[Senate Report 107-205]
[From the U.S. Government Publishing Office]



                                                       Calendar No. 442
107th Congress                                                   Report
                                 SENATE
 2d Session                                                     107-205
_______________________________________________________________________




                   PUBLIC COMPANY ACCOUNTING REFORM


                  AND INVESTOR PROTECTION ACT OF 2002


                               __________

                              R E P O R T

                                 OF THE

                     COMMITTEE ON BANKING, HOUSING,

                           AND URBAN AFFAIRS

                          UNITED STATES SENATE

                              to accompany

                                S. 2673

                             together with

                            ADDITIONAL VIEWS

                                     


                                     

                  July 3, 2002.--Ordered to be printed

       Filed, under the authority of the Senate of June 26, 2002
                               __________

                    U.S. GOVERNMENT PRINTING OFFICE
99-010                    WASHINGTON : 2002


            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut     PHIL GRAMM, Texas
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia                 CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware           RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan            JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey           MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii              JOHN ENSIGN, Nevada

           Steven B. Harris, Staff Director and Chief Counsel
             Wayne A. Abernathy, Republican Staff Director
                  Martin J. Gruenberg, Senior Counsel
                       Dean V. Shahinian, Counsel
                   Stephen R. Kroll, Special Counsel
                       Lynsey N. Graham, Counsel
                       Vincent M. Meehan, Counsel
                        Sarah A. Kline, Counsel
                Linda L. Lord, Republican Chief Counsel
                  Stacie Thomas, Republican Economist
                  Michelle Jackson, Republican Counsel
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                       George E. Whittle, Editor

                            C O N T E N T S

                              ----------                              
                                                                   Page

Introduction.....................................................     1
Purpose of the Legislation.......................................     2
Hearings.........................................................     2
Title-by-Title Summary of Major Provisions.......................     4
    Title I--Public Company Accounting Oversight Board...........     4
        A. Appointment and Operation of Board....................     6
        B. Registration of Accounting Firms......................     7
        C. 
          Auditing, Quality Control, Ethics, and Independence Stan
          dards
          and Rules..............................................     8
        D. Inspections of Registered Accounting Firms............     9
        E. Investigations and Disciplinary Proceedings...........    10
        F. Foreign Public Accounting Firms.......................    11
        G. SEC Oversight of the Board............................    12
        H. Accounting Principles.................................    12
        I. Funding...............................................    13
    Title II--Auditor Independence...............................    14
        A. Services Outside the Scope of Practice of Auditors....    15
        B. Audit Committee Pre-Approval of Audit and Non-Audit 
          Services...............................................    19
        C. Audit Partner Rotation................................    21
        D. Disclosures of Accounting Issues......................    21
        E. Cooling Off Period....................................    22
        F. The Bill Does Not Create State Regulatory Standards...    23
    Title III--Corporate Responsibility..........................    23
        A. Issuer Audit Committees...............................    23
        B. Corporate Responsibility for Financial Reports........    25
        C. Prohibited Influence..................................    26
        D. Forfeiture of Bonuses and Profits.....................    26
        E. Officer and Director Bars and Penalties...............    26
        F. 
          Prohibition on Insider Trades During Pension Fund Blacko
          ut
          Periods................................................    27
    Title IV--Enhanced Financial Disclosures.....................    28
        A. Accounting Adjustments................................    28
        B. Off-Balance Sheet Transactions........................    28
        C. Pro-Forma Financial Disclosures.......................    28
        D. Enhanced Disclosures of Loans.........................    29
        E. Disclosures of Transactions Involving Management......    30
        F. Management Assessment of Internal Controls............    31
        G. Exemptions for Investment Companies...................    31
        H. Code of Ethics for Senior Financial Officers..........    32
        I.  Disclosure of Audit Committee Financial Expert.......    32
    Title V--Analyst Conflicts of Interest.......................    32
    Title VI--Commission Resources and Authority.................    39
    Title VII--Studies and Reports...............................    42
Section-by-Section Analysis......................................    43
        Section 1. Short title and table of contents.............    43
        Section 2. Definitions...................................    43
        Section 3. Commission Rules and Enforcement..............    44
    Title I--Public Company Accounting Oversight Board...........    44
        Section 101. Establishment...............................    44
        Section 102. Registration with the Board.................    45
        Section 103. 
          Auditing, quality control, and independence standards
          and rules..............................................    46
        Section 104. Inspections of registered public accounting 
          firms..................................................    47
        Section 105. Investigations and disciplinary proceedings.    48
        Section 106. Foreign public accounting firms.............    49
        Section 107. Commission oversight of the Board...........    49
        Section 108. Accounting standards........................    50
        Section 109. Funding.....................................    50
    Title II--Auditor Independence...............................    51
        Section 201. Services outside the auditor scope of 
          practice...............................................    51
        Section 202. Pre-approval requirements...................    51
        Section 203. Audit partner rotation......................    51
        Section 204. Auditor report to Audit Committees..........    52
        Section 205. Conforming amendments.......................    52
        Section 206. Conflicts of interest.......................    52
        Section 207. 
          Study of mandatory rotation of registered public
          accounting firms.......................................    52
        Section 208. Commission authority........................    52
        Section 209. 
          Considerations by appropriate state regulatory
          authorities............................................    52
    Title III--Corporate Responsibility..........................    52
        Section 301. Issuer Audit Committees.....................    52
        Section 302. Corporate responsibility for financial 
          reports................................................    53
        Section 303. Prohibited influence........................    53
        Section 304. Forfeiture of certain bonuses and profits...    53
        Section 305. Officer and director bars and penalties.....    53
        Section 306. 
          Insider trades during pension fund blackout periods
          prohibited.............................................    53
    Title IV--Enhanced Financial Disclosures.....................    54
        Section 401. Disclosures in periodic reports.............    54
        Section 402. Enhanced disclosures of loans...............    54
        Section 403. Disclosures of transactions involving 
          management.............................................    54
        Section 404. Management assessment of internal controls..    54
        Section 405. Exemption...................................    54
        Section 406. Code of ethics for senior financial officers    54
        Section 407. Audit Committee financial expert............    55
    Title V--Analyst Conflicts of Interest.......................    55
        Section 501. Treatment of securities analysts by 
          registered securities associations.....................    55
    Title VI--Commission Resources and Authority.................    56
        Section 601. Authorization of appropriations.............    56
        Section 602. Appearance and practice before the SEC......    56
        Section 603. Federal court authority to impose penny 
          stock bars.............................................    56
        Section 604. 
          Qualifications of associated persons of brokers and
          dealers................................................    56
    Title VII--Studies and Reports...............................    56
        Section 701. GAO study and report regarding consolidation 
          of public accounting firms.............................    56
        Section 702. Commission study and report regarding rating 
          agencies...............................................    57
Changes in Existing Law..........................................    57
Regulatory Impact Statement......................................    57
Cost of Legislation..............................................    58
Additional views of:
    Senator Gramm................................................    66
    Senator Enzi.................................................    68

                                                       Calendar No. 442
107th Congress                                                   Report
                                 SENATE
 2d Session                                                     107-205

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



 
  PUBLIC COMPANY ACCOUNTING REFORM AND INVESTOR PROTECTION ACT OF 2002
                                _______
                                

                  July 3, 2002.--Ordered to be printed

 Filed, under the authority of the order of the Senate of June 26, 2002

                                _______
                                

    Mr. Sarbanes, from the Committee on Banking, Housing, and Urban 
                    Affairs, submitted the following

                              R E P O R T

                             together with

                            ADDITIONAL VIEWS

                         [To accompany S. 2673]

    The Committee on Banking, Housing and Urban Affairs 
reported an original bill to improve quality and transparency 
in financial reporting and independent audits and accounting 
services for public companies, to create a Public Company 
Accounting Oversight Board, to enhance the standard setting 
process for accounting practices, to strengthen the 
independence of firms that audit public companies, to increase 
corporate responsibility and the usefulness of corporate 
financial disclosure, to protect the objectivity and 
independence of securities analysts, to improve Securities and 
Exchange Commission resources and oversight, and for other 
purposes, and reports favorably thereon and recommends that the 
bill do pass.

                              Introduction

    On June 18, 2002, the Senate Committee on Banking, Housing, 
and Urban Affairs considered the ``Public Company Accounting 
Reform and Investor Protection Act of 2002,'' a bill to improve 
quality and transparency in financial reporting and independent 
audits and accounting services for public companies, to create 
a Public Company Accounting Oversight Board, to enhance the 
standard-setting process for accounting practices, to 
strengthen the independence of firms that audit public 
companies, to increase corporate responsibility and the 
usefulness of corporate financial disclosure, to protect the 
objectivity and independence of securities analysts, to improve 
Securities and Exchange Commission resources and oversight, and 
for other purposes. The Committee voted 17-4 to report the bill 
to the Senate for consideration as promptly as circumstances 
permit. Senators voting in favor of the motion to report the 
bill were: Sarbanes, Dodd, Johnson, Reed, Schumer, Bayh, 
Miller, Carper, Stabenow, Corzine, Akaka, Shelby, Bennett, 
Allard, Enzi, Hagel, and Bunning; Senators voting against the 
motion were: Gramm, Santorum, Crapo, and Ensign.

                       Purpose of the Legislation

    The purpose of the bill is to address the systemic and 
structural weaknesses affecting our capital markets which were 
revealed by repeated failures of audit effectiveness and 
corporate financial and broker-dealer responsibility in recent 
months and years. The bill creates a strong independent board 
to oversee the conduct of the auditors of public companies, and 
it strengthens auditor independence from corporate management 
by limiting the scope of non-audit services that auditors can 
offer their public company audit clients. However, the bill 
applies only to the auditing of public companies. The statutory 
intent is that state regulatory authorities should make 
independent determinations of the proper standards for small- 
and medium-sized accounting firms that do not audit public 
companies; state authorities should not presume that the 
standards applied under the bill should apply to those 
companies under state regulatory schemes.
    The bill also requires steps to enhance the direct 
responsibility of senior corporate management for financial 
reporting and for the quality of financial disclosures made by 
public companies. The bill establishes clear statutory rules to 
limit, and expose to public view, possible conflicts of 
interest affecting securities analysts. Finally, the bill 
authorizes substantially higher funding for the Securities and 
Exchange Commission.

                                Hearings

    The Banking Committee's action followed ten hearings on the 
accounting and investor protection issues raised by the 
financial revelations involving Enron and other public 
companies. These issues include: the integrity of certified 
financial audits; appropriate accounting principles and 
auditing standards; the effectiveness of the accounting 
regulatory oversight system; the importance of auditor 
independence for the quality of audits; conflicts of interest, 
and the compromise to auditor independence, raised by 
accounting firms' increased offering of consulting services to 
audit clients; the completeness of corporate disclosure in SEC 
filings and shareholder communications; conflicts of interest 
among securities underwriters and affiliated stock analysts; 
insider abuses; corporate responsibility; and the adequacy of 
resources available to the Securities and Exchange Commission 
to meet its responsibilities.
    On February 12, 2002, the Committee heard from a panel of 
five former Chairmen of theSecurities and Exchange Commission: 
Roderick M. Hills, Chairman, 1975-77; Harold M. Williams, Chairman, 
1977-81; David Ruder, Chairman, 1987-89; Richard C. Breeden, Chairman, 
1989-93; and Arthur Levitt, Jr., Chairman, 1993-2000.\1\
---------------------------------------------------------------------------
    \1\ John Shad, the SEC's Chairman from 1981-87, is deceased.
---------------------------------------------------------------------------
    On February 14, 2002, Paul Volcker, Chairman of the 
Trustees of the International Accounting Standards Committee, 
and former Chairman of the Board of Governors of the Federal 
Reserve System, and Sir David Tweedie, Chairman of the 
International Accounting Standards Board, and former Chairman 
of the United Kingdom's Accounting Standards Board, appeared 
before the Committee to discuss ``International Accounting 
Standards and Necessary Reforms to Improve Financial 
Reporting.''
    On February 26, 2002, a panel of three former Chief 
Accountants of the Securities and Exchange Commission and a 
former Chairman of the Financial Accounting Standards Board 
testified on ``Oversight of the Accounting Profession, Audit 
Quality and Independence, and Formulation of Accounting 
Principles.'' The witnesses were Walter P. Schuetze, Chief 
Accountant, 1992-95; Michael H. Sutton, Chief Accountant, 1995-
98; Lynn E. Turner, Chief Accountant, 1998-2001; and Dennis R. 
Beresford, Chairman, Financial Accounting Standards Board, 
1987-97.
    On February 27, 2002, the Committee heard testimony on 
``Corporate Governance'' from John H. Biggs, Chairman, 
President, and Chief Executive Officer, Teachers' Insurance and 
Annuity Association--College Retirement Equities Fund (TIAA-
CREF), and former member of the Public Oversight Board; and Ira 
M. Millstein, Senior Partner, Weil, Gotshal & Manges LLP, and 
Co-Chair of the Blue Ribbon Committee on Improving the 
Effectiveness of Corporate Audit Committees.
    On March 5, 2002, the Committee heard from David M. Walker, 
Comptroller General of the United States; as well as Robert 
Glauber, Chairman and Chief Executive Officer, National 
Association of Securities Dealers, Inc., and former Under 
Secretary for Finance, Department of Treasury, under President 
Bush (1989-1992); Joel Seligman, Dean and Ethan A. H. Shepley 
University Professor, Washington University School of Law; and 
John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia 
University Law School.
    On March 6, 2002, the Committee heard testimony on 
``Oversight of the Accounting Profession, Audit Quality and 
Independence, and Formulation of Accounting Principles'' from 
Shaun O'Malley, Chairman, 2000 Public Oversight Board Panel on 
Audit Effectiveness, and former Chairman, Price Waterhouse LLP; 
Lee Seidler, Deputy Chairman, 1978 American Institute of 
Certified Public Accountants (``AICPA'') Commission on 
Auditors' Responsibilities, and Managing Director Emeritus, 
Bear Stearns & Co.; Arthur R. Wyatt, former President, American 
Accounting Association, and Professor of Accountancy Emeritus, 
University of Illinois; Abraham Briloff, Emanuel Saxe 
Distinguished Professor Emeritus, Baruch College, City 
University of New York; and Bevis Longstreth, Member, 2000 
Public Oversight Board Panel on Audit Effectiveness, and former 
Commissioner, Securities and Exchange Commission (1981-84).
    On March 14, 2002, the Committee heard from representatives 
of the accounting industry, the American Enterprise Institute, 
and The Brookings Institution. The witnesses were James G. 
Castellano, Chairman, AICPA, and Managing Partner, Rubin, 
Brown, Gornstein & Co. LLP; James S. Gerson, Chairman, Auditing 
Standards Board, AICPA, and Partner, PricewaterhouseCoopers 
LLP; William Balhoff, Chairman, AICPA Private Company Practice 
Section; Olivia F. Kirtley, former Chair, AICPA; James E. 
Copeland, Jr., Chief Executive Officer, Deloitte & Touche LLP; 
Peter J. Wallison, Resident Fellow and Co-Director, Financial 
Deregulation Project, American Enterprise Institute; and Robert 
E. Litan, Director, Economic Studies Program, The Brookings 
Institution.
    On March 19, 2002, the Committee heard from two members of 
the recently-disbanded Public Oversight Board (``P.O.B.''): 
Charles A. Bowsher, former Comptroller General of the United 
States, who was the P.O.B.'s Chairman; and Aulana L. Peters, 
former Commissioner, Securities and Exchange Commission (1984-
88), who was a member of the P.O.B.; as well as from L. William 
Seidman, former Chairman, Federal Deposit Insurance Corporation 
and Resolution Trust Corporation, and former Partner, Seidman & 
Seidman; John C. Whitehead, former Co-Chairman, Goldman Sachs & 
Co., Co-Chair of the Blue Ribbon Committee on Improving the 
Effectiveness of Corporate Audit Committees, and former Deputy 
Secretary of State (1985-89); and Michael Mayo, Managing 
Director, Prudential Securities, Inc.
    On March 20, 2002, the Committee heard from a variety of 
interested parties including Thomas A. Bowman, President and 
Chief Executive Officer, Association for Investment Management 
and Research; Howard M. Metzenbaum, Chairman, Consumer 
Federation of America, and former U.S. Senator; Damon Silvers, 
Associate General Counsel, AFL-CIO; and Sarah Teslik, Executive 
Director, Council of Institutional Investors.
    On March 21, 2002, the Committee heard testimony from 
Harvey L. Pitt, Chairman, Securities and Exchange Commission.

               Title-by-Title Summary of Major Provisions


           TITLE I--PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD

    Title I of the bill creates a Public Company Accounting 
Oversight Board (the ``Board''), to provide for more effective 
oversight of the part of the nation's accounting industry that 
audits public companies. Title I reflects significant portions 
of S. 2004, authored by Senators Dodd and Corzine, as well as 
the terms of an amendment offered at the Committee's June 18 
mark-up by Senator Enzi, which was adopted by voice vote.
    The new Board may, subject to review by the Securities and 
Exchange Commission (the ``SEC'' or the ``Commission''), 
establish, adopt, or modify auditing, quality control, ethics, 
and independence standards for public company audits, inspect 
accounting firms, investigate potential violations of 
applicable rules relating to audits, and impose sanctions if 
those violations are established. The Board will have authority 
only with respect to audits of public companies. It has no 
jurisdiction over the work of accountants in auditing other 
companies.
    The Board will bring together various issues and 
responsibilities that have in the past been subject to what one 
Committee witness characterized as ``a bewildering array of 
monitoring groups'' \2\ under the auspices of the accounting 
profession. As Shaun O'Malley, Chairman of the 2000 Panel on 
Audit Effectiveness (and former Chairman of Price Waterhouse 
LLP), explained to the Committee in greater detail:
---------------------------------------------------------------------------
    \2\ Testimony of John H. Biggs, Chairman, President and CEO, 
Teachers' Insurance and Annuity Association--College Retirement 
Equities Fund (TIAA-CREF), and former member of the Public Oversight 
Board, before the Committee on February 27, 2002.

          The profession's combination of public oversight and 
        voluntaryself-regulation is extensive, Byzantine, and 
insufficient. The Panel found that the current system of governance 
lacks sufficient public representation, suffers from divergent views 
among its members as to the profession's priorities, implements a 
disciplinary system that is slow and ineffective, lacks efficient 
communication among its various entities and with the SEC, and lacks 
unified leadership and oversight.\3\
---------------------------------------------------------------------------
    \3\ Testimony of Shaun O'Malley, Chairman, 2000 Public Oversight 
Board Panel on Audit Effectiveness, and former Chairman, Price 
Waterhouse LLP, before the Committee on March 6, 2002.

    Twenty witnesses who appeared before the Committee in its 
ten days of hearings on accounting reform and investor 
protection stressed the need for a strong Board to oversee the 
auditors of public companies. Paul Volcker, the former Chairman 
---------------------------------------------------------------------------
of the Federal Reserve Board, told the Committee that:

        [o]ver the years, there have also [i.e., in addition to 
        the SEC] been repeated efforts to provide oversight by 
        industry or industry/public member boards. By and 
        large, I think we have to conclude that those efforts 
        at self-regulation have been unsatisfactory. Thus, 
        experience strongly suggests that governmental 
        oversight, with investigation and enforcement powers, 
        is necessary to assure discipline.\4\
---------------------------------------------------------------------------
    \4\ Testimony of Paul Volcker, Chairman of the Trustees of the 
International Accounting Standards Committee, and former Chairman of 
the Board of Governors of the Federal Reserve System, before the 
Committee on February 14, 2002.

Charles W. Bowsher, the Comptroller General of the United 
States from 1981-1996 and the last Chairman of the Public 
Oversight Board (P.O.B.),\5\ as well as former SEC Commissioner 
Aulana Peters and John Biggs, who were also members of the 
P.O.B., made the same recommendation when they testified before 
the Committee.\6\ They were also among the number of witnesses 
who emphasized that any Board must be created by statute to 
establish its authority properly and firmly.
---------------------------------------------------------------------------
    \5\ The Public Oversight Board was created in 1977 as part of self-
regulatory efforts by the accounting industry. In January 2002, the 
P.O.B. voted unanimously to disband, in ``recognition of the obstacles 
to achieving this goal [i.e., effective self-regulation] which have 
been encountered in recent years, and given the proposal of the SEC in 
consultation with the AICPA and the SEC Practice Section Executive 
Committee, without input from the Public Oversight Board, to reorganize 
the self-regulatory structure. * * * '' Resolution of the Public 
Oversight Board, January 20, 2002. Available at http://
www.publicoversightboard.org/about.htm.
    \6\ Testimony of Charles A. Bowsher, Chairman, Public Oversight 
Board, and former Comptroller General of the United States, before the 
Committee on March 29, 2002; testimony of Aulana L. Peters, Member, 
Public Oversight Board and former Commissioner, Securities and Exchange 
Commission (1984-88), before the Committee on March 19, 2002; Biggs 
Testimony, February 27, 2002.
---------------------------------------------------------------------------
    The concerns of the Committee extend beyond immediate 
allegations of wrongdoing, to the fundamental principles on 
which the functioning of free markets and the protection of 
investors are based. Each of the country's federal securities 
laws--the 1933, 1934, 1935, and 1940 Acts--requires 
comprehensive financial statements that must be prepared, in 
the words of the Securities Act of 1933, by ``an independent 
public or certified accountant.'' \7\ Professor Benjamin 
Graham's seminal textbook for securities analysts explains why:

    \7\ Schedule A(25) of the Securities Act of 1933, 15 U.S.C. 
Sec. 77(aa)(25) (emphasis added); see also section 13(a)(2) of the 
Securities Exchange Act of 1934, 15 U.S.C. Sec. 78m(a)(2), section 14 
of the Public Utility Holding Company Act of 1935, at U.S.C. Sec. 79n, 
and section 30(g) of the Investment Company Act of 1940, 15 U.S.C. 
Sec. 80a-29(g).
---------------------------------------------------------------------------
          Prior to the SEC legislation * * * it was by no means 
        unusual to encounter semi-fraudulent distortions of 
        corporate accounts * * * almost always for the purpose 
        of making the results look better than they were, and 
        it was generally associated with some scheme of stock-
        market manipulation in which the management was 
        participating.\8\
---------------------------------------------------------------------------
    \8\ Graham, Dodd, and Cottle, Security Analysis, 108 (4th ed., 
1962).

However, the franchise given to public accountants by the 
securities laws is conditional; it comes in return for the 
CPA's faithful assumption of a public trust. (The Supreme 
Court's now-classic statement of that trust, in United States 
v. Arthur Young, 465 U.S.C. 805 (1984) is discussed below.) The 
testimony heard by the Committee repeatedly indicated that a 
number of forces have undermined the fulfillment of this public 
trust over the years. Lee Seidler, Deputy Chairman of a 1978 
commission organized to review ``auditors' responsibilities,'' 
told the Committee that, twenty-five years ago, that commission 
had found a gap between the reasonable expectations of users of 
financial statements and the performance of auditors that has 
---------------------------------------------------------------------------
not improved since. He continued:

        in 1978 [the commission] also said: the public 
        accounting profession has failed to react and evolve 
        rapidly enough to keep pace with the speed of change in 
        the American business environment. And unfortunately, a 
        quarter of a century later, I have to repeat that. It's 
        identical.\9\
---------------------------------------------------------------------------
    \9\ Testimony of Lee Seidler, former partner, Bear Stearns & Co. 
and Deputy Chair of the 1978 Commission on Auditors' Responsibilities, 
before the Committee on March 6, 2002.
---------------------------------------------------------------------------

A. Appointment and operation of board

    The successful operation of the Board depends upon its 
independence and professionalism. The Board will have five 
members, each of whom must have a demonstrated commitment to 
the interests of investors, as well as an understanding of the 
financial disclosures required of public companies, and the 
responsibilities for those disclosures, under the federal 
securities laws. Three members of the Board will have a general 
background, and two members will have an accountancy 
background.\10\ (The Board's Chairperson may have an 
accountancy background, but if so, he or she may not have been 
a practicing accountant for at least five years prior to 
appointment to the Board.)
---------------------------------------------------------------------------
    \10\ Senator Enzi suggested that the bill require, not merely 
permit, that two Board members have an accountancy background.
---------------------------------------------------------------------------
    Board members are to be appointed by the SEC after 
consultation with the Federal Reserve Board and the Department 
of the Treasury. They will serve full-time, for five-year 
(staggered) terms, with a two-term limit. To further assure 
their independence, Board members may engage in no other 
business activities of any nature, or receive any payments from 
any accounting firms (except for standard retirement payments) 
or other persons. In addition, former Board members will be 
subject to a one-year ``cooling off'' period at the end of 
their Board service, during which time they may not work for an 
accounting firm registered with the Board.
    It is essential that the Board have a strong, well-trained, 
and experienced staff, of sufficient size to carry out its 
responsibilities. A number of witnesses emphasized, for 
example, that inspections must no longer be left to ``peer 
reviews'' of one accounting firm by another.\11\ The bill makes 
it plain, as the Committee intends, that the Board is to 
provide for staff salaries that are fully competitive with 
those for comparable private-sector self-regulatory, 
accounting, technical, supervisory, or related staff or 
management positions.\12\
---------------------------------------------------------------------------
    \11\ Testimony of Harold M. Williams, former SEC Chairman (1977-
81), before the Committee on February 12, 2002; Biggs Testimony, 
February 27, 2002; testimony of Joel Seligman, Dean and Ethan A.H. 
Shepley University Professor, Washington University School of Law, 
before the Committee on March 5, 2002; testimony of Bevis Longstreth, 
Member, 2000 Public Oversight Board Panel on Audit Effectiveness, and 
former Commissioner, Securities and Exchange Commission (1981-84), 
before the Committee on March 6, 2002; cf. testimony of Robert Glauber, 
Chairman and Chief Executive Officer, National Association of 
Securities Dealers, Inc., and former Under Secretary for Finance, 
Department of Treasury, under President Bush (1989-1992), before the 
Committee on March 5, 2002.
    \12\ The Board itself will be a corporation created under the D.C. 
Nonprofit Corporation Act. It will be neither an agency nor 
establishment of the federal government, and its members and employees 
are not to be deemed to be federal officers or employees by reason of 
their Board service.
---------------------------------------------------------------------------
    Prompt Action is Essential. The Committee believes that the 
new oversight arrangements must come into effect quickly. The 
SEC is to appoint the initial Board within three months of the 
bill's enactment, so that the Board can take the steps 
necessary to begin its operation within six months of its 
appointment, and the registration of accounting firms (below) 
can be completed within six months after the Board begins 
operation.

B. Registration of accounting firms

    Accounting firms that audit public companies must register 
with the Board, no later than six months after the SEC 
determines that the Board is ready to begin operation. It is 
unlawful for a firm that has not registered to continue to 
audit public companies.
    Conditioning eligibility to audit public companies on 
registration with the Board is the linchpin of the Board's 
authority. Suspension or revocation of registration renders a 
firm unable to continue its public company audit practice.
    As part of its registration process, each accounting firm 
must execute a consent to comply with any requests, within the 
Board's authority, for documents or testimony made in the 
course of the Board's operation. The firm must also agree to 
obtain (and ultimately, if necessary, to enforce) similar 
consents from the firm's partners and employees, who are 
subject to the Board's investigative and disciplinary 
jurisdiction.
    Certain necessary information is to accompany the 
registration materials (including a list of the firm's 
accountants who perform public company audits), and the Board 
will determine within 45 days of receipt whether an application 
is complete and the applicant can be registered. Basic 
registration information is to be public, but each accounting 
firm may protect from public disclosure information that it 
reasonably identifies as proprietary or that is otherwise 
protected by law. Each registrant is to file a report annually 
to update the required information.
    The Board is to assess a registration fee, and an annual 
fee, to recover the costs of processing and reviewing 
applications and annual reports.

C. Auditing, quality control, ethics, and independence standards and 
        rules

    The bill requires the Board to establish or adopt auditing, 
quality control, and ethics standards for the audit of public 
companies. The Committee has concluded that the Board's plenary 
authority in this area is essential for the Board's effective 
operation, a position taken during the hearings by a number of 
witnesses, including former SEC Chairman Levitt, former 
Comptroller General Bowsher, and former FDIC Chairman Seidman 
(himself once a principal of a substantial accounting 
firm).\13\
---------------------------------------------------------------------------
    \13\ Testimony of Arthur Levitt, former SEC Chairman (1993-2000), 
before the Committee on February 12, 2002; Bowsher Testimony, March 19, 
2002; testimony of L. William Seidman, former Chairman, Federal Deposit 
Insurance Corporation and Resolution Trust Corporation, and former 
partner, Seidman & Seidman, before the Committee on March 19, 2002.
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    The Board's standard-setting authority, however, is neither 
intended nor structured to exclude practicing accountants from 
participation in the standard-setting process. The Board may 
adopt as part of its rules (and modify as appropriate for that 
purpose, at the time of adoption or thereafter), any portion of 
a statement of auditing, quality control, or ethics standards 
that meets the bill's statutory tests and that is proposed (i) 
by a professional group of accountants (designated by a rule of 
the Board for that purpose), or (ii) by one or more advisory 
groups of practicing accountants or other interested parties 
convened by the Board. (Pre-existing standards of designated 
professional groups of accountants may be adopted during the 
Board's transitional period.) The Board is to cooperate on an 
ongoing basis with the designated professional groups of 
accountants noted above, with its own advisory groups, and with 
other interested groups (and the accounting profession and the 
investing public at large), in examining the need for changes 
in any standards subject to Board authority. It is to recommend 
issues for inclusion on the agendas of these groups, take other 
steps to facilitate the standard-setting process, and respond 
in a timely fashion to requests for changes in the standards. 
Finally, rules are open to comment by accountants and any other 
interested persons in a public process before they are approved 
either by the Board or, ultimately, by the SEC. Many of these 
provisions were suggested by Senator Enzi.
    Particular Standards Required by the Bill. Although the 
Board's power to establish or adopt auditing and related 
standards extends to the full range of those standards, the 
bill specifies certain provisions that must be part of the 
standards. These include (i) preparation, and maintenance for 
at least seven years, by public company auditors of audit work 
papers and related information in sufficient detail to support 
each audit's conclusions, (ii) ``second partner'' review and 
approval of each public company audit report and its issuance, 
and (iii) inclusion in each audit report of a description of 
the auditor's testing of the public company's systems for 
compliance with the requirements of section 13(b)(2) of the 
Securities Exchange Act and of the company's controls over its 
receipts and expenditures, together with specific notation of 
any significant defects or material noncompliance of which the 
auditor should know on the basis of such testing. In addition, 
the quality control standards adopted by the Board must address 
an accounting firm's monitoring of ethics and independence; 
internal and external consulting on audit issues; audit 
supervision; hiring, development, and advancement of audit 
personnel; acceptance and continuance of engagements; and 
internal inspection.
    Auditor Independence. The Board is also authorized to issue 
rules to implement the provisions of title II of the bill 
relating to auditor independence. That authority is discussed 
in greater detail in connection with title II, below.

D. Inspections of registered accounting firms

    Virtually every witness who addressed the details of 
auditor oversight agreed on the critical need for a regular and 
comprehensive review, by an independent body of inspectors, of 
each audit firm's compliance with audit standards and 
procedures. A program of inspections is essential to identify 
problems in firm procedures, training, and ``culture'' before 
those problems can produce audit failures that trigger large 
investor losses and threaten confidence in the capital 
markets.\14\
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    \14\ See, e.g., Ruder Testimony, February 12, 2002; Seligman 
Testimony, March 5, 2002; Seidler Testimony, March 6, 2002.
---------------------------------------------------------------------------
    The Board is to inspect the operations of each registered 
accounting firm, in order to assess compliance of that firm, 
and of its partners and employees, with the new statute, the 
Board's rules, and professional accounting standards. 
Initially, firms that audit more than 100 public companies are 
to be inspected each year, and firms that audit 100 or fewer 
public companies are to be inspected at least every three 
years. The Board is given the power to adjust these inspection 
schedules if it finds different schedules to be consistent with 
the bill's purposes, the protection of investors, and the 
public interest.
    During an inspection, the Board is to review particular 
audit engagements (that it selects) of a firm and the firm's 
general quality control systems and policies, as well as to 
perform such other testing of the firm's audit, supervisory, 
and quality control procedures as is necessary or appropriate. 
The Board is specifically given authority to require firms to 
retain their records for inspection purposes regardless of 
whether retention of those records is otherwise required.
    After each inspection, the Board will prepare an inspection 
report, which will be available for comment in draft form by 
the firm under inspection. Quality control defects found by the 
Board may be disposed of simply by corrective action, but 
specific violations identified duringinspections may form the 
basis for a more formal investigation or disciplinary action by the 
Board and are to be reported, if appropriate, to the SEC and relevant 
state accountancy boards; final inspection reports are to be sent to 
the SEC and relevant state accountancy boards in any event. The reports 
will also be made public, subject to appropriate protection of 
confidential or proprietary information. However, firms will be given 
12 months to correct defects in their quality control systems, to the 
satisfaction of the Board, before portions of the reports dealing with 
those defects are added to the public record.\15\
---------------------------------------------------------------------------
    \15\ The bill creates a right to interim SEC review of certain 
inspection-related disputes.
---------------------------------------------------------------------------

E. Investigations and disciplinary proceedings

    Committee witnesses stressed that the Board must possess 
investigative and disciplinary authority. Arthur Levitt, who 
served as Chairman of the SEC during most of the 1990s, told 
the Committee that:

          We need a truly independent oversight body that has 
        the power not only to set the standards by which audits 
        are performed, but also to conduct timely 
        investigations that cannot be deferred for any reason 
        and to discipline accountants.\16\
---------------------------------------------------------------------------
    \16\ Levitt Testimony, February 12, 2002.

Robert Glauber, the Chairman and CEO of the National 
---------------------------------------------------------------------------
Association of Securities Dealers, explained that:

          Any form of private-sector regulation must be 
        empowered to effectively enforce the rules: [it must 
        possess] the ability to levy meaningful fines, place 
        conditions on continued participation in the industry, 
        suspend, and where appropriate, banish those who 
        misbehave from the industry. This ``ultimate sanction'' 
        is both a powerful deterrent for would-be violators and 
        an important investor protection.\17\
---------------------------------------------------------------------------
    \17\ Glauber Testimony, March 5, 2002. John Biggs said simply: 
``Accounting firms must know that they cannot refuse to open their 
books or prevent their staff from cooperating with this new agency.'' 
Biggs Testimony, February 27, 2002.

In response, the bill grants the Board broad authority to 
investigate any act or practice, or omission, by a registered 
accounting firm, or its associated persons, that may violate 
the new statute, the Board's rules, professional accounting 
standards, or the portions of the Federal securities laws (and 
SEC rules) relating to the preparation and issuance of audit 
reports and the obligations and liabilities of accountants with 
respect to those reports.
    The Board's rules are to prescribe fair investigative and 
disciplinary procedures. It may, under those rules, require 
testimony or the production of audit work papers and other 
documents from (and may inspect the records of) registered 
firms or their associated persons, and it may suspend or revoke 
the registration of a firm, or suspend or bar from further 
association with a firm an ``associated person,'' for non-
cooperation with a Board investigation, subject to review of 
that action by the SEC.\18\
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    \18\ The Board may request, but not require, the testimony of, or 
production of documents, in the possession of any other person (for 
example, an audit firm's client). Its rules may provide for procedures 
to seek issuance of a subpoena from the SEC to any person.
---------------------------------------------------------------------------
    Committee witnesses also emphasized that information 
gathered by Board investigators should be ``privileged from 
outsiders'' during the investigative process. Under the bill, 
any information gathered in the course of an investigation is 
to be confidential and privileged for all purposes (including 
civil discovery), unless and until particular information is 
presented in connection with a public proceeding. However, the 
Board may disclose investigative information, if it determines 
that such disclosure is ``necessary to accomplish the purposes 
of the Act or to protect investors,'' to the SEC, any federal 
financial supervisor (if the investigation pertains to an 
institution under the latter's supervision), the Attorney 
General, and, with the SEC's permission, to state attorneys 
general, in connection with criminal investigations, or state 
accountancy boards. (The Board may also refer an investigation 
to the SEC or other agencies to which disclosure of information 
is permitted.)
    A full range of sanctions is available if the Board finds 
that a registered firm (or its partners or employees) has 
violated one or more of the rules within the Board's 
investigative jurisdiction. Potential sanctions include 
revocation or suspension of an accounting firm's registration, 
or of the ability of particular individuals to remain 
associated with that firm or become associated with any other 
registered accounting firm (effectively barring the subject of 
the sanction from participating in audits of public companies), 
substantial civil money penalties,\19\ required professional 
education or training, and censure; the breadth of these 
sanctions is intended to encourage flexible and appropriate 
action, designed to correct if possible. The Board's ability to 
suspend or bar an associated person from the auditing of public 
companies, and its ability to impose civil money penalties 
above a certain amount, is limited to situations involving 
intentional, knowing, or reckless conduct, or repeated 
negligent conduct.
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    \19\ Fines imposed by the Board are to be used to fund a 
scholarship program for students in undergraduate or graduate programs 
in accounting.
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    An important provision of the bill permits the Board to 
impose sanctions upon a registered accounting firm for failure 
reasonably to supervise a partner or employee who is found to 
have violated applicable rules. The terms for liability for 
failure to supervise are similar to those that apply to broker-
dealers under section 15(b)(4) of the Securities Exchange Act 
of 1934; they permit an accounting firm to defend itself from 
supervisory liability by showing that its internal control 
procedures were reasonable and were operating fully in the 
situation at issue.
    The Board's determination that a violation has occurred and 
that a sanction should be imposed may be appealed to the 
Commission (as described below). Disciplinary sanctions must be 
reported to the Commission, appropriate state or foreign boards 
of accountancy, and the public (once any stay of enforcement 
pending appeal has been lifted).

F. Foreign public accounting firms

    Companies that sell shares to U.S. investors, and are 
subject to the federal securities laws, can be organized and 
operate in any part of the world. Their financial statements 
are not necessarily audited by U.S. accounting firms, and the 
Committee believes that there should be no difference in 
treatment of a public company's auditors under the bill simply 
because of a particular auditor's place of operation. 
Otherwise, a significant loophole in the protection offered 
U.S. investors would be built into the statutory system.
    Thus, accounting firms organized under the laws of 
countries other than the United States that issue audit reports 
for public companies subject to the U.S. securities laws are 
covered by the bill in the same manner as domestic accounting 
firms, subject to the exemptive authority of both the Board and 
the SEC. (Registration under the bill will not in itself 
provide a basis for subjecting a foreign accounting firm to 
U.S. jurisdiction other than with respect to controversies 
between such a firm and the Board.) The Board is also 
authorized to determine that other foreign accounting firms 
play a sufficiently substantial role in the preparation and 
furnishing of such reports for particular issuers that their 
coverage under the bill is necessary or appropriate to protect 
investors and the public interest.
    Finally, the bill sets terms for the production in the 
United States by a foreign public accounting firm of its audit 
work papers, for any audit in which the foreign accounting firm 
issues an opinion or otherwise performs material services upon 
which an accounting firm registered under the bill relies in 
issuing all or part of a public company audit report. The 
foreign firm is deemed, by performing such work, to have 
consented to production, and the domestic accounting firm that 
relies on the foreign accounting firm's work must have secured, 
as a condition of its reliance, the foreign firm's agreement to 
the production.

G. SEC oversight of the Board

    The Board is subject to SEC oversight and review to assure 
that the Board's policies are consistent with the 
administration of the federal securities laws, and to protect 
the rights of accounting firms and individuals subject to the 
Board's jurisdiction. Oversight also allows the public an 
important forum for commenting on Board rules relating to 
auditing, quality control, and related standards.
    The rules for SEC oversight of the Board are generally the 
same as those that apply to SEC oversight of the National 
Association of Securities Dealers, under section 19 of the 
Securities Exchange Act. Thus, the Board's proposed rules will 
be filed with the SEC and published by the SEC for public 
comment; SEC approval is necessary in most cases before rules 
of the Board take effect, and the SEC may itself abrogate or 
amend Board rules (as well as disapprove proposed Board rules). 
(Transitional rules are to be separately approved by the SEC at 
the time of the SEC's determination that the Board is ready to 
begin operation.) Disciplinary sanctions imposed by the Board 
are subject to SEC review and may be canceled or modified (or 
in some cases enhanced) by the SEC. The SEC can relieve the 
Board of any responsibility to enforce any provision of the 
bill, or censure or limit operations of the Board, or remove a 
Board member, for cause. Finally, the bill makes clear that any 
violations of its terms will constitute a violation of the 
Securities Exchange Act itself for purposes of the SEC's 
enforcement (including injunctive and cease-and-desist) 
authority under that Act, so that the SEC may proceed under the 
bill's provisions directly if appropriate.

H. Accounting principles

    Since 1973, the SEC has generally required public companies 
operating in the United States to prepare their financial 
statements in accordance with ``principles, standards, and 
practices'' promulgated by the Financial Accounting Standards 
Board (the ``FASB'') in the absence of specific SEC 
pronouncements on particular accounting questions.\20\ The bill 
seeks to formalize the SEC's reliance on the FASB and, as 
discussed below, to strengthen the independence of the FASB by 
assuring its funding and eliminating any need for it to seek 
contributions from accounting firms or companies whose 
financial statements must conform to FASB's rules. Thus, the 
bill amends the Securities Act of 1933 specifically to allow 
the SEC to recognize as ``generally accepted'' (for securities 
law purposes) accounting principles established by a private 
entity that is funded as outlined in the bill (described below) 
and that has adopted procedures (including acting by majority 
vote) to ensure prompt consideration of necessary changes to 
the body of accounting principles.
---------------------------------------------------------------------------
    \20\ Accounting Series Release No. 150, 3 SEC Dock. 275 (1973).
---------------------------------------------------------------------------
    An important issue presented to the Committee was the 
potential difference between an accounting regime that contains 
detailed rules for the treatment of particular items, and a 
regime that simply outlines general concepts (or 
``principles'') to be applied to particular items. Witnesses 
noted the possibility that the overly-detailed approach of U.S. 
standard-setters may have delayed updating of necessary 
guidance and at the same time drawn the focus of auditors away 
from the overriding principle that a set of financial 
statements, taken as a whole, must fairly and completely 
reflect the economic results and operations of the company 
being audited. To allow more careful consideration of the 
differences between various formulations of accounting 
standards, the bill requires the Commission to conduct a study, 
within 12 months, of the adoption by the U.S. financial 
reporting system of a principles-based accounting system.

I. Funding

    The Committee's witnesses overwhelmingly agreed that both 
the Board and the FASB required guaranteed sources of funding, 
in order to protect their independence. Several witnesses 
testified to the problems various attempts at oversight of 
auditors had encountered when voluntary funding was withheld. 
With respect to the FASB, Michael Sutton, a former SEC Chief 
Accountant, testified to the Committee that ``[t]o restore 
confidence in our standards setters, we should take immediate 
steps to secure independent funding for the FASB--funding that 
does not depend on contributions from constituents that have a 
stake in the outcome of the process.'' \21\
---------------------------------------------------------------------------
    \21\ Testimony of Michael Sutton, former SEC Chief Accountant 
(1995-98), before the Committee on February 26, 2002.
---------------------------------------------------------------------------
    Under the bill, public companies are required to pay 
``accounting support fees'' to support the annual budgets of 
the Board and the FASB. (The Board's budget will be subject to 
approval by the SEC.) Amounts payable by public companies to 
either body will generally be allocated among those companies 
based on relative average annual monthly market capitalization 
for the 12 months prior to the year to which the support fee 
relates; both the Board and the FASB are permitted to 
differentiate among various classes of public companies in 
allocating fees.

                     TITLE II--AUDITOR INDEPENDENCE

    The issue of auditor independence is at the center of this 
legislation. Public confidence in the integrity of financial 
statements of publicly-traded companies is based on belief in 
the independence of the auditor from the audit client. As noted 
above, each of the country's federal securities laws requires 
comprehensive financial statements that must be prepared, in 
the words of the Securities Act of 1933, by ``an independent 
public or certified accountant.''
    The statutory independent audit requirement has two sides. 
It grants a franchise to the nation's public accountants--their 
services, and only their services, and certification, must be 
secured before an issuer of securities can go to market, have 
the securities listed on the nation's stock exchanges, or 
comply with the reporting requirements of the securities laws. 
This is a source of significant private benefit to the public 
accountants.
    But the franchise is conditional. It comes in return for 
the CPA's assumption of a public duty and obligation. As a 
unanimous Supreme Court noted nearly 20 years ago: ``In 
certifying the public reports that collectively depict a 
corporation's financial status, the independent auditor assumes 
a public responsibility. * * * [That auditor] owes ultimate 
allegiance to the corporation's creditors and stockholders, as 
well as to the investing public. This `public watchdog' 
function demands that the accountant maintain total 
independence from the client at all times and requires complete 
fidelity to the public trust.'' United States v. Arthur Young, 
465 U.S. 805, 817-18 (1984) (emphasis added).
    Richard Breeden, Chairman of the SEC from 1989-93, put it 
succinctly in testimonybefore the Committee:

          While companies in the U.S. do not have to employ a 
        law firm, an underwriter, or other types of 
        professionals, federal law requires a publicly-traded 
        company to hire an independent accounting firm to 
        perform an annual audit. In addition to this shared 
        federal monopoly, more than a hundred million investors 
        in the U.S. depend on audited financial statements to 
        make investment decisions. This imbues accounting firms 
        with a high level of public trust, and also explains 
        why there is a strong federal interest in how well the 
        accounting system functions. \22\
---------------------------------------------------------------------------
    \22\ Testimony of Richard Breeden, former SEC Chairman (1989-93), 
before the Committee on February 12, 2002.

    There is arguably an inherent conflict in the fact that an 
auditor is paid by the company for which the audit is being 
performed. That conflict is implicit in the relationship 
between the auditor and the audit client. In the last 15 years, 
however, the rapid growth in management consulting services 
offered by the major accounting firms has created a second, 
more substantial conflict that has eroded the independence that 
the auditor must bring to the audit function.
    According to the SEC, 55 percent of the average revenue of 
the big five accounting firms came from accounting and auditing 
services in 1988. Twenty-two percent of the average revenue 
came from management consulting services. By 1999, those 
figures had fallen to 31 percent for accounting and auditing 
services, and risen to 50 percent for management consulting 
services. Recent data reported to the SEC showed on average 
public accounting firms' non-audit fees comprised 73 percent of 
their total fees, or $2.69 in non-audit fees for every $1.00 in 
audit fees. At the same time, the frequency of financial 
restatements by public companies has dramatically increased. 
From 1990-97, the number of public company financial 
restatements averaged 49 per year, but jumped to an average of 
150 per year in 1999 and 2000.
    For these reasons, the bill includes a number of provisions 
directed to the issue of auditor independence.

A. Services outside the scope of practice of auditors

    A number of the witnesses who testified before the 
Committee during the course of the hearings, as well as other 
informed observers, argued that the growth in the non-audit 
consulting business done by the large accounting firms for 
their audit clients has so compromised the independence of the 
audits that a complete prohibition is required on the provision 
of consulting services by accounting firms to their audit 
clients.
    Perhaps the strongest advocates of this view have been the 
managers of large pension funds who are entrusted with people's 
retirement savings. James E. Burton, Chief Executive Officer of 
the California Public Employees' Retirement System (CalPERS), 
which manages pension and health benefits for more than 1.3 
million members with aggregate holdings totaling almost $150 
billion, has stated: ``We believe that the inherent conflicts 
created when an external auditor is simultaneously receiving 
fees from a company for non-audit work cannot be remedied by 
anything less than a bright-line ban. An accounting firm should 
be an auditor or a consultant, but not both to the same 
client.'' \23\
---------------------------------------------------------------------------
    \23\ Letter from James E. Burton, Chief Executive Officer, 
California Public Employees' Retirement System (CalPERS), to Chairman 
Paul S. Sarbanes, June 26, 2002.
---------------------------------------------------------------------------
    John Biggs is Chairman of Teachers Insurance and Annuity 
Association--College Retirement Equities Fund (TIAA-CREF), the 
largest private pension system in the world providing pensions 
and other financial products to the education and research 
community. TIAA-CREF manages approximately $275 billion in 
pension assets for over 2 million participants. Mr. Biggs has 
stated:

          Another critical element in reforming audit practices 
        is a bright line division between audit and consulting 
        functions. We believe such separation will help restore 
        public trust in corporate financial statements. For 
        example, TIAA-CREF does not allow our public audit firm 
        to provide any consulting services to us, and our 
        policy even bars our auditor from providing tax 
        services. * * *
          Our long-term policy has served us well in assuring 
        the independence of our auditors. Because auditors owe 
        their primary duty to the shareholders, questions about 
        the primacy of that duty are raised if the audit firm 
        provides other, potentially more lucrative, consulting 
        services to the company. The board and the public 
        auditor should both see to it that, in fact as well as 
        in appearance, the auditor reports to the independent 
        board audit committee and acts on behalf of 
        shareholders. The key reason why awarding consulting 
        contracts and other non-audit work to the audit firm is 
        troubling is because it results in conflicting 
        loyalties. While the board's audit committee is 
        formally responsible for hiring and firing the outside 
        auditor, management controls virtually all the other 
        types of non-audit work the audit firm may do for the 
        company. Those contracts with management blur the 
        reporting relationship--it is difficult to believe that 
        auditors do not feel pressure for the overall success 
        of their firm with the client. Even their own 
        compensation packages may be tied to consulting and 
        non-audit services being provided by their firm to the 
        company. * * *
          Congress has a clear mandate from the shareholders 
        and the general public to act strongly and swiftly. By 
        requiring public companies to use different accounting 
        firms for their audit and consulting services and by 
        establishing an independent board with real authority 
        to oversee the accounting profession you will be taking 
        important steps toward reversing the crisis of 
        confidence in financial markets that exists today. \24\
---------------------------------------------------------------------------
    \24\ Letter from John H. Biggs, Chairman, President and CEO, 
Teachers' Insurance and Annuity Association--College Retirement 
Equities Fund (TIAA-CREF), to Chairman Paul S. Sarbanes, June 28, 2002.

    In addition, respected former corporate leaders and former 
public officials endorsed this approach. For example, John 
Whitehead, former Co-Chairman of Goldman Sachs and former Co-
Chairman of the Blue Ribbon Committee on Improving the 
Effectiveness of Corporate Audit Committees, told the 
---------------------------------------------------------------------------
Committee:

          I have reached the conclusion that the accounting 
        firm that does the audit should not do other advisory 
        work for the company. Without that, the independence of 
        the auditor's work will always be suspect. I reach that 
        decision reluctantly but I don't see that it is 
        possible to restore public confidence in the 
        independence of the auditors without it. \25\
---------------------------------------------------------------------------
    \25\ Testimony of John C. Whitehead, former Co-Chairman, Goldman 
Sachs & Co., and former Deputy Secretary of State, before the Committee 
on March 19, 2002.

    Walter Schuetze, a former SEC Chief Accountant (who is also 
a former Big 8 accounting firm partner and an original member 
of the FASB), stated, ``I would support a complete separation 
and allow the audit firm to provide only audit services to the 
audit client. No other services whatsoever.'' \26\ Former SEC 
Chairman Harold Williams also suggested that a complete ban on 
consulting services be considered for audit clients of 
accounting firms. \27\
---------------------------------------------------------------------------
    \26\ Testimony of Walter P. Schuetze, former SEC Chief Accountant 
(1992-95), before the Committee on February 26, 2002.
    \27\ Williams Testimony, February 12, 2002.
---------------------------------------------------------------------------
    The Committee considered adopting a complete prohibition on 
non-audit services by accounting firms for their audit clients, 
but instead decided on a somewhat more flexible approach. The 
approach adopted by the Committee is supported by former 
Comptroller General Bowsher, former SEC Chairman Arthur Levitt, 
and former Federal Reserve Board Chairman Paul Volcker. \28\
---------------------------------------------------------------------------
    \28\ Bowsher Testimony, March 19, 2002; Levitt Testimony, February 
12, 2002; Volcker Testimony, February 14, 2002.
---------------------------------------------------------------------------
    The bill provides that it shall be unlawful for a public 
accounting firm registered with the Board which performs an 
audit for a public company to provide, contemporaneously with 
the audit, the following non-audit services:
          (1) bookkeeping or other services related to the 
        accounting records or financial statements of the audit 
        client;
          (2) financial information systems design and 
        implementation;
          (3) appraisal or valuation services, fairness 
        opinions, or contribution-in-kind reports;
          (4) actuarial services;
          (5) internal audit outsourcing services;
          (6) management functions or human resources;
          (7) broker or dealer, investment adviser, or 
        investment banking services;
          (8) legal services and expert services unrelated to 
        the audit; and
          (9) any other services that the Board determines, by 
        regulation, is impermissible.
    The Board may, on a case-by-case basis, exempt any person, 
issuer, public accounting firm, or transaction from the 
prohibition on the provision of non-audit services to the 
extent that such exemption is necessary or appropriate in the 
public interest and is consistent with the protection of 
investors. A registered public accounting firm may engage in 
any non-audit service, including tax services, that is not on 
the list for an audit client only if the activity is approved 
in advance by the audit committee of the issuer. No limitations 
are placed on accounting firms in providing non-audit services 
to public companies which they do not audit or to any non-
public companies.
    The need for this provision was clearly stated by David M. 
Walker, Comptroller General of the United States, in a 
statement he released on June 18, in which he said:

          I believe that legislation that will provide a 
        framework and guidance for the SEC to use in setting 
        independence standards for public company audits is 
        needed. History has shown that the AICPA [American 
        Institute of Certified Public Accountants] and the SEC 
        have failed to update their independence standards in a 
        timely fashion and that past updates have not 
        adequately protected the public's interests. In 
        addition, the accounting profession has placed too much 
        emphasis on growing non-audit fees and not enough 
        emphasis on modernizing the auditing profession for the 
        21st century environment. Congress is the proper body 
        to promulgate a framework for the SEC to use in 
        connection with independence related regulatory and 
        enforcement actions in order to help ensure confidence 
        in financial reporting and safeguard investors and the 
        public's interests.
          The independence provision [of the bill] * * * 
        strikes a reasoned and reasonable balance that will 
        enable auditors to perform a range of non-audit 
        services for their audit clients and an unlimited range 
        of non-audit services for their non-audit clients. Most 
        importantly, the proposed legislation adopts a 
        ``principle based'' and ``substance over form'' 
        approach that can stand the test of time and, if 
        adopted, will better protect the public's interests. In 
        my opinion, the time to act on independence legislation 
        is now. \29\
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    \29\ Statement of David Walker, Comptroller General of the United 
States, June 18, 2002.

    Some argue that standards for auditor independence should 
be left to the SEC and the new Board. The approach adopted by 
the bill reflects the Committee's belief that the issue of 
auditor independence is so fundamental to the problems 
currently being experienced in our financial markets that 
statutory standards are needed to assure the independence of 
the auditor from the audit client.
    The intention of this provision is to draw a clear line 
around a limited list of non-audit services that accounting 
firms may not provide to public company audit clients because 
their doing so creates a fundamental conflict of interest for 
the accounting firms. The list is based on simple principles. 
An accounting firm, in order to be independent of its audit 
client, should not audit its own work, which would be involved 
in providing bookkeeping services, financial information 
systems design, appraisal or valuation services, actuarial 
services, and internal audit outsourcing services to an audit 
client. The accounting firm should not function as part of 
management or as an employee of the audit client, which would 
be required if the accounting firm provides human resources 
services such as recruiting, hiring, and designing compensation 
packages for the officers, directors, and managers of an audit 
client. The accounting firm should not act as an advocate of 
the audit client, which would be involved in providing legal 
and expert services to an audit client in legal, 
administrative, or regulatory proceedings, or serving as a 
broker-dealer, investment adviser, or investment banker to an 
audit client, which places the auditor in the role of promoting 
a client's stock or other interests.
    The accounting industry itself has announced voluntarily 
that it will not provide two of these non-audit services--
internal audit services and financial information systems 
design and implementation--to public company audit clients 
because of the conflicts they present. The other prohibited 
non-audit services also pose clear conflicts of interest for 
accounting firms when provided for audit clients. For example, 
in its oversight hearing earlier this year on the failure of 
Superior Bank, FSB, in Hinsdale, Illinois, the Committee 
learned first-hand the risks associated with allowing 
accounting firms to audit their own work. \30\ In that case, 
the accounting firm audited and certified a valuation of risky 
residual assets calculated according to a methodology it had 
provided as a consultant. The valuation was excessive and led 
to the failure of the institution.
---------------------------------------------------------------------------
    \30\ ``Analysis of the Failure of Superior Bank, FSB, Hinsdale, 
Illinois,'' Hearing before the Senate Committee on Banking, Housing, 
and Urban Affairs, February 7, 2002.
---------------------------------------------------------------------------
    The Board is given authority to make case-by-case 
exemptions in instances where the Board believes an exemption 
is in the public interest and consistent with the protection of 
investors. Further, no limitations are placed on accounting 
firms in providing non-audit services to public companies that 
they do not audit or to any private companies. The purpose is 
to assure the independence of the audit, not to put an end to 
the provision of non-audit services by accounting firms.
    In summary, the bill adopts a strong, balanced approach to 
assure that in return for the significant private benefits 
conferred on accounting firms by our securities laws, they 
maintain their independence from the companies they audit and 
fulfill their ``public trust.''

B. Audit committee pre-approval of audit and non-audit services

    The legislation requires that audit services, as well as 
non-audit services other than those proscribed by the bill, 
must be pre-approved by the audit committee of the public 
company's board of directors. The Committee heard testimony on 
the role that the audit committee of a public company should 
play in connection with the engagement of an auditor to provide 
audit and non-audit services contemporaneously. Michael Sutton, 
former Chief Accountant of the SEC, said, ``Whatever non-audit 
services might be permitted, I think they should be permitted 
only with the approval of the audit committee.'' \31\ Former 
SEC Commissioner Bevis Longstreth told the Committee:
---------------------------------------------------------------------------
    \31\ Sutton Testimony, February 26, 2002.

          I suggest a simple exclusionary rule covering 
        virtually all non-auditservices, in place of the deeply 
complex, existing rule that I hope, by now, to have convinced you is 
ineffective. This rule would redefine the category of services to be 
barred as including everything other than the work involved in 
performing an audit and other work that is integral to the function of 
the audit. Use of such an exception should require at least the 
following: (a) Before any such service is rendered, a finding by the 
client's audit committee that special circumstances make it obvious 
that the best interests of the company and its shareholders will be 
served by retaining its audit firm to render such service and that no 
other vendor of such service can serve those interests as well; (b) 
Forthwith upon the making of such a finding, submission of a written 
copy thereof to the SEC and the SRO having jurisdiction over the 
profession; and (c) In the company's next proxy statement for election 
of directors, disclosure of such finding by the audit committee and the 
amount paid and expected to be paid to the auditor for such 
service.\32\
---------------------------------------------------------------------------
    \32\ Longstreth Testimony, March 6, 2002.

    After studying this issue, the Committee believes the 
protection of investors warrants a requirement that a public 
company's audit committee approve in advance the services that 
the auditor will provide to such company (if those services are 
not explicitly prohibited under the bill). Accordingly, the 
bill requires the audit committee of a public company to pre-
approve all of the services, both audit and non-audit, provided 
to that company by a registered public accounting firm. The 
bill does not require an issuer's audit committee to pre-
approve non-audit services provided by an accounting firm that 
is not auditing the issuer.
    The bill does not require the audit committee to make a 
particular finding in order to pre-approve an activity. The 
members of the audit committee shall vote consistent with the 
standards they determine to be appropriate in light of their 
fiduciary responsibilities and such other considerations they 
deem to be relevant.
    The audit committee must pre-approve a non-audit service 
before it commences. The audit committee may pre-approve at any 
time in advance of the activity. For example, an audit 
committee may grant pre-approval at its March meeting for a 
non-audit service that would begin in August. However, the 
Commission or the Board under its general authority may specify 
a maximum period of time in advance of which the approval may 
not be granted, such as, for example, requiring the pre-
approval to be granted no earlier than one year prior to the 
commencement of the service.
    The bill does not limit the number of non-audit services 
that the audit committee may pre-approve at one meeting or 
occasion. The Committee intends, however, that each non-audit 
service be specifically identified in order to be approved by 
the audit committee. The Committee does not intend for the 
statutory requirement to be satisfied by an audit committee 
voting, for example, to permit ``any service that management 
determines appropriate for the auditor to perform'' or ``all 
non-audit services permissible under law.''
    The Committee has chosen to offer audit committees a 
delegation option in their administration of the pre-approval 
requirement. The bill permits the audit committee to delegate 
to one or more of its members (who are members of the board of 
directors) the authority to pre-approve non-audit services. 
After a delegated member has granted a pre-approval, he or she 
is required to report the decision at the next meeting of the 
full audit committee. This delegation of authority may be 
useful where, for example, the audit committee is asked to 
determine whether or not to permit the issuer's auditor to 
perform a new non-audit service within a short period of time.
    The Committee has taken into account the atypical 
circumstance where an auditor is providing to the issuer a 
service that was anticipated to be an audit service within the 
scope of the engagement, but is later discovered to be a non-
audit service. The bill provides that the pre-approval 
requirement is waived with respect to a non-audit service if: 
(1) the service was not recognized by the issuer at the time of 
the audit engagement to be a non-audit service, (2) the 
aggregate amount paid for all services described in (1) is not 
more than 5 percent of the total amount of revenues paid by the 
issuer to the auditor, and (3) the service is promptly brought 
to the attention of the audit committee, and (4) the audit 
committee approves the activity prior to the conclusion of the 
audit. This post-approval may be granted by the entire audit 
committee or by one or more audit committee members (who are 
members of the board of directors) to whom authority to grant 
such approvals has been delegated by the audit committee. This 
flexibility was suggested by Senator Enzi.
    The bill requires that the audit committee approvals be 
disclosed to investors in periodic reports filed with the 
Commission.
    The bill specifically notes that audit services ``may 
entail providing comfort letters in connection with securities 
underwriting'' in order to make clear that providing such a 
comfort letter is an audit service.

C. Audit partner rotation

    The Committee heard testimony from numerous witnesses on 
whether, in order to maintain the objectivity of its audits, an 
issuer should be required to rotate its audit firm after a 
number of consecutive years. For example, former SEC Chairman 
Arthur Levitt proposed ``that serious consideration be given to 
requiring companies to change their audit firm--not just the 
partners--every 5-7 years to ensure that fresh and skeptical 
eyes are always looking at the numbers.'' \33\ Former SEC 
Chairman Harold Williams recommended a requirement that issuers 
``[h]ire auditors with a fixed term with no right to terminate 
for five or seven years.'' \34\ John Whitehead, former Co-
Chairman, Goldman Sachs & Co., recommended requiring ``[t]erm 
limits of 8 to 10 years.'' \35\ Lynn Turner, former SEC Chief 
Accountant, recommended requiring ``mandatory rotation (5 to 7 
years).'' \36\
---------------------------------------------------------------------------
    \33\ Levitt Testimony, on February 12, 2002.
    \34\ Williams Testimony, February 12, 2002.
    \35\ Whitehead Testimony, March 19, 2002.
    \36\ Testimony of Lynn Turner, former SEC Chief Accountant (1998-
2001), before the Committee on February 26, 2002.
---------------------------------------------------------------------------
    Other witnesses felt that accounting firm rotation could be 
disruptive to the issuer and that the costs of mandatory 
rotation might outweigh the benefits. Former SEC Chairman Rod 
Hills said that ``[f]orcing a change of auditors can only lower 
the quality of audits and increase their costs.'' \37\ Shaun 
O'Malley, Chairman, 2000 Public Oversight Board Panel on Audit 
Effectiveness, said that ``forcing issuers to change auditors 
every few years * * * would undermine audit effectiveness.'' 
\38\
---------------------------------------------------------------------------
    \37\ Testimony of Roderick M. Hills, former SEC Chairman (1975-77), 
before the Committee on February 12, 2002.
    \38\ O'Malley Testimony, March 6, 2002.
---------------------------------------------------------------------------
    The Committee determined that the possibility of requiring 
audit firm rotation merits further study. The bill directs the 
U.S. General Accounting Office (``GAO'') to analyze the merits 
and potential effects of requiring mandatory rotation of 
auditors, and to report its analysis to Congress within one 
year.
    While the bill does not require issuers to rotate their 
accounting firms, the Committee recognizes the strong benefits 
that accrue for the issuer and its shareholders when a new 
accountant ``with fresh and skeptical eyes'' evaluates the 
issuer periodically. Accordingly, the bill requires a 
registered public accounting firm to rotate its lead partner 
and its review partner on audits so that neither role is 
performed by the same accountant for the same issuer for more 
than five consecutive years. \39\
---------------------------------------------------------------------------
    \39\ The ``lead'' partner is the partner who is in charge of the 
audit engagement. The ``review'' partner refers to the outside partner 
brought in to review the work done by the lead partner and the audit 
team.
---------------------------------------------------------------------------

D. Disclosures of accounting issues.

    The Committee believes that it is important for the audit 
committee to be aware of key assumptions underlying a company's 
financial statements and of disagreements that the auditor has 
with management. The audit committee should be informed in a 
timely manner of such disagreements, so that it can 
independently review them and intervene if it chooses to do so 
in order to assure the integrity of the audit.
    Accordingly, the bill requires a registered independent 
public accounting firm performing an audit for a public company 
to report in a timely manner to that company's audit committee 
(1) the critical accounting policies and practices to be used; 
(2) all alternative treatments of financial information within 
GAAP (generally accepted accounting principles) that have been 
discussed with management; (3) any accounting disagreements 
between the auditor and management; and (4) other material 
written communications between the auditor and management.

E. Cooling off period

    The Committee received extensive testimony on whether to 
impose a cooling off period between an accountant's employment 
by an auditor and his or her employment by an issuer. Several 
witnesses advocated this requirement, in order to enhance the 
integrity of an audit. Former Comptroller General Bowsher 
recommended to the Committee that ``[e]ngagement and other 
partners who are associated with an audit should be prohibited 
from taking employment with the affected firm until a two-year 
`cooling off' period has expired.'' \40\ Lynn Turner, former 
SEC Chief Accountant, said, ``Cooling off periods should last 
two years. Close the door between the audit firm, its partners 
and employees, and the company being audited.'' \41\ Other 
witnesses also gave testimony that ``the revolving door between 
audit firms and their audit clients'' should be closed by 
enacting a cooling off period. James E. Copeland, Jr., Chief 
Executive Officer, Deloitte & Touche LLP, opposed a cooling off 
period because of concerns that it would ``impose unwarranted 
costs on the public, the client and the profession.'' \42\
---------------------------------------------------------------------------
    \40\ Bowsher Testimony, March 19, 2002.
    \41\ Turner Testimony, February 26, 2002.
    \42\ Testimony of James E. Copeland, Jr., Chief Executive Officer, 
Deloitte & Touche LLP, before the Committee on March 14, 2002.
---------------------------------------------------------------------------
    The Committee considered various options, including 
imposing a cooling off period of one, two, or three years, and 
applying a cooling off period to all employees who worked for 
the auditor, regardless of whether they worked on the audit of 
a particular issuer and regardless of the position they would 
take with that issuer, or applying a cooling off period only to 
certain groups of employees.
    The Committee decided to impose a one-year cooling off 
period that would apply to an employee of the accounting firm 
who worked on the issuer's audit and subsequently seeks to be 
employed by that issuer in a senior management capacity. Thus, 
the bill provides that an accounting firm may not provide audit 
services for a public company if that company's chief executive 
officer, controller, chief financial officer, chief accounting 
officer, or other individual serving in an equivalent position, 
was employed by the accounting firm during the one year before 
the start of the audit services. The cooling off period does 
not take effect if the CEO or other senior official worked for 
the auditor but did not work on the issuer's audit or if a 
member of the audit team is hired by the issuer for a position 
other than CEO, CFO, controller, chief accounting officer, or 
an equivalent position. However, if an issuer hires an 
accountant from the audit team as its CEO, for example, it 
would be required to change auditors.

F. The bill does not create state regulatory standards

    Titles I and II are designed to apply only to accounting 
firms that audit public companies. They are not designed to 
apply to audits of private companies. Nonetheless, some have 
raised the concern that the bill could lead state regulatory 
authorities to impose similar requirements for audits of 
private companies.
    The bill indicates clearly that Congress does not intend 
that state regulatory authorities should find this Act 
controlling in their regulation of non-registered accountants. 
The bill states that it is the intention of the Act that, in 
supervising non-registered accounting firms, state regulatory 
authorities should make an independent determination of the 
proper standards, and should not presume the standards applied 
by the Board under this bill to be applicable to small- and 
medium-sized non-registered accounting firms. Senators Hagel 
and Enzi proposed this provision.

                 TITLE III--B CORPORATE RESPONSIBILITY

    In further response to recent corporate failures, title III 
of the bill makes a number of changes to improve the 
responsibility of public companies for their financial 
disclosures. To that end, the bill incorporates a number of 
reform proposals made by the President on March 7, 2002. These 
reforms are supplemented with additional provisions that the 
Committee believes will improve investor protection in 
connection with the operation of public companies.
    Recent events have highlighted the failure of companies' 
internal audit committees to properly police their auditors and 
have raised awareness of the need for strong, competent audit 
committees with real authority. Several witnesses suggested 
that the Committee make changes in the role of audit committees 
in order to enhance the audit process. In response, under the 
bill, the SEC must draft rules directing national securities 
exchanges and associations to require listed companies to 
comply with a number of enumerated provisions regarding audit 
committees. The Committee believes that the bill's approach to 
strengthening audit committees will help avoid future auditing 
breakdowns.
    The bill also contains a number of provisions aimed at 
corporate management. Defects in procedures for monitoring 
financial results and controls have been blamed for recent 
corporate failures. The bill therefore requires CEOs and CFOs 
to certify their companies' financial reports, outlaws fraud 
and deception by managers in the auditing process, prevents 
CEOs and CFOs from benefitting from profits they receive as a 
result of misstatements of their company's financials,and 
facilitates the imposition of judicial bars against officers and 
directors who have violated the securities laws. Finally, title III 
includes a provision intended to prevent employees from being required 
to hold company stock in their retirement accounts while officers and 
directors are free to sell their shares.

A. Issuer audit committees

    Oversight of Auditors. Witnesses at the Committee's 
hearings suggested that the auditing process may be compromised 
when auditors view their main responsibility as serving the 
company's management rather than its full board of directors or 
its audit committee. For this reason, the bill requires audit 
committees to be directly responsible for the appointment, 
compensation, and oversight of the work of auditors, and 
requires auditors to report directly to the audit committee.
    Many witnesses testified as to the importance of these 
provisions. In particular, witnesses believed that the hiring 
and firing of the auditor should be the exclusive province of 
the audit committee. A number of witnesses emphasized that 
``audit committees [should] be solely responsible for the 
retention of accounting firms and be responsible for the fees 
paid to them.'' \43\ Sarah Teslik, Executive Director of the 
Council of Institutional Investors, told the Committee that 
``perhaps [the] single first step [Congress] should take to 
increase auditor independence is to require a listing standard 
[of the national securities exchanges and associations] that 
the audit committee of the board hire and fire the auditors,'' 
the approach taken by the bill.\44\ Additional witnesses who 
supported making the audit committee responsible for hiring and 
firing the auditors included: Robert E. Litan, Director of the 
Economic Studies Program of The Brookings Institution; Damon 
Silvers, Associate General Counsel of the AFL-CIO; and former 
U.S. Comptroller General Bowsher.\45\
---------------------------------------------------------------------------
    \43\ See, e.g., Seligman Testimony, March 5, 2002.
    \44\ Testimony of Sarah Teslik, Executive Director, Council of 
Institutional Investors, before the Committee on March 20, 2002.
    \45\ Testimony of Robert E. Litan, Director, Economic Studies 
Program, The Brookings Institution, before the Committee on March 14, 
2002; testimony of Damon Silvers, Associate General Counsel, AFL-CIO, 
before the Committee on March 20, 2002; Bowsher Testimony, March 19, 
2002.
---------------------------------------------------------------------------
    Audit Committee Member Independence. Many recent failures 
have been attributed to close ties between audit committee 
members and management. In 1998-99, the NYSE and Nasdaq 
sponsored the Blue Ribbon Committee on Improving the 
Effectiveness of Corporate Audit Committees. The Blue Ribbon 
Committee, chaired by Committee witnesses Ira Millstein and 
John Whitehead, made a number of recommendations to enhance 
audit procedures and effectiveness, including recommendations 
to increase the independence of audit committee members. Mr. 
Millstein and Mr. Whitehead, as well as Blue Ribbon Committee 
member John Biggs, testified at the hearings in support of 
adoption of the Blue Ribbon Committee's recommendations.\46\ 
Consistent with their recommendations, the bill enhances audit 
committee independence by barring audit committee members from 
accepting consulting fees or being affiliated persons of the 
issuer or the issuer's subsidiaries other than in the member's 
capacity as a member of the board of directors or any board 
committee.
---------------------------------------------------------------------------
    \46\ Testimony of Ira Millstein, Senior Partner, Weil, Gotshal & 
Manges LLP, before the Committee on February 27, 2002; Whitehead 
Testimony, March 19, 2002; Biggs Testimony, February 27, 2002.
---------------------------------------------------------------------------
    The audit committee independence provisions were supported 
by a number of witnesses in addition to Messrs. Millstein, 
Whitehead, and Biggs. Former SEC Chairman Arthur Levitt 
testified that ``as a listing condition, stock exchanges should 
require at least a majority of company boards to meet a strict 
definition of independence,'' including barring audit committee 
members from accepting consulting fees from the company.\47\ 
Former SEC Chairman Roderick M. Hills and Washington University 
School of Law Dean Seligman also recommended that Congress 
require that companies have independent audit committees.\48\ 
Former Senator Howard Metzenbaum, the Chairman of Consumer 
Federation of America, testified that lack of independence 
frequently leads audit committees to have a ``fealty to the 
management that an audit committee shouldn't have.'' \49\
---------------------------------------------------------------------------
    \47\ Levitt Testimony, February 12, 2002.
    \48\ Hills Testimony, February 12, 2002; Seligman Testimony, March 
5, 2002.
    \49\ Testimony of Howard M. Metzenbaum, Chairman, Consumer 
Federation of America, and former U.S. Senator, before the Committee on 
March 20, 2002.
---------------------------------------------------------------------------
    Additional Audit Committee Responsibilities. The bill 
contains several additional provisions regarding audit 
committees. The bill requires audit committees to have in place 
procedures to receive and address complaints regarding 
accounting, internal control, or auditing issues. Further, the 
bill includes an amendment by Senator Stabenow providing 
protection for corporate ``whistleblowers'' by specifying that 
audit committees must establish procedures for employees' 
anonymous submission of concerns regarding accounting or 
auditing matters.
    The bill also requires public companies to provide their 
audit committees with authority and funding to engage 
independent counsel and other advisers as they determine 
necessary in order to carry out their duties. Comptroller 
General Walker agreed that audit committee members must be 
``adequately resourced,'' suggesting that audit committee 
members ``may need their own staff.'' \50\
---------------------------------------------------------------------------
    \50\ Testimony of David Walker, Comptroller General of the United 
States, before the Committee on March 5, 2002.
---------------------------------------------------------------------------
    In light of recent events, the Committee believes that 
these audit committee provisions should be codified in the 
securities laws in order to help rectify auditing misconduct 
and to enhance the effectiveness of audit committee oversight 
of public company audits.

B. Corporate responsibility for financial reports

    The Committee believes that management should be held 
responsible for the financial representations of their 
companies. The bill therefore clearly establishes that CEOs and 
CFOs are responsible for the presentation of material in their 
company's financial reports. Under one of the recommendations 
put forward by the President on March 7, ``CEOs would 
personally attest each quarter that the financial statements 
and company disclosures accurately and fairly disclose the 
information of which the CEO is aware that a reasonable 
investor should have to make an informed investment decision.'' 
In effect the bill adopts this proposal, in an approach 
developed with Senator Miller, by requiring CEOs and CFOs to 
certify, in periodic reports containing financial statements 
filed with the Commission pursuant to section 13(a) or 15(d) of 
the Exchange Act, the appropriateness of financial statements 
and disclosures contained therein, and that those financials 
and disclosures fairly present the company's operations and 
financial condition.
    These provisions reflect the Committee's concern regarding 
the reliability of companies'audited financial statements. In 
his testimony before the Committee, former SEC Chairman Breeden 
recognized that there is ``growing doubt about whether audited 
financial statements are believable.'' \51\ Council of Institutional 
Investors Executive Director Sarah Teslik echoed this concern in 
testifying that ``CEOs, audit committee members and outside auditors'' 
should be required to ``sign the financials as true and accurate.'' 
\52\
---------------------------------------------------------------------------
    \51\ Breeden Testimony, on February 12, 2002.
    \52\ Teslik Testimony, March 20, 2002.
---------------------------------------------------------------------------

C. Prohibited influence

    Numerous witnesses testifying before the Committee, 
including Shaun O'Malley, Chair of the 2000 Public Oversight 
Board Panel on Audit Effectiveness, and Sarah Teslik, Council 
of Institutional Investors Executive Director, were concerned 
with addressing fraud and misconduct in the audit process.\53\ 
In response, title III of the bill makes it unlawful for any 
officer or director of an issuer, or person acting under the 
direction thereof, to fraudulently influence, coerce, 
manipulate, or mislead any accountant engaged in preparing an 
audit of that issuer, for the purpose of rendering the audit 
report misleading. The Commission is provided with exclusive 
authority to enforce this section. The bill establishes a 90-
day deadline for proposed rules or regulations by the 
Commission under this section, and a 270-day deadline for final 
rules or regulations.
---------------------------------------------------------------------------
    \53\ O'Malley Testimony, March 6, 2002; Teslik Testimony, March 20, 
2002.
---------------------------------------------------------------------------

D. Forfeiture of bonuses and profits

    Recent events have raised concern about management 
benefitting from unsound financial statements, many of which 
ultimately result in corporate restatements. The President has 
recommended that ``CEOs or other officers should not be allowed 
to profit from erroneous financial statements,'' and that ``CEO 
bonuses and other incentive-based forms of compensation 
[sh]ould be disgorged in cases of accounting restatement and 
misconduct.''
    Title III includes provisions designed to prevent CEOs or 
CFOs from making large profits by selling company stock, or 
receiving company bonuses, while management is misleading the 
public and regulators about the poor health of the company. The 
bill requires that in the case of accounting restatements that 
result from material non-compliance with SEC financial 
reporting requirements, CEOs and CFOs must disgorge bonuses and 
other incentive-based compensation and profits on stock sales, 
if the non-compliance results from misconduct. The required 
disgorgement applies to amounts received for the 12 months 
after the first public issuance or filing of a financial 
document embodying such financial reporting requirement. Under 
this section, the SEC may exempt any person from this 
requirement as it deems necessary and appropriate.

E. Officer and director bars and penalties

    Title III also includes several measures affecting officers 
and directors who have violated the securities laws. The staff 
of the Commission indicated to the Committee staff that when 
enforcement proceedings are brought under the securities laws, 
courts in some cases have been reluctant to impose prospective 
bars against violators serving as officers or directors of 
companies. The bill would facilitate not only the SEC's 
prevention of individuals who have violated the securities laws 
from serving as officers and directors, but also the imposition 
of penalties on violators of securities laws.
    Currently, it must be proved that an officer or director 
has both violated the securities laws, and has shown 
``substantial unfitness'' to serve before a bar can be imposed. 
The Commission has argued that the ``substantial unfitness'' 
standard for imposing bars is inordinately high, causing courts 
to refrain from imposing bars even in cases of egregious 
misconduct. The proposed bill rectifies this deficiency by 
modifying the standard governing imposition of officer and 
director bars from ``substantial unfitness'' to ``unfitness.''
    These provisions also reflect the President's 
recommendation that ``CEOs or other officers who clearly abuse 
their power should lose their right to serve in any corporate 
leadership positions.''
    The Commission has also suggested that it should be allowed 
to obtain additional relief in enforcement cases. For a 
securities law violation, currently an individual may be 
ordered to disgorge funds that he or she received ``as a result 
of the violation.'' Rather than limiting disgorgement to these 
gains, the bill will permit courts to impose any equitable 
relief necessary or appropriate to protect, and mitigate harm 
to, investors.

F. Prohibition on insider trades during pension fund blackout periods

    As former SEC Chairman Breeden observed, ``The spectacle of 
corporate insiders plundering their own companies or selling 
their stock quietly in advance of a looming collapse has 
awakened a sense of revulsion among investors who were left 
with worthless stock.'' \54\ In some cases, officers and 
directors have profited by selling off large portions of 
company stock during a time when employees were prevented from 
selling company stock in their section 401(k) retirement plans. 
To address this problem, the bill prohibits key individuals 
from engaging in transactions involving any equity security of 
the issuer during a ``blackout'' period when at least half of 
the issuer's individual account plan participants are not 
permitted to purchase, sell, or otherwise transfer their 
interest in that equity security. Upon Senator Miller's 
recommendation, this section applies to directors and executive 
officers in order to ensure that the prohibition is limited to 
individuals in policy-making positions.
---------------------------------------------------------------------------
    \54\ Breeden Testimony, on February 12, 2002.
---------------------------------------------------------------------------
    The bill provides added protection for participants in 
retirement plans by requiring that they be provided with 
written notice at least 30 days before a blackout period. Two 
exceptions to the 30-day notice are provided in response to 
Senator Enzi's recommendations. First, an exception is allowed 
in cases where a deferral of the blackout period to comply with 
the 30-day notice requirement would violate ERISA provisions 
that require fiduciaries to act exclusively on behalf of 
participants, and those that require trustees to act prudently, 
in their decisions regarding plan assets. Second, an exception 
may be provided where the inability to provide the notice is 
due to unforeseeable events or circumstances beyond the 
reasonable control of the plan administrator.
    The Committee is concerned that without the provisions of 
title III, our financial markets will witness numerous 
corporate restatements in the future. The Committee believes 
that title III incorporates needed reforms that will enhance 
corporate responsibility among public companies.

                TITLE IV--ENHANCED FINANCIAL DISCLOSURES

    The Committee heard testimony about the imperative 
necessity for investors to have accurate and full financial 
information available on a timely basis in order to make 
appropriate investment decisions. The Committee has identified 
certain key disclosures that require legislative action.

A. Accounting adjustments

    The bill requires that financial statements filed with the 
Commission reflect the material adjustments under GAAP that 
have been identified by the auditor.

B. Off-balance sheet transactions

    Former SEC Chairman Richard Breeden testified, after the 
problems of Enron Corp. and its special purpose entities, on 
the need for ``enhance[d] disclosure of `off-balance sheet' 
transactions and debt.'' \55\ To address this need, the bill 
requires annual and quarterly reports filed with the SEC to 
disclose all material off-balance sheet transactions, 
arrangements, obligations (including contingent obligations), 
and other relationships of the issuer with unconsolidated 
entities or other persons that may have a material current or 
future effect on financial condition, changes in financial 
condition, results of operations, liquidity, capital 
expenditures, capital resources, or significant components of 
revenues or expenses.
---------------------------------------------------------------------------
    \55\ Breeden Testimony, February 12, 2002.
---------------------------------------------------------------------------

C. Pro-forma financial disclosures

    Thomas A. Bowman, President and CEO of the Association for 
Investment Management and Research (AIMR), testified before the 
Committee on his concerns about the use of pro forma 
disclosures:

          Another creative way in which managements mislead 
        investors and manipulate investor expectations is by 
        communication of ``pro forma earnings,'' company-
        specific variations of earnings, or ``earnings before 
        the bad stuff.'' With all its deficiencies, we believe 
        that earnings data based on Generally Accepted 
        Accounting Principles (GAAP) are still the most useful 
        starting point for analysis of a company's performance. 
        Analysts and other investors at least know how GAAP 
        earnings are computed and, hence, there is some 
        comparability across companies. We believe that GAAP 
        earnings should always be displayed more prominently 
        than non-GAAP earnings data.
          Unfortunately, just the opposite seems to be the 
        norm, particularly in press releases where pro forma 
        earnings get the most emphasis and GAAP earnings may 
        not be mentioned at all. GAAP earnings and associated 
        balance sheet may only become available to investors in 
        SEC filings one to two weeks after pro forma earnings 
        are announced.
          While pro forma earnings can be helpful supplemental 
        information for analysts, the practice of providing pro 
        forma earnings is widely abused. Companies selectively 
        exclude all sorts of financial reporting items, 
        including depreciation, amortization, payroll taxes on 
        exercises of options, investment gains and losses, 
        stock compensation expenses, acquisition-related and 
        restructuring costs. John Bogle, the respected 
        investment professional, recently noted in a speech to 
        the New York Society of Securities Analysts, ``In 2001, 
        1,500 companies reported pro forma earnings, what their 
        earnings would have been if bad things hadn't 
        happened.'' We recommend that either the FASB or SEC 
        curtail this practice or ensure that pro forma earnings 
        data never have more prominence than GAAP earnings in 
        company communications.\56\
---------------------------------------------------------------------------
    \56\ Testimony of Thomas A. Bowman, President and Chief Executive 
Officer, Association for Investment Management and Research, before the 
Committee on March 20, 2002.

Former Federal Reserve Board Chairman Paul Volcker also 
testified about concerns with pro forma earnings: ``Those 
problems, building over a period of years, have now exploded in 
a sense of crisis, a crisis as exemplified by the Enron 
collapse. But Enron is not the only symptom. We've had * * * 
too many doubts about pro forma earnings.'' \57\ Dean Joel 
Seligman testified that, after taking into account current 
regulatory efforts on disclosure of pro forma figures, ``[m]ore 
needs to be done.'' \58\
---------------------------------------------------------------------------
    \57\ Volcker Testimony, February 14, 2002.
    \58\ Seligman Testimony, March 5, 2002.
---------------------------------------------------------------------------
    The Committee seeks to address problems attendant to pro 
forma financial disclosures by requiring the SEC to promulgate 
rules requiring that issuers publish pro forma data with a 
reconciliation to comparable financial data calculated 
according to GAAP and in a way that is not misleading and does 
not contain untrue statements. The reconciliation presumes, and 
would require, the issuer to publish financial data calculated 
according to GAAP at the same time as it publishes pro forma 
data. This should enable investors to, at the least, 
simultaneously compare the pro forma financial data with the 
same types of financial disclosures (e.g., earnings) calculated 
according to GAAP for the comparable reporting period.
    The Committee recognizes from the recent experience of 
Enron Corp. and other public companies the need for additional 
types of disclosures. The Committee supports public and private 
efforts that result in greater quality, clarity, and 
completeness in the disclosures made by public companies.

D. Enhanced disclosures of loans

    Enron Corp. and other corporations have made loans to 
directors and executive officers totaling many millions of 
dollars.\59\ Many of these insider loans are disclosed to 
investors in the annual proxy materials months after they 
occur.
---------------------------------------------------------------------------
    \59\ For example:
    Two of Enron's top officials who were also board members--Kenneth 
Lay and Jeffery Skilling--received personal loans from Enron. Mr. Lay 
received more than $70 million in cash during one 12-month period and 
repaid the loan with his own Enron stock. Wall Street Journal (May 3, 
2002).
    WorldCom's board extended its former chief executive, Bernard 
Ebbers, a personal loan of $366.5 million. Richard Waters, Pressure 
Forces Ebbers to Leave WorldCom, Financial Times (May 1, 2002).
    Adelphia Communications made $3.1 billion in off-balance sheet 
loans to its founder, John Rigas, reportedly without the knowledge of 
its shareholders or board. Richard Waters, Rigas Agrees to Give Up 
Adelphia, Financial Times (May 24, 2002).
    In April, Qwest revealed in its proxy statement that it lent $4 
million to President and COO Afshin Mohebbi. It was reported that a 
portion of the loan will be used to pay the premium on his life 
insurance policy. Jim Seymour, Nacchio Dip: Qwest CEO Delays His Pay 
Raise, TheStreet.com (April 9, 2002).
    Global Crossing Ltd. eliminated or substantially reduced the terms 
of $18 million worth of personal loans the company made to two of its 
top executives in the months before the telecommunications company 
filed for bankruptcy protection, regulatory filings show. Elizabeth 
Douglass, Global Eased Loan Terms Compensation: The firm forgave or 
reduced advances to executives in the months before its Chapter 11 
filing, L.A. Times (February 7, 2002).
    AES Corp., a power producer, granted $1.5 million personal loans to 
both its chief financial officer and an executive vice president in 
October to prevent them from being forced to immediately sell company 
shares due to margin calls. AES Makes Loans To Two Executives To Cover 
Margin Calls, Wall Street Journal (March 26, 2002).
---------------------------------------------------------------------------
    In his testimony, former SEC Chairman Richard Breeden 
recommended that ``immediate 8-K disclosure'' of insider loans 
be required.\60\
---------------------------------------------------------------------------
    \60\ Breeden Testimony, February 12, 2002.
---------------------------------------------------------------------------
    The Committee is aware that investors are concerned about 
loans to insiders and want to know this information promptly 
after the loans are made in order to better inform 
theirinvestment decisions. The bill requires an issuer in its current 
reports to disclose within seven days, or such other time period 
determined to be appropriate by the SEC, all loans, except credit card 
loans, made by the issuer and its affiliates to any director or 
executive officer, specifying amounts paid and balances owed on such 
obligations and any conflicts of interest, as defined by the SEC. The 
Committee created an exemption from reporting for credit card loans 
made by the issuer to a director or executive officer in the ordinary 
course of the issuer's consumer credit business, of a type generally 
made available by the issuer to the public on market terms. The bill 
gives the SEC the flexibility to shorten the period to less than seven 
days or extend it to more than seven days if it deems appropriate.
    These provisions will result in information about insider 
loans and other conflicts of interest being disclosed in a 
timely manner so investors can consider such data in making 
their investment decisions.

E. Disclosures of transactions involving management

    The Committee received testimony that insiders should be 
required to report their transactions in the stock of their 
companies more promptly. Ira Millstein, Senior Partner, Weil, 
Gotshal & Manges LLP and Co-Chair of the Blue Ribbon Committee 
on Improving the Effectiveness of Corporate Audit Committees, 
testified that, ``SEC rules should be amended to mandate prompt 
disclosure of transactions between the corporation (or its 
affiliates) and members of senior management, directors or 
controlling shareholders.'' \61\ Former Comptroller General 
Bowsher echoed this objective when he testified: ``To 
discourage conflicts of interest involving public corporations, 
Congress should amend the Securities Exchange Act of 1934 to 
require more meaningful and timely disclosure of related party 
transactions among officers, directors, or other affiliated 
persons and the public corporation.'' \62\
---------------------------------------------------------------------------
    \61\ Millstein Testimony, February 27, 2002.
    \62\ Bowsher Testimony, March 19, 2002.
---------------------------------------------------------------------------
    At present, Section 16(a) of the Exchange Act requires 
insiders to report trades by the tenth day of the month 
following the month in which the transaction was executed. The 
Committee recognizes that some investors find trades by 
insiders to be probative of whether investing in a company is 
desirable and feel that, in today's markets, the current 
deadline imposed by Section 16(a) allows too long a delay in 
reporting.
    The bill would amend Section 16(a) to require directors, 
officers and 10 percent equity holders to report their 
purchases and sales of securities more promptly, that is, by 
the end of the second day following the transaction or such 
other time established by the SEC where the two-day period is 
not feasible. The purpose is to make available to investors 
information about insider transactions more promptly so they 
can make better informed investment decisions.

F. Management assessment of internal controls

    The Committee heard testimony from former Comptroller 
General Bowsher, who recommended:

          Management of public companies should be required to 
        prepare an annual statement of compliance with internal 
        controls to be filed with the SEC. The corporation's 
        chief financial officer and chief executive officer 
        should sign this attestation and the auditor should 
        review it. An auditor's review and report on the 
        effectiveness of internal controls would--as the 
        General Accounting Office (GAO) found in a 1996 
        report--improve ``the auditor's ability to provide more 
        relevant and timely assurances on the quality of data 
        beyond that contained in traditional financial 
        statements and disclosures.'' Both the POB and the 
        AICPA supported the recommendation when the GAO made 
        it, but the SEC did not adopt it.\63\
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    \63\  Bowsher Testimony, March 19, 2002.

    In order to enhance the quality of reporting and increase 
investor confidence, the bill requires that annual reports 
filed with the SEC must be accompanied by a statement by the 
management of the issuer that management is responsible for 
creating and maintaining adequate internal controls. Management 
must also present its assessment of the effectiveness of those 
controls. A similar requirement was enacted in 1991 and has 
been imposed on depository institutions through Section 36 of 
the Federal Deposit Insurance Act.
    In addition, the company's auditor must report on and 
attest to management's assessment of the company's internal 
controls. In requiring the registered public accounting firm 
preparing the audit report to attest to and report on 
management's assessment of internal controls, the Committee 
does not intend that the auditor's evaluation be the subject of 
a separate engagement or the basis for increased charges or 
fees. High quality audits typically incorporate extensive 
internal control testing. The Committee intends that the 
auditor's assessment of the issuer's system of internal 
controls should be considered to be a core responsibility of 
the auditor and an integral part of the audit report.

G. Exemptions for investment companies

    The bill exempts investment companies from certain 
disclosure requirements. The Committee feels that the 
objectives of those disclosure sections are adequately 
addressed byexisting Federal securities laws and the rules 
thereunder affecting investment companies.
    For example, Section 17(a) of the Investment Company Act of 
1940 and Rule 17j-1 thereunder prohibit affiliated persons of 
an investment company from borrowing money or other property 
from, or selling or buying securities or other property to or 
from the investment company, or any company that the investment 
company controls. Investment company officials therefore would 
not have any insider loans to report, as would be required 
under the bill.

H. Code of ethics for senior financial officers

    The problems surrounding Enron Corp. and other public 
companies raise concerns about the ethical standards of 
corporations and their senior financial managers. The Committee 
believes that investors have a legitimate interest in knowing 
whether a public company holds its financial officers to 
certain ethical standards in their financial dealings. The bill 
requires issuers to disclose whether or not they have adopted a 
code of ethics for senior financial officers and, if not, why 
not. This section was recommended by Senator Corzine.

I. Disclosure of audit committee financial expert

    As discussed above, the Committee received testimony about 
the important role played by the audit committee in corporate 
governance. The Committee believes the effectiveness of the 
audit committee depends in part on its members' knowledge of 
and experience in auditing and financial matters. Investors may 
find it relevant in making their investment decisions whether 
an issuer's audit committee has at least one member who has 
relevant, sophisticated financial expertise with which to 
discharge his or her duties.
    The bill requires the SEC to adopt rules requiring issuers 
to disclose whether their audit committees include among their 
members at least one ``financial expert.'' In defining 
``financial expert,'' the SEC shall consider whether a person 
understands GAAP and financial statements, has experience 
preparing or auditing financial statements, has experience with 
internal accounting controls, and understands audit committee 
functions.

                 TITLE V--ANALYST CONFLICTS OF INTEREST

    The Committee heard persuasive testimony that a serious 
problem exists regarding conflicts of interest between Wall 
Street stock analysts and their employing brokerage firms, on 
the one hand, and the public companies that the stock analysts 
cover, on the other hand. Growing knowledge of these conflicts 
is harming the integrity and credibility to the public of stock 
analyst recommendations.
    The Committee heard testimony from Thomas A. Bowman, 
President and CEO of the Association for Investment Management 
and Research, who said, ``Clearly, the erosion of investor 
confidence in the independence and objectivity of `Wall Street' 
research reports and recommendations * * * could seriously harm 
the reputation of the entire investment profession.'' \64\ He 
added, ``Only if the investing public believes that the 
information available to them is fair, accurate, and 
transparent can they have confidence in the integrity of the 
financial markets and the investment professionals who serve 
them.'' \65\ He explained how ``some Wall Street firms may 
pressure their analysts to issue favorable research on current 
or prospective investment-banking clients'' and that investors 
who receive recommendations ``may not be aware of the pressures 
on Wall Street analysts.'' \66\ Former SEC Chairman Richard 
Breeden suggested as a goal that Congress ``[i]mprove 
independence of stock analyst recommendations,'' explaining 
that ``[a]nalyst recommendations should be driven by analysis 
and fundamentals, not the pursuit of investment banking 
business for their firms.'' \67\
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    \64\ Bowman Testimony, March 20, 2002.
    \65\ Bowman Testimony, March 20, 2002.
    \66\ Bowman Testimony, March 20, 2002.
    \67\ Breeden Testimony, February 12, 2002.
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    The Attorney General of the State of New York, Eliot 
Spitzer, in a letter to Chairman Sarbanes, stated, ``Problems 
in this area have existed for several years and recently appear 
to have grown worse.'' \68\ In his office's extensive 
investigation of analyst recommendations, he said he has found 
that ``research reports and stock ratings of companies that 
were potential banking clients of [a major broker-dealer] were 
often distorted to assist the firm in obtaining and retaining 
investment banking business. One management document we 
obtained actually acknowledged the conflict and its results, 
stating: `We are off base on how we rate stocks and how much we 
bend over backwards to accommodate banking, etc.' We believe 
that the lack of research independence from investment banking 
likely extends to other firms as well.'' \69\
---------------------------------------------------------------------------
    \68\ Letter from Eliot Spitzer, Attorney General of the State of 
New York, to Chairman Paul S. Sarbanes, June 5, 2002.
    \69\ Spitzer Letter, June 5, 2002.
---------------------------------------------------------------------------
    The Committee feels that it is critical to restore investor 
confidence in this area. The bill is intended to prevent 
certain pressures on analysts which could compromise their 
objectivity and to provide disclosure to investors of certain 
conflicts of interest that can also influence the objectivity 
of the analyst in preparing a research report.
    The Committee received testimony specifically demonstrating 
that conflicts of interest distort securities analysts' 
recommendations. Professor John Coffee of Columbia Law School 
told the Committee of a number of studies that sought to assess 
the impact of conflicts of interest on the objectivity of 
securities analysts' recommendations:

          Several studies find that `independent' analysts 
        (i.e., analysts not associated with the underwriter for 
        a particular issuer) behave differently than analysts 
        who are so associated with the issuer's underwriter. 
        For example, Roni Michaely and Kent Womack find that 
        the long-run performance of firms recommended by 
        analysts who are associated with an underwriter was 
        significantly worse than the performance of firms 
        recommended by independent securities analysts.* * *
          Still another study by CFO Magazine reports that 
        analysts who work for full-service investment banking 
        firms have 6% higher earnings forecasts and close to 
        25% more buy recommendations than do analysts at firms 
        without such ties. Similarly, using a sample of 2,400 
        seasoned equity offerings between 1989 and 1994, Lin 
        and McNichols find that lead and co-underwriter 
        analysts' growth forecasts and particularly their 
        recommendations are significantly more favorable than 
        those made by unaffiliated analysts.\70\
---------------------------------------------------------------------------
    \70\ Testimony of John C. Coffee, Jr., Adolf A. Berle Professor of 
Law, Columbia University Law School, before the Committee on March 5, 
2002 (internal citations omitted).

    The Committee also heard testimony on a variety of specific 
analyst conflicts and the manner in which they might be 
addressed. These conflicts included the firm's manner of 
compensating the analyst, revenues to the firm from the subject 
company, pressure and coercion from the investment banking 
staff and others on the analyst, retaliation against the 
analyst, and the analyst's or the analyst's firm's ability to 
profit from stock ownership and trading.
    Chinese Walls. Dean Joel Seligman recommended addressing 
``whether investment banks have adequately maintained `Chinese 
walls' between retail brokerage and underwriting and whether, 
more fundamentally, securities firms that underwrite should be 
separated from retail brokerage.'' \71\ The bill creates new 
Section 15A(n)(1)(C) of the Securities Exchange Act of 1934, 
which mandates rules ``to establish structural and 
institutional safeguards within registered brokers or dealers 
to assure that securities analysts are separated by appropriate 
informational partitions within the firm from the review, 
pressure, or oversight of those whose involvement in investment 
banking activities might potentially bias their judgment or 
supervision.''
---------------------------------------------------------------------------
    \71\ Seligman Testimony, March 5, 2002.
---------------------------------------------------------------------------
    Blackout Periods. Professor Coffee cited abuses involving 
the so-called ``Booster Shot'' and recommended that research 
reports not be issued during certain periods. He testified:

          Firms contemplating an IPO increasingly seek to hire 
        as lead underwriter the firm that employs the star 
        analyst in their field. The issuer's motivation is 
        fueled in large part by the fact that the issuer's 
        management almost invariably is restricted from selling 
        its own stock (by contractual agreement with the 
        underwriters) until the expiration of a lock-up period 
        that typically extends six months from the date of the 
        offering. The purpose of the lock-up agreement is to 
        assure investors that management and the controlling 
        shareholders are not ``bailing out'' of the firm by 
        means of the IPO. But as a result, the critical date 
        (and market price) for the firm's insiders is not the 
        date of the IPO (or the market value at the conclusion 
        of the IPO), but rather the expiration date of the 
        lock-up agreement six months later (and the market 
        value of the stock on that date). From the perspective 
        of the issuer's management, the role of the analyst is 
        to ``maintain a buzz'' about the stock and create a 
        price momentum that peaks just before the lock-up's 
        expiration. To do this, the analyst may issue a 
        favorable research report just before the lock-up's 
        expiration (a so-called ``booster shot'' in the 
        vernacular). To the extent that favorable ratings 
        issued at this point seem particularly conflicted and 
        suspect, an NASD rule might forbid analysts associated 
        with underwriters from issuing research reports for a 
        reasonable period (say, thirty days) both before and 
        after the lock-up expiration date. Proposed Rule 2711 
        [of the NASD] stops well short of this and only extends 
        the ``quiet period'' so that it now would preclude 
        research reports for this first 40 days after an IPO. 
        Such a limited rule in no way interferes with the 
        dubious tactic of ``booster shots.'' \72\
---------------------------------------------------------------------------
    \72\ Coffee Testimony, March 5, 2002 (internal citations omitted).

    The bill directs that rules be adopted ``to define periods 
during which brokers or dealers who have participated, or are 
to participate, in a public offering of securities as 
underwriters or dealers should not publish or otherwise 
distribute research reports relating to such securities or to 
the issuer of such securities.'' The ``booster shot'' is a type 
of situation that the SEC and the self-regulatory organizations 
should consider in framing such rules.
    Services Provided. Mr. Bowman recommended disclosure of 
``the nature of the relationship or services provided'' by an 
analyst's firm to the subject company.\73\ The bill requires 
disclosure of the types of services provided.
---------------------------------------------------------------------------
    \73\ Bowman Testimony, March 20, 2002.
---------------------------------------------------------------------------
    Supervision by Investment Bankers and Disclosure of 
Investment Banking Relationships. Michael Mayo, Managing 
Director of Prudential Securities, recommended that Congress 
``[t]ake actions to minimize the interference of investment 
bankers with the job of research analysts'' and ``[d]isclose 
investment banking relationships to investors.'' \74\ The bill 
prohibits the pre-publication clearance of research or 
recommendations by investment banking or other staff not 
directly responsible for investment research and requires 
disclosure of whether the issuer is or has recently been a 
client of the analyst's firm, and if so, the services provided.
---------------------------------------------------------------------------
    \74\ Testimony of Michael Mayo, Managing Director, Prudential 
Securities, Inc., before the Committee on March 19, 2002.
---------------------------------------------------------------------------
    Lynn Turner, former SEC Chief Accountant, testified: ``As 
long as the investment-banking arm of Wall Street has influence 
over the work of the research analysts or their compensation, 
analysts will not be able to provide independent research.'' 
\75\ The bill requires the creation of rules that limit the 
supervision and compensatory evaluation of research personnel 
to officials who are not engaged in investment banking 
activities.
---------------------------------------------------------------------------
    \75\ Turner Testimony, February 26, 2002.
---------------------------------------------------------------------------
    Compensation from the Subject Firm to the Broker and Deal-
Based Analyst Pay. Mr. Mayo raised the concern, ``Does the 
retail investor know that the brokerage firm pitching shares is 
also earning investment banking fees from the company?'' and 
also recommended that the Congress ``eliminate deal-based 
incentive pay'' for research analysts.\76\ The bill requires 
disclosure of whether any compensation has been received by the 
broker-dealer from the issuer, subject to such exemptions as 
the Commission may determine necessary and appropriate to 
prevent disclosure of material non-public information regarding 
specific potential future investment banking transactions of 
such issuer, as is appropriate in the public interest and 
consistent with the protection of investors. The bill, while 
not eliminating deal-based pay, requires disclosure of whether 
the analyst received compensation based on an affiliate's 
investment banking revenues from the subject of any research 
report.
---------------------------------------------------------------------------
    \76\ Mayo Testimony, March 19, 2002.
---------------------------------------------------------------------------
    Retaliation. The Committee heard testimony about the 
serious problem of retaliation against analysts who wrote 
negative research reports. Professor Coffee testified, ``In 
self-reporting studies, securities analysts report that they 
are frequently pressured to make positive buy recommendations 
or at least to temper negative opinions.'' \77\ He added, 
``According to one survey, 61% of all analysts have experienced 
retaliation--threats of dismissal, salary reduction, etc.--as 
the result of negative research reports. Clearly, negative 
research reports (and ratings reductions) are hazardous to an 
analyst's career. Congress could either adopt, or instruct the 
NASD to adopt, an anti-retaliation rule: no analyst should be 
fired, demoted, or economically penalized for issuing a 
negative report, downgrading a rating, or reducing an earnings, 
price, or similar target.'' \78\
---------------------------------------------------------------------------
    \77\ Coffee Testimony, March 5, 2002.
    \78\ Coffee Testimony, March 5, 2002 (internal citations omitted).
---------------------------------------------------------------------------
    Eliot Spitzer, Attorney General of the State of New York, 
concluded that the analyst conflict regulations put forth by 
the self-regulatory organizations ``fall short of what should 
be legislated in this area [because], [f]or example, the 
regulations fail to address the problem of intimidation or 
retaliation against analysts who publish unfavorable research 
about a company.'' \79\
---------------------------------------------------------------------------
    \79\ Spitzer Letter, June 5, 2002.
---------------------------------------------------------------------------
    The bill requires rules to be promulgated to protect 
securities analysts from retaliation or intimidation because of 
negative, or otherwise unfavorable, research reports, subject 
to the proviso that such rules may not limit a broker-dealer 
from disciplining a securities analyst in accordance with firm 
policies and procedures for causes other than writing such a 
research report.
    Professor Coffee recommended that a no-retaliation rule 
should:

        not bar staff reductions or reduced bonuses based on 
        economic downturns or individualized performance 
        assessments. Thus, given the obvious possibility that 
        the firm could reduce an analyst's compensation in 
        retaliation for a negative report, but describe its 
        action as based on an adverse performance review of the 
        individual, how can this rule be made enforceable? The 
        best answer may be NASD arbitration. That is, an 
        employee who felt that he or she had been wrongfully 
        terminated or that his or her salary had been reduced 
        in retaliation for a negative research report could use 
        the already existing system of NASD employee 
        arbitration to attempt to reverse the decision. 
        Congress could also establish the burden of proof in 
        such litigation and place it on the firm, rather than 
        the employee/analyst. Further, Congress could entitle 
        the employee to some form of treble damages or other 
        punitive award to make this form of litigation viable. 
        Finally, Congress could mandate an NASD penalty if 
        retaliation were found, either by an NASD arbitration 
        panel or in an NASD disciplinary proceeding.\80\
---------------------------------------------------------------------------
    \80\ Coffee Testimony, March 5, 2002.

    The exception is intended to make certain that writing a 
negative research report does not protect an analyst who is, 
for example, incompetent or otherwise deficient. However, it is 
not intended to be used to permit a broker-dealer to discipline 
a good analyst for writing a negative report using a false 
pretext. In adopting a proposed rule, the SEC or a self-
regulatory organization should consider Professor Coffee's 
recommendations.
    Additional Analyst Issues. The Committee heard testimony 
about various additional concerns and recommendations to 
prevent analyst conflicts of interest and otherwise enhance 
investor protection, some of which are discussed below.
    Professor Coffee recommended ``A No-Selling Rule.'' He 
testified:

          If we wish the analyst to be a more neutral and 
        objective umpire, one logical step might be to preclude 
        the analyst from direct involvement in selling 
        activities. For example, it is today standard for the 
        ``star'' analyst to participate in ``road shows'' 
        managed by the lead underwriters, presenting its highly 
        favorable evaluation of the issuer and even meeting on 
        a one-to-one basis with important institutional 
        investors. Such sales activity seems inconsistent with 
        the much-cited ``Chinese Wall'' between investment 
        banking and investment research * * *.
          Although a ``no-selling'' rule would do much to 
        restore the objectivity of the analyst's role, one 
        counter-consideration is that the audience at the road 
        show is today limited to institutions and high net 
        worth individuals. Hence, there is less danger that the 
        analyst will overreach unsophisticated retail 
        investors. For all these reasons, this is an area where 
        a more nuanced rule could be drafted by the NASD at the 
        direction of Congress that would be preferable to a 
        legislative command.\81\
---------------------------------------------------------------------------
    \81\ Coffee Testimony, March 5, 2002.

    Dean Joel Seligman also recommended considering ``a new 
form of adviser liability for recommendations without a 
reasonable basis.'' \82\
---------------------------------------------------------------------------
    \82\ Seligman Testimony, March 5, 2002.
---------------------------------------------------------------------------
    Mr. Bowman recommended disclosure of ``[i]nvestment 
holdings of Wall Street analysts, their immediate families, the 
Wall Street firm's management and the firms themselves'' as 
well as disclosure of ``[m]aterial gifts received by the 
analyst from either the subject company or the Wall Street 
firm's investment-banking or corporate finance department.'' 
\83\
---------------------------------------------------------------------------
    \83\ Bowman Testimony, March 20, 2002.
---------------------------------------------------------------------------
    Mr. Bowman explained the need for greater explanatory 
information about analysts' rating systems. He said that 
``rating systems need to be overhauled so that investors can 
better understand how ratings are determined and compare 
ratings across firms. Ratings must be concise, clear, and 
easily understood by the average investor'' and he recommended 
disclosures of ``where and how to obtain information about the 
firm's rating system.'' \84\ He also said that ``Wall Street 
analysts and their firms should also be required to update or 
re-confirm their recommendations on a timely and regular basis, 
and more frequently in periods of high market volatility. They 
should be required to issue a ``final'' report when coverage is 
being discontinued and provide a reason for discontinuance. 
Quietly and unobtrusively discontinuing coverage or moving to a 
``not rated'' category, i.e., a ``closet'' sell, does not serve 
investors' interests.'' \85\
---------------------------------------------------------------------------
    \84\ Bowman Testimony, March 20, 2002.
    \85\ Bowman Testimony, March 20, 2002.
---------------------------------------------------------------------------
    The Committee also heard testimony about the intimidation 
of analysts by issuers. Mr. Bowman testified that:

        strong pressure to prepare ``positive'' reports and 
        make ``buy'' recommendations comes directly from 
        corporate issuers, who retaliate in both subtle, and 
        not so subtle, ways against analysts they perceive as 
        ``negative'' or not ``understanding'' their company. 
        Issuers complain to Wall Street firms'' management 
        about ``negative'' or uncooperative analysts. They 
        bring lawsuits against firms and analysts personally 
        for negative coverage. But more insidiously, they 
        ``blackball'' analysts by not taking their questions on 
        conference calls or not returning their individual 
        calls to investor relations or other company 
        management. This puts the ``negative'' analyst at a 
        distinct competitive disadvantage, increases the amount 
        of uncertainty an analyst must deal with in doing 
        valuation and making a recommendation, and 
        disadvantages the firm's clients, who pay for that 
        research. Such actions create a climate of fear and 
        intimidation that fosters neither independence nor 
        objectivity. Analysts walk a tightrope when dealing 
        with company managements. A false step may cost them an 
        important source of information and ultimately their 
        jobs.\86\
---------------------------------------------------------------------------
    \86\ Bowman Testimony, March 20, 2002.

    Mr. Mayo, a victim of issuer retaliation, gave testimony 
from first-hand experience of the problem. He said, ``It is 
still hard for an analyst to be objective and critical. When an 
analyst says ``Sell,'' there can be backlash from investors who 
own the stock, from the company being scrutinized, and even 
from individuals inside the analyst's firm. While much 
attention in Washington is being paid to the pressures related 
to a firm's investment banking operations, other pressures can 
be as great or more. The main point: Some companies may 
intimidate analysts into being bullish. Those who stand up may 
face less access to company information and perhaps backlashes, 
too.'' \87\
---------------------------------------------------------------------------
    \87\ Mayo Testimony, March 19, 2002.
---------------------------------------------------------------------------
    While the bill does not specifically identify remedies to 
these situations, it authorizes the Commission, or a registered 
securities association or exchange at the Commission's 
direction, to create rules to address such other issues as it 
determines appropriate and to require such other disclosures of 
conflicts of interest that are material to investors, research 
analysts, or the broker or dealer as it deems appropriate. The 
Commission, and the association and exchanges, should consider 
the issues noted above as they adopt other rules necessary and 
appropriate to protect investors in the area of analyst 
recommendations. The prohibition of specific activities 
identified in title V is not an exhaustive solution to the 
analyst conflicts problem, and the Committee expects the 
Commission and the self-regulatory organizations to use their 
authority to apply such additional rules as they deem 
appropriate.
    The bill requires that rules be adopted within one year. 
Existing rules that satisfy the requirements of the bill do not 
have to be reproposed or readopted. Existing rules that do not 
contradict the bill or that impose requirements that are not 
imposed by the bill do not have to be withdrawn or reproposed. 
For example, self-regulatory organization rules that require 
disclosure of statistics regarding analyst ratings or of the 
securities holdings of an analyst's family members in a subject 
company are not adversely affected by this bill.
    It should be noted that title V of the bill creates a new 
Section 15A(n)(B), (C) and (D) of the Exchange Act, which 
requires disclosure of simply ``affirmative'' or ``negative'' 
in response to ``whether'' an event has occurred. Further, 
Section 15A(n)(C) requires a description of the types of 
services provided, rather than a list of all specific services. 
This requirement is to enable the investor to assess whether 
the relationship is likely to influence the objectivity of the 
subjective portions of the research report.
    The new Section 15A(n)(B) of the Exchange Act created by 
the bill authorizes the Commission to grant exemptions to 
prevent disclosure of material non-public information about 
specific future investment banking revenues. In determining 
whether to grant an exemption, the Commission should take into 
account the importance that Congress places on providing 
investors with this information for making investment decisions 
and the likelihood that stating an affirmative response would 
divulge material non-public information that would be 
understood by investors, particularly in light of the size and 
complexity of the brokerage firm. For example, a complex 
brokerage firm which has received money from an issuer may be 
far less likely to disclose material nonpublic information 
simply by responding ``yes,'' and therefore not merit an 
exception, than a small firm that only is engaged to find 
buyers for an issuer and has received compensation.
    The Committee heard testimony from authorities which stated 
that the rules set forth by self-regulatory organizations are 
inadequate to address the analyst conflicts of interest issue. 
Former SEC Chairman Arthur Levitt testified, ``we must better 
expose Wall Street analysts' conflicts of interest * * * the 
New York Stock Exchange and the National Association of 
Securities Dealers [rulemaking] * * * is not enough.'' \88\ 
Also, Attorney General Spitzer stated ``the proposed 
regulations by the National Association of Securities Dealers 
and the New York Stock Exchange fall short of what should be 
legislated in this area.'' \89\ The Committee feels that while 
the NYSE and NASD rules will improve the quality of analysts' 
stock recommendations, title V is needed to address analyst 
conflicts and to strengthen investor protection.
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    \88\ Levitt Testimony, on February 12, 2002.
    \89\ Spitzer Letter, June 5, 2002.
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              TITLE VI--COMMISSION RESOURCES AND AUTHORITY

    The Committee determined that it is necessary to increase 
the resources available to the SEC and to increase the 
authority of the SEC to enable it more effectively to 
accomplish its mission of assuring the integrity of the markets 
and protecting investors.
    SEC Authorization. Witnesses before the Committee testified 
consistently and strongly that the SEC needs additional 
resources in order to effectively carry out its mission and 
protect investors. John Whitehead, former Co-Chairman, Goldman 
Sachs & Co., testified: ``I think the SEC is under-funded and 
has been for some years. When you consider the seriousness [to] 
the system of just one Enron, it's dangerous to fool around 
with relatively small increases in budgets that the SEC asks 
for.'' \90\ David Walker, U.S. Comptroller General, testified, 
``[T]he SEC's ability to fulfill its mission has become 
increasingly strained due in part to imbalances between the 
SEC's workload (such as filings, complaints, inquiries, 
investigations, examinations and inspections) and staff 
resources * * *. Over the last decade, securities markets have 
experienced unprecedented growth and change * * *. At the same 
time, the SEC has been faced with an ever-increasing workload 
and ongoing human capital challenges, most notably high staff 
turnover and numerous vacancies.'' \91\
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    \90\ Whitehead Testimony, March 19, 2002.
    \91\ Walker Testimony, March 5, 2002.
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    Former SEC Chairmen Roderick Hills, Harold Williams, 
Richard Breeden, and ArthurLevitt all supported increasing the 
SEC's resources.\92\ Chairman Breeden recommended that Congress 
``[s]trengthen the SEC's resources through expanded budget authority 
(offset by increased user fees), immediate and continuing funding of 
pay parity provisions, and addition of 200 new accounting 
positions.''\93\
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    \92\ Hills Testimony, February 12, 2002; Williams Testimony, 
February 12, 2002; Breeden Testimony, February 12, 2002; Levitt 
Testimony, February 12, 2002.
    \93\ Breeden Testimony, February 12, 2002.
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    Professor John Coffee testified, ``I think you're hearing 
from all of us that the SEC is resource-constrained and I think 
the less visible casualty of that are the offices such as the 
office of the chief accountant, where you can't really measure 
the output until a scandal like Enron comes along.''\94\
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    \94\ Coffee Testimony, March 5, 2002.
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    The Committee also received and considered the General 
Accounting Office report, ``SEC OPERATIONS: Increased Workload 
Creates Challenges,'' March 5, 2002 (GAO-02-302). GAO found 
that industry officials said ``the SEC's limited staff 
resources have resulted in substantial delays in SEC regulatory 
and oversight processes, which hampers competition and reduces 
market efficiencies. In addition, they said information 
technology issues need additional funding, and SEC needs more 
expertise to keep pace with rapidly changing financial markets. 
Finally, the officials said that SEC's reliance on a small 
number of seasoned staff to do the majority of the routine work 
does not allow those staff to adequately deal with emerging 
issues.''
    The bill authorizes an appropriation of $776,000,000 for 
the SEC for fiscal year 2003. This includes:
           $102,700,000 to fund pay on a par with the 
        federal bank regulators for SEC employees' salaries as 
        well as their fringe benefits, as authorized by the 
        Investor and Capital Markets Fee Relief Act (P.L. 107-
        123);
           $108,400,000 to fund enhanced information 
        technology, security enhancements, and recovery and 
        mitigation activities; and
           $98,000,000 to fund at least 200 more 
        professionals to oversee auditors and auditing 
        services, and additional staff to improve SEC 
        investigative and disciplinary efforts and strengthen 
        the SEC's oversight and regulation of market 
        participants and of issuer disclosure, securities 
        markets, and investment companies.
    Codifying Rule of Procedure. In its Rules of Procedure, the 
SEC has a procedure to discipline professionals, including 
accountants, who lack the requisite qualifications to practice 
before the Commission. Professor Coffee testified before the 
Committee that ``[t]he SEC's authority under Rule 102(e) was 
clouded by the D.C. Circuit's decision in Checkosky v. SEC, 139 
F.3d 221 (D.C. Cir. 1998) (dismissing Rule 102(e) proceeding 
against two accountants of a ``Big Five'' firm). The SEC 
revised Rule 102 in late 1998 in response to this decision (see 
Securities Act Rel. No. 7593 (Oct. 18, 1998)), but its 
authority in this area is still subject to some doubt that 
Congress may wish to remove or clarify.'' \95\ Lynn E. Turner, 
former SEC Chief Accountant, said, ``[t]he statutory authority 
of the SEC also needs to be examined and beefed up as it 
relates to Rule 102(e) proceedings.'' \96\
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    \95\ Coffee Testimony, March 5, 2002.
    \96\ Turner Testimony, February 26, 2002.
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    The bill codifies the authority of the SEC in 17 CFR 
210.102(e) to censure or deny, temporarily or permanently, the 
privilege of appearing or practicing before it to any person 
found by the SEC after notice and opportunity for hearing: (i) 
not to possess the requisite qualifications to represent 
others, (ii) to be lacking in character or integrity or to have 
engaged in unethical or improper professional conduct, or (iii) 
to have willfully violated, or willfully aided and abetted the 
violation of, any provision of the federal securities laws or 
the rules and regulations thereunder.
    Penny Stock Bar. Under current law, the penny stock bar is 
available only in administrative proceedings. However, the 
Commission frequently brings cases involving serious microcap 
or penny stock fraud in federal district court in order to 
obtain injunctive relief. In such a case, if the Commission 
also wishes to obtain a penny stock bar, it must bring a 
separate administrative proceeding, typically after the 
district court case is concluded. The Commission would be able 
to obtain all necessary relief more efficiently if the district 
courts had the authority to order penny stock bars.
    The bill authorizes federal courts to impose penny stock 
bars, or conditionally or unconditionally and temporarily or 
permanently prohibit a person from participating in a penny 
stock offering. The Commission has requested this authority in 
order to deal more swiftly with penny stock fraud.
    Qualifications of Associated Persons of Brokers and 
Dealers. The SEC staff has advised the Committee that in recent 
years, there has been a growing perception that fraud artists 
are able to exploit gaps in federal and state regulatory 
systems and to move from one sector of the financial services 
industry to another without sufficient impediment. The SEC 
lacks the enforcement authority to bar individuals from coming 
into the securities industry who have been found by other 
financial regulators to have engaged in fraudulent, deceptive, 
or dishonest conduct in other financial industries. The bill 
gives the SEC this power. In order to reduce the migration of 
fraud perpetrators into the securities industry, the bill 
authorizes the Commission to bar from the securities industry 
persons who have been suspended or barred by a state 
securities, banking, or insurance regulator because of 
fraudulent, manipulative, or deceptive conduct. The Commission 
requested this authority.

                     TITLE VII--STUDIES AND REPORTS

    The Committee identified two subjects of concern for 
additional study: the ongoing consolidation of the accounting 
industry and the performance of credit rating agencies.
    Historically, the accounting industry has been 
consolidating into fewer large accounting firms. James E. 
Copeland, CPA and Chief Executive Officer, Deloitte & Touche, 
testified, ``I've been on record since the last spate of 
proposed mergers saying that I thought the further 
consolidation of our industry would not be in the public's 
interest.'' \97\
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    \97\ Copeland Testimony, March 14, 2002.
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    The bill, in a section authored by Senator Akaka, directs 
the Comptroller General, in consultation with the SEC, similar 
regulatory agencies of the other G-7 nations, and the 
Department of Justice, to conduct a study identifying the 
factors that have led to the consolidation of public accounting 
firms since 1989, the impact of such consolidation, and 
solutions to any problems caused by such consolidation. The 
study shall also examine the problems faced by businesses as a 
result of limited competition among public accounting firms, 
and consider whether federal or state regulations impede 
competition among public accountingfirms. A report is to be 
submitted to the Senate Banking Committee and the House Financial 
Services Committee within one year of enactment of this legislation.
    The Federal regulation of credit-rating bureaus was raised 
at the hearing of March 21, 2002. The bill, in a section 
authored by Senator Bunning, directs the SEC to conduct a study 
of the role of credit rating agencies in the operation of the 
securities market, including an examination of the role of 
credit rating agencies in the evaluation of issuers, the 
importance of that role to investors, any impediments to the 
rating agencies' accurate appraisal of issuers, any barriers to 
entry into the business of acting as a credit rating agency, 
measures to improve the dissemination of information about 
issuers when credit rating agencies announce credit ratings, 
and any conflicts of interest in the operation of credit rating 
agencies. A report is to be submitted to the President, the 
Senate Banking Committee, and the House Financial Services 
Committee within 180 days of enactment.

                      Section-by-Section Analysis


Section 1. Short title and table of contents

Section 2. Definitions

    Section 2 contains a set of definitions of terms that are 
used in the bill.
    1. An ``appropriate state regulatory authority'' is a state 
authority responsible for licensing or other regulation of the 
practice of accounting in a state that has jurisdiction over an 
accounting firm or its personnel in connection with a 
particular matter.
    2. An ``audit'' is an examination of the financial 
statements of an issuer by an independent public accounting 
firm, in accordance with rules of the new accounting oversight 
board or the SEC, for the purpose of expressing an opinion on 
those statements. This definition should be read in connection 
with the definitions of ``issuer'' and ``audit report,'' below.
    3. An ``audit committee'' is a committee of an issuer's 
board of directors created to oversee the accounting and 
financial reporting processes and audits of the financial 
statements of the issuer.
    4. An ``audit report'' is a document, prepared following an 
audit performed for purposes of an issuer's compliance with the 
federal securities laws, in which a public accounting firm sets 
forth its opinion regarding a financial statement, report, or 
other document, or asserts that no such opinion can be 
expressed.
    5. The ``Board'' is the Public Company Accounting Oversight 
Board established by section 101 of the bill.
    6. The ``Commission'' is the U.S. Securities and Exchange 
Commission.
    7. An ``issuer'' is a company that issues or proposes to 
issue securities, if the securities are registered under 
section 12 of the Securities Exchange Act of 1934, or if the 
company is required to file reports with the SEC under section 
15(d) of the Securities Exchange Act (or will be required to 
file those reports at the end of the fiscal year in which a 
registration statement for the issuer's securities has become 
effective under the Securities Act of 1933).
    8. ``Non-audit services'' are professional services 
provided to an issuer by an accounting firm registered with the 
Board, other than those required to be provided in connection 
with an audit or other review of the issuer's financial 
statements.
    9. A ``person associated with a public accounting firm'' is 
a proprietor, partner, shareholder, principal, or an accountant 
or other professional employee of a public accounting firm, or 
any independent contractor or entity that shares in 
compensation or profits, or that participates on behalf of the 
firm in an activity, in connection with preparation or issuance 
of an audit report.
    10. ``Professional standards'' include (i) accounting 
principles established by the standard-setting body recognized 
under the bill or prescribed or recognized by the SEC that are 
relevant to particular audit reports or accounting firm quality 
control systems, and (ii) auditing standards, standards for 
attestation engagements, quality control policy, ethical and 
competency standards, and independence standards that relate to 
the preparation of audit reports and are established or adopted 
by the Board or SEC.
    11. A ``public accounting firm'' includes a proprietorship 
or entity engaged in the practice of public accounting or 
preparing or issuing audit reports. To the extent the new 
oversight board designates in its rules, the term can also 
include an associated person of an accounting firm.
    12. A ``registered public accounting firm'' is a firm that 
registers with the new oversight board, as required by section 
102 of the bill.
    13. The ``rules of the Board'' include both the formal 
bylaws and rules adopted by the new oversight board (subject to 
action of the SEC under section 107 of the bill) and stated 
policies, practices, and interpretations of the board that the 
SEC deems to be rules of the board.
    14. The term ``security'' has the same meaning as in 
section 3(a) of the Securities Exchange Act.
    15. The term ``securities laws'' has the meaning given that 
term in section 3(a)(47) of the Securities Exchange Act, and 
includes the SEC's rules, regulations and orders. (Section 
2(b), in a conforming amendment, makes the bill a part of the 
section 3(a)(47) definition.)
    16. A ``State'' includes any state of the United States, 
the District of Columbia, Puerto Rico, the Virgin Islands, and 
any other U.S. territory or possession.

Section 3. Commission rules and enforcement

     Section 3 generally gives the Securities and Exchange 
Commission (the ``Commission'' or the ``SEC'') authority to 
promulgate rules consistent with the Act and provides that a 
violation of the Act, or of any rule of the Commission or of 
the new Public Company Accounting Oversight Board created by 
title I of the Act, will be treated for all purposes as a 
violation of the Securities Exchange Act of 1934 and the rules 
thereunder; similarly, the new Board will be treated as if it 
were a self-regulatory organization under the 1934 Act for 
purposes of the Commission's investigative and enforcement 
authority. It should be emphasized that the new Board's own 
authority is limited to the work of accountants in auditing 
public companies; the Board has no jurisdiction with respect to 
the work of accountants in performing audits of other 
companies.
    Section 3 thus confirms that the Commission will have the 
authority to enforce the Act directly. Section 3 also makes 
clear that nothing in the Act or the rules of the new Board 
limits the Commission's own authority over accounting firms and 
their personnel, or accounting, auditing, independence, or 
other standards relating to auditors' reports.

           TITLE I--PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD

Section 101. Establishment

    Section 101 creates a new Public Company Accounting 
Oversight Board (the ``Board''). The Board will oversee the 
auditing of companies that are subject to the federal 
securities laws (i.e., companies (``public companies'' or 
``issuers'') that have chosen to sell stock or debt instruments 
to public investors). Accounting firms that perform audits of 
public companies must register withthe Board, and the Board 
will possess authority, subject to action by the Commission, to (i) set 
auditing, quality control, ethics, and independence standards (the 
latter supplementing statutory provisions on that subject), with 
respect to audits of the financial statements of public companies, (ii) 
inspect accounting firms' audit operations with respect to public 
companies, (iii) investigate potential violations by the firms or their 
partners or employees of the Act, the Board's rules, related provisions 
of the securities laws (and the Commission's rules), and professional 
accounting and conduct standards, and (iv) impose sanctions for 
violations. Again, the Board's authority in these areas is focused on, 
and limited to, the audit of public companies; it has no jurisdiction 
over accountants performing other audits. The Board is to submit an 
annual report of its activities to the Commission, which in turn is to 
send a copy to the House Committee on Financial Services and the Senate 
Committee on Banking, Housing, and Urban Affairs within 30 days of 
receipt.
    Legally, the Board will be a private nonprofit corporation 
subject to the District of Columbia Nonprofit Corporation Act. 
The Board will not be an agency or establishment of the United 
States. It is explicitly given authority to set compensation 
for its employees at levels comparable to similar positions in 
the private sector.
    Membership. Section 101(e) provides that the Board will 
have five members. The initial Board will be appointed by the 
Commission, after consultation with the Federal Reserve Board 
and the Department of the Treasury, within 90 days of the date 
of enactment; vacancies will be filled by the Commission after 
similar consultations. Board members will serve full-time, for 
five-year (staggered) terms, with a two-term limit. All Board 
members must have an understanding of the responsibilities for 
and the nature of the financial disclosures and accountants' 
responsibilities required by the securities laws. Three members 
of the Board will have a general background, and two members 
will have an accountancy background; the Board's Chairperson 
may be one of the two Board members with an accountancy 
background, but if so, he or she may not have been a practicing 
accountant for at least five years prior to appointment to the 
Board. Internal Board standard of conduct rules must include a 
one-year ban on practice before the Board (or before the 
Commission, with respect to Board-related matters) for former 
Board members and appropriate ``cooling off'' periods (not to 
exceed one year) for former Board staff.
    The initial Board's first task will be to hire staff, 
propose or adopt its first sets of rules and generally bring 
the organization into operational existence, so that the 
Commission can make a determination, required under section 
101(d) within 270 days of enactment, that the Board possesses 
the capacity to carry out its responsibilities and enforce 
compliance with title I of the Act.

Section 102. Registration with the Board

    The Commission's determination that the Board can begin to 
exercise its authority starts the running of a 180-day period 
within which each public accounting firm that prepares or 
issues audit reports for public companies must register with 
the Board. At the end of the 180-day period it will become 
unlawful for an unregistered accounting firm to audit a public 
company. (Again, lack of registration will have no effect on an 
accounting firm's ability to perform any other sort of work.) 
An application for registration must include information about 
the identity of the public companies for which an accounting 
firm currently or during the previous year performs or has 
performed audit work, certain current financial information 
about the accounting firm itself, a statement of the firm's 
quality control policies for its accounting and auditing 
practice, a list of the firm's accountants who participate in 
public company audits, and information about pending civil, 
criminal, or disciplinary actions, and client-auditor disputes, 
relating to the firm's audits of public companies. The 
application must also include a consent to compliance with any 
requests for documents or testimony, within the Board's 
authority, made to the registrant in the course of the Board's 
operation and an agreement to obtain and if necessary to 
enforce similar consents from the firm's partners and employees 
who participate in public company audits. Registered accounting 
firms will be required to report changes in this information to 
the Board annually (or more frequently if the Board so 
requires).
    Information submitted to the Board as part of each 
application will be made available to the public, subject to 
limitations to protect the confidentiality of proprietary, 
personal, and other information for which such protection is 
necessary or required by law. In particular, information 
``reasonably identified by [the registrant] as proprietary 
information'' will be withheld from disclosure.
    The Board is authorized by section 102(f) to impose a 
registration fee and an annual fee on each registrant, to cover 
the cost of processing and reviewing applications and annual 
reports.

Section 103. Auditing, quality control, and independence standards and 
        rules

    Section 103 requires the Board to establish auditing, 
quality control, and ethical standards, as required by the Act 
or the rules of the Commission or necessary or appropriate in 
the public interest or for the protection of investors, to be 
used by registered accounting firms in the preparation of audit 
reports for public companies. The Board is also to adopt rules 
to implement the provisions on the independence of public 
company auditors contained in title II of the Act.
    The Board's rules specifically must require (i) preparation 
and maintenance for 7 years by public company auditors of audit 
work papers and related information in sufficient detail to 
support each audit's conclusions, (ii) ``second partner'' 
review and approval of each public company audit report and its 
issuance, and (iii) inclusion in each audit report of a 
description of the auditor's testing of the public company's 
systems for compliance with the requirements of section 
13(b)(2) of the Securities Exchange Act and of the company's 
controls over its receipts and expenditures, together with 
specific notation of any significant defects or material 
noncompliance of which the auditor should know on the basis of 
such testing.
    Section 103 also specifies the subjects that the quality 
control standards adopted by the Board must address. These are: 
monitoring of ethics and independence; internal and external 
consulting on audit issues; audit supervision; hiring, 
development, and advancement of audit personnel; acceptance and 
continuance of engagements; and internal inspection.
    The Board may adopt as part of its rules (and modify as 
appropriate for that purpose, at the timeof adoption or 
thereafter), any portion of a statement of auditing, quality control, 
or ethics standards that meet the statutory test prepared (i) by a 
professional group of accountants designated by a rule of the Board for 
that purpose, or (ii) by one or more advisory groups convened by the 
Board. (Pre-existing standards of designated professional groups of 
accountants that may be adopted during the Board's nine-month 
transitional period are to be separately approved by the Commission at 
the time of the Commission's determination (pursuant to section 101(d), 
noted above) that the Board is ready to begin operation.)
    The Board will convene advisory groups of practicing 
accountants and other experts, as well as representatives of 
other interested groups (subject to appropriate conflict of 
interest rules), to make recommendations concerning, or propose 
drafts of, the content of any required standards for public 
company auditors.
    The Board is to cooperate on an ongoing basis with both the 
designated professional groups of accountants noted above, and 
with its own advisory groups, in examining the need for changes 
in any standards subject to Board authority. The Board is to 
recommend issues for inclusion on the agendas of these groups, 
and take other steps to facilitate the standard-setting 
process, and it is to respond in a timely fashion to requests 
for changes in the standards over which the Board has 
authority.
    Finally, the Board is to include a summary of the results 
of its standard-setting responsibilities in each of its annual 
reports. Each summary must include a discussion of the Board's 
work with any designated professional group of accountants or 
advisory group, as well as the Board's pending agenda for 
future standard-setting projects.

Section 104. Inspections of registered public accounting firms

    Section 104 outlines the duty of the staff of the Board to 
undertake annual inspections of registered public accounting 
firms that prepare audit reports for more than 100 public 
companies, and triennial inspections of firms that prepare 
audit reports for 100 or fewer public companies, to assess the 
degree of compliance by those firms with the Act, the rules of 
the Board, and professional standards relating to audits of 
public companies. (The inspection cycles for different-sized 
accounting firms may be subsequently changed by the Board.) The 
Board is to (i) identify in the course of each inspection any 
act, practice, or omission by the firm or its partners or 
employees revealed by the inspection that may violate the Act, 
the Board's or related Commission rules, the firm's own quality 
control policies, or professional standards, (ii) report any 
such finding, if appropriate, to the Commission and each state 
accountancy board with jurisdiction over the matter, and (iii) 
commence a formal investigation or take any appropriate 
disciplinary action with respect to the violation.
    The scope of each inspection will include both particular 
audit and review engagements (which may include engagements 
that are otherwise the subject of ongoing controversy between 
the accounting firm under inspection and third parties), 
selected solely by the Board, as well as a review of each 
firm's quality control system and its compliance with 
professional standards relating to audit reports for public 
companies. The term ``professional standards'' means, for 
purposes of title I and the Board's authorization, (i) 
generally accepted accounting principles, (ii) auditing 
standards, standards for attestation engagements and quality 
control policies, and ethical and competency standards that the 
Board adopts, and (iii) independence standards that the Board 
adopts to implement title II of the Act.
    The rules of the Board are to provide a procedure for 
review and comment on a draft inspection report by the firm 
inspected; the text of any comment by the firm on a draft 
inspection report is to be attached, with appropriate 
redactions to protect confidential information, to the final 
report. That report is to be sent to the Commission and the 
appropriate state board of accountancy and made available to 
the public (subject, again, to protection of confidential and 
proprietary information). Portions of an inspection report 
which deal with criticisms of or potential defects in the 
quality control systems of a firm will not be made public if 
the defects are addressed to the satisfaction of the Board 
within 12 months of the date of the report. In certain cases 
interim Commission review of certain inspection-related 
disputes is available.

Section 105. Investigations and disciplinary proceedings

    Section 105 outlines the investigative and disciplinary 
authority of the Board over firms that audit public companies 
and partners and employees of these firms.
    Investigations. Section 105(a) authorizes the Board to 
investigate any act or practice by a registered accounting 
firm, or its partners or employees, that may violate the Act, 
the Board's rules, professional standards, and the portion of 
the securities laws and SEC rules that relate to the 
preparation and issuance of audit reports and the obligations 
and liabilities of accountants with respect thereto. The Board 
may require testimony or production of documents or 
information, or inspect documents or information, in the 
possession of any registered public accounting firm or its 
partners or employees. The Board's investigative activities and 
any information gathered in the course of an investigation are 
to be confidential and privileged for all purposes (including 
civil discovery), unless and until particular information is 
presented in connection with a public proceeding. The Board may 
refer investigations to the Commission, any other federal 
functional regulator (in the case of an investigation relating 
to the audit of an institution subject to the jurisdiction of 
such functional regulator), and, at the direction of the 
Commission, to the Attorney General, state attorneys general in 
connection with any criminal investigation, or appropriate 
state boards of accountancy, and may share information derived 
from investigations with the same parties, but only if the 
Board determines that such disclosure is ``necessary to 
accomplish the purposes of the Act or to protect investors.'' 
The Board's investigators are granted civil immunity for their 
activities during an investigation to the same extent that a 
federal investigator would enjoy such immunity.
    Disciplinary proceedings. Section 105(b) authorizes the 
Board to impose a full range of sanctions if it finds that a 
registered firm, or its partners or employees, have engaged in 
any act or practice that violates the Act, the Board's rules, 
professional standards, or the portion of the securities laws 
(and SEC rules) relating to audits of public companies. 
Potential sanctions include revocation or suspension of the 
registration of an accounting firm, or of the ability of 
particular individuals to remain associated with that firm or 
become associated with any otherregistered accounting firm 
(effectively barring the subject of the sanction from participating in 
audits of public companies), substantial civil money penalties, 
required professional education or training, or censure; the Board's 
ability to suspend or bar an associated person from the auditing of 
public companies, and the Board's ability to impose civil money 
penalties above a certain amount, is limited to situations involving 
intentional, knowing, or reckless conduct, or repeated negligent 
conduct. The Board may also impose sanctions upon a registered 
accounting firm for failure reasonably to supervise a partner or 
employee (in terms similar to those that apply to broker-dealers under 
section 15(b)(4) of the Securities Exchange Act of 1934, which permit 
the firm to defend by showing that its internal control procedures were 
reasonable and were operating fully in the case at issue).
    The Board's rules must set out fully the procedural 
requirements for disciplinary proceedings. Disciplinary 
sanctions finally imposed must be reported to the Commission, 
appropriate state or foreign boards of accountancy, and the 
public (once any stay of enforcement pending appeal has been 
lifted). Any sanction may be appealed to the Commission under 
the provisions of section 107(c) (described below).
    Fines imposed by the Board are to be used to fund a 
scholarship program for students in undergraduate or graduate 
programs in accounting.

Section 106. Foreign public accounting firms

    Section 106 provides that accounting firms organized under 
the laws of countries other than the United States that issue 
audit reports for public companies subject to the U.S. 
securities laws are covered by the Act in the same manner as 
domestic accounting firms, subject to the exemptive authority 
of both the Board and the Commission. (Registration under the 
Act will not in itself provide a basis for subjecting a foreign 
accounting firm to U.S. jurisdiction other than with respect to 
controversies between such a firm and the Board.) The Board is 
authorized to determine that other foreign accounting firms 
play a sufficiently substantial role in the preparation and 
furnishing of such reports for particular issuers that their 
coverage under the Act is necessary or appropriate, in light of 
the purposes of the Act and in the public interest or for the 
protection of investors.
    Section 106 also sets terms for the production in the 
United States by a foreign public accounting firm of its audit 
work papers, for any audit in which the foreign accounting firm 
issues an opinion or otherwise performs material services upon 
which an accounting firm registered under the Act relies in 
issuing all or part of an audit report for a public company.

Section 107. Commission oversight of the Board

    Section 107 makes the Board generally subject to the same 
degree of control by the Commission as the National Association 
of Securities Dealers or the New York Stock Exchange. Section 
107(b) provides that the Board's proposed rules must be filed 
with the Commission and published by the Commission for public 
comment. No Board rule may take effect without Commission 
approval (except in limited situations), and the Commission 
retains the power not only to disapprove, but to abrogate or 
amend, any rules of the Board. Section 107(c) incorporates the 
provisions of section 19(d)(2) and (e)(1) of the Securities 
Exchange Act of 1934 to give the Commission full authority to 
review, modify, or cancel any disciplinary sanction imposed by 
the Board (including any sanction imposed for failure to comply 
with a demand for testimony or documents in the course of a 
Board investigation), either upon the Commission's own motion 
or on the motion of an aggrieved party. (The Commission may, in 
some cases, also review registration- or inspection-related 
disputes.) Finally, the Commission possesses authority to limit 
the authority and activities, or to censure, or even to remove 
members, of the Board itself, if the Commission finds that the 
Board, or a particular member, has violated, is unable to 
comply with, or has failed to enforce compliance with the Act, 
the Board's or the Commission's rules, or the securities laws, 
has failed to enforce compliance with professional standards, 
or, in the case of a particular Board member, has willfully 
abused his or her authority.

Section 108. Accounting standards

    Section 108 amends section 19 of the Securities Act of 1933 
specifically to allow the Commission to recognize as 
``generally accepted'' (for securities law purposes) accounting 
principles established by a standard-setting body that meets 
certain criteria. First, the body must be a private entity and 
be funded by public companies in the same manner as the Board 
(provided in section 109 of the Act), and it must have adopted 
procedures, including acting by majority vote, to ensure prompt 
consideration of necessary changes to the body of accounting 
principles. Second, the Commission must determine that the 
standard-setting body has the ability to assist the Commission, 
because the standard-setting body has proved able to improve 
the accuracy and effectiveness of financial reporting and the 
protection of investors. Any such standard-setting body must 
report annually to the Commission. Finally, section 108 
requires the Commission to conduct a study of the adoption by 
the U.S. financial reporting system of a principles-based 
accounting system.

Section 109. Funding

    Section 109 provides that the Board and the accounting 
principles standard-setting body recognized under section 108 
of title I are to be funded by an ``accounting support fee.'' 
(The Board's budget, but not the budget of the standard-setting 
body, is to be subject to approval by the Commission.) In the 
case of both the Board and the standard-setting body, the 
annual support fee is to be assessed against each public 
company. Amounts payable by public companies to either body 
will generally be allocated among those companies based on 
relative average annual monthly market capitalization for the 
12 months prior to the year to which the support fee relates; 
both the Board and the standard-setting body are permitted to 
differentiate among various classes of public companies, as 
necessary or appropriate, in allocating fees. Fees are to be 
collected in such manner as is deemed appropriate in each case.

                     TITLE II--AUDITOR INDEPENDENCE

Section 201. Services outside the auditor scope of practice

    The Act restricts a registered public accounting firm in 
the non-audit services it may provide to its audit clients that 
are public companies in order to preserve the firm's 
independence. The Act specifies eight categories of activities 
that an auditor may not provide to a public company that is its 
audit client. These include: (1) bookkeeping or other services 
related to the accountingrecords or financial statements of the 
issuer; (2) financial information systems design and implementation 
consulting services; (3) appraisal or valuation services, fairness 
opinions, or contribution-in-kind reports; (4) actuarial services; (5) 
internal audit services; (6) any management or human resources 
function; (7) broker, dealer, investment adviser, or investment banking 
services; and (8) legal services and expert services unrelated to the 
auditing service. In addition, the Public Company Accounting Oversight 
Board may determine that any other non-audit service is prohibited. The 
Board has the authority to grant exemptions on a case-by-case basis to 
the extent necessary or appropriate in the public interest and 
consistent with the protection of investors, subject to SEC review. A 
registered public accounting firm would be permitted to perform for a 
public company audit client any other non-audit service, including tax 
services, that the public company's Audit Committee pre-approves in 
accordance with the requirements adopted in Section 202.
    The Act would not affect the services that a registered 
public accounting firm provides to non-public companies or to 
public companies that are not its audit clients. Thus, a firm 
could provide any consulting service to any public company for 
which it does not provide audit services as well as to any non-
public company.

Section 202. Pre-approval requirements

    The Audit Committee of a public company must pre-approve 
all the services, both audit and non-audit, provided to that 
company by a registered public accounting firm. The public 
company is required to disclose the Audit Committee's approvals 
of non-audit services to shareholders in SEC filings. The pre-
approval requirement is waived if an auditor provides a service 
that was not recognized to be a non-audit service at the time 
of the engagement and if the aggregate amount of all such non-
audit services is 5% or less of total auditor fees and such 
services are promptly brought to the attention of the Audit 
Committee and approved by the Audit Committee prior to the 
completion of the audit. Approval may be made by one or more 
members of the Audit Committee, to whom such authority has been 
delegated. The decisions of any delegated member to pre-approve 
an activity shall be presented to the full Audit Committee at 
each of its meetings.

Section 203. Audit partner rotation

    A registered public accounting firm must rotate its lead 
partner and review partner on its audits of a public company so 
that no partner performs an audit on the same issuer as a lead 
partner or review partner for more than five consecutive years.

Section 204. Auditor report to Audit Committees

    A registered independent public accounting firm performing 
an audit for a public company will timely report to that 
company's Audit Committee the critical accounting policies and 
practices to be used and all alternative treatments of 
financial information within GAAP that have been discussed with 
management, any accounting disagreements between the auditor 
and management and other material written communications 
between the auditor and management.

Section 205. Conforming amendments

Section 206. Conflicts of interest

    An accounting firm may not provide audit services for a 
public company if that company's chief executive officer, 
controller, chief financial officer, chief accounting officer, 
or other individual serving in an equivalent position, was 
employed by the accounting firm and worked on the audit of the 
public company during the one year before the start of the 
audit services.

Section 207. Study of mandatory rotation of registered public 
        accounting firms

    The GAO will study the potential effects of requiring the 
mandatory rotation of registered public accounting firms and 
report to Congress within one year.

Section 208. Commission authority

    A registered independent public accounting firm must comply 
with the restrictions in sections 201-204 and 206 in order to 
perform an audit for a public company.

Section 209. Considerations by appropriate state regulatory authorities

    It is the intent of this Act that in supervising non-
registered accounting firms, state regulatory authorities 
should make an independent determination of the proper 
standards, and should not presume the standards applied by the 
Board under this Act to be applicable to small- and medium-
sized non-registered accounting firms.

                  TITLE III--CORPORATE RESPONSIBILITY

Section 301. Issuer Audit Committees

    The Exchange Act is amended to require the SEC to draft 
rules directing national securities exchanges and national 
securities associations to require listed companies to make 
Audit Committees responsible for the appointment, compensation, 
and oversight of the work of auditors and to require auditors 
to report directly to the Audit Committee. The amendments also: 
bar Audit Committee members from accepting consulting fees or 
being affiliated persons of the issuer or the issuer's 
subsidiaries other than in the member's capacity as a member of 
the board of directors or any board committee; require Audit 
Committees to have in place procedures to receive and address 
complaints regarding accounting, internal control or auditing 
issues; require Audit Committees to establish procedures for 
employees' anonymous submission of concerns regarding 
accounting or auditing matters; and require public companies to 
provide their Audit Committees with authority and funding to 
engage independent counsel and other advisers as they determine 
necessary.

Section 302. Corporate responsibility for financial reports

    CEOs and CFOs must certify, in periodic reports containing 
financial statements filed with the Commission pursuant to 
section 13(a) or 15(d) of the Exchange Act, the appropriateness 
of financial statements and disclosures contained therein, and 
that those financials and disclosures fairly present the 
company's operations and financial condition.

Section 303. Prohibited influence

    It is unlawful for any officer, director, or person acting 
under their direction to fraudulently influence, coerce, 
manipulate, or mislead any accountant engaged in preparing an 
audit report, for the purpose of rendering the audit report 
misleading.

Section 304. Forfeiture of certain bonuses and profits

    In the case of accounting restatements that result from 
material non-compliance with SEC financial reporting 
requirements, CEOs and CFOs must disgorge bonuses and other 
incentive-based compensation and profits on stock sales, if the 
non-compliance results from misconduct. The required 
disgorgement applies to the 12 months after the first public 
issuance or filing of a financial document embodying such 
financial reporting requirement. The SEC may exempt any person 
from this requirement as it deems necessary and appropriate.

Section 305. Officer and director bars and penalties

    The sanction of barring securities law violators from 
serving as officers or directors of public companies is 
strengthened by modifying the standard that governs judicial 
imposition of officer and director bars. In addition, courts 
may impose any equitable relief necessary or appropriate to 
protect, and mitigate harm to, investors.

Section 306. Insider trades during pension fund blackout periods 
        prohibited

    Directors and executive officers are prohibited from 
engaging in transactions involving any equity security of the 
issuer during a ``blackout'' period when at least half of the 
issuer's individual account plan participants are not permitted 
to purchase, sell or otherwise transfer their interest in that 
equity security. No blackout period may take effect until at 
least 30 days after written notice of the blackout is provided 
by the plan administrator to the participants or beneficiaries. 
Exceptions to the 30-day notice are allowed in cases: (1) where 
a deferral of the blackout period would violate ERISA fiduciary 
provisions; or (2) where the inability to provide the notice is 
due to unforeseeable events or circumstances beyond the 
reasonable control of the plan administrator.

                TITLE IV--ENHANCED FINANCIAL DISCLOSURES

Section 401. Disclosures in periodic reports

    A public company in periodic reports filed with the SEC 
will present: (1) disclosures of financial information that 
reflect all material correcting adjustments that have been 
identified by the auditor in accordance with GAAP and (2) the 
material off-balance sheet transactions, arrangements, 
obligations, and other relationships of the issuer with 
unconsolidated entities or other persons that may have a 
material current or future effect on financial condition, 
changes in financial condition, results of operations, 
liquidity, capital expenditures, capital resources or 
significant components of revenues or expenses.
    Issuers that disseminate ``pro forma'' financial 
information in their filings with the SEC, press releases or 
other public disclosures must present pro forma data in a 
manner that does not contain an untrue statement or omit to 
state a material fact necessary in order to make the 
information, in light of the circumstances under which it is 
presented, not misleading, and that reconciles it with the 
issuer's financial condition under GAAP.

Section 402. Enhanced disclosures of loans

    An issuer in its current reports must disclose within 7 
days, or such other time period determined to be appropriate by 
the SEC: (A) all loans, except credit card loans, made by the 
issuer and its affiliates to any executive officer or director, 
specifying amounts paid and balances owed on such obligations 
and (B) any conflicts of interest, as defined by the SEC.

Section 403. Disclosures of transactions involving management

    Section 16(a) of the Exchange Act is amended to require 
directors, officers and 10% equity holders to report their 
purchases and sales of securities more promptly, by the end of 
the second day following the transaction or such other time 
established by the SEC in any case in which the two-day period 
is not feasible.

Section 404. Management assessment of internal controls

    Annual reports filed with the SEC must be accompanied by a 
statement by the management of its responsibility for creating 
and maintaining adequate internal controls. Management must 
also present its assessment of the effectiveness of those 
controls. In addition, the company's auditor must report on and 
attest to management's assessment of the company's internal 
controls. Such attestation shall not be the subject of a 
separate engagement.

Section 405. Exemption

    Investment companies are exempted from the disclosure 
requirements of sections 401, 402 and 404.

Section 406. Code of ethics for senior financial officers

    Issuers are required to disclose whether or not they have 
adopted a code of ethics for senior financial officers, and if 
not, the reason therefor.

Section 407. Audit Committee financial expert

    The SEC is required to adopt rules to require issuers to 
disclose whether their Audit Committees include among their 
members at least one ``financial expert.'' In defining 
``financial expert,'' the SEC shall consider whether a person 
understands GAAP and financial statements, has experience 
preparing or auditing financials, has experience with internal 
accounting controls, and understands Audit Committee functions.

                 Title V--Analyst Conflicts of Interest


Section 501. Treatment of securities analysts by registered securities 
        associations

    The Act requires the Commission, or upon the authorization 
and direction of the Commission, a registered securities 
association or national securities exchange, within one year to 
adopt rules designed to address conflicts of interest facing 
securities analysts. The rules will (A) foster greater public 
confidence in securities research and protect the objectivity 
and independence of stock analysts who publish research 
intended for the public by (i) prohibiting the pre-
publicationclearance of such research or recommendations by investment 
banking or other staff not directly responsible for investment 
research, (ii) limiting the supervision and compensatory evaluation of 
such research personnel to officials who are not engaged in investment 
banking activities, and (iii) protecting securities analysts from 
retaliation or threats of retaliation by investment banking staff 
because of negative or otherwise unfavorable research reports that 
might adversely affect investment banking relations with the issuer 
described in the report, provided that the rules shall not limit the 
authority of a broker or dealer to discipline a securities analyst for 
causes other than such report in accordance with the firm's policies 
and procedures, (B) define periods during which broker-dealers who 
participate in a public offering of securities as underwriters or 
dealers shall not publish research or recommendations about the 
securities of the issuer, (C) establish structural and institutional 
safeguards within broker-dealers to assure that securities analysts 
preparing research reports are separated by appropriate informational 
partitions from the review, pressure, or oversight of those whose 
involvement in investment banking activities might potentially bias 
their judgment or supervision, and (D) address such other issues as the 
SEC or the SROs deem appropriate.
    The Act also requires the Commission, or upon the direction 
of the Commission, a registered securities association or 
national securities exchange, to adopt rules requiring 
disclosures about conflicts of interest in reports and public 
appearances. These disclosures include (A) the extent to which 
the analyst holds securities in the issuer, (B) whether 
compensation has been received from the issuer, subject to such 
exemptions as the Commission may determine appropriate and 
necessary to prevent disclosure of material non-public 
information regarding specific potential future investment 
banking transactions as is appropriate in the public interest 
and consistent with investor protection, (C) whether the issuer 
is or has recently been a client of the analyst's firm, and if 
so, the types of services provided, (D) whether the analyst 
received compensation based on an affiliate's investment 
banking revenues, and (E) such other disclosures as the SEC or 
the SROs deem appropriate. The regulator would have the 
authority to amend its rules.

              TITLE VI--COMMISSION RESOURCES AND AUTHORITY

Section 601. Authorization of appropriations

    There is authorized an appropriation of $776,000,000 for 
the SEC for fiscal year 2003, of which: $102,700,000 would fund 
the pay parity of salary and benefits for SEC employees, as 
authorized in the Investor and Capital Markets Fee Relief Act 
(P.L. 107-123); $108,400,000 would fund information technology, 
security enhancements, and recovery and mitigation activities 
in light of the terrorist attacks of September 11, 2001; and 
$98,000,000 would fund at least 200 more professionals to 
oversee auditors and auditing services, and additional staff to 
improve SEC investigative and disciplinary efforts and 
strengthen the SEC's oversight and regulation of market 
participants and of issuer disclosure, securities markets and 
investment companies.

Section 602. Appearance and practice before the SEC

    The SEC is authorized to censure or deny, temporarily or 
permanently, the privilege of appearing or practicing before it 
to any person found by the SEC after notice and opportunity for 
hearing: (i) not to possess the requisite qualifications to 
represent others, (ii) to be lacking in character or integrity 
or to have engaged in unethical or improper professional 
conduct, or (iii) to have willfully violated, or willfully 
aided and abetted the violation of any provision of the federal 
securities laws or the rules and regulations thereunder. This 
codifies Section 102(e) of the SEC's Rules of Practice.

Section 603. Federal court authority to impose penny stock bars

    Federal courts are authorized to conditionally or 
unconditionally and temporarily or permanently prohibit a 
person from participating in a penny stock offering.

Section 604. Qualifications of associated persons of brokers and 
        dealers

    The SEC is authorized to bar from the securities industry 
persons who have been suspended or barred by a state 
securities, banking or insurance regulator because of 
fraudulent, manipulative or deceptive conduct.

                     Title VII--Studies and Reports


Section 701. GAO study and report regarding consolidation of public 
        accounting firms

    The Comptroller General, in consultation with the SEC, 
similar regulatory agencies of the other G-7 nations, and the 
Department of Justice, is to conduct a study identifying the 
factors that have led to the consolidation of public accounting 
firms since 1989, the impact of such consolidation, and 
solutions to any problems caused by such consolidation. The 
study shall also examine the problems faced by businesses as a 
result of limited competition among public accounting firms, 
and consider whether federal or state regulations impede 
competition among public accounting firms. A report is to be 
submitted to the Senate Banking Committee and the House 
Financial Services Committee within one year of enactment.

Section 702. Commission study and report regarding credit rating 
        agencies

    The SEC is to conduct a study of the role of credit rating 
agencies in the operation of the securities market, including 
an examination of the role of credit rating agencies in the 
evaluation of issuers, the importance of that role to 
investors, any impediments to the rating agencies' accurate 
appraisal of issuers, any barriers to entry into the business 
of acting as a credit rating agency, measures to improve the 
dissemination of information about issuers when credit rating 
agencies announce credit ratings, and any conflicts of interest 
in the operation of credit rating agencies. A report is to be 
submitted to the President, the Senate Banking Committee, and 
the House Financial Services Committee within 180 days of 
enactment.

                        Changes in Existing Law

    On June 18, 2002, the Committee unanimously approved a 
motion by Senator Sarbanes to waive the Cordon rule. Thus, in 
the opinion of the Committee, it is necessary to dispense with 
the requirement of section 12 of Rule XXVI of the Standing 
Rules of the Senate in order to expedite the business of the 
Senate.

                      Regulatory Impact Statement

    In accordance with paragraph 11(b), rule XXVI, of the 
Standing Rules of the Senate, the Committee makes the following 
statement concerning the regulatory impact of the bill.
    The bill make structural changes in various aspects of the 
federal securities laws. Titles Ithrough IV and portions of 
title VI affect the auditing of public companies and financial 
disclosures by those companies and their managers. Title V affects 
conflicts of interest by employees of broker-dealers who issue research 
reports dealing with particular companies or industries.
    There are, according to the SEC, approximately 16,500 
public companies subject to the federal securities laws.\98\ 
Fewer than 15 percent of the nation's accounting firms audit 
any public companies, and only 20 firms have more than 30 audit 
clients.\99\ There are perhaps 75-100 registered broker-dealers 
that issue research reports of the type dealt with in title V, 
and perhaps as many as 5000 analysts who prepare those research 
reports.
---------------------------------------------------------------------------
    \98\ SEC budget testimony for FY 2003 gives the number as over 
17,000, Testimony Concerning Appropriations for Fiscal 2003 by Harvey 
L. Pitt, Chairman, U.S. Securities & Exchange Commission, before the 
Subcommittee on Commerce, Justice, State, and the Judiciary, Committee 
on Appropriations, United States House of Representatives, April 17, 
2002, while SEC Release 33-8109 gives the number as 16,242, SEC Release 
33-8109 (Proposed Rule: Framework for Enhancing the Quality of 
Financial Information Through Improvement of Oversight of the Auditing 
Process), http://www.sec.gov/rules/proposed/33-8109.htm at 71.
    \99\ See Proposed SEC Release 33-8109 at footnote 111, page 111.
---------------------------------------------------------------------------
    The bill establishes a comprehensive framework to modernize 
and reform the oversight of public company auditing, improve 
quality and transparency in financial reporting by those 
companies, and strengthen the independence of auditors. It 
promotes competition among service providers, enhances accurate 
investor decision-making throughout the capital markets, and 
seeks to correct shortcomings that have threatened the 
reputation of those markets for integrity.
    The legislation should have little additional impact upon 
the privacy of particular individuals. Information and 
documents held by the Public Company Accounting Oversight Board 
created by the bill are generally confidential and privileged 
until made public in connection with a particular public 
enforcement proceeding. Corporate managers and others affected 
by the bill are already subject to extensive reporting 
requirements under the federal securities laws.
    Specific rules issued by the SEC under various provisions 
of the bill will contain their own regulatory and paperwork 
estimates, as required by applicable law. Otherwise, it is 
difficult to measure, at this time, the extent to which the 
bill would impose additional costs beyond those described in 
the CBO estimate, below. In addition, the bill's net regulatory 
impact upon the economy can be positive, especially as its 
terms operate to reduce crises in corporate management and 
value of the sort the economy is now witnessing. Finally, the 
immediate regulatory impact of the bill must be weighed against 
the continuing serious adverse economic impact on investors, 
the markets, and the national economy of the failure of 
existing regulatory arrangements and the decline in investor 
confidence, here and abroad, that this failure has generated. 
For all of these reasons, the Committee has determined that 
more extensive compliance with rule XXVI(11)(b) than that 
contained above is impracticable.

                          Cost of Legislation

    Section 11(b) of rule XXVI of the Standing Rules of the 
Senate, and Section 403 of the Congressional Budget Impoundment 
and Control Act, require that each committee report on a bill 
contain a statement estimating the cost of the proposed 
legislation. The Congressional Budget Office has provided the 
following cost estimate and estimate of costs of private-sector 
mandates.

                                     U.S. Congress,
                               Congressional Budget Office,
                                     Washington, DC, June 27, 2002.
Hon. Paul S. Sarbanes,
Chairman, Committee on Banking, Housing, and Urban Affairs,
U.S. Senate, Washington, DC.
    Dear Mr. Chairman: The Congressional Budget Office has 
prepared the enclosed cost estimate for the Public Company 
Accounting Reform and Investor Protection Act of 2002.
    If you wish further details on this estimate, we will be 
pleased to provide them. The CBO staff contacts are Ken Johnson 
(for federal costs), Greg Waring (for the state and local 
impact), and Paige Piper/Bach (for the private-sector impact).
            Sincerely,
                                         Robert A. Sunshine
                                    (For Dan L. Crippen, Director).
    Enclosure.

               CONGRESSIONAL BUDGET OFFICE COST ESTIMATE

Public Company Accounting Reform and Investor Protection Act of 2002

    Summary: The bill would establish two new organizations--
the Public Company Accounting Oversight Board (Oversight Board) 
to regulate the accounting industry and the Standard-Setting 
Body to write national standards for accounting practices. The 
activities of these organizations would be overseen by the 
Securities and Exchange Commission (SEC). In addition, the bill 
would authorize the appropriation of $776 million in 2003 for 
the SEC's activities. Under the bill, both the SEC and the 
Oversight Board could assess civil penalties for violations of 
the bill's provisions. Any civil penalties collected by the 
Oversight Board would be spent on a scholarship program for 
accounting students. The bill also would require the General 
Accounting Office (GAO) to complete two studies of the 
accounting industry within one year of enactment.
    Based on information from the SEC, CBO estimates that 
implementing this bill would cost about $787 million over the 
2003-2007 period, assuming the appropriation of the necessary 
amounts. Under current law, the SEC's discretionary costs are 
offset by fees the agency collects from securities markets. 
Enactment of the bill would not change the amount of fees 
expected to be collected in the future. Assuming the continued 
collection of the regulatory fees assessed by the SEC, the 
commission would collect $1.3 billion in fees in 2003, and its 
net outlays would be -$621 million in that year. The two GAO 
studies also would cost an estimated $1 million in 2003, 
subject to the availability of appropriated funds. CBO 
estimates that the bill would have effects on revenues and 
direct spending, but that the net effect of those changes would 
be negligible each year. Because the bill would affect revenues 
and direct spending, pay-as-you-go procedures would apply.
    The bill contains an intergovernmental mandate as defined 
in the Unfunded Mandates Reform Act (UMRA), but CBO estimates 
that complying with that mandate would result in no costs to 
state, local, or tribal governments. Therefore, the threshold 
established by UMRA ($58 million in 2002, adjusted annually for 
inflation) would not be exceeded.
    The bill would impose several private-sector mandates, as 
defined by UMRA, on certain accounting firms, companies that 
issue registered securities, officers and directors of those 
companies, investment banking firms, and securities analysts. 
CBO cannot determine whether the direct cost of those mandates 
would exceed the annual threshold set by UMRA for private-
sector mandates ($115 million in 2002, adjusted annually for 
inflation). The mandate costs are difficult to estimate because 
(1) we do not have sufficient information to estimate the cost 
of prohibiting insider trading during blackout periods when 
investment activity is restricted; (2) the cost to comply with 
several of the mandates would depend on rules soon to be 
prescribed by the SEC under current authority; and (3) the cost 
to comply with several of the mandates would depend on rules 
that would be prescribed by the SEC under the bill.
    Estimated cost to the Federal Government: The estimated 
budgetary impact of the bill is shown in the following table. 
The costs of this legislation would fall within budget 
functions 370 (commerce and housing credit--for the SEC) and 
800 (general government--for GAO).

----------------------------------------------------------------------------------------------------------------
                                                                By fiscal year, in millions of dollars--
                                                       ---------------------------------------------------------
                                                           2002       2003      2004     2005     2006     2007
----------------------------------------------------------------------------------------------------------------
                                   SEC SPENDING--SUBJECT TO APPROPRIATION \1\

Gross SEC spending under current law:
    Budget authority..................................        409          0        0        0        0        0
    Estimated outlays.................................        408         90        0        0        0        0
Proposed changes:
    Authorization level...............................          0        776        5        5        5        5
    Estimated outlays.................................          0        592      180        5        5        5
Gross SEC spending under the bill:
    Authorization level...............................        409        776        5        5        5        5
    Estimated outlays.................................        408        682      180        5        5        5

                                CHANGES IN GAO SPENDING--SUBJECT TO APPROPRIATION

Estimated authorization level.........................          0          1        0        0        0        0
Estimated outlays.....................................          0          1        0        0        0        0

                      Memorandum

Estimated SEC offsetting collections\2\...............     -1,135     -1,303     n.a.     n.a.     n.a.     n.a.
----------------------------------------------------------------------------------------------------------------
\1\ Enactment of this legislation also would affect direct spending and revenues, but CBO estimates that the net
  amount of the effects would be negligible for each year.
\2\ The SEC collects fees to the extent provided in advance in appropriation acts. The amount of fees collected
  is not dependent on the amount appropriated. (The authority to collect such fees in 2002 has been triggered by
  the 2002 appropriation, but there is no appropriation yet for 2003 or future years.)

Note.--n.a.--not applicable.

Basis of estimate

    For this estimate, CBO assumes that the bill will be 
enacted by the end of fiscal year 2002. Assuming appropriation 
of the necessary funds, CBO estimates that implementing the 
bill would cost the SEC about $787 million and GAO about $1 
million during the 2003-2007 period. We estimate that the bill 
also would affect both revenues and direct spending, but that 
the net impact of those effects would be negligible for each 
year.
    The SEC is typically funded through fees the agency 
collects for registrations, transactions, and mergers of 
securities. Under current law, the fee rates are determined 
periodically by the SEC, and they are collected only to the 
extent provided in advance in appropriations acts. These fees 
are classified in the budget as offsets to the SEC's 
discretionary spending.
            Spending subject to appropriation
    The bill would authorize the appropriation of $776 million 
for all SEC activities in 2003. Of this amount, the bill would 
earmark $103 million for higher salaries for SEC employees, 
$108 million for security and information technology 
enhancements needed by the agency after the September 11th 
attacks, and $98 million for additional staff to monitor audit 
services. Based on the agency's historical spending patterns, 
CBO estimates that implementing this provision would result in 
gross outlays of about $592 million in 2003 and $768 million 
over the 2003-2004 period, assuming the appropriation of the 
necessary amounts. Adding these amounts to CBO's projections 
for fee collections in 2003, we estimate that the SEC's net 
spending would be -$621 million in that year.
    The bill also would require the SEC to review any sanctions 
or rules proposed by the Oversight Board. CBO estimates that 
the cost of these activities would be roughly comparable to the 
SEC's oversight of national securities exchanges and 
associations. Based on information from the SEC about the cost 
of such oversight, CBO estimates that the SECwould require 
about 40 staff members, at a cost of about $5 million a year, to review 
the rules and sanctions proposed by the new Oversight Board. Any 
amounts the SEC would spend to oversee accounting practices under the 
bill would be subject to the availability of appropriated funds.
    Under the bill, GAO would complete two reports to the 
Congress on the accounting industry within one year of 
enactment. Based on information from GAO, CBO estimates that 
conducting these two studies would cost the agency about $1 
million in 2003, subject to the availability of appropriated 
funds.
            Revenues and direct spending
    CBO estimates that implementing this bill also would affect 
direct spending and revenues. The effects would result from the 
bill's provisions creating an Oversight Board and a Standard-
Setting Body to oversee the accounting industry and from 
provisions relating to civil penalties.
    Costs of Creating the Oversight Board and Standard-Setting 
Body. The bill would require that annual financial reports 
filed by public companies under the securities laws must be 
audited by an accountant who is deemed qualified to do so by a 
new organization called the Public Company Accounting Oversight 
Board. CBO expects this provision would give the Oversight 
Board substantial authority to regulate and control entry into 
the accounting industry, thus exercising the sovereign power of 
the federal government. The fact that the board's rules, 
sanctions, funding sources, and annual budget would be approved 
by the SEC indicate a significant level of federal control over 
the board's operations and funding. For these reasons, CBO 
would consider the board's spending and the fees it would 
collect under the bill from public companies and accounting 
firms as part of the federal budget (even though the bill 
states it would not be part of the government).
    The bill also would require the SEC to designate an 
organization called the Standard-Setting Body to write national 
standards for accounting practices. Under current law, all 
annual financial statements filed by public companies must 
comply with such standards. The bill also would mandate that 
the Standard-Setting body assess fees on public companies using 
a formula that would be approved by the SEC, thereby giving the 
federal government control over the Standard-Setting Body's 
funding. Therefore CBO also would consider this body's 
collections and spending a part of the federal budget (even 
though the bill states it would be organized as a private 
entity).
    CBO expects that operating the Oversight Board, when fully 
implemented, would cost at least as much as similar activities 
that are now performed by the Public Oversight Board (POB) and 
the Independence Standards Board, and through peer reviews 
administered by the American Institute of Certified Public 
Accountants (AICPA). Before they recently disbanded, the POB 
and the Independence Standards Board spent about $8 million a 
year. The peer reviews administered by AICPA are conducted by 
other accounting firms. Based on information from AICPA, CBO 
estimates that these reviews could cost the Oversight Board at 
least $50 million a year. Similarly, CBO expects that the 
annual costs of the Standard-Setting Board would approach the 
$20 million spent each year by the Federal Accounting Standards 
Board (FASB), which performs standard-setting duties today.
    Under the bill, the Oversight Board and the Standard-
Setting Body would assess fees on the public to cover their 
costs. CBO expects that the net effect of the two 
organizations' collections and spending under this bill would 
not be significant in any year. Whether such collections would 
be categorized in the budget as revenues or offsetting receipts 
is uncertain because we do not know how the organizations would 
assess those fees.
    Civil Penalties.The bill also would authorize the SEC and 
the Oversight Board to enforce the bill's provisions with civil 
penalties. Such penalties are recorded in the budget as 
governmental receipts (revenues). Based on information from the 
SEC, CBO estimates that these provisions would increase 
revenues by less than $500,000 a year.
    Under the bill, any civil penalties collected by the 
Oversight Board would be spent on scholarships for accounting 
students in undergraduate or graduate programs. Because the 
amounts spent would equal the penalties collected by the 
accounting board, CBO estimates that the increase in direct 
spending also would be less than $500,000 per year.
    Pay-as-you-go considerations: The Balanced Budget and 
Emergency Deficit Control Act sets up pay-as-you-go procedures 
for legislation affecting direct spending or receipts. CBO 
estimates that the net pay-as-you-go effects of this bill would 
be insignificant for each year.
    Estimated impact on state, local, and tribal governments: 
Because it would preempt state authority to license or regulate 
the Public Company Accounting Oversight Board as a nonprofit 
corporation, the bill contains an intergovernmental mandate as 
defined in UMRA. CBO estimates that this preemption would not 
affect state budgets because, while it would limit the 
application of state law towards the board, it would not impose 
a duty on states that would result in additional spending. 
Therefore, the threshold established by UMRA ($58 million, in 
2002, adjusted annually for inflation) would not be exceeded. 
The remaining provisions of the bill contain no 
intergovernmental mandates and would impose no costs on state, 
local, or tribal governments.

Estimated impact on the private sector

    The bill would impose private-sector mandates, as defined 
by UMRA, on certain accounting firms, companies that issue 
registered securities, officers and directors of those 
companies, investment banking firms, and securities analysts. 
CBO cannot determine whether the direct cost of those mandates 
would exceed the annual threshold set by UMRA fro private-
sector mandates ($115 million in 2002, adjusted annually for 
inflation). The mandate costs are difficult to estimate because 
(1) we do not have sufficient information to estimate the cost 
of prohibiting insider trading during blackout periods when 
investment activity is restricted; (2) the cost to comply with 
several of the mandates would depend on rules soon to be 
prescribed by the SEC under current authority; and (3) the cost 
to comply with several of the mandates would depend on rules 
that would be prescribed by the SEC under the bill.
            Regulation of accounting firms
    Under the bill, a registered public accounting firm would 
be:
           Subject to a system of review by the Public 
        Company Accounting Oversight Board to be established 
        under the bill;
           Prohibited from offering both audit and 
        certain non-audit consulting services (designing or 
        implementing financial information systems or providing 
        internal audit services); and
           Required to retain all audit work papers for 
        at least seven years.
    According to the American Institute of Certified Public 
Accountants (AICPA) and other industry representatives, the 
accounting industry currently:
           Sponsors a transitional private entity that 
        reviews independent accountants:
           Has voluntarily stopped offering both audit 
        and such non-audit consulting services; and
           Retains financial statement working papers 
        and records for seven years.
    Therefore, CBO estimates that the direct cost to comply 
with those new mandates would be small.
    The bill would require an accounting firm to obtain a 
second review of audit reports from another auditor within the 
firm, and test and express an opinion on certain internal 
controls of public companies. The cost to obtain a second 
review and provide an opinion on compliance by a company would 
depend on rules to be prescribed by the SEC. Since the 
regulations have not been established, CBO cannot estimate the 
cost to comply with those mandates.
            Registration and accounting support fees
    The bill would require that the new Oversight Board and a 
designated Standard-Setting Body be independently funded by 
public companies. Based on information from the SEC, CBO 
estimates the annual cost of operating the oversight board and 
the standard-setting body would be approximately $80 million. 
The bill would require those organizations to levy fees on 
registered public accounting firms and an annual accounting 
support fee on issuers of securities. Currently, the accounting 
industry is self-regulated and voluntarily provides the funding 
for the regulatory organization, including peer reviews. 
According to the SEC and the industry, the cost of oversight 
and review required by the bill are similar to the costs now 
voluntarily incurred by the industry. Therefore the incremental 
cost to the private sector would be small.
            Auditor independence
    Section 203 of the bill would prohibit the lead and review 
partners of an accounting firm from providing audit services 
for the same company for more than five consecutive years. 
Based on information from the AICPA, CBO estimates that the 
direct cost to rotate lead and review partners would be 
minimal.
    Section 206 would prohibit an accounting firm from 
providing audit services for a public company if that company's 
chief executive officer, financial officer, controller, or 
other equivalent position was employed by the accounting firm 
during the year before the start of the audit services. Based 
on information from the AICPA, CBO anticipates that some firms 
would lose business that other accounting firms would gain. 
Therefore, CBO estimates that total direct cost to the 
accounting industry would be negligible.
            Corporate responsibility
    The bill contains provisions that would require greater 
corporate responsibility for financial reports. The cost of 
complying with those requirements would depend on rules that 
the SEC has agreed to propose, but not yet promulgated. 
Therefore, CBO cannot estimate the direct costs of complying 
with the following mandates:
     Section 301 would require the audit committee of a 
corporate board to be responsible for the appointment, 
compensation, and oversight of the work of their auditors. This 
section also would prohibit national securities exchanges and 
associations from listing companies that do not comply with 
certain audit committee standards.
     Section 302 would require chief executive officers 
and chief financial officers of public companies to certify the 
appropriateness of their company's periodic reports and to 
ascertain that the financial reports fairly reflect the 
operations and conditions of their companies.
            Periodic restrictions on insider trading
    Section 306 would prohibit certain owners and officers of a 
company from selling equity securities issued by that company 
during periods (called ``blackout'' periods) when participants 
in the retirement plan are restricted in their ability to 
direct investments. Such periods may occur for administrative 
reasons--for example, when a plan changes recordkeepers. This 
restriction would increase the financial exposure of affected 
owners and officers and, thus, could impose a cost on them. CBO 
does not have sufficient information to estimate the amount of 
that cost.
            Enhanced financial information disclosure
    Section 403 would require officers and directors of 
companies that issue securities and certain owners of such 
securities to disclose to the SEC any insider trading by a 
certain time. According to the SEC, insider trading disclosure 
is currently required to be reported to the SEC by the tenth 
day following the month in which the trade occurred. Thus, CBO 
estimates that the cost of providing such information on an 
expedited basis would be small.
    The bill also contains provisions that require increased 
disclosure of financial information. The cost of complying with 
those requirements would depend on rules that the SEC has 
agreed to propose, but not yet promulgated. Therefore, SEC 
cannot estimate the direct costs of complying with the 
following mandates:
     Under Title IV, the SEC would prescribe rules that 
would require companies that issue securities to report loans 
to insiders within a certain time period, to disclose material 
off balance sheet transactions and conflicts, and present pro 
forma data in a manner that is not misleading in periodic 
financial reports to the SEC.
     Section 404 would require a company and the 
company's auditor to attest to the company's internal control 
procedures in their annual reports. Public companies also would 
be required to disclose whether they have adopted a code of 
ethics for senior financial officers, and whether their audit 
committee has among its members a ``financial expert.''
            Analyst conflicts of interest
    Section 501 would require the SEC or a registered 
securities association or exchange to adopt rules to prohibit 
certain conflicts within investment banking firms that could 
compromise securities analysts' independence and to require 
security analysts to disclose other potential conflicts. The 
cost of prohibiting certain conflicts and disclosing additional 
information would depend on rules to be prescribed by the SEC 
or the directed authority. CBO does not have sufficient 
information to estimate the cost to comply with those mandates.
    Previous CBO Estimate: On April 26, 2002, CBO transmitted a 
cost estimate for H.R. 3763, the Corporate and Auditing 
Accountability, Responsibility, and Transparency Act of 2002, 
as passed by the House of Representatives on April 24, 2002. 
H.R. 3763 would require the SEC to oversee a new board that 
would regulate the accounting industry and to accelerate its 
review of annual reports filed by public companies. CBO 
estimated that implementing H.R. 3763 would cost about $150 
million over the 2003-2007 period, assuming the appropriation 
of the necessary amounts. Because of provisions that would 
create new civil penalties and a new accounting board that CBO 
considered part of the federal budget, CBO estimated that H.R. 
3763 also would cause revenues and direct spending to rise to 
insignificant net amounts for each year.
    For H.R. 3763, CBO identified similar private-sector 
mandates on accountants, companies that issue registered 
securities, officers and directors of those companies, and 
certain owners of the securities. CBO could not determine 
whether the total direct cost of those mandates would exceed 
the annual threshold established by UMRA for private-sector 
mandates as we did not have sufficient information to estimate 
the cost of prohibiting insider trading during blackout periods 
when investment activity is restricted.
    Estimate prepared by: Federal costs: Ken Johnson; impact on 
state, local and tribal governments: Greg Waring; impact on the 
private sector: Paige Piper/Bach.
    Estimate approved by: Peter H. Fontaine, Deputy Assistant 
Director for Budget Analysis.

                   ADDITIONAL VIEWS OF SENATOR GRAMM

    President Bush's Ten Point program for regulatory reform in 
corporate accounting and governance is an excellent plan, and 
he and his administration are to be commended for wasting no 
time in implementing it. The actions already being taken by the 
Securities and Exchange Commission, together with their 
published regulatory proposals, as well as the actions taken by 
our nation's stock markets, are firm, clear, and directed to 
the real problems. They represent substantial reform. It is 
also undeniable that changes are occurring in every board room, 
on every corporate audit committee, and with every accounting 
firm in America. But a legislative response is also called for.
    First of all though, it would be hard to overestimate the 
importance of maintaining our system of private setting of 
accounting standards through the Financial Accounting Standards 
Board (FASB). Neither Congress nor any other agency of the 
government should be in the business of setting accounting 
standards. A bad accounting standard set by an independent 
board is better than a good standard set by Congress. But we do 
need to establish a stable, reliable funding mechanism for 
FASB.
    With regard to legislation, the reported bill is better 
today than the bill as first proposed, yet the fundamental 
problems of the original bill remain. We should pass a bill 
that sets up an independent ethics supervisory board that will 
oversee and enforce the highest standards of ethics in public 
accounting. This board should be given power to determine what 
are conflicts of interest and to make determinations on 
questions of auditor independence. It should also be 
independently funded by a source that is committed to the 
purpose of funding that activity, and the funding source should 
be reliable.
    Yet, even though some flexibility has been added, the 
structure of the bill is still troubling. If we are going to 
create this independent panel, we should create one in which we 
can place our confidence, allowing the panel, for example, to 
set the standards as to what represents a conflict of interest. 
While it is tempting to vote on these things and to set out in 
government writ for all time what we mean and what we want, if 
we are trying to make this board powerful, why would we want to 
prejudge what the panel is going to decide? There is a 
fundamental difference between having the board make decisions 
or having Congress make them.
    When Congress prejudges the board's activities, we 
eliminate the flexibility that the board will need to apply 
statutory principles to the variety of circumstances that 
appear in the real world. The one-size-fits-all approach of the 
bill cripples the ability of the board to adjust to differences 
in situations among companies--particularly to distinguish 
between large and small companies--as well as to stay up to 
date with changes that occur over time.
    This will be particularly hard on smaller companies. While 
the legislation allows for exceptions to its ban on auditors 
providing companies with additional services, these exceptions 
can only be obtained on a case-by-case basis. It is the smaller 
companies who routinely obtain a number of services from their 
auditor and who can least afford to pay for a second or third 
auditing firm to provide these additional services. These 
smaller business will be most likely to need the exemptions. 
But the smaller the company, the less likely it will be able to 
afford the legal services to get its needed exemptions from the 
new board. This is not a small problem, as the bill would 
impose its new regulatory requirements on 17,000 companies--the 
vast majority of which are small businesses--all across the 
country.
    It may be easy to envision requiring that General Motors 
have six different accounting firms to comply with the conflict 
of interest rules. But it stretches reason and good judgment to 
legislate those same standards for Joe Green and Son Motor 
Repair of Texarkana. We should trust the board that we create 
and let them look at the feasibility for large and small 
companies, ask them to look at the benefits to shareholders, 
the integrity of the financial system and long term growth 
prospects. It is easy to envision that they might end up with 
standards that would be differentiated based on the size of 
accounting firms and the size of the businesses that are 
affected. We would preserve flexibility in doing this. One-
size-fits-all will hurt a lot of shareholders and the 
businesses in which they have invested. And heaping unnecessary 
costs on struggling small enterprises, it will hurt the 
economy.
    The point is, when you start setting out in law what 
auditing standards are, what the conflict of interest standard 
is, and the many other specific mandates in the bill, you 
eliminate flexibility, you eliminate the ability of the board 
to learn what works and what does not work, and you eliminate 
the ability of the board to differentiate between General 
Motors and Joe Green and Son, Incorporated. In the process of 
setting up a strong, independent board we have largely done our 
work. We ought not to be doing the board's work after that.
    In addition, before this legislation becomes law, the 
concerns of constitutional experts with regard to the 
appointment, regulatory powers, and taxing authority of this 
new supervisory board will need to be resolved.

                                                        Phil Gramm.

                    ADDITIONAL VIEWS OF SENATOR ENZI

    The collapse in the faith of corporate financial statements 
is alarming. Corporate executive abuses have shattered the 
savings and dreams of countless Americans. Broad and strong 
changes need to be implemented to restore that confidence and 
ensure these abuses do not take place in the future.
    A wave of new regulations and legislative proposals have 
been introduced to protect America's investors against 
corporate abuses. The securities' self-regulatory organizations 
(SROs), the Securities and Exchange Commission (SEC), the White 
House, and Congress are all working on different approaches 
with the same goal--to ensure executives are providing accurate 
and reliable information to the public.
    However, any approach must also be sensitive to the fact 
that auditors are a critical element in assuring the quality of 
a financial statement. Legislation that does not provide 
adequate liability protections for auditing firms will decrease 
the already minimal number of companies which can audit and 
evaluate complex and fast-growing companies. Without a 
competitive auditing industry, consumers may, at the end of the 
day, experience less reliable financial statements.
    I believe this legislation, as reported by the Senate 
Banking Committee, will provide a disincentive for small 
accounting firms to continue to audit publicly traded 
companies. These small accounting firms may only audit a 
relatively few public companies, and my fear is that this 
legislation would increase their liability exponentially, thus 
the firms would decide to cease offering services to public 
companies. With current litigation downsizing an already 
limited number of accounting firms, we cannot allow additional 
regulations to drive more firms from offering auditing services 
to public companies.
    The legislation also places a negative presumption on any 
approval of non-prohibited consulting services. Legislation 
should not mandate to audit committees that all consulting 
services are inherently conflicted. Audit committees should be 
left to make their own determination as to what services 
provided by their auditing companies is in the best interest of 
their shareholders.
    I also have concerns that the setting of auditing standards 
will be taken out of the hands of accountants. Auditing 
standards are complicated and detailed and the setting of them 
requires the knowledge and expertise of individuals who 
understand and work in the field of accounting. I am hesitant 
to allow a Board, of which the majority must be non-
accountants, to establish the standards under which accountants 
operate.
    I continue to support reform of the accounting industry and 
will continue to work toward that goal with this legislation. 
I, however, will work to change aspects of the bill which I 
believe will impose severe unintended and unnecessary 
consequences on the accounting industry and their clients.

                                                         Mike Enzi.

                                  
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