[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



 
                  THE IMPACT OF THE SARBANES-OXLEY ACT

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






                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                             APRIL 21, 2005

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 109-21



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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana          PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio                  MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, Jr., North          HAROLD E. FORD, Jr., Tennessee
    Carolina                         RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
VITO FOSSELLA, New York              STEVE ISRAEL, New York
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TIBERI, Ohio              JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
TOM FEENEY, Florida                  STEPHEN F. LYNCH, Massachusetts
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina   AL GREEN, Texas
KATHERINE HARRIS, Florida            EMANUEL CLEAVER, Missouri
RICK RENZI, Arizona                  MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania            DEBBIE WASSERMAN SCHULTZ, Florida
STEVAN PEARCE, New Mexico            GWEN MOORE, Wisconsin,
RANDY NEUGEBAUER, Texas               
TOM PRICE, Georgia                   BERNARD SANDERS, Vermont
MICHAEL G. FITZPATRICK, 
    Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina

                 Robert U. Foster, III, Staff Director






















                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    April 21, 2005...............................................     1
Appendix:
    April 21, 2005...............................................    35

                               WITNESSES
                        Thursday, April 21, 2005

Donaldson, Hon. William H., Chairman, Securities and Exchange 
  Commission.....................................................     7
McDonough, William J., Chairman, Public Company Accounting 
  Oversight Board................................................    10

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    36
    Hinojosa, Hon. Ruben.........................................    38
    Hooley, Hon. Darlene.........................................    40
    Kanjorski, Hon. Paul E.......................................    41
    Donaldson, Hon. William H....................................    43
    McDonough, William J.........................................    62

              Additional Material Submitted for the Record

Frank, Hon. Barney:
    Equity Group Investments, L.L.C., prepared statement.........    88
Tiberi, Hon. Patrick J.:
    American Bankers Association, prepared statement.............    90
McDonough, William J.:
    Written response to questions from Hon. Joseph Crowley.......   122
    Written response to questions from Hon. Vito Fossella........   105
    Written response to questions from Hon. Ruben Hinojosa.......   113
    Written response to questions from Hon. Deborah Pryce........   121
    Written response to questions from Hon. Nydia M. Velazquez...   107
Donaldson, Hon. William H.:
    Written response to questions from Hon. Ginny Brown-Waite....   128
    Written response to questions from Hon. Joseph Crowley.......   133
    Written response to questions from Hon. Ruben Hinojosa.......   113
    Written response to questions from Hon. Dennis Moore.........   141
    Written response to questions from Hon. Deborah Pryce........   125
    Written response to questions from Hon. Patrick J. Tiberi....   126
    Written response to questions from Hon. Nydia M. Velazquez...   132






















                  THE IMPACT OF THE SARBANES-OXLEY ACT

                              ----------                              


                        Thursday, April 21, 2005

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The Committee met, pursuant to call, at 10:05 a.m., in Room 
2128, Rayburn House Office Building, Hon. Michael G. Oxley 
[chairman of the committee] Presiding.
    Present: Representatives Oxley, Leach, Baker, Bachus, 
Royce, Tiberi, Kennedy, Feeney, Hensarling, Brown-Waite, 
Barrett of South Carolina, Neugebauer, Price of Georgia, 
Fitzpatrick, McHenry, Frank, Kanjorski, Waters, Sanders, 
Maloney, Gutierrez, Velzquez, Watt, Hooley, Sherman, Meeks, 
Lee, Moore of Kansas, Capuano, Crowley, Israel, Baca, Matheson, 
Miller of North Carolina, Scott, Green, Cleaver, Bean, 
Wasserman Schultz, and Moore of Wisconsin.
    The Chairman. The Committee will come to order. Pursuant to 
Rule 3(f)(2) of the rules of the Committee of Financial 
Services for the 109th Congress, the Chair announces he will 
limit recognition for opening statements to the Chair and 
Ranking Minority Member of the full Committee and the Chair and 
Ranking Minority Member of the Subcommittee on Capital Markets, 
Insurance and Government-Sponsored Enterprises, or their 
respective designees, not to exceed 16 minutes evenly divided 
between the majority and minority. The prepared statements of 
all members will be included in the record. The Chair 
recognizes himself for an opening statement.
    Good morning. And today we meet to discuss the impact of 
the Sarbanes-Oxley Act of 2002. The Committee will hear from 
the two regulators, Chairmen Donaldson and McDonough, charged 
with implementing key provisions of the Act. We welcome both of 
you back to the Committee and look forward to hearing your 
views on the benefits, and the costs of Sarbanes-Oxley, 
affectionately known as SOX.
    Although the legislation was passed less than 3 years ago, 
the benefits to investors and the capital markets have already 
been quite dramatic. Not entirely measurable in all areas, but 
dramatic nonetheless. The primary purpose of the Act was to 
restore investor faith in the reliability of corporate 
financial reporting. In this regard, the Act has been an 
unmitigated success. The audit process has clearly been 
strengthened. Now subject to rigorous oversight and precluded 
from offering certain non-audit services to audit clients, 
accountants have refocused on the audit, achieved, greater 
independence from their clients, and are insisting with 
success, on more transparent financial reporting.
    Replacing decades of ineffectual industry self-regulation, 
the Public Company Accounting Oversight Board conducts 
inspections of all registered accounting firms--annually for 
the largest firms--and has the authority to investigate and 
discipline accountants and firms that violate Board rules, SEC 
rules, or securities laws. This oversight by the PCAOB has 
served and will continue to serve, in my opinion, as an 
effective deterrent to unethical and illegal conduct.
    Oversight of management activities by corporate boards has 
been significantly improved. Directors, particularly audit 
committee members, are more engaged, more informed, and more 
independent of management and working harder. Corporate 
leaders, subject to stiffer criminal penalties and greater 
director oversight, are focused on the financial statement like 
never before. The certification provisions have been 
successful. Financial statements are more reliable today than 
they were before the Act was passed.
    Does this mean that Sarbanes-Oxley will eliminate fraud 
altogether? Of course not. No legislation can deliver such a 
benefit. But we are reducing the opportunities for fraud, 
making fraud more difficult to commit, and holding accountable 
those who break the law.
    The most famous, or infamous, section of the Act, of 
course, is section Section 404. Nothing is more central to 
sound financial reporting than the strong internal controls 
contemplated by Sarbanes-Oxley. I may have heard a complaint or 
two about the costs, but the benefits have not been disputed. 
And make no mistake, the costs associated with section Section 
404 are higher than anyone expected. That is a cause for 
concern, and I am particularly sensitive to any undue burden on 
small and mid-sized companies whose compliance costs are a 
higher percentage of total revenues.
    The question then becomes, can we achieve the unquestioned 
benefits of strong internal controls at a more reasonable cost. 
I believe we can and that we will. For starters, there seems to 
be a consensus that Section 404 costs will be reduced by as 
much as one-half next year, due to the fact that systems will 
be in place and documentation will be completed. I am 
encouraged by Chairman McDonough's recent comments about costs 
and his announcement that additional implementation guidance is 
forthcoming.
    The PCAOB standard instructs auditors to exercise 
professional judgment when performing the attestation required 
by the statute. Upcoming Board inspections will seek to 
determine whether a one-size-fits-all approach is being used on 
some audit engagements. We would also like to commend Chairman 
Donaldson for his leadership in this area. The Commission has 
rightly given small companies and foreign companies a delay in 
complying with Section 404. The Chairman has also organized a 
useful roundtable discussion on Section 404 to hear concerns 
from a broad spectrum of market participants and assembled an 
advisory committee of smaller public companies.
    And, finally, I am pleased that there is a consensus, or 
close to one, on the question of whether legislative 
modifications are necessary. Congress, regulators, accountants, 
issuers, and other interested parties generally agree that, to 
the extent changes are necessary, they can be done within the 
regulatory framework.
    I look forward to the testimony, and I yield to the 
gentleman from Massachusetts for an opening statement.
    Mr. Frank. Thank you, Mr. Chairman.
    I think it is time for us to address a very important issue 
involving corporate governance, and it is a matter of 
increasing expense, significantly increasing expense to 
corporations, and an expense which I do not believe is 
justified by value given. That is, I agree with some of the 
critics who think that we are facing a situation in which 
corporations, public corporations, in particular large ones, 
are spending far more than they should on something for which 
they do not get sufficient value and which in fact impinges on 
the shareholders. I am talking about executive compensation.
    Executive compensation is increasingly out of control. I 
have put up some charts here--actually, I haven't put them up; 
some very nice people who work for me have put them up at my 
request, and I appreciate it.
    That chart compares what CEOs are doing compared to 
shareholders. The blue line is CEOs, the red line is 
shareholders. To the extent that that correlates to red States 
and blue States, it was unintentional, but it is not a bad mix, 
as a matter of fact. The enormous increase percentage-wise in 
CEO compensation is compared to what shareholders are getting. 
That is, CEO compensation goes up substantially when the S&P 
index goes down.
    The next chart. This one compares the pay of CEO to the 
average worker from 1980 to 2003. We have a ratio of 42 to 1 in 
1980, we have a ratio of 500 to 1 today.
    In the next chart, lest people think I am talking here 
merely about envy, because I think we are talking about a 
serious social and economic problem. The compensation that is 
rapidly increasing for the people who run corporations has 
become macro-economically significant. This chart shows the 
percentage of company profits that are paid to the top 5 
executives in the Fortune 500 companies. It was 4.8 percent in 
1993, it was 10.3 percent in 2003, the last year for which we 
have gotten figures. When you are talking about that 
significant an increase, you are getting into things that 
affect performance. And I should say that I raise that in the 
context of this hearing for two reasons: One, we are told that 
the compliance costs with section Section 404 Sarbanes-Oxley 
are a significant drag on corporations. Well, not compared to 
the money they pay the top people. Now, if it were necessary to 
pay these people this amount of money to get them to run the 
corporations, then of course we wouldn't have a problem. I 
think the evidence is overwhelming that CEOs are compensated 
far beyond, on the whole, what would be economically justified.
    And I want to acknowledge here that I am drawing on work 
done by Professors Lucian, Bebchuk, and Jesse Freed, and the 
book that they have published on the subject, and also articles 
by Professor Bebchuk and Professor Yaneff Grinstein. It is very 
clear from their studies, it is clear as we see this, there are 
very few constraints on what the CEOs get. The boards of 
directors--and this is the second reason I mention this. It is 
relevant to corporate governance. Some of the corporate leaders 
have told us that they feel terribly beleaguered that they have 
been put upon by that unlikely combination, Sarbanes and Oxley; 
that they have, in fact, had imposed on them staggering burdens 
which interfere with their ability to function. Well, I think 
it is very clear that at least in one area of some importance 
to them, setting their own salaries, Sarbanes and Oxley might 
as well be Donald and Daisy Duck, because nobody lays a glove 
on these people when it comes to setting their own salaries, 
and I think that this is something that we have to address.
    We are in a difficult period in America today. We have 
growth going forward at a reasonable level, but inequality is a 
concomitant to that growth. Employment growth has stagnated to 
some extent. As I noted when Secretary Snow testified, in 2004, 
the President's Council of Economic Advisors said that we would 
get 325,000 jobs a month in this current growth.
    This year's Council of Economic Advisors' report 
unheraldedly projected 175,000. I asked Mr. Snow, he said, 
well, the chairman of the Council of Economic Advisors' went 
back to Harvard; he couldn't fully explain it. The trouble is, 
he took 150,000 jobs a month with him back to Harvard. Things 
must be going very well in Cambridge.
    But we have this problem of a slowdown in job growth. We 
have a problem even more so of wages stagnating. And for CEOs 
to be enjoying skyrocketing compensation which becomes 
statistically significant, 10 percent to the profits in 2003, 
at a time when wages also are stagnating, that causes a series 
of problems politically and socially.
    So as we look at the questions of corporate governance, I 
hope we will look at this. Because I believe that Sarbanes-
Oxley has worked well. I think with the distinguished 
leadership of these two gentlemen, we are going to be able to 
make some adjustments that would be appropriate, as is always 
to be expected when you do something new. But the agenda for 
corporate governance should be, what do we do next? Not, how do 
we go backwards? Thank you, Mr. Chairman.
    The Chairman. The gentleman's time has expired. The 
gentleman from Louisiana, Mr. Baker.
    Mr. Baker. I thank the Chairman, and wish to first 
acknowledge his good work and that of Senator Sarbanes in a 
time of business corporate governance of which few of us are 
proud, and that strong action was required and strong action 
was taken.
    I don't think there is any question that the implementation 
of Sarbanes-Oxley has brought to the corporate board room an 
awareness of their professional responsibilities and 
appropriate accountability for actions which are not consistent 
with the highest of standards. I do believe that there are 
elements to Sarbanes-Oxley, which have enhanced business 
function, and I think that on one aspect there is a tangible 
element to the implementation of Sarbanes-Oxley directly 
beneficial to shareholders.
    Since the passage of the Fair Fund in Sarbanes-Oxley, I am 
advised to date there have been in excess of $5 billion 
recouped from those who have engaged in fraudulent conduct for 
the benefit of shareholders directly. To my knowledge, this is 
the first time a program has been implemented to use government 
resources to recoup losses for shareholder benefit without the 
necessity of going to the trial bar. It is exceedingly 
successful, and some questioned its validity at the outset 
saying it would only amount to a small pizza for most 
shareholders. I would suggest modestly that a $5 billion pizza 
would be something to behold.
    On the other hand, no legislation of this magnitude can 
possibly be implemented without flaw. And I do believe the 
chairman's comments with regard to the cost of implementation 
and compliance of section Section 404 is something that 
warrants further study by the Committee, and action that might 
necessarily require legislative effort.
    Specifically, with regard to the PCAOB's methodology for 
assessing cost for the audit function, it is a statutory 
requirement that the PCAOB would not have the regulatory 
authority to visit should it even choose to do so. But I would 
certainly like to hear from the experts if there is an 
alternate methodology other than market cap, which might be 
more appropriate. It would seem to me, were there corporate 
misdoings and the market would respond by a runoff of market 
cap, that the subsequent assessment resulting from that audit 
would then be unnecessarily adversely impacted. So it might be 
an area where this Congress should act if the professionals 
tell us it is warranted.
    And, finally, with regard to the issue of corporate 
governance and that of executive compensation, I thought for a 
moment we were talking only about Fannie and Freddie. If they 
were pulled from the pile, it might bring the bell curve back 
in more in normal range. I recall just in bonuses only there 
were $245 million paid out in a 5-year period on which the 
financials cannot be relied that the earnings per share were 
indeed accurate. I share the concern about corporate abuse, but 
think we should go slowly in areas where the United States 
Congress really has no business.
    Mr. Chairman, I compliment you on good work and yield back.
    The Chairman. The gentleman yields back. The gentleman from 
Pennsylvania, Mr. Kanjorski.
    Mr. Kanjorski. Mr. Chairman, nearly 3 years ago after a 
surge of corporate and accounting scandals we adopted the 
Sarbanes-Oxley Act. As you know, I was intimately involved in 
every stage of the law's development from the first 
congressional hearing on the collapse of Enron through the 
final meeting of our bicameral conference committee. We are 
meeting today to review the effects of this historic law on our 
capital markets. In general, I believe that the landmark 
legislation has strengthened responsibility and enhanced 
investor confidence. In recent months, the Public Company 
Accounting Oversight Board and the Securities Exchange 
Commission have continued to pursue an ambitious agenda as they 
have worked to implement the reforms that Congress mandated.
    Today's hearing will help us to better appreciate their 
hard work in turning this functional statutory outline into an 
active regulatory system. It will also help us to understand 
the progress that we have made in bolstering investor 
confidence, restoring the integrity of financial statements, 
and rebuilding trust in our securities markets. Since the enact 
of Sarbanes-Oxley Act, we have also heard regular complaints 
from some about the cost of complying with the law. Most 
recently the statutes' provisions regarding internal control 
audits have become the subject of considerable public debate. I 
would therefore like to focus my comments this morning on this 
area of the law.
    We designed section Section 404 to require public traded 
companies and their auditors to assess internal controls, which 
is a firm's policies, practices, systems, and procedures to 
prevent abuse, protect against fraud, and ensure proper 
accounting. This section of the law requires companies to 
report their material weaknesses and their internal controls 
and work to fix these problems before financial reporting 
failures occur. As a result of this mandate, public 
corporations are decreasing their risk of future shareholder 
losses.
    Section 404 is another important benefit. It is helping 
corporate executives to better understand the financial 
reporting shortcomings within their companies, allowing them to 
recognize the nature of the problems earlier and adopt reforms 
and account procedures expeditiously. Such internal analysis by 
a company and external verification by an outside auditor is 
also helping to provide important assurances to the chief 
executive and financial officers of public companies who now 
must sign statements attesting to the accuracy and veracity of 
their financial statements under section 302 of the very same 
law.
    Today, we are fortunate to once again have before us the 
leaders of the Securities Exchange Commission and the Public 
Company Accounting Oversight Board. In their comments. I hope 
they will examine the implementation of and complaints 
regarding section Section 404. I know that both organizations 
have been diligently working to address these concerns, 
particularly by conducting outreach, holding forums, and 
providing assistance in these matters.
    It is my hope that both organizations will continue with 
these efforts, particularly for the smaller issuers that will 
have disproportionate costs in implementing these well-
intentioned reforms. I know that the Public Company Accounting 
Oversight Board intends to issue next month additional guidance 
in these matters. I expect that such guidance will maintain the 
spirit of the reforms that Congress envisioned but offer 
auditors greater flexibility in tailoring their examinations of 
internal controls to match the size and complexity of the kind. 
Such guidance should also help to improve the effectiveness of 
the law.
    In closing, Mr. Chairman, we cannot and should not remove 
the risks associated with investing. Our capital markets work 
well because of that risk. We should, however, ensure that 
every corporation plays by the rules; that all investors have 
access to reliable information needed to make prudent 
decisions; and that each party who violates our securities laws 
is held accountable. As the Securities and Exchange Commission 
and the Public Company Accounting Oversight Board work to 
achieve these objectives, it is appropriate for us to review 
their progress. Thank you, Mr. Chairman.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 41 in the appendix.]
    The Chairman. The gentleman yields back.
    We now turn to our distinguished witnesses today. And, 
again, gentlemen, thank you for once again appearing before the 
Committee. We have always appreciated your information that you 
bring the Committee and your hard work as dedicated public 
servants in dealing with some very tough issues.
    And, Chairman Donaldson, we will begin with you.

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

    Mr. Donaldson. Thank you. Chairman Oxley, Ranking Member 
Frank, and members of the Committee, thanks for inviting me to 
testify on behalf of the Securities and Exchange Commission 
concerning the implementation of the Sarbanes-Oxley Act of 
2002.
    A little over 2 years ago when I became chairman of the 
Commission, the headlines were still dominated by reports of 
financial fraud, lapses, and audit, corporate governance 
responsibilities, and intentional manipulation of accounting 
rules. Congress acted swiftly in the face of this breakdown by 
enacting the Sarbanes-Oxley Act which called for the most 
significant reforms affecting our capital markets since the 
Securities Exchange Act of 1934.
    Since enactment, the Act has affected dramatic change 
across corporate America and beyond and is helping to 
reestablish investor confidence and the integrity of corporate 
disclosures and financial reporting. Your strong support of the 
Act, along with the support of your counterparts in the Senate 
demonstrates Congress's demonstration to ensuring the integrity 
and vitality of our markets.
    Before turning to the particular provisions of Sarbanes-
Oxley Act, I want to start by saying that I am pleased to be 
testifying today alongside of Bill McDonough, the chairman of 
the Public Company Accounting Oversight Board. While he will 
testify more fully on the board's activities, I can assure you 
that the PCAOB has developed as a respected and effective 
organization under Chairman McDonough's leadership, and that 
Chairman McDonough has personally been instrumental in helping 
to forge the close bond between our organizations.
    The goals of Sarbanes-Oxley are far reaching, and aim to 
restore investor confidence in and ensure the integrity of the 
markets. Consequently, reforms in the Act address nearly every 
aspect of the Act in our Nation's capital markets. The Act 
called on the Commission to undertake nearly 20 rulemakings and 
studies. The Act also set ambitious deadlines for the 
Commission and, in most cases, required us to implement the 
final rule speedily.
    The Commission has completed the required rulemaking under 
the Act, having considered the thousands of letters of public 
comment that we received. The Nation's largest companies, 
comprising more than 95 percent of U.S. market capitalization, 
are now fully subject to the regulatory requirements of the 
Sarbanes-Oxley act. Just as the SOX Act was a landmark piece of 
legislation for Congress, the successful implementation of that 
legislation will be seen as a watershed in the history of the 
Commission.
    Given the scope and the scale of the task Congress placed 
before us, I am pleased to report that, with the dedication and 
hard work of our staff, the Commission's overall discharge of 
its rulemaking responsibility has been exceptionally on the 
mark in fulfilling the Act's objectives while avoiding 
unnecessary problems. Collectively, these accomplishments 
should have an enormous positive impact on the management and 
governance of U.S. public companies in the decades ahead, and 
they will safeguard the fundamental imperative that our markets 
be characterized by levels of investor confidence and 
participation that are second to none.
    Although most of the Act's benefits have been accomplished 
without substantial expense for market participants, we should 
not minimize the cost to public companies and their investors 
of achieving the full measure of the Act's objectives. In 
particular, the internal control reporting and auditing 
requirements which companies are dealing with for the first 
time have required significant outlays of time and expense. The 
short-term costs to improve internal control over financial 
reporting are, in my view, best seen as an investment, because 
over the long term, these improvements will result in 
structurally sounder corporate practices and more reliable 
financial reporting.
    While these critical goals now firmly in view call to roll 
back or weaken Sarbanes-Oxley generally as a result of concern 
over the cost of internal control reporting are, in my 
judgment, unjustified. At the same time, the Commission and the 
PCAOB must be sensitive to the need to recalibrate and adjust 
our rules and guidance to avoid unnecessary costs or unintended 
consequences. To this end, the Commission and the PCAOB will 
remain committed to the implementation of the Act in the most 
efficient and effective way.
    I would like to review briefly a few specific 
accomplishments. A central focus of Sarbanes-Oxley was to 
enhance the integrity of the audit process. We believe the new 
rules have already had a beneficial effect in strengthening the 
integrity of the independent audit. We have also seen that 
audit committees are taking their responsibility seriously, and 
they are much more sensitive to auditor independence issues.
    The Act has strengthened our ability to enforce the Federal 
securities laws. One of the toughest challenges facing the 
Commission has been recovering and, when appropriate, returning 
funds to injured investors. The Act gave the Commission two 
powerful tools to help meet this challenge: The fair funds 
provision, and the authority to seek a temporary freeze on 
extraordinary payments by an issuer. Before the Act, by law all 
civil penalties were paid into the U.S. Treasury. Now, the 
Commission has authority in certain circumstances to use civil 
penalties to help compensate injured investors. The Commission 
has authorized fair funds in over 100 cases with a total value 
of over $5.4 billion for anticipated distribution to harmed 
investors.
    Another objective of the Act was to improve executive 
responsibility and, quote, the tone at the top of public 
companies, a key theme that dates back to President Bush's 10-
point plan of March 2002. Among the government's reform, 
Sarbanes-Oxley called on us to institute, the CEO and CFO 
certification provisions that perhaps have perhaps had the 
greatest immediate impact by reinforcing executive 
responsibility for the financial reporting process of public 
companies. While CEOs and CFOs already had responsibility for 
company disclosures in the filings in question, the 
certification requirements have focused their attention on the 
completeness and accuracy of disclosure in new and very 
important ways.
    Complementing the focus on executive responsibility, the 
Act takes several important steps toward improving disclosure 
in the old financial reporting process. Accurate and reliable 
financial reporting is the bedrock of our disclosure-based 
system of Securities' regulation. Investor confidence and the 
reliability of information in a company's filings with the SEC 
is fundamental to the vibrancy of our markets. The Commission 
has adopted a number of reforms in this area to implement the 
Act. Although each of the reforms is important in its own 
right, the reform that has drawn the most attention recently is 
section Section 404's requirement that management and external 
auditors report on the effectiveness of a company's internal 
control over financial reporting. As I have said on other 
occasions, I believe the requirements of section Section 404 
may have the greatest long-term potential to improve financial 
reporting by companies. Much of the recent discussion about 
Section 404 has focused on the costs of implementation. There 
is no doubt costs have been higher than we and public companies 
anticipated, though I believe it important to note that a 
substantial portion of the cost may reflect initial startup 
expenses as many companies for the first time conducted a 
systemic review and documentation of their internal controls.
    In this regard, a number of commentators have suggested 
that costs in the second and subsequent years will decrease 
significantly. Nevertheless, we are monitoring the costs of 
section Section 404 implementation closely to ensure that its 
benefits are achieved in the most sensible way. We have 
actively sought feedback about our first-year experiences in 
implementing section Section 404 requirements in order to 
determine if commission rules and the PCAOB standards are 
operating as intended.
    Just last week, we held a public roundtable to review the 
first-year experience with implementation of the internal 
control requirements. We are paying particular attention to the 
impact on smaller companies, and our new advisory committee on 
smaller public companies held its first meeting last week also. 
Based on this feedback, we are now evaluating ways to make the 
process more efficient and effective while preserving its 
benefits. We are closely coordinating with the PCAOB, and I 
have instructed our staff to consider as quickly as possible 
how we could improve the guidance available to management and 
auditors in order to fine-tune the process. While we can and 
will do more on the subject of section Section 404. Any 
reflection upon the scandals that gave rise to the Sarbanes-
Oxley Act will reveal the enormous costs to investors of corner 
cutting and internal controls.
    As I have said before, I believe that the time, energy, and 
expense that companies are now investing in their internal 
controls will earn a handsome return in the years to come.
    I have covered our activities under the Sarbanes-Oxley in 
greater detail in my prepared statement for the Committee, and 
I, of course, would be happy to elaborate further this morning. 
Before concluding, however, I would offer my own observation 
that the real key to achieving the great potential of the 
Sarbanes-Oxley Act lies not with the Commission or the PCAOB, 
but with the dedicated and serious efforts of American 
businesses and their managers who probably have the most to 
gain from preserving the reputation of our markets as the best 
place in the world for investment capital.
    A wise man once remarked that capital will always go where 
it is welcomed and stay where it is well treated. I believe 
that a company that recognizes the true benefits of the Act in 
strengthening our capital markets will have no trouble seeing 
that effective compliance with Sarbanes-Oxley, doing the right 
thing is not only in the best interests of its investors but 
the long-term interests of the company itself.
    In conclusion, let me thank you again for your leadership 
and vital support in reestablishing and strengthening investor 
confidence in the integrity of our nation's capital markets. 
And, of course, I would be happy to answer any of your 
questions. Thank you.
    [The prepared statement of Hon. William H. Donaldson can be 
found on page 43 in the appendix.]
    The Chairman. Thank you, Chairman Donaldson.
    And Chairman McDonough, again, welcome back.


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

    Mr. McDonough. Thank you, Chairman Oxley, Ranking Member 
Frank, and members of the Committee. I am pleased to appear 
before you today and once again to be appearing with my friend 
Bill Donaldson. The President and the Senate brought him to 
Washington. He brought me here, and most days I am grateful, 
including today.
    With the Sarbanes-Oxley Act, the Congress took a giant step 
toward restoring investor confidence in financial reporting and 
auditing. The Act did not merely create a regulatory 
environment conducive to investor protection, it also reflected 
the powerful demand of the American people for fairness and 
honesty in the U.S. markets. I would like to commend this 
committee under Chairman Oxley's leadership both for its work 
in passing Sarbanes-Oxley and for its continued stewardship of 
our markets on behalf of American investors. It is the faith of 
those investors that fuels the growth and competitiveness of 
our economy.
    In response to the people's demand, the Sarbanes-Oxley Act 
created the Public Company Accounting Oversight Board to 
oversee the auditors of public companies and bolster investor 
confidence in public company financial statements. The Act 
provides a great deal of regulatory flexibility so that we can 
meet new challenges as they develop. Today, the PCAOB is well 
on its way to maintaining a continuous program of auditor 
oversight. The PCAOB staff numbers 319 in 8 cities, of whom 138 
are inspectors. By the end of 2005, we expect to have 
approximately 450 staff, and of those 219 will be inspectors.
    Our main growth area is in the experienced accountants who 
inspect the accounting firms that are registered with the 
PCAOB. Our goal is to inspect roughly 300 accounting firms per 
year.
    Our highest priority at this time is the continued 
implementation of our standard for auditing companies' internal 
control over financial reporting. Section 404 of the Sarbanes-
Oxley Act requires public companies annually to provide 
investors an assessment of the quality of their internal 
control over financial reporting accompanied by an auditor's 
attestation on the same subject.
    In the simplest terms, internal control provides reasonable 
assurance that the financial data being collected by a company 
provide meaningful and reliable information that can be used to 
produce accurate financial statements. With such assurance 
about internal control, investors can have much more confidence 
in the reliability of the corporate financial statement.
    Now, although the term internal control over financial 
reporting has only recently entered our common parlance, 
internal control is a familiar concept to most auditors who are 
required, under existing standards, at least to gain a basic 
understanding of internal control, as part of the financial 
statement audit. Companies have been required to have internal 
control over their accounting since Congress enacted the 
Foreign Corrupt Practices Act in 1977.
    However, the Sarbanes-Oxley Act's requirements took the 
responsibility of management and auditors to a different level. 
Today, under PCAOB Auditing Standard Number 2, auditors of 
public companies must not only obtain an understanding of 
internal control, but they must also examine its design and 
operation in order to reap the most benefit and to make the 
overall audit process as efficient as possible.
    We designed our standard around an integrated model. An 
integrated audit combines an audit of internal control over 
financial reporting with the audit of the financial statements. 
We believe this approach both enhances the overall reliability 
of company financial statements and is cost effective. Given 
the tight deadlines for 2004 implementation, however, many 
auditors were unable to fully integrate their work. This 
problem should be corrected for 2005, which should bring costs 
down considerably.
    Many companies have already reaped benefits from the 
internal control reporting process. For example, 74 percent of 
222 financial executives recently surveyed reported that their 
companies benefited from compliance with the Act. Of those, 33 
percent said that compliance lessened the risk of financial 
fraud. By identifying weaknesses before financial reporting 
failures occur, these companies are reducing the risk of a 
future loss of shareholder value.
    Although the benefits of enhanced internal control to 
investor confidence are potentially great, there have been 
concerns about the associated costs. Through our inspections of 
registered accounting firms, we will assess whether auditors 
implement new standards appropriately and effectively. 
Meanwhile, we have carefully monitored implementation of our 
internal control standard and on occasion have issued 
additional guidance to promote a consistent rational approach.
    Some have charged that auditors are implementing Auditing 
Standard Number 2 with a check-the-box mentality that focuses 
on minutia unlikely to affect the financial statements. Our 
guidance emphasizes that the focus should be on what is 
material to the financial statements, not on the trivial. 
Auditing Standard Number 2 expressly permits auditors 
considerable flexibility to rely on the work of others, 
including internal auditors, to complete some of the more 
detailed, time consuming tasks.
    In addition, some smaller companies have charged that they 
are disproportionately burdened because auditors are not 
tailoring their audit procedures to the nature and complexity 
of the client. Smaller, less complex businesses typically need 
less complex controls. Our guidance continues to reflect that 
view.
    Another area of concern for us is the misconception that 
companies may no longer look to their auditors for advice on 
difficult accounting issues. Auditors have long advised public 
companies on accounting issues and on internal control matters, 
and Auditing Standard Number 2 does not preclude that kind of 
advice and discussion.
    We are working to help auditors better understand our views 
on this matter so that they will have the confidence we won't 
second-guess their reasonable judgments on this area. Last 
week, we participated in the SEC's Roundtable on Internal 
Control to explore additional implementation questions. And 
there I pledged that the PCAOB would issue more guidance on May 
16th, including guidance that explains the top-down approach 
encouraged by auditing standard 2, and more clearly describes 
how the auditor's assessment of risk affects the amount of work 
that must be done to comply with the standard.
    Although public attention on the work of the PCAOB has 
recently focused most intensely on section Section 404, the 
longer term effects of our work will be the product of our 
inspections and our other oversight activities. PCAOB oversight 
is causing a profound shift in the character of public company 
auditing. We have seen changes in auditors' attitudes toward 
their accountability. The old system relied primarily on 
enforcement tools after a problem had already occurred. The 
risk that an auditor's errors would come to the attention of 
regulators was too often not sufficient to motivate auditors to 
take the tough stance necessary to head off potential 
misstatements in financial reports.
    Under the new system, auditors understand that their work 
is much more likely to be reviewed by the PCAOB's inspectors. 
Last year, our inspectors reviewed portions of more than 500 
audits performed by the largest 8 firms. Our inspectors have 
identified and encouraged appropriate resolution of numerous 
accounting and auditing problems that will improve the 
reliability of financial statements.
    Now, 2 years of inspecting the audits of the big four 
accounting firms has done nothing to shake my view that these 
firms operating at their best are capable of the highest 
quality auditing, and it has also done nothing to shake my 
view, Mr. Chairman, that the Congress, this committee led by 
you, acted wisely in creating independent oversight of the 
profession to help move firms in the direction of consistently 
operating at their best.
    I cannot say, and I do not believe that you would expect to 
hear that after only two inspection cycles we have identified 
and uprooted all the causes of auditing failures, nor would it 
be prudent to assume that the repercussions of pre-Sarbanes-
Oxley failures are behind the firms. But we have plainly made a 
start that amply vindicates the decision that Congress and this 
committee made in creating the inspection process.
    Over time, I believe this process is the most promising 
means we have available for protecting firms from their own 
failures due to audit risks and ultimately restoring investor 
confidence in the reliability of audits.
    In addition to the eight largest U.S. firms, we also 
oversee more than 900 small U.S. audit firms and more than 550 
foreign firms. Early on, some expressed concern that the Act 
might pose a barrier to small firms' ability to compete for 
public company audit clients. However, a number of small firms 
have actually increased the number of public companies that 
they audit. As for our oversight of non-U.S. accounting firms, 
we have used the flexibility afforded us in the Act to develop 
a framework that relies on cooperation with local country 
regulators.
    Over the past 18 months we have engaged in a constructive 
dialogue with relevant regulators in certain key non-U.S. 
jurisdictions. As I speak, PCAOB inspectors are sitting side by 
side with inspectors from the Canadian Public Accountability 
Board, reviewing the work of the Canadian firms that audit U.S. 
public companies. We are also far along in working out similar 
arrangements with the United Kingdom, Australia, France, and 
Japan. With our counterparts, we hope to do what we can to 
reduce overall risk to investors in securities markets 
throughout the world.
    Mr. Chairman, I am happy to answer any questions.
    [The prepared statement of William J. McDonough can be 
found on page 62 in the appendix.]
    The Chairman. Thank you, Mr. Chairman. And thanks to both 
of you. And particularly, I want to publicly acknowledge and 
appreciate your sincere efforts to follow the intent of the 
Act. I think too many times we, as policymakers, legislators 
pass legislation only to see it totally misinterpreted at the 
regulatory level much to our disgust. In this case, it is clear 
from the beginning that both of you gentlemen and the people 
that you work with have made it a point to follow the dictates 
of what the Congress passed in the Act and to make it as 
flexible as possible.
    I have to say that I guess all of us would do things 
differently and certainly in the context of the legislating 
during that white-hot period of corporate scandal. In looking 
back on it, I think to give you some more flexibility probably 
would have been the right thing to do. But having said that, I 
think there--and from the feedback we get from the roundtable 
discussions that you both participated in last week, a very 
positive way of getting to what all of us in the Congress 
wanted to do was restore investor confidence and make it work, 
and to that I want to publicly thank both of you.
    Let me describe Section 404, and ask you, Chairman 
McDonough, that it appears to me that maybe most of the cost of 
the implementation in Section 404 was at least partially due to 
some deferred maintenance in the internal controls system 
already existent. Is that a fair assessment?
    Mr. McDonough. I think it is, Mr. Chairman. It varies with 
the company. Some of the companies which have very complex 
internal financial structures already had very good internal 
control, probably had to do some documentation improvement of 
them. For medium and small-sized firms, very frequently the 
internal control is existent, but was kind of in the head of 
the guy who ran the place, and therefore there is deferred 
maintenance in actually establishing written documentation of 
what the controls are.
    Some of these controls are not very exotic; it is making 
sure that you are actually reconciling the bank statements with 
your cash book to make sure your cash account is right.
    A lot of this is very straightforward stuff. And I think 
that in the second year, a lot of companies will find that they 
have done the deferred maintenance and their internal costs 
should come down significantly. And we are making it very clear 
to the auditors that we expect their costs to come down, that 
there should not be unnecessary work. We also have to be 
careful at the same time that auditors really have to be 
working hard to make sure that they are protecting investors' 
rights. It is a very, very fine balance both for them and for 
us overseeing them.
    The Chairman. What is your assessment, Chairman McDonough, 
on the claim that auditors are engaging in perhaps defensive 
auditing, too conservative of auditing because of the potential 
threat of litigation? And, in addition, what are your views on 
whether we ought to look for ways to reduce potential liability 
particularly in light of the fact that we now have four 
accounting firms doing about 99 percent of the accounting? And 
lastly, is there the opportunity or the possibility of some of 
the mid-level or regional auditing firms to ultimately become 
one of the top nationwide auditing firms?
    Mr. McDonough. I think there is no question that auditing 
firms of all sizes, given the Sarbanes-Oxley Act arising out of 
scandals, that people are running very concerned about the 
threat of litigation either by civil suits against them or by 
the criminal authorities at either the Federal or State levels.
    Human beings, what we are, if you are scared, you tend to 
act very defensively. And I think there is no question that 
there is a certain amount of this defensive posturing, which is 
taking place.
    Whether or not there should be a limitation on liability 
for accounting firms is a very tough balancing act. On one 
side, you would say the positive is that it would make the 
firms less concerned, less scared, and therefore, they would 
use their judgment more effectively. On the other hand, they 
ought to do that anyway. And, therefore, I think that when and 
if the Congress in its wisdom should decide to provide limited 
liability, I would support it. In the meantime, we will proceed 
on the basis that the accountants should be doing their jobs 
properly anyway.
    On the very complex issue of whether there will be a number 
5 adding to hopefully the big four remaining alive and well, 
the Government Accountability Office, as required by the 
Sarbanes-Oxley Act, did a study and came, I think we would all 
agree, to the conclusion that it is not very likely that any 
firm in the number 5, 6, 7, or 8 position, or even something 
which is completely unlikely to happen, that all 4 of them 
would get together, it would still be a relatively small number 
5. What I think should happen is that there are issuers--
community banks come to mind--who use very large accounting 
firms because somehow they think that that is something that 
maybe their regulators or the rating agencies would like.
    And it really seems to me, to be very direct, Mr. Chairman, 
much more appropriate that they use an accounting firm more 
appropriate to their size. Therefore, I would like to see the 
numbers 5 through 8, and then the smaller accounting firms 
grow, become healthier and stronger, but I don't think we can 
hold out a realistic likelihood that that will result in 
another firm anywhere near the size of the big four.
    The Chairman. But you do think that the market can work, 
that, given time, we can have a leveling; that is, some of 
our--and I think it is a good point on the community banks, for 
example; it clearly would be much, and a lot cheaper probably, 
too, to engage with the mid-sized firms.
    Mr. McDonough. I think the market should evolve in a way 
that will have stronger accounting firms right through the size 
structure, and that is very much to be desired.
    The Chairman. Thank you.
    Chairman Donaldson, one of the contributions in the 
conference committee was the addition of the Fair Fund; 
Chairman Baker offered the amendment during the conference that 
created this fair fund. And I know you testified that there 
were $5.4 billion--that is with a B--in that fund. And of 
course that fund comes from fines and disgorgements for cases 
that the SEC undertakes. Could you give us a little more detail 
on how that fund is working and whether, in fact, it needs any 
kind of amendments at our level? Or can the SEC take care of 
some of the potential problems with regulatory means?
    Mr. Donaldson. Thank you. I think that, as I said, there is 
a large amount of money that has been designated for the Fair 
Funds. I think that the--
    The Chairman. If I could interject. That is less than, 
what, less than 3 years?
    Mr. Donaldson. Right.
    The Chairman. And it has grown to 5.4 billion, which I 
guess--there is no way to predict, I guess, by any of us how 
that fund would grow. But, anyway, I interjected. Go ahead and 
continue.
    Mr. Donaldson. It is a tremendous benefit that we can now 
convey to harmed shareholders. The actual distribution of the 
money is a complicated process. Basically, it requires 
retroactive reconstruction, if you will, of records as to who 
the harmed shareholders were at a particular period of time. I 
think you can see how complicated that gets. Fortunately, now, 
as we have moved ahead we are able to put the costs of doing 
that off on the companies that we have fined. In other words, 
we didn't do that at the beginning. We now have the authority 
to do that, so that the actual cost of this retrofitting is 
being borne in addition to the original--or built into the 
penalty to the company.
    The Chairman. I see. And are we talking in this case in 
terms of harmed investors? What is the universe? There are 
thousands, tens of thousands, millions?
    Mr. Donaldson. Millions.
    The Chairman. Millions.
    Mr. Donaldson. Yes. If you add it all up, millions.
    The Chairman. Okay.
    Mr. Donaldson. And, again, it is a very difficult exercise 
to identify the exact period, if you will, where the 
malfeasance took place.
    The Chairman. I understand.
    Mr. Donaldson. And within that to the intellectual exercise 
of determining who got hurt.
    The Chairman. Thank you.
    Mr. Donaldson. But we are making great progress. I think 
our administrators of the Fair Funds are getting more and more 
experienced in doing this.
    The Chairman. Thank you.
    The gentleman from Massachusetts.
    Mr. Frank. To begin, to both the chairmen, we talked about 
this a little bit before. I think Mr. Donaldson had some 
reference to it. There was a troubling article in The 
Washington Post earlier this week by David Brown suggesting 
that the interpretation of accounting rules regarding when you 
could give yourself credit for receiving revenue were 
interfering with the ability of the government to stockpile 
pediatric vaccines. And it did seem to me that this was 
something that, if it were a real problem, we could solve. And 
maybe it wasn't a real problem. Although obviously, somebody 
interpreted it that way. And as you know, I wrote to both of 
you and asked if there was anything that needed to be done in 
terms of regulation or legislation to clear that up, but I 
assumed it was something we could do quickly.
    So I would be interested, you said you had a chance to look 
at that, Mr. Donaldson. Did you have some response on that?
    Mr. Donaldson. Sure. Of course, I read The Washington Post 
article as did all of our people in charge. The basic thrust of 
that article, as you know, that many manufacturers have decided 
to stop participating in part because they may not recognize 
revenue when vaccines are placed in the stockpile. We are 
concerned, but I am also concerned that it may be slightly more 
complicated than just an accounting problem. It is not clear to 
us that the accounting is the real issue as opposed to perhaps 
the business economics of the existing program.
    But we certainly don't want to be an obstacle. We will sit 
down with any drug company that comes to us to see if we can 
work this out. There may be other ways to deal with the 
problem. For example, the contract with the government could 
perhaps be restructured to handle a particular problem. But we 
are willing and will sit down with any drug company and try to 
work through their particular problem.
    Mr. Frank. Thank you. And let me urge people, any drug 
company that has said that, and also to the people at the 
Department of Health and Human Services, if they get that 
answer, let us have them come and talk to you. And if a change 
is needed, we can do that. I had my own sense that maybe 
accounting was being used as an excuse for something else. But 
people may be erring on the side of being extra cautious, and I 
understand that. But I appreciate that, and I would hope we 
could get this one resolved fairly quickly. I don't see any 
kind of obstacle, if people are getting the money, there isn't 
a problem.
    I have spoken to others here, I have spoken to Henry Waxman 
who has been very involved in all this. And I appreciate what 
you are saying. I would hope that we could all follow up now 
and that the companies involved--I am going to ask HHS to make 
sure that the companies involved are in touch with you and your 
people. And I would hope we could get this one resolved pretty 
quickly. I am encouraged by what you say.
    Now, back on the subject of compensation. And I know, I 
guess there was some reference to whether or not this was 
really all Fannie Mae and Freddie Mac's fault. I guess, if it 
rains tomorrow, we will complain to them, too, and send to them 
for the umbrellas. But, in fact, we are talking about billions 
of dollars in compensation, so, in fact, their presence perhaps 
it would make no significant difference. A couple of questions 
here about that. Because they do go with the accounting. One of 
the--I am very much persuaded by the very extensive work that 
is done by the Professors Bedrick and Freed and Grinstein and 
others that mechanisms for--that CEO pay is largely self-
determined. That there are ineffective constraints, and it does 
look like, if you hire a consulting company, you get more 
money, because the consulting companies, not wanting to annoy 
the people who decide whether or not to hire them, tend to give 
them more.
    And there is also this apparent view on a corporation that 
if you are not paying your CEO above the average, then you must 
have a below average CEO. And, as everybody tries to get 
continuously above average, that, in and of itself, is a 
significant inflationary factor. It is the opposite of where I 
go with regard to businesses in general in America.
    Actually, it is an interesting economic rule, that we have 
every business in America operating on a constantly downward 
sloping playing field. That is, every business in America that 
has ever testified on a committee where I have been sitting has 
announced that they are on an unlevel playing field and that 
the competitors have an advantage. And it is striking to me 
that the universe consists entirely of companies that are at a 
disadvantage to other companies. I mean, I have never met a 
company that was at an advantage to any other.
    They should get a prize if they come forward. But the main 
check on executive compensation that gets too high, that it is 
unrelated to performance, that simply becomes an economic 
problem, the main constraint is publicity.
    Mr. Frank. In that case, let me ask you, Mr. McDonough, one 
of the suggestions we have had in the law of unintended 
consequences, Congress passed a law a few years ago that said 
if you pay the executive a salary that was way disproportionate 
to the average worker, that wasn't deductible. And we have 
encouraged people to get into other forms of compensation not 
covered by that. And particularly one of these we are told--
well, there are two that trouble me.
    One is pension arrangements, and those involved in Fannie 
Mae. The pension arrangements--we had the CEO of Fannie Mae at 
the time tell us that if there were accounting problems, he 
would be accountable. At least I thought that is what he said. 
Apparently, he said his benefits would be uncountable. I didn't 
hear him right. And they consisted of what seemed to me to be 
widely excessive pension benefits.
    You have the jurisdiction. What is the transparency of 
pension benefits? I think we are running into a little problem.
    And let me ask you, Mr. Donaldson, too. When we have these 
pension arrangements that kick in--and I appreciate the extra 
time, and I will try to wrap it up--but this combines with what 
I think is a perverse incentive effect. We have had a couple of 
mergers in Boston lately where very successful major 
enterprises in Boston sold themselves to other enterprises. 
But, in both cases, the CEOs made well over $100 million solely 
because of the sale, and that can't be irrelevant. It cannot be 
that the ability to make over $100 million has no effect on 
whether or not you make the sale, but it shouldn't be by any 
rational economic standards. And the problem is that those tie 
in, because very often the benefits are triggered by that kind 
of a sale.
    Let me ask both of you, finally, of the extent to which 
current accounting rules make all of the compensation 
arrangements, including the contingent ones in case of sale, 
fully transparent and is that something that maybe we could 
give some more attention to.
    Mr. Donaldson. Let me try to give you an answer on that 
over the short haul and over the long haul.
    Over the short haul, I think the first step in the whole 
issue of executive compensation should be based and addressed 
by the independence of the compensation committee. As mandated 
in Sarbanes-Oxley, as instituted by the stock exchange, we now 
have independent compensation committees, number one.
    Number two is those committees have the authority to hire 
the outside experts themselves, as opposed to corporate 
management hiring the compensation advisors. Now the Committees 
can bring in their own advisors and give those advisors the 
instructions they want to give them.
    Beyond that, I believe there needs to be a fundamental 
change in the management or rather the boards' and the 
compensation committee's understanding of exactly what 
performance is, exactly what are we rewarding people for.
    My own view on that is that we are way over too far onto 
the earnings per share and quarterly results and the numerical 
measures, if you will, of success in a corporation as opposed 
to the qualitative judgments on what is good performance, what 
do you mean by that, over what period of time, quality of 
products, et cetera, et cetera, et cetera.
    Now, having said that, we are taking steps now to increase 
the transparency of the total compensation package. Alan Beller 
in our Corporation Finance Division is hard at work now in 
developing a better way of displaying what the total 
compensation package is. And, again, you have to be a forensic 
accountant practically to understand in a current disclosure 
document exactly what the total package is that a corporate 
executive is getting in terms of not only salary, bonus and so 
forth, but post-employment bonuses, benefits and so forth. We 
will come up with a way of displaying this that we hope that 
will open the whole process up to the sunlight.
    Beyond that, I think it is important to note that we have 
felt that it was not the SEC's role to dictate compensation 
measures. It is our role to make each company disclose exactly 
what they are doing. And of course, I believe--and this is a 
longer answer than you wanted--I believe that sunlight will 
have its effect.
    Mr. Frank. It is very much the answer I wanted. I agree 
with you. This is not a case for us to act, but make sure the 
information is there.
    Mr. McDonough.
    Mr. McDonough. As you may remember, Mr. Frank, I think I 
was the first public official to speak out describing the 
excessive compensation when I was honored to give the 
anniversary of 9/11 speech at Trinity church at the foot of 
Wall Street.
    Mr. Frank. Your survival has emboldened me.
    Mr. McDonough. It is a matter of considerable concern to me 
because I live in some fear that since, in addition to your 
cogent remarks on the subject, I always describe the present 
level of executive compensation as morally outrageous, which I 
think it is, I think there is no question that none of us can 
figure out a way that you could have a law or a regulation that 
would control executive compensation. My friends at the SEC 
bringing it out more into the sunshine will help, but mainly 
what we need is the leadership of the American business 
community, for to get it through its head that the 
responsibility that they have to the American people as members 
of a single society is that this level of executive 
compensation is nuts. It has no economic theory behind it 
except one called greed, and it is time for it to get changed.
    The Chairman. Gentleman's time has expired.
    The gentleman from Louisiana, Mr. Baker.
    Mr. Baker. I thank the chairman.
    I wish to commend you both for taking on the administration 
of this Act in an aggressive and appropriate manner. I think it 
has brought about a heightened level of responsibility by those 
who govern public corporations.
    I do share the view that the compensation matter is one 
that should be brought to public light and we should examine 
ways to make sure the shareholders fully understand the scope 
of packages, but I think that is as far as one can comfortably 
go until some person within either of your organizations 
figures out a logical way to provide a remedy. However, there 
are elements to this that I think are pervasive in the system.
    CEOs and CFOs have a great responsibility to meet or beat 
the street every 90 days; and if they don't, they are fired. I 
think that is an insidious force in perverting compliance with 
the accounting rules and perhaps making ill-advised business 
judgments.
    If someone spends the money on Section 404 compliance 
because the law requires it and people are going to look, did 
that cause us a hit on our earnings, and the only defense you 
will have is the law made me do it, if by contrast you had 
spent the same amount of money on internal data processing in 
order to facilitate that knowledge and not be required by law 
and take a hit, he would perhaps be in some trouble. We have to 
incent corporate America to invest for the long haul, just like 
we try to incent our individual constituents to invest in the 
markets for decades not days; and I think that is an overhaul 
task of some immense proportion.
    With regard to Section 404 compliance, Chairman Donaldson, 
there is another way I would like to come at the problem of 
cost, particularly for moderate to small business enterprises, 
not necessarily changing the compliance requirements of Section 
404 but rather the trigger that brings you into compliance with 
Sarbanes-Oxley in the first place.
    As I understand it, it is a shareholder number or an asset 
size that brings you into the pot; and that shareholder number 
is fairly small, at least in my view. Is there any review 
ongoing as to whether those thresholds which trigger the 
compliance, because that is the group from which we get the 
largest complaint, that the compliance costs versus their 
operating budget is out of whack? Is that an approach that 
might merit some consideration?
    Mr. Donaldson. As a result of our concern on just that, we 
formed the Small Business Advisory Committee. That is made up 
of sitting CEOs and accountants and everybody that is involved 
in this issue, and they met last week. It is an outstanding 
committee.
    One of the first agenda items for them has been the 
definition of what is a small business, how do you define. We 
have had traditional market cap numbers, if you will, but those 
are misleading in terms of a true definition of what we are 
talking about when we talk about a small business. And I think 
you will see, as a result of the work they are doing and their 
advice to us, we will come up with some better definitions than 
we have now.
    Mr. Baker. I don't expect a response this morning, your 
answer to the chairman on the Fair Fund administration to 
identify for us any operational concerns that going forward we 
might address and some more detailed status of the operations 
of the Fair Fund administration today. It would be helpful. 
Thank you for your good work.
    Chairman McDonough, I want to jump quickly, going forward, 
the Section 404 compliance issue, I understand that May 16 of 
this year there will be additional guidance issued. Is it 
inappropriate to ask where we might be going or is that 
something that should be subject to later disclosure?
    Mr. McDonough. Here is what we are working on first, Mr. 
Chairman. On May 16, we will come out with all the guidance we 
can possibly bring to bear on telling auditors it is not a one-
size-fits-all, you are supposed to use judgment.
    When the people in the issuing companies say, here is the 
internal controls we have in mind, what do you think, you are 
not supposed to say, I can't talk about that, but, rather, that 
there be a relationship between the auditor, very much with the 
audit committee involved and the issuer that is for the benefit 
of the growth in our society.
    We have a Standing Advisory Group on our audit standards 
which meets on June 8 and 9. That entire meeting will be 
dedicated to additional thinking on guidance we bring to bear. 
The more we can get down to the nuts and bolts so we can tell 
people, here is the way to go about doing it, we can reach a 
point where we say here is a checklist--
    Mr. Baker. One of the little elements in the list, would 
that also apply to the subject of audit independence and tax 
advice?
    Mr. McDonough. We have a proposed rule. The comment period 
has ended. We have, I believe, 1,200 pages of comment; and I 
would hope that say within the next month we will be able to 
finalize that rule. Then it goes the SEC, and they put it out.
    Essentially, what we have in that rule, which I believe 
strongly in, we want to get auditors out of the business of 
giving tax advice of how you can pay, you know, take a little 
risk and pay less tax to Uncle Sam. That is terrible. They 
never should have been doing that, and we forbid it in this 
proposed rule.
    We also tell them they can't do the individual tax returns 
for senior executives, especially in the line of financial 
reporting.
    The other, more traditional work that audit firms have done 
for their issuers, we believe they should be allowed to 
continue to do. It is much more cost efficient for the issuer, 
and I think it is just a better way of trying to get as much 
cost benefit thinking as we can into the American economy and, 
at the same time, carry out the clear mandates of Sarbanes-
Oxley.
    The Chairman. Gentleman's time has expired.
    Gentleman from Pennsylvania.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Gentlemen, let me congratulate you on your operations thus 
far. I can assure--I don't know if I can speak for all the 
members of the Committee, but I sleep a lot better knowing that 
both of you are there. You have taken on a tremendous task, and 
you have been terribly successful to date. So we don't have a 
tendency to congratulate you as nearly as often.
    I am going to take the opportunity to get into two little 
areas that are really off the record. One is going back to the 
vaccine question. I have the largest manufacturer of injectable 
vaccines in my district, Sanofi pasteur. We have been working 
closely with HHS and the Securities and Exchange Commission; 
and I would appreciate, Mr. Donaldson, if you could reach down 
in your organization--and I don't want to put you on the spot 
to discuss it, but in the omnibus bill we had required a study 
to be completed by HHS in 90 days, and that has expired on 
March 15, and that study is not completed by HHS since they did 
not communicate with your organization until sometime in the 
middle of February. Just superficially, it appears there may be 
a tennis match of where the ball is and in whose court.
    I think it demands high-level executive talent to make sure 
that we resolve this issue. Because we are completing, one, to 
maintain these manufacturers in the United States; and, two, we 
certainly want to encourage inventories. If there is some 
accounting problem or it is a contract problem, I really don't 
care. I am interested in making sure we have the stockpile. So 
if you could attend to that.
    Now the second thing, and I bring it up with a lack of 
knowledge with all the ramifications, but yesterday we had the 
announcement of the possible privatization of the New York 
Stock Exchange. Quite frankly, I am very concerned, first and 
foremost, that the institution existed so well as a not-for-
profit organization now moving into the realm of a for-profit 
corporation--certainly they have the right to do that and may 
be the right thing to do. It may enhance the equity action of 
the whole country, and that may be good.
    I am concerned about two things, the self-regulatory 
organization of the exchange--it seems to me both the Congress 
and the SEC have some work to do here, and I don't want to put 
you on the spot because I am sure we are going to be passing on 
this transaction. But as you are passing on this transaction, I 
would hope that you would listen to some of these concerns and 
think about it.
    The second concern, which I had detailed discussions with 
the leadership of the exchange on, is my concern of the 
national security issue, which I think privatization has not 
taken into consideration. Now we have for the first time the 
capacity of foreign corporations or foreign countries being the 
equity owners of the largest equity market in the United 
States; and if for some perverse reason profit was not their 
motive but in fact some devious purpose to accomplish some end, 
they would have in their vital control 80 percent of the equity 
of this economy at their disposal.
    Under normal circumstances, the SEC is a reactive 
organization to pass on what has happened. But suddenly now, 
with little investment, maybe a half a million or a billion 
dollars, a foreign power or combo could control the largest 
equity market in the United States and not worry about their 
investment but be more worried about the advantages of 
attacking us economically. They could utilize this exchange for 
horrendous purposes.
    When I look at the normal protections that we have against 
subversion in our economy, profit has so much to do with 
keeping people on the correct road. But when you have the 
opportunity with little amount of equity to extraordinarily 
impact or affect an economy as large as that of the United 
States, this is sort--I don't know what protection--
    I know other exchanges have gone into privatization. I have 
raised that issue with them. They usually look at me and say, 
well, we never really thought of that. And they will say, we 
will know who owns this. But we all know you could own huge 
amounts of equity in this country in blind trusts or 
unidentifiable trusts. It is going to be very difficult to 
pierce this veil and get the transparency.
    It seems to me with the hook of self-regulatory control 
under the auspices of the Securities and Exchange Commission 
you may have the ability to structure something here and 
invariably have to work for Congress to establish wherever that 
regulatory organization will--ultimately may be. But certainly 
to examine that we are not at a national security risk here, 
not that it would happen now under the present administration 
of the exchange or even with countries, but some devious 
character out there sitting in some foreign land with an awful 
lot of oil money--I didn't mean that--could think about having 
a real impact on the American economy in a very cheap way, a 
lot less expensive than nuclear weaponry. So if you would pay 
attention that, I would appreciate it. And within the 
constraints of a regulator, if you would like to give us any of 
your feelings on that matter, I would appreciate it.
    Mr. Donaldson. Let me begin by saying that I don't and 
cannot comment on the specifics of the proposal as was just put 
forward, since it will ultimately come under our jurisdiction, 
but let me try to answer a couple of your questions.
    First of all, on the SRO issue and the whole regulatory 
side of the exchanges, we have been, as you know, concerned by 
trying to isolate the regulatory side of the exchanges from the 
business side, if you will, and we have had a proposal out 
there for comment, if you will, on just how in the future the 
regulatory aspect of exchange organization can be isolated from 
the business aspect.
    In the case of New York Stock Exchange, they have a model 
that has the regulatory side under the purview of independent 
directors and totally out of the chain of command, if you will. 
So we have been very concerned with that problem.
    We have also been concerned with how the financing of the 
independent regulatory oversight would take place, the 
precedents, if you will, of the revenues of the exchange going 
to the regulatory side.
    As far as the national security aspect, again, we have been 
thinking about this, and we have been working on it. Because it 
seemed to us that it was inevitable that the issue of public 
ownership was going to become more and more in the public view. 
Obviously, the NASDAQ situation is publicly held now; and we 
have been concerned about the constraints that we can put on, 
the reassurances we can put on the overall structure to make 
sure that what you just talked about doesn't happen. We will be 
incorporating in our--and, again, I am not referring to the 
present situation--we will be incorporating in our SRO 
governance standards our conclusions, if you will, on just how 
to do that.
    I might also say that the competition now between the 
marketplaces is happening just as it should. We have increased 
competition between the markets and the bringing together, if 
you will, of the New York Stock Exchange and the new structure 
illustrates that competition. It also illustrates the rising 
importance of electronic execution, if you will.
    It also brings forward, in my view, the importance of our 
recent national market system rulings in terms of individual 
investor protection. It is very important as we move toward 
electronic trading that we protect the individual investor, and 
it is very important that we have rules that are consistent 
across the marketplace. That is why that was such an important 
part of Reg NMS, the extension of the rules to not only the New 
York Stock Exchange but NASDAQ.
    The Chairman. Gentleman's time has expired.
    The gentleman from Alabama.
    Mr. Bachus. I thank the Chairman.
    Before I go into a more general line of questioning, I have 
got a bank-related question I want to ask Chairman McDonough. 
Some audit firms are beginning to require dispute resolution 
provisions in their engagement letters with the companies they 
audit, and these provisions prohibit the companies from suing 
the auditing firm. They require arbitration; and, even more 
importantly to me, they require the location of those 
arbitration proceedings. I know the banks have expressed 
concerns to us and also I think the bank regulators are 
concerned about possible safety and soundness issues related to 
this. Has the oversight board focused on this issue and have 
you had conversations with the bank regulators?
    Mr. McDonough. Mr. Bachus, my understanding is that the SEC 
has taken a position that when an accountant enters into an 
indemnity agreement with its audit client that provides the 
accountant immunity from liability it can jeopardize the 
accountant's independence. Now, under Sarbanes-Oxley, we now 
share responsibility for auditor independence with the SEC. We 
have--at the staff level, but also in our case involving me 
personally, we have been in discussions at the SEC and the 
PCAOB with the Federal banking regulators on this issue; and I 
think I can speak for all of us involved in these discussions 
by saying we are all concerned about that practice. We 
understand that the bank regulators intend to issue guidance on 
this issue in the near future, which I certainly like to see. 
We will monitor that practice very, very closely.
    Mr. Bachus. I want to focus on the bigger issues. Of the 
2,500 companies that filed by March, 8 percent of them reported 
material weaknesses in their internal controls. I think that 
alone tells you that Section 404 was necessary and validates 
the legislation and the need for internal control audits and 
reports. I think--I hope you agree that will result in a more 
accurate reporting and enhanced investor confidence. I know 
that one or two of my colleagues have said these are just a few 
bad apples, but 8 percent is a pretty surprising figure. Would 
you all agree?
    Mr. Donaldson. I think it is an important statistic, and it 
illustrates the positive impact that the whole Section 404 
approach takes. I do believe in our conversations with 
corporate executives that many of them, after they get done 
complaining about the costs, talk about the improved management 
oversight they have now and welcome this exercise they have 
gone through to identify their own weaknesses. So I think it 
has been positive.
    Mr. Bachus. Let me say this, and I wanted to say that 
first, that I think that it is necessary. I think it is 
positive. I think it has led to better confidence by investors, 
more accurate reporting.
    That being said, I think the main concern expressed on 
Sarbanes-Oxley is focused on Section 404; and I think the main 
criticism has been on the disproportionate costs to the smaller 
firms. One figure I saw was that the cost of these internal 
audit reports to companies of over $5 billion in revenue was 
$0.06 out of every dollar. But to companies of $100 million in 
revenue, the cost was $2.50, which is obviously 
disproportionate. I have read estimates I think from the 
oversight board and others that that cost ought to drop about 
50 percent in the second year.
    Having said that, and I know you have forms--and a lot of 
the criticism is the duplication between the internal audits 
and external audits, maybe extending the deadlines. I think 
another criticism is the need for risk-based audits.
    Would you like to comment on maybe ways we can lessen the 
costs on these smaller firms?
    Mr. McDonough. I think it is absolutely essential that we 
do so.
    I was a central banker five times longer than I have been 
an audit overseer, so maybe it is the central banker in me that 
says small- and medium-sized companies create all the increase 
in jobs in our economy. They are absolutely vital to the 
functioning of the American economy and therefore serve the 
interests of our people. There is no question that there are 
ways to reduce the cost. The use of the work of others was put 
right into our auditing standards.
    You may recall when I was here a year ago I said that we 
invented that cost benefit, thinking it isn't, in fact, in the 
statute, and Chairman Oxley was nice enough to say that he was 
glad that we had done so.
    I think we are going to be able to say that in our May 16 
guidance, that the audit plan should indicate exactly what work 
needs to be done. That has to be more thoughtfully done by the 
auditor, figure out how much work can be done by the work of 
others, especially reward a good internal audit capability by 
taking more advantage of it. At the end of the day, the auditor 
has to say, I know enough by my own work to be able to make a 
judgment.
    But taking advantage of the work of others is certainly, in 
my view, encouraged and, heaven knows, not precluded. We will 
then continue to work throughout--well, for the indefinite 
future. But we want to work at it really fast, because the more 
guidance we get out quicker, the more we improve the 2005 audit 
season so that some of this unnecessary expense that took place 
in the last year won't be repeated. Will we get beat out all of 
the unnecessary expense in 2005? I hope so, but I doubt it.
    So this is going to be a project where we have to keep 
working with the audit firms. That is why our inspections are 
so valuable. We made it very clear to the auditors that, yes, 
we would be critical if you didn't do enough work on internal 
control, but we will also be critical if we have the view that 
you did too much. Whether it is inspired by fear, as has been 
suggested earlier in my answer to the chairman, or even if it 
is a less attractive motivation, which is to run up the hours 
and the fees, we have to get a much better cost benefit 
equation into this necessary work to protect investors.
    Mr. Donaldson. Could I add two comments to that?
    Number one, I think on the smaller end of the scale, 
because of the delay and that coming under the implementation, 
if you will, there has been a learning curve out there as a 
result of what is going on to date. That learning curve is not 
only in the companies themselves but with the auditors 
themselves. I think we will see a natural improvement in the 
efficiency of the process simply having been through it once.
    The Chairman. Gentleman's time has expired.
    The gentleman from Illinois, Mr. Gutierrez.
    Mr. Gutierrez. Thank you very much, Mr. Chairman.
    Chairman McDonough, in response to Ranking Member Frank, 
you referenced your previous remarks where you predicted that 
Congress would take action to rein in executive pay; and you 
also called the gap in pay between executives and workers, 
quote, grossly immoral. You said, quote, the American dream is 
in danger. The loss of confidence in private sector leaders by 
the American people can be restored only if we convince them 
once again that the private sector at the top is not a closed 
club of people guided by their own selfishness and agreed, 
unquote. I thank you for that insightful observation, Mr. 
Chairman.
    As you know, my colleague, Mr. Frank, began and indicated 
that the first step regarding these obscene salary packages 
should involve clear disclosure so the shareholders and the 
public can follow the trail and discover the total compensation 
packages of these CEOs. I think the real solution is that 
shareholders should be able to directly decide their CEO's pay 
package. After all, it is their money footing the bill. What 
would you think, Mr. Chairman, of this type of proposal where 
there would be a direct linkage between shareholders and 
determining the package, pay package of a CEO?
    Mr. McDonough. Well, Congressman Gutierrez, you will recall 
that I am a native of Chicago, so thank you. I do stand by 
those remarks that you quoted for me.
    Actually, the shareholders do direct the compensation, 
because the directors of the company are supposed to represent 
the shareholders. I think if we say that shareholders are not 
being well protected if CEO compensation is too high that we 
have to say that the directors of public companies--not all 
public companies, some public companies--are actually improving 
their situation by coming up with a methodology which you and I 
and any other member of the American society can look at and 
say, well, that makes sense.
    But in many, many other cases, you look at the methodology 
and, essentially, it is what the Ranking Minority Member 
described as, you bring in an executive compensation consultant 
and the executive compensation consultant says, no, McDonough, 
you are a genius because you hired me. Of course, that is why 
he knows I am a genius; and, therefore, you should be in the 
top quartile of executive compensation and we will compare you 
just by chance with a group of companies that happen to pay a 
lot. That actually is what was happening. That is not a 
caricature, but, unfortunately, that is the truth. That 
shouldn't be happening if the directors of public companies are 
doing their jobs properly.
    Mr. Gutierrez. In the instances--because you are from 
Chicago, I thought you were going to give me that answer and go 
back to the board of directors. So I am happy that we are on 
the same page.
    Having said that, then what about the shareholders being 
able to veto a mistake made by the board of directors in terms 
of an excessive package of wages? Let us say the board of 
directors does something and the shareholders feel, God, look 
at all that money. What do you think of that instance? A veto 
process? They don't like it. Is there a procedure in which they 
should be able to get involved?
    In order to seriously address the issue of competence, 
because as you and Mr. Donaldson have expressed, we are 
beginning to make inroads after the lack of competence which 
ensued at the end of the last decade and the beginning of this 
one, but there are still stories that may continue to unfold. 
And as you declared, and I agree with you totally and I am 
happy you stand by those words, grossly immoral. What do you 
think of that?
    Mr. McDonough. I would be really trampling on the turf if I 
answered that question of my colleague and friend, Mr. 
Donaldson, because it has to do with the governance of 
corporations, which is the SEC area.
    I will make the comment, at the present time, a shareholder 
only has one choice, and that is to sell the shares. That 
doesn't impress me as the only choice that ought to be 
available.
    Mr. Gutierrez. I will take that as an answer.
    I would like to ask a question of Chairman Donaldson. You 
were quoted in Forbes magazine in 2003 where you referred to a, 
quote, disconnect between executive compensation and 
performance. You expressed fear that the business was slow to 
heed the public's outrage, quote. In my view--this is Chairman 
Donaldson--such cynicism is a major threat to the long-term 
growth and health of our economy.
    You added, without the confidence and participation of 
mainstream America--I thought that was the shareholders--our 
markets cannot resume their rightful and necessary place as the 
engine of American prosperity, end quote.
    Company directors must create, according to Mr. Donaldson's 
quote in the Forbes magazine, a corporate culture based on a 
philosophy of high ethical standards and accountability. And 
you said this culture must be engrained in the company's moral 
DNA, following up on Mr. McDonough talking about morality.
    Obviously, there is a serious ethical moral question, as 
both of you have been so widely quoted about the morality or 
lack of morality. However, you have CEOs like Robert 
Allbritton, who presided over Riggs Bank, an institution that 
systemically failed to comply with Bank Secrecy Act 
requirements and facilitated transactions for General Pinochet 
for years before these actions were finally acknowledged by the 
regulator, the OCC. In addition to his generous salary and 
sizeable stock options, which he exercised just before his 
resignation as chairman, earning him $5.7 million in a single 
day, here is somebody who violated the OCC, and we will let 
them continue to look at the things.
    The Chairman. Gentleman's time has expired. Could we hear 
the answer?
    Mr. Gutierrez. Could you just speak to that issue 
momentarily before the chairman cuts you off?
    Mr. Donaldson. Well, I think that the issue of compensation 
has to do--as I tried to say earlier, has to do with an 
appraisal of what good management is and what effect that has 
on the performance of the company; and I think it needs to be 
measured over a longer period of time than is currently there. 
I think there is a danger that if we somehow do not reward 
really good performance with really good rewards--and I believe 
the marketplace must be the determination of that, and that 
comes from a complete disclosure of just what these rewards 
are, and then the shareholders can make their own judgment as 
to whether the rewards they are getting in the marketplace are 
being fairly compensated. I think the problem is that there are 
rewards that are not disclosed and if disclosed would excite 
some shareholders.
    Mr. Gutierrez. Thank you very much. If I could submit some 
questions in writing to the two chairmen.
    The Chairman. The Gentleman from Texas.
    Mr. Hensarling. Thank you, Mr. Chairman. Let me add my 
voice to the chorus of those congratulating you for your 
leadership on Sarbanes-Oxley, a critical piece of legislation 
at a critical time in our Nation's history. Clearly, accounting 
firms and executives are held to higher standards, and we have 
our financial controls strengthened and more transparency, and 
investor confidence is up. Clearly, that is all the good.
    But sometimes when I hear from constituents about the 
application of Sarbanes-Oxley, it reminds me of some of these 
miracle drugs we see advertised on TV: Take the green pill. It 
is 97 percent effective, but side effects include premature 
baldness, bad breath and nausea. I think to some extent in my 5 
minutes I could say that Sarbanes-Oxley is 97 percent effective 
in curing what ails us, and I want to spend a little time 
talking about some of these possible side effects.
    I represent a Dallas, Texas, based congressional district; 
and I have seen an uptick in small public companies deciding to 
go private. Just a couple of examples.
    A company named Bestway, a rent-to-own company, they had a 
net income of $366,000 last year, and they spent almost 
$600,000 on their Section 404 compliance, and they decided to 
go private.
    Calloways, which is a nursery, had a $4.3 million loss in 
'03, $113,000 profit in '04, and they are saying that they have 
to spend an extra half a million dollars a year to meet all the 
public filing requirements. They have decided to go private as 
well.
    I have a twofold question. Number one, do you have any 
evidence that this is a trend that increasingly small public 
companies are choosing to go private because of the compliance 
costs? And if you do see a trend, what are the implications to 
the investor community and the economy? Chairman Donaldson?
    Mr. Donaldson. First of all, I think you have to put it in 
context relative to the numbers of small companies or relative 
to the number of companies out there. Those that have gone 
private are quite small. Nonetheless, they are more than they 
were in the past.
    I think you have to relate that to the public ownership 
boom, if you will, that took place during the escalating 
markets in the 1990s. There are a number of companies who never 
should have gone public, who were not ready for it and were not 
ready to accept the burdens of public ownership. There are 
obligations for liquidity and capital raising that comes from 
public ownership. There are burdens of regulation.
    Having said that, it is, I believe a natural process here 
where there are going to be some companies who are going to 
decide that the burdens and responsibilities are too great and 
would rather be a private company. And I think for the great 
majority of companies, there has been--the very reason for 
Sarbanes-Oxley, there has been inadequate attention to the 
expenses, the justified expenses of being public.
    Mr. Hensarling. You don't necessarily see a trend, but if 
you do see a trend you don't see a worrisome trend?
    Mr. Donaldson. I see an increase in companies going 
private. I think the rhetoric is a little ahead of the actual 
numbers. I mean, the numbers are very small relative to the 
thousands of companies that are public.
    Mr. Hensarling. Continuing to focus on the burden on 
smaller public companies, you get a lot of studies and 
anecdotal evidence crossing your desk. I happened to pick up a 
USA Today the other day flying back to Dallas, and they just 
mentioned a few companies. Priority Health Care, a pharmacy 
distributor, has 491 percent higher audit fees. Aaron Marantz, 
audit-related fees up 287 percent. A lumber company, Daletech 
Timber, 243 percent rise in their audit fees.
    Do you have some way to get your arms around all this as 
far as the size of magnitude, as far as the cost compliance for 
these smaller companies? Do you have any studies that you 
believe are valid and worthy of bringing to our attention?
    Mr. Donaldson. We are very concerned about the small 
company end of the economy. Obviously, that is the engine of 
growth in our economy, has been and will continue to be. We are 
very concerned about any sort of disadvantages that come from a 
one-size-fits-all application of Sarbanes-Oxley, and that is 
why we formed this advisory committee. And we are going to pay 
particular attention to smaller companies and the burdens on 
smaller companies, we are concerned about it and we are 
concerned about seeing if we can't cut away some of the chaff, 
if you will, in terms of the implementation of Sarbanes-Oxley.
    The Chairman. Gentleman's time has expired.
    The gentleman from Georgia, Mr. Scott.
    Mr. Scott. Thank you, Mr. Chairman.
    First, to you, Chairman Donaldson, I would like to ask you 
about the New York Stock Exchange and their move of going 
public. Is it your opinion it is a good move? I think from your 
earlier comments I think you were saying it would promote 
greater choice. Transparency might be better for faster 
transactions. Is that a fair assessment?
    Mr. Donaldson. Again, I am reluctant to comment publicly 
since we do have to pass, if you will, ultimately on the stock 
exchange proposal.
    Let me say two things. Number one is that I believe the 
proposal is reflective of the increasing competition between 
markets; and I think that is very healthy. It is very healthy 
not only domestically but as we emerge in a world order, if you 
will, to make the U.S. markets even more competitive on a 
worldwide basis.
    Mr. Scott. Let me ask you this. Now it has gone public, it 
comes under the purview of Sarbanes-Oxley. How do you feel that 
Sarbanes-Oxley would fall into this? Particularly given the 
past recent culture of the New York Stock Exchange, the recent 
scandals, the recent settlement of the $257 million, of the 
cheating of investors, some of the fallout from the Glasgow 
situation, how do you feel Sarbanes-Oxley will fit into this? 
How do you envision that?
    Mr. Donaldson. Clearly, in terms of the independence of the 
regulatory oversight at the New York Stock Exchange, I think a 
significant improvement has been made. You are referring now to 
things that happened before the structure was changed, the 
fines that we have given, and I would say that we have been 
very tough in enforcement.
    Mr. Scott. The culture has improved.
    Mr. Donaldson. And I believe the structure now and the 
personnel that has been brought in on the regulatory side is 
just what the SRO concept of oversight is all about.
    Mr. Scott. Mr. McDonough, let me go to you; and, 
incidentally, I want to thank you for stopping by my office. I 
thought we had a delightful visit.
    I want to talk about Section 404. Recently, 
PriceWaterhouse, KPMG and Ernst & Ernst and I think it was 
Deloitte Touche did a study, a survey, and in that survey it 
came out that there was an average uniform cost of $7.8 million 
for compliance with Section 404 and that the bulk of this was 
one-time costs. Do you have any breakdown on what these one-
time costs were?
    Secondly, it appears to be quite a bit. Do you foresee the 
costs or expenses going down?
    Mr. McDonough. Yes, Congressman Scott, I think they will go 
down. How much they go down will vary a lot by company. If the 
company had a lot of deferred maintenance, if they had to 
document internal controls, that was very expensive. That 
should be a one-time expense, and then they would have a big 
drop from year to year. If you had a company that had better-
developed internal controls, the past year's costs would be 
lower and, therefore, the likelihood of a big drop would be 
less.
    I think what we have to do--these conglomerate numbers are 
all very interesting, but they don't tell you much. You have to 
go in company by company and auditor by auditor and really see 
if they have the level of internal controls that really make 
sense for the nature of the issuing company. Some of them, in 
my view, clearly have more bells and whistles than they need, 
and that expense is inappropriate.
    There is no question that there is enough anecdotal 
evidence to figure out that some of the auditors have been 
overdoing it and how much work that they have required. We 
wished through the guidance through our standards group and 
then through our inspection process to make sure that that 
conduct gets improved as well.
    Here is one where I think that you really go at it issuer 
by issuer and audit engagement by audit engagement and try to 
drive down the unnecessary cost. We still have to protect the 
investors. That is what Sarbanes-Oxley is all about. But we 
have to do it where it is most cost effective with the special 
concern for the small- and medium-sized companies, that they 
are not spending money that they really don't need to be 
spending.
    The Chairman. The gentleman's time has expired.
    The gentleman from South Carolina.
    Mr. Barrett of South Carolina. Thank you, Mr. Chairman.
    Thank you, gentlemen, for being here today. Travel light 
and hit hard.
    Got two questions, real quick. Let us turn our attention to 
Section 404, the SEC-issued guidance to the accounting industry 
on certain treatment of the lease accounting practices. I have 
gotten several letters. I have gotten one from the Retail 
Leaders Industry Association, the National Restaurant 
Association, even the Chamber. They have expressed concern that 
retroactively applying these interpretations could have a 
tremendous adverse effect on the economy. Why did SEC insist on 
the interpretation being applied retroactively in the ninth 
inning for the form 10-K?
    Mr. Donaldson. On February 7, our chief accountant issued a 
response to the AICPA in which he clarified the staff's 
understanding regarding several lease accounting practices that 
were not compliant with pre-existing and long-standing 
accounting rules. These issues were initially identified by a 
few companies and their auditors who had already concluded 
without our staff involvement that certain leases had been 
accounted for in error based upon long-standing GAAP 
accounting.
    So, basically, the restatement raises the issue of whether 
a material weakness in internal controls exists for Section 404 
reporting. The issue of whether a restatement constitutes a 
material weakness in a particular instance is a matter to be 
resolved through discussions between a company's management and 
its auditors. It would be very difficult for us to 
categorically conclude that a particular type of restatement is 
never a material weakness. But the issue here was us trying to 
face up to this inconsistency as quickly as we could, 
particularly as the Section 404 compliance measures were 
coming.
    Mr. Barrett of South Carolina. I guess this leads into my 
second question. When you are talking about material weakness, 
due to some of the timings on these things, a lot of these 
companies are having reports written about them that they do 
have material weakness. My question is, how do I separate a 
company like that from the Enrons out there that have some 
serious material weaknesses? How do I differentiate between 
those two?
    Mr. Donaldson. Well, I think--and Chairman McDonough may 
want to answer this. I think the material weakness is an 
accounting concept, and it is something that must be arrived at 
with the accounting profession according to auditing standards. 
Beyond that, I mean, it is a matter of some judgment here as 
between the auditors and the company itself and the company's 
financial officials. I think the real issue here is the 
correction of the material weaknesses; and, again, I think we 
are going to see corrections coming quite rapidly.
    Did you want to add to that.
    Mr. McDonough. The decision of whether something is a 
significant deficiency or material weakness has to be done case 
by case.
    Let us assume that the decision is made by the issuer and 
the auditor it is a material weakness. The important thing is 
that there be disclosure, disclosure, disclosure, disclosure. 
Say exactly what happened, why it happened, what you plan to do 
about it; and then the auditor should also opine that, yes, we 
think that it is fixable in this way.
    We have just brought out a proposed standard, Congressman, 
that would say that if in the course of the year following a 
fiscal year in which an issuer has a material weakness the 
issuer says, I fixed the material weakness, and the issuer 
says, but I think I better get my auditor to agree with me, we 
are creating a methodology through a new rule that will 
establish how the auditor goes about that.
    In the real world, there are material weaknesses and 
material weaknesses. Some of them would probably make any 
sensible investor say, this is not a good company to be 
investing in. Others you would say, okay, they made a mistake, 
they admit it, and they are saying how they are going to fix 
it, and I have confidence they will fix it.
    The interesting thing is the securities market, if you 
watch the stock market performance, some companies come out and 
state a material weakness of the kind I described and explain 
it well; stock market reaction is not detectable. On the other 
hand, if they say that they have serious problems, the stock 
market reaction is indeed predictable; it is down. I think it 
is an indication that markets work.
    Mr. Donaldson. As a former security analyst, one man's or 
woman's material weakness may not be another's. There is an 
accounting concept here, and then there is the marketplace. As 
Chairman McDonough says, the marketplace will evaluate whether 
an accountant's concept of material weakness is really 
significant; and that will play out in the price of the stock.
    The Chairman. Gentleman's time has expired.
    Gentleman from New York, Mr. Meeks.
    Mr. Meeks. Thank you, Mr. Chairman.
    First, I want to thank Chairman McDonough for taking the 
time to visit me in my office and establishing a relationship 
when he first became the chairman of PCAOB; and I want to thank 
you and your staff for arranging to have a meeting in your 
offices, particularly Mary Hamlick. I want to thank you also 
for your frankness and your testimony, a frankness that is not 
often heard at this committee today.
    Let me ask you a couple of quick questions, given that I 
have heard the bells.
    Mr. McDonough, in response to Chairman Oxley a short while 
ago, you mentioned that more firms could be involved in 
auditing if more issuers used auditing firms that match their 
size instead of large firms. I was wondering, is there a way 
that regulators or Congress can encourage this to happen? 
Because one of my thoughts was there is only four firms that 
are doing all of the auditing and to increase the number of 
firms that are involved here, do you think there is any way 
that we could encourage this to happen?
    Mr. McDonough. I think we are actually doing it in this 
dialogue and the one I had earlier with the chairman.
    I think when the chairman of the PCAOB says that a smaller-
sized company or a community bank really ought to have an 
auditor that is more appropriate to its size, that rather says 
to that community bank or small company, well, if the chairman 
of the PCAOB and Congressman Meeks agree that that is 
appropriate, it kind of tells them it is okay. It isn't 
necessary to have some big fancy auditing firm if it really 
doesn't make a whole lot of sense for you.
    Mr. McDonough. So I think that we are both using the bully 
pulpit to get that message across.
    Another thing I think that these smaller firms can do, and 
this is a conversation we had with that very nice group that 
came to see us at your arrangement. We want, because we think 
it is most cost efficient, that you have an audit, which is an 
audit of both the financial statement and of internal controls. 
But a lot of companies actually need expert advice in 
establishing internal controls, and that is something that a 
smaller auditing firm could develop a real expertise at and be 
able to get a nice flow of income by being an expert adviser on 
people getting up good internal control mechanisms. And we at 
that meeting, and now, I am really encouraging that 
development.
    Mr. Meeks. What about, do you think they would bring down 
the cost of Section 404 by having the primary auditor 
subcontract out to smaller firms? Do you think that that would 
be a possibility, or do you believe that the regs are written 
in such a way that subcontractor joint ventures are not viable?
    Mr. McDonough. I don't think that would work. I was just 
turning to Laura Phillips, whom we call Miss Internal Control, 
and is my expert on this subject. The integrated audit we think 
is really the way to go, and therefore to subcontract part of 
the work, I just don't think it works. That is why I like the 
idea better that the issue were, say, if we really need some 
help in designing the internal controls, first of all, they 
ought to hire another firm. Their auditor shouldn't do that 
because you destroy independence in the process. So I think 
that is how we can bring some new business to the smaller firm 
as an expert adviser on the creation of internal controls.
    Now, I do recognize that that is probably a one-time 
proposition, but at least it brings them into the picture in as 
constructive a way as I think I can figure out.
    Mr. Meeks. Let me just ask this question. What are your 
thoughts on mandatory auditor rotation? And should the SEC or 
PCAOB have the authority to demand a change in auditors for a 
company where they suspect the relationship may be too cozy or 
where certain legal violations may have occurred?
    Mr. McDonough. I believe that the SEC could order an issue 
or two to change audit firms. So they have that authority. The 
larger question, should we have a general requirement for 
rotation of audit firms, unfortunately, I don't think it works 
because if you look at the large number of larger companies 
that deal with one of the big four audit firms, they would have 
a real problem in moving to one of the others because of the 
independence issue as we currently define it. If they have used 
one of the other three firms--and the chances are pretty high 
they have probably used all three of them for some kind of a 
consulting project, that new firm to which they might think of 
moving would flunk the independence test. It is one of the 
reasons that, since we have only four very large firms, I have 
a sincere continuing belief that we continue to have four very 
large firms and that no accident will come along which would 
present us with the enormous public policy challenge of what 
would we do if we had three.
    The Chairman. The gentleman's time has expired.
    The Chair would indicate that because we have three 15-
minute votes pending on the floor of the House, which is 
somewhat unprecedented, at least lately, and I have also been 
informed that we would have to pay Mr. McDonough overtime-- 
Since you are paid by the taxpayers as I am, we would still 
retain the same amount of pay, but Mr. McDonough is in a 
different category. Having said that, we will plan to adjourn 
the hearing.
    Let me first thank both of you again for an excellent 
hearing and excellent contributions, as usual, and indicate 
that some members may have additional questions for the panel 
which they may wish to submit in writing. Without objection, 
the hearing record will remain open for 30 days for members to 
submit written questions to those witnesses and to place their 
responses in the record. And, without objection, correspondence 
from the American Bankers Association regarding the 
implementation of the Sarbanes-Oxley Act will be made part of 
the record.
    [The following information can be found on page 90 in the 
appendix.]
    The Chairman. No further business coming before the 
Committee, the Committee stands adjourned.
    [Whereupon, at 12:05 p.m., the Committee was adjourned.]




                            A P P E N D I X



                             April 21, 2005

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