[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
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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\
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\1\ John Shad, the SEC's Chairman from 1981-87, is deceased.
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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:
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\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\
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\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
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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\
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\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.
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\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.
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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).
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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\
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\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
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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\
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\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.
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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.)
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\10\ Senator Enzi suggested that the bill require, not merely
permit, that two Board members have an accountancy background.
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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\
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\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.
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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\
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\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.
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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\
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\15\ The bill creates a right to interim SEC review of certain
inspection-related disputes.
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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\
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\16\ Levitt Testimony, February 12, 2002.
Robert Glauber, the Chairman and CEO of the National
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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\
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\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.
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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.
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\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\
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\21\ Testimony of Michael Sutton, former SEC Chief Accountant
(1995-98), before the Committee on February 26, 2002.
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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\
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\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\
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\23\ Letter from James E. Burton, Chief Executive Officer,
California Public Employees' Retirement System (CalPERS), to Chairman
Paul S. Sarbanes, June 26, 2002.
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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\
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\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
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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\
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\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\
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\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.
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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\
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\28\ Bowsher Testimony, March 19, 2002; Levitt Testimony, February
12, 2002; Volcker Testimony, February 14, 2002.
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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.
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\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.
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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:
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\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\
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\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.
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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.
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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\
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\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.
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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\
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\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.
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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\
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\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\
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\50\ Testimony of David Walker, Comptroller General of the United
States, before the Committee on March 5, 2002.
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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.
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\53\ O'Malley Testimony, March 6, 2002; Teslik Testimony, March 20,
2002.
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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.
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\55\ Breeden Testimony, February 12, 2002.
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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\
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\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\
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\57\ Volcker Testimony, February 14, 2002.
\58\ Seligman Testimony, March 5, 2002.
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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.
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\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).
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In his testimony, former SEC Chairman Richard Breeden
recommended that ``immediate 8-K disclosure'' of insider loans
be required.\60\
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\60\ Breeden Testimony, February 12, 2002.
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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\
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\61\ Millstein Testimony, February 27, 2002.
\62\ Bowsher Testimony, March 19, 2002.
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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\
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\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.
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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\
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\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.
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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\
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\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.
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\73\ Bowman Testimony, March 20, 2002.
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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.
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\74\ Testimony of Michael Mayo, Managing Director, Prudential
Securities, Inc., before the Committee on March 19, 2002.
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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.
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\75\ Turner Testimony, February 26, 2002.
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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.
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\76\ Mayo Testimony, March 19, 2002.
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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\
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\77\ Coffee Testimony, March 5, 2002.
\78\ Coffee Testimony, March 5, 2002 (internal citations omitted).
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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\
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\79\ Spitzer Letter, June 5, 2002.
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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\
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\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\
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\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\
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\82\ Seligman Testimony, March 5, 2002.
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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\
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\83\ Bowman Testimony, March 20, 2002.
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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\
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\84\ Bowman Testimony, March 20, 2002.
\85\ Bowman Testimony, March 20, 2002.
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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\
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\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\
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\87\ Mayo Testimony, March 19, 2002.
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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.