[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\
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    \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).
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    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.
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    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.
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    \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.
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    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\
---------------------------------------------------------------------------
    \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.
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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).
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    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\
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    \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.
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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\
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    \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.
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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.
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    \11\ Sarbanes-Oxley Act, Section 103(a)(3)(B).
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    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\
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    \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.
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    \13\ See PCAOB Release No. 2003-009 (June 30, 2003).
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    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.
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    \1\ ``PricewaterhouseCoopers'' refers to the network of member 
firms of PricewaterhouseCoopers International Limited, each of which is 
a separate and independent legal entity.
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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.
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    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
   Former Chairman, Board of Governors of the Federal Reserve System
                            October 2, 2003
          American Leadership and Business Responsibility \2\
---------------------------------------------------------------------------
    \2\ Excerpts from a September 24, 2003 address by Paul A. Volcker 
at Washington University, St. Louis.
---------------------------------------------------------------------------
    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.

                               ----------

                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.

                               ----------

                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.
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