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




 
      THE SARBANES-OXLEY ACT 4 YEARS LATER: WHAT HAVE WE LEARNED?

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

                                HEARING

                               before the

                   SUBCOMMITTEE ON REGULATORY AFFAIRS

                                 of the

                              COMMITTEE ON
                           GOVERNMENT REFORM

                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                             APRIL 5, 2006

                               __________

                           Serial No. 109-199

                               __________

       Printed for the use of the Committee on Government Reform


  Available via the World Wide Web: http://www.gpoaccess.gov/congress/
                               index.html
                      http://www.house.gov/reform


                                 ______

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                     COMMITTEE ON GOVERNMENT REFORM

                     TOM DAVIS, Virginia, Chairman
CHRISTOPHER SHAYS, Connecticut       HENRY A. WAXMAN, California
DAN BURTON, Indiana                  TOM LANTOS, California
ILEANA ROS-LEHTINEN, Florida         MAJOR R. OWENS, New York
JOHN M. McHUGH, New York             EDOLPHUS TOWNS, New York
JOHN L. MICA, Florida                PAUL E. KANJORSKI, Pennsylvania
GIL GUTKNECHT, Minnesota             CAROLYN B. MALONEY, New York
MARK E. SOUDER, Indiana              ELIJAH E. CUMMINGS, Maryland
STEVEN C. LaTOURETTE, Ohio           DENNIS J. KUCINICH, Ohio
TODD RUSSELL PLATTS, Pennsylvania    DANNY K. DAVIS, Illinois
CHRIS CANNON, Utah                   WM. LACY CLAY, Missouri
JOHN J. DUNCAN, Jr., Tennessee       DIANE E. WATSON, California
CANDICE S. MILLER, Michigan          STEPHEN F. LYNCH, Massachusetts
MICHAEL R. TURNER, Ohio              CHRIS VAN HOLLEN, Maryland
DARRELL E. ISSA, California          LINDA T. SANCHEZ, California
JON C. PORTER, Nevada                C.A. DUTCH RUPPERSBERGER, Maryland
KENNY MARCHANT, Texas                BRIAN HIGGINS, New York
LYNN A. WESTMORELAND, Georgia        ELEANOR HOLMES NORTON, District of 
PATRICK T. McHENRY, North Carolina       Columbia
CHARLES W. DENT, Pennsylvania                    ------
VIRGINIA FOXX, North Carolina        BERNARD SANDERS, Vermont 
JEAN SCMIDT, Ohio                        (Independent)
------ ------

                      David Marin, Staff Director
                Lawrence Halloran, Deputy Staff Director
                       Teresa Austin, Chief Clerk
          Phil Barnett, Minority Chief of Staff/Chief Counsel

                   Subcommittee on Regulatory Affairs

                 CANDICE S. MILLER, Michigan, Chairman
CHRIS CANNON, Utah                   STEPHEN F. LYNCH, Massachusetts
MICHAEL R. TURNER, Ohio              WM. LACY CLAY, Missouri
LYNN A. WESTMORELAND, Georgia        CHRIS VAN HOLLEN, Maryland
JEAN SCHMIDT, Ohio

                               Ex Officio

TOM DAVIS, Virginia                  HENRY A. WAXMAN, California
                       Ed Schrock, Staff Director
               Kristine Husar, Professional Staff Member
                         Benjamin Chance, Clerk
                     Krista Boyd, Minority Counsel


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on April 5, 2006....................................     1
Statement of:
    Feeney, Hon. Tom, a Representative in Congress from the State 
      of Florida; Hon. Mark S. Kirk, a Representative in Congress 
      from the State of Illinois; and Hon. Gregory W. Meeks, a 
      Representative in Congress from the State of New York......     9
        Feeney, Hon. Tom.........................................     9
        Kirk, Hon. Mark S........................................    17
        Meeks, Hon. Gregory W....................................    29
    Hinchman, Grace L., senior vice president, Financial 
      Executives International; Richard A. Hubbell, chief 
      executive officer, RPC & Marine Products Corp.; Robert P. 
      Dowski, chief financial officer, Allied Defense Group 
      [ADG]; Alex J. Pollock, resident fellow, American 
      Enterprise Institute; and Damon A. Silvers, associate 
      general counsel, American Federation of Labor and Congress 
      of Industrial Organizations................................    48
        Dowski, Robert P.........................................    65
        Hinchman, Grace L........................................    48
        Hubbell, Richard A.......................................    61
        Pollock, Alex J..........................................    72
        Silvers, Damon A.........................................    80
Letters, statements, etc., submitted for the record by:
    Dowski, Robert P., chief financial officer, Allied Defense 
      Group [ADG], prepared statement of.........................    68
    Feeney, Hon. Tom, a Representative in Congress from the State 
      of Florida, prepared statement of..........................    12
    Hinchman, Grace L., senior vice president, Financial 
      Executives International, prepared statement of............    51
    Hubbell, Richard A., chief executive officer, RPC & Marine 
      Products Corp., prepared statement of......................    63
    Kirk, Hon. Mark S., a Representative in Congress from the 
      State of Illinois, prepared statement of...................    20
    Meeks, Hon. Gregory W., a Representative in Congress from the 
      State of New York, prepared statement of...................    33
    Miller, Hon. Candice S., a Representative in Congress from 
      the State of Michigan, prepared statement of...............     4
    Pollock, Alex J., resident fellow, American Enterprise 
      Institute, prepared statement of...........................    75
    Silvers, Damon A., associate general counsel, American 
      Federation of Labor and Congress of Industrial 
      Organizations, prepared statement of.......................    83


      THE SARBANES-OXLEY ACT 4 YEARS LATER: WHAT HAVE WE LEARNED?

                              ----------                              


                        WEDNESDAY, APRIL 5, 2006

                  House of Representatives,
                Subcommittee on Regulatory Affairs,
                            Committee on Government Reform,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 10:08 a.m., in 
room 2154, Rayburn House Office Building, Hon. Candice S. 
Miller (chairman of the subcommittee) presiding.
    Present: Representatives Miller, Westmoreland, Lynch, and 
Clay.
    Staff present: Ed Schrock, staff director; Rosario 
Palmieri, deputy staff director; Kristina Husar and Joe 
Santiago, professional staff director; Benjamin Chance, clerk; 
Krista Boyd, minority counsel; and Jean Gosa, minority 
assistant clerk.
    Mrs. Miller. Good morning. Our third panelist is on his 
way, and I know our first panelist has another meeting to go 
to, and the ranking member said that was the sound of the ``Big 
Dig'' from Boston, so with that we will start.
    I want to welcome everyone this morning, and the 
Subcommittee on Regulatory Affairs will come to order.
    No one here can forget the turmoil caused by the corporate 
and accounting scandals involving Enron, Arthur Andersen, and 
certainly WorldCom as well. And as a reaction to the shocking 
behavior of all of these things, Congress acted very swiftly to 
pass legislation aimed at restoring order and trust in our 
Nation's financial markets, and with very good reason.
    After all, financial investment in our public markets and 
public companies is good not only for the companies, but for 
the financial security of average Americans. The more liquid 
our financial markets, the less expensive it is for American 
companies to raise capital, to grow their business, and to 
provide investors with a healthy return on their investment. 
This system encourages small companies to expand and it is also 
a recipe for dynamic growth in the job market.
    The Sarbanes-Oxley Act tried to restore investor confidence 
in the stock market by restricting accounting firms from 
performing a number of services for the companies that they 
audit. The act also required new disclosures for public 
companies and for the officers and directors of those 
companies. Among the other issues affected by the legislation 
are securities fraud, criminal and civil penalties for 
violating the security laws, blackouts for inside traders of 
pension fund shares, and protections for corporate 
whistleblowers.
    However, Congress might have acted just a bit too quickly 
as many unintended consequences have made the law more costly 
to business and to small businesses, in particular, than 
originally thought. We are holding this hearing today to 
examine some of these consequences and to look at possible 
solutions.
    Oftentimes it is very hard for policymakers to evaluate the 
cost and benefits of a regulation or a piece of legislation. In 
the case of Sarbanes-Oxley, we now have data which suggests 
that the cost of complying with specific provisions of the act 
is much greater than the actual benefits.
    For example, while the SEC initially estimated the cost to 
comply with Section 404 to be about $91,000 per company or 
$1.24 billion in the aggregate, multiple studies pegged the 
actual compliance cost at $35 billion, which is, of course, 
nearly 30 times the original estimate.
    But let's put this in perspective: Section 404 is only 168 
words long, and if you use the $35 billion figure, that is 
almost $21 million per word, and that is just the initial 
startup cost.
    As well, Section 404 has hit small and mid-size firms the 
hardest: as a percentage of revenue, smaller issuers in 2004 
spent 11 times more on the Sarbanes-Oxley implementation than 
did larger companies. Micro-cap companies, with revenues under 
$100 million, saw an 84 percent increase in outside audit fees 
as a result of the law. Small cap companies with revenues 
between $100 million and $700 million saw a 92 percent increase 
in audit fees. And S&P 500 companies saw an increase of 55 
percent in their audit fees.
    Smaller companies have limited resources which are now 
being allocated to Section 404 compliance, and there is great 
concern that the regulatory burden of Section 404 is currently 
diminishing their competitiveness through higher operating 
costs and management distraction from business opportunities 
and other risks.
    In addition to these high out-of-pocket costs, there may 
also be an opportunity cost that accompanies Section 404. When 
a company spends over $4 million a year to comply with a single 
regulation, they are unable to direct those substantial 
resources into capital formation, employee benefits and 
salaries, or even stock dividends. Moreover, the largest 
potential cost of Section 404 has yet to be quantified; the 
loss of opportunities for the American public to invest in 
small and innovative firms that have either delisted, gone 
dark, or declined to go public.
    These corporate managers have determined that the cost of 
being a public company is no longer outweighed by the benefits 
the firm gained through access to the deep liquid markets of 
the American Stock Exchanges. Removing a company from the 
public exchanges is costly to a firm in terms of lost prestige, 
decreased liquidity, higher cost of capital. And it is 
conceivable that the decision to delist results in slower 
growth, poor returns on investment and a weaker position in the 
global market; and of course it also results in less job 
creation.
    This is a tremendous hurdle that the American companies 
must overcome that most global competitors do not. Foreign 
companies that do not list their shares on American exchanges, 
do not face the same fixed cost imposed by Section 404. 
Accordingly, they are able to invest their resources into 
research and development, customer discounts and other forms of 
value creation.
    It is no wonder that at every hearing on regulation, 
witnesses always bring up Section 404 as a key regulation that 
is hurting Americans' ability to compete.
    It is certainly clear that the time has come for this 
Congress to begin a dialog on this important subject, sort of 
put our ear to the ground and hear directly from those who are 
affected by Section 404.
    So we certainly look forward to all the testimony of the 
witnesses today, and with that, I would recognize our ranking 
member, Representative Lynch, for his opening statement.
    [The prepared statement of Hon. Candice S. Miller follows:]

    [GRAPHIC] [TIFF OMITTED] T0899.001
    
    [GRAPHIC] [TIFF OMITTED] T0899.002
    
    [GRAPHIC] [TIFF OMITTED] T0899.003
    
    Mr. Lynch. Thank you Chairman Miller, and I appreciate the 
fact the we are holding this hearing. This is one of the most 
important securities related acts in the history of this 
country, and I think it is appropriate at this point to be 
reviewing its impact on medium and small-sized businesses.
    I am pleased to join, as well, my colleagues, Mr. Feeney 
and Mr. Kirk, and I know Mr. Meeks is on his way, to look at 
this.
    I hear a lot about this in my district. I want to associate 
myself with the remarks of the Chair. I understand the impetus 
of this act, the WorldCom and Enron scandals, and the lack of 
accountability that we had in our accounting practices, how 
investor reliability and accuracy had to be improved. But also, 
I am concerned with the unanticipated cost of compliance with 
especially Section 404 of the act, and I think we have to look 
very closely at that. There are definitely ways that we can 
improve the cost side of this equation, and not relinquish the 
accountability and the exactitude with which investors are 
helped in making their decisions.
    I know for a fact that some of my own constituent 
businesses in my district have suggested that such a thorough 
process is done during those examination years, that it would 
be possible, perhaps, to look at biannual, every 2 years, to 
have the audits conducted and have a statement of compliance on 
those alternate years that would basically reduce the cost by 
50 percent, even maintaining the existing language in place.
    So there are ways that I think we can help small and 
medium-sized businesses in compliance with the act without 
sacrificing one bit of the accountability that is provided by 
the act. There have been some successes with Sarbanes-Oxley, 
and we don't wan to jettison that in our pursuit of reducing 
costs of simplifying the act.
    I look forward to the comments of both our panels, and 
again, I appreciate Chairman Miller for convening this hearing.
    Thank you.
    Mrs. Miller. Thank you.
    Opening statement for Representative Clay?
    Mr. Clay. Thank you, Madam Chairman, for holding today's 
hearing on Sarbanes-Oxley and its impact on our smaller 
publicly traded companies. I welcome our witnesses, especially 
my colleagues and friends, Mr. Meeks, Mr. Feeney and Mr. Kirk.
    When Sarbanes-Oxley was enacted in 2002, our capital 
markets were suffering from investor anxiety directly relating 
to major accounting scandals that rivaled the S&L failures of 
the 1980's. While Enron and WorldCom became the public poster 
children of corporate fraud, the fact is there were numerous 
companies who were forced to restate earnings and future 
estimates due to fraud and faulty accounting practices. A 
complicit public accounting industry made these activities not 
exceptions, but standard practices in order to appease their 
short-term profit-driven clients.
    In response, Sarbanes-Oxley strengthened regulations over 
auditing practices, mandated executives to certify their annual 
financial statements, and increase penalties for accounting 
related fraud.
    A cornerstone of this legislation was Section 404, which 
required publicly traded companies to attest to their internal 
control for financial reporting and related activities. while 
Section 404 is a reasonable mandate to ask of companies, some 
smaller companies find compliance to be both cost prohibitive 
and time consuming. Although I am sympathetic to this claim, I 
am also wary, wary of returning to a period of lax internal 
practices and functions that will enable inadequate stewardship 
of investor resources.
    It is my hope that new SEC regulations, along with 
recommendations from our witnesses today, can help us achieve a 
balance that provides both adequate investor protections and 
relief for well-managed small businesses.
    This concludes my statement, Madam Chairman, and I yield 
back.
    Mrs. Miller. Other opening statements? Representative 
Westmoreland.
    Mr. Westmoreland. Thank you, Madam Chairman. I appreciate 
you having this hearing. We have an advisory committee at home 
in the district, and on our banking and finance advisory 
committee, the one thing that I have heard is this Section 404 
of the SOX.
    I have often been told that Congress had two speeds, dead 
still and knee-jerk reaction, and I think this comes under 
the--this particular section of this bill came under the knee-
jerk reaction. I don't know, out of the response to what 
happened maybe to Tyco and Enron and others, but they weren't 
prosecuted under this bill, they were prosecuted under laws 
that we already had on the books. And I think that you can see 
that there were laws there to protect and to punish those that 
caused the problem.
    So I hope, Mrs. Chairman, that when we look at this, that 
we can come up with some type of legislation or suggestion that 
would take some of the burden off of the small and middle-size 
companies as far as these audit fees.
    I had one small banker tell me that it was 10 percent of 
his bottom line to adhere to Sarbanes-Oxley. That is 
ridiculous. Audit fees, since 2003, have gone up anywhere from 
75 to 90 percent. This should have been called the auditors 
employment act of 2003. I look forward to hearing from both 
panels, and I hope, Mrs. Chairman, that we can come up with 
some type of idea to really reform this to where not only does 
it protect the investors in the company, but brings about some 
rational thinking.
    Thank you.
    Mrs. Miller. Thank you very much.
    Our first witness this morning is our distinguished 
colleague, Representative Tom Feeney from the 24th 
Congressional District of the great State of Florida. 
Congressman Feeney is in his second term and serves currently 
as a Deputy Whip. He has quickly become a leading advocate for 
exposing and fighting waste, fraud and abuse in the Federal 
Government. He serves as well on the House Financial Services, 
sits on the House Judiciary and Science Committee, and was a 
member of the Sarbanes-Oxley ``listening tour.''
    So Representative Feeney, the floor is yours. We look 
forward to your testimony, sir.

  STATEMENTS OF HON. TOM FEENEY, A REPRESENTATIVE IN CONGRESS 
FROM THE STATE OF FLORIDA; HON. MARK S. KIRK, A REPRESENTATIVE 
  IN CONGRESS FROM THE STATE OF ILLINOIS; AND HON. GREGORY W. 
 MEEKS, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NEW YORK

                  STATEMENT OF HON. TOM FEENEY

    Mr. Feeney. Thank you, Madam Chairman, Ranking Member 
Lynch, and members of the subcommittee. I don't think I could 
say it any better than the four of you have just said it. Mrs. 
Miller, I thought your introduction was very well done. I think 
Mr. Lynch put it best, time is at a minimum for Congress to 
look at where we are because we have some data in.
    I am very grateful to be joined by two colleagues, who, the 
three of us, with a couple of other colleagues, have engaged in 
a national listening tour to hear about some of the 
consequences of Sarbanes-Oxley.
    Some have called it the most comprehensive and important 
corporate governance reform since FDR was President. And I was 
kind of surprised when I got here--because I was not here when 
Sarbanes-Oxley was passed--that businessmen, both small and 
big, chief financial officers, CEOs, beat a path to my door to 
beg for some relief from current impacts of Sarbanes-Oxley and 
for small and mid cap companies that are not yet directly 
impacted, beg for prospective relief.
    I like to say, as my colleague did, that Congress has two 
speeds, zero and over-react, and it may be that in some ways we 
have overreacted with respect to Sarbanes-Oxley. So I am glad, 
that on a bipartisan basis, we can look at the advantages and 
keep them, look at the disadvantages and reform or eliminate 
them.
    We have heard some important positive things and effects 
from Sarbanes-Oxley. I want to make that clear from the 
beginning. So far from my portion of the listening tour I have 
concluded that there is general agreement that after SOX was 
passed we have tighter financial reporting, which is a good 
thing. Internal controls have improved across the board, and 
there is also more transparency in the overall auditing 
process. All of those things are cited approximately by 
Sarbanes-Oxley supporters as a reason that not all of this bill 
should be thrown out in its entirety. And as one suggestion, 
Section 404 is the target of virtually all of the major 
complaints. There have been some serious negatives in the way 
we have imposed and implemented Sarbanes-Oxley.
    On January 6th the Wall Street Journal pointed out, for 
example, that New York loses its edge in snagging foreign 
listings. In the year 2000, $9 of every $10 raised by a foreign 
company in a public market was raised primarily in New York, 
and in the United States of America.
    By the year 2005, the reverse was true, $9 of every $10 
raised by a foreign company in a public exchange is now raised 
in places like Luxembourg and London exchanges, the biggest 
spread favoring London. This is a startling number to me, and 
candidly, I believe that we are slowly and steadily outsourcing 
America's world lead in the capital markets.
    After a recent trip to Hong Kong, which Mr. Kirk was part 
of as well, I received very similar feedback regarding 
Sarbanes-Oxley from their Chief Financial Officer, Mr. Tung. He 
practically thanked me and Mr. Kirk for Sarbanes-Oxley and the 
competitive advantage it gave to the Hong Kong markets. The 
Financial Times stated in November 2005, ``Over the past few 
years, as more global investors have begun to invest in Asia, 
the New York Stock Exchange appears to have lost its lore for 
the region's leading companies. The roots of New York's recent 
difficulties in winning Asian companies' listing lies in the 
high burden of regulations and compliance.''
    Many of the participants in the listening tour also noted 
that 404 compliance ignores the indirect costs, and I think the 
chairman pointed to the opportunity costs of Sarbanes-Oxley 
compliance. Some of America's best and brightest leaders on 
corporate governance boards are spending more time complying 
with bureaucratic and accounting regulations than they are 
building a better mousetrap, a cheaper mousetrap, and then 
marketing the mousetrap; and that is really what we want to do 
in order to get American advantage.
    The opportunity cost is huge. A paper by Mr. Butler of 
Chapman University and AEI-Brookings Joint Center for 
Regulatory Studies, and Larry Ribstein of the University of 
Illinois School of Law cites the ``direct compliance costs of 
SOX are about $6 billion per year, but this expense--which 
basically represents payments to accountants--is a small 
fraction of the total compliance costs for firms. The indirect 
costs from having to divert company resources are much greater 
and based on a back-of-the-envelope calculation of how SOX 
impacted American markets, they can be estimated at about $1.1 
trillion.'' That is with a ``T'', and by the way, we have only 
impacted 5 percent of America's companies on the public markets 
so far.
    Now, as the CEO of Sun Microsystems put it, Scott McNealy, 
``What Sarbanes-Oxley has done in some ways is like throwing 
buckets of sand into the gears of the market economy.''
    Madam Chairman, you have more of my testimony, but I see I 
have run out of time. I would just suggest that it is time that 
we take a serious look at the current impacts of Sarbanes-
Oxley, the prospective impacts as mid-size and small companies 
are thrown into this briar patch, which is going to be very 
difficult for them to comply with, much more difficult than the 
large companies that are having such problems.
    Finally, I will quote from the regulator. Mr. McDonough, 
the former regulator, who just recently retired as chairman of 
the Public Company Accounting Oversight Board. I quote him in 
part in a recent Wall Street Journal interview, because even he 
acknowledged that in some ways Sarbanes-Oxley implementation 
has gone way overboard. On October 12, 2005 he told the 
Journal, ``In many cases it's clear that they [auditors] 
overdid it. There's no question that some auditors got it right 
on; there are other cases, in fact probably more, in which the 
auditors overdid it, and decided we better check everything 
under the sun. Why? Because [they're] also concerned about 
being sued--that it is appropriate for the well-being of the 
American people if companies have costs which simply don't have 
any appropriate offsetting benefit.''
    The bottom line is we have to do what benefits investors. 
If we are taking half of the bottom line out of the pockets of 
companies and giving it to auditors and to regulators, then 
financial investors around America are being hugely 
disadvantaged, and again, I want to thank the committee for 
paying attention to this very important issue to the American 
economy.
    [The prepared statement of Hon. Tom Feeney follows:]

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    [GRAPHIC] [TIFF OMITTED] T0899.008
    
    Mrs. Miller. Thank you very much, Representative Feeney.
    And our next witness is another one of our distinguished 
colleagues. This is Representative Mark Kirk from the 10th 
Congressional District of Illinois. He is currently in his 
third term. He is a member of the House Appropriations 
Committee and also serves on three of its subcommittees, 
Foreign Ops, Military Quality of Life and Veterans Affairs, and 
Science, State, Justice and Commerce. He is certainly a strong 
supporter of legislation that eases Government regulations, and 
also another member of the Sarbanes-Oxley listening tour.
    The floor is yours Representative Kirk. We look forward to 
your testimony, sir.

                 STATEMENT OF HON. MARK S. KIRK

    Mr. Kirk. Thank you, Chairman Miller. I have some testimony 
that I would like to with unanimous consent insert for the 
record.
    Mrs. Miller. Without objection.
    Mr. Kirk. And a letter from a wide industry of leading new 
industries for comments on this subject.
    Sarbanes-Oxley addressed some critical weaknesses in public 
markets, but to put it simply, I think we all support Section 1 
through 403 of Sarbanes-Oxley. It is just Section 404 I think 
that we have a bipartisan consensus on the need for reform. You 
see here wide agreement between conservatives, moderates and 
liberals that we need action. American Enterprise Institute, 
Nancy Pelosi, Eliot Spitzer, all agreeing that we need reform 
of Section 404.
    I have a presentation here that answers a basic question, 
which is: Does 404 add investor value, and would a retiree 
making decisions about their IRA, ever use 404 data in making a 
buy or sell decision on their retirement savings for the cost 
and benefit of Sarbanes-Oxley? We see that we fit a need, 
especially in the mismanagement of America's largest companies. 
But we have to balance the compliance of the act with the cost 
of doing that. We see with small companies that there is a 
great imbalance.
    My colleague from Florida quoted Bill McDonough that said 
that it would be inappropriate to spend too much on the 
compliance with this if we simply do not have an offsetting 
benefit, and what Chairman McDonough was driving toward, was, 
are we driving investor value? And I think, clearly, with the 
application of 404 to small companies, we are not. We see that 
SOX compliance already is costing about 50 times more than was 
estimated in 2002, exceeding about $6 billion so far. And the 
global position of the United States has been dramatically 
weakened in this area.
    We have a bipartisan Republican and Democratic consensus 
that whatever else we do, American financial markets should 
lead, and we clearly see that because of Section 404 compliance 
costs, American financial markets are rapidly falling behind.
    In our look at SOX and its application, we are also seeing 
a decline in R&D expenditures, and I think that is troubling 
for the long-term future.
    If you look here at the next chart, you will see that we 
have a greatly disproportionate cost of compliance leveled on 
small businesses in America of publicly traded companies. And I 
will just note, the category that I want to pay most attention 
to are companies less than $100 million, the great employers of 
the United States. The average $100 million employer, by the 
way, in America, makes a 6 percent profit, and so Sarbanes-
Oxley, by taking away almost 3 percent of that profit, means 
that we have reduced the profitability of the most dynamic 
small business sector in America by half with this one section 
of one law.
    We also see a trend of going private. You can see in the 
next slide, a well-known company, Vermont Teddy Bear, will not 
be in the public markets and will not offer their securities 
for sale to the public, citing this as a critical example of 
why they have turned to the private market.
    Brookstone, SunGard Data Systems, Toys R Us, AMC 
Entertainment, Loehmann's, all going private. And remember, one 
of the basic points of Sarbanes-Oxley was transparency and 
accountability. All of that is lost when a public company 
becomes private, accomplishing just the exact opposite of the 
core function of the act.
    In fact, Foley & Lardner reports, of 147 companies 
surveyed, 20 percent would like to go private. That is an 
almost doubling of the companies wanting to go in that 
direction.
    By the way, that reverses a 400-year trend in capitalism of 
companies going from private markets, where capital is 
relatively expensive, to public markets where it is a bit less 
expensive. That should be a great concern.
    When we look at other companies seeking a public 
alternative, we see that there is a great reluctance to go 
public, and we have a number of magazine articles and the Wall 
Street Journal reporting on that.
    My colleague from Florida though listed probably the most 
dramatic effect of Sarbanes-Oxley, and that is almost the 
disappearance of foreign listings on U.S. markets. Whether you 
represent Boston, New York, Chicago, or one of our other 
financial centers, you do agree that all of this work should 
come to the United States. It doesn't mean just jobs in the 
financial sector and for stockbrokers, it also means jobs for 
American accountants and American lawyers. Every single dollar 
is lost when we don't have those foreign listings. And you can 
see a 90 percent drop in foreign work coming to the United 
States.
    To conclude, we have been talking about three common sense 
reforms for Section 404. First of all, for small business 
relief, to look at the smallest companies in America. They 
represent only about 6 percent of the portfolio on the New York 
Stock Exchange, and to give them relief from 404, as the 
Commission and their Small Business Committee has been looking 
at.
    Another common sense reform: to permit auditors and 
consultants to actually talk to each other to decide what 
compliance is. Right now, we have pushed many small publicly 
traded companies into a Bermuda Triangle of having their 
consultants on Sarbanes-Oxley not being able to discuss any 
major compliance issues with their auditors, and so you cannot 
get an answer of what is compliance.
    And finally, to return to the traditional, Generally 
Accepted Accounting Principle of what a major problem is. We 
used to think of a material weakness as something that affected 
5 percent of the bottom line. We have lost that, and so right 
now we have a ridiculous situation where almost a box of lost 
pencils could be regarded as a material weakness. If every 
issue in the company is a material problem, then we have 
dramatically worsened the ability of anyone to manage their 
company, and I think that Sarbanes-Oxley was sold to the 
Congress as a way to help people run their companies, but if 
every issue is a material weakness, allowing trial lawyers to 
jeopardize the entire company, and therefore, the investor 
value, and where our retirees have put their funds, then we 
have actually worsened the problem, rather than improved it.
    So I thank the committee and look forward to your 
questions.
    [The prepared statement of Hon. Mark S. Kirk follows:]

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    Mrs. Miller. Thank you very much.
    Next the subcommittee will hear from another one of our 
distinguished colleagues, Representative Greg Meeks from the 
6th District of New York. He is currently serving his fifth 
term in Congress, and he serves on the House Financial Services 
Committee, and also on the House International Relations 
Committee. He is a very strong advocate for consumers, and 
along with the other representatives who testified today, is 
also a member of the Sarbanes-Oxley listening tour.
    So the floor is yours, Representative, and again, we 
certainly appreciate you joining us today and look forward to 
your testimony.

               STATEMENT OF HON. GREGORY W. MEEKS

    Mr. Meeks. Thank you, Chairwoman Miller and Ranking Member 
Lynch.
    I remember back in 2002 when the Enron scandal began to 
unfold. Week by week we learned more about the machinations of 
the senior executives of Enron that would ultimately lay low 
the seventh largest company in America, as well as one of the 
Big Six audit firms.
    Immediately after that, the WorldCom scandal took front and 
center. Following the aftermath of numerous hearings, including 
us witnessing one senior executive after another plead guilty--
or plead the Fifth--should have plead guilty--it was clear to 
members of the Financial Services Committee, as well as the 
majority of the rest of the House of Representatives, that 
Congress needed to act to maintain investor confidence in 
America's capital markets.
    The resulting Sarbanes-Oxley legislation was designed to 
improve corporate governance by holding board of directors more 
responsible for their oversight of the corporation, hold the 
CEOs and CFOs to task if they knowingly signed off on 
inaccurate statements, strengthening auditor standards, and 
forcing publicly traded companies to review, and if need be, 
improve their internal controls that ultimately led to the 
production of their financial statements.
    Let me say, Madam Chairman, that in the 8 years that I have 
sat on the Financial Services Committee, Sarbanes-Oxley is one 
of the two most significant pieces of legislation we have 
passed, along with Gramm-Leach-Bliley, which repealed the 
Depression Era Glass-Steagall Act.
    In some ways SOX is more significant because it affects all 
publicly traded companies and not just the financial sector. 
After Sarbanes-Oxley was passed and the Public Company 
Accounting Oversight Board was created, the PCAOB opened for 
public comment on their proposed rulemaking for Section 404. 
Even then, comments that were received by the PCAOB from 
companies such as Microsoft, addressed concerns that the audit 
of internal controls where a public auditor must attend to the 
soundness of a company's internal controls system would 
significantly increase the cost of public audit.
    During this time period, my office began conducting 
meetings with small groups of Tier 2 and Tier 3 accounting 
firms. The purpose of the meetings was to determine if the 
potential increase in the audit costs could be minimized by 
having the 404 work subcontracted to small accounting firms. 
Under SOX, there is some leeway for the public auditor to 
``rely on the work of others'' in providing their attestation 
on the soundness of the 404 audit.
    Not only did I suggest this to the PCAOB in writing during 
their comment period, but my office also arranged a meeting 
with members of the National Association of Black Accountants 
and the PCAOB to discuss these issues. Unfortunately, this 
option was not deemed viable by the PCAOB due to potential 
supervisory constraints between the major auditor and the 
subcontracted company.
    We are now some 4 years from the passing of Sarbanes-Oxley, 
and the jury appears to be deadlocked. Without question, 
Sarbanes-Oxley has achieved its goals in relation to improved 
corporate governance. As you know, I have joined with my 
colleagues, Congressman Kirk and Feeney, in a listening tour of 
companies that have to deal with Sarbanes-Oxley compliance. 
Companies listed on Nasdaq and the New York Stock Exchange, and 
members of the Chamber of Commerce, seem to concur on the 
corporate governance issues. There is a consensus that the 
board of directors have taken their fiduciary responsibilities 
more seriously, including meeting more, acting more 
independently of management, particularly in relation to the 
audit, and improving communication with shareholders.
    Many companies have expressed how Section 404 has forced 
them to review and tighten their internal controls, making them 
a more efficient and secure company. This is clearly a part of 
what SOX was meant to do. However, some of our intentions have 
backfired, and we are forced to recognize that phrase that we 
hate to hear as legislators, ``unintended consequences.'' 
Although there are several issues related to 404 compliance 
costs that I could mention, for the sake of time, I will limit 
my concerns to two issues.
    The first is the effect that the significant cost in 
financial and human resources of SOX implementation is having 
on small cap companies, particularly biotech. The second is the 
overall cost to our capital markets from companies that have 
either delisted, not listed, or have listed overseas.
    According to a survey conducted by Financial Executives 
International, member companies spent an average of $4.3 
billion for costs associated with internal control compliance. 
I have heard of companies going from approximately $400,000 for 
audit costs to over $1 million. According to that same FEI 
study, companies with revenues over $25 billion, spent an 
average of more than $14 million. The reality is that large cap 
companies can absorb these costs, but small cap companies 
simply cannot.
    In New York City we have an enclave of biotech firms. They 
are small firms whose primary business is research and 
development in health care, agriculture, industrial and 
environmental biotechnology products. In other words, their 
research leads to quality of life improvements that include 
cancer-related and other types of life-saving products.
    For many of these companies, documentation and testing of 
internal controls is the responsibility of their internal audit 
departments. Since in most cases there are only a few staffers, 
many of whom are part time, these companies now have to hire 
additional personnel or engage outside consultants to perform 
the required internal control testing. Many of the smaller 
biotech companies have had to redirect 10 percent of their 
full-time employee resources to comply with SOX. The cost has 
ranged from $300,000 to $500,000 for increase in internal 
staff, and $800,000 to $1 million for external consultants.
    I will give you one example. A New York biotech company 
that works on spinal cord injuries has a market capitalization 
of $99 million. It has 65 employees and survives on capital 
raised every round. It has a spending rate of $4 million for 
clinical trial and research and development for a possible 
product to cure spinal cord injuries. If it spends one million 
on SOX compliance, that equals 25 percent of its budget. That 
is an opportunity cost of $1 million that is not being spent on 
research to benefit humanity.
    I know that it was not the intention of the Financial 
Services Committee or this Congress as a whole to divert funds 
from life-altering research.
    My second concern, particularly as a Member from New York, 
is the issue of public listings of companies; 68.7 percent of 
companies are listed in the New York Stock Exchange, Nasdaq or 
the American Stock Exchange. This is a major artery in the 
lifeblood of the New York economy. According to Citigroup, as 
of the year 2000, $9 out of every $10 raised by foreign firms 
through new stock offerings was done in New York. In 2005, the 
$9 out of every $10 has moved to London or Luxembourg. In 
addition, hundreds of small corporations have already delisted.
    Let me just give you this quote as I wrap up. This is from 
the March 17, 2006 article in the Houston Business Journal: 
``Today, hundreds of U.S. companies are considering tapping the 
London Exchange's AIM as a promising source of quick capital. 
Faced with costly compliance requirements under Sarbanes-Oxley 
regulations passed 4 years ago in the United States, a growing 
number of small domestic companies suddenly are more open to 
the idea of crossing the ocean to use the more lightly 
regulated AIM. The overseas option is being weighed against 
U.S. exchanges such as Nasdaq.''
    Now, as a member of the International Relations Committee, 
I am in favor of development of other countries, but not by 
creating an unfair advantage against American companies and 
American markets.
    Let me close again by saying that I am not offering--I am 
not going to offer right this second a particular solution to 
the day, although, I do have remedies in mind. At this point I 
am still in a mode of listening to companies, American and 
foreign, so that I can offer a solution or support the 
solutions of my colleagues. I feel comfortable that we have 
heard and considered the best options before choosing any to 
avoid creating a bigger problem.
    It is also important for me to hear particularly from more 
minority firms, who are too often left out and not heard. And I 
ask all to join with me so that we can make sure that all their 
voices are here, because they are very definitely being 
affected by the SOX regulations.
    I end by just saying that this is not a Democrat or 
Republican issue. This is an American issue, and we have to 
work with this in a bipartisan manner to make sure that we 
don't continue with unintended consequences, and that we 
resolve this issue fairly for our businesses.
    Thank you, Madam Chair.
    [The prepared statement of Hon. Gregory W. Meeks follows:]

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    Mrs. Miller. Thank you so much. I think that was 
particularly well-said.
    Let me thank all of our witnesses for being here and tell 
you how absolutely delighted I was to listen to all of your 
testimony and the opening statements of my colleagues here as 
well. And being still a relatively new Member of Congress, one 
of the most distressing things for me has been the partisan 
atmosphere around this place. I think we can look at this in a 
very bipartisan way. As you say, before we are Republicans or 
Democrats, we are all Americans first, and this is an American 
problem and something that we need to address in a bipartisan 
way. And I think we can do so.
    I was a little bit concerned, even initially, calling this 
hearing. I wasn't here when Sarbanes-Oxley originally passed; I 
don't sit on the Financial Services Committee, either and have 
not been an official member of your listening tour. But I would 
think that you could probably go to all 435 Members and enlist 
any one of them, because we must all hear the same things in 
our district.
    As I mentioned to our ranking member before we started 
here, I am just outside of Detroit, so you can imagine all the 
auto suppliers and the small and mid-size businesses that I 
come in contact with every time I am out in my district, and 
they know that I am the chairman of this Subcommittee on 
Regulatory Affairs. So I will ask them, what is the biggest 
problem that you have with onerous governmental burdens? And 
they--I mean, if you took Sarbanes-Oxley out of the vocabulary, 
they would almost have nothing left to say, because that is the 
first thing they want to talk about. And this is every type of 
business.
    So it is something that we need to look at. This is a 
committee that has tried to look at various types of onerous 
governmental burdens. It was interesting, we were talking about 
manufacturing regulations, and here you have the National 
Manufacturers Association estimating that the structural costs 
of American-made goods are 23 to 24 points higher than any of 
our foreign competitors, and much of it is due to these kinds 
of things; particularly Section 404 in Sarbanes-Oxley. And when 
we do see jobs leaving our shores for other countries, like 
China or Mexico or India or what have you, guess what, those 
countries did not put this regulatory burden on us. We have 
done it to ourselves.
    So it is a very appropriate thing, I think, for us to take 
a good look in the mirror and see where we can go with this.
    I guess I would just throw this out to all of you as we--I 
think we are all concerned, of course, that we are not viewed 
as going soft on corporate governance after the rather horrific 
experiences that we went through with the Enrons and Tyco, etc. 
But if we were to revisit some of these corporate governance 
standards, do you think that some of the companies or even the 
American public might think that we are opening up a Pandora's 
Box? In other words, as bad as 404 is, that they are getting 
used to it? And the cost of compliance does seem to be coming 
down a bit as we are going through the second and third year of 
this. At least it is a known quantity.
    Mr. Kirk. Let me just briefly answer that, if we look at 
the markets the way the SEC does and look at companies at $750 
million in capitalization and below, and give some sort of 404 
relief to $750 and below, you still have 94 percent of public 
markets under full Sarbanes-Oxley compliance controls. And so I 
think that we have protected the main part of investors, 
especially retirement investors that are largely, 94 percent, 
invested in the very large companies, but we have also lifted a 
tremendous burden off the small employers, which employ over 
half of all Americans. And so I think the way that the Small 
Business Advisor Committee of the SEC and the way the 
Commission has looked at this dividing line is a very helpful 
one for the Congress.
    Mr. Feeney. Well, I think it is a very real concern that 
investors are--you know, there is an Enron trial going on as we 
speak. I won't prejudge the outcome of that, but as the 
chairwoman said, there are lots of protections for investors 
out there. No protection is going to work against bad apples 
that really want to commit outright fraud. And the bottom line 
is nothing in 404 is going to protect investors from people 
that are really evil. And we need to explain to Americans that 
regulations are appropriate and necessary; redundancy and red 
tape that does not add to investor confidence is disadvantaging 
Americans.
    I think, you know, Madam Chairman, you put it best, is 
foreign companies--to take Gregory's biotech example--is 
foreign companies are not spending 25 percent or 50 percent of 
their bottom line on compliance with redundant regulations and 
auditing, but instead putting money into finding the next cure 
for cancer or the next cure for AIDS. Good for humanity, but 
bad for the potential for American employers and American 
employees, and it puts us at a huge disadvantage.
    So let's keep what is good. Explain to Americans. I think 
we are trying to build the case to keep what is good, review 
what is bad, and either reform it or get rid of it.
    Mr. Meeks. Let me just concur. I think that Representative 
Westmoreland said, you know, basically what we do sometimes, we 
have knee-jerk reactions. And I think that we have to 
understand that it sometimes happens. We react to a situation 
and we act fast. But we can't throw the baby out with the bath 
water. I think that from the testimony that I have heard from a 
lot of individuals around the country, they all agree that a 
lot of Sarbanes-Oxley is good. But we are focusing on, and what 
Representative Kirk just talked about, I believe that we can 
have a cap so that we can make sure that the intention of the 
Members of Congress is had. And we can do that without people 
coming back and talking about the fact that we are opening up 
Pandora's Box. We can do that by saying that we still have the 
investors' confidence that Congressman Feeney just mentioned, 
but that we are also making sure that we are keeping companies 
public or having the desire to come public and not go overseas.
    Mr. Kirk. Madam Chairman, can I add one more thing?
    Mrs. Miller. Certainly.
    Mr. Kirk. Because this really is about investor confidence 
at its bottom. If I want to get a credit card tonight, go 
online at 3 o'clock in the morning and invest in the futures in 
pork bellies on the Shanghai Market, I bet there is a way to do 
it. And ultimately, investors will find a way around the 
protections that we think we have built up around them. If we 
have added value, they will invest their money in American 
markets. If we have added costs, they will find their way 
around it. That is happening with the major investors as we 
speak.
    Mrs. Miller. Yes. And I think Representative Kirk made a 
very good point when you were saying whether or not individual 
investors are actually looking at some of this data when they 
are deciding to invest in an IRA or what have you. So it is an 
interesting thing.
    My other question would be----
    Mr. Kirk. Can I just add----
    Mrs. Miller. Yes.
    Mr. Kirk. My staff talked to the Commission yesterday and 
asked if they had any report of any investor using a 404 
disclosure to buy or sell securities. And to date, the 
Commission has not one.
    Mr. Feeney. And neither do the rating services use 404. 
Moody's, Standard & Poors, they could care less about these 
things. And yet they are costing Americans--one estimate--$1.1 
trillion to our economy and nobody is using the stuff.
    Mrs. Miller. Well, you know, we are from the Government. We 
are here to help them. [Laughter.]
    What is your opinion on the lack of direct control, sort of 
the wiring diagram for this PCAOB, sort of the lack of direct 
control that the Congress has on that? Do you think their 
independence from congressional oversight is having any impact 
on their opinions, their guidance?
    Mr. Kirk. The Board, obviously, had some difficulties in 
starting up. We went from eight employees to now over 400. So 
we are finally getting an ability to issue an opinion and to 
have some common sense in the application of the act. But we 
have not yet had the tsunami of full 404 compliance hit the 
small business sector yet. And that is the critical issue for 
the Congress. If we have 100 percent compliance requirements on 
the small business sector, we should understand that we are 
only affecting 6 percent of public markets but we are 
dramatically weakening the employers of half of all Americans. 
And so that is the concern I have for the PCAOB and their 
compliance burden.
    Just imagine how many employers and how many public 
companies will be calling them, flooding their phone lines if a 
full requirement is imposed on them.
    Mr. Feeney. Madam Chairman, the problem is that everybody 
in the system is covering their rear ends. From the chief 
financial officer to the chief executive officer, they now have 
to certify total compliance with all of these things even if 
they had no knowledge. It is no longer a willful standard or a 
negligent standard, it is a zero-mistake standard. Everybody on 
the board of directors has to do that. The inside auditors that 
are advising the board of directors has to do that. The outside 
auditors, who are not allowed to talk to the inside auditors, 
they have no incentive whatsoever to use a reasonableness 
standard because they are going to be held personally, civilly, 
and perhaps criminally responsible for any mistake.
    Thus the hyperbole about, you know, finding every box of 
paper clips for a global company like IBM, or every box of 
pencils, it really has almost gotten to that point. And also, 
as you point out, the Accounting Oversight Board, there is no 
incentive for them to be reasonable. The incentive is to make 
sure that every single box that can be checked is checked. 
Nobody wants to be the guy that lost that box of paper clips.
    Mr. Meeks. I think that what Representative Feeney just 
said is right, because what he is talking about is basically 
reasonableness. And there is no incentive to be reasonable as 
of right now. It is protect yourself at all costs. And so 
therefore, you know, there is no room for you to do anything 
that may be a common-sense approach. It is if I don't make sure 
that I am absolutely 1,000--you know, even in criminal 
jurisprudence, you have beyond a reasonable doubt. This is 
not--this is zero doubt. So it is a standard that is so high 
that I don't know that it can be met.
    Mrs. Miller. Thank you.
    Representative Lynch.
    Mr. Lynch. Thank you. And again, I thank the panel.
    Let me ask you--and I understand the standard is a very 
high one and may in fact be unrealistic and it may have, as you 
have pointed out, negative consequences.
    Let's just take from the existing Section 404. I do want to 
point out, though, that Section 404, when people are assessing, 
you know, whether to buy a certain stock, whether to invest 
publicly, they wouldn't look at 404. They would look at the 
numbers, the financial numbers, for the performance of the 
company itself, the profit and loss, their value. And what 404 
does is it speaks to the accuracy or reliability of those 
numbers. You wouldn't look to Section 404. It is just a given 
that the companies to which it applies must comply.
    What about the idea, however, that right now Section 404 
requires an annual manager's statement, an annual assessment by 
the company supported by an outside auditor, you know, an 
independent auditor to come in here and say that the internal 
controls are in place and that they are reliable. That is a 
very extensive process. That is what is driving the costs of 
this rule.
    It would seem to me that thorough of a process does not 
need to be repeated every single year, and that if in, you 
know, 2006 a company goes through this--and it is a painstaking 
process and extremely thorough--it would seem that in 2007 it 
should be sufficient to have those managers and the folks in 
control at the company certify that last year's controls and 
procedures are in effect. And that should be enough for 
reliability and what we are talking about. And then in the next 
year, 2008, if 2 years have gone by, obviously, there may be 
the need to go back to the full-blown, full-tilt assessment 
again.
    But even if we adopted that system, where it is not annual, 
that we will trust for 1 year. If a company certifies that 
their internal controls and their internal procedures are still 
in place to the same degree or substantially to the same degree 
as they were in the previous year, that should be enough.
    In my mind, that would cut everything in half without 
changing, you know, a period or a comma in any of this, and it 
still would provide that reliability and that accountability 
that we are looking for under the bill. Because there has been 
some improvement on transparency and other things that have 
been very good here. And we are stuck on 404. But it just seems 
to me that enormous amounts of money and labor could be saved, 
without any measurable drop in quality of the reports and 
reliability for the investor, by going to a biannual reporting 
or biannual manager's statement on the reliability of internal 
controls and procedures.
    What are your thoughts?
    Mr. Kirk. Congressman, that is a very common-sense reform 
that would cut the work level in half. Also, remember what we 
are talking about. With a small publicly traded company, the 
entrepreneur largely sees the entire operation. We are talking 
about 10 and 20 employees. And so the issue of internal 
controls is entirely different than for an extremely large 
company where you really have some serious management issues.
    But one of the things that we learned on this listening 
tour is when you talk to rating agencies, like Moody's or 
Standard & Poors, which for most investors issue the critical 
buy and sell signal or the data package they use to asses a 
security, the 404 disclosures are in the 10-Ks that are 
submitted by the publicly traded companies. And even the rating 
agencies say they are not using this data. It is so turgid, it 
is so user-unfriendly that it is not driving investor value for 
a buy or sell signal.
    And then we have the issue of the London AIM Market, which 
is now marketed directly as a Sarbanes-Oxley-free environment. 
And I am worried because, you know, there is an unwritten story 
in the 1880's of how New York gained financial dominance over 
London and became the best and least expensive way to access 
capital markets and the financial center of the world market 
was transferred from London to the United States. They are 
beginning to gain back that financial leadership.
    But that is a critical issue in the rise of China. 
Congressman Feeney and I, when we were talking to Chinese 
entrepreneurs in the emergence of this $1 trillion economy, 
said now, because of Sarbanes-Oxley, they would not think ever 
of listing in the United States because of these compliance 
costs. And they are talking about bringing small, $50, $100, 
$200 million companies to market and they do not want to bring 
this work to the United States, where 5 years ago all of the 
work came to the United States.
    Mr. Feeney. Congressman Lynch, you made a very common-sense 
recommendation. We have actually heard a couple of 
recommendations and we want to hear more before we make a 
recommendation of which one I would think would be preferable. 
One would be semiannual or every third or every fourth year 
have the outside audit; your internal procedures would have to 
remain the same. Another way to do it is to allow the exchanges 
to, for example, have everybody pay in based on a pro rata 
share of their market capitalization. If they have 1,000 
companies and everybody is the same size, pay in to a little 
system and then have random testing like we do drug testing in 
some places. So that everybody has to stay on their toes, but 
they do not have to be duplicating and have this superfluous 
process where you have redundant mechanisms.
    But I would say that doesn't resolve the whole problem. You 
still have the issue of if you place this burden on small and 
mid-cap size companies as it remains today, I am afraid you 
would never get the next Dell or Microsoft to go public. And 
American--not only would they not grow to the size that they 
grew, but American investors would never have the opportunity 
to invest. I also believe the materiality standard is very 
important to address.
    But if you did those three things, boy, I think you would 
get to 90 percent of the problem.
    Mr. Meeks. I think your approach is a common-sense approach 
and I think that is what the listening tour has helped me with. 
I have found that the companies that we have listened to, 
nobody is really trying to avoid the scrutiny or anything of 
that nature. Nobody even--because they all have basically been 
straightforward and honest in saying we want to make sure there 
is transparency, we want to make sure that our internal 
controls are in place. It is just a cost. And we have to figure 
out and come out with different ideas of how we reduce the 
cost.
    And they came up themselves, voluntarily, with various 
ideas, you know, what Representative Feeney just talked about 
as far as--we can even act like a system like the IRS, where 
there are random audits. That would help us reduce our costs. 
We don't want to just say that we want to go back to the old 
way. We accept that things have changed. But we have to bring 
down the costs. And I think that is what the listening tour 
does. That is what has benefited me, is to hear good 
commonplace ideas on how we can make it better so that we don't 
have the unintended consequences ruling. And I think that we 
can do that.
    Mr. Lynch. OK, thank you.
    I yield back.
    Mrs. Miller. Mr. Westmoreland.
    Mr. Westmoreland. Thank you.
    Mr. Kirk, you know, if you look at the total cost of 
WorldCom, Enron, and Global Crossing, it is about $155 billion. 
And I believe the Rochester School of Business just got through 
putting out the fact that this is costing $1.4 trillion. Is 
that a good common-sense approach to fighting the problem? What 
is the source, do you think, of the disparity in the cost that 
was expected or that the SEC expected this to cost, as compared 
to what it is costing? And what do you think made that 
difference?
    Mr. Kirk. A couple of things. First of all, a lack of 
rationality in what is material. That is why it is so important 
to go back to the old traditional definition of materiality, 
because if every single lost pencil box is a material weakness, 
we are going to continue to have stories, as we do now, of CEOs 
spending a vast amount of their time trying to account for 
every single asset or liability, you know, almost on a real-
time basis, rather than thinking about new markets and 
innovation and research and development that we traditionally 
associate with growing a company.
    Another problem is we have four and a half major accounting 
firms. And generally, for a small employer, they will, when 
they seek to have a public accounting, will find that two or 
three of the large accounting firms are conflicted out because 
they are already working with competitors. And so the final 
accounting firm knows that they have this company in a box and 
will charge a very high price for their services.
    And remember, in the world of Sarbanes-Oxley, you can't 
have one accounting firm. You have to have two. You have one 
accounting firm to actually certify your books and another one 
to advise you as to how to implement 404. And those two firms 
cannot coordinate their activities to issue you a compliance 
signal or a noncompliance signal.
    So for all those reasons, we have costs that are very high.
    Last, let me just say this. And this is what Congressman 
Lynch pointed out, that we have--404 is a very short section of 
law. Enormous discretion is given to the Commission and to the 
PCAOB. This hearing is going to help in the process, because if 
we send a signal from the Congress that we have broad-based 
bipartisan support for rationalizing the implementation of 
these regulations, the PCAOB and the Commission can take action 
on their own to dramatically lessen this process.
    I think we are in the period here where, this year, this 
committee and our bipartisan group of members can send that 
signal. And my hope is the Board and the Commission will then 
take action to relieve this burden. And then, if not, I think 
the time comes next year for a listening tour to turn into a 
legislative tour.
    But I hope that the Board and the Commission will see this 
action by the Congress and take their own authority.
    Mrs. Miller. Yes, Representative Lynch?
    Mr. Lynch. I just want to clarify. I believe I misspoke. I 
was talking about biennial, which is every 2 years, not 
biannual, twice a year. Biennial, OK? [Laughter.]
    I don't want a riot going on out there.
    Mrs. Miller. We appreciate that clarification.
    Representative Clay.
    Mr. Clay. Thank you, Madam Chair, and thank you both for 
your testimony.
    In terms of the cost and compliance requirements under 
Section 404, how well is the accounting industry responding to 
the needs of industry? Are auditing firms recognizing the 
limits facing smaller capitalized firms in their evaluations 
and recommendations for corporate compliance? Both of you all 
can tackle it, please.
    Mr. Meeks. Well, that was just one of my points, where I 
said we had to open it up to tier 2 and tier 3 firms, because 
we were trying to make sure that there could be more 
competitiveness and more firms involved. When you have just the 
top firms, as Representative Kirk just talked about, they know, 
you know, two of the firms are already engaged, they know that 
they have the companies, and they can charge whatever they want 
to charge. They virtually have what is called a monopoly. That 
is driving costs up significantly.
    So I, again, suggest that we need to look again at the 
opportunity of tier 2 and tier 3 firms being able to be 
involved as a subcontractor getting involved and I think that 
would help drive some of the costs down.
    Mr. Clay. And you also mentioned some significant barriers 
that prevent small-cap companies from becoming compliant. Give 
me an example.
    Mr. Meeks. What I was talking about, I mean, when you talk 
about they can't compete because they don't have the 
wherewithal to deal with the Big Four firms. And as a result, 
you know, you find that many minority firms are directly 
affected, cannot compete, and thereby are out of business, and 
cannot have the opportunity to be the next Dell. We want to 
make sure that they are not left out of the game. And you have 
a significant number of minority accountants who are left out 
of the game. And this is a way that, I think, by adding them 
into the game, by adding tier 2 and tier 3 firms, then you are 
eliminating even some of the diversity issues that you may have 
in the industry by opening it up and giving everyone an 
opportunity.
    Mr. Clay. Mr. Kirk.
    Mr. Kirk. I would certainly agree that Representative Meeks 
has pointed out a critical need for either the Commission or 
the Congress to act that would help out small minority 
accounting firms get into this. They don't have that 
opportunity now because they don't have the brand name and 
ability to access and advise a client in this way.
    But even more importantly, in the wider market for small-
cap companies to be able to expand and grow their business, you 
have to really, really think about becoming a public company 
now in America, given the liabilities and uncertainties that 
you face because of full 404 compliance. I would like it for 
minority companies to be able to go public in an easier way, 
not a more difficult way. And that is the problem.
    Mr. Clay. Let me shift and share with you both, one of the 
reasons I believe in Section 404, is that it forces companies 
to pay attention to their information technology systems that 
are often susceptible to hacking, information breaches, and 
other activities that have dire economic consequences. If 
Section 404 requirements are not met, how can a company be 
certain its information system's proprietary data are secure? 
Have any of you given thought to----
    Mr. Kirk. I would just say remember what we are talking 
about, the information data system of a small company is 
probably two or three PCs in an office. We are talking about a 
common-sense approach of not going overboard. These are the 
most dynamic and largest employers in America, but they come in 
groups of 12 or 20 employees. So we are not talking about a 
very difficult control issue here. You are probably talking 
about one office suite and a set of computers that is similar 
to the set of computers in your own office.
    You know, remember the irony here--404 does not imply to 
congressional offices. Imagine the challenges you would have as 
a small employer employing 18 people if you had two large 
accounting firms unleashed on your operation, and were told 
that one gasoline receipt that may have been misplaced is now a 
material weakness and you could be brought--brought suit 
against you on behalf of some trial lawyers.
    That is the kind of issues that we are talking about, 
because I think every Member of Congress does understand that 
we employ 18 people, so we are exactly in the same position, 
management and control, as many of the companies that we are 
talking about.
    Mr. Meeks. Just look at my example of the biotech firm. I 
mean, this is a real example. This is what I had going--this is 
a biotech firm, mostly--a lot of part-time workers, very 
limited staff. And now they have to shift resources and shift 
people to comply, taking them away from the research and 
development that their existence is there for.
    So we have to make more of a common-sense approach to this, 
because otherwise the burden of a company being able to survive 
as a public company will not continue to exist, and they will 
stay private.
    Mr. Clay. I thank you both for the response, and I agree, 
we need to find a balance.
    Thank you, Madam Chairman.
    Mrs. Miller. Thank you all so very, very much. We certainly 
appreciate your time. And, you know, this is an oversight 
committee so it is appropriate, I think, that we begin a debate 
and have some oversight on various issues, certainly this 
Section 404. And I certainly agree with you all that--I am 
hoping that the Commission and the Board are listening to what 
is happening, as you are doing your listening tour on this.
    Hopefully, this can't be any secret to them, the problems 
that are out there and that in a bipartisan way the Congress 
does intend to take some action if they don't become a little 
more proactive themselves and look at some common-sense 
solutions as well.
    So again, we appreciate your time sincerely. We adjourn for 
the next panel to be seated.
    [Recess.]
    Mrs. Miller. OK. We will call the committee back to order. 
Since this is an oversight committee with subpoena authority, 
although we did not swear in the last panel, I do hope that you 
will bear with us and please rise and raise your right hands. I 
would like to swear you in.
    [Witnesses sworn.]
    Mrs. Miller. Thank you very much.
    Our first witness on the second panel is Grace Hinchman, 
who joined the Financial Executives International in 1999 as 
vice president for government relations. In 2000, she was 
promoted to senior vice president of public affairs. FEI is a 
professional association for senior-level corporate financial 
executives and is dedicated to advancing ethical and 
responsible financial management.
    The floor is yours, Ms. Hinchman. We certainly appreciate 
you joining with us today.

    STATEMENTS OF GRACE L. HINCHMAN, SENIOR VICE PRESIDENT, 
 FINANCIAL EXECUTIVES INTERNATIONAL; RICHARD A. HUBBELL, CHIEF 
   EXECUTIVE OFFICER, RPC & MARINE PRODUCTS CORP.; ROBERT P. 
 DOWSKI, CHIEF FINANCIAL OFFICER, ALLIED DEFENSE GROUP [ADG]; 
     ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN ENTERPRISE 
  INSTITUTE; AND DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL, 
    AMERICAN FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL 
                         ORGANIZATIONS

                 STATEMENT OF GRACE L. HINCHMAN

    Ms. Hinchman. Thank you, Madam Chairman Miller, Ranking 
Member Lynch, and members of the subcommittee, for this 
opportunity to appear before you today. My name is Grace 
Hinchman, and I am senior vice president of FEI. It is the 
leading organization of 15,000 members, including CFOs, 
treasurers, controllers, and other financial executives.
    FEI members represent the preparer community; that is, the 
financial executives responsible for the preparation of 
financial statements. Importantly, we are also users of 
financial statements, relying on financial reports of other 
companies in our investment and credit decisions. In both roles 
as a preparer and as a user, we welcome today's hearing.
    FEI strongly supports the goals of Sarbanes-Oxley. Overall, 
the SEC and the PCAOB have done an impressive job in striking a 
balance between efficiency and cost-effectiveness, while 
maintaining the intent of the statute. However, the rules and 
standards related to the implementation of Section 404 require 
significant attention.
    Although the SEC maintains final authority over the rules 
and standards to implement the requirements of 404, much of the 
rulemaking and standard setting has come from the PCAOB's 
Auditing Standard No. 2 [AS2].
    Since the SEC's approval of AS2 in June 2004, the PCAOB and 
the SEC have released additional guidance to supplement AS2 
through policy statements, detailed staff Q&As and roundtable 
discussions. FEI recognizes that this additional guidance has 
been helpful to both preparers and auditors alike, but they 
have fallen short in providing a completely effective and 
efficient implementation process.
    FEI firmly believes that Section 404 is workable and does 
not require congressional action. Both the SEC and the PCAOB 
have the authority today to right-size AS2 and Section 404 so 
they meet the capabilities of all public companies, large and 
small.
    I would be remiss if I did not mention the overall cost/
benefit of Sarbanes-Oxley. As recently as last month, FEI 
surveyed 274 public company members with average revenues of 
nearly $6 billion to gauge Section 404 compliance costs, and 
this survey is the fourth survey that we have done over the 
last several years, and Congressman Meeks had made reference to 
one in his testimony.
    The survey that we just did in March, last month, showed 
that in total companies audit attestation fees represent 44 
percent of their total annual audit costs. The average company, 
which is a company of $6 billion in annual revenues, expended 
approximately $1 million in internal costs, or approximately 
21,000 internal people hours. For year two filers, this average 
was only a 12-percent decrease from their first year of 
implementation. External costs for non-auditor-related 
consultants and vendors were $2.3 million. This was a decrease 
of approximately 22 percent for year two filers. Finally, audit 
fees were approximately $1.4 million, or a decrease of 13 
percent for year two filers.
    What this survey shows is that while companies have 
experienced some reduction in their cost of compliance, 
primarily their external costs, they are less than we had 
anticipated. As a result, the costs of Section 404 remain high 
and continue to be disproportionate to the requirements of 
annual compliance.
    In conclusion, FEI is confident that the SEC and the PCAOB 
are up to the task of right-sizing compliance requirements of 
Section 404 of Sarbanes-Oxley and they possess the authority to 
meet this challenge. We believe that a more balanced approach 
will be achieved and that this right-sizing will further reduce 
the costs of Sarbanes-Oxley.
    That concludes my remarks, and I would like to thank Madam 
Chairwoman and the members of the subcommittee for inviting FEI 
to participate in today's hearing.
    [The prepared statement of Ms. Hinchman follows:]

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    Mrs. Miller. Thank you so much.
    Our next witness is Richard Hubbell. He is the president 
and chief executive officer of RPC, Inc., which is a position 
he has held since 2003. He is also the president and chief 
operating officer of Marine Products Corp., a position that he 
has held since February 2001. Prior to this, he was president 
and chief operating officer of RPC, Inc., and also was an 
executive vice president of Rollins Communications, which he 
joined in February 1970.
    Mr. Hubbell, we appreciate you joining with us today, and 
we look forward to your testimony, sir.

                STATEMENT OF RICHARD A. HUBBELL

    Mr. Hubbell. Well, thank you very much. As mentioned, I am 
the chief executive officer of RPC, which is a small oilfield 
service company providing services and equipment to producers 
of oil and gas in the petroleum-producing regions of the United 
States and a few international markets. RPC has approximately 
1,600 employees, the majority of which are in the domestic 
United States. In order to deal with the cyclical nature of our 
business and provide the best possible return to our 
shareholders, we acquired a pleasure boat manufacturer in 1986. 
A few years ago, we decided that it was in the best interests 
of our shareholders to form a separate company and spin that 
pleasure boat manufacturer off. So that is why I am president 
and CEO of two New York Stock Exchange companies.
    Marine Products Corp. is the third largest manufacturer of 
sterndriven pleasure boats in the United States. We have two 
domestic manufacturing facilities and approximately 1,100 
domestic employees. Our strategies have provided good long-term 
returns to our shareholders. Today, the combined market 
capitalization of the two companies is approximately $1.7 
billion.
    As a result of the spin-off transaction I just outlined, I 
manage a small corporate headquarters staff that handles the 
common corporate functions of these two public companies. We 
believe that it is in the best interests of our shareholders to 
have this common headquarters structure, because it allows us 
to spread the costs and leverage the knowledge of our staff 
over such functions as accounting, public company reporting and 
compliance, and financial management. It also allows us to work 
more effectively with outside constituents such as our public 
accounting firm and our shareholders.
    We managed the implementation of the Sarbanes-Oxley Act of 
2002 in the same manner. For these companies, which are 
relatively small, this implementation created a large and 
ongoing structure which is expensive for our shareholders and 
time-consuming for our corporate and field employees. For 
example, during the last year prior to the implementation of 
Sarbanes-Oxley, our public company compliance costs for each 
company were approximately $70,000. After the implementation of 
Sarbanes-Oxley, our ongoing annual costs increased to $1 
million per company. So I have heard quotes of costs increasing 
100 percent. Ours is way, way more than that.
    I acknowledge the loss of confidence in the integrity of 
the business community that shook our society a few years ago, 
and I agree that decisive measures had to be taken in order to 
restore public confidence. I believe that my companies have 
benefited in certain ways from the documentation of internal 
controls, tightening of policies and procedures, and enhanced 
transparency in our operations and financial reporting that 
have resulted from our compliance with Sarbanes-Oxley.
    However, I also believe that my companies and our 
shareholders have not benefited in proportion to the expenses 
we have incurred. In addition, I believe that we have suffered 
certain opportunity costs since we are now spending more time 
to comply with and document policies and procedures than we had 
in the past. This means that we can devote less time to the 
analysis of our financial and operational results, management 
of the operations of our businesses, and the intangible aspects 
of company management that relate to experience and judgment. 
Sarbanes-Oxley has made many companies consider going private 
and has, I believe, prevented others from becoming public. This 
limits access to the capital markets for U.S. companies and, in 
the long run, damages American competitiveness in the global 
marketplace.
    In addition, I have serious concerns about the approach to 
the implementation of Section 404. The text of the provision 
itself is brief and ambiguous, and it provides a great deal of 
leeway to a company's public accounting firm as to what the 
accounting firm believes to be effective internal controls. In 
the case of my companies, we are a ``controlled corporation,'' 
both of them ``controlled corporations,'' with high insider 
ownership, and common sense dictates that a different level of 
testing and documentation than for public companies with a 
larger shareholder base. I believe that in the current 
environment, public accounting firms have been overzealous in 
their interpretation of 404, and in many cases have abandoned 
basic concepts of materiality and common sense. To allow public 
accounting firms to have this level of control ignores several 
conflicts of interest, because there is an inherent economic 
incentive to spend more time and conduct more testing on 
internal controls. As a result of the implementation of Section 
404, the work required by public companies to comply with 404 
has been overly burdensome and without a proportionate benefit 
to the financial community or investing public.
    Thank you very much.
    [The prepared statement of Mr. Hubbell follows:]

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    Mrs. Miller. Thank you.
    Our next witness is Mr. Robert Dowski. He has over 20 years 
of domestic and international experience in strategic planning, 
corporate financial reporting, and financial accounting 
systems. Prior to joining Allied Defense Group, he was a senior 
vice president and CFO of New Star, Inc. His financial 
management background includes positions with Gillette, GE, 
Space Net, Telecorp, PCS, and Hughes Network Systems.
    Mr. Dowski, you have the floor. We look forward to your 
testimony, sir.

                 STATEMENT OF ROBERT P. DOWSKI

    Mr. Dowski. Thank you very much. I think ADG should be a 
poster child for SOX. For those of you who have had a chance to 
look us up on the Internet, you know that the company has 
suffered through a restatement related to FAS 133. That is an 
ongoing process. We have been delayed in filing our 10-K and, 
in fact, have been working 80 hours a week with offsetting and 
corresponding amount of hours from our auditors trying to get 
through our second-year SOX issues. So this is a topic that is 
near and dear to my heart. So, with that, let me go through the 
testimony.
    ADG is a small public company. We are headquartered in 
Vienna, VA, and have seven operating units located overseas in 
Belgium and here in Texas and California. We design and 
manufacture medium caliber ammunition and products for the 
security, surveillance, and video transmission markets. We have 
approximately 700 employees and in 2005 produced approximately 
$110 million in revenues. Our largest operating unit produces 
$60 million of revenue and our smallest produces $6 million. We 
uncharacteristically lost over $20 million on the bottom line 
in 2005. 2005 was also the second year of our SOX 
implementation.
    I must be honest, Chairwoman Miller, and tell you that not 
all of that loss was attributable to our SOX compliance 
efforts. But like many other companies in the United States, we 
spent a great deal of time and effort trying to meet a set of 
one-size-fits-all regulations that did not, as enacted and 
thereafter interpreted, adequately differentiate between a 
company the size of ADG versus IBM.
    I come before the committee as a believer in the primary 
goals of the Sarbanes-Oxley legislation: providing more timely, 
accurate, and transparent information for investors. ADG 
believes that a well-run company should have and maintain good 
internal controls. As a company working hand in hand with our 
public auditors, we have made significant progress in improving 
our internal controls, and we will continue on that journey in 
2006 and beyond.
    But it has come at a cost. In 2005, we spent over $108 
million on external fees for SOX compliance and auditing. We 
spent that much and probably more on internal resources on 
documentation, testing, and related activities. That $3.6 
million in 2005 equates to over 62 cents of negative earnings 
for our shareholders, not to mention the unmeasured opportunity 
costs of efforts not spent on improving revenue, profit, and 
productivity within the company.
    Robert Greifeld, president and CEO of Nasdaq, in a recent 
Wall Street Journal editorial summarized the situation very 
well. He said, ``The burden of compliance is onerous, the cost 
is significant, and it falls disproportionately on smaller 
companies that are least able to pay.'' Their research has 
shown that the burden on small companies, as a percentage of 
revenue basis, is 11 times that of large companies.
    He went on to say, and we agree, that ``SOX is important, 
by and large it works. We have spent 3 years to assess its 
strengths and problems. Perhaps 90 percent of all complaints 
have their genesis in 20 lines of text in Section 404. The time 
has come to address those 404 concerns without diluting the 
essential investor protections that are the true legacy of SOX. 
Specifically, we should adopt the recommendations of the SEC's 
Advisory Committee on Smaller Public Companies, which has 
proposed an exemption from 404 for companies with less than 
$128 million in market cap and revenues under $125 million. 
Companies with up to $787 million in market cap, as long as 
they had revenues of less than $250 million, would receive a 
partial exemption. The companies exempted account for only 6 
percent of the U.S. market cap--which means 404 would still 
apply fully to 94 percent of equity market capitalization.''
    ADG agrees with these observations and supports his call 
for reforms and exemptions.
    In their discussion on cost/benefit, the Committee on 
Sponsoring Organizations [COSO], states that, ``The challenge 
under 404 is to find the right balance. Excessive control is 
costly and counterproductive.'' ADG believes that auditors 
should not have a one-size-fits-all checklist when auditing 
companies of different sizes, and regulators should amend the 
current rules to accommodate the special needs and 
circumstances faced by smaller companies.
    In smaller companies, such as ADG, the simple lack of 
people can be a liability. For example, it can be more 
difficult to achieve separation of duties that 404 calls for in 
many areas because of flatter organizations and smaller staffs. 
We have some operating units that have less than 40 people. 
Workers and managers in those typically have multiple roles and 
responsibilities, so you have a higher dependence on people 
doing the right thing. You also typically have a higher degree 
of direct and explicit knowledge of day-to-day activities since 
managers are much closer to the daily transactions than their 
peers at bigger companies. And yet there is no recognition of 
that in the standards of the transparency. Managers and 
executives should be allowed to place more reliance on 
monitoring than on control activities under those 
circumstances.
    The existing paradigm of documentation and testing creates 
huge burdens in small companies. Controls that exist but are 
not properly documented and tested internally are not 
considered by auditors in their assessments under SOX. 
Offsetting informal controls that are ingrained into the 
culture of small companies do not receive any credit in the 
existing evaluation process. We agree with COSO that internal 
control should be a process designed to provide reasonable 
assurance regarding the reliability of financial reporting. But 
we also agree with the rule of thumb for internal controls that 
benefits should outweigh the costs. The current construct of 
404 does not meet that criteria. If employees are spending 
excessive hours on fine-tuning internal controls, updating 
documentation, testing controls, evaluating and re-evaluating 
financial reports, and compiling more extensive information for 
their board of directors and audit committee, then other more 
important activities are not getting done.
    ADG agrees that it is time to address the 404 concerns 
without diluting the essential investor protections that are 
the true legacy of SOX. Proposals for exemptions for smaller 
companies should be considered. We should re-examine the 
standards for defining and measuring internal controls at 
large, medium, and small companies. It makes no sense to have 
one set of standards that apply equally to IBM and ADG.
    I realize I am out of time. Can I continue?
    Mrs. Miller. A few moments.
    Mr. Dowski. Let me make one final statement. Personally, I 
believe that auditors do not commit fraud. Dishonest people 
inside of companies do, and I think we have seen that in the 
press. Congress should increase the civil and criminal 
penalties on those people who violate the trust of 
shareholders. Violators should be forced to forfeit their 
assets and spend years in jail. When people who have defrauded 
investors and fellow employees out of billions of dollars are 
allowed to keep their fancy homes and other offshore assets, 
then how on Earth does punishment fit the crime?
    People with high ethical standards are the best defense of 
the public interest.
    Thank you for this opportunity to testify.
    [The prepared statement of Mr. Dowski follows:]

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    Mrs. Miller. Thank you very much.
    Our next witness is Mr. Alex Pollock. He has been a 
resident fellow at American Enterprise Institute since 2004, 
focusing on financial policy issues, including government-
sponsored enterprises, Social Security reform, accounting 
standards, and the issues that have been raised by the 
Sarbanes-Oxley Act. Previously he spent 35 years in banking, 
including 12 years as a president and chief executive officer 
of the Federal Home Loan Bank of Chicago.
    We appreciate your testimony here today, Mr. Pollock. The 
floor is yours, sir.

                  STATEMENT OF ALEX J. POLLOCK

    Mr. Pollock. Thank you very much, Madam Chairman, Ranking 
Member Lynch. I very much thank you for the opportunity to 
testify today, and these are my personal views on the issues. 
This hearing is very important and most timely. Everybody on 
the panels and on the subcommittee has repeated the amazing 
evidence from the market, from businesses all over the country, 
about the problems with Sarbanes-Oxley implementation. It is a 
great right in America of the people to petition their 
representatives for redress. I do not think there is any doubt 
that the people are petitioning the representatives for redress 
of the consequences of Sarbanes-Oxley, which was an act done 
with great good intentions, and as you pointed out, Madam 
Chairman, in your opening comments, we have had unintended, 
very adverse consequences. It is obvious this has been a 
tremendously expensive exercise in the creation of paperwork 
and bureaucracy, and the total costs of this exercise far 
outweigh the benefits which are likely to arise from it. And 
the burden of all this is, as many people have said, 
disproportionately high for smaller companies.
    It is important to remember that when excess costs are 
imposed on companies, they are actually imposed on 
shareholders, and it does not protect the shareholders to 
impose excess costs on them. Moreover, in my opinion, the 
historical record is very clear that the mechanical 
requirements which characterize the implementation of Sarbanes-
Oxley will not prevent, when the next bubble and boom time 
comes, the next set of frauds and scandals, which always appear 
during these times, and we will have our future Enrons and 
WorldComs, notwithstanding this mass of expensive paperwork.
    I want to quote from a typical experience with Sarbanes-
Oxley implementation. This is a letter to the SEC from one 
company. They note the ``concentration on minutia . . . 
redundant and inefficient operations, creation of an 
adversarial relationship with the audit firm . . . form over 
function . . . and unrealistic requirements . . .''
    The British Confederation of Industry, looking from abroad, 
points out, quite correctly, that ``Dealing with risks on the 
basis of a remote likelihood,'' which is the Sarbanes-Oxley 
implementation standard, not in the act itself but as 
implemented, ``other than a remote likelihood,'' that this not 
only imposes huge costs but makes the whole thing a nitpicking 
process, as we have heard from many people.
    And as has been noted, the SEC's Advisory Committee on 
Smaller Public Companies says that for the smaller public 
companies, relief from 404 is urgently needed.
    As has been noted, a highly interesting commentator, Eliot 
Spitzer, has described Sarbanes-Oxley implementation as an 
``unbelievable burden on small companies.''
    And what is apparent is that Congress did not intend all of 
this. The SEC did not intend it. Even the PCAOB did not intend 
it. This is all a runaway effect basically of fear, the fear on 
a lot of people's parts, and especially the fear on the part of 
accounting firms that they will be criticized for doing 
something wrong. They saw Arthur Andersen be destroyed.
    But, on the other hand, for these accounting firms, the 
implementation of Sarbanes-Oxley has been a revenue and a 
profit bonanza, quite the opposite of what the Senate committee 
report on Section 404 stated, namely, ``The Committee does not 
intend that the auditor's evaluation be the . . . basis for 
increased charges or fees.'' There is a line with great irony 
read in retrospect.
    I would like to suggest that Congress should act. I don't 
think it is wise to wait for the regulatory bureaucracies to do 
this. And I would like to highlight three steps I believe 
Congress should take. I think you should also do some things to 
restructure the PCAOB which are in my written testimony, but I 
will not mention them this morning.
    First, the best case would be to enact the provisions of 
H.R. 1641, a bill introduced last year by Congressman Flake of 
Arizona, which would, very simply, and in my view elegantly, 
make Section 404 of Sarbanes-Oxley voluntary as opposed to 
mandatory. This is an approach well suited to a market economy 
and a free society, and I simply point out that if investors 
really want the kind of heavy-handed documentation of internal 
controls called for by 404, an article of religious faith on 
the part of its proponents, then the companies will do it 
because the investors will demand it. I think we need to find 
out what investors really value, and this voluntary approach 
would do it.
    At the very minimum, as many other people have said, 
Congress should address Section 404 for smaller public 
companies, and the best way to do that is make it voluntary for 
smaller public companies. I do not actually think that 
exemption, which is talked about by the Advisory Committee, is 
the best approach. I would like to say voluntary with 
explanation and disclosure. So you as management, you decide 
how you are going to address internal controls. You disclose 
and explain it to the shareholders. They can make up their 
minds. We ought to, at a minimum, do that for smaller 
companies, best case for everybody.
    The second point, Congress should instruct the PCAOB to 
change the internal control review standard from this ``other 
than a remote likelihood'' to ``a material risk of loss or 
fraud.'' This was brought up on the first panel. I think it is 
exactly right, and it is the only way to get the accountants 
acting right.
    Third, Congress should state clearly that it understands 
the true nature of accounting, which is that accounting is not 
something objective but something full of subjective judgments, 
estimates of the future, which is unknowable, debatable 
competing accounting theories and complex compromises, art not 
science, and, therefore, it is essential to have the 
accountants closely advising and counseling their clients on 
the application of the ever more complex accounting standards 
which the Financial Accounting Standards Board is producing. 
And we have lost that, as has also been discussed.
    In conclusion, I think it is critical to take a number of 
steps, and I think Congress should take them, to bring under 
control the unintended effects, intended by nobody, which have 
proved so remarkably costly, bureaucratic, and inefficient, and 
they have been caused by the way that Sarbanes-Oxley has been 
implemented. I hope Congress will take these steps.
    Thanks again for the chance to be here.
    [The prepared statement of Mr. Pollock follows:]

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    Mrs. Miller. Thank you so much.
    And our final panelist today is Damon Silvers. He is an 
associate general counsel for the AFL-CIO. His responsibilities 
include corporate governance, pension, and general business law 
issues. He is a member of the Public Company Accounting 
Oversight Board Standing Advisory Group. He is also a member of 
the Financial Accounting Standards Board User Advisory Council 
and a member of the American Bar Association's Subcommittee on 
International Corporate Governance.
    We welcome you to the committee today, Mr. Silvers, and the 
floor is yours, sir.

                 STATEMENT OF DAMON A. SILVERS

    Mr. Silvers. Thank you very much, Chairwoman Miller, 
Congressman Lynch. On behalf of the AFL-CIO, I express our 
appreciation for being able to be here today and to discuss 
this obviously very important issue.
    I will say that before I begin my formal remarks, in very 
large part, we very much agree with what Ms. Hinchman said. Not 
all my remarks go straight to those points, and I don't want to 
associate myself with hers.
    Ms. Hinchman. And we do not often agree with the AFL-CIO. 
Thank you. [Laughter.]
    Mr. Silvers. Right. And as I said to Mr. Parks at the last 
hearing he and I testified at, it is an unusual experience. 
But, nonetheless, we do.
    Union members participate in benefit plans with over $5 
trillion in assets, and our actual union-sponsored plans have 
approximately $400 billion in assets. Those workers' pension 
funds are broadly invested in a variety of small-cap and total 
market index funds and are sizable shareholders in many small 
public companies. I have attached to my testimony a letter from 
one such fund that provides benefits to our members, the 
Florida State Board of Investment, that describes the ways in 
which that large fund is deeply invested in small companies.
    Union members participate in the capital markets also as 
individual shareholders and, like other investors, are 
frequently asked by brokers to consider investing in small and 
micro-cap companies. And I am particularly honored to be, I 
think, the only investor representative here speaking today.
    The integrity of public company financial statements is a 
prerequisite to the functioning of our capital markets. When 
investors lose confidence in financial statement integrity, 
stock and bond prices fall, interest rates for businesses rise, 
and investors seek out markets in which they have more 
confidence. With the current account deficit running at a rate 
in excess of $2 billion a day, the United States simply cannot 
afford to undermine the integrity of its capital markets in 
whole or in part, and that was the circumstance in which we 
found ourselves in the summer of 2002, at the time in which the 
Sarbanes-Oxley Act was enacted.
    However, the Sarbanes-Oxley Act did not create the 
requirement that companies maintain adequate internal controls. 
That requirement has been a matter of law for public companies 
since 1977. It has simply been a law that companies have 
ignored.
    Internal controls are among the most important mechanisms 
that ensure that company financial statements are honest and 
accurate. They range from passwords on key spread sheets to 
systems for counting inventory. If internal controls are weak, 
that weakness casts doubt on the accuracy of company financial 
statements. In the absence of effective internal controls, 
company financial statements simply cannot be relied upon.
    Weak internal controls are strongly correlated with 
problems in company financial statements. Since larger 
companies--accelerated filers--began to comply with SOX 404 
more than a year ago, according to the corporate governance 
firm Glass Lewis, most public company financial restatements 
have been at companies that have also had weaknesses in their 
internal controls.
    Small public companies disproportionately are involved in 
these restatements and in SEC enforcement actions. According, 
again, to Glass Lewis, in 2005 the smallest companies were more 
than twice as likely to have to restate their financials as 
large companies. Dana Hermanson, a professor of accounting at 
Kennesaw State University, has found that smaller public 
companies ``have accounted for the vast majority of accounting 
fraud causes brought by the Securities and Exchange 
Commission.''
    Consequently, the AFL-CIO opposes any effort to exempt any 
public company from its clear obligations under the Sarbanes-
Oxley Act with respect to internal controls. In addition, we 
strongly oppose any stealth effort to turn the audit of 
internal controls into anything other than what the statute 
requires--an audit sufficiently substantive to support an 
attestation by the audit firm that management's own assessment 
of its internal controls is correct.
    And we are not alone. Contrary to some of what has been 
said this morning, there is virtual unanimity in both the 
institutional and individual investor community about the 
importance of protecting the current scope of 404, a consensus 
which includes institutionally oriented organizations like the 
Council of Institutional Investors, and organizations oriented 
toward individual investors like the American Association of 
Retired Persons and the Consumer Federation of America.
    In addition, distinguished financial leaders like the 
former chairman of the Federal Reserve, Paul Volcker, and 
former SEC Chairman, Arthur Levitt, have opposed weakening 404 
and specifically warn Congress that the effort to do so could 
rank with other disastrous efforts by Congress to deregulated 
industries such as the savings and loan industry if it were to 
move forward.
    There are two ways of thinking about the costs versus the 
benefits of internal control audits. The first way is to try 
and compare the costs of complying with SOX 404 with the costs 
involved, for example, in the collapse of a large-cap public 
company. According to the folks who oppose the application of 
404, total costs were approximately $35 billion in 2004. This 
is approximately a third of a percent of the market cap of the 
companies involved, a ratio, for example, that is comparable to 
what I pay for fire insurance for my home. And it is less than 
half of the cost of any one of the major corporate collapses 
that occurred in just one company in 2001 and 2002.
    By the way, other people have very different numbers for 
what the costs are here. Audit Analytics, for example, cites 
the total audit costs, not 404 but total audit costs, for the 
Russell 3000 in 2004 as $2.7 billion.
    The second way to think about it is to compare the costs 
with the benefits that accrue at the individual company level 
from company management getting a tighter grip on their 
business and being able to manage more precisely. There has 
been some discussion of those benefits here on this panel, and 
they were described by Jeffrey Immelt, the CEO of General 
Electric, when he said, ``I think SOX 404 is helpful. It takes 
the control discipline we use in our factories and applies it 
to our financial statements.''
    Since 1933, the Federal Government has required companies 
that wish to sell their securities to the public to bear a 
number of costs related to investor protection. Each of these 
costs is higher as a percentage of either assets, revenues, or 
profits for small companies than for larger companies, and 
particularly is higher than revenue numbers for small startup-
stage companies. Each of these costs has an effective minimum, 
regardless of the size of the public company. Therefore, it is 
easy to draw charts that look dramatic but are, in fact, 
misleading about the impact on small companies of any kind of 
investor protection.
    The real question is: What are the minimum requirements to 
access the public markets, to call our members on the phone and 
try to sell them your stock?
    Now, of course, investors do not have an interest--and this 
comes to Ms. Hinchman's testimony. We do not have an interest 
in needlessly expensive internal control audits or audits 
driven by conflicts of interest and accounting firms' desire to 
recapture consulting revenue they had before, and a variety of 
other things that we suspect may be going on. And we do believe 
that in 2004 the audit firms did overcharge the public 
companies and investors were harmed by that.
    However, the appropriate response to that is the regulatory 
response from the SEC and the PCAOB, and not wholesale 
exemptions from vital investor protections, and sensible 
changes in the guidelines and rules, such as Arthur Levitt's 
proposal for reducing duplicate internal control documentation 
that is simply inappropriate and a waste of everyone's time and 
money.
    Ultimately, those who want to weaken Sarbanes-Oxley and 
exempt wholesale the majority of public companies who seek to 
sell their shares and bonds to individual investors, they must 
answer the question: Why should Congress allow a company that 
cannot attest or receive outside attestation that it has 
effective internal controls, why should such a company be 
allowed to sell shares or bonds to the investing public? And 
Congress, furthermore, if it wishes to go in that direction, 
will have to explain to the victims of future accounting fraud 
why it was that when we had a tough law that restored investor 
confidence we weakened it.
    Thank you.
    [The prepared statement of Mr. Silvers follows:]

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    Mrs. Miller. Thank you all so very much.
    Mr. Hubbell, I was interested to hear of your background in 
the marina business. My family was from the marina business, 
and I remember during the 1980's when Congress had some 
unintended consequences in the marina industry, the boating 
industry, when they passed the luxury tax and they wanted to 
make sure that they were taxing the rich. And, of course, what 
they did instead was drive most of the boat manufacturer 
companies that employed just average workers all over our 
Nation out of business, and the wealthy ended up buying boats 
from foreign nations and just documenting those boats offshore 
and bringing them in. So people do find a way all around that, 
and Sarbanes-Oxley, in some ways is, again, the unintended 
consequences, I think, of an action by Congress, unfortunately.
    Let me just ask generally one question. You know, we have 
said that the goal with Sarbanes-Oxley, of course, is full 
transparency and internal controls and tightening of financial 
reporting. How can we actually bring down the cost? I thought 
it was interesting to hear Mr. Dowski talk about the president 
of Nasdaq, some of the various recommendations that he had 
made. And Mr. Pollock mentioned about Representative Flake's 
piece of legislation about voluntary compliance. I am not quite 
sure about all of that, but I would just pick up a little bit 
on what Representative Lynch brought up earlier, which I 
thought was, again, as was mentioned, a common-sense approach.
    What is your thought about actually, rather than just 
changing 404, making it--that you would do reporting every 
other year or, even as Representative Feeney had mentioned, 
that you do something similar to what the IRS currently does 
with all of our tax returns, just a random sampling, which 
seems to be able to keep the entire Nation on its toes. Why not 
utilize that type of an approach here? I just throw that out to 
the panel.
    Mr. Hubbell. If I could comment on that, I think all those 
are good ideas. I think more importantly there have to be 
definitions applied, and somebody mentioned earlier this 
morning about materiality. Our net profit in both of our 
companies, after tax, for this prior year was about $80 million 
net after tax. And our auditing firm was using materiality of 
$100,000. Now, whenever you get to that small number, if that 
is their threshold, it took them a lot of time to try to look 
for $100,000 things.
    So I think if we could apply some definitions--in the case 
of our company, we are controlled corporation; insiders own 60 
percent, so it would be hard to argue that anything we do is in 
violation of the stockholders' interest. So it is things like 
that, I think just some definitions.
    Mrs. Miller. Yes?
    Mr. Pollock. Madam Chairman, I think that once every 2 
years would be a distinct improvement on every year. Once every 
3 years would be better. A voluntary standard would be even 
better.
    As I said in my testimony, you do not help shareholders by 
imposing excessive costs done to standards which are 
unreasonable, which the ``other than a remote likelihood'' 
standard is, in my judgment, entirely unreasonable. And that is 
what generates a lot of the excess paperwork, that plus the 
fear on the part of the accounting firms that any mistake is 
life-threatening in terms of professional life. When you are 
operating under fear like that you get unreasonable sorts of 
responses.
    So I think we ought to move in a positive direction, and I 
would support anything in a positive direction, but I would 
take several other steps besides the ones suggested.
    Ms. Hinchman. Madam Chairman.
    Mrs. Miller. Mr. Silvers first.
    Mr. Silvers. I think that the question is very well posed. 
I think that it is clear that we are in current--while as you 
can tell from my testimony we feel very strongly that public 
companies ought to have audited assessments of their internal 
controls and that individual investors particularly will be put 
at risk by, say, a voluntary system or an exemption, big 
institutions will have various ways of protecting themselves, 
and individuals I think will not.
    Given that those things are--that is our position, we do 
feel that it is important to explore the very question you are 
asking, which is: How can this be made more cost-effective? How 
can it be right-sized? And I like Ms. Hinchman's phrase there 
very much.
    I do not believe that running out--extending the time 
periods--I mean, A, I think as Congressman Lynch indicated, 
doing this every 2 years would require a change in the statute. 
I do not believe that is the right approach. I believe it is 
well intentioned, and I believe there are more dangerous things 
than doing that. But I do not believe it is the right approach, 
and here is why: because investors want to have annual 
financial statements they can rely upon, and having adequate 
internal controls at all times is a vital component of having a 
financial statement annually that you can rely upon.
    Now, that being said, I think that there is a reasonable 
basis--and I am affected by the testimony I have heard about 
this--that to look at the issue of whether the standard for 
materiality is the right--has been rightly phrased here.
    Now, frankly, I don't think that is Congress' job to do 
that. I think that we in general have an accounting system at 
every level where we rely upon independent bodies--FASB, COSO, 
PCAOB--to set these standards and to deal with the technical 
issues. But I think that this is one area that might be worth 
looking at.
    I also think that there are a variety of ways in which the 
practice in this area has become duplicative, and I think the 
best statement, as I indicated in my testimony, around this 
issue was the one by Arthur Levitt, just pointing out places 
where it appears that audit firm practice has essentially 
documented things twice.
    Finally, something that a number of commentators have noted 
about this situation is that while the PCAOB has given 
extensive guidance to audit firms as to what to do, almost no 
guidance has been given to issuers, to the folks at this table, 
as to how they ought to prepare their assessment. This is a 
responsibility that lies with the SEC. I do not want to be 
critical of the SEC. I think both under Chairman Cox and 
Chairman Donaldson that the Commission has been very ably led 
today and in recent years. But this has slipped through and 
needs to be addressed.
    The focus here throughout ought to be, again, this concept 
of right-sizing. We do need to see to it that audit firms know 
the difference between a 60-person company and a 600,000-person 
company, and that ought not to be too hard and should not 
require weakening fundamental investor protections.
    Mrs. Miller. Ms. Hinchman.
    Ms. Hinchman. Yes, thank you, chairman. I think that one of 
the things that was talked about in the earlier panel--and Mr. 
Hubbell had made reference to it as well--is this whole concern 
about materiality and about how the internal control audits are 
conducted. And I think that this is the big challenge, and FEI 
does believe that the PCAOB and the SEC has a very important 
role to help guide companies through that process. And I had 
mentioned in my verbal testimony that there were often Q&As 
from staff to try and give further guidance, and there were 
some tenets and principles that were articulated by the PCAOB 
and the SEC over the last 2 years to try and articulate and 
direct companies and auditors in particular to take a risk-
based approach to their audit, and to effectively not be 
concerned about, as I like to say, count the pencils in the 
supply room, but really look at the challenges that are going 
to be a high risk to the entire enterprise or company.
    And I think what Mr. Silvers says is absolutely true, that 
I think that the PCAOB and the SEC are up to the task to give 
the guidance to companies versus a company that has 60 
employees versus 2,000 employees. And there is an opportunity 
to scale the requirements and compliance for these provisions 
to those different size companies without an outright 
exemption.
    Mr. Pollock. My colleagues have a lot more faith in 
regulatory agencies than I do, Madam Chairman.
    Mrs. Miller. Mr. Dowski.
    Mr. Dowski. Yes, I listen with fascination to people that 
are not involved on a day-to-day basis with running companies. 
I will give you an example of the current standards of 
reasonableness in terms of the implementation of SOX 404. We 
have a company in California called MS Microwave. It has 40 
employees, does about $10 million of revenue, surveillance 
equipment.
    Under the current SOX regulations, they have an IT 
department that is actually one individual who runs their 
servers and keeps all their PCs up. We failed our SOX audit out 
there for many reasons, but one of which was we did not have 
adequate controls under IT. According to the SOX regulations 
that are enforced today by the auditing firms and by the PCAOB, 
that one individual had to hold a meeting, had to write out 
minutes, had to actually invite somebody else to the meeting so 
that there would be a witness to the meeting, and had to do 
that on a quarterly basis and review the statuses of his IT 
environment with at least two outside experts. That was deemed 
to be efficient and effective IT controls.
    It is insane. The way it is being enforced is insane. And I 
am not--I think there are a lot of arguments to be said against 
making exemptions. The problem is that 404 is all of 20 pages. 
Simply, somebody has to sit down and say, look, we cannot apply 
the same standard uniformly to a very large company and a very 
small company. There has to be an interpretation of the 
definition of reasonableness and materiality that many of the 
people have talked about, anecdotally or directly. And that is 
the thing, when you get right down to it, that drives small 
companies, like ADG, which is really a collection of seven even 
smaller companies, it drives you to drink because the standards 
are just unreasonable. You have separation of control duties. 
Three different people have to handle the checks. Somebody has 
to request the check. Somebody else has to print the check. And 
the third person has to sign it. In some organizations, we have 
one person doing the same thing, and yet it is a material 
weakness because we do not have those controls in place. It is 
just insane. So there has to be a standard of reasonableness 
applied.
    Mrs. Miller. Thank you.
    Representative Lynch.
    Mr. Lynch. Thank you, Madam Chairman.
    First of all, I just want to say, just as a matter of 
disclosure, I actually am a member of the AFL-CIO. I am an 
active member. I pay my dues every month, so I am probably an 
investor as well.
    I do want to say that--you know, and I have concerns from 
that end. I participate in a pension fund and a lot of my 
constituents do as well. And so I am very interested in the 
transparency and the accountability and the security that is 
provided by certain aspects of Sarbanes-Oxley.
    But I also know that these smaller businesses are really an 
incubator of great innovation in this country and that the 
burdens here are disproportionate to the protections they are 
providing.
    I heard Ms. Hinchman and also Mr. Pollock, they both sort 
of hit on the material risk standard, if you will, and whether 
or not moving to that standard would satisfy the concerns that 
you have raised. And I just--we have to have some balance here. 
We have to have some balance, because right now I think just 
the costs that we are talking about.
    And so I want anyone who feels equipped to address that 
issue--and I also want to talk about the biennial issue here 
about having these full, independent audits done every other 
year, because I have to say that having sat on a union pension 
fund, you know, as a trustee, the fact that a company has to go 
through this process in, say, the odd-number year and then they 
realize that the next year they are attesting to the internal 
controls and procedures that they have in place, it seems very 
odd that they would leap off that standard in the even-number 
years knowing that they are going to be inspected again on the 
odd-number year. I just do not see that divergence occurring 
under realistic circumstances. So I am less concerned with the 
every-other-year situation.
    But you may be right. It may not be the ideal solution 
here. Maybe it is something along Mr. Pollock's line of thought 
where it is voluntary in a sense, but with, you know, 
encouragement with the SEC and PCAOB, I don't know.
    The last--and I know I have given too many questions 
already, but Mr. Pollock and Ms. Hinchman also suggested that 
the SEC and the PCAOB already have the ability to do this 
internally, and you are right, I think they are well equipped 
to do that. But are they willing to? That seems to be my 
question. And do they not need under the circumstances some--do 
we need to act here? I get the sense that we do because nothing 
is happening. I would love to see this thing handled by the SEC 
or PCAOB, but I just do not know, with everything else they 
have going there--my goodness, we do not even have folks at the 
SEC to train and to coach the issuers in these cases how to go 
about compliance with Sarbanes-Oxley.
    So I am a little bit skeptical that they would be able to 
leap into the fray here and come up with a regulatory solution.
    Ms. Hinchman. Mr. Lynch, I think part of the challenge is, 
particularly with the PCAOB, when AS2 was issued, that they 
really did rely very heavily on what is called principle-based 
accounting. And they did that intentionally because there was a 
drive in the accounting, financial reporting world to go in 
that direction.
    Mr. Lynch. Principle as opposed to rule-based?
    Ms. Hinchman. Correct.
    Mr. Lynch. OK.
    Ms. Hinchman. But our auditing profession is very much 
reliant on rules-based accounting, and so it has been a very 
difficult transaction for the auditors to rely on AS2 and to 
make the determinations for how to interpret those principles, 
predominantly because of liability concerns. And we are 
sympathetic to that issue. I think that is a big part of what 
is driving the procedures and the way that people are 
performing these audits these days.
    But from year one to year two, I think that you have been 
able to see a growing sense of confidence, both on the 
auditor's part and also on management's part, on how to conduct 
these internal audits. And I think that would go a long way, if 
the PCAOB could give a little more rules-based direction on how 
to interpret and use AS2 and get out of some of the examples 
that Mr. Dowski had made mention to earlier, and allow them to 
really focus with confidence on a risk-based assessment on how 
to conduct the internal audit.
    I also think that the SEC does need to step up to the plate 
more, in terms of giving guidance to the issuers, as you said.
    Mr. Pollock. Congressman, I very much share your skepticism 
on whether the SEC and PCAOB would step up to this issue. It is 
quite clear that the SEC did not know what its regulation would 
entail. These are unintended consequences from their point of 
view as well, also for the PCAOB. They did not understand, when 
they were regulating, what was going to happen.
    Both the SEC and the PCAOB have subsequently quite severely 
criticized the accounting firms for what they have done, and as 
our colleague suggested here, the accountants, of course, have 
a rather serious conflict of interest in that the more burden 
there is, the more profitable they become.
    But neither the SEC nor the PCAOB accepted any 
responsibility for the morass of bureaucracy they caused, and 
if you think about the incentives, unlike Congress, which is a 
balancing body, to balance interests and balance costs and 
benefits, the incentive structure of any regulatory body is to 
avoid embarrassment at all costs and to be quite insensitive to 
the costs imposed on other people in order to make sure that 
you do not get in trouble. And I think we have that problem 
with both of these agencies.
    If I may just add one other comment, I do think that the 
status of the PCAOB needs to be reformed as well. It is clearly 
functionally a regulatory body. It needs to be brought under 
congressional oversight, appropriation, and control, just like 
every other regulator, and I do think that was a mistake in 
Sarbanes-Oxley which should be rectified.
    Mr. Silvers. Congressman, let me answer the two questions 
that you sort of posed conceptually, and then I want to make a 
remark about the regulatory agencies as well.
    The question of doing an internal control audit every 2 
years as opposed to every year really raises the question of: 
Is the internal control audit an integrated whole with the 
audit of financial statements? In our view it is. If you are 
not--and, you know, one could take the view that we only need 
an audit of the financial statements every 2 years. But if you 
are going to represent to investors on an annual basis that on 
X date you can rely on these numbers, you also need to, I 
think, provide investors an assurance that the process that 
produced those numbers has some integrity to it.
    I think that we are now sitting at a moment where we have 
just been through the startup period against a background in 
which public companies had essentially been lax in relation to 
internal controls because no one was watching. As I said in my 
testimony, there has been a requirement to have adequate 
internal controls for public companies for close to 30 years. 
But when people actually started, you know, opening up the hood 
and looking to see what was there, it turned out that really 
that was not what was going on at all.
    Now, so I think that is the conceptual issue your proposal 
raises, and candidly, I have heard it for the first time today, 
and my reaction I think would be the reaction of many people in 
the investor community, that we want an annual audited 
financial statement that we can count on and that integration 
matters. I mean, I understand what you are trying to achieve 
and am sympathetic with your ends, but I am not sure that is 
the right way to do it.
    Now, in relationship to the materiality standard, I do 
think that is an area that ought to be looked at, but I want to 
give you this warning. A, as I said earlier, I think this is an 
area--these kinds of standards are traditionally an area in the 
accounting area where Congress has deferred to these 
independent agencies on the details. It is very much the kind 
of oversight process the chairwoman alluded to before.
    The warning around materiality is this: If you have too 
high a number threshold around internal controls materiality, 
you run the risk that auditors will not be looking--that 
neither the internal financial controls people nor the auditors 
will be paying much attention to symptoms of larger problems, 
that very big problems tend to start small.
    I do not pretend to know what the right answer is here, but 
when you think about getting to the right answer, it is not 
just a question of is that particular control of that 
particular account likely to blow the company up. It is, are 
you learning something by looking at that, the weakness of that 
control that tells you that there are larger systemic risks. 
And we have to build that in somehow into the process.
    Now, finally, with respect to the regulatory agencies, the 
Nation owes a deep debt of gratitude to the Public Company 
Accounting Oversight Board. When it was established in the fall 
of 2002, we were in a crisis period. Thanks to Bill McDonough 
and to his successor, Bill Gradison, who is the Acting Chair, 
and the very good people who worked there, the fundamental 
integrity of the financial reporting system in the United 
States is not really in doubt today in the way it was in 
September 2002.
    I do not believe it is fair to characterize them the way 
that my friend Mr. Pollock has. Those people are dedicated 
servants to the Nation and we owe them a debt. Can they--and 
their colleagues at the SEC, whom I have equal and profound 
respect for, can they do the right-sizing that is really needed 
here? And I think the answer is unquestionably yes. Not only 
can they, but really no one else can. This involves a level of 
detail, expertise, and interaction with the various components 
here and attention over time that only those agencies really 
have, in conjunction with COSO, I believe. I do not think there 
is really an alternative, and I think that they are eminently 
able to do it.
    Mr. Dowski. I think that the key issue is whether or not 
they are willing to, in the environment that we are in today, 
take a risk and step out and interpret those rules in a less 
than uniform way. I think that is--you know, I think that is 
really at the heart of the debate on 404 if you really sort of 
break it down and look at why a lot of companies like ADG are 
saying that this is just not a workable implementation plan.
    You know, I think Ms. Hinchman hit on a good point in that 
there has to be a shift from historical rules-based to 
principle-based interpretation in a lot of the implementation 
areas, and that PCAOB has started down that path, but the 
auditors in the environment are in with the increased liability 
and what they saw happen to Arthur Andersen are simply sitting 
there wants to check the box. And if they have a schedule that 
they have to fill out and they cannot check every box, then 
they are going to keep working it until you can get closer to 
checking those boxes. They will make that one guy hold a 
meeting and write up some minutes and document it so they can 
check that box. And that is the thing that really has to be 
changed and adjusted. Whether the PCAOB can do it or the SEC 
can do it or whether Congress should do it, I mean, I think we 
ought to use the organizations we have and put the onus back on 
auditors.
    The other issue is that auditors have gone from being an 
advisor to companies to being an antagonist with companies, and 
that is really something that has happened. I have been doing 
this for 20 years, and since 2002, the biggest thing that has 
changed is the rules have gotten more complicated, and you 
cannot call up your audit partner and ask, ``Here is what I 
think about the interpretation of this opinion and here is what 
we are doing. Do you think this is the right thing?'' They will 
not give you an answer. They will say, ``Write it up. Send it 
to us, and we may or may not tell you that it is an issue.'' 
They may or may not tell you that during the quarter, and then 
at the end of the year, they will come back with a whole list 
of other questions that you did not answer correctly. And that 
is part of this, I think, environment that has to change and 
improve as we move through, you know, the reactions that we all 
had to what happened in 2002, and to an environment where this 
thing becomes a lot more rational.
    I mean, nobody is going to argue that the shareholders do 
not--are not entitled to good internal controls. I think people 
in the financial profession have been stressing good financial 
controls because they are the basis on which you make reliable 
financial statements. You know, long before this came up, 
people were focused on controls. The breakage now is because we 
have now taken one standard for what is an acceptable internal 
control and we are applying it uniformly against the landscape 
of the American economy, and it just does not make any sense at 
the practical level.
    Mr. Lynch. Thank you.
    Mrs. Miller. Thank you all so very, very much, sincerely, 
for your attendance today. I think this has been really a 
fascinating hearing, and again, I think the impetus for the 
hearing was everybody seeing that something is wrong with the 
404 and the way that it is being implemented, and as many of 
you mentioned, the Commission and the Board certainly have the 
ability to be proactive and to do something short of Congress 
taking legislative action and whether or not they have the 
will. A way that they may have the will is to see that 
Congress--there is sort of a growing momentum here 
congressionally for some action, and we would like to preclude 
that kind of a thing if they would move on something more 
reasonable. The standard always has to be reasonable.
    So we appreciate you all coming and appreciate the ranking 
member, and with that the meeting will be adjourned.
    [Whereupon, at 12:19 p.m., the subcommittee was adjourned.]

                                 
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