioning of our free enterprise system, as the
    previous panel I think so eloquently stated.
        This law seeks to improve investor confidence by requiring
    CEO and CFO certification of periodic reports, enhance
    disclosure requirements, and, finally, a redesigned approach to
    regulations of the accounting profession, including the
    important aspects of auditor independence. In general, we
    believe these rules have served their intended purposes
    extremely well.
        One of the most high-profile aspects of the Sarbanes-Oxley
    Act is the accountability it places on corporate executives to
    ensure that financial information is complete and correct.
    Enron and related scandals have placed the leadership and
    ethical standards of every executive in every corporation on
    the line, and I was particularly pleased to hear Ralph Larsen's
    testimony. Our CEO and I absolutely applaud these certification
    requirements, and we have signed these certificates without
    hesitation. This is a part of our job, and it is our
    responsibility.
        Issuer disclosure in both financial and nonfinancial arenas
    has improved significantly under Sarbanes-Oxley, and perhaps
    more importantly, management's time, energy, and focus on
    enhanced disclosure has increased.
        As a multinational company operating in over 100 countries,
    we have found that even though we had rigorous reporting and
    control environments, there were still improvements that could
    be made.
        On the other hand, I believe that it still remains to be
    seen whether the time, effort, and expense required to comply
    with Section 404 of the Act will ultimately result in
    significantly enhanced internal controls and procedures across
    corporate America. In our case, I believe it will.
        I also believe that the increased responsibility and focus
    that Sarbanes-Oxley has brought upon independent auditors is
    also a very positive development. The importance of the
    public's trust in accountants, particularly as it relates to
    the audits of public companies, cannot be emphasized enough. In
    that regard, I believe Congress has successfully implemented
    important changes designed to ensure auditor independence.
    These include, obviously, limiting the kinds of nonaudit
    services that can be performed for audit clients, restricting
    relationships that can result in a lack of independence,
    establishing ``cooling off'' periods, ensuring mandatory audit
    partner rotation, and, finally, the creation of the Public
    Company Accounting Oversight Board.
        The Act has also solidified an important link between the
    independent auditors and the audit committee of public company
    boards. At Baxter, we have had several of these processes in
    place for many years, including executive sessions between the
    audit committee and our independent auditors, as well as audit
    partner rotation. And several years ago, we took the step of
    actually having our board receive continuing education sessions
    at each audit committee meeting in areas of financial
    accounting and auditing, and our audit committee has responded
    very well to this training as well as the quiz that we give
    them on these topics. Overall, I believe that the new rules
    imposed by the Act with respect to public accounting firms and
    audit committees should result in significant positive change.
        In regards to boards, I believe the Act has had and will
    continue to have a significant positive impact on how boards
    interact with those of us in executive management.
        At Baxter, we are very proud of our strong commitment to
    maintaining the highest standards of corporate governance. In
    1995, we were one of the first companies to adopt formal
    corporate governance guidelines, long before this became in
    vogue in corporate America and actually a requirement of
    Sarbanes-Oxley. Most of the new rules that are now mandated are
    practices we have had in place for years, and, therefore, the
    new law has not dramatically impacted our practices.
        Therefore, Mr. Chairman, looking back at what has occurred
    since the enactment of Sarbanes-Oxley, I believe we see, on
    balance, a very positive and encouraging picture. To those who
    feel that Sarbanes-Oxley may have gone too far, I would say
    that the strong medicine is working, and we must not abandon
    the treatment just because there may be a few unwanted or
    unpleasant side effects. At the same time, to those who believe
    that Sarbanes-Oxley may not have gone far enough, I would also
    urge caution and strongly encourage them to closely monitor the
    impact of the law to just make sure that we have not tipped the
    balance too far in any one direction.
        Specifically, I believe we must continue to pay close
    attention to preserving the appropriate balance between Federal
    and State law, the potential erosion of the business judgment
    rule, increased liability for directors, and the increasing
    hesitancy of very qualified individuals to serve on corporate
    boards, especially the important role of the audit committee.
        Mr. Chairman, we very much appreciate having the
    opportunity to appear before the Committee today to underscore
    the importance of what you have accomplished so quickly with
    the enactment of Sarbanes-Oxley and to express our very strong
    support for the overall goals that this legislation is intended
    to serve.
        Thank you very much.
        Chairman Shelby. Thank you.
        Mr. Castellani.

                    STATEMENT OF JOHN J. CASTELLANI

                   PRESIDENT, THE BUSINESS ROUNDTABLE

        Mr. Castellani. Thank you, Mr. Chairman. I, too, appreciate
    the opportunity to share the Business Roundtable's view on the
    Sarbanes-Oxley Act and restoring investor confidence.
        I would like to begin by commending this Committee and your
    efforts and Senator Sarbanes' efforts to strengthen corporate
    governance and restore investor confidence over the past 2
    years. Our organization shares that objective, and we strongly
    supported the Act when it was being considered, and we have
    supported the SEC's efforts to implement it. And I think a word
    of thanks goes to the SEC. Despite a tight rulemaking schedule,
    it has taken the time to consider every rule, weigh its
    consequences, and solicit, and listen, to input from investors,
    companies, and others.
        The Act has put a necessary spotlight on corporate
    governance and financial reporting. Our members have viewed the
    Act as an opportunity to enhance their corporate governance
    practices and
    financial reporting procedures. In addition, the Roundtable
    companies have implemented, voluntarily at this point, many of
    the proposed New York Stock Exchange and Nasdaq corporate
    governance reforms, with independent boards of directors,
    entirely independent audit, nominating, and compensation
    committees, and written committee charters.
        And I would like to talk about a recent survey that we did
    of our companies and our members, which we believe shows that
    they are not only living up to the requirements of Sarbanes-
    Oxley but also the spirit of these reforms.
        For example, 88 percent of the Roundtable companies report
    increased involvement in board and committee meetings by
    members of the audit, nominating, and compensation committees.
    Over 90 percent report increased involvement by the board as a
    whole. In keeping with the spirit of the reforms, audit
    committees today have taken on ownership of the relationship
    with independent auditors, making it clear that the auditors
    report to the committee and not to the management.
        Our companies also report a dramatic increase in director
    evaluations. Seventy percent of our companies are performing
    director evaluations this year compared to 44 percent in 2002.
    As we stated in our own Principles of Corporate Governance,
    directors should only serve so long as they add value to the
    board, and the recent rise in these evaluations reflect our
    companies' renewed commitment to board quality and
    accountability.
        We also support enhanced communications with shareholders,
    and, to that end, we have supported recent SEC efforts to
    increase disclosure about nominating committee processes and to
    require disclosure concerning the shareholder communications
    with the board. In fact, our survey shows that two-thirds of
    the Roundtable companies have discussed with their own
    nominating committees a process to communicate and to respond
    to shareholder proposals and inquiries. An equal number have a
    process in place to communicate and respond to shareholder
    nominations of board candidates.
        Moreover, we strongly supported the New York Stock Exchange
    and Nasdaq proposals to require regularly scheduled executive
    sessions of independent directors. In fact, the independent
    directors of 55 percent of our companies expect to meet in
    executive session five or more times this year. The norm has
    become that they are meeting both before and after the full
    meetings of the board.
        The New York Stock Exchange also proposed to require that a
    director be designated to preside at executive sessions of
    independent directors. Our members agree it is important to
    provide leadership for a company's independent directors. In
    our survey, 55 percent of the Roundtable companies reported
    that they have named an independent lead director as either an
    independent chairman, a lead director, or a presiding outside
    director.
        Finally, 8 in 10 Roundtable companies report their boards
    of directors are at least 75 percent independent, and 9 in 10
    report at least two-thirds of their directors are independent,
    exceeding both the proposed New York Stock Exchange and Nasdaq
    requirements.
        Although much progress has been made in the implementation
    of Sarbanes-Oxley, the implementation is not complete. The SEC
    has provided an extended effective date for its rules relating
    to internal controls, which were addressed in questions to the
    earlier panel. And, in fact, those controls and that time
    period needs to be completed. The CEO's of the Business
    Roundtable believe that good corporate governance should be
    equated with a high value for all of our shareholders and our
    other stakeholders.
        We are mindful of the potential for overregulation of
    corporate governance becoming an overhang on the economy. But
    we have not reached that point. We need to be careful going
    forward that we are fair in creating the obligations and
    restrictions in the name of corporate governance and we do not
    create, in doing so, an overhang on the economy that eliminates
    risk-taking and eliminates the ability of our enterprises to
    create wealth and to create jobs. We do not want directors and
    managers to be afraid to take risks, but we want them and
    insist that they have the highest standards of corporate
    governance.
        We are moving forward in other areas to address some of the
    issues that the earlier panel addressed. First, we are
    examining how to better train current and future business
    leaders and to enhance the role of ethics in the decisionmaking
    process. Second, we are working to bring more sense and
    transparency to executive compensation. Finally, we are
    continuing to develop and share best practices in corporate
    governance so that companies and their boards and management
    can learn what works most effectively.
        Congress did its job in enacting the Sarbanes-Oxley Act,
    and the SEC is doing its job in implementing the Act. We, in
    corporate America and at the Business Roundtable, recognize
    that the rest is up to us.
        Thank you.
        Chairman Shelby. Mr. Grinstein.

                    STATEMENT OF KEITH D. GRINSTEIN

                    CHAIRMAN, COINSTAR INCORPORATED

        Mr. Grinstein. Chairman Shelby, it is a pleasure to be here
    today.
        I am here representing the small and mid-cap, Nasdaq-listed
    companies, publicly traded companies. Somebody had to do it and
    they found me.
        I am a nonexecutive chairman for one mid-cap Nasdaq-listed
    company, and I am an independent board director for two other
    Nasdaq-listed companies. So, I am the independent director that
    both of these panels have been talking about today.
        I am also sitting here before you solely as an individual
    and nothing that I say today should reflect these companies,
    which have all gone out of their way actually to enact all of
    the provisions of Sarbanes-Oxley, and it is an honor to serve
    on these companies.
        I would like to briefly begin by actually referring to the
    Jackson 5 briefly, where they said that one bad apple does not
    spoil the whole bunch, but a few bad apples can destroy
    investor confidence. That was the issue that we were facing in
    the markets today.
        As Mr. Larsen said earlier, you cannot legislate morality,
    and that is true. But this Act has gone a long way to making
    sure that if you step over the line, you are going to pay a
    heavy price for lacking morality.
        Horatio Alger, in my view, is the cornerstone of the
    American capital markets. The fact that any individual can
    start with very little and can raise themselves up is the key
    driving force in the American economy. That being said, Horatio
    Alger thrives on a fair playing field and access to fair and
    efficient capital markets.
        The lack of investor trust and the recent corporate
    scandals that have been discussed in this room have seriously
    eroded investor trust and have limited the access, especially
    when you are talking about small and mid-cap companies, to
    efficient capital markets. Recently, over the last 6 months, as
    many companies went private as went public, as it became clear
    that access to these markets was not available and the costs of
    remaining public were high. However, I think that this Act has
    done a spectacular job of beginning the process of turning the
    tide and bringing investor confidence back, and will allow
    capital formation so small and mid-cap companies, where much of
    the productivity gains that we are looking for to drive the
    economy in the future will rest. I am very pleased to be here
    strongly in support of the Act today.
        Briefly, I would like to say that while I have had no
    immediate contact with corporate fraud, there is a change in
    the attitude among board members since the passage of this Act.
    There is less deference given to management recommendations,
    more questions are asked, members are better prepared--and I am
    speaking now for myself--I am better prepared. I felt I was a
    good board member before; I am a much better board member
    today.
        There are more meetings, more attorneys, God bless them,
    and there are more auditors and accountants at every turn. It
    is an unavoidable consequence of increased responsibility.
        That increased responsibility does not come without a cost.
    It has been referred to several times, that in order to restore
    investor confidence, we are going to pay more money. Chairman
    Volcker referred here that it is okay if the auditor firms make
    more money, as long as we are getting better audits. That I
    agree with. Splitting the audit and the consulting fees was a
    critical feature here. Audit should not be and cannot continue
    to be a loss leader to get more lucrative consulting contracts.
    That has, I think, significantly improved the quality and the
    length of the audit process.
        Let me talk a little bit about the cost of implementation.
    This is something I am very familiar with, sitting on three,
    publicly traded, small cap companies. The range is from a small
    cap of a minimum of $250,000 a year in increased cost, going
    all the way up to a million dollars a year for a mid-cap, or
    $500 million to a billion company. These are significant costs
    for companies that trade between $50 million and a billion
    dollars. More director time, more director fees, more auditor
    fees, increased insurance costs, which was not discussed
    earlier, and ultimately the threat of increased litigation,
    which is a big concern. We have not yet seen it, but we need to
    be very wary and keep a watchful eye for increased litigation
    that will come out of compliance or fuzzy compliance with this
    Act. There may need to be some safe harbor provisions put into
    this Act at some point if excessive litigation shows up.
        Looking forward. This was the right legislation at the
    right time. God only knows what investor confidence would look
    like today if we were facing these corporate scandals, if we
    were looking at these courtroom battles on a daily basis,
    without Sarbanes-Oxley Regulation FD, and all of the
    improvements that have been done over the last 2 years.
        In conclusion, there has been a subtle shift of power away
    from the CEO as a demagogue and toward the fiduciary
    responsibility of the CEO, the management team, and the board
    as fiduciaries for the public. It is a little bit too early to
    tell whether or not we need to tweak the legislation. I stand
    before you here today and say it was the right thing at the
    right time, and I think it is up to the SEC and this Committee
    over time to see where the law takes us. The increased costs
    are justified because of the increased confidence. Welcome to
    the ``no spin zone'' in corporate America.
        Chairman Shelby. Thank you. That was a strong presentation.
        Mr. Trumka.

                     STATEMENT OF RICHARD L. TRUMKA

           SECRETARY-TREASURER, AMERICAN FEDERATION OF LABOR

                AND CONGRESS OF INDUSTRIAL ORGANIZATIONS

        Mr. Trumka. Thank you, Mr. Chairman. My name is Richard
    Trumka, and I am Secretary-Treasurer of the AFL -CIO. The AFL -
    CIO member unions sponsor benefit plans with over $400 billion
    in assets, and collectively bargained benefit plans that union
    members participate in hold over $5 trillion in assets. For
    working families, our retirement security is, in large part,
    dependent upon the integrity of our capital markets.
        Mr. Chairman, we believe Sarbanes-Oxley is a success more
    than a year after passage, not just because of the specific
    provisions of the Act but because of the tone the Act set and
    the message it sent.
        However, the job begun by this Committee last year is not
    complete. Key elements of the investor protection agenda remain
    to be enacted here in Congress, at the Securities and Exchange
    Commission, at FASB, and the Public Accounting Oversight Board.
    While we are generally pleased with the work done by those
    agencies, we believe there is still an unfinished corporate
    reform agenda that they and Congress should turn to.
        I would like to lay out some of those elements, Mr.
    Chairman. First, our legal system continues to suffer from real
    deficiencies in the extent to which both individuals and
    institutions can defraud the investing public and get away with
    it. Despite your best efforts, in many circumstances lawyers,
    accountants, and investment banks can still aid and abet
    companies that commit securities fraud and enjoy immunity from
    investor lawsuits. That is wrong, and only Congress can fix it.
        There are also areas where the Public Securities Litigation
    Reform Act has made it easier to defraud the investing public
    and get away with it. Sarbanes-Oxley addressed one such area by
    lengthening the statute of limitations, but there are others,
    such as the PSLRA's repeal of joint and several liability for
    securities fraud and the blanket immunity it grants for
    forward-looking statements that remain. Again, these problems
    with the PSLRA can only be addressed by Congress.
        However, as important as litigation can be to both
    deterring corporate wrongdoing and dealing with its
    consequences, it cannot be a substitute for real working
    corporate governance and accountability on the part of company
    management. As long as CEO's dominate the selection process for
    company directors, we simply will not see at problem companies
    the kind of vigorous independent boards that we need and that
    Sarbanes-Oxley calls for.
        That is why the labor movement believes the most important
    effort now underway to address the continuing governance
    problems at our public companies is the SEC's rulemaking
    initiative to give long-term investors with a substantial stake
    in companies the right to have their board nominees included on
    management's proxy.
        Today, it is practically impossible for even the largest
    long-term investors, the TIAA-CREF's and CalPERS, to nominate
    and run their own candidates for the boards of public
    companies, so we have elections in name only.
        Of course, CEO's know that investors have limited options.
    They know that they can ignore shareholder votes on runaway
    executive compensation or company audit policies, and there is
    little that shareholders can do about it. So we strongly
    support the SEC and Chairman Donaldson's efforts in this area,
    and fervently hope that what will emerge from rulemaking is
    real access to the proxy for long-term investors.
        Finally, I would like to take note that, despite everything
    that has happened, we will have inadequate disclosure to
    investors of the facts of executive pay and what financial
    impact that pay has on the companies that award it. Despite
    FASB Chairman Bob Herz's hard work in this area, stock options
    still are not required to be expensed, a state of affairs that
    amounts to a subsidy to an inappropriate form of executive
    compensation.
        As we have seen over and over again in the last year,
    investors simply are not given enough information about the
    CEO's deferred compensation plan. While these matters are
    properly in the hands of the SEC and FASB, they are key
    elements of the post-Sarbanes-Oxley agenda.
        While much has been accomplished since Sarbanes-Oxley was
    passed, the work of reform is not complete. In response to
    Senator Corzine's question, there is no better evidence about
    the lack of buy-in than the recent comments of one of the most
    influential people in corporate America, Ken Langone, CEO of
    Invemed Associates, a former Chairman of the New York Stock
    Exchange's Compensation Committee, a Member of the Compensation
    Committee at General Electric, and three other public
    companies, and Lead Director at Home Depot.
        Mr. Langone, who is actually responsible for the pay
    package the Stock Exchange offered Richard Grasso and was
    involved in the pay and benefits offered to Jack Welch, remains
    unapologetic. He told the press last week that given the chance
    to vote for Grasso's pay package, he would do it again. As long
    as that attitude continues, Mr. Chairman, with key
    decisionmakers in corporate America, there is a lot of work to
    be done.
        One last point, if I might, sir.
        Chairman Shelby. Yes, sir.
        Mr. Trumka. Fortunately, the independent agencies that are
    active in the area of corporate governance are, by and large,
    stepping up to the plate. The SEC, PCAOB, and FASB have all
    responded admirably to both the specific mandates of Sarbanes-
    Oxley and the tone set by the passage of that legislation. The
    labor movement surely urges this Committee and Congress as a
    whole to recognize that work and to fund it and to protect the
    independence of those agencies as they go about their vital
    tasks.
        I want to thank this Committee and your leadership, Mr.
    Chairman, for the wonderful work you have done to try to help
    restore confidence to our markets.
        Chairman Shelby. Thank you.
        Mr. Anderson, could you briefly elaborate on the
    implementation factors of the internal control provisions of
    Section 404?
        Mr. Anderson. Absolutely. Contrary to Mr. Bowsher's earlier
    testimony, even though I do believe that we have very strong
    internal controls, this is not without cost. Certainly, if one
    just took a ``check the box'' approach----
        Chairman Shelby. Everything costs, doesn't it?
        Mr. Anderson. Clearly, from our perspective, we are using
    this as an opportunity, as you said earlier, to improve our
    business. We are already seeing some benefit from taking a very
    thorough look at our internal control environment around the
    world and making changes to improve that environment. I do
    believe, in the long-run, the increased cost will be justified
    when one looks at what is at stake from the perspective of
    restoring trust in the markets.
        Chairman Shelby. Mr. Grinstein, how do you think Sarbanes-
    Oxley has impacted capital formation for small and medium-sized
    companies?
        Mr. Grinstein. Sure.
        Chairman Shelby. You have had a lot of experience there.
        Mr. Grinstein. Yes. Thank you.
        It is a hard time to evaluate. This is just a data point,
    as I think Mr. Volcker said earlier. Over the last 4 or 5
    months, as I briefly mentioned--and it is in my testimony--as
    many companies went private as went public. That was a
    concerning thing. I think that had more to do with investor
    confidence, and obviously the turbulence in the markets.
        I think that Sarbanes-Oxley has imposed a burden on the
    small and mid-cap companies. It was discussed at the first
    panel, too. Because this was really aimed at the large
    companies. The simpler, small companies are bearing a burden.
    When you are chugging along and making three, four, five, six
    million dollars a year, to add a million dollars in cost is
    very difficult.
        That being said, I do not believe that anywhere in the
    world there exists more efficient capital markets, and by
    protecting those capital markets--already I saw on the docket
    for the coming quarter double the number of companies are going
    public. I think very soon we will see a much larger number of
    companies going public than going private again, which has been
    the historical norm.
        Chairman Shelby. That was one of our concerns early on in
    the formation of the legislation, you will recall. We did not
    want to put too big a burden on the small and medium-sized
    companies who churn our economy.
        Mr. Grinstein. By the way, we appreciate it and see where
    the changes are.
        The other thing I think is going to happen is that there is
    going to become more competition in the independent audit
    feature. More people are going to become certified consultants
    in that area, specifically in the internal audit function, and
    as there becomes more companies in that area, as it was
    referred to earlier, as these companies grow, there will be
    more competition and the costs will go down and more
    efficiency. That is what we need to see.
        Chairman Shelby. Thank you.
        Mr. Castellani, regarding corporate risk taking, we
    certainly do not want to take risk out of the market. We would
    have no market at all. What have you heard from your members
    regarding the impact of the Act on corporate innovation and
    risk taking?
        Mr. Castellani. Mr. Chairman, as we have surveyed and we
    continue to survey our members and talk to our members about
    the Act, its implementation, and its effect on the business
    process, the overwhelming concern, or the overwhelming
    sentiment, is that it has not adversely affected the risk
    taking process the way the Act has been constructed and the way
    it is being implemented.
        There are costs. The costs are certainly less of a
    percentage to our members, which are the very largest
    corporations, than they are to the companies that Mr. Grinstein
    has been referring to. As I said in my testimony, perhaps the
    greatest area of cost is going to be within the area of
    implementing the internal control and internal control
    reporting requirements.
        But there is a concern, and the concern has to be watched
    and analyzed, and that is that we do not inhibit the business
    risk-taking process by going beyond what is required for good
    corporate governance. I do not think we are there yet. You have
    heard from the earlier panel that there is some concern about
    being able to recruit and retain good, active, and independent
    directors. That is a concern and it is getting more difficult.
        We have to be careful that we do not criminalize the
    business decisionmaking process and risk taking, such that we
    all avoid it. That is our concern.
        Chairman Shelby. That would destroy the market, would it
    not?
        Mr. Castellani. Pardon.
        Chairman Shelby. That would destroy the market?
        Mr. Castellani. That would destroy the market.
        Chairman Shelby. Mr. Trumka, some people are not convinced
    that reform efforts will continue. How do investors ensure that
    executives and directors push for further reforms within their
    companies?
        Mr. Trumka. By having totally independent boards and giving
    long-term investors the right to have the proxy and nominate
    those boards. I think there is no substitute for that
    independent board, and having the long-term investors, people
    with interest in the company long term, having a say in who
    gets on that proxy and actually having a real election.
        Chairman Shelby. Mr. Castellani, what is your perspective
    regarding increasing shareholder participation--stockholders,
    as we know, obviously own the company--and how can it be done
    effectively? Sometimes it seems that they are totally ignored.
        Mr. Castellani. We think it is important that obviously the
    boards are responsive to shareholder concerns, as they should
    be responsible to all of the stakeholders' concerns.
        I think there are several things that need to be examined
    as the SEC moves forward. Certainly we support the SEC's stated
    objective, which is to get at those few companies, rogue
    directors, and unresponsive boards, that are ignoring the
    shareholders.
        In the SEC staff report, however, a number of options have
    been brought forward that may not necessarily get to that
    stated objective. First, if you use triggers that were
    described in the staff report, you run the risk, in our own
    analysis, of getting companies that were never intended. Some
    of the triggers, as we have looked at last year's proxy season,
    would encompass more than 100 companies, including many of
    which are considered having the highest standard of corporate
    governance.
        Second, we think it is going to be very important that the
    SEC define very carefully what constitutes a shareholder, both
    from the standpoint of how large that shareholder must be--most
    all of our members have at least 1 percent shareholders in
    them--and also, how shareholders could aggregate to bringing a
    director nominee forward.
        Third, we think that it is important that in all this
    rulemaking we ensure that we achieve good corporate governance,
    that we are not laying open a process----
        Chairman Shelby. That is the key, is it not?
        Mr. Castellani. Absolutely.--that we are not opening a
    process for organizations and shareholders who have agendas
    that are different than corporate governance to co-opt a board
    and cause the disruption that we have seen in boards that have
    competing agendas, different directors with different agendas,
    that have adversely affected the ability of the enterprise to
    prosper and create jobs and create wealth.
        Chairman Shelby. Senator Sarbanes.
        Senator Sarbanes. Thank you very much, Mr. Chairman.
        First of all, I want to thank the panel for coming today
    and for their contributions as we engage in this oversight
    hearing. Let me continue along the lines of the subject matter
    the Chairman was asking about.
        Mr. Castellani, do you think that the access that investors
    have, particular institutional investors, to placing
    representatives on the board is adequate currently, or do you
    think it needs to be enhanced?
        Mr. Castellani. Senator, our members think that what needs
    to be enhanced is precisely what we have supported, and is part
    of the process that the SEC is going forward on. That is that
    it should be very clear to all shareholders the criteria by
    which directors are selected and the process by which director
    nominees are moved forward to the proxy statement.
        Second, sir, we believe that boards need to be responsive
    to shareholders. They need to meet and explain the board's
    position when shareholders bring forth positions that are
    inconsistent with what the board has been recommending.
        Third, we do support, as I had said, a process that can be
    implemented to provide more shareholder access to the
    nomination process, provided it meets the test of providing
    additional, good corporate governance, making sure that it is
    focused on shareholders who are, indeed, shareholders, not just
    share renters, that they are, indeed, long-term shareholders,
    and that we are ending up with directors who meet the
    requirements that, in fact, are imposed on us by Sarbanes-
    Oxley, that they are independent, that they have an expertise
    that they bring forward, that they contribute to the board's
    governance, that they contribute to increasing the viability of
    the enterprise in which they are going to be sitting. So we
    would support those reforms if you can meet that test.
        Senator Sarbanes. I take it that, in effect, that means you
    hold the view that the current system is not adequate and needs
    to be addressed.
        Mr. Castellani. The improvements that have been made in----
        Senator Sarbanes. There may be questions about how to
    address it, but you do not assert that that issue should be
    just left alone?
        Mr. Castellani. No, particularly for those boards who are
    unresponsive, those few companies that are unresponsive,
    absolutely.
        Senator Sarbanes. Mr. Trumka, what is your view on this
    thing? I think you are both in the ballpark that changes need
    to be made, that we just cannot stay where we are. The question
    is what changes and how are they conditioned and so forth.
        You have heard the various items that Mr. Castellani
    enumerated. I would be interested in your reaction.
        Mr. Trumka. First of all, I am glad you asked, Senator
    Sarbanes, because we do have definitely held positions on it.
        First of all, the 1 percent threshold that he advocated we
    think is far too high. That would eliminate people like TIAA-
    CREF's and CalPERS, many of our pension funds who hold these
    shares for the long-term. I mean the real long-term. That type
    of a threshold would be far, far too high.
        Second, the trigger that he recommends would be far too
    high and would create too much of a lag between the time the
    trigger comes into effect and the time you can actually
    nominate somebody. It could be as long as 18 months, and 18
    months to some companies could be an eternity. So we would hope
    what was done is have a trigger that lets us long-term
    shareholders, like pension funds, like TIAA-CREF, like CalPERS,
    not speculators, not hedge funds--we agree on that part--but
    that the trigger not be too high. A 1 percent threshold would
    eliminate far too many people and eliminate the people who
    actually want to participate more.
        Senator Sarbanes. Mr. Castellani, if the limitations that
    are being discussed are arrived at, do you think the
    shareholders then should have direct access to the corporate
    proxy ballot in order to place their nominees before the
    shareholders?
        Mr. Castellani. Obviously, Senator, the devil is in the
    details, and that is why we are looking forward to the SEC
    moving forward on this rulemaking. But again, to reiterate, if
    it is aimed at those few companies which----
        Senator Sarbanes. I understand your position.
        Mr. Castellani. --and it could work out--Excuse me, sir.
        Senator Sarbanes. Otherwise, you are not getting very far
    if they do not have access to the proxy, are you? I mean, that
    is pretty key, is it not, in giving the shareholders any real
    ability to impact on the composition of the board?
        Mr. Castellani. Absolutely. Let me reiterate. We have been
    working and providing information and comment to the SEC so
    that we make sure in those instances, where this type of
    dramatic action is needed, where this kind of dramatic action
    is needed, that access is given to the shareholders, to the
    proxy statement. But with the test that this is significant,
    represents a significant number of shareholders, is aimed at
    egregious and unresponsive action, and will result in good
    corporate governance, not the opportunity for people with other
    agendas to move those forward and disrupt the company's ability
    to prosper.
        Senator Sarbanes. I was struck by this ad that appeared in
    The Wall Street Journal on Thursday, September 25. ``In the
    wake of scandals like Enron and WorldCom, investors deserve a
    true voice in director elections.'' It then talks about open
    access for shareholders as the next critical step of corporate
    reform.
        Now, they say let us make sure the reforms are responsive
    and responsible. Then they indicate protect against frivolous
    challenges by requiring significant shareholder involvement,
    protect against corporate raiders by limiting involvement to
    long-time shareholders, protect against hostile takeovers by
    limiting the number of investor-nominated candidates to less
    than a majority, and protect against unresponsive boards by
    giving investors timely access to the ballot. I thought that,
    in effect, was saying there are certain potential abuses that
    could happen, that we want to guard against. Then they set
    those out--the corporate raiders, the hostile takeovers,
    frivolous challenges.
        How did all of that sound to you?
        Mr. Castellani. I think it misses a point that is
    important, and I should have mentioned earlier in my answer to
    your question.
        One of the things that is fundamental in the reforms that
    have been enacted over the last 12 to 18 months is something
    that has been mentioned I think by every member of this panel
    and the previous panel, and that is the need for independent
    boards of directors, particularly majority independent boards
    of directors.
        What the Business Roundtable has supported and what our
    members are implementing is ensuring that the nominating
    committees are made up entirely of independent directors so as
    to avoid the kind of thing that Mr. Trumka just referred to in
    his testimony; that is, that CEO's pick the members of their
    board of directors.
        The key, in our view, is to have an entirely independent
    nominating committee. We think, with that, which we are seeing
    now implemented across corporate America, we will have better,
    higher quality members of boards of directors, who are more
    attentive, active, and are representing the view of the
    shareholders more capably to the views of all of the
    stakeholders of a corporation.
        We would like to see that implemented first. It is a
    dramatic change, but we think an important and necessary
    change, and that the remedies that were advocated in that ad,
    the remedies that are being considered by the SEC, should that
    system fail, be focused only very narrowly on those companies
    that fail to implement and fail to be responsive to the reforms
    that we have talked about in the new listing standards and
    within the Sarbanes-Oxley Act--that is, the independent members
    of the nominating committee.
        Senator Sarbanes. Mr. Trumka, what do you say to that?
        Mr. Trumka. To the ad?
        Senator Sarbanes. To his comment about the ad, to the
    comment we just heard about the ad.
        Mr. Trumka. First of all, I do not think we disagree that
    there should be more independence on the nominating committee,
    and that that should raise the level of directors. However,
    that does not suffice the overall game because you still need a
    check and that check is for shareholders to be able to appoint
    directors when the needs of those shareholders are not being
    met.
        I think the ad, if you take it literally, sounds like--and
    I will borrow a phrase from corporate America--a poison pill.
    It sounds like people who do not want to give shareholders,
    long-term shareholders, institutional shareholders, real access
    to the proxy, so they will create barriers so high that it
    cannot be done.
        We would say that I do not think a company can get hurt by
    having shareholders put an independent director on the board,
    or a couple of independent directors, even if it is those 100
    or 200 or 500 of the Standard & Poor 1,000. If they are
    qualified directors, and the shareholders want them there to
    speak for the shareholders, I think it only strengthens the
    company, it strengthens management, and it gives everybody
    significantly more faith in the capital markets so that they
    can save and invest with a lot more comfort.
        Senator Sarbanes. Mr. Castellani, do you feel that if you
    get one, two, or even three dissident members on the board, who
    are always raising questions about corporate practices--whether
    it is environment or labor, issues that you traditionally do
    not think are within the purview of the corporate board--that
    is going to, in effect, prevent the corporation from
    functioning in any normal way?
        I preface that by pointing out that we try to run a
    committee here and we do not regard a dissident voice as
    impeding the ability of the committee to function. We have to
    deal with it if it comes up, and sometimes it can be
    difficult----
        Chairman Shelby. Every day.
        [Laughter.]
        Senator Sarbanes. It can be difficult and awkward, but we
    manage to do it and everyone feels they have been represented
    and have been heard.
        I am just curious on whether there is a mindset here that
    says, ``oh my god, we are going to have this couple of voices
    here pounding away and we just cannot handle that.''
        Mr. Castellani. Senator, first of all, let me make sure the
    Committee understands that good directors are good directors
    who question everything, who want to get to the bottom of
    decisions that are made. There is a difference between a
    director who is being active and aggressive in seeking out
    information and a director who has an agenda that may be
    counter to the stated objective of the corporation.
        There has been a fair amount of experience with dissident
    directors. For example, in the past they have been on
    corporations where they felt the corporation was accumulating
    too much cash and, therefore, the cash should have been
    distributed to all of the shareholders when, in fact, just a
    couple of years after that it found that that same company was
    cash short. There have been examples where a dissident director
    has taken a position about being in a particular market or not
    being in a particular market, when a company has lost an
    opportunity to expand its revenues and expand its opportunities
    for jobs.
        More importantly, it removes the cohesiveness that good
    boards and good companies show in their directors and their
    governance, where we have seen companies with dissident
    directors, dissident by the definition of not questioning but
    having fundamentally different objectives from where the
    company is going, have had boards were you have had to meet ad
    hoc separately from that dissident or those dissident directors
    in order to get their business done.
        The last point I would make is that there is a
    misperception that corporations are democracies. In fact, they
    are not. Under State laws, and the way they are chartered, they
    are to represent all stakeholders, and the boards are to
    implement their fiduciary responsibility, not necessarily in a
    democratic way, not necessarily by the majority vote of all
    shareholders. Shareholders always have the opportunity to vote
    by leaving. It is our members' hope that they do not do that.
    We want shareholders that stay as investors for the long-term.
        In fact, one of the issues which was addressed by the
    previous panel and the commissioners of the Conference Board
    was that shareholding has gone from a long-term proposition in
    a very short period of time to one that is less than a year,
    including by some of the institutions that have been named
    here. They have moved to very short holding periods.
        So it is not a democracy. I do not think you can equate it
    to this Committee because it has to move and move very quickly,
    and move probably more often than a committee of Congress,
    which has to do with the legislative process. It cannot be as
    deliberative and it has to satisfy all of its stakeholders and
    sometimes in a very, very expeditious manner.
        Senator Sarbanes. Is it your position that if a majority of
    the shareholders of a corporation want to follow a certain
    path, that that can be ignored?
        Mr. Castellani. If that path is inconsistent with the
    fiduciary responsibility the directors have, and the directors
    feel there is a good business reason not to do that, it has, in
    fact, provided a circumstance that the best path would be to do
    something else.
        Senator Sarbanes. To whom do the directors owe their
    fiduciary duty?
        Mr. Castellani. To all shareholders at the same time.
        Senator Sarbanes. If a majority of those shareholders want
    to pursue a certain course of action, then what happens?
        Mr. Castellani. If it is a majority of the shareholders of
    the shares that are held, or the shares that are voted at the
    time, their responsibility is to the shares that are held.
        Senator Sarbanes. Let's assume that.
        Mr. Castellani. If it is a majority of the shares that are
    held and the shareholders make that known, and it is consistent
    with the fiduciary responsibility of the board, then the board
    should employ that.
        Senator Sarbanes. Is there a fiduciary responsibility
    different from responding to the majority view of the
    shareholders?
        Mr. Castellani. In some cases, I am told it can be. For
    example, the elimination of a poison pill requirement. Let us
    use that as an example. There was a proxy initiative that
    showed up on a lot of corporations' proxy statements, and has
    shown up over the last several years. There are some companies
    that have felt it was better to enhance shareholder value, long
    term, for all stakeholders by having such provisions to avoid
    takeover by a financial buyer who intended to either dissipate
    the company's asserts and the jobs that were incumbent on it,
    or to resell it to somebody else. So it was inconsistent and
    they did not adopt it.
        Senator Sarbanes. I am not going to pursue the subject
    because it is a very large subject.
        Chairman Shelby. Mr. Trumka wants to comment.
        Senator Sarbanes. But I am taken aback by this notion
    that--I mean, I do not know who you put the final ultimate
    decision on if you deny the majority of the shareholders having
    that authority.
        Mr. Castellani. No, I am not saying----
        Senator Sarbanes. We are back to the imperial CEO, the
    imperial board.
        Mr. Grinstein.
        Mr. Grinstein. Senator Sarbanes, I would jump in here. I
    disagree gently. I have agreed with much of what you have said
    today. I actually do think corporations are democracies and
    what we are doing is actually reinforcing that.
        The directors from the State law, you are exactly right.
    They do have a fiduciary duty to all shareholders or all
    stakeholders. However, if a majority of shareholders disagree
    with what those directors are doing, those directors are going
    to be voted out. That is the ultimate democracy. The President
    of the United States is responsible to all the citizens, but if
    a majority does not agree, you are going to be voted out,
    Senators, Congressmen, whoever.
        Senator Sarbanes. Yes, we are all very mindful of that.
        [Laughter.]
        Mr. Grinstein. And sitting on a board, especially in light
    of Sarbanes-Oxley, we are all very mindful of that, too. So
    when you are acting in a fiduciary responsibility, if you feel
    you have a majority of your shareholders who are opposing
    something, you are going to be very mindful of that.
        I also want to say I agree on the nominating committees,
    that by diversifying the nominating committees to independent
    directors only, that will have a tremendous effect. It is going
    to take time because boards are staggered, so these directors
    are only coming up every other year, every third year. So the
    effects of Sarbanes-Oxley and the independent directors on the
    nominating committees is only going to take place over time. It
    is going to take 2 or 3 years, or several cycles, until we
    begin to see the diversity in the boards coming in, or several
    annual meeting cycles.
        Senator Sarbanes. Mr. Trumka.
        Mr. Trumka. I would just like to make a couple of points.
    First of all, we do agree with Mr. Castellani that we have
    never found corporations to be democracies.
        [Laughter.]
        We would like to change that, however.
        Second of all, it is not necessarily true that if a
    majority of shareholders disagree with a director that they
    will get voted out. If you do not have access to the proxy,
    management puts those same people forward and you do not get to
    vote on anybody. That is why having this provision and letting
    shareholders have access to the proxy is so important.
        I want to make this very important point. There is a
    difference between formal independence and psychological
    dependence. A board member may be formally independent but
    psychologically dependent upon management. Only by having
    shareholders, long-term shareholders with access to the proxy
    can you guarantee the psychological independence of those board
    members as well.
        Senator Sarbanes. Mr. Chairman, I would close with one
    point.
        Chairman Shelby. Go ahead.
        Senator Sarbanes. I want to read to you a statement made by
    Chairman Donaldson before the Committee last week and ask for
    your reaction to it. This is the Chairman of the SEC.
        ``The short-term costs of compliance,'' referring to the
    legislation, ``particularly efforts to improve internal
    control, should be seen, in my view, as an investment. In the
    long-term, I believe that the reforms realized from the Act
    will result in sounder corporate practices and more reliable
    financial reporting.''
        ``New requirements coming out of the Act, such as personal
    certification by CEO's and CFO's of a company's financial
    disclosures, will renew focus on the independence of corporate
    boards and the focus on internal controls and procedures will
    strengthen companies in the long-run if they focus on the
    underlying intent of the Act rather than on mere compliance.''
        ``Companies that view the new laws as opportunities,
    opportunities to improve internal controls, improve the
    performance of the board, and improve their public reporting,
    will be better run, more transparent, and more attractive to
    investors.'' That is Chairman Donaldson.
        I would be interested in your reaction to that statement of
    the Chairman.
        Mr. Castellani. From our standpoint, from the Business
    Roundtable member companies, we could not agree more.
        Senator Sarbanes. Okay.
        Ms. Grinstein. I could not agree more.
        Senator Sarbanes. Mr. Trumka.
        Mr. Trumka. Yes.
        Mr. Anderson. We are in absolute agreement.
        Senator Sarbanes. Thank you all very much.
        Chairman Shelby. I will be brief. We have had two good
    panels today.
        Every SEC Chairman who has come before this Committee--and
    I have only been here 17 years on the Banking Committee--I have
    asked the question: Who owns the company; who owns the
    corporation? Every one of them emphatically said the
    shareholders. The shareholders, as we all know, own the
    corporations. The directors, the CEO, and the directors do not.
    We understand that it be fundamental.
        So if the shareholders own the corporation, I believe that
    where they have a greater voice and they do elect directors--
    and sometimes that is stacked against them, the participation
    in the election of directors. I think that is what concerns
    some people, because I have seen in my tenure here on the
    Banking Committee, in just looking out at the market, that
    sometimes CEO's and directors think and act as if they own the
    company. But if the shareholders fundamentally, as we know and
    agree, own the company, I think they have a great fiduciary
    relationship to that.
        What is wrong with letting the shareholders, the owners,
    participate, even if they own just a few shares, if they so
    desire?
        Thank you for appearing here today. I think we have all
    learned a lot today. The hearing is adjourned.
        [Whereupon, at 1 p.m., the hearing was adjourned.]
        [Prepared statements supplied for the record follow:]

                   PREPARED STATEMENT OF SENATOR WAYNE ALLARD

        I would like to thank Chairman Shelby for holding this important
    hearing today to discuss the impact of the Sarbanes-Oxley Act on
    accounting firms, financial reporting, and investor confidence. The
    passage of this landmark legislation one year ago was the first step in
    restoring public and investor confidence which had resulted from
    repeated failures in financial reporting and auditing.
        Our capital market system is fueled by accurate financial reporting
    and disclosure. A relationship of trust must be established between
    investors and companies in order for continued and increased
    participation in the markets to occur. After the repeated corporate
    scandals, the industry has been given the chance to redeem its
    reputation, through the standards and requirements set forth in
    Sarbanes-Oxley. What an opportune time for companies to repair what has
    broken down, and advance the U.S. markets that are revered by the rest
    of the world.
        I have been pleased to hear the progress that both the Securities
    and Exchange Commission and the Public Company Accounting Oversight
    Board have made thus far in implementing Sarbanes-Oxley, and I look
    forward to hearing today about the progress that the industry has made,
    and any concerns or difficulties that have arisen so far. Thank you to
    each of our witnesses for agreeing to testify today. I look forward to
    your testimony.

                                   ----------

                    PREPARED STATEMENT OF CHARLES A. BOWSHER

           Former Chairman, Public Company Accounting Oversight Board
                                October 2, 2003

        Thank you Mr. Chairman. My name is Charles Bowsher. I am the former
    Chairman of the Public Company Accounting Oversight Board. I also
    served as Comptroller General of the United States and head of the
    General Accounting Office from 1981 to 1996. I was a partner of Arthur
    Andersen & Co. from 1971 to 1981, and served as Assistant Secretary of
    the Navy (Financial Management from 1967 to 1971). Prior to that I was
    associated with and served as a partner at Andersen between 1956 to
    1967 in the firm's Chicago office. Presently, I serve as a director of
    several public companies and have recently been made a member of the
    Board of Governors of the National Association of Securities Dealers
    (NASD).
        I am pleased to be here today to discuss the recommendations of the
    Conference Board's Commission on Public Trust and Private Enterprise,
    and specifically the seven principles with recommendations and specific
    best practices for each that are contained in Part 3 of The Conference
    Board Commission's January 2003 report * concerning Audit and
    Accounting. This report is the second issued by the Commission--the
    first one was issued on September 17, 2002 and discussed the issue of
    executive compensation. In addition, I will describe what progress we
    think has been made in the last year, and what concerns we still have
    for the future.
    ---------------------------------------------------------------------------
        * Held in Senate Banking Committee files.
    ---------------------------------------------------------------------------
        By way of background, The Conference Board (the world's leading
    business network) convened a 12 member Commission in June 2002 to
    address the causes of declining public and investor trust in companies,
    their leaders and America's capital markets. The 12 members of the
    Commission, in addition to myself, included Peter Peterson (Chairman of
    the Blackstone Group, former Secretary of Commerce and Chairman of the
    Federal Reserve Bank of New York), John Snow (Chairman and CEO of CSX
    Corporation and former Chairman of The Business Roundtable), John Biggs
    (former Chairman, President, and CEO of TIAA-CREF), John Bogle (founder
    and former Chairman of Vanguard Group, Inc.), Peter Gilbert (Chief
    Investment
    Officer of the State Employees' Retirement System of the Commonwealth
    of Pennsylvania), Andrew Grove (Chairman of Intel Corporation), Ralph
    Larsen (former Chairman and CEO of Johnson & Johnson and former
    Chairman of The Business Council), Arthur Levitt, Jr. (former SEC
    Chairman and former Chairman of the American Business Conference) Lynn
    Sharp Paine (Professor at the Harvard Business School), Warren Rudman
    (former Senator and a partner at Paul, Weiss, Rifkind, Wharton &
    Garrison) and Paul Volcker (former Chairman of the Board of Governors
    of the Federal Reserve System), who is with me today to discuss two of
    the seven principles in Part 3 of the Commission's January 2003 report.
        To begin, I strongly believe the Sarbanes-Oxley Act of 2002, which
    was largely the work of this Committee, is an excellent piece of
    legislation, especially in
    regard to audit and accounting issues. This legislation was long
    overdue. As one Business Week headline stated, the reforms of the
    1930's were not adequate for the 1990's.
        The introduction to Part 3, Audit and Accounting, of the Conference
    Board report clearly defines the importance of effective audits and the
    need for continued reform. I would quote two key paragraphs:

            The audit process is integral to the confidence required for
            the financial markets to operate effectively. Every public
            company must be audited annually by a firm of independent
            accountants. In the last several years, crises involving
            companies such as Enron, WorldCom, Xerox, Cendant, Adelphia,
            and Tyco have focused attention on the integrity of the audit
            process and its oversight. The public's trust--including that
            of investors, insurers, and creditors--that audited financial
            statements provide an accurate picture of the company's
            finances is essential for the confidence that the capital
            markets require. The alleged auditing failures associated with
            the recent corporate scandals have been a major factor in the
            erosion of that trust.

        The Sarbanes-Oxley Act (the ``Act'') of 2002, the proposed New York
    Stock Exchange listing standards, and the Nasdaq corporate governance
    proposals have each focused on a number of structural reforms to
    improve the independence of the outside auditors and to strengthen
    their oversight by the audit committees composed of financially
    literate independent directors, at least one of whom, under the New
    York Stock Exchange listing requirements, must have specific financial
    expertise. The Conference Board Commission on Public Trust and Private
    Enterprise believes that the following seven principles, particularly
    with respect to larger public companies, will strengthen the reforms
    begun by the Act and the NYSE to bolster the public's confidence in
    audited financial statements.

        The first major issue that the Conference Board report addressed is
    the need for an enhanced role for audit committees. We recommend that
    corporate boards should make sure and devote sufficient resources and
    time to implement Sections 301 and 407 of the Sarbanes-Oxley Act,
    especially in regard to:

     the independence and qualifications of the audit committee
        members;
     the need for one member of the audit committee to be a
        financial expert;
     the need for conducting an annual assessment of the
        performance of the audit committee and its members;
     the right of the audit committee to retain certain outside
        advisors or educational consultants as they deem appropriate.

        Many of the recommendations in our report, and those in Sarbanes-
    Oxley Act, that relate to an enhanced role of the audit committee were
    previously discussed and recommended in the 1999 Blue Ribbon Committee
    Report on Improving the Effectiveness of Corporate Audit Committees,
    which was created by the New York Stock Exchange (NYSE) and the NASD in
    response to concerns about the financial reporting process as expressed
    by the then Chairman of the U.S. Securities and Exchange Commission
    (SEC).
        It is heartening to report that it appears that numerous public
    company boards in the last year have moved forward to strengthen their
    audit committees. Audit committee members who were not independent and/
    or properly qualified have been replaced, and many very qualified
    financial experts have been named to audit committees. The General
    Electric (GE) Board is a good example. However, it appears that not all
    boards have moved forward on this much needed reform and this is an
    area that the SEC should monitor on an annual basis when the proxy and
    annual reports on Form 10-K are submitted. I would think the Committee
    might wish to consider requiring an annual report from the SEC on this
    issue.
        The second major issue the Conference Board report addressed is
    that of audit committee member education and the need for an
    orientation program for each member of the committee as well as the
    need for continuing education programs.
        The third major issue that the Conference Board report addressed is
    that of improving internal controls and internal auditing, which was an
    important section (404) of the Sarbanes-Oxley Act. Our report states
    that every public company board, and especially the audit committee,
    should make enterprise risk assessment and internal controls high
    priorities in order to facilitate the certification and report
    processes required by Sections 302 and 404 of the Sarbanes-Oxley Act.
        The Public Company Accounting Oversight Board (PCAOB) has not yet
    issued the standards for Section 404. However, it is my view that many
    public companies are moving ahead to document and improve their
    internal controls in order to be ready to include a management report
    in their 2004 annual report and to be ready for their outside audit
    firm to review and attest to the company's report on internal controls.
        For companies that have adequate and well documented internal
    controls and an adequate internal audit function, it will not find the
    reporting on internal controls to be a major or costly effort. However,
    those companies that have not put an emphasis on internal controls will
    have a one-time investment to make, but investors will be much better
    protected once management and outside auditors can attest to proper
    internal controls. This area is the basic framework for the CEO and CFO
    certifications regarding the annual financial statements and quarterly
    reports.
        The PCAOB and the SEC must monitor this area very carefully and
    again, should keep this Committee informed about the progress achieved
    beginning with the 2004 company reports.
        An important consideration to keep in mind is that outside auditors
    should not be involved in the documentation of clients' accounting and
    operating controls. This is in keeping with the principle that an
    external auditor should not audit its own work. The Sarbanes-Oxley Act
    specifically prohibits an external auditor from performing internal
    audit services for audit clients.
        The fourth area that the Commission report addressed was auditor
    rotation. We recommend that in order to assure the independence of any
    audit, the audit committee should seriously consider rotating outside
    audit firms when some or all of the following circumstances exist:

     the audit firm has been employed by the company for a
        substantial period of time, for example, over 10 years;
     one or more former partners or managers of the audit firm are
        employed by the company; and,
     significant nonaudit services are provided to the company--
        even if approved by the audit committee.

        I recognize that the General Accounting Office (GAO) was requested
    by Section 207 of the Act to study and report on the issue of mandatory
    rotation of registered public accounting firms. As of now, this report
    has not been issued by the GAO.
        It is interesting to note that the recently released WorldCom
    report requires rotation of the auditors every 10 years.
        My fellow Commission member, Paul Volcker, will discuss the next
    two major issues that the Conference Board report addressed--
    professional advisers for the audit committees and services performed
    by accounting firms.
        The last major issue that the Conference Board report addressed
    directly relates to the Big Four firms which, as a recent GAO report
    indicated, audit most of the public companies in the United States and
    the rest of the industrial world. Our concluding paragraph in this
    section of our report stated that the business model, strategies, and
    focus of the Big Four should ensure that quality audits are their
    number one priority. The Big Four must be sure that they each represent
    a ``gold standard'' in auditing.
        The question here is this: Has the leadership of the Big Four
    accounting firms each examined their business model to ensure that it
    is consistent with the idea that quality audits represent their number
    one priority?
        Many observers of the accounting profession would say ``no,'' that
    the Big Four firms have still not changed, are primarily focused on
    their litigation risks, and are resistant to major reform. Some,
    including the Big Four firms, would be more positive. One firm has
    invested heavily in full page advertisements in The New York Times and
    Wall Street Journal to convince the public that the answer is ``yes.''
        I believe the jury is still out. Daily press coverage and other
    reports of continued problems with Big Four audits and other
    professional work indicates that much work and rethinking is still to
    be done.
        A very distinguished accounting professor, Art Wyatt of the
    University of Illinois, just gave a very thoughtful speech entitled
    ``Accounting Professionalism--They Just Don't Get It'' to the recent
    annual meeting of the American Accounting Association, which is the
    group that represents the accounting professors of all our major
    universities. I commend this speech to the Committee (Mr. Wyatt's
    speech is available on the American Accounting Association website,
    www.aaahq.org).
        I certainly agree with SEC Chairman Donaldson's recent statement
    before the House Financial Services Committee when he said that ``[w]e
    should all realize . . . that the PCAOB alone cannot restore investor
    confidence in the integrity of the accounting profession. If these
    efforts are to be successful, each accountant, from the CEO of the
    accounting firm to its most recently hired employee, must demonstrate a
    willingness to place the interests of investors above all else.
    Remaining independent and `telling it like it is' is fundamental.''
        Mr. Chairman, this concludes my prepared testimony. I would be
    happy to answer any questions you may have.

                   PREPARED STATEMENT OF PAUL A. VOLCKER \1\
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        \1\ I have submitted, in lieu of a new statement, excerpts from
    remarks made on Sept. 24, 2003, which directly pertain to the subject
    of the hearing.
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       Former Chairman, Board of Governors of the Federal Reserve System
                                October 2, 2003
              American Leadership and Business Responsibility \2\
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        \2\ Excerpts from a September 24, 2003 address by Paul A. Volcker
    at Washington University, St. Louis.
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        Cast your minds back only a few years to the mid-1990's. Powered
    both by new technology and the ideology of free markets, the
    integration of markets internationally was in full swing . . .
        But then, in the glow of seeming success, something unexpected and
    disturbing happened. We had a succession of financial and economic
    crises, first in Mexico and then in Asia, in Russia, and back to Latin
    America. Those were big setbacks for the emerging world. With few
    exceptions, individual countries have not yet returned to earlier
    growth trends . . .
        In the wake of the crises, the theme of much of the analysis was
    that the emerging economies were fragile and vulnerable because of
    long-standing weaknesses in their business practices: in accounting and
    auditing, in the prevalence of cronyism and corruption, in badly skewed
    distributions of incomes, and in a lack of respect for the rule of law.
    If only, the refrain went, those countries would adopt western, and
    particularly American business practices, then the opening of financial
    markets would have proceeded more smoothly, with fewer excesses and
    surprises.
        Well, from the perspective of today, all that seems simplistic, to
    say the least. We have had to recognize that our own stock market
    performances and accolades of business performance exaggerated reality.
    Enron, WorldCom, Tyco, Adelphia, Arthur Andersen--now the New York
    Stock Exchange itself--have cast a different light on things. We
    obviously have a lot of work to do here at home if we are to restore
    confidence in our own securities markets and make good on our implicit
    claim to be a model for the world economy.
        There are those who would dismiss the scandals as the work of a few
    bad apples. We are warned not to overreact, at the risk of undermining
    entrepreneurial energy and the spirit of innovation.
        Well, I do not want to overreact, but I have been at least as
    concerned by a sense of denial or complacency.
        I know perfectly well that the great mass of American businesses
    performs with skill and honesty as they respond to the incentives and
    competitive pressures in the marketplace. But we have seen enough
    examples of malfeasance, misfeasance, and nonfeasance to know that we
    are dealing with more than isolated anomalies. The egregious examples
    are a reflection of a wider willingness to cut accounting corners, to
    press at the edges of acceptable business practices, to tolerate
    conflicts of interest, and to find elaborate and questionable ways and
    means around established accounting principles and tax regulations.
        The demand for a response and some basic reforms strikes me as
    entirely legitimate, just as the financial excesses of the 1890's and
    1920's led to constructive change that we now take for granted.
    Accounting Reform and Sarbanes-Oxley
        The accounting and auditing profession, sadly epitomized by the
    demise of Arthur Andersen, has borne the brunt of the criticism and the
    reform effort. There is a certain justification in that.
        The auditing profession bears a clear and unique burden of
    attesting to the validity and integrity of a company's accounts. That
    responsibility of auditors, incorporated in law, runs to the investing
    public--to the market for private capital--rather than to the companies
    that hire and pay them. Honesty in accounting and reporting is, after
    all, the bedrock of the efficient allocation of capital.
        There can no longer be doubt that internal conflicts within
    accounting firms greatly increased in recent years and became
    essentially unmanageable. All the big
    accounting firms took a basic decision to become general business
    consultants and advisers, sensing that those services would be more
    lucrative than the core auditing function. In the process, the drive
    for revenues had the consequence of eroding the auditing discipline
    that lay at the core of their professional responsibility.
        This was an area, in my opinion and that of many others, that
    demanded a legislative response. If reliable accounting and auditing is
    essential to an effective capitalist system, I have come to realize
    what a demanding profession it is. There are very large intellectual
    and practical challenges. It is not a matter of obstructive technicians
    with green eye-shades, but a most demanding responsibility.
        The sad fact is efforts at voluntary reform and professional self-
    regulation have been weak and ineffective. The need for a legislative
    response became clear.
        The Sarbanes-Oxley Act appropriately deals with three crucial
    areas.
        First, the conflicts associated with the spread of consulting
    services have been sharply reduced. The sale of many nonaudit services
    to audit clients is now prohibited or restricted, leading all but one
    of the remaining ``Big Four'' accounting firms to sell or spin off
    their lucrative high-tech consulting practices.
        Second, auditing standards and review of actual auditing
    practices--both revealed by events to have been inadequate--has been
    delegated to a new regulatory body, the Public Company Auditing
    Oversight Board.
        Third, the new Board, operating alongside the SEC under strong
    leadership, should be able to maintain the degree of oversight and
    surveillance that we have long assumed with respect to our securities
    market generally. In particular, the SEC now has the leadership, the
    funding, and potentially the staffing to meet its responsibilities in a
    world of finance ever increasing in complexity.
        In focussing on accounting, auditing, and the SEC, I do not want to
    lose sight of the responsibilities of other so-called ``gate keepers''
    in the financing process. Accounting firms were not alone in designing
    and encouraging elaborate schemes to circumvent accounting principles,
    to dodge taxes, and to embellish and smooth earnings. Far from it,
    there were battalions of investment bankers, lawyers, consultants, and
    financial engineers prepared to go to the edge or even beyond ethical
    practice. Too often they have lent their professional authority to
    practices of their own clients that fraudulently misrepresent operating
    results. In the process, investors are ill-served and the long-term
    prospects for the business jeopardized.
        I do not think our great schools of business can entirely escape
    responsibility. I was taken aback a while ago when one of the leaders
    of Wall Street, sharing with me his sense of distress about the
    perceived lapse of standards, commented ``What do you expect when our
    best business schools for 20 years have preached the doctrine that the
    only measure of success is the price of a company's stock, with the
    implication that any means of enhancing that price short of overtly
    criminal or unethical behavior is fair game?''
        As I overcame my surprise, I had to agree there was at least a
    grain of truth in what he said.

    Corporate Governance
        Here, I would suggest, we are entering an area that is really
    beyond the ability of law and regulation to address. The discharge of
    professional responsibilities and methods of corporate governance--the
    arrangements made to run and oversee the operations of our business
    firms--seems to me to require a rather different approach. The hundreds
    of thousands of businesses in the United States, from the tiniest to
    the huge multinational corporations, can hardly be fit into a common
    pattern.
        If government must tread with caution, there has been no shortage
    of comment and debate. Dozens of conferences and commissions and
    learned essays have opined on what, if anything, needs to be done. Long
    checklists of good practice have been developed--the appropriate size
    of board, the independence of directors, the emphasis on the auditing
    committee, appropriate remuneration practices, and on and on. Much of
    that strikes me as helpful.
        But it is also clear one size cannot fit all. In the end, what will
    count is something less tangible, something that cannot be fully
    reflected in any checklist of good practice.
        Boards of directors tend to be collegial bodies. The natural
    instinct is to support management. After all, they typically have been
    chosen by the chief executive officer; at the very least, he or she has
    heavily influenced the choice of directors. Or, if the CEO is
    relatively new, the appointment is by the Board, and that also implies
    a readiness and desire to provide strong support.
        The CEO, in turn, naturally looks to the Board for counsel and
    support of strategic plans, of personnel appointments, succession
    planning, and the like. In effect, the Board acts in support of
    management, which raises a rather basic question.
        It is the job of the CEO to manage. The basic and unique
    responsibility of the Board is rather different. It is to oversee--to
    satisfy itself that the CEO and his team are acting with integrity and
    in the best long-term interest of the stockholders. That implies a
    certain distance from the CEO, a skeptical eye, and a concern for other
    ``stakeholders'' important to the success of the corporation. A
    priority must be attention to the integrity of management.
        In sum, directors need to maintain independence--independence in
    fact as well as in form.
        It seems to me, and increasingly to many others, that this is an
    area in which we need a change from what has been embedded in American
    corporate doctrine. The argument has been that combining the function
    of Chairman and CEO focuses responsibility, assures a clear line of
    authority, and encourages quick and effective decisionmaking. And so it
    does.
        The difficulty is the ``imperial CEO'' may not leave much room for
    the Board to provide really effective oversight. True independence
    requires effective Board leadership, leadership able and willing to
    shape the agenda and to encourage full and regular discussion without
    management present.
        My point is that it is difficult at best--and sometimes not
    possible--for those contrasting responsibilities of management and
    oversight to be discharged by a single person.
        I realize the pattern of a nonexecutive chairman will not fit all
    companies. It may well not be suitable for new ventures and small
    corporations, for privately owned companies or in transitional
    circumstances. But I do think, for large public companies with widely
    dispersed ownership, a separation of the oversight and management
    functions should be recognized as preferable, as indeed is common
    practice abroad. At the least, companies departing from that practice
    should be required to explain and rationalize that decision, and to
    provide for a reasonable substitute such as a ``presiding'' or ``lead''
    director.

    Executive Compensation
        I suppose no issue has raised more questions about corporate
    management and Board oversight than the matter of executive
    remuneration, in my mind justly so. I have seen reference to a truly
    disturbing statistic. Fifteen years ago, the average compensation of an
    American corporation reportedly ran to about 40 or 50 times the pay of
    the average employee; today that ratio approximates 500 times.
        What is it that today produces, as a matter of course, tens of
    millions of dollars of compensation for CEO's in a single year, and
    occasional pay-offs of well over $100 million? Does it indeed take that
    kind of pay to motivate top executives? Are the powerful incentives
    involved really constructive, or have they encouraged excessive risk
    and even unethical behavior?
        Those are serious questions, too often ignored in what clearly
    became a kind of competitive game, ratcheting pay higher and higher to
    maintain parity with one's peers.
        One aspect has become rather clear. The escalating patterns of
    compensation over the past decade or so are, directly and indirectly, a
    by-product of the wide-spread use of stock options . . .
        In the 1990's, in the midst of the greatest bull market in all of
    history, those options paid off in amounts far beyond anything that
    could have been foreseen by the Boards that granted them. The fact is
    the dramatic evaluation of the overall stock market lifted almost all
    individual stocks. The result was companies granting stock options
    richly rewarded their executives even when business performance fell
    below average. There have been grotesque examples of leaders of failing
    companies ``cashing in'' not long before the default. It is hard to
    maintain that fixed price options without downside risk truly aligned
    incentives with an ordinary stockholder.
        The fact of the matter is that the enormous jump in total executive
    compensation was a reflection of the largely unanticipated payoffs on
    stock options in the 1990's. In effect, a new norm was established for
    executive pay, aided and abetted by the legions of compensation
    consultants quick to suggest to their clients the importance of
    maintaining comparable--or more likely, above average--pay.
        Look no further than the stated rationale for the amounts paid the
    executive head of the New York Stock Exchange, once thought of as
    rather semi-public responsibility. The sums were justified as
    comparable to the pay of major financial companies, whose compensation
    is typically importantly in equity shares and stock
    options.
        There is no doubt that stock options can provide a powerful
    incentive. For cash poor, risky, and innovative companies they may well
    have an important role. In any case, the decision will appropriately be
    made by the dominant owner or owners. That is a very different
    situation from the large, established public company, with ample
    financial resources and widely dispersed owners without direct
    decisionmaking authority.
        Conceptually, the idea that executives and employees should have a
    stake in the financial performance of their own company surely makes
    sense. Equity ownership in some amount--taking the risk of losses as
    well as gains--should help align interests with owners. But taken to an
    extreme, particularly with heavy use of one-way options, there are
    demonstrable dangers.
        Again, I do not say this is a matter for legislation; it is rather
    a matter of encouraging appropriate patterns of corporate behavior.
    Good accounting practices have a part to play. The strong and effective
    resistance in the past to the expensing of stock options by American
    business cannot, I believe, any longer be intellectually defended.
        Several leading American corporations have recently decided
    voluntarily to expense grants of options, an approach, I believe, that
    will soon become required accounting practice right around the world.
    Others have now gone further, deciding to end fixed-price stock options
    entirely or to sharply reduce their use . . .

    Conclusion
        In sum, we are beginning to see real progress in bringing our
    practice of auditing, oversight, and corporate governance closer to
    what we have long preached . . .
        Most fundamentally, it seems to me, we as a society need to restore
    and emphasize the importance in the business world of strong
    professional values and ethical behavior.
        I know that cannot be legislated, certainly not in any detail. But
    I do not believe either, as some have argued, it is all a matter of
    what we have learned at Mother's knee, beyond later influence.
        Rather, it seems to me, there is the intangible but real matter of
    societal norms, broadly understood and recognized, not just as a matter
    of professional and individual pride. What is at stake is the
    foundation of a truly democratic, competitive market system . . .
        If this new world of globalization is to be a prosperous and
    peaceful world--a world in which a democratic system of capitalism is,
    indeed, the model--we would better make sure our own markets are
    performing both effectively and ethically.

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                    PREPARED STATEMENT OF BRIAN P. ANDERSON
               Chief Financial Officer, Baxter International Inc.
                                October 2, 2003

        Mr. Chairman, and Members of the Committee: I am Brian P. Anderson,
    Senior Vice President and the Chief Financial Officer of Baxter
    International Inc. Baxter International is a global health-care
    company, listed on the New York Stock Exchange, with approximately $8
    billion in sales and 50,000 employees in more than 100 countries
    worldwide.
        I am very pleased to have this opportunity to join you today, along
    with my colleagues from the business community and others, to look at
    the Sarbanes-Oxley Act 1 year later. Looking back, 2 years after the
    Enron story became public, followed by WorldCom, Adelphia, Tyco, and
    Global Crossing, one easily concludes that these corporate governance
    and accounting scandals seriously threatened the public confidence that
    is fundamental to the efficiency of our capital markets, an essential
    component of our free enterprise system. By passing the Sarbanes-Oxley
    Act of 2002, Congress took a bold step toward restoring public
    confidence and rebuilding trust. The question before us now is whether
    this law, and the tools it provides for reform, have accomplished the
    intended objective of restoring public trust through meaningful change
    within corporate America.
        The Sarbanes-Oxley Act seeks to effect change through many avenues.
    For purposes of my comments today, I will address them within the
    fundamental structure that comprises our modern corporate system: The
    shareholders/investors, the board of directors, and the senior
    management of the corporation.
        Beginning with the management of the corporation, I believe the
    most significant aspect of the Sarbanes-Oxley Act in this regard is the
    visibility and emphasis it places on corporate executives to ensure
    that financial information is correct. Obviously, the public's
    confidence in the integrity of financial reporting was seriously eroded
    as a result of the corporate scandals, and the individual investors who
    invested their funds based on this information were ultimately the ones
    who were most harmed by this failure. As you are aware, the Act places
    responsibility for ensuring enhanced and accurate financial statement
    disclosure not only upon management of corporations, but also upon
    public accountants and audit committees of board of directors.
        Among the measures designed to improve investor confidence in
    corporate reporting are (1) significantly enhanced and more timely
    financial and nonfinancial disclosure requirements, (2) CEO/CFO
    certification of periodic reports and (3) a redesigned approach to
    regulations of the accounting profession, including auditor
    independence. In general, my opinion is that these rules have served
    their intended purpose well. Issuer disclosure in both financial and
    nonfinancial arenas has improved significantly and, perhaps just as
    importantly, management's time, energy, and focus on enhanced
    disclosure has increased, whether through disclosure committees or
    otherwise. This necessarily serves to protect investors and ensure the
    reliability of the financial information available to the investing
    public. One of the most positive outgrowths of this initiative will
    hopefully be an increase within corporations of a climate of
    compliance.
        For example, at Baxter, we formalized our disclosure committee and
    documented our disclosure controls and procedures, which we found to be
    a productive and worthwhile exercise. We found that, for a
    multinational company operating in over 100 countries, we had a very
    rigorous reporting and control environment; however, there were
    improvements that could still be made. We view this as a living and
    breathing process that, in accordance with the new rules, is reviewed
    on an ongoing basis and refined as necessary.
        On the other hand, I believe that it still remains to be seen
    whether the time, effort, and expense required by issuers and
    management to comply with Section 404 of the Act (not to mention the
    independent auditors) will ultimately result in significantly enhanced
    internal controls and procedures. Please do not misunderstand my
    comment: I believe management should acknowledge its responsibility for
    the adequacy of the company's internal control structure and procedures
    for financial reporting, and should assess the effectiveness of the
    company's internal control over financial reporting. At this point,
    however, it is not obvious to me that corporations today have mastered
    the most effective method of accomplishing this goal.
        While I understand and agree with the intent behind Section 404 of
    the Act, the time and costs involved are not insignificant or
    incremental. It will virtually double Baxter's internal and external
    audit costs. Complying with Section 404 of the Act not only imposes
    significant and time-consuming obligations on reporting companies, but
    it also requires an attestation of management's internal control report
    by independent auditors. My overall concern here is that both reporting
    companies and external auditors will spend an enormous amount of time,
    energy, and money to ensure compliance with Section 404 without
    necessarily achieving the desired outcome of ensuring that companies
    have systems in place to identify potential weaknesses in their
    financial reporting.
        In general, however, I believe that the increased responsibilities
    and focus that Sarbanes-Oxley has brought upon independent auditors is
    a positive development. The importance of the public's trust in
    accountants, particularly as it relates to audits of public companies,
    cannot be emphasized enough. In that regard, I believe that Congress
    has, through Sarbanes-Oxley, successfully implemented important and
    significant changes designed to ensure auditor independence. By
    severely limiting the kinds of nonaudit services that can be performed
    for audit clients, restricting relationships that can result in a lack
    of independence, establishing ``cooling off'' periods, and ensuring
    mandatory audit partner rotation, there should be significantly
    improved independence of audit firms from their public company clients.
        In addition, I support the notion that the previous system of
    accounting firm self-regulation required substantial revision.
    Accordingly, I believe that the creation of a Public Company Accounting
    Oversight Board will serve to enhance investor confidence in the value
    that independent auditors can bring to our corporate system.
        The Act has also, through Section 202, solidified an important link
    between the independent auditors and the audit committees of boards. At
    Baxter, we have had several of these initiatives and processes in place
    for many years, including executive sessions between the audit
    committee and our independent auditors, and audit partner rotation. We
    have, since the enactment of the Act, changed our practices in the area
    of nonaudit work to conform to the new rules. Overall, I believe that
    the new rules imposed by the Act with regard to public audit firms and
    their activities should result in significant positive change.
        Turning to boards of directors, I believe that the Act has had and
    will continue to have a significant positive impact on how boards
    interact with management and each other. The exposure of serious
    problems around corporate governance and the heightened awareness of
    this topic have served to put the public spotlight on issues such as
    board independence, board qualifications, and the roles and
    responsibilities of board committees. This can only improve
    accountability and responsibility of our corporate boards, which, in
    turn, means better representation on behalf of the shareholders.
        At Baxter, we are proud of our strong commitment to maintaining the
    highest standards of corporate governance. In 1995, Baxter became one
    of the first companies to adopt formal Corporate Governance Guidelines,
    long before corporate America was required to meet today's new
    standards. Most of the new rules the Government now mandates are
    practices we have had in place for years. In fact, as a result of
    Baxter's many years of attention to corporate governance, the Sarbanes-
    Oxley Act as well as the proposed New York Stock Exchange rules, has
    not dramatically impacted Baxter's practices.
        The company's corporate governance guidelines, which are annually
    renewed and revised as appropriate, address issues such as board size,
    structure, composition, qualifications, diversity, director term
    limits, retirement ages, strategic planning and succession planning.
    Working with our chief corporate governance officer, the board
    continually discusses Baxter's governance practices, changing our
    policies when necessary and identifying areas where we need to improve
    our performance.
        The board recently adopted categorical independence criteria by
    which director independence will be assessed. As of September 2003, 10
    out of 11 directors were independent under the new criteria, with Harry
    Kraemer, Baxter's chairman and CEO, being the only nonindependent
    director.
        While our CEO and other members of our executive management team
    attend board committee meetings to share their thoughts and
    perspectives, our board and its committees also regularly meet in
    executive session without any members of Baxter's management team
    present. These ``executive sessions'' (where no management is present)
    are very important to help ensure the objectivity of the board. But we
    recognize that these practices were not necessarily commonplace prior
    to enactment of Sarbanes-Oxley, and we commend Congress for raising the
    bar for all companies.
        With respect to shareholders, I believe the Sarbanes-Oxley Act has
    had, and will continue to have a positive impact. While shareholder
    confidence was justifiably shaken by corporate scandal and fraudulent
    behavior, there is a renewed energy and optimism among shareholders
    these days. The Sarbanes-Oxley Act, as well as the pending changes to
    be implemented by the New York Stock Exchange and Nasdaq, have provided
    shareholders with confirmation that their government is attempting to
    eliminate opportunities for abuse. Debate is increasing regarding the
    rights of shareholders and the matters over which they should have
    control, or at least a voice. Shareholders are seeking control over
    executive compensation, increased access to the proxy statement,
    increased participation in corporate affairs, and direct access to the
    board, including board nominations.
        Thus, Mr. Chairman, looking back at what has occurred since the
    enactment of Sarbanes-Oxley, I believe we see on balance a very
    positive and encouraging picture. It is clear that, in light of the
    corporate governance and accounting scandals that began to emerge 2
    years ago, strong medicine was needed quickly to restore investor
    confidence, create independent oversight, and eliminate the serious
    conflicts of interest that led to these abuses in the first place.
        To those who feel that Sarbanes-Oxley may have gone too far, I
    would say that the strong medicine appears to be working and that we
    must not abandon the treatment just because there may be some unwanted
    or unpleasant side effects. At the same time, to those who might feel
    that Sarbanes-Oxley may not have gone far enough, I would also urge
    caution and strongly encourage them to closely monitor the impact of
    the law to make sure we have not tipped the balance too far in any one
    direction.
        Specifically, looking forward, I believe we must pay close
    attention to the balance between Federal and State law, the potential
    erosion of the business judgment rule, increased liability for
    directors, and the increasing hesitancy of qualified individuals to
    serve on corporate boards, especially on audit committees.
        Federal law historically has regulated the securities markets by
    requiring specified financial public disclosures from publicly traded
    companies. State law, on the other hand, has provided guidance on
    corporate governance, such as corporate structure, shareholder rights,
    and the fiduciary responsibilities of directors. Although neither the
    Sarbanes-Oxley Act, nor the pending exchange proposals, technically
    create a new cause of action for stockholders, some of the provisions
    within Sarbanes-Oxley, as well as pending stock exchange rules, overlap
    into areas traditionally covered by State law, such as definitions of
    director independence and audit committee composition and
    responsibilities.
        In addition, with the balance between Federal and State law in
    flux, the State courts are sending the signal that they too are
    expecting more from corporate boards. The Delaware Supreme Court
    recently has reversed several chancery court decisions that upheld
    director decisionmaking, and the decision of the Chancery Court in In
    re the Walt Disney Company to deny the defendants' motion to dismiss
    points to a willingness by the courts to second guess director
    decisionmaking and question the good faith and duty of care elements of
    the business judgment rule. The consequences of this trend may be the
    creation of a new standard of care for directors that could dissuade
    some qualified, high caliber individuals from serving as a director of
    a public company because of the uncertain potential liability.
        Finally, I believe all three of the constituencies I have
    addressed--corporate management, corporate boards, and shareholders--
    would be better served if the SEC exercised its authority to implement
    more of the Sarbanes-Oxley provisions through its well established and
    respected rulemaking process. The SEC has been granted the authority to
    address unfair and inequitable situations that might arise out of, for
    example, the Section 402 loan restrictions, or to provide guidance
    where there are questions of interpretation, but the Commission has
    stated it will not do so.
        Mr. Chairman, we very much appreciate having the opportunity to
    appear before this Committee today to underscore the importance of what
    you have accomplished with the enactment of the Sarbanes-Oxley Act, and
    to express our strong support for the overall goals that this
    legislation is intended to serve. As I hope I have articulated, I
    believe that Congress has addressed in a full and fair manner all
    aspects of our public corporate system through legislation that impacts
    corporate management, corporate boards and corporate shareholders, and
    has taken a dramatic step toward restoring public trust and confidence
    in our capital markets system. I would be happy to respond to any
    questions you might have.

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                    PREPARED STATEMENT OF JOHN J. CASTELLANI
                       President, The Business Roundtable
                                October 2, 2003

        Good morning. My name is John Castellani, and I am President of The
    Business Roundtable, an association of CEO's of leading corporations
    with a combined workforce of more than 10 million employees in the
    United States and $3.7 trillion in annual revenues. I appreciate this
    opportunity to share the Roundtable's views on implementation of the
    Sarbanes-Oxley Act and restoring investor confidence.
        I would like to begin by commending this Committee for your efforts
    to strengthen corporate governance and restore investor confidence over
    the past 2 years. The Business Roundtable has been a leader in
    advocating corporate governance reforms for over three decades,
    beginning in the 1970's with our first statement on corporate
    governance and continuing through the 1980's and 1990's with numerous
    publications addressing corporate governance best practices. In May
    2002, we published our Principles of Corporate Governance, a set of
    best practices designed to guide corporate governance practices and
    further U.S. companies' ability to compete, create jobs, and generate
    economic growth. The Roundtable strongly supported the Sarbanes-Oxley
    Act, and we have supported the SEC's efforts to implement it.
        And a word of thanks to the SEC. Despite a tight rulemaking
    schedule, it took the time to consider every rule, weigh its
    consequences, and solicit--and listen to--input from investors,
    companies, and others.
        The Sarbanes-Oxley Act put a necessary spotlight on corporate
    governance and financial reporting. Our members have viewed the Act as
    an opportunity to enhance their corporate governance practices and
    financial reporting procedures. In addition, Roundtable companies have
    implemented--voluntarily at this point--many of the proposed New York
    Stock Exchange and Nasdaq corporate governance reforms, with
    independent boards of directors, entirely independent audit, nominating
    and compensation committees and written committee charters.
        A recent survey of Roundtable companies shows that our members are
    committed to living up to the spirit, not just the letter, of all of
    these reforms.
        For example, 88 percent of Roundtable companies report increased
    involvement in board and committee meetings by members of the audit,
    nominating, and compensation committees, and over 90 percent report
    increased involvement by the board as a whole. In keeping with the
    spirit of the reforms, audit committees today have taken ``ownership''
    of the relationship with independent auditors, making it clear that
    auditors report to the committee, not to management.
        Roundtable companies also report a dramatic increase in director
    evaluations, with 70 percent of companies performing director
    evaluations this year compared to 44 percent in 2002. As we stated in
    our Principles of Corporate Governance, directors should serve only so
    long as they add value to the board, and the recent rise in director
    evaluations reflects companies' renewed commitment to board quality and
    accountability.
        The Business Roundtable supports enhanced communications with
    shareholders, and, to that end, we supported recent SEC efforts to
    increase disclosure about nominating committee processes and to require
    disclosure concerning shareholder communications with the board. In
    fact, two-thirds of Roundtable companies have discussed with their
    nominating committees a process to communicate and respond to
    shareholder proposals and inquiries. An equal number have a process in
    place to communicate and respond to shareholder nominations of board
    candidates.
        Moreover, the Roundtable has strongly supported the New York Stock
    Exchange and Nasdaq proposals to require regularly scheduled executive
    sessions of independent directors. In fact, the independent directors
    of 55 percent of Roundtable companies expect to meet in executive
    session five or more times this year. In many cases, directors today
    are convening in executive session before or after each meeting of the
    full board.
        The New York Stock Exchange also has proposed to require that a
    director be designated to preside at executive sessions of the
    independent directors. Our members agree that it is important to
    provide leadership for a company's independent directors. In our recent
    survey, 55 percent of Roundtable companies reported that they have
    named an independent lead director as either an independent chairman,
    lead director, or presiding outside director. This indicates the
    diversity of approaches to board leadership that companies take,
    depending on their unique circumstances.
        Finally, 8 in 10 Roundtable companies report that their boards of
    directors are at least 75 percent independent, and 9 in 10 report that
    at least two-thirds of their directors are independent, exceeding the
    proposed New York Stock Exchange and Nasdaq listing standard
    requirements. As we stated in our Principles of Corporate Governance,
    providing objective, independent judgment is at the core of the board's
    oversight function--a key to good corporate governance.
        Although much progress has been made, implementation of the
    Sarbanes-Oxley Act is not complete. For example, the SEC provided an
    extended effective date for its rules relating to internal controls
    over financial reporting to give companies and their accounting firms
    time to comply on a better and more cost-effective basis. Nevertheless,
    these rules may prove to be the most costly of the Sarbanes-Oxley Act
    reforms.
        I mention these costs not to begrudge them. Rather, many of the
    costs associated with Sarbanes-Oxley are necessary and appropriate. At
    the same time, we need to remember that business must satisfy the needs
    of a large set of stakeholders--our shareholders, our employees, our
    customers, and the communities in which we operate. To do that, we must
    run our companies in an effective and ethical manner. In this regard,
    good corporate governance should be equated with high value for all of
    our shareholders and other stakeholders. We should not so overly focus
    on regulating the mechanics of corporate governance that we lose sight
    of creating that value.
        We need to be mindful of the potential for over regulation of
    corporate governance becoming another overhang on the economy. The
    economy currently faces several overhangs: The war on terrorism and the
    war in Iraq, the bursting of the bubble of the 1990's and the collapse
    of stock valuations, and the corporate scandals of the past 18 months.
    We must be careful that we do not go so far in creating obligations and
    restrictions in the name of corporate governance that we create another
    overhang. We do not want directors and managers to become so afraid to
    take risks that we stifle the entrepreneurial spirit that is an
    essential characteristic of American business.
        All of us--Congress, the SEC, the securities markets, and the
    corporate community--have worked hard to restore investor confidence
    over the past 2 years, and we are proud of those efforts. Nevertheless,
    as I said before, there is still work to be done. The SEC should move
    expeditiously to approve the proposed New York Stock Exchange and
    Nadsaq corporate governance listing standards, and companies should
    continue--as they have been doing--to set standards for transparency,
    honesty, and fairness that go beyond the law and reflect a culture of
    integrity.
        At the Business Roundtable, our companies will continue our work to
    improve corporate governance practices. We have a number of initiatives
    underway. First, we are examining how we can better train both current
    and future business leaders to enhance the role of ethics in their
    decisionmaking process. Second, we are working to bring more sense and
    transparency to executive compensation. Finally, we are continuing to
    develop and share best practices in corporate governance so that
    companies and their boards and management can learn what works most
    effectively.
        Congress did its job in enacting the Sarbanes-Oxley Act, and the
    SEC is doing its job in implementing the Act. We recognize that the
    rest is up to us.

                    PREPARED STATEMENT OF KEITH D. GRINSTEIN

                        Chairman, Coinstar Incorporated
                                October 2, 2003

        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee, thank you for the privilege of appearing before you today to
    discuss the implementation of the Sarbanes-Oxley Act of 2002.
    Background
        I am currently a member of the boards of directors of three small
    to mid-sized public companies traded on Nasdaq: Coinstar Inc., F5
    Networks, and Nextera Enterprises, Inc. Although a member of the boards
    of these companies, I appear here today solely on my own personal
    behalf, and not as a representative of those companies. I am not
    authorized to comment on our own board deliberations.
        Coinstar is a Bellevue, Washington-based company which develops,
    owns, and operates a network of automated, self-service, coin-counting
    and processing machines that provide consumers with a convenient means
    to convert loose coins into cash. Coinstar's market capitalization is
    roughly $280 million and is listed under the symbol CSTR. I am an
    independent/nonemployee director and serve as Chairman of the Board of
    Directors and serve on three board committees: the audit committee, the
    compensation committee, and the nominations/corporate governance
    committee. Consistent with proposed NASD rules, Coinstar has a majority
    of independent board members.
        F5 Networks Inc. is a Seattle company that provides integrated
    products and services to manage, control, and optimize Internet
    traffic. F5 Networks would be considered a mid-cap company with a
    market capitalization of roughly $500 million and trades under the
    symbol FFIV. I am an independent, nonemployee director of F5 Networks
    and serve on the audit committee and compensation committees of the
    board. F5 Networks does not have a nominations committee. F5 Networks
    also has a majority of independent board members.
        Nextera, is headquartered in Cambridge, Massachusetts. Nextera's
    primary asset is Lexecon, an economics consulting firm whose clients
    include major law firms and the corporations that they represent,
    government and regulatory agencies, public and private utilities, and
    national and multinational corporations. Nextera trades under the
    symbol NXRA, and has a market capitalization of roughly $17 million. I
    am one of three independent, nonemployee directors of Nextera, and I
    serve on two board committees, the audit committee and compensation
    committee of the board. Nextera does not have a nominations committee.
    As a closely held company, Nextera is exempt from the board
    independence requirements of NASD rules.
        In addition to my affiliation with publicly traded companies, I am
    an attorney and sit on the boards of three privately held companies and
    am a founding partner of Second Avenue Partners, a private venture
    capital firm in Seattle that provides funding and support to Pacific
    Northwest early-stage companies.

    Significant Tangible Benefits of Sarbanes-Oxley
        My connection with public companies predates passage of the Act,
    and thus my perspective on the significance of the changes brought
    about by the Act comes from the perspective of one who has lived
    intimately with the preexisting obligations imposed on those
    responsible for governing publicly-traded companies. Further, my
    perspective also comes from involvement in companies that have sought
    scrupulously to comply with their Federal disclosure obligations, have
    not been the
    subject of investigations by Federal or State authorities, and where I
    have been privileged to serve with a group of outstanding fellow
    directors, who have genuinely sshould do the right thing.
        As an initial matter, it is important to recall that prior to the
    date of the Act, while the Nasdaq had certain requirements for listed
    companies such as requiring audit committees, corporations are
    creatures of State law and State law does not dictate how a company is
    to be governed. State law does however spell out the duties of
    directors such as the duty of care and loyalty. Nonetheless there was a
    growing understanding among public companies that certain corporate
    governance practices were better than others. Except as a matter of
    disclosure, there was no Federal law concerning corporate governance
    and the Federal law simply required disclosure of the company's
    practices, most notably in connection with its proxy statements and its
    annual and periodic reports.
        Further, prior to passage of the Act the existing Federal and State
    proscriptions against fraud and the Federal disclosure obligations were
    taken seriously and the existing criminal sanctions were a significant
    deterrent to wrongdoing. There was, however, a mood of complacency that
    had crept into the board rooms, especially in the heady days of the
    bull market. This complacency led to excessive latitude being given to
    management in the conduct of corporate affairs and less attention given
    to the independent oversight function of board members.
        This manifested itself in several ways: Boards gave undue deference
    to management in matters such as (1) compensation packages, (2)
    recommendations of management about corporate decisions, (3) accounting
    policy and disclosure matters, and (4) nominations for future
    directors. This also meant that directors would frequently not voice
    issues that could be viewed as questioning the judgment of management.
        Directors serve for many reasons but often for the money and
    prestige associated with board membership. Because management often
    controls the director selection process, board members could be held
    hostage to that management. Although I have not directly experienced
    this in my tenure, it seems that there are few directors that may place
    undue importance on the money and prestige of board membership. This
    may have caused some board members to acquiesce in management demands
    for larger and larger compensation packages and to condone the
    reporting of the financial consequences of poor management decisions
    through issuing management-friendly audit reports.
        The notorious and well-known corporate scandals that prompted
    passage of the Act have brought about a marked change in attitude in
    the board room. There has been less deference being given to management
    initiatives. Questions that went unasked before are being asked now.
    Board meetings are more frequent and board members are better prepared
    at meetings. Management has provided us with more information, we see
    more attorneys at board meetings, board committee charters are being
    written or reviewed by outside counsel, and more attention is being
    paid to corporate governance and structure. Boards are adopting written
    compensation policies, and tend to be more ``hands on'' with respect to
    pay-package decisions. Issues that before would not have even been
    discussed, are being presented to the board for discussion and advice.
        It is difficult to isolate specifically those provisions of the Act
    that have had this effect. I will point to just a few of the most
    important changes.

    Audit Committees
        I sit on three audit committees. The requirement for independent
    audit committees and the specification of their powers have been
    markedly strengthened by the Act. Even on the boards where I sit that
    had adopted the best practices guidance for performance of their duties
    even before the passage of the Act, the audit committee members have
    undertaken to take their duties even more seriously and their powers
    have been strengthened. The auditors also appreciate more clearly than
    before that they work for the audit committees, not management. We see
    two important changes: Auditors are more responsive to our requests,
    and auditors are giving more attention to their audits.

    Consulting Services by Auditors
        The audit committees on which I sit do not authorize our auditors
    to engage in consulting services. Auditors do not invite the potential
    for conflict. This has been a marked change wrought by both the SEC's
    2001 independence rules and the changes adopted by the Act.

    Internal Control Audits
        Companies are now required to have quarterly internal control
    audits. Where before these internal audits may have been performed by
    our auditors as part of nonaudit services, the auditor independence
    reforms have required us to look elsewhere for those services. There is
    increased competition for these services, increased information to
    audit committees, and a renewed focus on responsibility--we are getting
    a good work product.

    CEO/CFO Certifications
        The certification process has been a disciplining process for
    executives and financial officers, and that disciplining process has
    filtered down to others within the company who report to them. From the
    board's perspective, it has provided us with additional comfort as to
    our ability to rely on management's representations concerning internal
    controls and the financial condition of the company.

    Costs of Implementation
        There can be no question that the Act has increased the cost to
    companies of compliance. For small and mid-cap companies these
    increased costs are a significant drain on the bottom line. Such
    companies have fewer assets and less revenue over which to amortize
    implementation and continuing compliance liabilities and expenses. In
    my personal view, the benefit in investor confidence and the improved
    corporate governance that is taking place, is worth the cost. It is
    hard to put a short-term price tag on the lack of investor confidence
    that was mushrooming out of control at the time of passage of the Act.
        In general, I estimate that compliance with the Act imposes a
    direct cost on a small cap company of about $250,000 per year, and a
    larger mid-cap company of closer to $1 million. Some of these costs are
    likely to be recurring costs, and some of these costs are likely to be
    one time costs and could level off as we gain more experience in
    administering the changes brought by the Act.
        Let me summarize the components of those costs:

    More Board of Director Time
        Directors are compensated by a per-meeting fee and by the amount of
    time spent on matters. Since enactment of the Act, we have had more
    frequent board meetings and more frequent meetings of board committees.
    This is especially true in the case on the audit committees. This
    translates into a direct increase in board fees.

    Increased Auditor Fees
        As I have noted, auditors are spending more time on engagements,
    and the direct interaction between audit committees and the auditor has
    increased. Further, another direct increased cost is caused by the new
    requirement that annual and quarterly reports be issued more quickly.
    There is an increased demand on auditors to conduct their review more
    rapidly before the quarterly and annual reports are filed. This
    translates into a direct total increase in auditor fees.

    Increased Insurance Costs
        Companies have seen the cost of Director & Officer insurance
    increase by between 15 percent and 30 percent. In my experience this is
    an increase of about $100,000 in premiums for each $10 million in
    insurance coverage. As I understand it, insurance companies have not
    yet begun to see a substantial increase in actual outlays, but the
    premiums have increased because of a perceived increase in risk;
    premiums may level off in time as we have more experience under the
    Act.

    Legal Fees
        We see more attorneys at every phase of our work on boards. This
    includes work on drafting or redrafting board or committee charters,
    attendance at board, and committee meetings and on consultations with
    management.

    Looking Forward
        The Act was landmark legislation that was needed at the time and
    has had a profound impact on corporate America and the accounting and
    brokerage industry. There has not been sufficient time to assess the
    impact of the changes brought about by the Act, including the indirect
    benefit of increased investor confidence, and the intangible benefit of
    better corporate governance. The direct Federal oversight over the
    accounting profession was long overdue and I have already seen a marked
    improvement in accountant responsiveness. I am optimistic that the Act
    strikes the appropriate balance between federalization of certain
    aspects of corporate governance and increased Federal disclosure
    obligations.
        There are some areas on which the Committee should pay particular
    attention. The cost of initial compliance for small and mid-cap
    companies is significant for those companies. If those costs increase
    and do not level off or decrease over time, then these companies are
    faced with a long-term compliance cost drain. In particular, we have
    little experience with increased costs of litigation spawned by the new
    duties imposed by the Act. If we see a significant increase in
    litigation costs, then the Committee may want to consider enacting some
    safe-harbors to curb abusive and unwarranted litigation in the future.
        As a venture capitalist, I am well aware that there are alternative
    sources of capital than the public markets and that at some point
    companies could be driven to those alternative sources if the costs of
    being public financing keep escalating. However, I have seen no
    evidence that the Act has had that effect, for example that the Act has
    driven companies that otherwise would have become public to those
    alternative capital sources.

    Conclusion
        Enactment of the Act was the right thing to do at the right time--a
    time of a severe crisis in investor confidence in publicly traded
    companies. From my vantage point, I have seen a subtle shift in the
    balance of power away from corporate management and toward independent
    members of boards of directors and ultimately shareholders. There are a
    number of procedural and substantive rules adopted by the SEC in
    implementing the Act and some of those rules have only recently been
    implemented and there has not been sufficient time yet to assess their
    merit or to evaluate their true costs. And I remain optimistic that as
    we gain more experience administering the Act, the initial costs of
    implementation may be reduced substantially. But the increased costs of
    implementation and compliance of the provisions of the Act are in my
    judgment a necessary price of restoring investor confidence in publicly
    traded companies.
        Thank you. I look forward to your questions.

                                   ----------

                    PREPARED STATEMENT OF RICHARD L. TRUMKA
               Secretary-Treasurer, American Federation of Labor
                    and Congress of Industrial Organizations
                                October 2, 2003

        Good morning, Chairman Shelby and Senator Sarbanes. My name is
    Richard Trumka and I am the Secretary-Treasurer of the American
    Federation of Labor and Congress of Industrial Organizations. The AFL -
    CIO's member unions sponsor benefit plans with over $400 billion in
    assets, and collectively bargained benefit plans that union members
    participate in hold over $5 trillion in assets. For America's working
    families' retirement security is in large part dependent on the
    integrity of our capital markets.
        The labor movement strongly supported the passage of the Sarbanes-
    Oxley Act of 2002. America's working families owe a great debt of
    gratitude to Senator Sarbanes for authoring the Act, and to this
    Committee, for passing what would become Sarbanes-Oxley in a bipartisan
    vote before the WorldCom scandal broke. Your leadership came at a time
    when many predicted Congress would do nothing in response to the
    growing wave of scandal engulfing our Nation's public companies.
        I would like to review the key features of the Act that have
    markedly improved investor protections.

     the Act put an end to most consulting by public company audit
        firms;
     the Act created the Public Company Accounting Oversight Board
        (PCAOB), which after a controversial start has proven to be a
        strong, yet flexible independent regulator;
     the Act requires independence and expertise on company audit
        committees, and makes clear the importance of strong and
        independent boards generally;
     the Act bans loans to insiders at public companies, putting an
        end to a key executive compensation abuse; and provides for
        disgorgement of executive stock profits in certain circumstances;
        and
     the Act reinforces the fundamental principle of our securities
        law--that companies must disclose to investors what a reasonable
        investor would want to know before making an investment decision,
        and that the obligation to do so truthfully rests on senior
        management.

        In the last year, these provisions have been impressively augmented
    by the work of the SEC and the PCAOB. The SEC and its staff have
    stepped up and addressed through rulemaking several vital issues, for
    example by ensuring that attorneys for public companies act in the
    interests of the company, and not just in the interests of the
    companies' executives. The Commission has also followed the logic of
    Sarbanes-Oxley in properly demanding increased disclosure from powerful
    market actors like hedge funds that have been allowed to operate in
    secret.
        The PCAOB is currently addressing the vital issue of financial
    controls at public companies. I can tell you as the Chief Financial
    Officer of the AFL -CIO that proper financial controls are critical to
    the responsible management of any large organization. The events of the
    last few years have shown the need to strengthen these controls at
    public companies, and to give company management who are trying to do
    the right thing some guidance as to what are appropriate safeguards. We
    have confidence that the PCAOB will do just that.
        More than a year later, we believe Sarbanes-Oxley is a success, not
    just because of the specific provisions of the Act, but because of the
    tone the Act set and the message it sent. In the first proxy season
    after the Act passed, investors acted themselves to push companies to
    have really independent boards, to reign in executive pay, and to
    manage their audit process more effectively. The AFL -CIO is very proud
    of the role that unions and worker pension funds have played in these
    efforts by sponsoring 360 such proposals, 48 of which received majority
    votes at company annual meetings. These proposals led to real changes
    in executive compensation at companies like GE, Coca-Cola, Tyco,
    Hewlett-Packard, and Alcoa.
        We have also seen in recent events at the New York Stock Exchange,
    a powerful message that runaway executive pay is simply no longer
    acceptable, even in the case of individuals who have performed well.
        Sarbanes-Oxley also serves as a guide to appropriate corporate
    governance in institutions that actually are not subject to the Act.
    Since May 8 of this year, I have served as the Chair of the Corporate
    Governance Committee of the Board of ULLICO Inc., a private company
    owned by unions and union pension funds where there was serious
    wrongdoing by prior management. Among the first acts taken by the new
    board the shareholders elected last spring was to move the company
    toward voluntary compliance with the relevant provisions of Sarbanes-
    Oxley, including CEO certification of the company's financial
    statements and the Act's audit committee provisions.
        However, the job begun by this Committee last year is not complete.
    Key elements of the investor protection agenda remain to be enacted,
    here in Congress, at the Securities and Exchange Commission, and at
    FASB, and the Public Accounting Oversight Board. While we are generally
    pleased with the work done at those agencies, we believe there is still
    an unfinished corporate reform agenda that they and Congress should
    turn to.
        In the remainder of my testimony, I would like to lay out some key
    elements of what remains to be done.
        First, our legal system continues to suffer from real deficiencies
    in the extent to which both individuals and institutions can defraud
    the investing public and get away with it. Despite your best efforts,
    Mr. Chairman, in many circumstances lawyers, accountants and investment
    banks can still aid and abet companies that commit securities fraud and
    enjoy immunity from investor lawsuits. This is wrong, and really only
    Congress can fix it.
        There are also areas where the Private Securities Litigation Reform
    Act has made it easier to defraud the investing public and get away
    with it. Sarbanes-Oxley addressed one such area by lengthening the
    statute of limitations, but there are others such as the PSLRA's repeal
    of joint and several liability for securities fraud and the blanket
    immunity it grants for ``forward looking statements'' that remain.
    Again, these problems with the PSLRA can only be addressed by Congress.
        However, as important as litigation can be to both deterring
    corporate wrongdoing and dealing with its consequences, it can not
    substitute for real working corporate governance and accountability on
    the part of company management. And as long as CEO's dominate the
    selection process for company directors, we simply will not see at
    problem companies the kind of vigorous independent boards that we need
    and that Sarbanes-Oxley called for.
        That is why the labor movement believes the most important effort
    now underway to address the continuing governance problems at our
    public companies is the SEC's rulemaking initiative to give long-term
    investors with a substantial stake in public companies the right to
    have their board nominees included on management's proxy.
        Today, it is practically impossible for even the largest long-term
    investors, the TIAA-CREF's and CalPERS, to nominate and run their own
    candidates for the boards of public companies. So we have elections in
    name only. At one company we know of, Lockheed Martin, a former Enron
    director continues to be nominated by management despite unprecedented
    shareholder opposition, and the only thing shareholders can do is
    withhold their vote--they have no alternative candidate to vote for.
        And of course, CEO's know that investors have limited options. They
    know they can ignore shareholder votes on runaway executive
    compensation or company audit policies, and there is little that
    shareholders can do. So we strongly support the SEC and Chairman
    Donaldson's efforts in this area, and fervently hope that what will
    emerge from rulemaking is real access to the proxy for long-term
    investors.
        Finally, I would like to note that despite everything that has
    happened, we still have inadequate disclosure to investors of the facts
    of executive pay and what financial impact that pay has on the
    companies that award it. Despite FASB Chairman Bob Herz's hard work in
    this area, stock options still are not required to be expensed, a state
    of affairs that amounts to a subsidy to an inappropriate form of
    executive compensation. And as we have seen over and over again in the
    last year, investors simply are not given enough information about
    CEO's deferred compensation plans. While these are matters properly in
    the hands of the SEC and FASB, they are key elements of the post-
    Sarbanes-Oxley agenda.
        While much has been accomplished since Sarbanes-Oxley was passed,
    the work of reform is not complete. There is no better evidence of that
    than the recent comments of one of the most influential people in
    corporate America, Ken Langone, CEO of Invemed Associates, former chair
    of the New York Stock Exchange's Compensation Committee, member of the
    Compensation Committee at General Electric and three other public
    companies, and Lead Director at Home Depot. Mr. Langone, who is
    actually responsible for the pay package the Stock Exchange offered
    Richard Grasso and was involved in the pay and benefits offered to Jack
    Welch, remains unapologetic. He has told the press that given the
    chance to vote for Grasso's pay package, he would do so again. As long
    as this is the attitude among key decision makers in corporate America,
    there is work to be done.
        Fortunately, the independent agencies that are active in the area
    of corporate governance are by and large stepping up to the plate. The
    SEC, the PCAOB, and FASB have all responded admirably to both the
    specific mandates of Sarbanes-Oxley and the tone set by the passage of
    that legislation. The labor movement urges this Committee and Congress
    as a whole to recognize that work, to fund it, and to protect the
    independence of those agencies as they go about their vital tasks.
        Let me conclude by expressing my deepest appreciation to the
    Committee on behalf of the working families of the AFL -CIO for
    inviting the AFL -CIO to appear today, and our hope that we will
    continue to be able to work together on these vital issues for all
    Americans. Thank you.